Case studies
illustrate how
the principles of
economics are
applied using
contemporary,
relevant examples
STUDY HACK #18
Explaining the work to
friends and family helps you
understand and remember
what you’ve learnt.
Ash, student, Sydney
STONECASH ∙ GANS ∙ KING ∙ BYFORD ∙ IVANOVSKI ∙ MANKIW
Boost your
understanding
of the concepts
in each chapter
with recent news
articles that connect
economic ideas to
current affairs
8TH EDITION
Introduces you to
the essentials of
macroeconomics,
helping you to
learn important
tools for economic
analysis
— PRINCIPLES OF —
Give yourself the advantage —
own this subject! This book has
the essentials you need!
Macroeconomics
BE UNSTOPPABLE
— PRINCIPLES OF —
Macroeconomics
ROBIN STONECASH
JOSHUA GANS
STEPHEN KING
MARTIN BYFORD
KRIS IVANOVSKI
N. GREGORY MANKIW
ISBN 978-0170445658
9
7 8 01 7 0 4 4 5 6 5 8
8TH ASIA-PACIFIC EDITION
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
— PRINCIPLES OF —
Macroeconomics
ROBIN STONECASH
JOSHUA GANS
STEPHEN KING
MARTIN BYFORD
KRIS IVANOVSKI
N. GREGORY MANKIW
8TH ASIA-PACIFIC EDITION
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
00_Stonecash_8e_45658_SB_FM_txt.indd 1
25/08/20 9:45 PM
To
Belanna, Ariel & Annika
Jacqueline & Rebecca
Catherine & Nicholas
ii
Copyright
2021 Cengage
Part 1 Firm behaviour and
the organisations
of Learning.
industry All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
00_Stonecash_8e_45658_SB_FM_txt.indd 2
25/08/20 9:45 PM
— PRINCIPLES OF —
Macroeconomics
ROBIN STONECASH
JOSHUA GANS
STEPHEN KING
MARTIN BYFORD
KRIS IVANOVSKI
N. GREGORY MANKIW
8TH ASIA-PACIFIC EDITION
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
00_Stonecash_8e_45658_SB_FM_txt.indd 3
25/08/20 9:45 PM
Principles of Macroeconomics
8th Edition
Robin Stonecash
Joshua Gans
Stephen King
Martin Byford
Kris Ivanovski
N. Gregory Mankiw
Head of content management: Dorothy Chiu
Content manager: Rachael Pictor
Content developer: Eleanor Yeoell, Rhiannon Bowen
Project editor: Raymond Williams
Text designer: James Steer
Cover designer: Watershed Art (Leigh Ashforth)
Editor: Greg Alford
Permissions/Photo researcher: Debbie Gallagher
Proofreader: Sylvia Marson
Indexer: Max McMaster, Master Indexing
Cover: pika111
Typeset by MPS Limited
Any URLs contained in this publication were checked for currency during the
production process. Note, however, that the publisher cannot vouch for the ongoing
currency of URLs.
Seventh edition published 2018
Adapted from Principles of Macroeconomics, 9th edition, by N. Gregory Mankiw,
published by Cengage © 2021
© 2021 Cengage Learning Australia Pty Limited
Copyright Notice
This Work is copyright. No part of this Work may be reproduced, stored in a retrieval
system, or transmitted in any form or by any means without prior written permission of
the Publisher. Except as permitted under the Copyright Act 1968, for example any fair
dealing for the purposes of private study, research, criticism or review, subject to
certain limitations. These limitations include: Restricting the copying to a maximum of
one chapter or 10% of this book, whichever is greater; providing an appropriate notice
and warning with the copies of the Work disseminated; taking all reasonable steps to
limit access to these copies to people authorised to receive these copies; ensuring
you hold the appropriate Licences issued by the Copyright Agency Limited (“CAL”),
supply a remuneration notice to CAL and pay any required fees. For details of CAL
licences and remuneration notices please contact CAL at Level 11, 66 Goulburn
Street, Sydney NSW 2000, Tel: (02) 9394 7600, Fax: (02) 9394 7601
Email: info@copyright.com.au
Website: www.copyright.com.au
For product information and technology assistance,
in Australia call 1300 790 853;
in New Zealand call 0800 449 725
For permission to use material from this text or product, please email
aust.permissions@cengage.com
National Library of Australia Cataloguing-in-Publication Data
ISBN: 9780170445658
A catalogue record for this book is available from the National Library of Australia
Cengage Learning Australia
Level 7, 80 Dorcas Street
South Melbourne, Victoria Australia 3205
Cengage Learning New Zealand
Unit 4B Rosedale Office Park
331 Rosedale Road, Albany, North Shore 0632, NZ
For learning solutions, visit cengage.com.au
Printed in Singapore by 1010 Printing International Limited.
1 2 3 4 5 6 7 24 23 22 21 20
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
00_Stonecash_8e_45658_SB_FM_txt.indd 4
25/08/20 9:45 PM
BRIEF
CONTENTS
Preface to this edition xv
Preface to the original edition xviii
To the students xix
About the authors xx
Acknowledgements xxii
Part I
Introduction 3
Chapter 1
Chapter 2
Chapter 3
Ten principles of economics 4
Thinking like an economist 22
Interdependence and the gains
from trade 49
Part 2
Supply and demand:
How markets work 65
Chapter 4
The market forces of supply and
demand 66
Part 3The data of macroeconomics 93
Chapter 5
Chapter 6
Measuring a nation’s income 94
Measuring the cost of living 115
Part 4
The real economy
in the long run 135
Chapter 7
Chapter 8
Chapter 9
Production and growth 136
Saving, investment and the financial
system 167
The natural rate of unemployment 195
Part 5
Money and prices
in the long run 223
Chapter 10
Chapter 11
The monetary system 224
Inf lation: Its causes and costs 249
Part 6The macroeconomics of open
economies 277
Chapter 12
Chapter 13
Open-economy macroeconomics:
Basic concepts 278
A macroeconomic theory of the open
economy 303
Part 7Short-run economic f luctuations 327
Chapter 14
Chapter 15
Chapter 16
Chapter 17
Aggregate demand and aggregate
supply 328
The influence of monetary
and fiscal policy on aggregate demand 355
The short-run trade-off between
inf lation and unemployment 380
Contemporary macroeconomics
topics 403
Part 8
Final thoughts 437
Chapter 18
Five debates over macroeconomic
policy 438
Glossary 452
Suggestions for reading 456
Index 458
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
00_Stonecash_8e_45658_SB_FM_txt.indd 5
25/08/20 9:45 PM
CONTENTS
Preface to this edition xv
Preface to the original edition xviii
To the students xix
About the authors xx
Acknowledgements xxii
Part I Introduction 3
Chapter 1
Ten principles of economics 4
Introduction 5
How people make decisions 5
Principle 1: People face trade-offs 5
Principle 2: The cost of something is what you give
up to get it 6
Principle 3: Rational people think at the margin 7
Principle 4: People respond to incentives 8
How people interact 10
Principle 5: Trade can make everyone better
off 11
Principle 6: Markets are usually a good way to
organise economic activity 12
Principle 7: Governments can sometimes improve
market outcomes 14
How the economy as a whole works 15
Principle 8: A country’s standard of living depends
on its ability to produce goods and services 15
Principle 9: Prices rise when the government prints
too much money 16
Principle 10: Society faces a short-run trade-off
between inflation
and unemployment 17
Study tools 19
Chapter 2
Thinking like an economist 22
Introduction 23
The economist as scientist 23
The scientific method: Observation, theory and
more observation 23
The role of assumptions 24
Economic models 25
Our first model: The circular-flow diagram 25
Our second model: The production possibilities
frontier 27
Microeconomics and macroeconomics 30
The economist as adviser 30
Positive versus normative analysis 31
Economists in government 31
Why economists’ advice is not always
followed 32
Economists in business 33
Why economists disagree 33
Differences in scientific judgements 33
Differences in values 34
What Australian economists think 34
Study tools 36
Appendix: Graphing – a brief review 39
Chapter 3
Interdependence and the gains
from trade 49
Introduction 50
A parable for the modern economy 50
Production possibilities 51
Specialisation and trade 52
Comparative advantage: The driving force of specialisation 54
Absolute advantage 54
Opportunity cost and comparative advantage 54
Comparative advantage and trade 55
The price of trade 56
Applications of comparative advantage 57
Should Serena Williams mow her own lawn? 57
Should Australia trade with other countries? 58
Study tools 61
Part 2 S
upply and demand:
How markets work 65
Chapter 4
The market forces of supply and
demand 66
Introduction 67
Markets and competition 67
What is a market? 67
What is competition? 67
Demand 68
The demand curve: The relationship between price
and quantity demanded 68
Market demand versus individual demand 70
Shifts in the demand curve 71
Supply 75
The supply curve: The relationship between price
and quantity supplied 76
Market supply versus individual supply 76
Shifts in the supply curve 77
Supply and demand together 80
Equilibrium 80
Three steps for analysing changes in equilibrium
82
Study tools 88
Part 3 T
he data of
macroeconomics 93
Chapter 5
Measuring a nation’s income 94
Introduction 95
The economy’s income and expenditure 95
The measurement of gross domestic product 97
‘GDP is the market value …’ 97
‘… of all …’ 97
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
00_Stonecash_8e_45658_SB_FM_txt.indd 6
25/08/20 9:45 PM
‘… final …’ 98
‘… goods and services …’ 98
‘… produced …’ 98
‘… within a country …’ 98
‘… in a given period of time’ 99
The components of GDP 99
Alternative measures of income 101
Real versus nominal GDP 102
A numerical example 103
The GDP deflator 104
GDP and economic wellbeing 106
So why do we look at GDP at all? 106
International differences in GDP and the quality of
life 108
Study tools 112
Chapter 6
Measuring the cost of living 115
Introduction 116
The consumer price index 116
How the consumer price index is calculated
117
Problems in measuring the cost of living 120
The GDP deflator versus the consumer price index 124
Correcting economic variables for the effects of
inflation 126
Dollar figures from different times 126
Indexation 127
Real and nominal interest rates 127
Study tools 131
Part 4 T
he real economy
in the long run 135
Chapter 7
Production and growth 136
Introduction 137
Economic growth around the world 138
Productivity: Its role and determinants 141
Why is productivity so important? 141
How is labour productivity determined? 142
The production function 146
Economic growth and public policy 147
The importance of saving and
investment 147
Diminishing returns to physical capital and the
catch-up effect 148
Investment from abroad 150
Education 151
Health and nutrition 152
Property rights, markets, trust and political
stability 153
Free trade 154
Discouraging excessive population growth
158
Research and development 160
Study tools 164
Chapter 8
Saving, investment and the
financial system 167
Introduction 168
Financial institutions in the Australian economy 168
Financial markets 169
Financial intermediaries 173
Summing up 174
Saving and investment in the national income accounts 176
Some important identities 177
The meaning of saving and investment 178
The market for loanable funds 179
Supply of and demand for loanable
funds 180
How government policies can affect saving and investment 182
Policy 1: Taxes and saving 182
Policy 2: Taxes and investment 184
Policy 3: Government budgets – surplus or deficit? 185
Study tools 192
Chapter 9
The natural rate
of unemployment 195
Introduction 196
Identifying unemployment 197
How is unemployment measured? 197
Is unemployment measured correctly? 201
How long are the unemployed without
work? 203
Why is there unemployment? 203
Classical unemployment 204
Minimum-wage laws 204
Unions and collective bargaining 206
The theory of efficiency wages 208
Frictional unemployment 212
The inevitability of frictional unemployment 212
Public policy and job search 213
Unemployment benefits 213
Structural unemployment 214
Study tools 218
Part 5 M
oney and prices
in the long run 223
Chapter 10
The monetary system 224
Introduction 225
The meaning of money 225
The functions of money 226
Kinds of money 226
Money in the Australian economy 228
The Reserve Bank of Australia 231
Organisation of the RBA 232
Changes in the RBA’s role 233
Banks and the money supply 236
The simple case of 100 per cent reserve
banking 236
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
00_Stonecash_8e_45658_SB_FM_txt.indd 7
25/08/20 9:45 PM
Money creation with fractional-reserve
banking 237
The money multiplier 238
Bank capital, leverage and the Global Financial
Crisis of 2008 239
Monetary policy in Australia today 241
Problems in controlling the money supply 243
Study tools 246
Chapter 11
Inf lation: Its causes and costs 249
Introduction 250
The causes of inf lation 251
The level of prices and the value of money 251
Money supply, money demand and monetary
equilibrium 251
The effects of a monetary injection 253
A brief look at the adjustment process 255
The classical dichotomy and monetary
neutrality 256
Velocity and the quantity equation 257
The inf lation tax 259
The Fisher effect 260
The costs of inflation 263
A fall in purchasing power? The inflation fallacy 264
Shoeleather costs 264
Menu costs 265
Relative-price variability and the misallocation of
resources 266
Inflation-induced tax distortions 266
Confusion and inconvenience 267
A special cost of unexpected inflation: Arbitrary
redistributions of wealth 267
Study tools 273
Part 6 T
he macroeconomics of
open economies 277
Chapter 12
Open-economy macroeconomics:
Basic concepts 278
Introduction 279
The international flows of goods and capital 279
The flow of goods: Exports, imports and net
exports 279
The flow of financial resources: Net foreign
investment 285
The equality of the current account and the capital
and financial accounts 287
Saving, investment and their relationship to the
international flows 288
The prices for international transactions: Real and nominal
exchange rates 291
Nominal exchange rates 291
Real exchange rates 292
A first theory of exchange-rate determination: Purchasingpower parity 293
The basic logic of purchasing-power
parity 293
Implications of purchasing-power parity 294
Limitations of purchasing-power parity 298
Study tools 300
Chapter 13
A macroeconomic theory of the
open economy 303
Introduction 304
Supply of and demand for loanable funds and foreign-currency
exchange 304
The market for loanable funds 305
The market for foreign-currency exchange 306
Net foreign investment: The link between the two
markets 308
Simultaneous equilibrium in two markets 310
Government budget deficits 312
Trade policy 316
Political instability and capital flight 319
Study tools 323
Part 7 S
hort-run economic
f luctuations 327
Chapter 14
Aggregate demand and aggregate
supply 328
Introduction 329
Three key facts about economic f luctuations 329
Fact 1: Economic fluctuations are irregular and
unpredictable 329
Fact 2: Most macroeconomic quantities fluctuate
together 331
Fact 3: As output falls, unemployment rises 331
Explaining short-run economic fluctuations 333
How the short run differs from the long
run 334
The basic model of economic fluctuations 334
The aggregate-demand curve 335
The aggregate-supply curve 338
Two causes of recession 344
The effects of a shift in aggregate
demand 344
The effects of a shift in aggregate supply 347
Study tools 351
Chapter 15
The influence of monetary
and fiscal policy on aggregate
demand 355
Introduction 356
How monetary policy influences aggregate demand 356
The downward slope of the aggregate-demand
curve 359
The theory of liquidity preference 360
How fiscal policy influences aggregate demand 363
Changes in government purchases 363
The multiplier effect 363
The crowding out effect 364
Changes in taxes 366
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
00_Stonecash_8e_45658_SB_FM_txt.indd 8
25/08/20 9:45 PM
Using policy to stabilise the economy 368
The case for active stabilisation policy 368
The case against active stabilisation policy 371
Automatic stabilisers 372
The economy in the long run and the short run 373
Study tools 376
Chapter 16
The short-run trade-off
between inf lation and
unemployment 380
Introduction 381
The Phillips curve 381
Origins of the Phillips curve 381
Aggregate demand, aggregate supply and the
Phillips curve 382
Shifts in the Phillips curve: The role of expectations 384
The long-run Phillips curve 384
Expectations and the short-run Phillips curve
386
Shifts in the Phillips curve: The role of supply shocks 391
The cost of reducing inflation 393
The sacrifice ratio 394
Rational expectations and the possibility
of costless disinf lation 395
The Accord approach 396
A low-inflation era 398
Study tools 400
Chapter 17
Contemporary macroeconomics
topics 403
Introduction 404
What does globalisation mean? 404
Overview of the main elements of financial crises 410
The causes of the GFC 411
Rising household debt 412
Opaque mortgage securitisation 413
Ill-designed government policies 415
Loose monetary policy 416
Global economic trends and imbalances 416
The European debt contagion 417
Policy responses to the GFC 419
What kind of shocks caused the
GFC? 419
The self-correction of the GFC shocks:
The theory 420
Macroeconomic policy response to the GFC
shocks: The theory 421
Macroeconomic policy responses to the GFC
shocks: The reality 422
Lessons from the GFC 427
Slow wages growth 428
Study tools 433
Part 8 Final thoughts 437
Chapter 18
Five debates over macroeconomic
policy 438
Introduction 439
That monetary and fiscal policymakers should
try to stabilise the economy 439
Pro: Policymakers should try to stabilise the
economy 439
Con: Policymakers should not try to stabilise the
economy 440
That monetary policy should be made by rule
rather than by discretion 440
Pro: Monetary policy should be made by
rule 441
Con: Monetary policy should not be made
by rule 441
That the central bank should aim for zero inflation 442
Pro: The central bank should aim for zero
inflation 442
Con: The central bank should not aim for zero
inflation 443
That the government should balance its budget 444
Pro: The government should balance its
budget 444
Con: The government should not balance its
budget 445
That the tax laws should be reformed to encourage
saving 447
Pro: The tax laws should be reformed to encourage
saving 447
Con: The tax laws should not be reformed to
encourage saving 448
Study tools 450
Glossary 452
Suggestions for reading 456
Index 458
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
00_Stonecash_8e_45658_SB_FM_txt.indd 9
25/08/20 9:45 PM
Guide to the text
As you read this text you will find a number of features in every
chapter to enhance your study of macroeconomics and help you
understand how the theory is applied in the real world.
PART OPENING FEATURES
The chapter list outlines the
chapters contained in each part
for easy reference.
The macroeconomics
of open economies
PART SIX
Chapter 12 Open-economy macroeconomics: Basic concepts
Chapter 13 A macroeconomic theory of the open economy
CHAPTER OPENING FEATURES
Identify the key concepts that
the chapter will cover with the
learning objectives at the start of
each chapter.
7
Production and growth
The term productivity refers to the quantity of goods and services that a worker can
produce for each hour of work. In the case of Crusoe’s economy, it is easy to see that
productivity is the key determinant of living standards and that growth in productivity is
the key determinant of improvements in living standards. The more fish Crusoe can catch
Learning
per hour,objectives
the more he can eat at dinner. If Crusoe finds a better place to catch fish or a smarter
way
of doing
his productivity
rises.
in productivity makes Crusoe better
After
reading
thisso,chapter,
you should
be This
able increase
to:
off – he
could eat the
extra fish,
or he around
could spend
less time fishing and devote more time to
LO7.1
understand
economic
growth
the world
other
activities
hethe
enjoys.
LO7.2 understand
role of productivity and its determinants
LO7.3The
examine
growth
public policy.
key roleeconomic
of productivity
in and
determining
living standards is as true for nations as it is
for stranded sailors. Recall that an economy’s gross domestic product (GDP) measures three
things at once – the total production, the total income earned in the economy and the total
expenditure on the economy’s goods and services. The reason GDP can measure these three
things simultaneously is that, for the economy as a whole, they must be equal. Put simply,
workers and owners of capital get paid their income for what they produce and use this
income to purchase the goods and services produced in the economy.
The implication is that Australians are more prosperous than Nigerians mainly because
Australian workers are more productive than Nigerian workers. The Chinese have enjoyed
more rapid growth in living standards than Venezualans primarily because Chinese workers
have experienced more rapidly growing productivity. Indeed, one of the Ten Principles of
Economics in chapter 1 is that a country’s standard of living depends on its ability to produce
goods and services.
The above discussion implies that in order to understand the large differences in living
standards across countries or over time, we must focus on the production of goods and
services. But seeing the link between prosperity and productivity is only the first step. It
leads naturally to the next question: Why are some economies so much better at producing
goods and services than others?
136
FEATURES WITHIN CHAPTERS
Definitions or explanations of
important key terms are located
in the margin for quick reference.
A full list of key terms are also
available in the glossary, which
can be found at the back of the
book.
How is labour productivity determined?
Although productivity is uniquely important in determining Robinson Crusoe’s standard of
living, many factors determine Crusoe’s productivity. Crusoe will catch more fish, for instance,
if he has more fishing rods, if he has been trained in the best fishing techniques, if his island
has a plentiful fish supply or if he has figured out the best places and times on his island to
fish. Each of these determinants of Crusoe’s productivity – which we can call physical capital,
human capital, natural resources and technological knowledge – has a counterpart in more
complex and realistic economies. Let’s consider each of these factors in turn.
Physical capital
physical capital
the stock of
equipment and
structures that are
used to produce
goods and services
Workers are more productive if they have tools with which to work. The stock of equipment
and structures that are used to produce goods and services is called physical capital, or
just capital. For example, when woodworkers make furniture, they use saws, lathes and
drill presses. More tools allow work to be done more quickly and more accurately. That is,
a worker with only basic hand tools can make less furniture each week than a worker with
sophisticated and specialised woodworking equipment.
As you may recall from chapter 2, the inputs used to produce goods and services are called
the factors of production. An important feature of physical capital is that, unlike labour, it is a
produced factor of production. That is, capital is an input into the production process that in
the past was an output from the production process. The woodworker uses a lathe to make the
leg of a table. Earlier, the lathe itself was the output of a firm that manufactures lathes. The
lathe manufacturer in turn used other equipment to make its product. Thus, capital is a factor
of production used to produce all kinds of goods and services, including more capital.
142
Part 4 The real economy in the long run
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
00_Stonecash_8e_45658_SB_FM_txt.indd 10
25/08/20 9:45 PM
processes. Similarly, labour relates to the quantity of workers in terms of the number of hours
they supply, while human capital expresses the quality and intellectual capacity of people
with regard to economic activities. To use a relevant metaphor, technological knowledge
is the quality of society’s textbooks, whereas human capital is the zeal and ingenuity with
which individuals write these textbooks and learn from them.
Based on the above discussion, it will probably not surprise you that labour productivity
depends on physical capital and human capital, as well as technological knowledge. You
will, however, soon see that physical capital only has a temporary effect: Ongoing increases
in the number of machines per worker cannot permanently sustain economic growth. This
is in contrast to human capital and technological knowledge, both of which improve the
quality of the production inputs rather than just adding more inputs.
FEATURES WITHIN CHAPTERS
Analyse practical applications
of concepts through the
case studies and test your
understanding with the
associated questions.
CASE
STUDY
Are natural resources or global warming limits to growth?
The world’s population is far larger today than it used to be (in 1800 it was around one
billion, one-seventh of what it is now), and most people are enjoying a much higher
standard of living. A perennial debate concerns whether this growth in population and
living standards can continue in the future.
Many commentators have argued that natural resources provide a limit to how
much the world’s economies can grow. At first, this argument might seem hard to
ignore. If the world has only a fixed supply of non-renewable natural resources,
how can population, production and living standards continue to grow over time?
Eventually, won’t supplies of oil and minerals start to run out? When these shortages
start
to occur,
they stop
economic
and, saving
perhaps,
even
force living
Although
thewon’t
accounting
identity
S = I growth
shows that
and
investment
are equal for
standards to fall?
the economy as a whole, this does not have to be true for every individual household or
In the early 1970s, a group of researchers at the Massachusetts Institute of
firm. Mary’s saving can be greater than her investment, and she can deposit the excess in
Technology (MIT) in the US were commissioned to undertake analysis of whether
a bank.
Jerry’s saving can be less than his investment and he can borrow the shortfall from
this would in fact happen. They published a book called The Limits to Growth. They
a bank.
Banks
andbyother
make
individual
differences
concluded
that
aboutfinancial
2020, weinstitutions
would reach
peakthese
production
– that
we would between
not be
saving
and
investment
possible
byoutput
allowing
person’s
to finance
another
person’s
able to
continue
to increase
our
of one
goods
as we saving
would run
out of key
inputs
of
investment.
non-renewable resources. The researchers were criticised – their computer modelling
made simplistic assumptions, they didn’t consider technological advances and so on.
It appears that they weren’t entirely accurate about their predictions … and yet … We
are experiencing changes to our climate that may force us to limit our production to
prevent catastrophic changes to our environment.
Having
discussed
someare
of less
the concerned
important about
financial
institutions
in our economy
and their
Most
economists
running
out of resources
as the source
What
Australian
role,
are
ready to buildprogress
a model of
financial
markets. Our
purpose
in doingmany
so is to
explain
of we
limits.
Technological
has
led to discoveries
that
have replaced
noneconomists
think with
how
financialresources
markets
coordinate
the economy’s
saving
investment.
The model also
renewable
renewables
or that allow
us toand
recycle
the non-renewables.
gives
uscompare
a tool with
we can
analyse
various
economic
and government
If we
thewhich
economy
today
with the
economy
of thedevelopments
past, we see various
ways
debate. Of the economists surveyed,
There are a number of government
in which
the use of natural
resources
has improved. Modern cars, particularly hybrids,
policies
that
saving
and investment.
84.9 per cent agree with the statement:
policies
thatinfluence
are generally
opposed
by
require
litres of petrol
per kilometre.
houses have
insulation
and
To keepfewer
things
we65.2
assume
that the New
economy
onlybetter
one
financial
‘Prior to has
approval
of any
majormarket,
public called
economists.
For simple,
example,
per cent
require less
to heat and
cool them.
Recycling
allowstosome
non-renewable
the
forenergy
loanable
. All
this market
deposit
savings and all
infrastructure
project,
antheir
independent
ofmarket
economists
would likefunds
to see
an savers
end go to
resources
to
be
reused.
Solar
panels
on
houses
and
the use
of batteries
to store
borrowers
go toduty
this market
tosales
get their
loans. Inand
this
market
there
is onestudy
interest
rate,be
which
expert
cost–benefit
should
to the stamp
on home
(stamp
energy generated during the day are now fairly common.
conducted and released publicly.’ Only
arereturn
state taxes
payable
youof borrowing.
is duties
both the
on saving
andwhen
the cost
Half a century ago, some people were concerned about the excessive use of tin and
per
cent of
respondents
disagree.
buy
orassumption
sell an asset),
19.2
per cent
of 8.5
The
of awhile
single
financial
market
is, of
course,
not
realistic. We
have seen that
copper. At the time, these were crucial commodities – tin was used to make many food
respondents
disagree.
As experts,
the role
the
economy has
many types
of financial
institutionsSource:
and instruments.
But, as we
discussed
ESA Policy Opinion
of Australian
containers, and copper was used to make telephone
wire.
Some peopleSurvey
advocated
Economists 2011,the
http://esacentral.org.au/
economists
public
policy formation
inof
chapter
2, recycling
theinart
inand
building
an of
economic
model is
world
mandatory
rationing
tin and copper
so simplifying
that supplies
would
bein order to
publications/useful
-links/2011-policy-opinion-survey
is to analyse
proposals
andhere,
inform
public
explain
it. For
purposes
we
can however,
ignore theplastic
diversity
of financial
institutions
available
for our
future
generations.
Today,
has replaced
tin as
a materialand
assume
that the
economy
has a single
financial
market.
for making
many
food containers,
and
phone calls
often travel over fibre-optic cables,
which
made from
sand.
Technological
progress
once-crucial
natural oppose
Why are
do policies
such
as stamp
duties persist
if has
the made
experts
overwhelmingly
resources
less necessary.
them?
The reason
may be that economists have not yet convinced the general public that
But
are
all
these
technological
efforts
enough
to
continued
economic
growth?
these policies are undesirable. One of the purposes ofpermit
this book
is to help
you understand
One way to answer this question is to look at the prices of natural resources. In a market
LO8.3 The market for loanable funds
Gain insights into recent policy
issues using data from Economics
Society of Australia with the What
Australian economists think
boxes.
Useful macroeconomic facts
can be found in FYI boxes. They
will provide you with additional
information and material to
support key concepts within each
chapter.
market for loanable
funds
a (virtual) place where
those who supply and
demand funds interact
FYI
the economist’s view of these and other subjects and, perhaps, to persuade you that it is the
Question: If you put $100 in a bank
right
one. value
Present
144
account (that pays interest) today, how
Imagine that someone offered to give
much money will you have in N years?
today or $100 in 10 years.
That is, what will be the future value of
Which would you choose? This is an easy
this $100?
question.
Getting
$100 today
is clearlyinnovation.Answer
just
before you
do arguably
discourages
As Boldrin
state:the
‘Insofar as
: Let’sand
useLevine
r to denote
Give two
reasonsyou
whycan
twoalways
economic
advisers to the federal government might disagree
better,
because
deposit
interest
rate them
expressed
decimal form
(so
innovators
have unique
ideas, it may
make sense
to reward
with in
monopolies
to make
about
a question
of policy.
the
money
in a bank,
still have it in 10
interest
rate of 5
per cent means
r=
sure we get advantage of their unusual talentsan
… As
it happens,
simultaneous
discoveries
years and earn interest along the way. The
0.05).
If interest
is paid eachexcessive
year, andpatent
tend to be the rule rather than the exception’. Third
and
most importantly,
lesson: Money today is more valuable than if this interest paid remains in the bank
protection inhibits a key driver of prosperity, namely learning from others. As the authors
the same amount of money in the future.
to earn more
interest (a
processhave
argue:Now
‘Imitation
is aa harder
great thing.
It is among theaccount
most powerful
technologies
humans
consider
question:
called compounding, which you learnt
ever
developed’.
Imagine
$100
The
first that
two someone
chapters offered
of this you
book
have introduced
youearlier
to the
ideas and
methods
about in an
chapter),
the $100
will of
today
or
$200
in
10
years.
Which
would
you
economics. We are now ready to get to work. Inbecome
the next(1chapter,
we after
start1learning
inrmore
+ r) × $100
year, (1 +
)×
choose?
To the
answer
this question,
you need
detail
about
principles
of economic
behaviour
(1 +and
r) ×economic
$100 afterpolicy.
2 years, (1 + r) × (1 + r) ×
some
wayproceed
to compare
sums
of book,
money
from
(1asked
+ r) × $100
after
yearsofand
sointellectual
on. After
As you
through
this
you
will be
to draw
on3many
your
different points of time. Economists do this
N
N years,
(1 +John
r) ×Maynard
$100.
skills. It may be helpful to keep in mind some advice
fromthe
the$100
greatbecomes
economist
with
present value.
The important
Why aisconcept
researchcalled
and development
(R&D)
for long-run
economic
For example,
if the
interestgrowth?
rate is 5 per
Keynes:
present value of any future sum of money
cent, then the value of the $100 in 10 years’
The
studythat
of economics
not seem to require any specialised
gifts of an
is the amount
today
would bedoes
needed,
10
time will be (1.05) × $100, which is $163.
unusually
highto
order.
Is it not
… a very easy subject compared with the higher
at current interest
rates,
produce
that
Now suppose you are going
Using
experiments
to
evaluate
aid andQuestion
ignite: prosperity
philosophy
or pure science? An easy subject, at which very few
future sum. branches
To learn of
how
to use the
to be paid $200 in N years. What is the
excel!
The
paradox
finds
itseffective
explanation,
in that the
master-economist
To
figureofout
what
policies
are
low-income
nations,
economists
concept
present
value,
let’s
work
through inperhaps,
present value of this future payment?
must
possess
a
rare
combination
of
gifts.
He
must
be
mathematician,
historian,
are
increasingly
turning
to
randomised
controlled
experiments
used in
a couple of simple problems.
Part 4 The real economy in the long
run
you
$100
CHECK YOUR UNDERSTANDING
Conclusion: Let’s get going
CHECK YOUR UNDERSTANDING
Expand your knowledge
of economics related to
contemporary events In the
news. These boxes provide news
articles about economics in the
real world.
IN THE
NEWS
statesman, philosopher – in some degree. He must understand symbols and speak
medical trials.
in words. He must contemplate the particular in terms of the general, and touch
abstract and
in the same flight of thought.
must
study the
So heHe
and
a bunch
ofpresent
his colleagues
What it takes
toconcrete
lift families
179
Because ofin
differences
in GDP
growth
rates,ofthe
countries
by with
income
the light of the
past for
the purposes
the ranking
future.
Noof
part
of man’s
or thechanges
had
a radical
idea:
Test nature
aid
same
out
of poverty
Chapter 8 Saving, investment and the financial system
his institutions
must
entirely outside
his
regard.
He must be
purposeful
and
substantially
over
time. Japan
islie
a country
that has
risen relative
to
others
between
1950is,
and
method
doctors
use
to test
drugs (that
by Michaeleen
Doucleff
disinterested
a simultaneous
as aloof
and
incorruptible
as
an
artist,
randomized
control
trials).
1990
and 2015
has fallen
sinceinthen.
The risemood;
of China
and
other
South
East
Asianyetcountries still
15 May
sometimes as near the earth as a politician.
The
idea
is quiteand
simple.
Give some
continues. Two
countries that have fallen behind are
New
Zealand
Argentina.
In 1950,
Eighteen years ago, Dean Karlan was a
aid with
but others
nothing.
New
Zealand
was one
of
thepractice,
richest countries
infamilies
the world,
average
incomeThen
nearly as
This
is abright-eyed
tall order.
But
with
fresh,
graduate
studentyou
in will become more and more accustomed to thinking
follow
both groups,
and seeincome
if the in New
high
as the
United
and well above
the United
Kingdom.
Today, average
like
an
economist.
economics
at theStates
Massachusetts
Institute
actually
made aIndifference
in the had
Zealand
is well below
average
income what
in the USaid
and
in Australia.
1950, Venezuela
of Technology.
He wanted
to answer
long run.
almost
fourlike
times
the income
of its South American neighbour, Brazil. Today, Venezuela’s
seemed
a simple
question:
Karlan, who’s now a professor at
average
income
only
justKarlan
over half
‘Does
globalisaid
work?’
says.that of Brazil’s. Australia’s story is somewhere in
Yale University, says many people were
He was
reading
a bunch
of studies had the highest per capita income in the world, but
between
these
two. In
1900, Australia
skeptical. ‘I have many conversations with
on
the
topic.
But
none
of
them
actually
by 1970 it had fallen to around seventh in the rankings.
By 1991,
Australia
was
longer in
say, ‘You
wantmaking.
to dono
what?
Today, you can find economists involved in manypeople
areas ofwho
government
decision
answered
thehad
question.
‘We
weremost
tearing
the
topEconomists
10 and
behind
European
countries
intorelative
terms. Since
havefallen
a valuable
role to play western
in government
because
they
understand
Whyprecisely
would
you
want
do that?’
Chapter 2
our Australia’s
hair
outdecisions
reading
thesetrade-offs,
paperseconomic
because
that all
involve
and because
they are
skilled
in evaluating
thosefamilies
trade-since
then,
relatively
strong
growth
(we
have
had
nosome
recession
One
issue
is
that
go 1992)
it
was
frustrating,’
he
says.
‘[We]
never
really
offs.Australia’s
Economists are
also ablerise,
to useattacking
another of the
Principles
of Economics – people
has seen
ranking
theTen
top
10 again.
home
empty-handed,
withrespond
no aid. So
felt like
the papers
were really
satisfactory.’
to incentives
– to identify
possible
unintended consequences of policy proposals. We saw an
the idea seems
unethical.
Butthat
Karlan
These data show that the world’s richest countries
have no
guarantee
they will
example
of this in
the that
‘babyno
bonus’
study in Chapter 1, and unintended consequences of
One
problem
was
onecase
was
disagrees.
whole point
of this
is to in
stay the
richest and
thatisthe
world’s
poorest
countries
are ‘The
not doomed
forever
to remain
well-meaning
policies
a theme
that we
actually
testing global
aid
programs
—will return to often throughout this book.
hecountries
says.
‘Ifthe
we
findahead
out
poverty.
But
what
explains
these
changes
over help
time?more
Why
dothe
some
zoom
In Australia,
economists
skilled
in macroeconomics
work people,’
in
Treasury
and
methodically
— to
see if they
really
andwe
what
in five years
Department
of
Finance
to
provide
advice
on taxation
andworks
fiscal policy,
andtake
indoesn’t,
the
while others lag behind? These are precisely
thewhat
questions
that
upReserve
next.
35
Thinking like an economist
Bank studying monetary and financial issues. Economists skilled in microeconomics
haven’t
the scientific
workbeen
in the taking
Productivity
Commissionmethod
advising the government
on microeconomic
reform, around
So Karlan
and collaborators
to problems
poverty,’Competition
he says. and Consumer Commission advising on issues related
and at theof
Australian
the world, including those at the Abdul
Take,
for instance,
a charity
thatingives
to competition
policy.
Economists
all areas of government are supported by their
Latif Jameel Poverty Action Lab at MIT
colleagues
at The
the Australian
Bureaucheck
of Statistics,
a family
a cow.
charity might
on who construct the statistical information
and the nonprofit Innovations for
that is used
in alater
wide variety
of government
the family
a year
and say,
‘Wow! The decision making and economic research.
Poverty
Action,
decided
totake
out the
What has
been the approximate
annual
growth
rate
of real
GDP
per
person
intry
Australia
Political
seek the
inputwith
of economists
in developing
the
policies
that
they
to
family is
doingparties
so much
better
this
with
oneofinof
the
toughest
and elections.
China over
theall,past
half century?
Before
reading
the rest
the
chapter,
canproblems
you
After
economic
‘credibility’
is often
a idea
prominent
issue
election
campaigns.
cow. Cows must be the reason.’
out
there:
helping
families
getbetween
out of
suggest
any possible
explanations
for the differences
in economic
growth
rates
Politicians,
of all parties,
rely on the economists
in the
Parliamentary
Budget
Office to
provide
But
maybe itcostings
wasn’t the
cow
that
non-partisan
theirperiod?
proposed policies, andextreme
independent
analysis of economic and
poverty.
Australia
and China overofthis
improved
theissues.
family’s life. Maybe it had a
budgetary
An anti-poverty program in
bumper
crop
that of
year
or property
values
The
influence
economists
on policy
goes beyondBangladesh,
their role as advisers
and
policymakers;
called BRAC, looked like
and writings can affect policy indirectly. Economist John Maynard Keynes
wenttheir
up research
in the neighborhood.
it was successful. It seemed to help
offered thisreally
observation:
Researchers
weren’t doing those
nearly 400 000 families who were
experiments, Karlan
The ideassays.
of economists and political philosophers, both when they are right and
living off less than $1.25 each day.
Test your progress through each
section by answering the Check
your understanding questions as
you progress through the chapter.
CHECK YOUR UNDERSTANDING
LO7.2 Productivity: Its role and determinants
when they are wrong, are more powerful than is commonly understood. Indeed,
Explaining the large
variation in living standards around the world is, in one sense, very
the world is ruled by little else. Practical men, who believe themselves to be
quitethe
exempt
from intellectualcan
influences,
are usually the slaves
of single
some defunct
easy. As we will see,
explanation
be summarised
in a
word – productivity. But,
Madmen in authority, who hear voices in the air, are distilling their
in another sense, economist.
the international
variation is deeply puzzling. To explain why incomes are
frenzy from some academic scribbler of a few years back.
so much higher in some countries than in others, we must look at the many (economic as
Chapter 7
These words were written in 1935, but they remain true today. Indeed, the ‘academic
well as non-economic) factors that determine a nation’s productivity.
ICONS
The Key figure icon highlights
content relating to a key figure in
economics.
scribbler’ now influencing public policy is often Keynes himself.
161
Production and growth
economists’ so
advice
is not always followed
Why isWhy
productivity
important?
KEY
FIGURES
Economists
who advise
the government
know
that their growth
recommendations
are not always
Let’s begin
our study
of productivity
and
economic
by developing
a simple model
heeded. Frustrating as this can be, it is easy to understand. The process by which economic
based policy
loosely
on Daniel Defoe’s famous novel, Robinson Crusoe. Robinson Crusoe, as you
is actually made differs in many ways from the idealised policy process assumed in
may recall,
is
a
sailor
stranded
on
a
desert
island.
Because
Crusoe
lives
alone, he catches his
economics textbooks.
text,
whenever we
economic
policy,
we often
on oneof Crusoe’s
own fish,Throughout
grows histhis
own
vegetables
anddiscuss
makes
his own
clothes.
We focus
can think
question:
is the bestand
policy
for the government
to pursue?
We act as
if policy
were set
activities
– hisWhat
production
consumption
of fish,
vegetables
and
clothing
– as being a
by a benevolent queen. Once the queen determines the ‘right’ policy, she has no difficulty
simple economy. By examining Crusoe’s economy, we can learn some lessons that also apply
putting her ideas into action.
to more complex
and
realistic
economies.
In the real world, determining the right policy is only part of a leader’s job, sometimes
What
determines
Crusoe’s
standard
living?
answer is
obvious.
Crusoe is good
the easiest
part. After
the prime
ministerofhears
fromThe
her economic
advisers
whatIfpolicy
they deem
she turns
to otherand
advisers
for clothes,
related input.
The well.
prime Ifminister’s
at catching
fish, best,
growing
vegetables
making
he lives
he is bad at doing
communications advisers will tell her how best to explain the proposed policy to the public,
these things,
he lives poorly. Because Crusoe gets to consume only what he produces, his
and they will try to anticipate any misunderstandings that might make the challenge more
living difficult.
standard
ispress
tied advisers
to his productive
Her
will tell her ability.
how the news media will report on her proposal
and what opinions will likely be expressed on the nation’s editorial pages. Her legislative
advisers will tell her how parliament will view the proposal, what amendments members of
the Senate will suggest, and the likelihood that the two houses of parliament will pass some
141
32
Copyright 2021 Cengage Learning. All Rights Reserved.
May not be copied, scanned, or duplicated, in whole or in part. Chapter
WCN
02-200-202
7 Production and growth
Part 1 Introduction
00_Stonecash_8e_45658_SB_FM_txt.indd 11
25/08/20 9:45 PM
END-OF-CHAPTER FEATURES
At the end of each chapter you will find several tools to help you to review, practise and
extend your knowledge of the key learning objectives.
STUDY
STUDY
STUDY
TOOLS
TOOLS
TOOLS
Review your understanding of the key
chapter topics with the Summary.
Quickly navigate to Key concepts
introduced in the chapter with this list
of key terms.
Summary
LO5.1 Because every transaction has a buyer and a seller, the total expenditure in the
economy must equal the total income in the economy.
LO5.2 Gross domestic product (GDP) measures an economy’s total expenditure on newly
LO5.1 Because every transaction has a buyer and a seller, the total expenditure in the
produced goods and services and the total income earned from the production of
economy must equal the total income in the economy.
these goods and services. More precisely, GDP is the market value of all final goods and
LO5.2 Gross domestic product (GDP) measures an economy’s total expenditure on newly
LO5.1 Because
every transaction
a buyer
a seller,
total expenditure in the
services produced
within a has
country
in aand
given
periodthe
of time.
produced goods and services and the total income earned from the production of
must among
equal the
total
income in of
the
economy. – consumption, investment,
LO5.3 economy
GDP is divided
four
components
expenditure
these goods and services. More precisely, GDP is the market value of all final goods and
LO5.2 Gross
domestic
productand
(GDP)
an economy’sincludes
total expenditure
government
purchases
netmeasures
exports. Consumption
spending on newly
goods and
services produced within a country in a given period of time.
produced
and services
andexception
the total of
income
earned
the production
of
services bygoods
households,
with the
purchases
of from
new housing.
Investment
LO5.3 GDP is divided among four components of expenditure – consumption, investment,
these
goods
and services.
precisely,
is the market
value
of all finalpurchases
goods and
includes
spending
on new More
equipment
andGDP
structures,
including
households’
government purchases and net exports. Consumption includes spending on goods and
services
produced
within a country
in a given
period
of time.
of new housing.
Government
purchases
include
spending
on goods and services by
services by households, with the exception of purchases of new housing. Investment
LO5.3 GDP
divided
components
expenditure
consumption,
investment,
local,isstate
andamong
federalfour
governments.
Netofexports
equal –the
value of goods
and services
includes spending on new equipment and structures, including households’ purchases
government
purchases and
and sold
net exports.
Consumption
spending
onand
goods
and
produced domestically
abroad (exports)
minusincludes
the value
of goods
services
of new housing. Government purchases include spending on goods and services by
services
byabroad
households,
with
the exception
of purchases of new housing. Investment
produced
and sold
domestically
(imports).
local, state and federal governments. Net exports equal the value of goods and services
new equipment
and structures,
including
households’
purchases
LO5.4 includes
Nominal spending
GDP useson
current
prices to value
the economy’s
production
of goods
and
produced domestically and sold abroad (exports) minus the value of goods and services
of
new housing.
Government
purchases
include
spending
onthe
goods
and services
by
services.
Real GDP
uses constant
base-year
prices
to value
economy’s
production
produced abroad and sold domestically (imports).
local,
stateand
andservices.
federal governments.
Net –exports
equalfrom
the the
value
of goods
and services
of goods
The GDP deflator
calculated
ratio
of nominal
to real
LO5.4 Nominal GDP uses current prices to value the economy’s production of goods and
produced
domestically
andofsold
abroad
(exports)
minus the value of goods and services
GDP – measures
the level
prices
in the
economy.
services. Real GDP uses constant base-year prices to value the economy’s production
abroad
and sold
domestically
(imports).
LO5.5 produced
GDP is a good
measure
of economic
wellbeing
because higher incomes mean people
of goods and services. The GDP deflator – calculated from the ratio of nominal to real
LO5.4 Nominal
GDP of
uses
prices
toto
value
economy’s
of goods
and
can buy more
thecurrent
things that
add
theirthe
wellbeing.
But production
it is not a perfect
measure
GDP – measures the level of prices in the economy.
services.
RealFor
GDP
uses constant
base-year
pricesoftoleisure
value the
of wellbeing.
example,
GDP excludes
the value
andeconomy’s
the value ofproduction
a clean
LO5.5 GDP is a good measure of economic wellbeing because higher incomes mean people
of
goods and as
services.
deflator
– calculated
ratio of inequality
nominal to
environment,
well asThe
the GDP
negative
impact
of greater from
levelsthe
of income
orreal
can buy more of the things that add to their wellbeing. But it is not a perfect measure
GDP
crime.– measures the level of prices in the economy.
of wellbeing. For example, GDP excludes the value of leisure and the value of a clean
LO5.5 GDP is a good measure of economic wellbeing because higher incomes mean people
environment, as well as the negative impact of greater levels of income inequality or
can buy more of the things that add to their wellbeing. But it is not a perfect measure
crime.
of wellbeing. For example, GDP excludes the value of leisure and the value of a clean
environment,
of greater levels
investment,
p. 100of income inequality or
consumption,
p. 100as well as the negative impact
crime. p. 104
net exports, p. 100
GDP deflator,
Summary
Summary
Key concepts
Key concepts
government
p. 100
consumption,purchases,
p. 100
gross
domestic
(GDP), p. 97
GDP deflator,
p.product
104
gross national
product (GNP),
government
purchases,
p. 100p. 98
consumption, p. 100
gross domestic product (GDP), p. 97
GDP deflator, p. 104
gross national product (GNP), p. 98
government purchases, p. 100
gross domestic product (GDP), p. 97
Questions
review
gross national for
product
(GNP), p. 98
Key concepts
Practice questions
Practice questions
nominal
GDP,
103
investment,
p.p.
100
real
GDP, p. 103
net exports,
p. 100
value added,
nominal
GDP,p.
p.101
103
investment, p. 100
real GDP, p. 103
net exports, p. 100
value added, p. 101
nominal GDP, p. 103
real GDP, p. 103
value added, p. 101
1 Explain why an economy’s income must equal its expenditure.
Questions
for review
2
Which contributes
more to GDP – the production of a tonne of wheat or the production of
a tonne of coal? Why?
1 Explain why an economy’s income must equal its expenditure.
3 A farmer sells milk to a cheesemaker for $2. The cheesemaker uses the milk to make
2 Which contributes
more to GDP – the production of a tonne of wheat or the production of
Questions
for review
cheese, which is sold for $6. What is the contribution to GDP?
a tonne of coal? Why?
1
economy’s
income
equal
its expenditure.
4 Explain
Over thewhy
lastan
three
years, Kane
paidmust
$5000
buying
new parts to restore his vintage car.
3 A farmer sells milk to a cheesemaker for $2. The cheesemaker uses the milk to make
2 Which
contributes
more
to GDP –for
the
production
a tonne
of wheat
the production
of
Today he
sells the car
at auction
$20
000. Howof
does
this sale
affector
current
GDP?
cheese, which is sold for $6. What is the contribution to GDP?
tonne
of coal?
Why?
5 a
List
the four
components
of GDP. Give an example of each.
4 Over the last three years, Kane paid $5000 buying new parts to restore his vintage car.
3
sells
milkthe
to economy
a cheesemaker
for $2.
cheesemaker
to make
6 A
Infarmer
the year
2020,
produces
200The
serves
of fish anduses
chipsthe
formilk
$9.50
each. In the
Today he sells the car at auction for $20 000. How does this sale affect current GDP?
cheese,
which
sold for produces
$6. What is
theserves
contribution
to GDP?
year 2021,
the is
economy
250
of fish and
chips for $12.75 each. Calculate
5 List the four components of GDP. Give an example of each.
4 Over
theGDP,
last three
years,
Kane
buying
newyear.
parts(Use
to restore
vintage
car. By
nominal
real GDP
and
the paid
GDP$5000
deflator
for each
2020 ashis
the
base year.)
6 In the year 2020, the economy produces 200 serves of fish and chips for $9.50 each. In the
Today
he sells thedoes
car at
auction
for $20
000.
How does
GDP?Why is
what percentage
each
of these
three
statistics
rise this
fromsale
oneaffect
year current
to the next?
year 2021, the economy produces 250 serves of fish and chips for $12.75 each. Calculate
5 List
the fourfor
components
ofhave
GDP.aGive
example
it desirable
a country to
largeanGDP?
Give of
aneach.
example of something that would
nominal GDP, real GDP and the GDP deflator for each year. (Use 2020 as the base year.) By
6 In
theGDP
yearand
2020,
produces 200 serves of fish and chips for $9.50 each. In the
raise
yetthe
be economy
undesirable.
what percentage does each of these three statistics rise from one year to the next? Why is
year 2021, the economy produces 250 serves of fish and chips for $12.75 each. Calculate
it desirable for a country to have a large GDP? Give an example of something that would
nominal GDP, real GDP and the GDP deflator for each year. (Use 2020 as the base year.) By
raise GDP and yet be undesirable.
what percentage does each of these three statistics rise from one year to the next? Why is
it desirable for a country to have a large GDP? Give an example of something that would
raise GDP and yet be undesirable.
Practice questions
Test your knowledge and consolidate
your learning through Apply and
revise and Practice questions,
containing multiple choice questions
and problems and applications.
Multiple choice
112
1
GDP includes:
a Consumption, Investment, Government Transfers, Exports
Part 3 The data of macroeconomics b
112
Consumption,
Multiple
choice Private Investment, Government Investment, Exports and Imports
c Consumption, Private and Government Investment, Government Expenditure and Net
GDPExports
includes:
a Consumption, Investment, Government Transfers,
Exports
d
Revenue and
Imports
b the
Consumption,
Investment,
Government
and Imports
If
nominal GDPPrivate
of HobbitLand
in 2020
is $2 350Investment,
000 and theExports
GDP deflator
in 2020 is
Part 3 The data of macroeconomics 103
c Consumption,
Private
Government
and Net
and the base year
forand
the Government
GDP deflatorInvestment,
is 2016, what
is real GDP Expenditure
in 2020:
Exports
a $2
281 553
d $2
Consumption,
Investment, Government Revenue and Imports
b
420 500
2 cIf the
$2nominal
350 000GDP of HobbitLand in 2020 is $2 350 000 and the GDP deflator in 2020 is
103$1
and
the
base year for the GDP deflator is 2016, what is real GDP in 2020:
d
807
692
a $2 281
553
3 Which
of the
following should not be included in GDP:
b Your
$2 420
500
a
purchase
of a new pair of pants.
c Qantas’
$2 350 000
b
purchase of a new ticketing kiosk.
$1bank’s
807 692
cd A
purchase of an existing building for a new office.
3 d
Which
the following
be included
in GDP:
TheofRoyal
Australianshould
Navy’snot
purchase
of a new
patrol boat.
a Your purchase
of a new pair
of pants.
4 According
to the information
in Table
5.4, Australia has a higher life expectancy and
b Qantas’
a new ticketing
higher
meanpurchase
years of of
schooling
and yet kiosk.
Norway is ranked as number 1 on the Human
c A bank’s purchase
of Australia
an existing
building 2.
forWhich
a newof
office.
Development
Index and
is number
the following must be true?
d Australia’s
The Royal Australian
Navy’s
of a new patrol boat.
a
schooling isn’t
as purchase
good as Norway’s.
4 b
According
to real
the information
in Table
5.4, Australia has a higher life expectancy and
Norway’s
GDP per person
is higher.
mean years
of schooling
and yet
Norway is ranked as number 1 on the Human
chigher
Australia’s
distribution
of income
is worse.
Development
Indextreat
and Australia
is number
2.as
Which
of the
following must be true?
d Norway doesn’t
its old people
as well
Australia
does.
Australia’s
schooling isn’t
as good
as Norway’s.
5 a
If Australia
is experiencing
rising
inflation,
then
b Norway’s
real is
GDP
per person
is higher.
a
nominal GDP
growing
faster than
real GDP.
cb Australia’s
distribution
of
income
is
worse.
nominal GDP is growing faster than the GDP deflator.
d
treatfaster
its oldthan
people
as well
as Australia does.
c Norway
real GDPdoesn’t
is growing
nominal
GDP.
5 If
is is
experiencing
rising
inflation,
then
d Australia
real GDP
growing faster
than
the GDP
deflator.
a nominal GDP is growing faster than real GDP.
b nominal GDP is growing faster than the GDP deflator.
c real GDP is growing faster than nominal GDP.
real
GDP is growing
faster
thanwould
the GDP
deflator.
1 d
What
components
of GDP
(if any)
each
of the following transactions affect? Explain.
1
Part 3 The data of macroeconomics
112
2
Problems and applications
a
A family buys a new LED TV.
b Aunt Maria buys a new iPad.
Problems
and applications
c Kia sells a Rio from its inventory.
1
2
3
2
3
4
5
4
5
What
components
GDP (ifticket.
any) would each of the following transactions affect? Explain.
d
You
buy a movieoftheatre
a The
A family
buys a new
LED South
TV.
e
government
of New
Wales creates a new light rail system in Sydney.
Aunt parents
Maria buys
iPad.
fb Your
buyaanew
bottle
of South Australian wine.
c Ford
Kia sells
a Rio
from its shuts
inventory.
g
Motor
Company
down its factory in Campbellfield, Victoria.
d You
buy a movie
theatre ticket.
The
‘government
purchases’
component of GDP does not include spending on transfer
e The government
New South
Walesabout
creates
new light rail
system
in Sydney.
payments
like welfareofbenefits.
Thinking
thea definition
of GDP,
explain
why transfer
fpayments
Your parents
buy a bottle of South Australian wine.
are excluded.
g Ford
Motor
Company
shutspurchases
down its factory
Campbellfield,
Victoria.
Why
do you
think
households’
of newin
housing
are included
in the investment
The ‘government
purchases’
component
of GDP does
not include
component
of GDP
rather than
the consumption
component?
Canspending
you thinkon
oftransfer
a reason
payments
like welfare
benefits.
Thinking about
the definition
of GDP, in
explain
why transfer
that
households’
purchases
of refrigerators
should
also be included
investment
rather
payments
are excluded.
than
in consumption?
To what other consumption goods might this logic apply?
Why
dochapter
you think
households’
purchases
of new
housing
are included
in the
investment
As
the
states,
GDP does
not include
the value
of volunteer
work.
Do you
think GDP
component
of GDP
than theWould
consumption
component?
Can
you think
a reason
should
include
suchrather
transactions?
this make
GDP a better
measure
of of
economic
that households’ purchases of refrigerators should also be included in investment rather
wellbeing?
than in
To what
other
consumption
goods
might
logicthink
apply?
Look
onconsumption?
the ABS website
to find
the base
year for real
GDP.
Whythis
do you
the ABS
As the chapter
states,
does not include the value of volunteer work. Do you think GDP
updates
the base
yearGDP
periodically?
should include such transactions? Would this make GDP a better measure of economic
wellbeing?
Look on the ABS website to find the base year for real GDP. Why do you think the ABS
updates the base year periodically?
113
Chapter 5 Measuring a nation’s income
113
Chapter 5 Measuring a nation’s income
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
00_Stonecash_8e_45658_SB_FM_txt.indd 12
25/08/20 9:45 PM
Guide to the online
resources
FOR THE INSTRUCTOR
Cengage is pleased to provide you with a selection of resources
that will help you prepare your lectures and assessments. These
teaching tools are accessible via cengage.com.au/instructors for
Australia or cengage.co.nz/instructors for New Zealand.
MINDTAP
Premium online teaching and learning tools are available on the MindTap platform - the
personalised eLearning solution.
MindTap is a flexible and easy-to-use platform that helps build student confidence and
gives you a clear picture of their progress. We partner with you to ease the transition to
digital – we’re with you every step of the way.
The Cengage Mobile App puts your course directly into students’ hands with course
materials available on their smartphone or tablet. Students can read on the go, complete
practice quizzes or participate in interactive real-time activities.
MindTap for Principles of Economics is full of innovative resources to support critical
thinking, and help your students move from memorisation to mastery! Includes:
• Principles of Economics eBook
• Concept clips
• Graphing workshops
• Video problem walkthroughs
• Video lessons
• Study guide
• Aplia problem sets
• Aplia news analysis
• Adaptive test preparation
• Practice quizzes
• MobLab games and experiments
MindTap is a premium purchasable
eLearning tool. Contact your Cengage
learning consultant to find out how
MindTap can transform your course.
INSTRUCTOR’S MANUAL
The Instructor’s manual includes:
•
•
•
•
•
Learning objectives
Key point summaries
Chapter outline
Check your understanding questions
Questions for review and practice questions
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
00_Stonecash_8e_45658_SB_FM_txt.indd 13
25/08/20 9:45 PM
COGNERO TEST BANK
This bank of questions has been developed in conjunction with the text for creating
quizzes, tests and exams for your students. Deliver these through your LMS and in your
classroom.
POWERPOINT™ PRESENTATIONS
Use the chapter-by-chapter PowerPoint slides to enhance your lecture presentations and
handouts by reinforcing the key principles of your subject.
ARTWORK FROM THE TEXT
Add the digital files of graphs, tables, pictures and flow charts into your course
management system, use them in student handouts, or copy them into your lecture
presentations.
FOR THE STUDENT
MINDTAP
MindTap is the next-level online learning tool that helps you get better grades!
MindTap gives you the resources you need to study – all in one place and available when
you need them. In the MindTap Reader, you can make notes, highlight text and even find a
definition directly from the page.
If your instructor has chosen MindTap for your subject this semester, log in to MindTap to:
• Get better grades
• Save time and get organised
• Connect with your instructor and peers
• Study when and where you want, online and mobile
• Complete assessment tasks as set by your instructor
When your instructor creates a course using MindTap, they will let you know your course
link so you can access the content. Please
purchase MindTap only when directed by
your instructor. Course length is set by
your instructor.
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
00_Stonecash_8e_45658_SB_FM_txt.indd 14
25/08/20 9:45 PM
PREFACE
TO THIS
EDITION
Studying economics should invigorate and enthral. It should challenge students’ preconceptions
and provide them with a powerful, coherent framework for analysing the world they live in. Yet,
all too often, economics textbooks are dry and confusing. Rather than highlighting the important
foundations of economic analysis, these books focus on the ‘ifs’ and ‘buts’. The motto underlying
this book is that it is ‘the rule, not the exception’ that is important. Our aim is to show the power of
economic tools and the importance of economic ideas for people’s prosperity and wellbeing.
This book has been designed particularly for students in Australia. However, we are keenly
aware of the diverse mix of students studying this subject. When choosing examples and
applications, we have kept an international focus. Whether the issue is the international capital
flows in Indonesia or inflation targeting in Australia, examples have been chosen for their relevance
and to highlight that the same economic questions are being asked in many countries. The specific
context in which economics is applied may vary but the lessons and insights offered by the
economic way of thinking are universal.
To boil economics down to its essentials, we had to consider what is truly important for students
to learn in their first course in economics. As a result, this book differs from others not only in its
length but also in its orientation.
It is tempting for professional economists writing a textbook to take the economist’s point of
view and to emphasise those topics that fascinate them and other economists. We have done our
best to avoid that temptation. We have tried to put ourselves in the position of students seeing
economics for the first time. Our goal is to emphasise the material that students should and do find
interesting about the study of the economy.
One result is that more of this book is devoted to applications and policy, and less is devoted to
formal economic theory, than is the case with many other books written for the principles course.
For example, after students learn about the demand for and supply of loanable funds in chapter
8, they immediately apply these tools to answer important macroeconomic questions facing the
Australian economy, such as: How do changes in government tax policy affect the nation’s ability to
invest in new capital equipment? These principles are extended to the open economy in chapter 13,
where students learn about the demand for and supply of foreign exchange and immediately apply
the new tools to explain capital flight from Indonesia during the Asian economic crisis.
Throughout this book we have tried to return to applications and policy questions as often
as possible. Most chapters include case studies illustrating how the principles of economics are
applied. In addition, ‘In the news’ boxes offer excerpts from newspaper articles showing how
economic ideas shed light on the current issues facing society. It is our hope that after students
finish their first course in economics, they will think about news stories from a new perspective and
with greater insight.
To write a brief and student-friendly book, we had to consider new ways to organise the
material. This book includes all the topics that are central to a first course in economics, but the
topics are not always arranged in the traditional order. What follows is a whirlwind tour of this text.
This tour will, we hope, give instructors some sense of how the pieces fit together.
Chapter 1, ‘Ten principles of economics’, introduces students to the economist’s view of the
world. It previews some of the big ideas that recur throughout economics, such as opportunity cost,
marginal decision making, the role of incentives, the gains from trade and the efficiency of market
allocations. Throughout the book, we refer regularly to the Ten Principles from Economics in
xv
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
00_Stonecash_8e_45658_SB_FM_txt.indd 15
Preface to this edition
25/08/20 9:45 PM
chapter 1 to remind students that these principles are the foundation for most economic analysis. A
key icon in the margin calls attention to these references.
Chapter 2, ‘Thinking like an economist’, examines how economists approach their field of
study. It discusses the role of assumptions in developing a theory and introduces the concept of
an economic model. It also discusses the role of economists in making policy. The appendix to this
chapter offers a brief refresher course on how graphs are used and how they can be abused.
Chapter 3, ‘Interdependence and the gains from trade’, presents the theory of comparative
advantage. This theory explains why individuals trade with their neighbours, and why nations
trade with other nations. Much of economics is about the coordination of economic activity
through market forces. As a starting point for this analysis, students see in this chapter why
economic interdependence can benefit everyone. This is done using a familiar example of trade in
household chores among flatmates.
The next chapter introduces the basic tools of supply and demand. Chapter 4, ‘The market
forces of supply and demand’, develops the supply curve, the demand curve, the notion of market
equilibrium, elasticity and its applications to different markets, and uses the tools of supply,
demand and government to examine price controls, such as rent control and the award wage
system, and tax incidence.
Beginning in chapter 5, the book turns to the topics of macroeconomics. The coverage starts
with the issues of measurement. Chapter 5, ‘Measuring a nation’s income’, discusses the meaning
of gross domestic product and related statistics from the national income accounts. Chapter 6,
‘Measuring the cost of living’, discusses the measurement and use of the consumer price index, and
considers other measures of inflation.
The next three chapters describe the behaviour of the real economy in the long run over which
wages and prices are flexible. Chapter 7, ‘Production and growth’, examines the determinants
of the large variation in living standards over time and across countries. Chapter 8, ‘Saving,
investment and the financial system’, discusses the types of financial institutions in our economy
and examines the role of these institutions in allocating resources. Chapter 9, ‘The natural rate
of unemployment’, considers the long-run determinants of the unemployment rate, including
minimum-wage laws, the market power of unions, the role of efficiency wages and the efficacy of
job search.
Having described the long-run behaviour of the real economy, the book then turns to the longrun behaviour of money and prices. Chapter 10, ‘The monetary system’, introduces the economist’s
concept of money and the role of the central bank in influencing the amount of money in the
economy. Chapter 11, ‘Inflation: Its causes and costs’, develops the link between money growth and
inflation and discusses the social costs of inflation.
The next two chapters present the macroeconomics of open economies. Chapter 12, ‘Openeconomy macroeconomics: Basic concepts’, explains the relationship among saving, investment
and the trade balance, the distinction between the nominal and real exchange rate, and the theory
of purchasing-power parity. Chapter 13, ‘A macroeconomic theory of the open economy’, presents
a classical model of the international flow of goods and capital. The model sheds light on various
issues, including the link between budget deficits and trade deficits and the macroeconomic effects
of trade policies. Because instructors differ in how much they emphasise this material, these
chapters were written so they could be used in different ways. Some instructors may choose to
cover chapter 12 but not chapter 13; others may skip both chapters; and others may choose to defer
the analysis of open-economy macroeconomics until the end of their courses.
After fully developing the long-run theory of the economy in chapters 7 to 13, the book turns
its attention to explaining short-run fluctuations around the long-run trend. This organisation
simplifies the teaching of the theory of short-run fluctuations because, at this point in the course,
students have a good grounding in many basic macroeconomic concepts. Chapter 14, ‘Aggregate
demand and aggregate supply’, begins with some facts about the business cycle and then
introduces the model of aggregate demand and aggregate supply. Chapter 15, ‘The influence of
xvi
Preface to this edition
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
00_Stonecash_8e_45658_SB_FM_txt.indd 16
25/08/20 9:45 PM
monetary and fiscal policy on aggregate demand’, explains how policymakers can use the tools at
their disposal to shift the aggregate-demand curve. Chapter 16, ‘The short-run trade-off between
inflation and unemployment’, explains why policymakers who control aggregate demand face a
trade-off between inflation and unemployment. It examines why this trade-off exists in the short
run, why it shifts over time, and why it does not exist in the long run.
Chapter 17, ‘Contemporary macroeconomics topics’, is devoted to globalisation – how events in
one national economy flow over into other countries through interconnections in financial markets.
The Global Financial Crisis of 2008 is covered as an extreme example of interconnected economies.
Slow wages growth in Australia is discussed, as are the causes of the GFC.
The book concludes with chapter 18, ‘Five debates over macroeconomic policy’. This capstone
chapter considers five controversial issues facing policymakers: the proper degree of policy
activism in response to the business cycle, the choice between rules and discretion in the conduct
of monetary policy, the desirability of reaching zero inflation, the importance of balancing the
government’s budget, and the need for tax reform to encourage saving. For each issue, the chapter
presents both sides of the debate and encourages students to make their own judgements.
Robin E. Stonecash
Joshua S. Gans
Stephen P. King
Martin C. Byford
Kris Ivanovski
xvii
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
00_Stonecash_8e_45658_SB_FM_txt.indd 17
Preface to this edition
25/08/20 9:45 PM
PREFACE TO
THE ORIGINAL
EDITION
During my twenty-year career as a student, the course that excited me most was the two-semester
sequence on the principles of economics I took during my freshman year in college. It is no
exaggeration to say that it changed my life.
I had grown up in a family that often discussed politics over the dinner table. The pros and
cons of various solutions to society’s problems generated fervent debate. But, in school, I had
been drawn to the sciences. Whereas politics seemed vague, rambling and subjective, science was
analytic, systematic and objective. While political debate continued without end, science made
progress.
My freshman course on the principles of economics opened my eyes to a new way of thinking.
Economics combines the virtues of politics and science. It is, truly, a social science. Its subject
matter is society – how people choose to lead their lives and how they interact with one another.
But it approaches its subject with the dispassion of a science. By bringing the methods of science to
the questions of politics, economics tries to make progress on the fundamental challenges that all
societies face.
I was drawn to write this book in the hope that I could convey some of the excitement about
economics that I felt as a student in my first economics course. Economics is a subject in which a
little knowledge goes a long way. (The same cannot be said, for instance, of the study of physics or
the Japanese language.) Economists have a unique way of viewing the world, much of which can
be taught in one or two semesters. My goal in this book is to transmit this way of thinking to the
widest possible audience and to convince readers that it illuminates much about the world around
them.
I am a firm believer that everyone should study the fundamental ideas that economics has to
offer. One of the purposes of general education is to make people more informed about the world
in order to make them better citizens. The study of economics, as much as any discipline, serves
this goal. Writing an economics textbook is, therefore, a great honour and a great responsibility.
It is one way that economists can help promote better government and a more prosperous future.
As the great economist Paul Samuelson put it, ‘I don’t care who writes a nation’s laws, or crafts its
advanced treaties, if I can write its economics textbooks.’
N. Gregory Mankiw
July 2000
xviii
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Preface to the original edition
00_Stonecash_8e_45658_SB_FM_txt.indd 18
25/08/20 9:45 PM
TO THE STUDENTS
‘Economics is a study of mankind in the ordinary business of life.’ So wrote Alfred Marshall, the
great nineteenth-century economist, in his textbook Principles of Economics. Although we have
learned much about the economy since Marshall’s time, this definition of economics is as true today
as it was in 1890, when the first edition of his text was published.
Why should you, as a student in the twenty-first century, embark on the study of economics?
There are three main reasons.
The first reason to study economics is that it will help you understand the world in which you
live. There are many questions about the economy that might spark your curiosity. Why are houses
more expensive in Sydney than in Perth? Why do airlines charge less for a return ticket if the
traveller stays over a Saturday night? Why are some people paid so much to play tennis? Why are
living standards so meagre in many African countries? Why do some countries have high rates of
inflation while others have stable prices? Why are jobs easy to find in some years and hard to find in
others? These are just a few of the questions that a course in economics will help you answer.
The second reason to study economics is that it will make you a more astute participant in the
economy. As you go about your life, you make many economic decisions. While you are a student,
you decide how many years you will continue with your studies. Once you take a job, you decide
how much of your income to spend, how much to save and how to invest your savings. Someday
you may find yourself running a small business or a large corporation, and you will decide what
prices to charge for your products. The insights developed in the coming chapters will give you a
new perspective on how best to make these decisions. Studying economics will not by itself make
you rich, but it will give you some tools that may help in that endeavour.
The third reason to study economics is that it will give you a better understanding of the
potential and limits of economic policy. As a voter, you help choose the policies that guide the
allocation of society’s resources. When deciding which policies to support, you may find yourself
asking various questions about economics. What are the burdens associated with alternative forms
of taxation? What are the effects of free trade with other countries? What is the best way to protect
the environment? How does a government budget deficit affect the economy? These and similar
questions are always on the minds of policymakers whether they work for a local council or the
prime minister’s office.
Thus, the principles of economics can be applied in many of life’s situations. Whether the future
finds you reading the newspaper, running a business or running a country, you will be glad that you
studied economics.
Robin E. Stonecash
Joshua S. Gans
Stephen P. King
Martin C. Byford
Kris Ivanovski
N. Gregory Mankiw
xix
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
00_Stonecash_8e_45658_SB_FM_txt.indd 19
To the students
25/08/20 9:45 PM
ABOUT
THE
AUTHORS
Robin Stonecash is Director
of Executive Education and the
Global EMBA at the University
of Sydney’s Business School.
She was previously Director
of Executive Education at
the Business School at the
University of Technology,
Sydney, and Director of
Stonecash Associates, a
boutique consulting firm.
She studied economics at
Swarthmore College, the
University of Wisconsin
and the University of
New South Wales. She
has taught a variety of
courses in microeconomics,
macroeconomics and
international trade to
undergraduates and graduates.
She currently consults on
strategy and negotiation as
well as teaching economics,
strategy and negotiation to
MBA and executive students.
Professor Stonecash’s
research interests currently
focus on agribusiness in
Australia and New Zealand
and the impact of leadership
programs on leadership
effectiveness. Her work has
been published in several
journals, including Economic
Record, Prometheus and Public
Performance and Management
Review. Professor Stonecash
has also done several studies
on the efficiency gains
from outsourcing. She has
consulted widely for private
companies and government
organisations such as AusAID
and the Departments of
Ageing and Disability and
Community Services.
Professor Stonecash lives
in Sydney with her husband,
Mark.
Joshua Gans holds the
Jeffrey S. Skoll Chair in
Technical Innovation and
Entrepreneurship and is
a Professor of Strategic
Management at the Rotman
School of Management,
University of Toronto. He
studied economics at the
University of Queensland
and Stanford University.
He currently teaches
digital economics and
entrepreneurship to MBA
students. Professor Gans’
research ranges over many
fields of economics, including
economic growth, game
theory, regulation and the
economics of technological
change and innovation. His
work has been published in
academic journals including
the American Economic
Review, Journal of Economic
Perspectives, Journal of
Political Economy and the
Rand Journal of Economics.
Joshua also has written the
popular books Parentonomics,
Information Wants to be Shared,
The Disruption Dilemma,
Prediction Machines, Innovation
+ Equality and Economics
in the Age of COVID-19.
Currently, he is department
editor at Management Science.
He has also undertaken
consulting activities
(through his consulting
firm, CoRE Research),
advising governments and
private firms on the impact
of microeconomic reform
and competition policy in
Australia. In 2007, he was
awarded the Economic Society
of Australia’s Young Economist
Award for the Australian
economist under 40 who has
made the most significant
contribution to economic
knowledge. In 2008, he was
elected as a Fellow of the
Academy of Social Sciences
Australia.
Professor Gans lives in
Toronto with his partner,
Natalie Lippey, and children,
Belanna, Ariel and Annika.
Stephen King is a
Commissioner with Australia’s
Productivity Commission
and an adjunct Professor
of Economics at Monash
University. He has previously
been Dean of Business
and Economics at Monash
University, a member of
the Economic Regulation
Authority of Western
Australia, a member of the
National Competition Council
and a Commissioner at the
Australian Competition
and Consumer Commission.
After starting (and stopping)
studying Forestry and
Botany, Stephen completed
an economics degree at
xx
About the authors
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
00_Stonecash_8e_45658_SB_FM_txt.indd 20
25/08/20 9:45 PM
the Australian National
University. He completed his
PhD at Harvard University in
1991. Stephen has taught a
variety of courses, including
teaching introductory
economics for 11 years at
Harvard University, Monash
University and the University
of Melbourne.
Professor King has
researched and published in a
wide range of areas, including
law and economics, game
theory, corporate finance,
privatisation and tax policy.
From 2012 to 2016, he had
a regular column in The
Conversation and he has a
YouTube channel where you
can view companion videos
for introductory economics.
Stephen regularly provides
advice to government, private
firms and the Courts on a
range of issues relating to
regulation and competition
policy. He is a Lay Member of
the High Court of New Zealand
and a Fellow of the Academy
of Social Sciences in Australia.
Professor King lives in
Melbourne with his wife, Mary.
Their two children, Jacqui
and Rebecca, have grown up,
graduated, and run away from
home.
Martin Byford is Senior
Lecturer of Economics at RMIT
University. Prior to joining
RMIT, he was Assistant
Professor of Economics at
the University of Colorado at
Boulder. Martin discovered
economics during the final
year of a combined Arts and
Civil Engineering degree.
Realising that he had made a
terrible error in his choice of
vocation, Martin went back to
university to study economics.
He completed a PhD at the
University of Melbourne
in 2007. Martin has taught
introductory microeconomics
at RMIT campuses in Australia
and Singapore.
Dr Byford’s research is
primarily in the fields of
industrial organisation and
microeconomic theory. He
has published in academic
journals including the
Journal of Economic Theory,
International Journal of
Industrial Organization and
Journal of Economics and
Management Strategy. Martin
also contributes to economic
policy debates on a diverse
range of topics, including the
design of the banking system
and labour market reform.
Dr Byford lives in Melbourne
with his wife, Siobhan, and
their son, Robert.
Kris Ivanovski is a Scholarly
Teaching Fellow within the
Department of Economics
at Monash University. He
has a demonstrated history
of working in the higher
education industry and is
skilled in Policy Analysis,
Stata, Economic Research,
Data Analysis, and Statistical
Modelling. Kris’ strong
education experience includes
roles at the University of
Melbourne and Deakin, as well
as a PhD focused in Economics
from Monash University.
N. Gregory Mankiw is
Professor of Economics at
Harvard University. As a
student, he studied economics
at Princeton University and
MIT. As a teacher, he has
taught macroeconomics,
microeconomics, statistics and
principles of economics. He
even spent one summer long
ago as a sailing instructor on
Long Beach Island.
Professor Mankiw is a
prolific writer and a regular
participant in academic and
policy debates. His work has
been published in scholarly
journals, such as the American
Economic Review, Journal of
Political Economy and Quarterly
Journal of Economics, and in
more popular forums, such
as The New York Times, The
Boston Globe and The Wall
Street Journal. He is also the
author of the best-selling
intermediate-level textbook
Macroeconomics (Worth
Publishers). In addition to
his teaching, research and
writing, Professor Mankiw
is a research associate of the
National Bureau of Economic
Research, an adviser to the
Federal Reserve Bank of
Boston and the Congressional
Budget Office, and a member
of the ETS test development
committee for the advanced
placement exam in economics.
Professor Mankiw lives
in Wellesley, Massachusetts,
with his wife and three
children.
xxi
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
00_Stonecash_8e_45658_SB_FM_txt.indd 21
About the authors
25/08/20 9:45 PM
ACKNOWLEDGEMENTS
In adapting this book, we have benefited from the input of a wide range of talented people. We
would like to thank all those people who helped us with this task. We wish to thank Professor
Lance Fisher of the Macquarie University, Ian Macfarlane and Glenn Stevens, former and current
Governors of the Reserve Bank of Australia, Trevor Stegman of the University of New South Wales
and Ian Harper of the University of Melbourne for useful discussions. We would also like to thank
those economists who read and commented on portions of this manuscript, including:
Dr Jayanath Ananda, Central Queensland University
Dr Dinusha Dharmaratna, Monash College
Ratbek Dzhumashev, Monash Unversity
Aunchisa Foo, University of Western Australia.
Parvinder Kler, Griffith University
Tommy Tang, QUT Business School
Additionally, we would like to extend our thanks to the reviewers from the previous editions, whose
feedback has helped guide the direction of each edition. We would also like to thank Isaac Callaway
for his contribution to the text.
We give special acknowledgement to Sue Hornby, formerly of the Australian Graduate School
of Management, Frank Lowy Library, now head librarian for the Reserve Bank of Australia. She
provided excellent research assistance. Thanks also to Pat Matthews.
Finally, we would like to thank Jan Libich for his contributions to previous editions of the text.
xxii
Acknowledgements
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
00_Stonecash_8e_45658_SB_FM_txt.indd 22
25/08/20 9:45 PM
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
00_Stonecash_8e_45658_SB_FM_txt.indd 23
25/08/20 9:45 PM
PART ONE
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
01_Stonecash_8e_45658_SB_txt.indd 2
24/08/20 5:57 PM
Introduction
Chapter 1 Ten principles of economics
Chapter 2 Thinking like an economist
Chapter 3 Interdependence and the gains from trade
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
01_Stonecash_8e_45658_SB_txt.indd 3
24/08/20 5:57 PM
1
Ten principles
of economics
Learning objectives
After reading this chapter, you should be able to:
LO1.1 recognise that people face trade-offs when they make decisions, and discuss
how the nature of these trade-offs influences their behaviour
LO1.2 explain why trade among people or nations can be good for everyone, and
discuss why markets are a good, but not perfect, way to allocate resources
LO1.3 identify the factors that drive some significant trends in the overall economy.
4
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
01_Stonecash_8e_45658_SB_txt.indd 4
24/08/20 5:57 PM
Introduction
The word economy comes from the Greek word oikonomos, which means ‘one who manages a
household’. At first, this origin might seem peculiar. But, in fact, households and economies
have much in common.
A household faces many decisions. It must decide which members of the household
do which tasks and what each member receives in return: Who cooks dinner? Who does
the laundry? Who gets the extra dessert at dinner? Who gets to use the car? In short,
the household must allocate its scarce resources (time, dessert, petrol) among its various
members, taking into account each member’s abilities, efforts and desires.
Like a household, a society faces many decisions. A society must decide what jobs will
be done and who will do them. It needs some people to grow food, other people to make
clothing and still others to design computer software. Once society has allocated people
(as well as land, buildings and machines) to various jobs, it must also allocate the output of
the goods and services that they produce. It must decide who will eat caviar and who will
eat potatoes. It must decide who will drive a Porsche, and who will take the bus.
The management of society’s resources is important because resources are scarce.
Scarcity means that society has limited resources and therefore cannot produce all the
goods and services people wish to have. Just as each member of a household cannot get
everything he or she wants, each individual in society cannot attain the highest standard of
living to which he or she might aspire.
Economics is the study of how society manages its scarce resources. In most societies,
resources are allocated not by an all-powerful dictator but through the combined choices of
millions of households and firms. Economists, therefore, study how people make decisions –
how much they work, what they buy, how much they save and how they invest their savings.
Economists also study how people interact with one another. For instance, they examine
how the many buyers and sellers of a good interact to determine the price at which the good
is sold and the quantity that is sold. Finally, economists analyse the forces and trends that
affect the economy as a whole, including the growth in average income, the fraction of the
population that cannot find work and the rate at which prices are rising.
The study of economics has many facets, but it is unified by several central ideas. In
the rest of this chapter, we look at Ten Principles of Economics. Don’t worry if you don’t
understand them all at first or if you are not completely convinced. We explore these ideas
more fully in later chapters. The 10 principles are introduced here to give you an overview of
what economics is all about.
scarcity
the limited nature of
society’s resources
economics
the study of how
society manages its
scarce resources
LO1.1 How people make decisions
There is no mystery about what an economy is. Whether we are talking about the economy
of Sydney, of Australia or of the whole world, an economy is just a group of people interacting
with one another as they go about their lives. Because the behaviour of an economy reflects
the behaviour of the individuals who make up the economy, our first four principles concern
individual decision making.
Principle 1: People face trade-offs
You may have heard the saying, ‘There’s no such thing as a free lunch’. To get something
that we like, we usually have to give up something else that we also like. Making decisions
requires trading off one goal against another.
5
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN
02-200-202
Chapter
1 Ten principles of economics
01_Stonecash_8e_45658_SB_txt.indd 5
24/08/20 5:57 PM
efficiency
the property of
society getting the
most it can from its
scarce resources
equity
the property of
distributing economic
prosperity uniformly
among the members
of society
Consider Carol, a student, who must decide how to allocate her most valuable resource –
her time. She can spend all her time studying economics; she can spend all of her time
studying psychology; or she can divide her time between the two fields. For every hour
she studies one subject, she gives up an hour she could have used studying the other.
And for every hour Carol spends studying, she gives up an hour that she could have spent
sleeping, bike riding, watching YouTube clips, or working at her part-time job for some
extra spending money.
Consider parents deciding how to spend their family income. They can buy food or
clothing, or have a holiday. Or they can save some of their income for retirement or their
children’s education. When they choose to spend an extra dollar on one of these goods, they
have one less dollar to spend on some other good.
When people are grouped into societies, they face different kinds of trade-offs. The
classic trade-off is between ‘guns and butter’. The more society spends on national
defence (guns) to protect our shores from foreign aggressors, the less we can spend on
consumer goods (butter) to raise our standard of living. Also important in modern society
is the trade-off between a clean environment and a high level of income. Laws that
require firms to reduce pollution usually raise the cost of producing goods and services.
Because of these higher costs, these firms end up earning smaller profits, paying lower
wages, charging higher prices or some combination of these three. Thus, while pollution
regulations give us a cleaner environment and the improved health that comes with it,
this benefit comes at the cost of reducing the wellbeing of the regulated firms’ owners,
workers and customers.
Another trade-off society faces is between efficiency and equity. Efficiency means that
society is getting the greatest possible benefit from its scarce resources. Equity means
that those benefits are distributed uniformly among society’s members. In other words,
efficiency refers to the size of the economic pie, and equity refers to how the pie is divided
between individuals.
When government policies are being designed, these two goals often conflict. Consider,
for instance, policies aimed at achieving a more equitable distribution of economic
wellbeing. Some of these policies, such as the age pension or unemployment benefits, try
to help those members of society who are most in need. Others, such as the individual
income tax, ask the financially successful to contribute more than others to support the
government. Although these policies achieve greater equity, they reduce efficiency. When
the government redistributes income from the rich to the poor, it reduces the reward for
working hard; as a result, people may work less and produce fewer goods and services. In
other words, as the government tries to cut the economic pie into more equitable slices, the
pie itself shrinks in size.
Recognising that people face trade-offs does not by itself tell us what decisions they
will or should make. A student should not abandon the study of psychology just because
doing so would increase the time available for the study of economics. Society should
not stop protecting the environment just because environmental regulations reduce our
material standard of living. The government should not ignore the disadvantaged just
because helping them would distort work incentives. Nonetheless, people are likely to make
good decisions only if they understand the options that they have available. Our study of
economics, therefore, starts by acknowledging life’s trade-offs.
Principle 2: The cost of something is what you give up to get it
Because people face trade-offs, making decisions requires comparing the costs and benefits
of alternative courses of action. In many cases, however, the cost of some action is not as
obvious as it might first appear.
6
Part 1 Introduction
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
01_Stonecash_8e_45658_SB_txt.indd 6
24/08/20 5:57 PM
Consider the decision whether to go to university. The benefits include intellectual
enrichment and a lifetime of better job opportunities. But what is the cost? To answer this
question, you might be tempted to add up the money you or your parents spend on fees,
books, rent and food. Yet this total does not truly represent what you give up to spend a year
at university.
There are two problems with this calculation. First, it includes some things that are not
really costs of university education. Even if you quit university, you would need a place to
sleep and food to eat. Rent and food are costs of going to university only to the extent that
they may be more expensive because you are at university. Second, this calculation ignores
the largest cost of going to university – your time. When you spend a year listening to
lectures, reading textbooks and writing assignments, you cannot spend that time working
at a job and earning money. For most students, the wages given up to attend university are
the largest cost of their education.
The opportunity cost of an item is the best alternative you give up to get that item.
When making any decision, decision makers should take into account the opportunity
costs of each possible action. In fact, they usually do. For example, some young athletes can
earn millions if they forgo university and play professional sports. Their opportunity cost of
university is very high. Not surprisingly, they often decide that the benefit of a university
education is not worth the opportunity cost.
opportunity cost
the best alternative
that must be given up
to obtain some item
Principle 3: Rational people think at the margin
rational people
people who
systematically and
purposefully do the
best they can to
achieve their objectives
marginal change
a small incremental
adjustment to a
plan of action
Source: Shutterstock.com/rafapress
Economists normally assume that people are rational. Rational people systematically and
purposefully do the best they can do to achieve their objectives, given the opportunities
they have. As you study economics, you will encounter firms that decide how many workers
to hire and how much of their product to manufacture and sell to maximise profits. You will
encounter individuals who decide how much time to spend working, and what goods and
services to buy with the resulting income to achieve the highest possible level of satisfaction.
Rational people know that decisions in life are rarely black and white but usually involve
shades of grey. At dinnertime, you don’t ask yourself ‘Should I fast or eat like a pig?’ More
likely, the question you face is ‘Should I eat that extra spoonful of mashed potatoes?’ When
exams roll around, your decision is not between blowing them off and studying 24 hours
a day, but whether to spend an extra hour reviewing your notes instead of posting selfies
on Instagram. Economists use the term marginal change to describe a small incremental
adjustment to an existing plan of action. Keep in mind that margin means ‘edge’, so marginal
changes are adjustments around the edges of what you are doing. Rational people often
make decisions by comparing marginal benefits and marginal cost.
For example, suppose you are considering watching a movie tonight. You pay $12 a
month for a streaming service that gives you unlimited access to its films and TV shows,
and you typically watch eight movies a month. What cost should you take into account
when deciding whether to watch another movie? You might at first think the answer
is $12/8, or $1.50, which is the average cost
of a movie. More relevant for your decision,
however, is the marginal cost – the extra cost
that you would incur by streaming another film.
Here, the marginal cost is zero because you pay
the same $12 for the service regardless of how
many movies you watch. In other words, at the
margin, streaming a movie is free. The only cost
of watching a movie tonight is the time it takes
away from other activities, such as working at a
Many streaming services set the
job or (better yet) reading this textbook.
marginal cost of a movie equal to zero.
7
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN
02-200-202
Chapter
1 Ten principles of economics
01_Stonecash_8e_45658_SB_txt.indd 7
24/08/20 5:57 PM
Thinking at the margin also works for business decisions as well. Consider an airline
deciding how much to charge passengers who fly standby. Suppose that flying a 200-seat
plane from Brisbane to Perth costs the airline $100 000. In this case, the average cost of
each seat is $100 000/200, which is $500. One might be tempted to conclude that the airline
should never sell a ticket for less than $500. But the airline can often increase its profits
by thinking at the margin. Imagine that a plane is about to take off with 10 empty seats
and a standby passenger waiting at the gate will pay $300 for a seat. Should the airline sell
the ticket? Of course it should. If the plane has empty seats, the cost of adding one more
passenger is tiny. Although the average cost of flying a passenger is $500, the marginal cost
is merely the cost of the sandwich and coffee that the extra passenger will consume and
the small bit of jet fuel needed to carry the extra passenger’s weight. As long as the standby
passenger pays more than the marginal cost, selling the ticket is profitable. Thus, a rational
airline can increase profits by thinking at the margin.
Marginal decision making can help explain some otherwise puzzling economic
phenomena. Here is a classic question: Why is water so cheap, while diamonds are so
expensive? Humans need water to survive, while diamonds are unnecessary. Yet people are
willing to pay much more for a diamond than for a cup of water. The reason is that a person’s
willingness to pay for a good is based on the marginal benefit that an extra unit of the good
would yield. The marginal benefit, in turn, depends on how many units a person already has.
Although water is essential, the marginal benefit of an extra cup is small because water is
plentiful. By contrast, no one needs diamonds to survive, but because diamonds are so rare,
the marginal benefit of an extra diamond is large.
A rational decision maker takes an action if and only if the action’s marginal benefit
exceeds its marginal cost. This principle explains why people use streaming services as
much as they do, why airlines are willing to sell tickets below average cost, and why people
are willing to pay more for diamonds than for water. It can take some time to get used to the
logic of marginal thinking, but the study of economics will give you ample opportunity to
practise.
Principle 4: People respond to incentives
incentive
something that
induces a person to act
An incentive is something that induces a person to act, such as the prospect of a
punishment or reward. Because rational people make decisions by comparing costs and
benefits, they respond to incentives. You will see that incentives play a central role in the
study of economics. One economist went so far as to suggest that the entire field could be
summarised simply: ‘People respond to incentives. The rest is commentary.’
Incentives are key to analysing how markets work. For example, when the price of apples
rises, people decide to eat fewer apples. At the same time, apple orchards decide to hire more
workers and harvest more apples. In other words, a higher price in a market provides an
incentive for buyers to consume less and an incentive for sellers to produce more. As we
will see, the influence of prices on the behaviour of consumers and producers is crucial to
understanding how the economy allocates scarce resources.
Public policymakers should never forget about incentives. Many policies change the
costs or benefits that people face and, as a result, alter their behaviour. A tax on petrol, for
instance, encourages people to drive smaller, more fuel-efficient cars. That is one reason
people drive smaller cars in Europe and Australia, where petrol taxes are higher, than in
the United States, where petrol taxes are low. A petrol tax also encourages people to take
public transportation rather than drive, to live closer to where they work, or to switch to
electric cars.
When policymakers fail to consider how their policies affect incentives, they often end
up facing unintended consequences. For example, consider public policy towards seat belts
and car safety. Today, all cars have seat belts, but this was not the case in the 1950s. In the
8
Part 1 Introduction
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
01_Stonecash_8e_45658_SB_txt.indd 8
24/08/20 5:57 PM
late 1960s, the rising death toll from motor vehicle accidents generated much public concern
over car safety. State and federal governments responded with laws requiring new cars to
be equipped with seat belts, and requiring drivers and passengers to wear their seat belts.
How does a seat belt law affect car safety? The direct effect is obvious. When a person
wears a seat belt, the likelihood of surviving a major accident rises. But that is not the
end of the story. The law also affects behaviour by altering incentives. The relevant
behaviour here is the speed and care with which drivers operate their cars. Driving
slowly and carefully is costly because it uses the driver’s time and energy. When deciding
how safely to drive, rational people compare, perhaps unconsciously, the marginal
benefit from safer driving with the marginal cost. As a result, they drive more slowly
and carefully when the benefit of increased safety is high. For example, when roads are
wet or visibility is poor, people drive with greater care and attention than they do when
conditions are clear.
Consider how a seat belt law alters a driver’s cost–benefit calculation. Seat belts
make accidents less costly by reducing the risk of injury or death. In other words, seat
belts reduce the benefits of slow and careful driving. People respond to wearing seat
belts as they would to an improvement in road conditions – by driving faster and less
carefully. The result of a seat belt law, therefore, is a larger number of accidents. The
decline in safe driving has a clear, adverse impact on pedestrians, who are more likely
to find themselves in an accident but (unlike the drivers) don’t have seat belts to give
them protection.
At first, this discussion of incentives and seat belts might seem like idle speculation. Yet,
in a classic 1975 study, economist Sam Peltzman argued that car safety laws in the United
States have, in fact, had many of these effects. According to Peltzman’s evidence, US laws
give rise to both fewer deaths per accident, and also to more accidents. He concluded that
the net result was little change in the number of driver deaths and an increase in the number
of pedestrian deaths.
Peltzman’s analysis of car safety is an offbeat and controversial example of the
general principle that people respond to incentives. When analysing any policy, we must
consider not only the direct effects but also the less obvious, indirect effects that work
through incentives. If the policy changes incentives, it will cause people to alter their
behaviour.
Choosing when the stork comes
In the decade between 2004 and 2014, the Australian Government made a payment
to parents for every baby born. These payments were known as the ‘baby bonus’, and
ranged in value between $3000 and $5437 across the lifetime of the scheme. The story of
the baby bonus has lessons for how people respond to incentives and why governments
(and others) need to anticipate these responses.
In May 2004, the then Treasurer, Peter Costello, announced a $3000 payment (rising
to $5000 in 2008) for every child born after 1 July 2004. This meant that the parents
of someone whose birthday was 30 June 2004 or earlier would receive nothing. But
hold off a day or so, and they would get $3000. This created an incentive for parents
to delay births, if they could. And by agreeing with their doctors to schedule planned
caesareans and inductions a little later, births could be moved.
The graph in Figure 1.1 shows what happened.
Notice that there was a dip in births in the last week of June followed by a sharp rise
on 1 July 2004. Indeed, that day had the most number of recorded births on a single
day in Australian history. And if you think this might just be ‘fiddling the books’, 2 July
had the seventh-highest number of births.
CASE
STUDY
9
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN
02-200-202
Chapter
1 Ten principles of economics
01_Stonecash_8e_45658_SB_txt.indd 9
24/08/20 5:57 PM
FIGURE 1.1 Births in Australia, June–July 2004
No. of
births
900
800
700
600
500
400
June 3 June 10 June 17 June 24 July 1
July 7
July 14 July 21 July 28
Source: Joshua Gans and Andrew Leigh, ‘Born on the First of July’, Journal of Public Economics, Vol. 93,
Nos 1–2, February 2009, pp. 246–63.
In their paper ‘Born on the First of July’, Joshua Gans and Andrew Leigh estimated
that 1167 births were shifted from June to July that year, all as a result of the baby bonus.
Medical organisations raised concerns about the health consequences of maternity
hospital congestion caused by this, while economists argued that the policy should have
been ‘phased in’ so there were no big jumps in payments on any given day. Nonetheless,
politicians have failed to heed these warnings. On 1 July 2006, the Howard government
raised the baby bonus by $834. Gans and Leigh again found shifts in birth timing, but of a
lower magnitude (around 700 births).
Source: Joshua Gans and Andrew Leigh, ‘Born on the First of July’, Journal of Public Economics,
Vol. 93, Nos 1–2, February 2009, pp. 246–63.
Questions
1 The federal government ended
baby bonus payments in 2014. What
incentives are created by the ending
of the payments?
2
How would you expect people to
respond to these incentives?
CHECK YOUR UNDERSTANDING
Describe an important trade-off you recently faced. Give an example of some action that
has both a monetary and non-monetary opportunity cost. Describe an incentive your
parents offered you in an effort to influence your behaviour.
LO1.2 How people interact
The first four principles discussed how individuals make decisions. As we go about our lives,
many of our decisions affect not only ourselves but other people as well. The next three
principles present some key ideas about how people interact with one another.
10
Part 1 Introduction
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
01_Stonecash_8e_45658_SB_txt.indd 10
24/08/20 5:57 PM
Principle 5: Trade can make everyone better off
You may have heard on the news how Australian workers compete with overseas workers
for jobs, and Australian businesses compete with overseas firms for sales. In some ways, this
competition is real because Australian workers and firms produce many of the same goods
that are produced overseas. A company mining iron ore in the Pilbara competes for the same
customers as iron ore producers in Brazil, South Africa and Peru. Banks in Victoria compete
with those in Hong Kong and New York to provide financial services.
Yet it is easy to be misled when thinking about competition among countries. Trade
between Australia and another country is not like a sports contest, where one side wins
and the other side loses. The opposite is true: trade between two countries can make each
country better off.
To see why, consider how trade affects your family. When a member of your family looks
for a job, he or she competes against members of other families who are looking for jobs.
Families also compete against one another when they go shopping, because each family
wants to buy the best goods at the lowest prices. So, in a sense, each family in the economy
is competing with all other families.
Despite this competition, your family would not be better off isolating itself from all
other families. If it did, your family would need to grow its own food, sew its own clothes
and build its own home. Clearly, your family gains much from trading with others. Trade
allows each person to specialise in the activities he or she does best, whether it is farming,
sewing or home building. By trading with others, people can buy a greater variety of goods
and services at lower cost.
Like families, countries also benefit from being able to trade with one another. Trade
allows countries to specialise in what they do best and to enjoy a greater variety of goods
and services. The Chinese, the Japanese, the Germans and the Indonesians are as much our
partners in the world economy as they are our competitors.
Outsourcing your own job
The principle that ‘trade can make everyone better off’ is illustrated by this case
of an American software developer who outsourced his own job to China.
IN THE
NEWS
Software developer Bob outsources own job and whiles away
shifts on cat videos
by Caroline Davies
When a routine security check by a US-based company showed someone was
repeatedly logging on to their computer system from China, it naturally sent alarm bells
ringing. Hackers were suspected and telecoms experts were called in.
It was only after a thorough investigation that it was revealed that the culprit was
not a hacker, but ‘Bob’ (not his real name), an ‘inoffensive and quiet’ family man and the
company’s top-performing programmer, who could be seen toiling at his desk day after
day and staring diligently at his monitor.
For Bob had come up with the idea of outsourcing his own job – to China. So, while a
Chinese consulting firm got on with the job he was paid to do, on less than one-fifth of
his salary, he whiled away his working day surfing Reddit, eBay and Facebook.
The extraordinary story has been revealed by Andrew Valentine, senior investigator
at US telecoms firm Verizon Business, on its website, securityblog.verizonbusiness.com.
Verizon’s risk team was called by the unnamed critical infrastructure company last
year, ‘asking for our help in understanding some anomalous activity that they were
witnessing in their VPN logs’, wrote Valentine.
The company had begun to allow its software developers to occasionally work from
home and so had set up ‘a fairly standard VPN [virtual private network] concentrator’ to
facilitate remote access.
11
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN
02-200-202
Chapter
1 Ten principles of economics
01_Stonecash_8e_45658_SB_txt.indd 11
24/08/20 5:57 PM
When its IT security department started actively monitoring logs being generated
at the VPN, ‘What they found startled and surprised them: an open and active VPN
connection from Shenyang, China! As in this connection was live when they discovered
it,’ wrote Valentine.
What was more, the developer whose credentials were being used was sitting at his
desk in the office.
‘Plainly stated, the VPN logs showed him logged in from China, yet the employee is
right there, sitting at his desk, staring into his monitor.’
Verizon’s investigators discovered ‘almost daily connections from Shenyang, and
occasionally these connections spanned the entire workday’.
The employee, whom Valentine calls Bob, was in his mid-40s, a ‘family man,
inoffensive and quiet. Someone you wouldn’t look twice at in an elevator.’
But an examination of his workstation revealed hundreds of pdf invoices from a third
party contractor/developer in Shenyang.
‘As it turns out, Bob had simply outsourced his own job to a Chinese consulting firm.
Bob spent less than one-fifth of his six-figure salary for a Chinese firm to do his job for
him.’
He had physically FedExed his security RSA ‘token’, needed to access the VPN, to China
so his surrogates could log in as him.
When the company checked his web-browsing history, a typical ‘work day’ for Bob
was: 9am, arrive and surf Reddit for a couple of hours, watch cat videos; 11.30am, take
lunch; 1pm, eBay; 2pm-ish, Facebook updates, LinkedIn; 4.40pm–end of day, update
email to management; 5pm, go home.
The evidence, said Valentine, even suggested he had the same scam going across
multiple companies in the area.
‘All told, it looked like he earned several hundred thousand dollars a year, and only
had to pay the Chinese consulting firm about fifty grand annually’.
Meanwhile, his performance review showed that, for several years in a row, Bob had
received excellent remarks for his codes which were ‘clean, well written and submitted
in a timely fashion’.
‘Quarter after quarter, his performance review noted him as the best developer in
the building,’ wrote Valentine.
Bob no longer works for the company.
Source: ‘Software developer Bob outsources own job and whiles away shifts on cat videos’, by
Caroline Davies, The Guardian, 16 January 2013.
Copyright Guardian News & Media Ltd 2020.
Principle 6: Markets are usually a good way to organise economic activity
market economy
an economy that
allocates resources
through the
decentralised decisions
of many firms and
households as they
interact in markets for
goods and services
The collapse of communism in the Soviet Union and Eastern Europe in the late 1980s and
early 1990s was one of the last century’s most transformative events. Communist countries
operated on the premise that government workers were in the best position to guide
economic activity. These workers, called central planners, decided what goods and services
were produced, how much was produced and who produced and consumed these goods and
services. The theory behind central planning was that only the government could organise
economic activity in a way that promoted economic wellbeing for the country as a whole.
Most countries that once had centrally planned economies have abandoned this system
and instead have adopted market economies. In a market economy, the decisions of a
central planner are replaced by the decisions of millions of firms and households. Firms
decide whom to hire and what to make. Households decide which firms to work for and what
to buy with their incomes. These firms and households interact in the marketplace, where
prices and self-interest guide their decisions.
12
Part 1 Introduction
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
01_Stonecash_8e_45658_SB_txt.indd 12
24/08/20 5:57 PM
At first glance, the success of market economies is puzzling. In a market economy, no
one is looking out for the economic wellbeing of society as a whole. Decisions are made by
millions of self-interested households and firms. It might sound like chaos. Yet this is not the
case. Market economies have proven remarkably successful in organising economic activity
to promote overall prosperity.
In his 1776 book An Inquiry into the Nature and Causes of the Wealth of Nations, economist
Adam Smith explained the success of market economies. He noted that households and
firms interacting in markets act as if they are guided by an ‘invisible hand’ that leads them to
desirable market outcomes. One of our goals in this book is to understand how this invisible
hand works its magic.
As you study economics, you will learn that prices are the instrument with which the
invisible hand directs economic activity. In any market, buyers look at the price when
deciding how much to demand, and sellers look at the price when deciding how much to
supply. As a result of these decisions, prices reflect both the value of a good to society and
the cost to society of making the good. Smith’s great insight was that prices adjust to guide
these individual buyers and sellers to reach outcomes that, in many cases, maximise the
wellbeing of society as a whole.
Smith’s insight has an important corollary: When a government prevents prices
from adjusting naturally to supply and demand, it impedes the invisible hand’s ability to
coordinate the millions of households and firms that make up the economy. This corollary
explains why taxes adversely affect the allocation of resources. Taxes distort prices and
thus the decisions of households and firms. It also explains the problems caused by policies
that directly control prices, such as rent control. And it explains the failure of communism.
In communist countries, prices were not determined in the marketplace but were dictated
by government central planners. These planners lacked the necessary information about
consumers’ tastes and producers’ costs, which in a market economy is reflected in prices.
Central planners failed because they tried to run the economy with one hand tied behind
their backs – the invisible hand of the marketplace.
FYI
Adam Smith and the role of markets
Adam Smith is often seen as the founder of modern economics.
When his great book An Inquiry into the Nature and Causes of the
Wealth of Nations was published in 1776, England and Europe
were going through a period of major social, political and economic
upheaval. The Industrial Revolution was changing the economic
landscape just as the American and the French revolutions were
to change the political and social landscape. Smith’s book reflects
a point of view that was gaining importance at the time – that
individuals are usually best left to their own devices, without the
heavy hand of government directing their actions. This political
philosophy provides the intellectual foundation for the market
Adam Smith
economy, and for a free society more generally.
Why do decentralised market economies work well? Is it
because people can be counted on to treat one another with love and kindness? Not at
all. Here is Adam Smith’s description of how people interact in a market economy:
KEY
FIGURES
Man has almost constant occasion for the help of his brethren, and it is in vain for him to
expect it from their benevolence only. He will be more likely to prevail if he can interest
their self-love in his favour, and show them that it is for their own advantage to do for him
what he requires of them … Give me that which I want, and you shall have this which you
13
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN
02-200-202
Chapter
1 Ten principles of economics
01_Stonecash_8e_45658_SB_txt.indd 13
24/08/20 5:57 PM
want, is the meaning of every such offer; and it is in this manner that we obtain from one
another the far greater part of those good offices which we stand in need of.
It is not from the benevolence of the butcher, the brewer, or the baker that we expect
our dinner, but from their regard to their own interest. We address ourselves, not to their
humanity but to their self-love, and never talk to them of our own necessities but of their
advantages. Nobody but a beggar chooses to depend chiefly upon the benevolence of his
fellow-citizens …
Every individual … neither intends to promote the public interest, nor knows how much
he is promoting it … He intends only his own gain, and he is in this, as in many other cases,
led by an invisible hand to promote an end which was no part of his intention. Nor is it
always the worse for the society that it was no part of it. By pursuing his own interest he
frequently promotes that of the society more effectually than when he really intends to
promote it.
Smith is saying that participants in the economy are motivated by self-interest and that
the ‘invisible hand’ of the marketplace guides this self-interest into promoting general
economic wellbeing.
Many of Smith’s insights remain at the centre of modern economics. Our analysis
in the coming chapters will allow us to express Smith’s ideas and conclusions more
precisely and to analyse fully the strengths and weaknesses of a market-based
economy.
Principle 7: Governments can sometimes improve market outcomes
property rights
the ability of an
individual to own and
exercise control over
scarce resources
market failure
a situation in which
a market left on its
own fails to allocate
resources efficiently
externality
the uncompensated
impact of one
person’s actions
on the wellbeing
of a bystander. A
positive externality
makes the bystander
better off. A negative
externality makes the
bystander worse off.
market power
the ability of a single
economic actor
(or small group of
actors) to have a
substantial influence
on market prices
If the invisible hand of the market is so great, why do we need government? One purpose of
studying economics is to refine your view about the proper role and scope of government policy.
One reason we need government is that the invisible hand can work its magic only if
government enforces the rules and maintains the institutions that are key to a market
economy. Most important, markets work only if property rights are enforced so individuals
can own and control scarce resources. A farmer won’t grow food if she expects her crop to
be stolen; a restaurant won’t serve meals unless it is assured that customers will pay before
they leave; and a film company won’t produce movies if too many potential customers avoid
paying by making illegal copies. We all rely on government-provided police and courts to
enforce our rights over the things we produce – and the invisible hand depends on our ability
to enforce those rights.
Another reason we need government is that, although the invisible hand is powerful,
it is not omnipotent. There are two broad rationales for a government to intervene in the
economy and change the allocation of resources that people would choose on their own: to
promote efficiency and to promote equity. That is, most policies aim either to enlarge the
economic pie or to change how the pie is divided.
Consider first the goal of efficiency. Although the invisible hand usually leads markets
to allocate resources to maximise the size of the economic pie, this is not always the case.
Economists use the term market failure to refer to a situation in which the market on
its own fails to allocate resources efficiently. As we will see, one possible cause of market
failure is an externality, which is the impact of one person’s actions on the wellbeing of a
bystander. The classic example of an externality is pollution. When the production of a good
pollutes the air and creates health problems for those who live near the factories, the market
on its own may fail to take this cost into account. Another possible cause of market failure
is market power, which refers to the ability of a single person or firm (or a small group
of them) to unduly influence market prices. For example, suppose that everyone in town
needs water but there is only one well. The owner of the well does not face the rigorous
competition with which the invisible hand normally keeps self-interest in check; she may
take advantage of this opportunity by restricting the output of water so she can charge a
higher price. In the presence of externalities or market power, well-designed public policy
can enhance economic efficiency.
14
Part 1 Introduction
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
01_Stonecash_8e_45658_SB_txt.indd 14
24/08/20 5:57 PM
Now consider the goal of equity. Even when the invisible hand is yielding efficient
outcomes, it can nonetheless leave big differences in economic wellbeing. A market economy
rewards people according to their ability to produce things that other people are willing to
pay for. The world’s best soccer player earns more than the world’s best chess player simply
because people are willing to pay more to see soccer than chess. The invisible hand does not
ensure that everyone has sufficient food, decent clothing and adequate health care. Many
public policies, such as the tax and social welfare systems, aim to achieve a more equitable
distribution of economic wellbeing.
To say that the government can improve on market outcomes at times does not mean
that it always will. Public policy is made by politicians operating in a political process that is
far from perfect. Sometimes policies are designed simply to reward the politically powerful.
Sometimes they are made by well-intentioned leaders who are not fully informed. As you
study economics, you will become a better judge of when a government policy is justifiable
because it promotes efficiency or equity and when it is not.
CHECK YOUR UNDERSTANDING
Why is a country better off not isolating itself from all other countries? Why do we have
markets and, according to economists, what roles should governments play in them?
LO1.3 How the economy as a whole works
We started by discussing how individuals make decisions and then looked at how people
interact with one another. All these decisions and interactions together make up ‘the
economy’. The last three principles concern the workings of the economy as a whole.
Principle 8: A country’s standard of living depends on its ability to produce goods
and services
The differences in living standards around the world are staggering. In 2017, the average
Australian had an income (in US dollars) of about $50 000. In the same year, the average
South Korean earned $37 000, the average New Zealander earned $39 000 and the average
Indian earned $7000. Not surprisingly, this large variation in average income is reflected
in various measures of the quality of life. Citizens of high-income countries have more
computers, more cars, better nutrition, better health care, and longer life expectancy than
do citizens of low-income countries.
Changes in living standards over time are also large. In Australia, incomes have
historically grown about 2 per cent per year (after adjusting for changes in the cost of
living). At this rate, average real income doubles every 35 years.
What explains these large differences in living standards among countries and over
time? The answer is surprisingly simple. Almost all variation in living standards is
attributable to differences in countries’ productivity – that is, the amount of goods and
services produced by each hour of a worker’s time. In nations where workers can produce a
large quantity of goods and services per hour, most people enjoy a high standard of living;
in nations where workers are less productive, most people must endure a more meagre
existence. Similarly, the growth rate of a nation’s productivity determines the growth rate
of its average income.
The relationship between productivity and living standards is simple, but its implications
are far-reaching. If productivity is the primary determinant of living standards, other
productivity
the quantity of goods
and services produced
from each hour of
a worker’s time
15
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN
02-200-202
Chapter
1 Ten principles of economics
01_Stonecash_8e_45658_SB_txt.indd 15
24/08/20 5:57 PM
explanations must be less important. For example, it might be tempting to credit labour
unions or award wage laws for the rise in living standards of Australian workers over the
past century. Yet the real hero of Australian workers is their rising productivity.
The relationship between productivity and living standards also has profound
implications for public policy. When thinking about how any policy will affect living
standards, the key question is how it will affect our ability to produce goods and services.
To boost living standards, policymakers need to raise productivity by ensuring that workers
are well educated, have the tools needed to produce goods and services and have access to
the best available technology.
Principle 9: Prices rise when the government prints too much money
Source: © Tribune Content Agency All rights reserved.
inflation
an increase in the
overall level of prices
in the economy
In January 1921, a daily newspaper in Germany cost 0.30 of a mark. Less than two years
later, in November 1922, the same newspaper cost 70 000 000 marks. All other prices in
the economy rose by similar amounts. This episode is one of history’s most spectacular
examples of inflation, an increase in the overall level of prices in the economy.
Although Australia and New Zealand have never experienced inflation even close to that
in Germany in the 1920s, inflation has at times been an economic problem. During the 1970s,
for instance, the overall level of prices more than doubled, and political leaders lived under
the catchcry ‘Fight Inflation First!’ In contrast, in the first two decades of the twenty-first
century, inflation has run at about 2.5 per cent per year; at this rate, it would take almost 30
years for prices to double. Because high inflation imposes various costs on society, keeping
inflation at a reasonable rate is a goal of economic policymakers around the world.
What causes inflation? In almost all cases of large or persistent inflation, the culprit
is growth in the quantity of money. When a government creates large quantities of the
nation’s money, the value of the money falls. In Germany in the early 1920s, when prices
were on average tripling every month, the quantity of money was also tripling every month.
Although less dramatic, the economic history of Australia, New Zealand and the United
States points to a similar conclusion – the high inflation of the 1970s was associated with
rapid growth in the quantity of money, and the return of low inflation in the 1990s was
associated with slower growth in the quantity of money.
16
Part 1 Introduction
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
01_Stonecash_8e_45658_SB_txt.indd 16
24/08/20 5:57 PM
Principle 10: Society faces a short-run trade-off between inflation
and unemployment
While an increase in the quantity of money primarily has the effect of raising prices in the
long run, in the short run the story is more complex. Most economists describe the short-run
effects of money growth as follows:
• Increasing the amount of money in the economy stimulates the overall level of
spending and thus the demand for goods and services.
• Higher demand may over time cause firms to raise their prices, but in the meantime, it
also encourages them to hire more workers and produce a larger quantity of goods and
services.
• More hiring means lower unemployment.
This line of reasoning leads to one final economy-wide trade-off: a short-run trade-off
between inflation and unemployment.
Although some economists still question these ideas, most accept that society faces
a short-run trade-off between inflation and unemployment. This simply means that, over
a period of a year or two, many economic policies push inflation and unemployment in
opposite directions. Policymakers face this trade-off regardless of whether inflation and
unemployment both start out at high levels (as they did in the 1980s), at low levels (as they
did in the late 1990s), or someplace in between. This short-run trade-off plays a key role in
the analysis of the business cycle – the irregular and largely unpredictable fluctuations in
economic activity, as measured by the production of goods and services or the number of
people employed.
Policymakers can exploit the short-run trade-off between inflation and unemployment
using various policy instruments. By changing the amount that the government spends, the
amount it taxes, and the amount of money it prints, policymakers can influence the overall
demand for goods and services. Changes in demand in turn influence the combination of
inflation and unemployment that the economy experiences in the short run. Because these
instruments of economic policy are so powerful, how policymakers should use them to
control the economy, if at all, is a subject of continuing debate.
business cycle
fluctuations in
economic activity,
such as employment
and production
CHECK YOUR UNDERSTANDING
What factors determine a country’s standard of living? How does printing more money
affect a country’s economy in the long run and in the short run?
Conclusion: The big ideas underpinning economics
You now have a taste of what economics is all about. In the coming chapters, we will develop
many specific insights about people, markets and economies. Mastering these insights will
take some effort, but the task is not overwhelming. The field of economics is based on a few
big ideas that can be applied in many different situations.
17
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN
02-200-202
Chapter
1 Ten principles of economics
01_Stonecash_8e_45658_SB_txt.indd 17
24/08/20 5:57 PM
Throughout this book, we will refer to the Ten Principles of Economics introduced in this
chapter and summarised in Table 1.1. Keep these building blocks in mind: Even the most
sophisticated economic analysis is founded on these 10 principles.
TABLE 1.1 Ten principles of economics
How people make decisions
1: People face trade-offs.
2: The cost of something is what you give up to get it.
3: Rational people think at the margin.
4: People respond to incentives.
How people interact
5: Trade can make everyone better off.
6: Markets are usually a good way to organise economic activity.
7: Governments can sometimes improve market outcomes.
How the economy as a whole
works
8: A country’s standard of living depends on its ability to produce
goods and services.
9: Prices rise when the government prints too much money.
10: S
ociety faces a short-run trade-off between inflation and
unemployment.
18
Part 1 Introduction
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
01_Stonecash_8e_45658_SB_txt.indd 18
24/08/20 5:57 PM
LO1.1 The fundamental lessons about individual decision making are that people face tradeoffs among alternative goals, that the cost of any action is measured in terms of forgone
opportunities, that rational people make decisions by comparing marginal costs and
marginal benefits, and that people change their behaviour in response to the incentives
they face.
LO1.2 The fundamental lessons about interactions among people are that trade can be
mutually beneficial, that markets are usually a good way of coordinating trade among
people, and that governments can potentially improve market outcomes if there is
some market failure or if the market outcome is inequitable.
LO1.3 The fundamental lessons about the economy as a whole are that productivity is
the ultimate source of living standards, that money growth is the ultimate source
of inflation, and that society faces a short-run trade-off between inflation and
unemployment.
Key concepts
business cycle, p. 17
economics, p. 5
efficiency, p. 6
equity, p. 6
externality, p. 14
incentive, p. 8
inflation, p. 16
marginal change, p. 7
market economy, p. 12
market failure, p. 14
market power, p. 14
opportunity cost, p. 7
productivity, p. 15
property rights, p. 14
rational people, p. 7
scarcity, p. 5
STUDY TOOLS
Summary
Apply and revise
1 Give three examples of important trade-offs that you face in your life.
2What alternatives would you include when determining your opportunity cost of a dinner at
a fancy restaurant?
3 Water is necessary for life. Is the marginal benefit of a glass of water large or small?
4 Why should policymakers think about incentives?
5 Why isn’t trade among countries like a game with some winners and some losers?
6 What does the ‘invisible hand’ of the marketplace do?
7 What are ‘efficiency’ and ‘equity’, and what do they have to do with government policy?
8 Why is productivity important?
9 What is inflation, and what causes it?
10 How are inflation and unemployment related in the short run?
Practice questions
Multiple choice
1
2
Economics is best defined as the study of
a how society manages its scarce resources.
b how to run a business most profitably.
c how to predict inflation, unemployment and stock prices.
d how the government can stop the harm from unchecked self-interest.
Your opportunity cost of going to a movie is
a the price of the ticket.
b the price of the ticket plus the cost of any drink and popcorn you buy at the theatre.
c the total cash expenditure needed to go to the movie plus the value of your time.
d zero, as long as you enjoy the movie and consider it a worthwhile use of time and
money.
19
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN
02-200-202
Chapter
1 Ten principles of economics
01_Stonecash_8e_45658_SB_txt.indd 19
24/08/20 5:57 PM
3
4
5
6
A marginal change is one that
a is not important for public policy.
b incrementally alters an existing plan.
c makes an outcome inefficient.
d does not influence incentives.
Adam Smith’s ‘invisible hand’ refers to
a the subtle and often hidden methods that businesses use to profit at consumers’
expense.
b the ability of free markets to reach desirable outcomes, despite the self-interest of
market participants.
c the ability of government regulation to benefit consumers, even if the consumers are
unaware of the regulations.
d the way in which producers or consumers in unregulated markets impose costs.
Governments may intervene in a market economy in order to
a protect property rights.
b correct a market failure due to externalities.
c achieve a more equal distribution of income.
d all of the above
If a nation has high and persistent inflation, the most likely explanation is
a the central bank creating excessive amounts of money.
b unions bargaining for excessively high wages.
c the government imposing excessive levels of taxation.
d firms using their monopoly power to enforce excessive price hikes.
Problems and applications
1
2
3
4
5
6
7
Describe some of the trade-offs faced by each of the following:
a a family deciding whether to buy a new car
b a politician deciding how much to increase spending on national parks
c a company director deciding whether to open a new factory
d a professor deciding how much to prepare for a lecture
e a recent university graduate deciding whether to undertake graduate studies.
You are trying to decide whether to take a holiday. Most of the costs of the holiday
(airfare, hotel, forgone wages) are measured in dollars, but the benefits of the holiday are
psychological. How can you compare the benefits with the costs?
You were planning to spend Saturday working at your part-time job, but a friend asks you
to go swimming at the beach. What is the true cost of going swimming? Now suppose that
you had been planning to spend the day studying at the library. What is the cost of going
swimming in this case? Explain.
You win $100 in a lottery. You have a choice between spending the money now and putting
it away for a year in a bank account that pays 5 per cent interest. What is the opportunity
cost of spending the $100 now?
The company that you manage has invested $5 million in developing a new product, but
the development is not quite finished. At a recent meeting, your salespeople report that the
introduction of competing products has reduced the expected sales of your new product to
$3 million. If it would cost $1 million to finish development, should you go ahead and do so?
What is the most that you should pay to complete development?
There has been some discussion about changes to unemployment benefits that will result
in payments being withdrawn after two years for those able to work.
a How do these changes in the laws affect the incentives for working?
b How might these changes represent a trade-off between equity and efficiency?
Explain whether each of the following government activities is motivated by a concern
about equity or a concern about efficiency. In the case of efficiency, discuss the type of
market failure involved.
a regulating fixed-line telephone prices
b providing some poor people with vouchers that can be used to buy food
c prohibiting smoking in public places
20
Part 1 Introduction
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
01_Stonecash_8e_45658_SB_txt.indd 20
24/08/20 5:57 PM
d breaking up Google and Facebook into smaller companies, each focused on a different
product (for example, search, advertising, mobile operating systems)
e imposing higher personal income tax rates on people with higher incomes
f instituting laws against driving while intoxicated.
8 Discuss each of the following statements from the standpoints of equity and efficiency:
a ‘Everyone in society should be guaranteed the best health care possible.’
b ‘The minimum wage should provide each worker with sufficient income to enjoy a
comfortable standard of living.’
9In what ways is your standard of living different from that of your parents or grandparents
when they were your age? Why have these changes occurred?
10 Suppose Australians decided to save more of their incomes. If banks lend this money to
businesses, which use the money to build new factories, how might higher saving lead
to faster productivity growth? Who do you suppose benefits from higher productivity? Is
society getting a free lunch?
11 Printing money to cover expenditures is sometimes referred to as an ‘inflation tax’. Who do
you think is being ‘taxed’ when more money is printed? Why?
21
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN
02-200-202
Chapter
1 Ten principles of economics
01_Stonecash_8e_45658_SB_txt.indd 21
24/08/20 5:57 PM
2
Thinking like
an economist
Learning objectives
After reading this chapter, you should be able to:
LO2.1 explain how economists apply the methods of science and use models, to shed
light on the world
LO2.2 differentiate between positive and normative statements, and discuss the role of
economists in making policy
LO2.3 explain why economists sometimes disagree with one another.
22
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
02_Stonecash_8e_45658_SB_txt.indd 22
24/08/20 5:59 PM
Introduction
Every field of study has its own language and its own way of thinking. Mathematicians talk
about axioms, integrals and vector spaces. Psychologists talk about ego, id and cognitive
dissonance. Lawyers talk about premeditation, torts and promissory estoppel.
Economics is no different. Supply, demand, elasticity, comparative advantage, consumer
surplus, deadweight loss – these terms are part of the economist’s language. In the coming
chapters, you will encounter many new terms and some familiar words that economists use
in specialised ways. At first, this new language may seem needlessly obscure. But, as you
will see, its value lies in its ability to provide you with a new and useful way of thinking
about the world in which you live.
The purpose of this book is to help you learn the economist’s way of thinking. Just as
you cannot become a mathematician, psychologist or lawyer overnight, learning to think
like an economist will take some time. Yet, with a combination of theory, case studies and
examples of economics in the news, this book will give you ample opportunity to develop
and practise this skill.
Before delving into the substance and details of economics, it is helpful to have an
overview of how economists approach the world. This chapter, therefore, discusses the
field’s methodology. What is distinctive about how economists confront a question? What
does it mean to think like an economist?
elasticity
a measure of the
responsiveness of
quantity demanded
or quantity supplied
to one of its
determinants
LO2.1 The economist as scientist
Economists try to tackle their subject with a scientist’s objectivity. They approach the study
of the economy in much the same way as a physicist approaches the study of matter and a
biologist approaches the study of life: They devise theories, collect data and then analyse
these data in an attempt to verify or refute their theories.
To beginners, the claim that economics is a science can seem odd. After all, economists
do not work with test tubes or telescopes. The essence of science, however, is the scientific
method – the dispassionate development and testing of theories about how the world
works. This method of inquiry is as applicable to studying a nation’s economy as it is to
studying the earth’s gravity or a species’ evolution. As Albert Einstein once put it: ‘The
whole of science is nothing more than a refinement of everyday thinking.’
Although Einstein’s comment is as true for social sciences – such as economics – as it is
for natural sciences such as physics, most people are not accustomed to looking at society
through the scientific lens. So let’s discuss some of the ways in which economists apply the
logic of science to examine how an economy works.
scientific method
the dispassionate
development and
testing of theories
about how the
world works
The scientific method: Observation, theory and more observation
Isaac Newton, the seventeenth-century scientist and mathematician, is said to have
become intrigued one day when he saw an apple fall from an apple tree. This observation
motivated Newton to develop a theory of gravity that applies not only to an apple falling
to the ground but also to any two objects in the universe. Subsequent testing of Newton’s
theory has shown that it works well in many circumstances (but not all, as Einstein would
later show). Because Newton’s theory has been so successful at explaining what we observe
around us, it is still taught in undergraduate physics courses around the world.
23
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN
02-200-202
Chapter
2 Thinking like an economist
02_Stonecash_8e_45658_SB_txt.indd 23
24/08/20 5:59 PM
Source: PEANUTS © 1989 Peanuts
Worldwide LLC. Dist. By ANDREWS
MCMEEL SYNDICATION. Reprinted with
permission. All rights reserved.
randomised
controlled trials
conducting a trial
where participants are
separated into two
groups (a treatment
and a control) in order
to identify the impact
of a policy change
This interplay between theory and observation also occurs in economics. An economist
might live in a country experiencing rapid increases in prices and be moved by this
observation to develop a theory of inflation. The theory might assert that high inflation
arises when the government prints too much money. To test this theory, the economist
could collect and analyse data on prices and money from many different countries. If
growth in the quantity of money were completely unrelated to the rate of price increase, the
economist would start to doubt the validity of this theory of inflation. If money growth and
inflation were strongly correlated in international data, as in fact they are, the economist
would gain confidence in the theory.
Although economists use theory and observation like other scientists, they face an
obstacle that makes their task especially challenging: In economics, conducting experiments
is challenging. Physicists studying gravity can drop many objects in their laboratories to
generate data to test their theories. By contrast, economists studying inflation are not
allowed to manipulate a nation’s monetary policy simply to generate useful data. Economists,
like astronomers and evolutionary biologists, usually have to make do with whatever data
the world gives them. Nonetheless, in some important domains, economists have been able
to engage in randomised controlled trials. MIT professor Amy Finkelstein led a study in
Oregon that examined how the introduction of public health insurance impacted health,
health care use, financial security (increasing them) and emergency room use (having no
effect). It was able to do this because it set up a real-world situation where some people
received public insurance while others did not.
To find a substitute for laboratory experiments, economists pay close attention to the
natural experiments offered by history. When a war in the Middle East interrupts the supply
of crude oil, for instance, oil prices around the world skyrocket. For consumers of oil and oil
products, such an event depresses living standards. For economic policymakers, it poses a
difficult choice about how best to respond. But for economic scientists, the event provides
an opportunity to study the effects of a key natural resource on the world’s economies, and
this opportunity persists long after the wartime increase in oil prices is over. Throughout
this book, therefore, we consider many historical episodes. Studying these episodes is
valuable because they give us insight into the economy of the past and, more importantly,
because they allow us to illustrate and evaluate economic theories of the present.
The role of assumptions
If you ask a physicist how long it would take for a marble to fall from the top of a 10-storey
building, she will answer the question by assuming that the marble falls in a vacuum. Of
course, this assumption is false. In fact, the building is surrounded by air, which exerts
friction on the falling marble and slows it down. Yet the physicist will correctly point out
that friction on the marble is so small that its effect would be negligible in this instance.
Assuming the marble falls in a vacuum greatly simplifies the problem without substantially
affecting the answer.
24
Part 1 Introduction
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
02_Stonecash_8e_45658_SB_txt.indd 24
24/08/20 5:59 PM
Economists make assumptions for the same reason. Assumptions can simplify the
complex world and make it easier to understand. To study the effects of international
trade, for example, we may assume that the world consists of only two countries and that
each country produces only two goods. In reality, there are many countries, each of which
produces thousands of different types of goods. But by considering a world with only two
countries and two goods, we can focus our thinking on the essence of the problem. Once we
understand international trade in this simplified imaginary world, we are in a better position
to understand international trade in the more complex world in which we live.
The art in scientific thinking – whether in physics, biology or economics – is deciding
which assumptions to make. Suppose, for instance, that instead of dropping a marble from
the top of the building, we were dropping a beach ball of the same weight. Our physicist
would realise that the assumption of no friction is far less accurate in this case: Friction
exerts a greater force on the beach ball because it is much larger than a marble. The
assumption that gravity works in a vacuum is reasonable when studying a falling marble
but not when studying a falling beach ball.
Similarly, economists use different assumptions to answer different questions. Suppose
that we want to study what happens to the economy when the government changes the
number of dollars in circulation. An important piece of this analysis, it turns out, is how
prices respond. Many prices in the economy change infrequently. The supermarket price
of milk, for instance, changes only once every few years. Knowing this fact may lead us to
make different assumptions when studying the effects of the policy change over different
time horizons. For studying the short-run effects of the policy, we may assume that prices do
not change much. We may even make the extreme assumption that all prices are completely
fixed. For studying the long-run effects of the policy, however, we may assume that all prices
are completely flexible. Just as a physicist uses different assumptions when studying falling
marbles and falling beach balls, economists use different assumptions when studying the
short-run and long-run effects of a change in the quantity of money.
Economic models
Secondary school biology teachers teach basic anatomy with plastic replicas of the
human body. These models have all the major organs – the heart, the liver, the kidneys
and so on – and allow teachers to show their students in a simple way how the important
parts of the body fit together. Because these plastic models are not actual human bodies,
no one would mistake the model for a real person. Despite this lack of realism – indeed,
because of this lack of realism – studying these models is useful for learning how the
human body works.
Economists also use models to learn about the world, but instead of being made of plastic,
their models mostly consist of diagrams and equations. Like a biology teacher’s plastic
model, economic models omit many details to allow us to see what is truly important. Just
as the biology teacher’s model does not include all of the body’s muscles and blood vessels,
an economist’s model does not include every feature of the economy.
As we use models to examine various economic issues throughout this book, you will
see that all the models are built on assumptions. Just as a physicist begins the analysis of a
falling marble by assuming away the existence of friction, economists assume away many
details of the economy that are irrelevant to the question at hand. All models – in physics,
biology or economics – simplify reality in order to improve our understanding of it.
Our first model: The circular-flow diagram
The economy consists of millions of people engaged in many activities – buying, selling,
working, hiring, manufacturing and so on. To understand how the economy works, we must
find some way to simplify our thinking about all these activities. In other words, we need a
25
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN
02-200-202
Chapter
2 Thinking like an economist
02_Stonecash_8e_45658_SB_txt.indd 25
24/08/20 5:59 PM
circular-flow
diagram
a visual model of
the economy that
shows how dollars
flow through markets
among households
and firms
model that explains, in general terms, how the economy is organised and how participants
in the economy interact with one another.
Figure 2.1 presents a visual model of the economy, called a circular-flow diagram. In
this model, the economy has two types of decision makers: households and firms. Firms
produce goods and services using various inputs, such as labour, land and capital (buildings
and machines). These inputs are called the factors of production. Households own the factors
of production and consume all the goods and services that the firms produce.
FIGURE 2.1 The circular flow
Revenue
Goods
and services
sold
FIRMS
• Produce and sell
goods and services
• Hire and use factors
of production
Inputs for
production
Wages, rent
and profit
MARKETS
FOR
GOODS AND SERVICES
• Firms sell
• Households buy
Spending
Goods and
services
bought
HOUSEHOLDS
• Buy and consume
goods and services
• Own and sell factors
of production
Labour, land
MARKETS
and capital
FOR
FACTORS OF PRODUCTION
• Households sell
Income
• Firms buy
Flow of goods
and services
Flow of dollars
This diagram is a schematic representation of the organisation of the economy. Decisions are
made by households and firms. Households and firms interact in the markets for goods and
services (where households are buyers and firms are sellers) and in the markets for the factors of
production (where firms are buyers and households are sellers). The outer set of arrows shows the
flow of dollars and the inner set of arrows shows the corresponding flow of goods and services.
Households and firms interact in two types of markets. In the markets for goods and services,
households are buyers and firms are sellers. In particular, households buy the output of goods
and services that firms produce. In the markets for the factors of production, households are
sellers and firms are buyers. In these markets, households provide firms with the inputs that
the firms use to produce goods and services. The circular-flow diagram offers a simple way of
organising all the transactions that occur between households and firms in the economy.
The two loops in the circular-flow diagram are distinct but related. The inner loop of
the diagram represents the flows of inputs and outputs. Households sell the use of their
labour, land and capital to the firms in the markets for the factors of production. Firms then
use these factors to produce goods and services. The outer loop of the circular-flow diagram
represents the corresponding flow of dollars. Households spend money to buy goods and
services from the firms. Firms use some of the revenue from these sales to pay for the factors
of production, such as the wages of their workers. What is left is the profit for the firm
owners, who themselves are members of households.
26
Part 1 Introduction
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
02_Stonecash_8e_45658_SB_txt.indd 26
24/08/20 5:59 PM
Let’s take a tour of the circular flow by following a dollar coin as it makes its way from
person to person through the economy. Imagine that the dollar begins at a household, sitting
in, say, your pocket. If you want to buy a latté, you take the dollar (along with a few other
coins) to the market for coffee, which is one of the many markets for goods and services. When
you buy your favourite drink at your local cafe, the dollar moves into the cafe’s cash register,
becoming revenue for the firm. The dollar doesn’t stay at the cafe for long, however, because
that firm spends it on inputs in the markets for factors of production. For instance, the cafe
might use the dollar to pay rent to its landlord for the space it occupies or to pay the wages of
its workers. In either case, the dollar enters the income of some household and, once again, is
back in someone’s pocket. At that point, the story of the economy’s circular flow starts again.
The circular-flow diagram is a very simple model of the economy. A more complex and realistic
circular-flow model would include, for instance, the roles of government and international
trade. (A portion of that dollar you gave to the cafe might be used to pay taxes or to buy coffee
beans from a farmer in Ecuador.) Yet these details are not crucial for a basic understanding of
how the economy is organised. Because of its simplicity, this circular-flow diagram is useful to
keep in mind when thinking about how the pieces of the economy fit together.
Our second model: The production possibilities frontier
Most economic models, unlike the circular-flow diagram, are built using the tools of
mathematics. Here we consider one of the simplest models, called the production possibilities
frontier, and see how this model illustrates some basic economic ideas.
Although real economies produce thousands of goods and services, let’s imagine an
economy that produces only two goods – cars and computers. Together, the car industry
and the computer industry use all of the economy’s factors of production. The production
possibilities frontier is a graph that shows the various combinations of output – in this
case, cars and computers – that the economy can possibly produce given the available
factors of production and the available production technology that firms can use to turn
these factors into output.
Figure 2.2 is an example of a production possibilities frontier. In this economy, if all
resources were used in the car industry, the economy would produce 1000 cars and no
computers. If all resources were used in the computer industry, the economy would produce
3000 computers and no cars. The two end points of the production possibilities frontier
represent these extreme possibilities.
More likely, the economy divides its resources between the two industries, producing
some cars and some computers. For example, it could produce 700 cars and 2000 computers,
shown in the figure by point A. Or, by moving some of the factors of production to the
computer industry from the car industry, the economy can produce 600 cars and 2200
computers, represented by point C.
Because resources are scarce, not every conceivable outcome is feasible. For example,
no matter how resources are allocated between the two industries, the economy cannot
produce the amount of cars and computers represented by point D. Given the technology
available for manufacturing cars and computers, the economy does not have the factors
of production to support that level of output. With the resources it has, the economy can
produce at any point on or inside the production possibilities frontier, but it cannot produce
at points outside the frontier.
An outcome is said to be efficient if the economy is getting all it can from the scarce
resources it has available. Points on (rather than inside) the production possibilities frontier
represent efficient levels of production. When the economy is producing at such a point, say
point A, there is no way of producing more of one good without producing less of the other.
The same holds for point C. But point B represents an inefficient outcome. For some reason,
perhaps widespread unemployment, the economy is producing less than it could from the
production
possibilities frontier
a graph that shows the
various combinations
of output that the
economy can possibly
produce given the
available factors of
production and the
available production
technology
27
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN
02-200-202
Chapter
2 Thinking like an economist
02_Stonecash_8e_45658_SB_txt.indd 27
24/08/20 5:59 PM
FIGURE 2.2 The production possibilities frontier
Quantity of
computers
produced
3000
D
C
2200
A
2000
1000
0
Production
possibilities
frontier
B
300
600 700
1000
Quantity of
cars produced
The production possibilities frontier shows the combinations of output – in this case, cars
and computers – that the economy can possibly produce. The economy can produce any
combination on or inside the frontier. Points outside the frontier are not feasible given
the economy’s resources. The slope of the production possibilities frontier measures the
opportunity cost of a car in terms of computers. This opportunity cost varies, depending on how
much of the two goods the economy is producing.
resources it has available – it is producing only 300 cars and 1000 computers. If the source
of the inefficiency is eliminated, the economy can increase its production of both goods. For
example, if the economy moves from point B to point C, its production of cars increases from
300 to 600, and its production of computers increases from 1000 to 2200.
One of the Ten Principles of Economics discussed in Chapter 1 is that people face tradeoffs. The production possibilities frontier shows one trade-off that society faces. Once we
have reached an efficient point on the frontier, the only way of producing more of one good is
to produce less of the other. When the economy moves from point C to point A, for instance,
society produces 100 more cars, but at the expense of producing 200 fewer computers.
This trade-off helps us to understand another of the Ten Principles of Economics: the cost
of something is what you give up to get it. This is called the opportunity cost. The production
possibilities frontier shows the opportunity cost of one good as measured in terms of the
other good. When society moves from point C to point A, it gives up 200 computers to get
100 additional cars. That is, at point C, the opportunity cost of 100 cars is 200 computers. Put
another way, the opportunity cost of each car is two computers. Notice that the opportunity
cost of a car equals the slope of the production possibilities frontier. (Slope is discussed in
the graphing appendix to this chapter.)
The opportunity cost of a car in terms of the number of computers is not constant in
this economy but depends on how many cars and computers the economy is producing.
This is reflected in the shape of the production possibilities frontier. Because the production
possibilities frontier in Figure 2.2 is bowed outward, the opportunity cost of a car is highest
when the economy is producing many cars and few computers, where the frontier is steep.
When the economy is producing few cars and many computers, the frontier is flatter, and
the opportunity cost of a car is lower.
28
Part 1 Introduction
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
02_Stonecash_8e_45658_SB_txt.indd 28
24/08/20 5:59 PM
Economists believe that production possibilities frontiers often have this bowed-out
shape. When the economy is using most of its resources to make computers, the production
possibilities frontier is relatively flat. Workers and machines best suited to making cars, like
skilled autoworkers, are being used to make computers. If some of these skilled autoworkers
are moved from computer production to the car industry, the economy will not have to
sacrifice much computer production in order to increase car production. Each computer the
economy gives up yields a substantial increase in the number of cars. The opportunity cost
of a car, in terms of computers forgone, is small. In contrast, when the economy is using
most of its resources to make cars, the production possibilities frontier is quite steep. In this
case, the resources best suited to making cars are already in the car industry. Producing an
additional car means moving some of the best computer technicians out of the computer
industry and making them autoworkers. As a result, producing an additional car will mean a
substantial loss of computer output. The opportunity cost of a car is high, and the production
possibilities frontier is steep.
The production possibilities frontier shows the trade-off between the production of
different goods at a given time, but the trade-off can change over time. For example, suppose
a technological advance in the computer industry raises the number of computers that a
worker can produce each week. This advance expands society’s set of opportunities. For
any given number of cars, the economy can make more computers. If the economy does not
produce any computers, it can still only produce 1000 cars, so one end point of the frontier
stays the same. But if the economy devotes some of its resources to the computer industry,
it will produce more computers from those resources. As a result, the production possibilities
frontier shifts outwards, as in Figure 2.3.
FIGURE 2.3 A shift in the production possibilities frontier
Quantity of
computers
produced
4000
3000
2100
2000
0
E
A
700 750
1000
Quantity of
cars produced
A technological advance in the computer industry shifts the production possibilities frontier
outwards, increasing the number of cars and computers the economy can produce.
29
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN
02-200-202
Chapter
2 Thinking like an economist
02_Stonecash_8e_45658_SB_txt.indd 29
24/08/20 5:59 PM
This figure shows what happens when an economy grows. Society can move production
from a point on the old frontier to a point on the new frontier. Which point it chooses
depends on its preferences for the two goods. In this example, society moves from point A to
point E, enjoying more computers (2100 instead of 2000) and more cars (750 instead of 700).
The production possibilities frontier simplifies a complex economy to highlight some
basic but powerful ideas: scarcity, efficiency, trade-offs, opportunity cost and economic
growth. As you study economics, these ideas will recur in various forms. The production
possibilities frontier offers one simple way of thinking about them.
Microeconomics and macroeconomics
microeconomics
the study of how
households and
firms make decisions
and how they
interact in markets
macroeconomics
the study of economywide phenomena,
including inflation,
unemployment and
economic growth
Many subjects are studied on various levels. Consider biology, for example. Molecular
biologists study the chemical compounds that make up living things. Cellular biologists
study cells, which are made up of many chemical compounds and, at the same time, are
themselves the building blocks of living organisms. Evolutionary biologists study the many
varieties of animals and plants and how species change gradually over the centuries.
Economics is also studied on various levels. We can study the decisions of individual
households and firms. We can study the interaction of households and firms in markets for
specific goods and services. Or we can study the operation of the economy as a whole, which
is just the sum of the activities of all these decision makers in all these markets.
The field of economics is traditionally divided into two broad subfields. Microeconomics
is the study of how households and firms make decisions and how they interact in specific
markets. Macroeconomics is the study of economy-wide phenomena. A microeconomist
might study the effects of the discovery of a new gas reserve in Queensland on energy
production, the impact of foreign competition on the domestic car industry or the effects
of education on workers’ earnings. A macroeconomist might study the effects of borrowing
by the federal government, the changes over time in the economy’s unemployment rate, or
alternative policies to raise growth in national living standards.
Microeconomics and macroeconomics are closely intertwined. Because changes in the
overall economy arise from the decisions of millions of individuals, it is impossible to understand
macroeconomic developments without considering the underlying microeconomic decisions.
For example, a macroeconomist might study the effect of a cut in income tax on the overall
production of goods and services. But to analyse this issue, the macroeconomist must consider
how the tax cut affects households’ decisions about how much to spend on goods and services.
Despite the inherent link between microeconomics and macroeconomics, the two fields
are distinct. Because microeconomics and macroeconomics tackle different questions, each
field has its own set of models, which are often taught in separate courses.
CHECK YOUR UNDERSTANDING
In what sense is economics like a science? Draw a production possibilities frontier for
a society that produces food and clothing. Show an efficient point, an inefficient point
and an infeasible point. Show the effects of a drought. Define microeconomics and
macroeconomics.
LO2.2 The economist as adviser
Often, economists are asked to explain the causes of economic events. Why, for example,
is unemployment higher for teenagers than for older workers? Sometimes economists are
asked to recommend policies to improve economic outcomes. What, for instance, should
30
Part 1 Introduction
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
02_Stonecash_8e_45658_SB_txt.indd 30
24/08/20 5:59 PM
the government do to improve the economic wellbeing of teenagers? When economists are
trying to explain the world, they are scientists. When they are helping to improve it, they
are policy advisers.
Positive versus normative analysis
To help clarify the two roles that economists play, let’s examine the use of language. Because
scientists and policymakers have different goals, they use language in different ways.
For example, suppose that two people are discussing minimum-wage laws. Here are two
statements you might hear:
Polly:
Minimum-wage laws cause unemployment.
Norma: The government should raise the minimum wage.
Ignoring for now whether you agree with these statements, notice that Polly and Norma
differ in what they are trying to do. Polly is speaking like a scientist – she is making a claim
about how the world works. Norma is speaking like a policymaker – she is making a claim
about how she would like to change the world.
In general, statements about the world are of two types. One type, such as Polly’s, is
positive. Positive statements are descriptive. They make a claim about how the world is.
A second type of statement, such as Norma’s, is normative. Normative statements are
prescriptive. They make a claim about how the world ought to be.
A key difference between positive and normative statements is how we judge their
validity. We can, in principle, confirm or refute positive statements by examining evidence.
An economist might evaluate Polly’s statement by analysing data on changes in minimum
wages and changes in unemployment over time. In contrast, evaluating normative
statements involves values as well as facts. Norma’s statement cannot be judged using data
alone. Deciding what is good or bad policy is not merely a matter of science. It also involves
our views on ethics, religion and political philosophy.
Positive and normative statements are fundamentally different, but within a person’s
set of beliefs, they are often intertwined. In particular, positive views about how the world
works affect our normative views about what policies are desirable. Polly’s claim that the
minimum wage causes unemployment, if true, might lead us to reject Norma’s conclusion
that the government should raise the minimum wage. Yet our normative conclusions cannot
come from positive analysis alone; they involve value judgements as well.
As you study economics, keep in mind the distinction between positive and normative
statements because it will help you stay focused on the task at hand. Much of economics is
positive: It just tries to explain how the economy works. Yet those who use economics often
have normative goals: They want to learn how to improve the economy. When you hear
economists making normative statements, you know they are speaking not as scientists
but as policy advisers.
positive statements
claims that attempt
to describe the
world as it is
normative
statements
claims that attempt
to prescribe how the
world should be
Economists in government
Former US President Harry Truman once said that he wanted to find a one-armed economist.
When he asked his economists for advice, they always answered, ‘On the one hand … On the
other hand …’
Truman was right in realising that economists’ advice is not always straightforward.
This tendency is rooted in one of the Ten Principles of Economics in Chapter 1 – people face
trade-offs. Economists are aware that trade-offs are involved in most policy decisions. A
policy might increase efficiency at the cost of equity. It might help future generations but
hurt the current generation. An economist who says that all policy decisions are easy or
clear-cut is an economist not to be trusted.
31
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN
02-200-202
Chapter
2 Thinking like an economist
02_Stonecash_8e_45658_SB_txt.indd 31
24/08/20 5:59 PM
Today, you can find economists involved in many areas of government decision making.
Economists have a valuable role to play in government precisely because they understand
that all decisions involve trade-offs, and because they are skilled in evaluating those tradeoffs. Economists are also able to use another of the Ten Principles of Economics – people respond
to incentives – to identify possible unintended consequences of policy proposals. We saw an
example of this in the ‘baby bonus’ case study in Chapter 1, and unintended consequences of
well-meaning policies is a theme that we will return to often throughout this book.
In Australia, economists skilled in macroeconomics work in the Treasury and the
Department of Finance to provide advice on taxation and fiscal policy, and in the Reserve
Bank studying monetary and financial issues. Economists skilled in microeconomics
work in the Productivity Commission advising the government on microeconomic reform,
and at the Australian Competition and Consumer Commission advising on issues related
to competition policy. Economists in all areas of government are supported by their
colleagues at the Australian Bureau of Statistics, who construct the statistical information
that is used in a wide variety of government decision making and economic research.
Political parties seek the input of economists in developing the policies that they take to
elections. After all, economic ‘credibility’ is often a prominent issue in election campaigns.
Politicians, of all parties, rely on the economists in the Parliamentary Budget Office to provide
non-partisan costings of their proposed policies, and independent analysis of economic and
budgetary issues.
The influence of economists on policy goes beyond their role as advisers and policymakers;
their research and writings can affect policy indirectly. Economist John Maynard Keynes
offered this observation:
KEY
FIGURES
The ideas of economists and political philosophers, both when they are right and
when they are wrong, are more powerful than is commonly understood. Indeed,
the world is ruled by little else. Practical men, who believe themselves to be
quite exempt from intellectual influences, are usually the slaves of some defunct
economist. Madmen in authority, who hear voices in the air, are distilling their
frenzy from some academic scribbler of a few years back.
These words were written in 1935, but they remain true today. Indeed, the ‘academic
scribbler’ now influencing public policy is often Keynes himself.
Why economists’ advice is not always followed
Economists who advise the government know that their recommendations are not always
heeded. Frustrating as this can be, it is easy to understand. The process by which economic
policy is actually made differs in many ways from the idealised policy process assumed in
economics textbooks.
Throughout this text, whenever we discuss economic policy, we often focus on one
question: What is the best policy for the government to pursue? We act as if policy were set
by a benevolent queen. Once the queen determines the ‘right’ policy, she has no difficulty
putting her ideas into action.
In the real world, determining the right policy is only part of a leader’s job, sometimes
the easiest part. After the prime minister hears from her economic advisers what policy
they deem best, she turns to other advisers for related input. The prime minister’s
communications advisers will tell her how best to explain the proposed policy to the public,
and they will try to anticipate any misunderstandings that might make the challenge more
difficult. Her press advisers will tell her how the news media will report on her proposal
and what opinions will likely be expressed on the nation’s editorial pages. Her legislative
advisers will tell her how parliament will view the proposal, what amendments members of
the Senate will suggest, and the likelihood that the two houses of parliament will pass some
32
Part 1 Introduction
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
02_Stonecash_8e_45658_SB_txt.indd 32
24/08/20 5:59 PM
version of the prime minister’s proposal into law. Her political advisers will tell her which
groups will organise to support or oppose the proposed policy, how this proposal will affect
her standing among different groups in the electorate, and whether it will change support
for any of the prime minister’s other policy initiatives. After weighing all this advice, the
prime minister then decides how to proceed.
Making economic policy in a representative democracy is a messy affair – and there are
often good reasons why prime ministers (and other politicians) do not advance the policies
that economists advocate. Economists offer crucial input to the policy process, but their
advice is only one ingredient of a complex recipe.
Economists in business
Government is not the only place you will find economists. While economists have always
played a role in large multinational corporations – advising on macroeconomics trends and
currency movements – increasingly, economists are involved in important elements of
business innovation.
Google’s search results have advertisements placed above and beside them. It was
an economist, Hal Varian, who designed the auction that tells Google which advertisers
should have their ads placed first and how to ensure they pay for the privilege. Susan
Athey became the first Chief Economist of Microsoft and led developments there in using
artificial intelligence to power many of their new innovative products. Today, economists
are important advisers at Facebook, Uber, Airbnb and Amazon.
CHECK YOUR UNDERSTANDING
Give an example of a positive statement and an example of a normative statement. Name
three parts of government that regularly rely on advice from economists.
LO2.3 Why economists disagree
‘If all the economists were laid end to end, they would not reach a conclusion.’ This quip from
George Bernard Shaw is revealing. Economists as a group are often criticised for giving conflicting
advice to policymakers. Former US President Ronald Reagan once joked that if the game Trivial
Pursuit were designed for economists, it would have 100 questions and 3000 answers.
Why do economists so often appear to give conflicting advice to policymakers? There
are two basic reasons:
• Economists may disagree about the validity of alternative positive theories of how the
world works.
• Economists may have different values and, therefore, different normative views about
what policies should try to accomplish.
Let’s discuss each of these reasons.
Differences in scientific judgements
Several centuries ago, astronomers debated whether the earth or the sun was at the centre of
the heavens. More recently, climatologists have debated whether the earth is experiencing
global warming and, if so, why. Science is an ongoing search for understanding about the
world around us. It is not surprising that, as the search continues, scientists can disagree
about the direction in which truth lies.
33
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN
02-200-202
Chapter
2 Thinking like an economist
02_Stonecash_8e_45658_SB_txt.indd 33
24/08/20 5:59 PM
Economists often disagree for the same reason. Although the field of economics sheds
light on much about the world (as you will see throughout this book), there is still much
to be learned. Sometimes economists disagree because they have different hunches
about the validity of alternative theories. Sometimes they disagree because of different
judgements about the size of the parameters that measure how economic variables are
related.
For example, economists debate whether the government should levy taxes based on
a household’s income or its consumption (spending). In Australia, advocates of the goods
and services tax (GST), introduced in 2000, believed that the change would encourage
households to save more, because income that is saved would not be taxed. Higher saving,
in turn, would free resources for capital accumulation, leading to more rapid growth in
productivity and living standards. Those opposing the GST believed that household saving
would not respond much to a change in the tax laws. These two groups of economists held
different views about the tax system because they had different positive views about the
responsiveness of saving to tax incentives.
Differences in values
Suppose that Jack and Jill both take the same amount of water from the town well. To pay
for maintaining the well, the town taxes its residents. Jack has income of $150 000 and is
taxed $15 000, or 10 per cent of his income. Jill has income of $40 000 and is taxed $8000, or
20 per cent of her income.
Is this policy fair? If not, who pays too much and who pays too little? Does it matter
that Jill’s low income is due to a medical disability? Would your opinion change if Jill’s
low income resulted from her decision to pursue an acting career? Does it matter whether
Jack’s high income is due to a large inheritance or to his willingness to work long hours at
a dreary job?
These are difficult questions about which people are likely to disagree. If the town hired
two experts to study how it should tax its residents to pay for the well, it would not be
surprising if they offered conflicting advice.
This simple example shows why economists sometimes disagree about public policy. As
we learned earlier in our discussion of normative and positive analysis, policies cannot be
judged on scientific grounds alone. Economists give conflicting advice sometimes because
they have different values. Perfecting the science of economics will not tell us whether Jack
or Jill pays too much.
What Australian economists think
Because of differences in scientific judgements and differences in values, some disagreement
among economists is inevitable. Yet one should not overstate the amount of disagreement.
Economists agree with one another far more than is sometimes understood.
In 2011, the Economic Society of Australia (ESA) surveyed the views of more than
500 Australian economists. The respondents reflect the diverse career paths available
to economists, representing industry, government and university sectors. The survey
highlights policy areas in which there exists a broad consensus among Australian
economists, as well as those areas that remain the subject of significant disagreements. At
key points throughout this book, the opinions of Australian economists are highlighted in
‘What Australian economists think’ boxes such as the one below.
34
Part 1 Introduction
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
02_Stonecash_8e_45658_SB_txt.indd 34
24/08/20 5:59 PM
What Australian
economists think
There are a number of government
policies that are generally opposed by
economists. For example, 65.2 per cent
of economists would like to see an end
to the stamp duty on home sales (stamp
duties are state taxes payable when you
buy or sell an asset), while 19.2 per cent of
respondents disagree. As experts, the role
of economists in public policy formation
is to analyse proposals and inform public
debate. Of the economists surveyed,
84.9 per cent agree with the statement:
‘Prior to approval of any major public
infrastructure project, an independent
and expert cost–benefit study should be
conducted and released publicly.’ Only
8.5 per cent of respondents disagree.
Source: ESA Policy Opinion Survey of Australian
Economists 2011, http://esacentral.org.au/
publications/useful -links/2011-policy-opinion-survey
Why do policies such as stamp duties persist if the experts overwhelmingly oppose
them? The reason may be that economists have not yet convinced the general public that
these policies are undesirable. One of the purposes of this book is to help you understand
the economist’s view of these and other subjects and, perhaps, to persuade you that it is the
right one.
CHECK YOUR UNDERSTANDING
Give two reasons why two economic advisers to the federal government might disagree
about a question of policy.
Conclusion: Let’s get going
The first two chapters of this book have introduced you to the ideas and methods of
economics. We are now ready to get to work. In the next chapter, we start learning in more
detail about the principles of economic behaviour and economic policy.
As you proceed through this book, you will be asked to draw on many of your intellectual
skills. It may be helpful to keep in mind some advice from the great economist John Maynard
Keynes:
The study of economics does not seem to require any specialised gifts of an
unusually high order. Is it not … a very easy subject compared with the higher
branches of philosophy or pure science? An easy subject, at which very few
excel! The paradox finds its explanation, perhaps, in that the master-economist
must possess a rare combination of gifts. He must be mathematician, historian,
statesman, philosopher – in some degree. He must understand symbols and speak
in words. He must contemplate the particular in terms of the general, and touch
abstract and concrete in the same flight of thought. He must study the present
in the light of the past for the purposes of the future. No part of man’s nature or
his institutions must lie entirely outside his regard. He must be purposeful and
disinterested in a simultaneous mood; as aloof and incorruptible as an artist, yet
sometimes as near the earth as a politician.
This is a tall order. But with practice, you will become more and more accustomed to thinking
like an economist.
35
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN
02-200-202
Chapter
2 Thinking like an economist
02_Stonecash_8e_45658_SB_txt.indd 35
24/08/20 5:59 PM
STUDY TOOLS
Summary
LO2.1 Economists try to approach their subject with a scientist’s objectivity. Like all scientists,
they make appropriate assumptions and build simplified models in order to understand
the world around them. The field of economics is divided into two subfields –
microeconomics and macroeconomics. Microeconomists study decision making
by households and firms and the interaction among households and firms in the
marketplace. Macroeconomists study the forces and trends that affect the economy as
a whole.
LO2.2 A positive statement is an assertion about how the world is. A normative statement is
an assertion about how the world ought to be. While positive statements can be judged
based on facts and the scientific method, normative statements entail value judgements
as well. When economists make normative statements, they are acting more as policy
advisers than as scientists.
LO2.3 Economists who advise policymakers offer conflicting advice either because of
differences in scientific judgements or because of differences in values. At other times,
economists are united in the advice they offer, but policymakers may choose to ignore
the advice because of the many forces and constraints imposed on them by the political
process.
Key concepts
circular-flow diagram, p. 26
macroeconomics, p. 30
microeconomics, p. 30
normative statements, p. 31
positive statements, p. 31
production possibilities frontier, p. 27
randomised controlled trials, p. 24
scientific method, p. 23
Apply and revise
1
2
3
4
5
6
7
8
9
10
In what ways is economics like a science?
Why do economists make assumptions?
Should an economic model describe reality exactly?
Name a way that your family interacts in the markets for the factors of production and a
way that it interacts in the markets for goods and services.
Name one economic interaction that isn’t covered by the simplified circular-flow diagram.
Draw and explain a production possibilities frontier for an economy that produces milk and
cookies. What happens to this frontier if a disease kills half of the economy’s cows?
Use a production possibilities frontier to describe the idea of efficiency.
What are the two subfields into which economics is divided? Explain what each subfield
studies.
What is the difference between a positive and a normative statement? Give an example of
each.
Why do economists sometimes offer conflicting advice to policymakers?
Practice questions
Multiple choice
1
2
An economic model is
a a mechanical machine that replicates the functioning of the economy.
b a fully detailed, realistic description of the economy.
c a simplified representation of some aspect of the economy.
d a computer program that predicts the future of the economy.
The circular-flow diagram illustrates that, in markets for the factors of production,
a households are sellers, and firms are buyers.
b households are buyers, and firms are sellers.
c households and firms are both buyers.
d households and firms are both sellers.
36
Part 1 Introduction
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
02_Stonecash_8e_45658_SB_txt.indd 36
24/08/20 5:59 PM
3
4
5
6
A point inside the production possibilities frontier is
a efficient, but not feasible.
b feasible, but not efficient.
c both efficient and feasible.
d neither efficient nor feasible.
An economy produces hot dogs and hamburgers. If a discovery of the remarkable health
benefits of hot dogs were to change consumers’ preferences, it would
a expand the production possibilities frontier.
b contract the production possibilities frontier.
c move the economy along the production possibilities frontier.
d move the economy inside the production possibilities frontier.
All of the following topics fall within the study of microeconomics except
a the impact of cigarette taxes on the smoking behaviour of teenagers.
b the role of Microsoft’s market power in the pricing of software.
c the effectiveness of antipoverty programs in reducing homelessness.
d the influence of the government budget deficit on economic growth.
Which of the following is a positive, rather than a normative, statement?
a Law X will reduce national income.
b Law X is a good piece of legislation.
c The federal parliament ought to pass law X.
d The High Court should repeal law X.
Problems and applications
1
2
3
4
Draw a circular-flow diagram. Identify the parts of the model that correspond to the flow of
goods and services and the flow of dollars for each of the following activities:
a Sam pays a shopkeeper $1 for a litre of milk.
b Terry earns $16.50 per hour working at a fast-food restaurant.
c Uma spends $13 to see a film.
d Violet earns $10 000 from her 10 per cent ownership of Acme Industrial.
Imagine a society that produces military goods and consumer goods, which we’ll call ‘guns’
and ‘butter’.
a Draw a production possibilities frontier for guns and butter. Explain why it most likely
has a bowed-out shape.
b Show a point that is impossible for the economy to achieve. Show a point that is feasible
but inefficient.
c Imagine that the society has two political parties; call them the Hawks (who want a strong
military) and the Doves (who want a smaller military). Show a point on your production
possibilities frontier that the Hawks might choose and a point the Doves might choose.
d Imagine that an aggressive neighbouring country reduces the size of its military. As a
result, both the Hawks and the Doves reduce their desired production of guns by the
same amount. Which party would get the bigger ‘peace dividend’, measured by the
increase in butter production? Explain.
The first principle of economics discussed in Chapter 1 is that people face trade-offs. Use a
production possibilities frontier to illustrate society’s trade-off between a clean environment
and high incomes. What do you suppose determines the shape and position of the
frontier? Show what happens to the frontier if engineers develop a car engine with almost
no emissions.
An economy consists of three workers: Larry, Moe and Curly. Each works 10 hours a day
and can produce two services: mowing lawns and washing cars. In an hour, Larry can either
mow one lawn or wash one car; Moe can either mow one lawn or wash two cars; and Curly
can either mow two lawns or wash one car.
a Calculate how much of each service is produced under the following circumstances,
which we label A, B, C and D:
i All three spend all their time mowing lawns. (A)
ii All three spend all their time washing cars. (B)
iii All three spend half their time on each activity. (C)
iv Larry spends half his time on each activity, while Moe only washes cars and Curly
only mows lawns. (D)
37
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN
02-200-202
Chapter
2 Thinking like an economist
02_Stonecash_8e_45658_SB_txt.indd 37
24/08/20 5:59 PM
5
6
7
b Graph the production possibilities frontier for this economy. Using your answers to part
(a), identify points A, B, C and D on your graph.
c Explain why the production possibilities frontier has the shape it does.
d Are any of the allocations calculated in part (a) inefficient? Explain.
Classify the following topics as relating to microeconomics or macroeconomics:
a a family’s decision about how much income to save
b the effect of government regulations on car emissions
c the impact of higher saving on economic growth
d a firm’s decision about how many workers to hire
e the relationship between the inflation rate and changes in the quantity of money.
Classify each of the following statements as positive or normative. Explain.
a Society faces a short-term trade-off between inflation and unemployment.
b A reduction in the growth rate of the money supply will reduce the rate of inflation.
c The Reserve Bank should reduce the growth rate of the money supply.
d Society ought to require people on social security benefits to look for jobs.
e Lower tax rates encourage more work and more saving.
We have seen that disagreements between economists can be divided into disagreements
concerning positive statements, and disagreements concerning normative statements.
a Would you expect economists to disagree less about positive statements as time goes
on? Explain.
b Would you expect economists to disagree less about normative statements as time goes
on? Explain.
c What are the implications of your answers for the way in which economists’ views of
public policy evolve over time?
38
Part 1 Introduction
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
02_Stonecash_8e_45658_SB_txt.indd 38
24/08/20 5:59 PM
Appendix: Graphing – a brief review
Many of the concepts that economists study can be expressed with numbers – the price
of bananas, the quantity of bananas sold, the cost of growing bananas and so on. Often
these economic variables are related to one another. When the price of bananas rises,
people buy fewer bananas. One way of expressing the relationships among variables is
with graphs.
Graphs serve two purposes. First, when economists develop theories, graphs offer a
visual way to express ideas that might be less clear if described with equations or words.
Second, when economists analyse data, graphs provide a way of finding how variables
are, in fact, related in the world. Whether we are working with theory or with data,
graphs provide a lens through which a recognisable forest emerges from a multitude
of trees.
Numerical information can be expressed graphically in many ways, just as a thought
can be expressed in words in many ways. A good writer chooses words that will make an
argument clear, a description pleasing or a scene dramatic. An effective economist chooses
the type of graph that best suits the purpose at hand.
In this appendix we discuss how economists use graphs to study the mathematical
relationships among variables. We also discuss some of the pitfalls that can arise when
using graphical methods.
Three common graphs are shown in Figure 2A.1. The pie chart in panel (a) shows the sources
of tax revenue for the federal government. A slice of the pie represents each source’s share
of the total. The bar graph in panel (b) compares how much various large corporations are
worth. The height of each bar represents the dollar value of each firm. The time-series graph
in panel (c) traces the Australian–US dollar exchange rate over time. The height of the line
shows the number of US dollars that can be bought by one Australian dollar in each year.
You have probably seen similar graphs presented in newspapers and magazines.
Graphs of two variables: The coordinate system
The three graphs in Figure 2A.1 are useful in showing how a variable changes over time or
across individuals, but they are limited in how much they can tell us. These graphs display
information only on a single variable. Economists are often concerned with the relationships
between variables. Thus, they need to be able to display two variables on a single graph. The
coordinate system makes this possible.
Suppose you want to examine the relationship between study time and average
mark. For each student in your class, you could record a pair of numbers – hours per week
spent studying and average mark. These numbers could then be placed in parentheses
as an ordered pair and appear as a single point on the graph. Albert, for instance, is
represented by the ordered pair (25 hours per week, 75 per cent average), and his ‘Whatme-worry?’ classmate Alfred is represented by the ordered pair (five hours per week,
40 per cent average).
We can graph these ordered pairs on a two-dimensional grid. The first number in each
ordered pair, called the x-coordinate, tells us the horizontal location of the point. The second
number, called the y-coordinate, tells us the vertical location of the point. The point with
both an x-coordinate and a y-coordinate of zero is known as the origin. The two coordinates
in the ordered pair tell us where the point is located in relation to the origin – x units to the
right of the origin and y units above it.
APPENDIX
Graphs of a single variable
39
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN
02-200-202
Chapter
2 Thinking like an economist
02_Stonecash_8e_45658_SB_txt.indd 39
24/08/20 5:59 PM
FIGURE 2A.1 Types of graphs
(a) Pie chart
6%
25%
Income taxes
Indirect taxes
Non-tax revenue
69%
180
BHP Billiton
($169.3)
(b) Bar graph
April 2013 market capitalisation
(in billions of dollars)
160
140
120
Commonwealth
Bank of Australia
($109.5)
100
80
60
Telstra
($55.9)
40
Woolworths
($42.7)
20
0
Exchange rate: US$ per A$
1.4
(c) Time-series graph
1.2
1
0.8
0.6
0.4
0.2
0
1972 1977 1982 1987 1992 1997 2002 2007 2012
Year
The pie chart in panel (a) shows the sources of revenue for the federal government. The bar
graph in panel (b) compares how much various large corporations are worth. The time-series
graph in panel (c) traces the Australian–US dollar exchange rate over time.
Source: (a) Department of the Treasury, http://budget.gov.au/2011-12/content/fbo/html/part_1.htm, 2011–12 Final Budget
Outcome; (b) Yahoo! Finance, http://au.finance.yahoo.com/; (c) Reserve Bank of Australia, www.rba.gov.au/statistics/histexchange-rates/index.html, Exchange Rate Data.
40
Part 1 Introduction
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
02_Stonecash_8e_45658_SB_txt.indd 40
24/08/20 5:59 PM
Figure 2A.2 graphs average marks against study time for Albert, Alfred and their
classmates. This type of graph is called a scatter plot because it plots scattered points.
Looking at this graph, we immediately notice that points further to the right also tend to be
higher. Because higher study time is associated with higher marks, we say that these two
variables have a positive correlation. In contrast, if we were to graph party time and marks,
it is likely that we would find that higher party time is associated with lower marks, and
we say that these two variables have a negative correlation. In either case, the coordinate
system makes the correlation between the two variables easy to see.
FIGURE 2A.2 Using the coordinate system
Average
mark (%)
100
95
90
85
80
75
Albert
(25, 75)
70
65
60
55
50
45
Alfred
(5, 40)
40
35
0
5
10
15
20
25
30
40 Study
time
(hours per week)
35
Average mark is measured on the vertical axis and study time on the horizontal axis. Albert,
Alfred and their classmates are represented by various points. We can see from the graph that
students who study more tend to get higher marks.
Curves in the coordinate system
Students who study more do tend to get higher marks, but other factors also influence a
student’s mark. Previous preparation is an important factor, for instance, as are talent,
attention from teachers, even eating a good breakfast. A scatter plot like Figure 2A.2 does
not attempt to isolate the effect that study has on marks from the effects of other variables.
Often, however, economists prefer looking at how one variable affects another, holding
everything else constant.
41
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN
02-200-202
Chapter
2 Thinking like an economist
02_Stonecash_8e_45658_SB_txt.indd 41
24/08/20 5:59 PM
To see how this is done, let’s consider one of the most important graphs in economics:
the demand curve. The demand curve traces the effect of a good’s price on the quantity of
the good consumers want to buy. Table 2A.1 shows how the number of novels that Emma
buys depends on her income and on the price of novels. When novels are cheap, Emma
buys them in large quantities. As they become more expensive, she borrows books from
the library instead of buying them or chooses to go to a film instead of reading. Similarly,
at any given price, Emma buys more novels when she has a higher income. That is, when
her income increases, she spends part of the additional income on novels and part on
other goods.
TABLE 2A.1 Novels purchased by Emma
This table shows the number of novels Emma buys at various incomes and prices. For any given
level of income, the data on price and quantity demanded can be graphed to produce Emma’s
demand curve for novels.
Income
Price
$20 000
$30 000
$40 000
$10
2 novels
5 novels
8 novels
9
6
9
12
8
10
13
16
7
14
17
20
6
18
21
24
5
22
25
28
Demand curve, D3
Demand curve, D1
Demand curve, D2
We now have three variables – the price of novels, income and the number of novels
purchased – which is more than we can represent in two dimensions. To put the information
from Table 2A.1 in graphical form, we need to hold one of the three variables constant and
trace the relationship between the other two. Because the demand curve represents the
relationship between price and quantity demanded, we hold Emma’s income constant and
show how the number of novels she buys varies with the price of novels.
Suppose that Emma’s income is $30 000 per year. If we place the number of novels
Emma purchases on the x-axis and the price of novels on the y-axis, we can graphically
represent the third column of Table 2A.1. When the points that represent these entries
from the table – (five novels, $10), (nine novels, $9) and so on – are connected, they form
a line. This line, shown in Figure 2A.3, is known as Emma’s demand curve for novels; it
tells us how many novels Emma purchases at any given price, holding income constant.
The demand curve is downward-sloping, indicating that the quantity of novels demanded
is negatively related to the price. (Conversely, when two variables move in the same
direction, the curve relating them is upward-sloping, and we say that the variables are
positively related.)
Now suppose that Emma’s income rises to $40 000 per year. At any given price, Emma will
purchase more novels than she did at her previous level of income. Just as earlier we drew
Emma’s demand curve for novels using the entries from the third column of Table 2A.1,
we now draw a new demand curve using the entries from the fourth column of the table.
42
Part 1 Introduction
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
02_Stonecash_8e_45658_SB_txt.indd 42
24/08/20 5:59 PM
FIGURE 2A.3 Demand curve
Price of
novels
$11
10
(5, $10)
(9, $9)
9
(13, $8)
8
(17, $7)
7
(21, $6)
6
5
(25, $5)
4
Demand, D1
3
2
1
0
5
10
15
20
25
30
Quantity
of novels
purchased
The line D1 shows how Emma’s purchases of novels depend on the price of novels when her
income is held constant. Because the price and the quantity demanded are negatively related,
the demand curve slopes downwards.
This new demand curve (curve D2) is shown alongside the old one (curve D1) in Figure 2A.4;
the new curve is a similar line drawn further to the right. We therefore say that Emma’s
demand curve for novels shifts to the right when her income increases. Likewise, if Emma’s
income were to fall to $20 000 per year, she would buy fewer novels at any given price and
her demand curve would shift to the left (to curve D3).
In economics, it is important to distinguish between movements along a curve and shifts
of a curve. As we can see from Figure 2A.3, if Emma earns $30 000 per year and novels cost
$8 each, she will purchase 13 novels per year. If the price of novels falls to $7, Emma will
increase her purchases of novels to 17 per year. The demand curve, however, stays fixed in
the same place. Emma still buys the same number of novels at each price, but as the price
falls she moves along her demand curve from left to right. In contrast, if the price of novels
remains fixed at $8 but her income rises to $40 000, Emma increases her purchases of novels
from 13 to 16 per year. Because Emma buys more novels at each price, her demand curve
shifts out, as shown in Figure 2A.4.
There is a simple way to tell when it is necessary to shift a curve. When a variable that
is not named on either axis changes, the curve shifts. Income is on neither the x-axis nor the
y-axis of the graph, so when Emma’s income changes, her demand curve must shift. Any
change that affects Emma’s purchasing habits besides a change in the price of novels will
result in a shift in her demand curve. If, for instance, the public library closes and Emma
must buy all the books she wants to read, she will demand more novels at each price and
her demand curve will shift to the right. Or if the price of films falls and Emma spends
43
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN
02-200-202
Chapter
2 Thinking like an economist
02_Stonecash_8e_45658_SB_txt.indd 43
24/08/20 5:59 PM
FIGURE 2A.4 Shifting demand curves
Price of
novels
$11
10
(13, $8)
9
(16, $8)
8
(10, $8)
7
6
5
4
3
When income
decreases, the
demand curve
shifts to the left.
D3
(income =
$20 000)
When income, increases,
the demand curve
shifts to the right.
D2 (income =
D1
(income = $40 000)
$30 000)
2
1
0
5
10
13 15 16
20
25
30
Quantity
of novels
purchased
The location of Emma’s demand curve for novels depends on how much income she earns. The
more she earns, the more novels she will purchase at any given price, and the further to the
right her demand curve will lie. Curve D1 represents Emma’s original demand curve when her
income is $30 000 per year. If her income rises to $40 000 per year, her demand curve shifts to
D2. If her income falls to $20 000 per year, her demand curve shifts to D3.
more time at the pictures and less time reading, she will demand fewer novels at each
price, and her demand curve will shift to the left. By contrast, when a variable on an axis
of the graph changes, the curve does not shift. We read the change as a movement along
the curve.
Slope
One question we might want to ask about Emma is how much her purchasing habits respond
to changes in price. Look at the demand curve shown in Figure 2A.5. If this curve is very
steep, Emma purchases nearly the same number of novels regardless of whether they are
cheap or expensive. If this curve is much flatter, the number of novels Emma purchases is
more sensitive to changes in the price. To answer questions about how much one variable
responds to changes in another variable, we can use the concept of slope.
The slope of a line is the ratio of the vertical distance covered to the horizontal distance
covered as we move along the line. This definition is usually written out in mathematical
symbols as follows:
Slope =
Δy
Δx
where the Greek letter Δ (delta) stands for the change in a variable. In other words, the slope
of a line is equal to the ‘rise’ (change in y) divided by the ‘run’ (change in x).
44
Part 1 Introduction
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
02_Stonecash_8e_45658_SB_txt.indd 44
24/08/20 5:59 PM
FIGURE 2A.5 Calculating the slope of a line
Price of
novels
$11
10
9
(13, $8)
8
7
6
8
6
2
21
13
8
(21, $6)
5
Demand, D 1
4
3
2
1
0
5
10
13 15
20 21
25
30
Quantity
of novels
purchased
To calculate the slope of the demand curve, we can look at the changes in the x- and
y-coordinates as we move from the point (21 novels, $6) to the point (13 novels, $8). The slope
of the line is the ratio of the change in the y-coordinate (–2) to the change in the x-coordinate
(+8), which equals –1/4.
For an upward-sloping line, the slope is a positive number because the changes in y and x
move in the same direction: if y increases, so does x, and if y decreases, so does x. For a fairly
flat upward-sloping line, the slope is a small positive number. For a steep upward-sloping
line, the slope is a large positive number.
For a downward-sloping line, the slope is a negative number because the changes in y
and x move in opposite directions: if y increases, x decreases, and if y decreases, x increases.
For a fairly flat downward-sloping line, the slope is a small negative number. For a steep
downward-sloping line, the slope is a large negative number.
A horizontal line has a slope of zero because in this case the y-variable never changes.
A vertical line is said to have an infinite slope because the y-variable can take any value
without the x-variable changing at all.
What is the slope of Emma’s demand curve for novels? First of all, because the curve
slopes down, we know the slope will be negative. To calculate a numerical value for the
slope, we must choose two points on the line. With Emma’s income at $30 000, she will
purchase 21 novels at a price of $6 or 13 novels at a price of $8. When we apply the slope
formula, we are concerned with the change between these two points; in other words, we
are concerned with the difference between them, which lets us know that we will have to
subtract one set of values from the other, as follows:
Slope =
first y-coordinate − second y-coordinate
first x-coordinate − second x-coordinate
=
6−8
21 − 13
=
−2
8
=
−1
4
45
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN
02-200-202
Chapter
2 Thinking like an economist
02_Stonecash_8e_45658_SB_txt.indd 45
24/08/20 5:59 PM
Figure 2A.5 shows graphically how this calculation works. Try calculating the slope of
Emma’s demand curve using two different points. You should get exactly the same result,
–1/4. One of the properties of a straight line is that it has the same slope everywhere. This is
not true of other types of curves, which are steeper in some places than in others.
The slope of Emma’s demand curve tells us something about how responsive her
purchases are to changes in the price. A small slope (a negative number close to zero)
means that Emma’s demand curve is relatively flat; in this case, she adjusts the number
of novels she buys substantially in response to a price change. A larger slope (a negative
number further from zero) means that Emma’s demand curve is relatively steep; in this
case, she adjusts the number of novels she buys only slightly in response to a price
change.
Cause and effect
Economists often use graphs to advance an argument about how the economy works. In
other words, they use graphs to argue about how one set of events causes another set of
events. With a graph like the demand curve, there is no doubt about cause and effect. Because
we are varying price and holding all other variables constant, we know that changes in the
price of novels cause changes in the quantity Emma demands. Remember, however, that our
demand curve came from a hypothetical example. When graphing data from the real world,
it is often more difficult to establish how one variable affects another.
The first problem is that it is difficult to hold everything else constant when measuring
how one variable affects another. If we are not able to hold variables constant, we might
decide that one variable on our graph is causing changes in the other variable when those
changes are actually being caused by a third omitted variable not pictured on the graph.
Even if we have identified the correct two variables to look at, we might run into a second
problem – reverse causality. In other words, we might decide that A causes B when in fact
B causes A. The omitted-variable and reverse-causality traps require us to proceed with
caution when using graphs to draw conclusions about causes and effects.
Omitted variables
To see how omitting a variable can lead to a deceptive graph, let’s consider an example.
Imagine that the government, spurred by public concern about the large number of
deaths from cancer, commissions an exhaustive study from Big Brother Statistical
Services. Big Brother examines many of the items found in people’s homes to see which
of them are associated with the risk of cancer. Big Brother reports a strong relationship
between two variables – the number of cigarette lighters that a household owns and the
probability that someone in the household will develop cancer. Figure 2A.6 shows this
relationship.
What should we make of this result? Big Brother advises a quick policy response. It
recommends that the government discourage the ownership of cigarette lighters by taxing
their sale. It also recommends that the government require warning labels: ‘Big Brother has
determined that this lighter is dangerous to your health’.
In judging the validity of Big Brother’s analysis, one question is paramount. Has Big
Brother held constant every relevant variable except the one under consideration? If the
answer is no, the results are suspect. An easy explanation for Figure 2A.6 is that people
who own more cigarette lighters are more likely to smoke cigarettes and that cigarettes, not
lighters, cause cancer. If Figure 2A.6 does not hold constant the amount of smoking, it does
not tell us the true effect of owning a cigarette lighter.
This story illustrates an important principle – when you see a graph being used to
support an argument about cause and effect, it is important to ask whether the movements
of an omitted variable could explain the results you see.
46
Part 1 Introduction
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
02_Stonecash_8e_45658_SB_txt.indd 46
24/08/20 5:59 PM
FIGURE 2A.6 Graph with an omitted variable
Risk of
cancer
0
Number of lighters in house
The upward-sloping curve shows that households with more cigarette lighters are more
likely to develop cancer. Yet we should not conclude that ownership of lighters causes cancer
because the graph does not take into account the number of cigarettes smoked.
Reverse causality
Economists can also make mistakes about causality by misreading its direction. To see how
this is possible, suppose the Association of Australian Anarchists commissions a study of
crime in Australia and arrives at Figure 2A.7, which plots the number of violent crimes per
thousand people in major cities against the number of police officers per thousand people.
The Anarchists note the curve’s upward slope and argue that since police increase rather
than decrease the amount of urban violence, law enforcement should be abolished.
FIGURE 2A.7 Graph suggesting reverse causality
Violent
crimes
(per 1000
people)
0
Police officers
(per 1000 people)
The upward-sloping curve shows that cities with a higher concentration of police are more
dangerous. Yet the graph does not tell us whether police cause crime or crime-plagued cities
hire more police.
47
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN
02-200-202
Chapter
2 Thinking like an economist
02_Stonecash_8e_45658_SB_txt.indd 47
24/08/20 5:59 PM
Figure 2A.7, however, does not prove the Anarchists’ point. The graph simply shows
that more dangerous cities have more police officers. The explanation for this may be that
more dangerous cities hire more police. In other words, rather than police causing crime,
crime may cause police. We could avoid the danger of reverse causality by running a
controlled experiment. In this case, we would randomly assign different numbers of police
to different cities and then examine the correlation between police and crime. Without such
an experiment, establishing the direction of causality is difficult at best.
It might seem that we could determine the direction of causality by examining which
variable moves first. If we see crime increase and then the police force expand, we reach one
conclusion. If we see the police force expand and then crime increase, we reach the other
conclusion. This approach, however, is also flawed: often people change their behaviour
not in response to a change in their present conditions but in response to a change in their
expectations about future conditions. A city that expects a major crime wave in the future,
for instance, might well hire more police now. This problem is even easier to see in the case
of babies and station wagons. Couples often buy a station wagon in anticipation of the birth
of a child. The station wagon comes before the baby, but we would not want to conclude
that the sale of station wagons causes the population to grow!
There is no exhaustive set of rules that specifies when it is appropriate to draw causal
conclusions from graphs. Yet just keeping in mind that cigarette lighters don’t cause cancer
(omitted variable) and that station wagons don’t cause babies (reverse causality) will keep
you from falling for many faulty economic arguments.
48
Part 1 Introduction
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
02_Stonecash_8e_45658_SB_txt.indd 48
24/08/20 5:59 PM
3
Interdependence and
the gains from trade
Learning objectives
After reading this chapter, you should be able to:
LO3.1 explain how everyone can benefit when people trade with one another
LO3.2 use comparative advantage to explain the gains from trade
LO3.3 apply the theory of comparative advantage to everyday life and national policy.
49
49
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
03_Stonecash_8e_45658_SB_txt.indd 49
24/08/20 5:59 PM
Introduction
Consider your typical day. You wake up in the morning and you pour yourself juice from
oranges grown in the Riverina region of New South Wales, and coffee from beans grown in
Colombia. Over breakfast, you read a BuzzFeed article written in the United States, on your
phone made in China. You get dressed in clothes made from cotton grown in India, and sewn
in factories in Thailand. You drive to university in a car made of parts manufactured in more
than a dozen countries around the world. Then you open up your economics textbook written
by authors living in Massachusetts, Toronto, the Gold Coast and Melbourne, published by a
company located in Melbourne, and printed on paper made from trees grown in Tasmania.
Every day you rely on many people from around the world, most of whom you have never
met, to provide you with the goods and services that you enjoy. Such interdependence is
possible because people trade with one another. Those people who provide you with goods
and services are not acting out of generosity. Nor is some government agency directing them
to satisfy your desires. Instead, people provide you and other consumers with the goods and
services they produce because they get something in return.
In subsequent chapters, we will examine how an economy coordinates the activities of
millions of people with varying tastes and abilities. As a starting point for this analysis, in
this chapter we consider the reasons for economic interdependence. One of the Ten Principles
of Economics in Chapter 1 is that trade can make everyone better off. We now examine this
principle more closely. What exactly do people gain when they trade with one another?
Why do people choose to become interdependent?
The answers to these questions are key to understanding the modern global economy.
Most countries today import many of the goods and services they consume, and they
export many of the goods and services they produce. The analysis in this chapter explains
interdependence not only among individuals but also among nations. As we will see, the
gains from trade are much the same whether you are buying a haircut from your local barber
or a T-shirt made by a worker on the other side of the world.
LO3.1 A parable for the modern economy
To understand why people choose to depend on others for goods and services and how
this choice improves their lives, let’s examine a simple economy – the economy inside a
household. Imagine that there are two chores that need to be completed in the household –
cooking and laundry. And there are two people living in the house – Leonard and Sheldon –
each of whom likes to eat and to wear clean and neatly ironed clothes.
The gains from trade are clearest if Leonard can cook but cannot do laundry, while
Sheldon can do the laundry but cannot cook. In one scenario, Leonard and Sheldon could
choose to have nothing to do with each other. Leonard would cook for himself and Sheldon
would wash and iron his own clothes. After several months of eating cold meat and biscuits,
Sheldon might decide that self-sufficiency is not all it’s cracked up to be. Leonard, whose
clothing could not have a worse odour, would be likely to agree. It is easy to see that trade
would allow them to enjoy greater variety – each could eat well and wear clean clothes.
Although this scene shows most simply how everyone can benefit from trade, the gains
would be similar if Leonard and Sheldon were each capable of doing the other task, but only
at great cost. Suppose, for example, that Leonard can wash clothes, but that he is not very
good at it. Similarly, suppose that Sheldon can cook, but that he can prepare only a few
basic dishes. In this case, it is easy to see that Leonard and Sheldon can each benefit by
specialising in what he does best and then trading with the other.
The gains from trade are less obvious, however, when one person is better at producing
every good. For example, suppose that Leonard is better at cooking and better at doing the
50
Part 1 Introduction
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
03_Stonecash_8e_45658_SB_txt.indd 50
24/08/20 5:59 PM
laundry than Sheldon. In this case, should Leonard remain self-sufficient? Or is there still
reason for him to trade with Sheldon? To answer this question, let’s look more closely at the
factors that affect such a decision.
Production possibilities
Suppose that Leonard and Sheldon each have 12 spare hours a week to work on household
chores and can devote this time to cooking, laundry or a combination of the two. Table 3.1
shows the amount of time each person requires to produce one unit of each good – a decent
meal and a basket of clean clothes. Sheldon can wash and iron a basket of clothes in four
hours and cook a meal in two hours. Leonard, who is more productive in both activities,
needs only half an hour to cook a meal and can wash and iron a basket of clothes in
three hours.
TABLE 3.1 The production opportunities of Sheldon and Leonard
Hours needed to complete:
Maximum quantity completed in 12 hours:
1 meal
1 basket
Meals
Baskets
Sheldon
2
4
6
3
Leonard
½
3
24
4
Panel (a) of Figure 3.1 illustrates the amounts of laundry and cooking that Sheldon can
produce. If he spends all 12 hours of his time on doing the laundry, he cleans three baskets
of clothes but does not cook. If he spends all his time cooking, he produces six meals and
washes no clothes. If Sheldon spends four hours doing laundry and eight hours cooking, he
cooks four meals and washes and irons one basket of clothes. The figure shows these three
possible outcomes and all others in-between.
FIGURE 3.1 The production possibilities frontier
(a) Sheldon’s production possibilities frontier
(b) Leonard’s production possibilities frontier
Meals
Meals
24
6
A
4
B
12
0
1
3
Laundry (baskets)
0
2
4
Laundry (baskets)
Panel (a) shows the combinations of meals and laundry that Sheldon can produce. Panel (b) shows the combinations of
meals and laundry that Leonard can produce. Both production possibilities frontiers are derived from Table 3.1 and the
assumption that Sheldon and Leonard each work 12 hours per week on domestic chores.
51
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole
or in3part.
WCN 02-200-202and the gains from trade
Chapter
Interdependence
03_Stonecash_8e_45658_SB_txt.indd 51
24/08/20 5:59 PM
The graph in panel (a) is Sheldon’s production possibilities frontier. As we discussed
in Chapter 2, a production possibilities frontier shows the various mixes of output that an
economy can produce. It illustrates one of the Ten Principles of Economics in Chapter 1 – people
face trade-offs. Here, Sheldon faces a trade-off between cooking and doing laundry.
You may recall that the production possibilities frontier in Chapter 2 is drawn bowed
out. In that case, the rate at which society could trade one good for the other depended on
the amounts that were being produced. Here, however, Sheldon’s ‘technology’ allows him
to switch between one chore and the other at a constant rate (as summarised in Table 3.1).
We can see the constant rate of trade-off illustrated in the graph as Sheldon’s production
possibilities frontier is a straight line.
Panel (b) of Figure 3.1 shows the production possibilities frontier for Leonard. If he
spends all 12 hours of his time cooking, he produces 24 meals but does no laundry. If he
spends all his time on laundry, he washes four baskets but cooks no meals. If Leonard
divides his time equally, spending six hours on each activity, he cooks 12 meals and washes
two baskets of clothes per week. Once again, the production possibilities frontier shows all
the possible outcomes.
If Leonard and Sheldon choose to go it alone, rather than trade with each other, then
each consumes exactly what he produces. In this case, the production possibilities frontier
is also the consumption possibilities frontier. That is, without trade, Figure 3.1 shows the
possible combinations of cooking and laundry that Leonard and Sheldon can each produce
and then consume.
Although these production possibilities frontiers are useful in showing the trade-offs
that Leonard and Sheldon face, they do not tell us what they will each choose to do. To
determine their choices, we need to know something about their tastes. Let’s suppose they
choose the combinations identified by points A and B in Figure 3.1 – Sheldon produces
and consumes four meals and washes one basket while Leonard produces and consumes
12 meals and washes two baskets of clothing.
Specialisation and trade
After several months of combination B, Leonard gets an idea and talks to Sheldon:
Leonard: Sheldon, have I got a deal for you! I know how to improve life for both of
us. I think you should stop cooking altogether and devote all your time
to laundry. According to my calculations, if you spend 12 hours a week
washing and ironing, you’ll get three baskets of laundry done every
week. If you do one basket of laundry for me each week, and an extra
basket every second week, then I’ll cook you five meals a week. In the
end, you’ll be able to eat cooked meals more often and you’ll get your
clothes cleaner as well. [To illustrate his point, Leonard shows Sheldon
panel (a) of Figure 3.2.]
Sheldon: (sounding sceptical) That seems like a good deal for me. But I don’t
understand why you are offering it. If the deal is so good for me, it can’t
be good for you too.
Leonard: Oh, but it is! If I spend nine hours a week cooking and three hours doing
laundry, I’ll make 18 meals and also have time spare to do another basket
of laundry. After I give you five meals in exchange for the extra basketand-a-half that you wash and iron, I’ll be able to eat 13 meals at home
and I’ll have more clean shirts, trousers and, most importantly, socks
and underwear. In the end, I will be much happier than I am now. [He
points out panel (b) of Figure 3.2.]
52
Part 1 Introduction
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
03_Stonecash_8e_45658_SB_txt.indd 52
24/08/20 5:59 PM
FIGURE 3.2 How trade expands the set of consumption opportunities
(b) Leonard’s production possibilities frontier
(a) Sheldon’s production possibilities frontier
Meals
Meals
24
6
A*
5
4
A
Sheldon’s
consumption
with trade
0
1
11/2
3
B*
13
12
Sheldon’s
consumption
without trade
B
0
Laundry (baskets)
Leonard’s
consumption
with trade
Leonard’s
consumption
without trade
2 21/2
4
Laundry (baskets)
The proposed trade between Sheldon and Leonard offers each a combination of meals and baskets of clean clothes
that would be impossible in the absence of trade. In panel (a), Sheldon gets to consume at point A* rather than point A.
In panel (b), Leonard gets to consume at point B* rather than point B. Trade allows each to consume more meals and
have more clean clothes.
Sheldon: I don’t know … This sounds too good to be true.
Leonard: It’s really not as complicated as it seems at first. Here – I’ve summarised
my proposal for you in a simple table. [Leonard hands Sheldon a copy of
Table 3.2.]
Sheldon: (after pausing to study the table) These calculations seem correct, but I’m
puzzled. How can this deal make us both better off?
Leonard: We can both benefit because trade allows each of us to specialise in
doing what we do best. You will spend more time doing laundry and less
time cooking. I will spend more time cooking and less time washing and
ironing. As a result of specialisation and trade, each of us can consume
more of great meals, and wear cleaner clothes, without spending any
more time on our chores. What could be better?
TABLE 3.2 The gains from trade: A summary
Without trade:
Production and
consumption
Sheldon
Leonard
With trade:
Production
Trade
Consumption
Gains from
trade
4 meals
0 meals
Gets 5 meals
5 meals
1 meal
1 basket
3 baskets
for 1½ baskets
1½ baskets
½ basket
12 meals
18 meals
Gives 5 meals
13 meals
1 meal
2 baskets
1 basket
for 1½ baskets
2½ baskets
½ basket
53
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole
or in3part.
WCN 02-200-202and the gains from trade
Chapter
Interdependence
03_Stonecash_8e_45658_SB_txt.indd 53
24/08/20 5:59 PM
CHECK YOUR UNDERSTANDING
Draw an example of a production possibilities frontier for Robinson Crusoe, a shipwrecked
sailor who spends his time gathering coconuts and catching fish. Does this frontier limit
Crusoe’s consumption of coconuts and fish if he lives by himself? Does he face the same
limits if he can trade with native residents on the island?
LO3.2 Comparative advantage: The driving force of specialisation
Leonard’s explanation of the gains from trade, though correct, poses a puzzle – if Leonard is
better at both cooking and laundry, how can Sheldon ever specialise in doing what he does
best? Sheldon doesn’t seem to do anything best. To solve this puzzle, we need to look at the
principle of comparative advantage.
As a first step in developing this principle, consider the following question. In our example,
who does the laundry at lower cost – Sheldon or Leonard? There are two possible answers,
and in these two answers lie both the solution to our puzzle and the key to understanding
the gains from trade.
Absolute advantage
absolute advantage
the ability to produce
a good using fewer
inputs than another
producer
One way to answer the question about the cost of doing the laundry is to compare the inputs
required by the two housemates. Economists use the term absolute advantage when
comparing the productivity of one person, firm or nation with that of another. The producer
that requires a smaller quantity of inputs to produce a good is said to have an absolute
advantage in producing that good.
In our example, time is the only input, so we can determine absolute advantage by looking
at how much time each type of production takes. Leonard has an absolute advantage both in
laundry and cooking, because he requires less time than Sheldon to produce a unit of either
good. Leonard needs only three hours to do a basket of laundry, whereas Sheldon needs four
hours. Similarly, Leonard needs only half an hour to cook a meal whereas Sheldon needs two
hours. Thus, if we measure cost in terms of the quantity of inputs used, Leonard has a lower
cost of doing laundry and a lower cost of cooking.
Opportunity cost and comparative advantage
There is another way to look at the cost of laundry. Rather than comparing inputs required,
we can compare the opportunity costs. Recall from Chapter 1 that the opportunity cost of
some item is what we give up to get that item. In our example, we assumed that Sheldon
and Leonard each spend 12 hours a week on household chores. Time spent doing laundry,
therefore, takes away from time available for cooking. When reallocating time between the
two goods, Leonard and Sheldon give up units of one good to produce units of the other
good, moving along their production possibility frontiers. The opportunity cost measures
the trade-off between the two goods that each faces.
Let’s first consider Leonard’s opportunity cost. According to Table 3.1, doing a basket of
clothes takes Leonard three hours of work. When Leonard spends that three hours doing
laundry, he spends three hours less cooking. Because Leonard needs only half an hour to
produce one meal, three hours of work would yield six meals. Hence, Leonard’s opportunity
cost of one basket is six meals.
Now consider Sheldon’s opportunity cost. Washing and ironing one basket takes him
four hours. Because he needs two hours to cook a meal, four hours would yield two meals.
Hence, Sheldon’s opportunity cost of doing one basket of laundry is two meals.
54
Part 1 Introduction
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
03_Stonecash_8e_45658_SB_txt.indd 54
24/08/20 5:59 PM
Table 3.3 shows the opportunity cost of cooking and laundry for Sheldon and Leonard.
Notice that the opportunity cost of cooking is the inverse of the opportunity cost of laundry.
Because one clean basket of laundry costs Leonard six meals, one meal costs Leonard onesixth of a basket of laundry. Similarly, because doing one basket of laundry costs Sheldon
two meals, one meal costs Sheldon half a basket of laundry.
TABLE 3.3 The opportunity cost of meals and baskets of clean clothes
Opportunity cost of one:
Meal (in terms of baskets given up)
Basket (in terms of meals given up)
Sheldon
½
2
Leonard
16
6
Economists use the term comparative advantage when describing the opportunity cost
of two producers. The producer who has the smaller opportunity cost of producing a good
is said to have a comparative advantage in producing that good. In our example, Sheldon
has a lower opportunity cost of laundry than Leonard: A basket of laundry costs Sheldon
two meals, but costs Leonard six meals. Conversely, Leonard has a lower opportunity cost
of cooking than Sheldon: A meal costs Leonard one-sixth of a basket of laundry, but it
costs Sheldon half of a basket. Thus, Sheldon has a comparative advantage in laundry, and
Leonard has a comparative advantage in cooking.
Although it is possible for one person to have an absolute advantage in both goods (as
Leonard does in our example), it is impossible for the same person to have a comparative
advantage in both goods. Because the opportunity cost of one good is the inverse of the
opportunity cost of the other, if a person’s opportunity cost of one good is relatively high, his
opportunity cost of the other good must be relatively low. Comparative advantage reflects
the relative opportunity cost. Unless two people have exactly the same opportunity cost,
one person will have a comparative advantage in one good and the other person will have a
comparative advantage in the other good.
comparative
advantage
the ability to produce
a good at a lower
opportunity cost than
another producer
Comparative advantage and trade
The gains from specialisation and trade are based not on absolute advantage but on
comparative advantage. When each person specialises in producing the good in which he or
she has a comparative advantage, total production in the economy rises. This increase in the
size of the economic pie can be used to make everyone better off.
In our example, Sheldon spends more time doing laundry and Leonard spends more time
cooking meals. As a result, the total production of laundry rises from three to four baskets
and the total production of cooked meals rises from 16 to 18. Leonard and Sheldon share the
benefits of this increased production.
We can also look at the gains from trade in terms of the price that each person pays the
other. Because Leonard and Sheldon have different opportunity costs, they can both get a
bargain. That is, each benefits from trade by obtaining a good at a price that is lower than
his opportunity cost of that good.
Consider the proposed deal from Sheldon’s viewpoint. Sheldon gets five meals in
exchange for cleaning an extra one-and-a-half baskets of laundry. In other words, Sheldon
buys each meal for a price of three-tenths of a basket of laundry. This price of a meal is lower
than his opportunity cost of cooking, which is half a basket. Thus, Sheldon benefits from the
deal because he gets to buy meals at a good price.
Now consider the deal from Leonard’s viewpoint. Leonard buys a basket of laundry for
a price of just over three meals. This price of laundry is lower than his opportunity cost of
55
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole
or in3part.
WCN 02-200-202and the gains from trade
Chapter
Interdependence
03_Stonecash_8e_45658_SB_txt.indd 55
24/08/20 5:59 PM
laundry, which is six meals. Thus, Leonard benefits because he gets to buy a laundry service
at a good price.
The story of Leonard and Sheldon has a simple moral, which should now be clear – trade
can benefit everyone in society because it allows people to specialise in activities in which they
have a comparative advantage.
FYI
The legacy of Adam Smith and David Ricardo
Economists have long understood the principle
of comparative advantage. Here is how the great
economist Adam Smith put the argument:
It is a maxim of every prudent master of a family,
never to attempt to make at home what it will cost
him more to make than to buy. The tailor does not
attempt to make his own shoes, but buys them off
the shoemaker. The shoemaker does not attempt
to make his own clothes but employs a tailor. The
farmer attempts to make neither the one nor the
other, but employs those different artificers. All of
them find it for their interest to employ their whole
industry in a way in which they have some advantage
over their neighbours, and to purchase with a part of
its produce, or what is the same thing, with the price
of part of it, whatever else they have occasion for.
KEY
FIGURES
David Ricardo
This quotation is from Smith’s 1776 book The Wealth of Nations, which was a
landmark in the analysis of trade and economic interdependence.
Smith’s book inspired David Ricardo, a millionaire stockbroker, to become an
economist. In his 1817 book On the Principles of Political Economy and Taxation,
Ricardo developed the principle of comparative advantage as we know it today. He
considered an example with two goods (wine and cloth) and two countries (England
and Portugal). He showed that both countries can gain by opening up trade and
specialising based on comparative advantage.
Ricardo’s theory is the starting point of modern international economics, but his
defence of free trade was not a mere academic exercise. Ricardo put his economic
beliefs to work as a member of the British Parliament, where he opposed the Corn
Laws, which restricted grain imports.
The conclusions of Adam Smith and David Ricardo on the gains from trade have
held up well over time. Although economists often disagree on questions of policy,
they are united in their support of free trade. Moreover, the central argument for
free trade has not changed much in the past two centuries. Even though the field of
economics has broadened its scope and refined its theories since the time of Smith
and Ricardo, economists’ opposition to trade restrictions is still based largely on the
principle of comparative advantage.
The price of trade
The principle of comparative advantage establishes that there are gains from specialisation
and trade, but it raises a couple of related questions: What determines the price at which
trade takes place? How are the gains from trade shared between the trading parties? The
precise answers to these questions are beyond the scope of this chapter, but we can state
one general rule: For both parties to gain from trade, the price at which they trade must lie
between their opportunity costs.
56
Part 1 Introduction
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
03_Stonecash_8e_45658_SB_txt.indd 56
24/08/20 5:59 PM
In our example, Leonard and Sheldon agreed to trade at a rate of three-tenths of a basket
of laundry for each meal. This price is between Leonard’s opportunity cost (one-sixth of
a basket of laundry per meal) and Sheldon’s opportunity cost (half of a basket of laundry per
meal). The price need not be exactly three-tenths, but it must be somewhere between onesixth and a half for both parties to gain.
To see why the price has to be in this range, consider what would happen if it were not.
If the price of a meal were below one-sixth of a basket of laundry, both Leonard and Sheldon
would want to buy meals, because the price would be below each of their opportunity costs.
Similarly, if the price of a meal were above half of a basket of laundry, both would want
to sell meals, because the price would be above their opportunity costs. But this economy
(Leonard and Sheldon’s household) has only two people. They cannot both be buyers of
meals, nor can they both be sellers. Someone has to take the other side of the deal.
A mutually advantageous trade can be struck at a price between one-sixth and a half. In
this price range, Leonard wants to sell meals and buy baskets of laundry, and Sheldon wants
to sell baskets of laundry and buy meals. Each party can buy a service at a price that is lower
than his or her opportunity cost of that service. In the end, each person specialises in the
service in which he has a comparative advantage and, as a result, is better off.
CHECK YOUR UNDERSTANDING
Robinson Crusoe can gather 10 coconuts or catch one fish per hour. His friend Friday
can gather 30 coconuts or catch two fish per hour. What is Crusoe’s opportunity cost of
catching one fish? What is Friday’s? Who has an absolute advantage in catching fish? Who
has a comparative advantage in catching fish?
LO3.3 Applications of comparative advantage
The principle of comparative advantage explains interdependence and the gains from trade.
Because interdependence is so prevalent in the modern world, the principle of comparative
advantage has many applications. Here are two examples, one fanciful and one of great
practical importance.
Should Serena Williams mow her own lawn?
Serena Williams is a great athlete. She is one of the best tennis players in the world and has
23 Grand Slam singles titles. Very likely, she is better at other activities, too. For example,
Serena can probably mow her lawn faster than anyone else. But just because she can mow
her lawn fast, does this mean she should?
To answer this question, we can use the concepts of opportunity cost and comparative
advantage. Let’s say that Serena can mow her lawn in two hours. In that same two hours, she
could film a television commercial for sports shoes and earn $1 000 000. In contrast, Todd,
who lives down the road, can mow Serena’s lawn in four hours. In that same four hours, he
could work at Coles supermarket and earn $40.
In this example, Serena’s opportunity cost of mowing the lawn is $1 000 000 and Todd’s
opportunity cost is $40. Serena has an absolute advantage in mowing lawns because she can
do the work in less time. Yet Todd has a comparative advantage in mowing lawns because he
has the lower opportunity cost.
The gains from trade in this example are tremendous. Rather than mowing her own
lawn, Serena should make the commercial and hire Todd to mow the lawn. As long as Serena
pays Todd more than $40 and less than $1 000 000, both of them are better off.
57
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole
or in3part.
WCN 02-200-202and the gains from trade
Chapter
Interdependence
03_Stonecash_8e_45658_SB_txt.indd 57
24/08/20 5:59 PM
Should Australia trade with other countries?
Just as individuals can benefit from specialisation and trade with one another, as Leonard
and Sheldon did, so can populations of people in different countries. Many of the goods that
Australians enjoy are produced abroad and many of the goods produced in Australia are sold
abroad. Goods produced abroad and sold domestically are called imports. Goods produced
domestically and sold abroad are called exports.
To see how countries can benefit from trade, suppose there are two countries, Australia
and Japan, and two goods, food and cars. Imagine that the two countries produce cars
equally well – an Australian worker and a Japanese worker can each produce one car per
month. By contrast, because Australia has more fertile land, it is better at producing food:
An Australian worker can produce 2 tonnes of food per month, whereas a Japanese worker
can produce only 1 tonne of food per month.
The principle of comparative advantage states that each good should be produced by the
country that has the lower opportunity cost of producing that good. Because the opportunity
cost of a car is 2 tonnes of food in Australia but only 1 tonne of food in Japan, Japan has a
comparative advantage in producing cars. Japan should produce more cars than it wants
for its own use and export some of them to Australia. Similarly, because the opportunity
cost of a tonne of food is one car in Japan but only half a car in Australia, Australia has
a comparative advantage in producing food. Australia should produce more food than it
wants to consume and export some of it to Japan. Through specialisation and trade, both
countries can have more food and more cars.
To be sure, the issues involved in trade among nations are more complex than this
example suggests. Most important, each country has many people, and trade may affect
them in different ways. When Australia exports food and imports cars, the impact on an
Australian farmer is not the same as the impact on an Australian car worker. As a result,
international trade can make some individuals worse off, even as it makes the country as a
whole better off. Yet this example teaches us an important lesson: Contrary to the opinions
sometimes voiced by politicians and political commentators, international trade is not like
war, in which some countries win and others lose. Trade allows all countries to achieve
greater prosperity.
imports
goods and services
that are produced
abroad and sold
domestically
exports
goods and services
that are produced
domestically and
sold abroad
IN THE
NEWS
Economics within a marriage
An economist argues that you shouldn’t always unload the dishwasher just
because you’re better at it than your partner.
You’re dividing the chores wrong
by Emily Oster
No one likes doing chores. In happiness surveys, housework is ranked down there with
commuting as activities that people enjoy the least. Maybe that’s why figuring out who
does which chores usually prompts, at best, tense discussion in a household and, at
worst, outright fighting.
If everyone is good at something different, assigning chores is easy. If your partner
is great at grocery shopping and you are great at the laundry, you’re set. But this isn’t
always – or even usually – the case. Often one person is better at everything. (And let’s
be honest, often that person is the woman.) Better at the laundry, the grocery shopping,
the cleaning, the cooking. But does that mean she should have to do everything?
Before my daughter was born, I both cooked and did the dishes. It wasn’t a big deal,
it didn’t take too much time, and honestly I was a lot better at both than my husband.
His cooking repertoire extended only to eggs and chili, and when I left him in charge of
the dishwasher, I’d often find he had run it ‘full’ with one pot and eight forks.
58
Part 1 Introduction
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
03_Stonecash_8e_45658_SB_txt.indd 58
24/08/20 5:59 PM
After we had a kid, we had more to do and less time to do it in. It seemed like it was
time for some reassignments. But, of course, I was still better at doing both things. Did
that mean I should do them both?
I could have appealed to the principle of fairness: We should each do half. I could
have appealed to feminism – surveys show that women more often than not get the
short end of the chore stick. In time-use data, women do about 44 minutes more
housework than men (2 hours and 11 minutes versus 1 hour and 27 minutes). Men
outwork women only in the areas of ‘lawn’ and ‘exterior maintenance.’ I could have
suggested he do more chores to rectify this imbalance, to show our daughter, in the
Free to Be You and Me style, that Mom and Dad are equal and that housework is fun if we
do it together! I could have simply smashed around the pans in the dishwasher while
sighing loudly in the hopes he would notice and offer to do it himself.
But luckily for me and my husband, I’m an economist, so I have more effective tools
than passive aggression. And some basic economic principles provided the answer.
We needed to divide the chores because it is simply not efficient for the best cook and
dishwasher to do all the cooking and dishwashing. The economic principle at play here
is increasing marginal cost. Basically, people get worse when they are tired. When I
teach my students at the University of Chicago this principle, I explain it in the context of
managing their employees. Imagine you have a good employee and a not-so-good one.
Should you make the good employee do literally everything?
Usually, the answer is no. Why not? It’s likely that the not-so-good employee is better
at 9 a.m. after a full night of sleep than the good employee is at 2 a.m. after a 17-hour
workday. So you want to give at least a few tasks to your worse guy. The same principle
applies in your household. Yes, you (or your spouse) might be better at everything.
But anyone doing the laundry at 4 a.m. is likely to put the red towels in with the white
T-shirts. Some task splitting is a good idea. How much depends on how fast people’s
skills decay.
To ‘optimize’ your family efficiency (every economist’s ultimate goal – and yours,
too), you want to equalize effectiveness on the final task each person is doing. Your
partner does the dishes, mows the lawn, and makes the grocery list. You do the cooking,
laundry, shopping, cleaning, and paying the bills. This may seem imbalanced, but when
you look at it, you see that by the time your partner gets to the grocery-list task, he is
wearing thin and starting to nod off. It’s all he can do to figure out how much milk you
need. In fact, he is just about as good at that as you are when you get around to paying
the bills, even though that’s your fifth task.
If you then made your partner also do the cleaning – so it was an even four and four –
the house would be a disaster, since he is already exhausted by his third chore while
you are still doing fine. This system may well end up meaning one person does more,
but it is unlikely to result in one person doing everything.
Once you’ve decided you need to divide up the chores in this way, how should you
decide who does what? One option would be randomly assigning tasks; another would
be having each person do some of everything. One spousal-advice website I read
suggested you should divide tasks based on which ones you like the best. None of these
are quite right. (In the last case, how would anyone ever end up with the job of cleaning
the bathroom?)
To decide who does what, we need more economics. Specifically, the principle of
comparative advantage. Economists usually talk about this in the context of trade.
Imagine Finland is better than Sweden at making both reindeer hats and snowshoes.
But they are much, much better at the hats and only a little better at the snowshoes.
The overall world production is maximized when Finland makes hats and Sweden
makes snowshoes.
We say that Finland has an absolute advantage in both things but a comparative
advantage only in hats. This principle is part of the reason economists value free trade,
but that’s for another column (and probably another author). But it’s also a guideline for
how to trade tasks in your house. You want to assign each person the tasks on which
59
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole
or in3part.
WCN 02-200-202and the gains from trade
Chapter
Interdependence
03_Stonecash_8e_45658_SB_txt.indd 59
24/08/20 5:59 PM
Illustration by Robert Neubecker.
he or she has a comparative advantage.
It doesn’t matter that you have an absolute
advantage in everything. If you are much,
much better at the laundry and only a little
better at cleaning the toilet, you should
do the laundry and have your spouse get
out the scrub brush. Just explain that it’s
efficient!
In our case, it was easy. Other than
using the grill – which I freely admit is the
husband domain – I’m much, much better at
cooking. And I was only moderately better
One person is better at every chore,
at the dishes. So he got the job of cleaning
including laundry, but does that mean
up after meals, even though his dishwasher
he or she should have to do everything?
loading habits had already come under
scrutiny. The good news is another economic
principle I hadn’t even counted on was soon in play: learning by doing. As people do a
task, they improve at it. Eighteen months into this new arrangement the dishwasher is
almost a work of art: neat rows of dishes and everything carefully screened for ‘top-rack
only’ status. I, meanwhile, am forbidden from getting near the dishwasher. Apparently,
there is a risk that I’ll ‘ruin it.’
Source: From Slate. © 2012 The Slate Group. All rights reserved.
Used under license.
CHECK YOUR UNDERSTANDING
Suppose that the world’s fastest typist happens to be trained in brain surgery. Should that
person type for herself or hire a secretary? Explain.
Conclusion: Trade can make everyone better off
You should now understand more fully the benefits of living in an interdependent economy.
When Chinese companies buy Australian iron ore, when residents of Tasmania buy a
mango grown in the Northern Territory and when you spend Friday night babysitting for
neighbours rather than going out, the same economic forces are at work. The principle of
comparative advantage shows that trade can make everyone better off.
Having seen why interdependence is desirable, you might naturally ask how it is
possible. How do free societies coordinate the diverse activities of all the people involved in
their economies? What ensures that goods and services will get from those who should be
producing them to those who should be consuming them? In a world with only two people,
such as Leonard and Sheldon, the answer is simple: These two people can directly bargain
and allocate resources between themselves. In the real world with billions of people, the
answer is less obvious. We take up this issue in the next chapter, where we see that free
societies allocate resources through the market forces of supply and demand.
60
Part 1 Introduction
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
03_Stonecash_8e_45658_SB_txt.indd 60
24/08/20 5:59 PM
LO3.1 Each person consumes goods and services produced by many other people, both in
our country and around the world. Interdependence and trade are desirable because
they allow everyone to enjoy a greater quantity and variety of goods and services.
LO3.2 There are two ways to compare the abilities of two people to produce a good. The
person who can produce the good with the smaller quantity of inputs is said to have an
absolute advantage in producing the good. The person who has the lower opportunity
cost of producing the good is said to have a comparative advantage. The gains from
trade are based on comparative advantage, not absolute advantage.
LO3.3 Trade makes everyone better off because it allows people to specialise in those activities
in which they have a comparative advantage. The principle of comparative advantage
applies to countries as well as to people. Economists use the principle of comparative
advantage to advocate free trade among countries.
Key concepts
absolute advantage, p. 54
comparative advantage, p. 55
exports, p. 58
imports, p. 58
Apply and revise
1
2
3
4
5
6
Under what conditions is the production possibilities frontier linear rather than bowed out?
Explain how absolute advantage and comparative advantage differ.
Give an example in which one person has an absolute advantage in doing something but
another person has a comparative advantage.
Is absolute advantage or comparative advantage more important for trade? Explain your
answer using the example in your answer to question 3.
If two parties trade based on comparative advantage and both gain, in what range must the
price of the trade lie?
Why do economists oppose policies that restrict trade among nations?
STUDY TOOLS
Summary
Practice questions
Multiple choice
1
2
3
In an hour, David can wash two cars or mow one lawn, while Ron can wash three cars or
mow one lawn. Who has the absolute advantage in car washing, and who has the absolute
advantage in lawn mowing?
a David in washing, Ron in mowing
b Ron in washing, David in mowing
c David in washing, neither in mowing
d Ron in washing, neither in mowing
Once again, in an hour, David can wash two cars or mow one lawn, while Ron can wash
three cars or mow one lawn. Who has the comparative advantage in car washing, and who
has the comparative advantage in lawn mowing?
a David in washing, Ron in mowing
b Ron in washing, David in mowing
c David in washing, neither in mowing
d Ron in washing, neither in mowing
When two individuals produce efficiently and then make a mutually beneficial trade based
on comparative advantage,
a they both obtain consumption outside their production possibilities frontier.
b they both obtain consumption inside their production possibilities frontier.
c one individual consumes inside his production possibilities frontier, while the other
consumes outside his.
d each individual consumes a point on his own production possibilities frontier.
61
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole
or in3part.
WCN 02-200-202and the gains from trade
Chapter
Interdependence
03_Stonecash_8e_45658_SB_txt.indd 61
24/08/20 5:59 PM
4
5
6
Which goods will a nation typically import?
a Those goods in which the nation has an absolute advantage.
b Those goods in which the nation has a comparative advantage.
c Those goods in which other nations have an absolute advantage.
d Those goods in which other nations have a comparative advantage.
Suppose that in Australia, producing a tonne of beef takes 10 hours of labour, while
producing a shirt takes two hours of labour. In China, producing 1 tonne of beef takes
40 hours of labour, while producing a shirt takes four hours of labour. What will these
nations trade?
a China will export beef, while Australia will export shirts.
b China will export shirts, while Australia will export beef.
c Both nations will export shirts.
d There are no gains from trade in this situation.
Mark can cook dinner in 30 minutes and wash the laundry in 20 minutes. His roommate
takes half as long to do each task. How should the roommates allocate the work?
a Mark should do more of the cooking based on his comparative advantage.
b Mark should do more of the washing based on his comparative advantage.
c Mark should do more of the washing based on his absolute advantage.
d There are no gains from trade in this situation.
Problems and applications
1
2
3
4
Maria can read 20 pages of economics in an hour. She can also read 50 pages of sociology
in an hour. She spends five hours per day studying.
a Draw Maria’s production possibilities frontier for reading economics and sociology.
b What is Maria’s opportunity cost of reading 100 pages of sociology?
Australian and Japanese workers can each produce four cars per year. An Australian worker
can produce 10 tonnes of grain per year, whereas a Japanese worker can produce 5 tonnes
of grain per year. To keep things simple, assume that each country has 100 million workers.
a For this situation, construct a table similar to Table 3.1.
b Graph the production possibilities frontier of the Australian and Japanese economies.
c For Australia, what is the opportunity cost of a car? Of grain? For Japan, what is the
opportunity cost of a car? Of grain? Put this information in a table similar to Table 3.3.
d Which country has an absolute advantage in producing cars? In producing grain?
e Which country has a comparative advantage in producing cars? In producing grain?
f Without trade, half of each country’s workers produce cars and half produce grain. What
quantities of cars and grain does each country produce?
g Starting from a position without trade, give an example in which trade makes each
country better off.
Monica and Rachel are flatmates. They spend most of their time working, but they leave
some time for their favourite activities – making pizza and fine coffee. Monica takes five
minutes to make a pot of coffee and half an hour to make a pizza. Rachel takes 15 minutes
to make a pot of coffee and one hour to make a pizza.
a What is each flatmate’s opportunity cost of making a pizza? Who has the absolute
advantage in making pizza? Who has the comparative advantage in making pizza?
b If Rachel and Monica trade foods with each other, who will trade away pizza in exchange
for coffee?
c The price of pizza can be expressed in terms of pots of coffee. What is the highest price
at which pizza can be traded that would make both flatmates better off? What is the
lowest price? Explain.
Suppose that there are 10 million workers in South Korea and that each of these workers
can produce either two cars or 30 bags of wheat in a year.
a What is the opportunity cost of producing a car in South Korea? What is the opportunity
cost of producing a bag of wheat in South Korea? Explain the relationship between the
opportunity costs of the two goods.
b Draw South Korea’s production possibilities frontier. If South Korea chooses to consume
10 million cars, how much wheat can it consume without trade? Label this point on the
production possibilities frontier.
62
Part 1 Introduction
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
03_Stonecash_8e_45658_SB_txt.indd 62
24/08/20 5:59 PM
c
5
6
Now suppose that Thailand offers to buy 10 million cars from South Korea in exchange
for 20 bags of wheat per car. If South Korea continues to consume 10 million cars, how
much wheat does this deal allow South Korea to consume? Label this point on your
diagram. Should South Korea accept the deal?
England and Scotland both produce scones and jumpers. Suppose that an English worker
can produce 50 scones per hour or one jumper per hour. Suppose that a Scottish worker
can produce 40 scones per hour or two jumpers per hour.
a Which country has the absolute advantage in the production of each good? Which
country has the comparative advantage?
b If England and Scotland decide to trade, which commodity will Scotland trade to
England? Explain.
c If a Scottish worker could produce only one jumper per hour, would Scotland still gain
from trade? Would England still gain from trade? Explain.
The following table describes the production possibilities of two cities:
Maroon shirts per worker
per hour
Blue shirts per worker
per hour
Brisbane
3
3
Sydney
2
1
a
7
8
9
Without trade, what is the price of blue shirts (in terms of maroon shirts) in Brisbane?
What is the price in Sydney?
b Which city has an absolute advantage in the production of each colour shirt? Which city
has a comparative advantage in the production of each colour shirt?
c If the cities trade with each other, which colour shirt will each export?
d What is the range of prices at which trade can occur?
A German worker takes 400 hours to produce a car and two hours to produce a case of
wine. A French worker takes 600 hours to produce a car and X hours to produce a case
of wine.
a For what values of X will gains from trade be possible? Explain.
b For what values of X will Germany export cars and import wine? Explain.
Suppose that in a year an American worker can produce 100 shirts or 20 computers and a
Chinese worker can produce 100 shirts or 10 computers.
a For each country, graph the production possibilities frontier. Suppose that without
trade the workers in each country spend half their time producing each good. Identify
this point in your graphs.
b If these countries were open to trade, which country would export shirts? Give a specific
numerical example and show it on your graphs. Which country would benefit from
trade? Explain.
c Explain at what price of computers (in terms of shirts) the two countries might trade.
d Suppose that China catches up with American productivity so that a Chinese worker can
produce 100 shirts or 20 computers in a year. What pattern of trade would you predict
now? How does this advance in Chinese productivity affect the economic wellbeing of
the two countries’ citizens?
Are the following statements true or false? Explain in each case.
a ‘Two countries can achieve gains from trade even if one of the countries has an
absolute advantage in the production of all goods.’
b ‘Certain very talented people have a comparative advantage in everything they do.’
c ‘If a certain trade is good for one person, it can’t be good for the other one.’
d ‘If a certain trade is good for one person, it must also be good for the other one.’
63
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole
or in3part.
WCN 02-200-202and the gains from trade
Chapter
Interdependence
03_Stonecash_8e_45658_SB_txt.indd 63
24/08/20 5:59 PM
PART
PART TWO
ONE
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
04_Stonecash_8e_45658_SB_txt.indd 64
24/08/20 4:31 PM
Supply and demand:
How markets work
Chapter 4 The market forces of supply and demand
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
04_Stonecash_8e_45658_SB_txt.indd 65
24/08/20 4:31 PM
4
The market forces
of supply and demand
Learning objectives
After reading this chapter, you should be able to:
LO4.1 identify a competitive market
LO4.2 explain what determines the demand for a good in a competitive market
LO4.3 explain what determines the supply of a good in a competitive market
LO4.4 describe how supply and demand together determine the price of a good, and
how prices allocate scarce resources in market economies.
66
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
04_Stonecash_8e_45658_SB_txt.indd 66
24/08/20 4:31 PM
Introduction
When a cyclone hits Queensland, the price of bananas rises in supermarkets throughout the
country. During warmer months, the price of hotel rooms in a Falls Creek skiing resort falls.
When a war breaks out in the Middle East, the price of petrol in Australia rises and the price
of a used SUV falls. What do these events have in common? They all show the workings of
supply and demand.
Supply and demand are the two words that economists use most often – and for good
reason. Supply and demand are the forces that make market economies work. They
determine the quantity of each good produced and the price at which it is sold. If you want
to know how any event or policy will affect the economy, you must think first about how it
will affect supply and demand.
This chapter introduces the theory of supply and demand. It considers how buyers and
sellers behave and how they interact with one another. It shows how supply and demand
determine prices in a market economy and how prices, in turn, allocate the economy’s
scarce resources.
LO4.1 Markets and competition
The terms supply and demand refer to the behaviour of people as they interact with one
another in competitive markets. Before discussing how buyers and sellers behave, let’s first
consider more fully what we mean by the terms market and competition.
What is a market?
A market is a group of buyers and sellers of a particular good or service. The buyers as a
group determine the demand for the product and the sellers as a group determine the supply
of the product.
Markets take many forms. Sometimes markets are highly organised, such as the
sharemarket, or the market for agricultural commodities, like the Sydney fish market. In
these markets, buyers and sellers meet at a specific time and place. Buyers come knowing
how much they are willing to buy at various prices, and sellers come knowing how much
they are willing to sell at various prices. An auctioneer facilitates the process by keeping
order, arranging sales, and (most importantly) finding the price that matches the quantity
that sellers want to sell with the quantity that buyers want to buy.
More often, markets are less organised. For example, consider the market for ice-cream
in a particular town. Buyers of ice-cream do not meet together at any one time or at any
one place. The sellers of ice-cream are in different locations and offer somewhat different
products. There is no auctioneer calling out the price of ice-cream. Each seller posts a price
for an ice-cream and each buyer decides how many ice-cream cones to buy at each store.
Nonetheless, these consumers and producers of ice-cream are closely connected. The icecream buyers are choosing from the various ice-cream sellers to satisfy their cravings, and
the ice-cream sellers are all trying to appeal to the same ice-cream buyers to make their
businesses successful. Even though it is not as organised, the group of ice-cream buyers and
ice-cream sellers forms a market.
market
a group of buyers and
sellers of a particular
good or service
What is competition?
The market for ice-cream, like most markets in the economy, is highly competitive. Each
buyer knows that there are several sellers from which to choose. Each seller is aware that
their product is similar to that offered by other sellers. As a result, the price and quantity of
ice-cream are not determined by any single buyer or seller. Rather, price and quantity are
determined by all buyers and sellers as they interact in the marketplace.
67
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole
or in part.
WCN
02-200-202
Chapter
4 The
market
forces of supply and demand
04_Stonecash_8e_45658_SB_txt.indd 67
24/08/20 4:31 PM
competitive market
a market in which
there are many buyers
and many sellers
so that each has a
negligible impact on
the market price
Economists use the term competitive market to describe a market in which there are so
many buyers and so many sellers that each has a negligible impact on the market price. Each
seller has limited control over the price because other sellers are offering similar products. A
seller has little reason to charge less than the going price, and if more is charged then buyers
will make their purchases elsewhere. Similarly, no single buyer of ice-cream can influence
the price of ice-cream because each buyer purchases only a small amount.
In this chapter we assume that markets are perfectly competitive. To reach this highest
form of competition, a market must have two characteristics:
1 The goods offered for sale are all exactly the same.
2 The buyers and sellers are so numerous that no single buyer or seller has any influence
over the market price.
Because buyers and sellers in a perfectly competitive market must accept the price the
market determines, they are said to be price takers. At the market price, buyers can buy all
they want and sellers can sell all they want.
There are some markets in which the assumption of perfect competition applies
perfectly. In the international wheat market, for example, there are thousands of farmers
who sell wheat and billions of consumers who use wheat and wheat products. Because no
single buyer or seller can influence the price of wheat, each takes the market price as given.
Not all goods and services, however, are sold in perfectly competitive markets. Some
markets have only one seller and this seller sets the price. Such a seller is called a monopoly.
Your local water company, for instance, may be a monopoly. Residents of your town probably
have only one company from which to buy tap water. Still other markets fall between the
extremes of perfect competition and monopoly.
Despite the diversity of market types we find in the world, assuming perfect competition
is a useful simplification and, therefore, a natural place to start. Perfectly competitive
markets are easier to analyse because everyone participating in them takes the price as
given by market conditions. Moreover, because some degree of competition is present in
most markets, many of the lessons that we learn by studying supply and demand under
perfect competition apply to more complex markets as well.
CHECK YOUR UNDERSTANDING
What is a market? What are the characteristics of a perfectly competitive market?
LO4.2 Demand
We begin our study of markets by examining the behaviour of buyers. To focus our thinking,
let’s keep in mind a particular good – ice-cream.
The demand curve: The relationship between price and quantity demanded
quantity demanded
the amount of a good
that buyers are willing
and able to purchase
law of demand
the claim that, other
things being equal, the
quantity demanded of
a good falls when the
price of the good rises
The quantity demanded of any good is the amount of the good that buyers are willing and
able to purchase. As we will see, many things determine the quantity demanded of a good,
but in our analysis of how markets work, one determinant plays a central role: the good’s
price. If the price of ice-cream rose to $20 per scoop, you would buy less ice-cream. You might
buy frozen yoghurt instead. If the price of ice-cream fell to $0.50 per scoop, you would buy
more. This relationship between price and quantity demanded is true for most goods in
the economy and, in fact, is so pervasive that economists call it the law of demand. Other
things being equal, when the price of a good rises, the quantity demanded of the good falls,
and when the price falls, the quantity demanded rises.
68
Copyright
2021 Cengage
Part 2 Supply and demand:
How markets
work Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
04_Stonecash_8e_45658_SB_txt.indd 68
24/08/20 4:31 PM
Table 4.1 shows how many ice-creams Catherine would buy each month at different
prices of ice-cream. If ice-creams are free, Catherine eats 12 ice-creams per month. At $1.00
each, Catherine buys 10 ice-creams per month. As the price rises further, she buys fewer and
fewer ice-creams. When the price reaches $6.00, Catherine doesn’t buy any ice-cream at all.
Table 4.1 is a demand schedule, a table that shows the relationship between the price of
a good and the quantity demanded, holding constant everything else that influences how
much of the good consumers want to buy.
TABLE 4.1 Catherine’s demand schedule
Price of an ice-cream
demand schedule
a table that shows
the relationship
between the price
of a good and the
quantity demanded
Quantity of ice-creams demanded
$0.00
12
1.00
10
2.00
8
3.00
6
4.00
4
5.00
2
6.00
0
The graph in Figure 4.1 uses the numbers from the table to illustrate the law of demand.
By convention, the price of ice-cream is on the vertical axis and the quantity of ice-cream
demanded is on the horizontal axis. The line relating price and quantity demanded is called
the demand curve. The demand curve slopes downward because, other things being equal,
a lower price means a greater quantity demanded.
demand curve
a graph of the
relationship between
the price of a good
and the quantity
demanded
FIGURE 4.1 Catherine’s demand curve
Price of an
ice-cream
$6.00
5.00
4.00
3.00
2.00
1.00
0
1
2
3
4
5
6
7
8
9
10
11 12
Quantity of
ice-creams
This demand curve, which graphs the demand schedule in Table 4.1, illustrates how the quantity
demanded of the good changes as its price varies. Because a lower price increases the quantity
demanded, the demand curve slopes downwards.
69
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole
or in part.
WCN
02-200-202
Chapter
4 The
market
forces of supply and demand
04_Stonecash_8e_45658_SB_txt.indd 69
24/08/20 4:31 PM
FIGURE 4.2 Market demand as the sum of individual demands
Catherine’s demand
Nicholas’ demand
Price of an
ice-cream
Price of an
ice-cream
$6.00
$6.00
5.00
5.00
4.00
4.00
3.00
3.00
2.00
2.00
1.00
1.00
0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of
ice-creams
0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of
ice-creams
The market demand curve is found by adding horizontally the individual demand curves. At a price of $4, Catherine
demands four ice-creams, and Nicholas demands three ice-creams. The quantity demanded in the market at this price is
seven ice-creams.
Market demand versus individual demand
The demand curve in Figure 4.1 shows an individual’s demand for a product. To analyse
how markets work, we need to determine the market demand, which is the sum of all the
individual demands for a particular good or service.
Table 4.2 shows the demand schedules for ice-cream of two people – Catherine and
Nicholas. At any price, Catherine’s demand schedule tells us how much ice-cream she buys,
and Nicholas’ demand schedule tells us how much ice-cream he buys. The market demand
is the sum of the two individual demands.
TABLE 4.2 Individual and market demand schedules
Price of an
ice-cream
$0.00
1.00
Catherine
Nicholas
Market
12 +
7=
19
10
6
16
2.00
8
5
13
3.00
6
4
10
4.00
4
3
7
5.00
2
2
4
6.00
0
1
1
The graph in Figure 4.2 shows the demand curves that correspond to these demand
schedules. Notice that we add the individual demand curves horizontally to obtain the
market demand curve. That is, to find the total quantity demanded at any price, we add the
individual quantities found on the horizontal axis of the individual demand curves. Because
70
Copyright
2021 Cengage
Part 2 Supply and demand:
How markets
work Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
04_Stonecash_8e_45658_SB_txt.indd 70
24/08/20 4:31 PM
Market demand
Price of an
ice-cream
$6.00
5.00
4.00
3.00
2.00
1.00
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19
( 4 3)
Quantity of
ice-creams
we are interested in analysing how markets work, we will work most often with the market
demand curve. The market demand curve shows how the total quantity demanded of a good
varies as the price of the good varies, while all other factors that affect how much consumers
want to buy are held constant.
Shifts in the demand curve
Because the market demand curve is drawn holding other things constant, it need not
be stable over time. If something happens to alter the quantity demanded at any given
price, the demand curve shifts. For example, suppose that medical researchers suddenly
announce a new discovery – people who regularly eat ice-cream live longer, healthier lives.
The discovery would raise the demand for ice-cream. At any given price, buyers would
now want to purchase a larger quantity of ice-cream and the demand curve for ice-cream
would shift.
Figure 4.3 illustrates shifts in demand. Any change that increases the quantity
demanded at any given price, such as our imaginary discovery by medical researchers, shifts
the demand curve to the right and is called an increase in demand. Any change that reduces
the quantity demanded at every price shifts the demand curve to the left and is called a
decrease in demand.
Changes in many variables can shift the demand curve. Let’s consider the most important.
Income
What would happen to your demand for ice-cream if you lost your job one summer? Most
likely, it would fall. A lower income means that you have less to spend in total, so you would
have to spend less on some – and probably most – goods. If the demand for a good falls when
income falls, the good is called a normal good.
normal good
a good for which,
other things being
equal, an increase
in income leads
to an increase in
quantity demanded
71
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole
or in part.
WCN
02-200-202
Chapter
4 The
market
forces of supply and demand
04_Stonecash_8e_45658_SB_txt.indd 71
24/08/20 4:31 PM
FIGURE 4.3 Shifts in the demand curve
Price of an
ice-cream
Increase
in demand
Decrease
in demand
Demand curve, D3
0
Demand
curve, D1
Demand
curve, D2
Quantity of
ice-creams
Any change that raises the quantity that buyers wish to purchase at a given price shifts the
demand curve to the right. Any change that lowers the quantity that buyers wish to purchase at
a given price shifts the demand curve to the left.
inferior good
a good for which,
other things being
equal, an increase
in income leads
to a decrease in
quantity demanded
substitutes
two goods for which
a decrease in the
price of one good
leads to a decrease
in the demand for
the other good
complements
two goods for which
a decrease in the
price of one good
leads to an increase
in the demand for
the other good
CASE
STUDY
Not all goods are normal goods. If the demand for a good rises when income falls, the
good is called an inferior good. An example of an inferior good might be bus rides. As your
income falls, you are less likely to buy a car or take a taxi and more likely to take the bus.
Prices of related goods
Suppose that the price of frozen yoghurt falls. The law of demand says that you will buy
more frozen yoghurt. At the same time, you will probably buy less ice-cream. Because icecream and frozen yoghurt are both cold, sweet, creamy desserts, they satisfy similar desires.
When a fall in the price of one good reduces the demand for another good, the two goods
are called substitutes. Substitutes are often pairs of goods that are used in place of each
other, such as hot dogs and hamburgers, butter and margarine, and cinema tickets and video
streaming.
Now suppose that the price of chocolate topping falls. According to the law of demand,
you will buy more chocolate topping. Yet, in this case, you will likely buy more ice-cream as
well, since ice-cream and topping are often used together. When a fall in the price of one good
raises the demand for another good, the two goods are called complements. Complements
are often pairs of goods that are used together, such as petrol and cars, computers and
software, and skis and ski-lift tickets.
Are smartphones and tablets substitutes or complements?
The advent of mobile computing has changed the way we interact with computers
and the internet. You may carry a mobile device, such as a smartphone or tablet, with
you, using it to access online services, create documents or play games. But are the
different types of mobile device, smartphone and tablet substitutes or complements?
Let’s explore this question by considering the case of Madeleine and Alexandra, two
users of these devices.
Madeleine uses her tablet to take notes in class. These notes are synced to her
smartphone wirelessly, via the cloud, allowing Madeleine to review her notes on her
phone during her bus trip home.
72
Copyright
2021 Cengage
Part 2 Supply and demand:
How markets
work Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
04_Stonecash_8e_45658_SB_txt.indd 72
24/08/20 4:31 PM
Source: Shutterstock.com/tatayuki.
Alexandra uses both her phone and
tablet to surf the internet, write emails
and check Facebook. Both of these
devices allow Alexandra to access these
online services.
For Madeleine, smartphones and
tablets are complements. She gets greater
functionality out of her two devices when
they are used together. For Alexandra,
they are substitutes. Both smartphones
and tablets fulfil more or less the same
function in Alexandra’s life.
This case illustrates the role that
an individual consumer’s behaviour
plays in determining the nature of the
relationship between two goods or
services. Two goods can be complements
for one person and substitutes for
another. Because of this, when it comes
to the market as a whole, we can only
determine if smartphones and tablets are
complements or substitutes by observing
how a change in the market price of one
product affects the quantity demanded
of the other.
How do you use your smartphone?
Questions
1 Provide another example of two
goods that are complements for
some people, and substitutes
for others. How might people
consume the two goods together?
2 How might one good act as a
substitute for the other?
Tastes
Perhaps the most obvious determinant of your demand for any good or service is your tastes.
If you like ice-cream, you buy more of it. Economists normally do not try to explain people’s
tastes because tastes are based on historical and psychological forces that are beyond the
realm of economics. Economists do, however, examine what happens when tastes change.
Expectations
Your expectations about the future may affect your demand for a good or service today.
If you expect to earn a higher income next month, you may choose to save less now and
spend more of your current income on ice-cream. If you expect the price of ice-cream to fall
tomorrow, you may be less willing to buy an ice-cream at today’s price.
Number of buyers
In addition to the preceding factors, which influence the behaviour of individual buyers,
market demand depends on the number of these buyers. If Peter, another consumer of icecream, were to join Catherine and Nicholas, the quantity demanded in the market would be
higher at every price, and market demand would increase.
Summary
The demand curve shows what happens to the quantity demanded of a good as its price
varies, holding constant all the other variables that influence buyers. When one of these
other variables changes, the quantity demanded at each price changes, and the demand
curve shifts. Table 4.3 lists the variables that influence how much of a particular good
consumers choose to buy.
73
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole
or in part.
WCN
02-200-202
Chapter
4 The
market
forces of supply and demand
04_Stonecash_8e_45658_SB_txt.indd 73
24/08/20 4:31 PM
TABLE 4.3 Variables that influence buyers
Variables that affect quantity demanded
A change in this variable …
Price
Represents a movement along the demand curve
Income
Shifts the demand curve
Prices of related goods
Shifts the demand curve
Tastes
Shifts the demand curve
Expectations
Shifts the demand curve
Number of buyers
Shifts the demand curve
If you have trouble remembering whether you need to shift or move along the demand
curve, it helps to recall a lesson from the appendix to Chapter 2. A curve shifts when there is
a change in a relevant variable that is not measured on either axis. Because the price is on the
vertical axis, a change in price represents a movement along the demand curve. By contrast,
income, the prices of related goods, tastes, expectations and the number of buyers are not
measured on either axis, so a change in one of these variables shifts the demand curve.
CASE
STUDY
Two ways to reduce the quantity of smoking demanded
Because smoking can lead to various illnesses, policymakers often want to reduce the
amount that people smoke. There are two ways that policy can attempt to achieve this
goal.
One way to reduce smoking is to shift the demand curve for cigarettes and other
tobacco products. Public service announcements, mandatory health warnings on
cigarette packets and the prohibition of cigarette advertising are all policies aimed at
reducing the quantity of cigarettes demanded at any given price. If successful, these
policies shift the demand curve for cigarettes to the left, as in panel (a) of Figure 4.4.
Alternatively, policymakers can try to raise the price of cigarettes. If the government
taxes the manufacture of cigarettes, for example, cigarette companies pass much
of this tax on to consumers in the form of higher prices. A higher price encourages
smokers to reduce the number of cigarettes they smoke. In this case, the reduced
amount of smoking does not represent a shift in the demand curve. Instead, it
represents a movement along the same demand curve to a point with a higher price
and lower quantity, as in panel (b) of Figure 4.4.
How much does the amount of smoking respond to changes in the price of
cigarettes? Economists have attempted to answer this question by studying what
happens when the tax on cigarettes changes. They have found that a 10 per cent
increase in the price causes a 4 per cent reduction in the quantity demanded.
Teenagers are found to be especially sensitive to the price of cigarettes – a 10 per cent
increase in the price causes a 12 per cent drop in teenage smoking.
A related question is how the price of cigarettes affects the demand for other
products, such as marijuana. Opponents of cigarette taxes often argue that tobacco
and marijuana are substitutes, so that high cigarette prices encourage marijuana
use. By contrast, many experts on substance abuse view tobacco as a ‘gateway drug’
leading the young to experiment with other harmful substances. Most studies of the
data are consistent with this view – they find that higher cigarette prices are associated
with reduced use of marijuana. In other words, tobacco and marijuana appear to be
complements rather than substitutes.
74
Copyright
2021 Cengage
Part 2 Supply and demand:
How markets
work Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
04_Stonecash_8e_45658_SB_txt.indd 74
24/08/20 4:31 PM
Source: Shutterstock.com/Olaf Speier.
Questions
1 Suppose that the government
legalised marijuana, allowing it to
be sold by licensed retailers. How
would you expect legalisation of
marijuana to affect demand for
cigarettes?
2 Now suppose that the government
also placed a tax on marijuana,
raising its price. How would the
tax on marijuana affect demand
for cigarettes?
What is the best way to stop this?
FIGURE 4.4 Shifts in the demand curve versus movements along the demand curve
(a) A shift in the demand curve
Price of
cigarettes,
per packet
A policy to discourage
smoking shifts the
demand curve to the left.
A
B
$4.00
0
10
D2
(b) A movement along the demand curve
Price of
cigarettes,
per packet
C
$8.00
A tax that raises the price of
cigarettes results in a movement
along the demand curve.
A
4.00
D1
20
Number of cigarettes
smoked per day
0
12
20
D1
Number of cigarettes
smoked per day
If warnings on cigarette packets convince smokers to smoke less, the demand curve for cigarettes shifts to the left.
In panel (a), the demand curve shifts from D1 to D2. At a price of $4 per packet, the quantity demanded falls from 20 to
10 cigarettes per day, as reflected by the shift from point A to point B. In contrast, if a tax raises the price of cigarettes,
the demand curve does not shift. Instead, we observe a movement to a different point on the demand curve. In panel
(b), when the price rises from $4 to $8, the quantity demanded falls from 20 to 12 cigarettes per day, as reflected by the
movement from point A to point C.
CHECK YOUR UNDERSTANDING
List the determinants of the demand for pizza. Give an example of a demand schedule for
pizza, and graph the implied demand curve. Give an example of something that would shift
this demand curve. Would a change in the price of pizza shift this demand curve?
LO4.3 Supply
We now turn to the other side of the market and examine the behaviour of sellers. Once
again, to focus our thinking, let’s consider the market for ice-cream.
75
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole
or in part.
WCN
02-200-202
Chapter
4 The
market
forces of supply and demand
04_Stonecash_8e_45658_SB_txt.indd 75
24/08/20 4:31 PM
The supply curve: The relationship between price and quantity supplied
quantity supplied
the amount of a good
that sellers are willing
and able to sell
law of supply
the claim that, other
things being equal, the
quantity supplied of a
good rises when the
price of the good rises
supply schedule
a table that shows
the relationship
between the price
of a good and the
quantity supplied
supply curve
a graph of the
relationship
between the price
of a good and the
quantity supplied
The quantity supplied of any good or service is the amount that sellers are willing and
able to sell. There are many determinants of quantity supplied, but once again price plays
a special role in our analysis. When the price of ice-cream is high, selling ice-cream is quite
profitable and so the quantity supplied is large. The sellers of ice-cream work long hours,
buy many ice-cream machines and hire many workers. In contrast, when the price of icecream is low, selling ice-cream is less profitable, so sellers produce less ice-cream. At a low
price, some sellers may even shut down, reducing their quantity supplied to zero. This
relationship between price and quantity supplied is called the law of supply: Other things
being equal, when the price of a good rises, the quantity supplied of the good also rises, and
when the price falls, the quantity supplied falls as well.
Table 4.4 shows the quantity supplied by Tony, an ice-cream seller, at various prices of
ice-cream. At a price below $2.00, Tony does not supply any ice-cream at all. As the price
rises, he supplies a greater and greater quantity. This is the supply schedule, a table that
shows the relationship between the price of a good and the quantity supplied, holding
constant everything else that influences how much of the good producers want to sell.
The graph in Figure 4.5 uses the numbers from the table to illustrate the law of supply.
The curve relating price and quantity supplied is called the supply curve. The supply curve
slopes upwards because, other things being equal, a higher price means a greater quantity
supplied.
TABLE 4.4 Tony’s supply schedule
FIGURE 4.5 Tony’s supply curve
Price of an ice-cream
($)
Quantity of ice-creams
supplied
$0.00
0
1.00
0
2.00
1
3.00
2
4.00
3
5.00
4
6.00
5
Price of an
ice-cream
$6.00
5.00
4.00
3.00
2.00
1.00
0
1
2
3
4
5
6
7
8
9 10 11 12 Quantity of
ice-creams
This supply curve, which graphs the supply schedule in
Table 4.4, shows how the quantity supplied of the good
changes as its price varies. Because a higher price increases
the quantity supplied, the supply curve slopes upwards.
Market supply versus individual supply
Just as market demand is the sum of the demands of all buyers, market supply is the sum
of the supplies of all sellers. Table 4.5 shows the supply schedules for two ice-cream
producers – Tony and Sonia. At any price, Tony’s supply schedule tells us the quantity
76
Copyright
2021 Cengage
Part 2 Supply and demand:
How markets
work Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
04_Stonecash_8e_45658_SB_txt.indd 76
24/08/20 4:31 PM
of ice-cream that Tony supplies, and Sonia’s supply schedule tells us the quantity of icecream that Sonia supplies. The market supply is the sum of the supplies from the two
individuals.
TABLE 4.5 Individual and market supply schedule
Price of an ice-cream
$0.00
Tony
Sonia
Market
0+
0=
0
1.00
0
0
0
2.00
1
0
1
3.00
2
2
4
4.00
3
4
7
5.00
4
6
10
6.00
5
8
13
The graph in Figure 4.6 shows the supply curves that correspond to the supply
schedules. As with demand curves, we add the individual supply curves horizontally to
obtain the market supply curve. That is, to find the total quantity supplied at any price, we
add the individual quantities found on the horizontal axis of the individual supply curves.
The market supply curve shows how the total quantity supplied varies as the price of the
good varies, holding constant all the other factors beyond price that influence producers’
decisions about how much to sell.
Shifts in the supply curve
Because the market supply curve is drawn holding other things constant, when one of these
factors changes, the supply curve shifts. For example, suppose that the price of sugar falls.
Because sugar is an input into the production of ice-cream, the lower price of sugar makes
selling ice-cream more profitable. This raises the supply of ice-cream: At any given price,
sellers are now willing to produce a larger quantity. Thus, the supply curve for ice-cream shifts
to the right.
Figure 4.7 illustrates shifts in supply. Any change that raises quantity supplied at every
price, such as a fall in the price of sugar, shifts the supply curve to the right and is called an
increase in supply. Similarly, any change that reduces the quantity supplied at every price
shifts the supply curve to the left and is called a decrease in supply.
There are many variables that can shift the supply curve. Let’s consider the most
important ones.
Input prices
To produce their output of ice-cream, sellers use various inputs – cream, sugar, flavouring, icecream machines, the buildings in which the ice-cream is made, and the labour of workers who
mix the ingredients and operate the machines. When the price of one or more of these inputs
rises, producing ice-cream becomes less profitable, and sellers supply less ice-cream. If input
prices rise substantially, some sellers might shut down and supply no ice-cream at all. Thus, the
quantity supplied of a good is negatively related to the prices of the inputs used to make the good.
Technology
The technology for turning the inputs into ice-cream is yet another determinant of the
quantity supplied. The invention of the mechanised ice-cream machine, for example,
reduced the amount of labour necessary to make ice-cream. By reducing sellers’ costs, the
advance in technology raised the quantity of ice-cream supplied.
77
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole
or in part.
WCN
02-200-202
Chapter
4 The
market
forces of supply and demand
04_Stonecash_8e_45658_SB_txt.indd 77
24/08/20 4:31 PM
FIGURE 4.6 Market supply as the sum of individual supplies
Tony’s supply
Sonia’s supply
Price of an
ice-cream
Price of an
ice-cream
$6.00
$6.00
5.00
5.00
4.00
4.00
3.00
3.00
2.00
2.00
1.00
1.00
0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of
ice-creams
0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of
ice-creams
The market supply curve is found by adding horizontally the individual supply curves. At a price of $4, Tony supplies three
ice-creams and Sonia supplies four ice-creams. The quantity supplied in the market at this price is seven ice-creams.
Expectations
The quantity of ice-cream a seller supplies today may depend on its expectations about the
future. For example, if a seller expects the price of ice-cream to rise in the future, it may put
some of its current production into storage and supply less to the market today.
Number of sellers
In addition to the preceding factors, which influence the behaviour of individual sellers,
market supply depends on the number of sellers. If Tony or Sonia were to retire from the icecream business, the supply in the market would fall.
Summary
The supply curve shows what happens to the quantity supplied of a good when its price
varies, holding constant all the other variables that influence sellers. When one of these
other variables changes, the quantity supplied at each price changes, and the supply curve
shifts. Table 4.6 lists the variables that affect how much of a good producers choose to sell.
Once again, to remember whether you need to shift or move along the supply curve, keep
in mind that a curve shifts only when there is a change in a relevant variable that is not named
on either axis. The price is on the vertical axis, so a change in price represents a movement
along the supply curve. By contrast, because input prices, technology, expectations and the
number of sellers are not measured on either axis, a change in one of these variables shifts
the supply curve.
78
Copyright
2021 Cengage
Part 2 Supply and demand:
How markets
work Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
04_Stonecash_8e_45658_SB_txt.indd 78
24/08/20 4:31 PM
Market supply
Price of an
ice-cream
$6.00
5.00
4.00
3.00
2.00
1.00
0 1 2 3 4 5 6 7 8 9 1011121314 1516 171819
( 3 4)
Quantity of
ice-creams
FIGURE 4.7 Shifts in the supply curve
Price of an
ice-cream
Supply curve, S3
Decrease
in supply
Supply
curve, S1
Supply
curve, S2
Increase
in supply
0
Quantity of
ice-creams
Any change that raises the quantity that sellers wish to produce at a given price shifts the
supply curve to the right. Any change that lowers the quantity that sellers wish to produce at a
given price shifts the supply curve to the left.
79
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole
or in part.
WCN
02-200-202
Chapter
4 The
market
forces of supply and demand
04_Stonecash_8e_45658_SB_txt.indd 79
24/08/20 4:31 PM
TABLE 4.6 Variables that influence sellers
Variables that affect quantity supplied
A change in this variable …
Price
Represents a movement along the supply curve
Input prices
Shifts the supply curve
Technology
Shifts the supply curve
Expectations
Shifts the supply curve
Number of sellers
Shifts the supply curve
CHECK YOUR UNDERSTANDING
List the determinants of the supply of pizza. Give an example of a supply schedule for
pizza, and graph the implied supply curve. Give an example of something that would shift
this supply curve. Would a change in the price of pizza shift this supply curve?
LO4.4 Supply and demand together
equilibrium
a situation in which
supply and demand
have been brought
into balance
Having analysed supply and demand separately, we now combine them to see how they
determine the price and quantity of a good sold in a market.
equilibrium price
the price that balances
quantity supplied and
quantity demanded
Figure 4.8 shows the market supply curve and market demand curve together. Notice that
there is one point at which the supply and demand curves intersect. This point is called
the market’s equilibrium. The price at this intersection is called the equilibrium price and
Equilibrium
FIGURE 4.8 The equilibrium of supply and demand
Price of an
ice-cream
Supply
$4.00
Equilibrium
price
Equilibrium
Demand
Equilibrium
quantity
0 1 2 3 4 5 6 7 8 9 10 11 12 13
Quantity of
ice-creams
The equilibrium is found where the supply and demand curves intersect. At the equilibrium
price, the quantity supplied equals the quantity demanded. Here the equilibrium price is $4.
At this price, seven ice-creams are supplied and seven ice-creams are demanded.
80
Copyright
2021 Cengage
Part 2 Supply and demand:
How markets
work Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
04_Stonecash_8e_45658_SB_txt.indd 80
24/08/20 4:31 PM
the quantity is called the equilibrium quantity. Here the equilibrium price is $4.00 per
ice-cream, and the equilibrium quantity is seven ice-creams.
The dictionary defines the word equilibrium as a situation in which various forces are
in balance. This definition applies to a market’s equilibrium as well. At the equilibrium price,
the quantity of the good that buyers are willing and able to buy exactly balances the quantity
that sellers are willing and able to sell. The equilibrium price is sometimes called the marketclearing price because, at this price, everyone in the market has been satisfied: Buyers have
bought all they want to buy, and sellers have sold all they want to sell.
The actions of buyers and sellers naturally move markets towards the equilibrium of
supply and demand. To see why, consider what happens when the market price is not equal
to the equilibrium price.
Suppose first that the market price is above the equilibrium price, as in panel (a) of
Figure 4.9. At a price of $5.00 per ice-cream, the quantity of the good supplied (10 icecreams) exceeds the quantity demanded (four ice-creams). There is a surplus of the good:
Producers are unable to sell all they want at the going price. A surplus is sometimes called
a situation of excess supply. When there is a surplus in the ice-cream market, for instance,
sellers of ice-cream find their freezers increasingly full of ice-cream they would like to sell
but cannot. They respond to the excess supply by cutting their prices. Falling prices, in
turn, increase the quantity demanded and decrease the quantity supplied. These changes
represent movements along the supply and demand curves (not shifts in the curves). Prices
continue to fall until the market reaches the equilibrium.
equilibrium quantity
the quantity supplied
and the quantity
demanded at the
equilibrium price
surplus
a situation in which
quantity supplied
is greater than
quantity demanded
FIGURE 4.9 Markets not in equilibrium
(a) Excess supply
(b) Excess demand
Price of an
ice-cream
Price of an
ice-cream
Surplus
Supply
Supply
$5.00
4.00
$4.00
3.00
Shortage
Demand
0
4
7
Quantity
demanded
10
Quantity
supplied
Quantity of
ice-creams
0
4
Quantity
supplied
7
Demand
10
Quantity
demanded
Quantity of
ice-creams
In panel (a), there is excess supply. Because the market price of $5.00 is above the equilibrium price, the quantity supplied
(10 ice-creams) exceeds the quantity demanded (four ice-creams). Suppliers try to increase sales by cutting the price of an
ice-cream and this moves the price towards its equilibrium level. In panel (b), there is excess demand. Because the market
price of $3.00 is below the equilibrium price, the quantity demanded (10 ice-creams) exceeds the quantity supplied (four
ice-creams). Because too many buyers are chasing too few goods, suppliers can take advantage of the shortage by raising
the price. Hence, in both cases, the price adjustment moves the market towards the equilibrium of supply and demand.
81
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole
or in part.
WCN
02-200-202
Chapter
4 The
market
forces of supply and demand
04_Stonecash_8e_45658_SB_txt.indd 81
24/08/20 4:31 PM
shortage
a situation in which
quantity demanded
is greater than
quantity supplied
law of supply and
demand
the claim that the
price of any good
adjusts to bring
the supply and
demand for that
good into balance
Suppose now that the market price is below the equilibrium price, as in panel (b) of
Figure 4.9. In this case, the price is $3.00 per ice-cream and the quantity of the good
demanded exceeds the quantity supplied. There is a shortage of the good: Consumers are
unable to buy all they want at the going price. A shortage is sometimes called a situation
of excess demand. When a shortage occurs in the ice-cream market, buyers have to wait in
long lines for a chance to buy the few ice-creams that are available. With too many buyers
chasing too few goods, sellers can respond to excess demand by raising their prices without
losing sales. These price increases cause the quantity demanded to fall and the quantity
supplied to rise. Once again, these changes represent movements along the supply and
demand curves, and they move the market towards the equilibrium.
Thus, regardless of whether the price starts off too high or too low, the activities of the
many buyers and sellers automatically push the market price towards the equilibrium price.
Once the market reaches its equilibrium, all buyers and sellers are satisfied and there is no
upward or downward pressure on the price. How quickly equilibrium is reached varies from
market to market, depending on how quickly prices adjust. In most free markets, however,
surpluses and shortages are only temporary because prices eventually move towards their
equilibrium levels. Indeed, this phenomenon is so pervasive that it is sometimes called the
law of supply and demand – the price of any good adjusts to bring the supply and demand
of that good into balance.
Three steps for analysing changes in equilibrium
So far we have seen how supply and demand together determine a market’s equilibrium, which
in turn determines the price of the good and the amount of the good that buyers purchase and
sellers produce. The equilibrium price and quantity depend on the positions of the supply and
demand curves. When some event shifts one of these curves, the equilibrium in the market
changes, resulting in a new price and a new quantity exchanged between buyers and sellers.
When analysing how some event affects a market, we proceed in three steps. First, we
decide whether the event shifts the supply curve, the demand curve or, in some cases, both
curves. Second, we decide whether the curve shifts to the right or to the left. Third, we use
the supply-and-demand diagram to compare the initial equilibrium with the new one, which
shows how the shift affects the equilibrium price and quantity. Table 4.7 summarises these
three steps. To see how this recipe is used, let’s consider various events that might affect the
market for ice-cream.
TABLE 4.7 A three-step program for analysing changes in equilibrium
1
Decide whether the event shifts the supply or demand curve (or perhaps both).
2
Decide in which direction the curve shifts.
3
Use the supply-and-demand diagram to see how the shift changes the equilibrium.
Example: A change in market equilibrium due to a shift in demand
Suppose that one summer the weather is very hot. How does this event affect the market for
ice-cream? To answer this question, let’s follow our three steps.
1 The hot weather affects the demand curve by changing people’s taste for ice-cream.
That is, the weather changes the amount of ice-cream that consumers want to buy at
any given price. The supply curve is unchanged because the weather does not directly
affect the quantity of ice-cream that firms wish to sell.
2 Because hot weather makes people want to eat more ice-cream, the demand curve
shifts to the right. Figure 4.10 shows this increase in demand as the shift in the
demand curve from D1 to D2. This shift indicates that the quantity of ice-cream
demanded is higher at every price.
82
Copyright
2021 Cengage
Part 2 Supply and demand:
How markets
work Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
04_Stonecash_8e_45658_SB_txt.indd 82
24/08/20 4:31 PM
FIGURE 4.10 How an increase in demand affects the equilibrium
Price of an
ice-cream
1. Hot weather increases
the demand for ice-cream ...
Supply
$5.00
New equilibrium
4.00
2. ... resulting
in a higher
price ...
Initial
equilibrium
D2
D1
0
7
3. ... and a higher
quantity sold.
10
Quantity of
ice-creams
An event that raises quantity demanded at any given price shifts the demand curve to the right.
The equilibrium price and the equilibrium quantity both rise. Here, an abnormally hot summer
causes buyers to demand more ice-cream. The demand curve shifts from D1 to D2, which causes
the equilibrium price to rise from $4.00 to $5.00 and the equilibrium quantity to rise from seven
to 10 ice-creams.
3 At the old price of $4, there is now an excess demand for ice-cream and this shortage
induces sellers to raise the price. As Figure 4.10 shows, the increase in demand raises
the equilibrium price from $4.00 to $5.00 and the equilibrium quantity from seven to 10
ice-creams. In other words, the hot weather increases both the price of ice-cream, and
the quantity of ice-cream sold.
Shifts in curves versus movements along curves
Notice that when hot weather drives up the price of ice-cream, the amount of ice-cream that
firms supply rises, even though the supply curve remains the same. In this case, economists
say there has been an increase in ‘quantity supplied’ but no change in ‘supply’.
‘Supply’ refers to the position of the supply curve, whereas the ‘quantity supplied’ refers
to the amount producers wish to sell. In this example, supply does not change because
the weather does not alter firms’ desire to sell at any given price. Instead, the hot weather
alters consumers’ desire to buy at any given price and thereby shifts the demand curve. The
increase in demand causes the equilibrium price to rise. When the price rises, the quantity
supplied rises. This increase in quantity supplied is represented by the movement along the
supply curve.
To summarise, a shift in the supply curve is called a ‘change in supply’ and a shift in
the demand curve is called a ‘change in demand’. A movement along a fixed supply curve
is called a ‘change in the quantity supplied’, and a movement along a fixed demand curve is
called a ‘change in the quantity demanded’.
83
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole
or in part.
WCN
02-200-202
Chapter
4 The
market
forces of supply and demand
04_Stonecash_8e_45658_SB_txt.indd 83
24/08/20 4:31 PM
Example: A change in market equilibrium due to a shift in supply
Suppose that, during another summer, a bushfire destroys several ice-cream factories. How
does this event affect the market for ice-cream? Once again, to answer this question, we
follow our three steps.
1 The fire affects the supply curve. By reducing the number of sellers, the fire changes
the amount of ice-cream that firms produce and sell at any given price. The demand
curve is unchanged because the fire does not directly change the quantity of ice-cream
consumers wish to buy.
2 The supply curve shifts to the left because, at every price, the quantity of ice-cream
that firms are willing and able to sell is reduced. Figure 4.11 illustrates this decrease in
supply as a shift in the supply curve from S1 to S2.
3 At the old price of $4.00 there is now an excess demand for ice-cream. This shortage
causes ice-cream sellers to raise the price. As Figure 4.11 shows, the shift in the supply
curve raises the equilibrium price from $4.00 to $5.00 and lowers the equilibrium
quantity from seven to four ice-creams. As a result of the fire, the price of ice-cream
rises and the quantity of ice-cream sold falls.
FIGURE 4.11 How a decrease in supply affects the equilibrium
Price of an
ice-cream
S2
1. A bushfire reduces
the supply of ice-cream ...
S1
New
equilibrium
$5.00
Initial equilibrium
4.00
2. ... resulting
in a higher
price ...
Demand
0
4
7
3. ... and a lower
quantity sold.
Quantity of
ice-creams
An event that reduces quantity supplied at a given price shifts the supply curve to the left. The
equilibrium price rises, and the equilibrium quantity falls. Here, a bushfire causes sellers to
supply less ice-cream. The supply curve shifts from S1 to S2, which causes the equilibrium price
to rise from $4.00 to $5.00 and the equilibrium quantity to fall from seven to four ice-creams.
Example: A change in both supply and demand
Now suppose that the hot weather and the fire occur at the same time. To analyse this
combination of events, we again follow our three steps.
1 We determine that both curves must shift. The hot weather affects the demand curve
because it alters the amount of ice-cream that consumers want to buy at any given
84
Copyright
2021 Cengage
Part 2 Supply and demand:
How markets
work Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
04_Stonecash_8e_45658_SB_txt.indd 84
24/08/20 4:31 PM
FIGURE 4.12 A shift in both supply and demand
(b) Price rises, quantity falls
Price of an
ice-cream
Price of an
ice-cream
(a) Price rises, quantity rises
Large
increase in
demand
New
equilibrium
S2
S1
S2
S1
New
equilibrium
P2
P2
P1
D2
Small
decrease in
supply
D1
Q1
Q2
Quantity of
ice-creams
Large
decrease in
supply
P1
D2
Initial equilibrium
Initial equilibrium
0
Small
increase in
demand
D1
0
Q2
Q1
Quantity of
ice-creams
Here we observe a simultaneous increase in demand and decrease in supply. Two outcomes are possible. In panel (a), the
equilibrium price rises from P1 to P2, and the equilibrium quantity rises from Q1 to Q2. In panel (b), the equilibrium price
again rises from P1 to P2, but the equilibrium quantity falls from Q1 to Q2.
price. At the same time, the fire alters the supply curve because it changes the amount
of ice-cream that firms want to sell at any given price.
2 The curves shift in the same directions as they did in our previous analysis – the
demand curve shifts to the right and the supply curve shifts to the left. Figure 4.12
illustrates these shifts.
3 As Figure 4.12 shows, there are two possible outcomes that might result, depending on
the relative size of the demand and supply shifts. In both cases, the equilibrium price
rises. In panel (a), where demand increases substantially and supply falls just a little, the
equilibrium quantity also rises. In contrast, in panel (b), where supply falls substantially
and demand rises just a little, the equilibrium quantity falls. Thus, these events certainly
raise the price of ice-cream, but their impact on the amount of ice-cream sold is ambiguous.
A pandemic shifts the supply curve
In this chapter we have seen three examples of how to use supply and demand
curves to analyse a change in equilibrium. Whenever an event shifts the supply
curve, the demand curve, or perhaps both curves, you can use these tools
to predict how the event will alter the price and quantity sold in equilibrium.
This article provides another example of how a pandemic that reduces supply
reduces the quantity sold and raises the price.
IN THE
NEWS
Preparing for the apocalypse
Suppose people become concerned that an apocalyptic event was on the horizon. This
may be a zombie or alien invasion, but it also could be another crisis such as COVID-19 –
the pandemic the world experienced in 2020 when a deadly virus spread widely. Given
that these events are likely associated with shortages of goods and services (that is, the
anticipation that supply will be drastically reduced as production becomes difficult) what
should we expect to happen?
85
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole
or in part.
WCN
02-200-202
Chapter
4 The
market
forces of supply and demand
04_Stonecash_8e_45658_SB_txt.indd 85
24/08/20 4:31 PM
The theory of supply and demand gives you part of the answer: prices should rise.
When there is a shortage (that is, demand exceeds supply at current prices), we expect
the prices of goods to increase to a point where demand will again equal supply.
In March 2020, when the news of COVID-19 and its seriousness hit the world’s
media, there was concern that there would be shortages of some goods. This included
protective goods like hand sanitiser as well as commonly used items like toilet paper.
Did prices rise?
Both hand sanitiser and toilet paper are durable goods. You can buy them today,
store them and they will still be useful tomorrow. If you are a consumer of such goods
and you expect that there will soon be a shortage, what do you do? What you do is that
you buy more than you need now – that is, you hoard those goods. This means that
prior to there ever being a reduction in supply, there is an increase in demand. The
theory of supply and demand, therefore, predicts that a shortage will arise even before
there are any disruptions in supply. For this reason, prices should rise quickly.
This is what happened. The price of hand sanitiser rose by tenfold before supplies
ran out for a period of time. The price of toilet paper, on the other hand, did not change
very much even though there was a shortage and supply did run out.
Why did toilet paper’s price not change much? The explanation lies in the fact that
toilet paper is mostly sold through chain supermarkets who did not want to increase
its price (even for some short-run profits) because this might harm their brand image
with customers. In addition, toilet paper is used at home and at work. While supplies of
toilet paper packaged for home ran short, because people were not at work for a period
during COVID-19, there was an excess supply of toilet paper packaged for work. Toilet
paper can be repackaged and so supply disruptions proved temporary.
CHECK YOUR UNDERSTANDING
Analyse what happens to the market for pizza if the price of tomatoes rises. Analyse what
happens to the market for pizza if the price of hamburgers falls.
Conclusion: How prices allocate resources
This chapter has analysed supply and demand in a single market. Our discussion has
centred around the market for ice-cream, but the lessons learned here apply to most other
markets as well. Whenever you go to a shop to buy something, you are contributing to the
demand for that item. Whenever you look for a job, you are contributing to the supply of
labour services. Because supply and demand are such pervasive economic phenomena, the
model of supply and demand is a powerful tool for analysis. We use this model repeatedly in
the following chapters.
One of the Ten Principles of Economics discussed in Chapter 1 is that markets are usually
a good way to organise economic activity. Although it is still too early to judge whether
market outcomes are good or bad, in this chapter we have begun to see how markets work.
In any economic system, scarce resources have to be allocated among competing uses.
Market economies harness the forces of supply and demand to serve that end. Supply and
demand together determine the prices of the economy’s many different goods and services;
prices in turn are the signals that guide the allocation of resources.
For example, consider the allocation of beachfront land. Because the amount of this land
is limited, not everyone can enjoy the luxury of living by the beach. Who gets this resource?
The answer is: whoever is willing to pay the price. The price of beachfront land adjusts until
the quantity of land demanded exactly balances the quantity supplied. Thus, in market
economies, prices are the mechanism for rationing scarce resources.
86
Copyright
2021 Cengage
Part 2 Supply and demand:
How markets
work Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
04_Stonecash_8e_45658_SB_txt.indd 86
24/08/20 4:31 PM
Similarly, prices determine who produces each good and how much is produced. For
instance, consider farming. Because we need food to survive, it is crucial that some people
work on farms. What determines who is a farmer and who is not? In a free society, there is
no government planning agency making this decision and ensuring an adequate supply of
food. Instead, the allocation of workers to farms is based on the job decisions of millions of
workers. This decentralised system works well because these decisions depend on prices.
The prices of food and the wages of farm workers (the price of their labour) adjust to ensure
that enough people choose to be farmers.
If a person had never seen a market economy in action, the whole idea might seem
preposterous. Economies are large groups of people engaged in many interdependent
activities. What prevents decentralised decision making from degenerating into chaos?
What coordinates the actions of the millions of people with their varying abilities and
desires? What ensures that what needs to get done does, in fact, get done? The answer,
in a word, is prices. If market economies are guided by an invisible hand, as Adam Smith
famously suggested, then the price system is the baton with which the invisible hand
conducts the economic orchestra.
87
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole
or in part.
WCN
02-200-202
Chapter
4 The
market
forces of supply and demand
04_Stonecash_8e_45658_SB_txt.indd 87
24/08/20 4:31 PM
STUDY TOOLS
Summary
LO4.1 Economists use the model of supply and demand to analyse competitive markets. In a
competitive market, there are many buyers and sellers, each of whom has little or no
influence on the market price.
LO4.2 The demand curve shows how the quantity of a good demanded depends on the price.
According to the law of demand, as the price of a good falls, the quantity demanded
rises. Therefore, the demand curve slopes downwards. In addition to price, other
determinants of the quantity demanded include income, tastes, expectations, and the
prices of substitutes and complements. When one of these other factors changes, the
quantity demanded at each price changes, and the demand curve shifts.
LO4.3 The supply curve shows how the quantity of a good supplied depends on the price.
According to the law of supply, as the price of a good rises, the quantity supplied rises.
Therefore, the supply curve slopes upwards. In addition to price, other determinants
of the quantity supplied include input prices, technology and expectations. When one
of these other factors changes, the quantity supplied at each price changes, and the
supply curve shifts.
LO 4.4 In market economies, prices are the signals that guide economic decisions and thereby
allocate scarce resources. The intersection of the supply and demand curves represents
the market equilibrium. At the equilibrium price, the quantity demanded equals the
quantity supplied. The behaviour of buyers and sellers naturally drives markets towards
their equilibrium. When the market price is above the equilibrium price, there is excess
supply, which causes the market price to fall. When the market price is below the
equilibrium price, there is excess demand, which causes the market price to rise.
Key concepts
competitive market, p. 68
complements, p.72
demand curve, p. 69
demand schedule, p.69
equilibrium, p. 80
equilibrium price, p. 80
equilibrium quantity, p. 81
inferior good, p. 72
law of demand, p. 68
law of supply, p. 76
law of supply and demand, p. 82
market, p. 67
normal good, p. 71
quantity demanded, p. 68
quantity supplied, p. 76
shortage, p. 82
substitutes, p. 72
supply curve, p. 76
supply schedule, p. 76
surplus, p. 81
Apply and revise
1
2
3
4
5
6
7
What is a competitive market? Briefly describe a type of market that is not perfectly
competitive.
What are the demand schedule and the demand curve, and how are they related? Why
does the demand curve slope downwards?
Does a change in consumers’ tastes lead to a movement along the demand curve or to a
shift in the demand curve? Does a change in price lead to a movement along the demand
curve or to a shift in the demand curve? Explain your answers.
Harry’s income declines, and as a result, he buys more carrot juice. Is carrot juice an inferior
or a normal good? What happens to Harry’s demand curve for carrot juice?
What are the supply schedule and the supply curve, and how are they related? Why does
the supply curve slope upwards?
Does a change in producers’ technology lead to a movement along the supply curve or to
a shift in the supply curve? Does a change in price lead to a movement along the supply
curve or to a shift in the supply curve? Explain your answers.
Define the equilibrium of a market. Describe the forces that move a market towards its
equilibrium.
88
Copyright
2021 Cengage
Part 2 Supply and demand:
How markets
work Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
04_Stonecash_8e_45658_SB_txt.indd 88
24/08/20 4:31 PM
8
9
Beer and pies are complements because they are often enjoyed together. When the price
of beer rises, what happens to the supply, demand, quantity supplied, quantity demanded
and the price in the market for pies?
Describe the role of prices in market economies.
Practice questions
Multiple choice
1
2
3
4
5
6
A change in which of the following will NOT shift the demand curve for hamburgers?
a the price of meat pies
b the price of hamburgers
c the price of hamburger buns
d the income of hamburger consumers
An increase in ______ will cause a movement along a given demand curve, which is called a
change in ______.
a supply, demand
b supply, quantity demanded
c demand, supply
d demand, quantity supplied
Movie tickets and Blu-rays are substitutes. If the price of Blu-rays increases, what happens
in the market for movie tickets?
a The supply curve shifts to the left.
b The supply curve shifts to the right.
c The demand curve shifts to the left.
d The demand curve shifts to the right.
The discovery of a large, new reserve of crude oil will shift the ______ curve for petrol, leading
to a ______ equilibrium price.
a supply, higher
b supply, lower
c demand, higher
d demand, lower
If the economy goes into a recession and incomes fall, what happens in the markets for
inferior goods?
a Prices and quantities both rise.
b Prices and quantities both fall.
c Prices rise, quantities fall.
d Prices fall, quantities rise.
Which of the following might lead to an increase in the equilibrium price of meat pies and a
decrease in the equilibrium quantity of meat pies sold?
a an increase in the price of tomato sauce, a complement to meat pies
b an increase in the price of tacos, a substitute for meat pies
c an increase in the price of beef, an input into meat pies
d an increase in consumer incomes, as long as meat pies are a normal good
Problems and applications
1
2
Explain each of the following statements using supply-and-demand diagrams.
a When a cyclone hits Queensland, the price of bananas rises in supermarkets
throughout the country.
b On Tuesdays, cinemas discount tickets.
c When a war breaks out in the Middle East, the price of petrol rises and the price of a
used SUV falls.
‘An increase in the demand for notebooks raises the quantity of notebooks demanded, but
not the quantity supplied.’ Is this statement true or false? Explain.
89
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole
or in part.
WCN
02-200-202
Chapter
4 The
market
forces of supply and demand
04_Stonecash_8e_45658_SB_txt.indd 89
24/08/20 4:31 PM
3 Consider the market for SUVs. For each of the events listed here, identify which of the
determinants of demand or supply are affected. Also indicate whether demand or supply is
increased or decreased.
a People decide to have more children.
b A strike by steelworkers raises steel prices.
c Engineers develop new automated machinery for the production of SUVs.
d The price of sedans rises.
e A stock-market crash lowers people’s wealth.
4 Consider the markets for film-streaming services, TVs, and cinema tickets.
a For each pair, identify whether they are complements or substitutes.
i film-streaming services and TVs
ii film-streaming services and cinema tickets
iii TVs and cinema tickets
b Suppose a technological advance reduces the cost of manufacturing TVs. Draw a
diagram to show what happens in the market for TVs.
c Draw two more diagrams to show how the change in the market for TV screens affects
the markets for film-streaming services and cinema tickets.
5 Over the last 30 years, technological advances have reduced the cost of computer chips.
How do you think this affected the market for computers? For computer software? For
typewriters?
6 Using supply-and-demand diagrams, show the effect of the following events on the market
for woollen jumpers:
a An outbreak of ‘foot-and-mouth’ disease hits sheep farms in New Zealand.
b The price of leather jackets falls.
c Taylor Swift appears in a woollen jumper in her latest video.
d New knitting machines are invented.
7 Tomato sauce is a complement (as well as a condiment) for hot dogs. If the price of hot
dogs rises, what happens to the market for tomato sauce? For tomatoes? For tomato juice?
For orange juice?
8 The market for pizza has the following demand and supply schedules:
Price ($)
Quantity demanded
Quantity supplied
4
135
26
5
104
53
6
81
81
7
68
98
8
53
110
9
39
121
a
Graph the demand and supply curves. What are the equilibrium price and quantity in
this market?
b If the actual price in this market were above the equilibrium price, what would drive the
market towards the equilibrium?
c If the actual price in this market were below the equilibrium price, what would drive the
market towards the equilibrium?
9 Consider the following events: Scientists reveal that eating oranges decreases the risk
of diabetes, and at the same time, farmers use a new fertiliser that makes orange trees
produce more oranges. Illustrate and explain what effect these changes have on the
equilibrium price and quantity of oranges.
10 Because macaroni and cheese are often eaten together, they are complements.
a We observe that both the equilibrium price of cheese and the equilibrium quantity of
macaroni have risen. What could be responsible for this pattern: a fall in the price of
flour or a fall in the price of milk? Illustrate and explain your answer.
b Suppose instead that the equilibrium price of cheese has risen but the equilibrium
quantity of macaroni has fallen. What could be responsible for this pattern: a rise in the
price of flour or a rise in the price of milk? Illustrate and explain your answer.
90
Copyright
2021 Cengage
Part 2 Supply and demand:
How markets
work Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
04_Stonecash_8e_45658_SB_txt.indd 90
24/08/20 4:31 PM
11 Suppose that the price of tickets at your local cinema is determined by market forces.
Currently, the demand and supply schedules are as follows:
Price ($)
Quantity demanded
Quantity supplied
4
1000
800
8
800
800
12
600
800
16
400
800
20
200
800
9
39
121
a
Draw the demand and supply curves. What is unusual about this supply curve? Why
might this be true?
b What are the equilibrium price and quantity of tickets?
c Demographers tell you that next year there will be more film-goers in the area. The
additional people will have the following demand schedule:
Price ($)
Quantity demanded
4
400
8
300
12
200
16
100
Now add the old demand schedule and the demand schedule for the new people
to calculate the new demand schedule for the entire area. What will be the new
equilibrium price and quantity?
91
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole
or in part.
WCN
02-200-202
Chapter
4 The
market
forces of supply and demand
04_Stonecash_8e_45658_SB_txt.indd 91
24/08/20 4:31 PM
PART THREE
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
05_Stonecash_8e_45658_SB_txt.indd 92
24/08/20 4:31 PM
The data of
macroeconomics
Chapter 5 Measuring a nation’s income
Chapter 6 Measuring the cost of living
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
05_Stonecash_8e_45658_SB_txt.indd 93
24/08/20 4:31 PM
5
Measuring a
nation’s income
Learning objectives
After reading this chapter, you should be able to:
LO5.1 consider why an economy’s total income equals its total expenditure
LO5.2 learn how gross domestic product (GDP) is defined and calculated
LO5.3 see the breakdown of GDP into its four major components
LO5.4 learn the distinction between real GDP and nominal GDP
LO5.5 consider whether GDP is a good measure of economic wellbeing.
94
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
05_Stonecash_8e_45658_SB_txt.indd 94
24/08/20 4:31 PM
Introduction
When you finish university and start looking for a full-time job, your experience will, to a
large extent, be shaped by prevailing economic conditions. In some years, firms throughout
the economy are expanding their production of goods and services, employment is rising
and jobs are easy to find. In other years, firms are cutting back on production, employment
is declining and finding a good job takes a long time. Not surprisingly, any university
graduate would rather enter the labour force in a year of economic expansion than in a year
of economic contraction.
Because the condition of the overall economy profoundly affects all of us, changes in
economic conditions are widely reported by the media. Indeed, it is hard to look at a news
website without seeing some newly reported statistic about the economy. The statistic
might measure the total income of everyone in the economy (GDP), the rate at which
average prices are rising (inflation), the percentage of the labour force that is out of work
(unemployment), total spending at stores (retail sales), or the imbalance of trade between
Australia and the rest of the world (the trade deficit). All these statistics are macroeconomic.
Rather than telling us about a particular household or firm, they tell us something about the
entire economy.
As you may recall from chapter 2, economics is divided into two branches – microeconomics
and macroeconomics. Microeconomics is the study of how individual households and firms
make decisions and how they interact with one another in markets. Macroeconomics is the
study of the economy as a whole. The goal of macroeconomics is to explain the economic
changes that affect many households, firms and markets at once. Macroeconomists consider
diverse questions: Why is average income high in some countries and low in others? Why
do prices rise rapidly in some periods of time but are more stable in other periods? Why do
production and employment expand in some years and contract in others? These diverse
questions are all macroeconomic because they concern the workings of the entire economy.
Because the economy as a whole is just a collection of many households and many firms
interacting in many markets, microeconomics and macroeconomics are closely linked. The
basic tools of supply and demand, for instance, are as central to macroeconomic analysis as
they are to microeconomic analysis. Yet studying the economy in its entirety raises some
new and intriguing challenges.
In this chapter and the next one, we discuss some of the data that economists and
policymakers use to monitor the overall economy. These data reflect the economic changes
that macroeconomists try to explain. This chapter considers gross domestic product, or simply
GDP, which measures the total income of a nation. GDP is the most closely watched economic
statistic because it is thought to be the best single measure of a society’s economic wellbeing.
LO5.1 The economy’s income and expenditure
If you were to judge how a person is doing economically, you might first look at his or her
income. A person with a high income can more easily afford life’s necessities and luxuries.
It is no surprise that people with higher incomes enjoy higher standards of living – better
housing, better health care, fancier cars, more opulent holidays and so on.
The same logic applies to a nation’s overall economy. When judging whether the
economy is doing well or poorly, it is natural to look at the total income that everyone in the
economy is earning. That is the task of gross domestic product (GDP).
GDP measures two things at once – the total income of everyone in the economy and the
total expenditure on the economy’s output of goods and services. The reason that GDP can
perform the trick of measuring both total income and total expenditure is that these two
things are really the same. For an economy as a whole, income must equal expenditure.
95
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Chapter
WCN 02-200-202
5 Measuring a nation’s income
05_Stonecash_8e_45658_SB_txt.indd 95
24/08/20 4:31 PM
Why is this true? The reason that an economy’s income is the same as its expenditure is
simply that every transaction has two parties: a buyer and a seller. Every dollar of spending
by some buyer is a dollar of income for some seller. Suppose, for instance, that Karen pays
Doug $100 to mow her lawn. In this case, Doug is a seller of a service and Karen is a buyer.
Doug earns $100 and Karen spends $100. Thus, the transaction contributes equally to the
economy’s income and to its expenditure. GDP, whether measured as total income or total
expenditure, rises by $100.
Another way to see the equality of income and expenditure is with the circular-flow
diagram in Figure 5.1. (You may recall this circular-flow diagram from chapter 2.) This
diagram describes all the transactions between households and firms in a simple economy.
In this economy, households buy goods and services from firms; these expenditures flow
through the markets for goods and services. The firms in turn use the money they receive
from sales to pay workers’ wages, landowners’ rent and firm owners’ profit; this income flows
through the markets for the factors of production. In this economy, money continuously
flows from households to firms and then back to households.
FIGURE 5.1 The circular-flow diagram
Revenue
Goods
and services
sold
FIRMS
Produce and sell
goods and services
Hire and use factors
of production
Inputs for
production
Wages, rent
and profit
MARKETS
FOR
GOODS AND SERVICES
Firms sell
Households buy
Spending
Goods and
services
bought
HOUSEHOLDS
Buy and consume
goods and services
Own and sell factors
of production
Labour, land
MARKETS
and capital
FOR
FACTORS OF PRODUCTION
Households sell
Income
Firms buy
5 Flow of goods
and services
5 Flow of dollars
Households buy goods and services from firms, and firms use their revenue from sales to pay
wages to workers, rent to landowners and profit to firm owners. GDP equals the total amount
spent by households in the market for goods and services. It also equals the total wages, rent
and profit paid by firms in the markets for the factors of production.
We can calculate GDP for this economy in one of two ways – by adding up the total
expenditure by households or by adding up the total income (wages, rent and profit) paid
by firms. Because all expenditure in the economy ends up as someone’s income, GDP is the
same regardless of how we calculate it.
96
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 3 The data of macroeconomics
05_Stonecash_8e_45658_SB_txt.indd 96
24/08/20 4:31 PM
The real economy is, of course, more complicated than the one illustrated in Figure 5.1. In
particular, households do not spend all of their income. Households pay some of their income
to the government in taxes, and they save and invest some of their income for use in the
future. In addition, households do not buy all goods and services produced in the economy.
Some goods and services are bought by governments and some are bought by firms that plan
to use them in the future to produce their own output. Yet, regardless of whether a household,
government, or firm buys a good or service, the transaction has a buyer and seller. Thus, for
the economy as a whole, expenditure and income are always the same.
CHECK YOUR UNDERSTANDING
What two things does gross domestic product measure? How can it measure two things
at once?
LO5.2 The measurement of gross domestic product
Now that we have discussed the meaning of gross domestic product in general terms, let’s be
more precise about how this statistic is measured. Here is a definition of GDP:
• gross domestic product (GDP) is the market value of all final goods and services
produced within a country in a given period of time.
This definition might seem simple enough. But, in fact, many subtle issues arise when
calculating an economy’s GDP. Let’s therefore consider each phrase in this definition with
some care.
gross domestic
product (GDP)
the market value of
all final goods and
services produced
within a country in a
given period of time
‘GDP is the market value …’
You have probably heard the adage, ‘You can’t compare apples and oranges’. Yet GDP does
exactly that. GDP adds together many different kinds of products into a single measure
of the value of economic activity. To do this, it uses market prices. Because market prices
measure the amount people are willing to pay for different goods, they reflect the value of
those goods. If the price of an apple is twice the price of an orange, then an apple contributes
twice as much to GDP as does an orange.
‘… of all …’
GDP tries to be comprehensive. It includes all items produced in the economy and sold
legally in markets. GDP measures the market value of not just apples and oranges, but also
pears and grapefruit, books and films, haircuts and health care, and so on.
GDP also includes the market value of the housing services provided by the economy’s
stock of housing. For rental housing, this value is easy to calculate – the rent equals both the
tenant’s expenditure and the landlord’s income. Yet many people own the place where they
live and, therefore, do not pay rent. The government includes this owner-occupied housing
in GDP by estimating its rental value. In essence, GDP is based on the assumption that the
owners pay themselves this imputed rent, so the rent is included both in their expenditure
and in their income.
There are some products, however, that GDP excludes because measurement of them
is so difficult. GDP excludes items produced and sold illicitly, like illegal drugs. It also
excludes most items that are produced and consumed at home and, therefore, never enter
the marketplace. Vegetables you buy at the supermarket are part of GDP; vegetables you
grow in your garden are not.
97
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Chapter
WCN 02-200-202
5 Measuring a nation’s income
05_Stonecash_8e_45658_SB_txt.indd 97
24/08/20 4:31 PM
These exclusions from GDP can at times lead to paradoxical results. For example, when
Karen pays Doug to mow her lawn, that transaction is part of GDP. If Karen were to marry
Doug, the situation would change. Even though Doug may continue to mow Karen’s lawn,
the value of the mowing is now left out of GDP because Doug’s service is no longer sold in
a market. Thus, when Karen and Doug marry, GDP falls (assuming, of course, that Karen no
longer pays Doug to mow the lawn).
‘… final …’
When Australian Paper makes paper which Hallmark uses to make a greeting card, the
paper is called an intermediate good, and the card is called a final good. GDP includes only
the value of final goods. The reason is that the value of intermediate goods is already
included in the prices of the final goods. Adding the market value of the paper to the
market value of the card would be double counting. That is, it would (incorrectly) count
the paper twice.
An important exception to this principle arises when an intermediate good is produced
and, rather than being used, is added to a firm’s inventory to be used or sold at a later date.
In this case, the intermediate good is taken to be ‘final’ for the moment, and its value as
inventory investment is added to GDP. When the inventory of the intermediate good is later
used or sold, the firm’s inventory investment is negative, and GDP for the later period is
reduced accordingly.
‘… goods and services …’
GDP includes tangible goods (food, clothing, cars) and intangible services (haircuts, house
cleaning, doctors’ visits). When you buy a song from iTunes by your favourite band or a
t-shirt with your favourite band’s name on it, you are buying a good, and the purchase price
is part of GDP. When you pay to hear a concert by the same group, you are buying a service,
and the ticket price is also part of GDP.
‘… produced …’
GDP includes goods and services currently produced. It does not include transactions
involving items produced in the past. When Ford produces and sells a new car, the value of
the car is included in GDP. When one person sells a used car to another person, the value of
the used car is not included in GDP.
‘… within a country …’
gross national
product (GNP)
the market value of
all final goods and
services produced by
permanent residents
of a nation within a
given period of time
GDP measures the value of production within the geographic confines of a country. When
Japanese residents work temporarily in Australia, their production is part of Australian
GDP. When an Australian resident owns a factory in Malaysia, the profit from production
at that factory is not part of Australian GDP, it is part of Malaysia’s GDP. Thus, items are
included in a nation’s GDP if they are produced domestically, regardless of the nationality
of the producer.
Another statistic, called gross national product (GNP), takes a different approach
to dealing with the goods and services produced by foreigners. GNP is the value of the
production of a nation’s permanent residents. When Japanese residents work temporarily
in Australia, their production is not part of Australian GNP, it is part of Japan’s GNP. When
an Australian resident owns a factory in Malaysia, the profit from production at the factory
is part of Australian GNP. Thus, income is included in a nation’s GNP if it is earned by the
nation’s permanent residents (called nationals), regardless of where they earn it.
Throughout this book, we follow the standard practice of using GDP to measure the
value of economic activity. For most purposes, however, the distinction between GDP and
98
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 3 The data of macroeconomics
05_Stonecash_8e_45658_SB_txt.indd 98
24/08/20 4:31 PM
GNP is not very important. In Australia and most other countries, domestic residents are
responsible for most domestic production, so GDP and GNP are quite close.
‘… in a given period of time’
GDP measures the value of production that takes place within a specific interval of time.
Usually that interval is a year or a quarter (three months). GDP measures the economy’s
flow of income and expenditure during that interval.
When the government reports the GDP for a quarter, it usually presents GDP ‘at an
annual rate’. This means that the figure reported for quarterly GDP is the amount of income
and expenditure during the quarter multiplied by 4. The government uses this convention
so that quarterly and annual figures on GDP can be compared more easily.
In addition, when the government reports quarterly GDP, it presents the data after they
have been modified by a statistical procedure called seasonal adjustment. The unadjusted
data show clearly that the economy produces more goods and services during some times
of the year than during others. (As you might guess, December’s Christmas shopping
season is a high point.) When monitoring the condition of the economy, economists and
policymakers often want to look beyond these regular seasonal changes. Therefore,
government statisticians adjust the quarterly data to take out the seasonal cycle. The GDP
data reported in the news are always seasonally adjusted.
Now let’s repeat the definition of GDP:
• gross domestic product (GDP) is the market value of all final goods and services
produced within a country in a given period of time.
It should now be apparent that GDP is a sophisticated measure of the value of economic
activity. In advanced courses in macroeconomics, you will learn more of the subtleties
that arise in its calculation. But even now you can see that each phrase in this definition is
packed with meaning.
CHECK YOUR UNDERSTANDING
Which contributes more to GDP – the production of a tonne of wool or the production of a
tonne of iron ore? Why?
LO5.3 The components of GDP
Spending in the economy takes many forms. At any moment, the Tan family may be having
lunch at Burgers Hut; Bega Cheese may be building a new processing factory; the Royal
Australian Air Force (RAAF) may be procuring new jet fighters; and Qantas may be buying
an aeroplane from Airbus. GDP accounts for all of these various forms of spending on goods
and services.
To understand how the economy is using its scarce resources, economists are often
interested in studying the composition of GDP among various types of spending. To do this,
GDP (which we denote as Y) is divided into four components: consumption (C), investment
(I), government purchases (G) and net exports (NX):
Y = C + I + G + NX
This equation is an identity – an equation that must be true by the way the variables in
the equation are defined. In this case, because each dollar of expenditure included in GDP
is placed into one of the four components of GDP, the total of the four components must be
equal to GDP.
99
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Chapter
WCN 02-200-202
5 Measuring a nation’s income
05_Stonecash_8e_45658_SB_txt.indd 99
24/08/20 4:31 PM
investment
spending on new
capital equipment,
inventories and
structures, including
household purchases
of new housing
government
purchases
spending on goods
and services by local,
state and federal
governments
net exports
spending on
domestically
produced goods by
foreigners (exports)
minus spending on
foreign goods by
domestic residents
(imports) – also called
the trade balance
We have just seen an example of each component. Consumption is spending by
households on goods and services, like the Tan’s lunch at Burgers Hut. Investment is
the purchase of new capital equipment, inventories and structures, like the Bega factory.
Investment also includes expenditure on new housing. (By convention, expenditure on
new housing is the one form of household spending categorised as investment rather than
consumption.) Government purchases include spending on goods and services by local,
state and federal governments, like the RAAF’s purchase of new jet fighters. Net exports
equal the purchases of domestically produced goods by foreigners (exports) minus the
domestic purchases of foreign goods (imports). A domestic firm’s purchase from a producer
in another country, like the Qantas purchase of a plane from Airbus, decreases net exports.
The ‘net’ in ‘net exports’ refers to the fact that imports are subtracted from exports.
This subtraction is made because imports of goods and services are included in other
components of GDP. For example, suppose that a household buys a $50 000 car from Audi,
the German car-maker. That transaction increases consumption by $50 000 because
car purchases are part of consumer spending. It also reduces net exports by $50 000
because the car is an import. In other words, net exports include goods and services
produced abroad (with a minus sign) because these goods and services are included in
consumption, investment and government purchases (with a plus sign). Thus, when a
domestic household, firm, or government buys a good or service from abroad, the purchase
reduces net exports – but because it also raises consumption, investment or government
purchases, it does not affect GDP.
The meaning of ‘government purchases’ also requires clarification. When the
government pays the salary of an Army general, that salary is part of government purchases.
But what happens when the government pays a pension benefit to one of the elderly? Such
government spending is called a transfer payment because it is not made in exchange for a
currently produced good or service. From a macroeconomic standpoint, transfer payments
are like a tax rebate. Like taxes, transfer payments alter household income, but they do not
reflect the economy’s production. No new goods or services are produced in the process
of the government giving a transfer payment to an individual. Because GDP is intended
to measure the income from (and expenditure on) the production of goods and services,
transfer payments are not counted as part of government purchases.
Table 5.1 shows the composition of Australian GDP in 2018. In this year, the GDP
of Australia was about $1900 billion. If we divide this number by the 2018 Australian
population of just about 25 million, we find that GDP per person – the amount of
expenditure for the average Australian – was $76 006. Consumption made up 56 per cent
of GDP, or $42 567 per person. Investment was $14 574 per person. Government purchases
were $17 981 per person. Net exports were $884 per person. This number is positive
because Australians spent less on foreign goods than foreigners purchased from us. In
most of the 17 years from 2000 to 2017, this number was negative – indicating that the
value of our imports was greater than the value of our exports in those years.
TABLE 5.1 GDP and its components
This table shows total GDP for the Australian economy in 2018 and the breakdown of GDP into its
four components.
GDP 2018
Consumption
Total (in $ billion)
Per person ($)
% of total
1 064
42 567
56.0
Investment
364
14 574
19.2
Government purchases
450
17 981
23.7
22
884
1.1
1 900
76 006
Net exports
Total GDP
Source: ABS Data, Cat. No. 5206, Table 3
consumption
spending by
households on
goods and services,
with the exception
of purchases of
new housing
100
100
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 3 The data of macroeconomics
05_Stonecash_8e_45658_SB_txt.indd 100
24/08/20 4:31 PM
FYI
A different way to arrive at GDP
If you go to the ABS website and look at the annual GDP figures (as you are asked to do
in question 8 in ‘Problems and applications’ at the end of the chapter), you’ll wonder
where we got the figures we’ve presented in Table 5.1. But some simple additions will
get you the same results we’ve shown. The ABS presents the information in a slightly
different way by showing:
• final consumption expenditure – which includes both household and government
consumption
• total gross fixed capital formation – both business and government investment
• exports less imports.
So the published data lumps all consumption together, whether household or
government, and all investment together, whether business or government. That’s because
some government expenditure is consumption (like the purchase by a government
department of paper clips) and some government expenditure is investment (like building a
new bridge or road). Sometimes we’re interested in private sector spending vs public sector
(so we would use the C + I + G + NX approach) and sometimes we’re interested in how much
of GDP is being generated for current consumption and how much for investment in future
production capabilities (when we would be happy with the approach that the ABS presents).
No matter which approach we use, when we add it all up, it should be the same!
Alternative measures of income
When the Australian Bureau of Statistics (ABS) calculates the nation’s GDP every three months,
it uses three approaches to calculate the value of national output. The first measure, GDP(E),
uses the expenditure approach to calculate national income. This is the approach described
in the text. The other measures are GDP(I), the income approach, and GDP(P), the production
approach. Conceptually, the three measures are the same but, in practice, they can differ because
of the different data sources for each measure. They also differ more in the short run. Over
time, more accurate estimates of the data become available, which allow the ABS to update its
calculation of GDP. The ABS also calculates various other measures of income for the economy.
These other measures differ from GDP by excluding or including certain categories of income.
What follows is a brief description of the other two measures of GDP (Table 5.2). The diagram in
Figure 5.2 shows the relationship between other income measures.
TABLE 5.2 The relationship between GDP(I) and GDP(P)
Gross domestic product income
approach (GDP(I))
•The sum of factor incomes, consumption of
fixed capital (depreciation) and net indirect
taxes.
•Factor incomes include wages, salaries
and supplements paid to labour and
profit received by both private and public
businesses.
•Depreciation, which is the wear and tear
on the economy’s stock of equipment and
structures, like trucks rusting and lightbulbs
burning out.
•In the national income accounts prepared
by the ABS, depreciation is called the
‘consumption of fixed capital’.
Gross domestic product production
approach (GDP(P))
•Taking the market value of goods and services
produced by an industry and deducting the
cost of goods and services used up by the
industry in the productive process.
•Referred to by the ABS as ‘intermediate
consumption’.
•This approach uses a concept called value
added to calculate GDP. When a firm produces
a good, it must buy inputs. In the process of
production, the firm transforms the inputs into
something else. The value added to the inputs
is referred to as the ‘value added’.
•When the ABS uses this approach to calculate
GDP, the value of the inputs must be
subtracted from the value of the final product
to avoid double counting, because GDP is the
value of final goods and services.
value added
the value of a firm’s
output minus the
value of its inputs
101
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Chapter
WCN 02-200-202
5 Measuring a nation’s income
05_Stonecash_8e_45658_SB_txt.indd 101
24/08/20 4:31 PM
FIGURE 5.2 Relationships among other income measures
Imports of
goods and
services
National
turnover of
goods and
services
Gross
domestic
product
Imports of
goods and
services
Gross
domestic
product at
factor cost
Imports of
goods and
services
Domestic
factor incomes
Imports of
goods and
services
Imports of
goods and
services
Imports of
goods and
services
Net income
paid overseas
Net income
paid overseas
Net income
paid overseas
Net transfers
to overseas
Net transfers
to overseas
National
income
National
disposable
income
Exports of
goods and
services
Net lending
to overseas
Gross national
expenditure
Gross national
expenditure
Indirect taxes
less subsidies
Indirect taxes
less subsidies
Consumption
of fixed capital
Consumption
of fixed capital
Consumption
of fixed capital
The figure shows the relationships among various measures of expenditure, income and output. National turnover is
the total of expenditure on all goods and services, including expenditure on imports. Gross domestic product subtracts
imports from national turnover to get a value of goods and services produced within the domestic economy. The value of
domestic production can also be obtained by adding up the incomes of domestic factors of production. The figure shows
how taxes and subsidies, payments to and receipts from overseas, and borrowing and lending are accounted for in the
national income accounts.
Source: Constructed from ABS, Cat. No. 5216.0, 2000
Although the various measures of income differ in detail, they almost always tell the
same story about economic conditions. When GDP is growing rapidly, these other measures
of income are usually growing rapidly. And when GDP is falling, these other measures are
usually falling as well. For monitoring fluctuations in the overall economy, it does not matter
much which measure of income we use.
CHECK YOUR UNDERSTANDING
What are the four components of expenditure? Give an example of each?
LO5.4 Real versus nominal GDP
As we have seen, GDP measures the total spending on goods and services in all markets
in the economy. If total spending rises from one year to the next, one of two things must
be true: (1) the economy is producing a larger output of goods and services, or (2) goods
and services are being sold at higher prices. When studying changes in the economy over
time, economists want to separate these two effects. In particular, they want a measure of
the total quantity of goods and services the economy is producing that is not affected by
changes in the prices of those goods and services.
To do this, economists use a measure called real GDP. Real GDP answers a hypothetical
question: What would be the value of the goods and services produced this year if we
valued these goods and services at prices that prevailed in some specific year in the past?
102
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 3 The data of macroeconomics
05_Stonecash_8e_45658_SB_txt.indd 102
24/08/20 4:31 PM
By evaluating current production using prices that are fixed at past levels, real GDP shows
how the economy’s overall production of goods and services changes over time.
To see more precisely how real GDP is constructed, let’s consider an example.
A numerical example
Table 5.3 shows some data for an economy that produces only two goods – burgers and
salads. The table shows the quantities of the two goods produced and their prices in the
years 2020, 2021 and 2022.
TABLE 5.3 Real and nominal GDP
This table shows how to calculate real GDP, nominal GDP and the GDP deflator for a hypothetical
economy that produces only burgers and salads.
Year
2020
Price and quantities
Price of burgers
$
Quantity of
burgers
Price of salads
$
Quantity of
salads
7
45
8
40
2021
9
60
10
60
2022
12
90
14
100
Year
2020
Calculating nominal GDP
($7 per burger × 45 burgers) + ($8 per salad × 40 salads) = $635
Nominal
GDP ($)
635
2021
($9 per burger × 60 burgers) + ($10 per salad × 60 salads) = $1 140
1 140
2022
($12 per burger × 90 burgers) + ($14 per salads × 100 salads) = $2 480
2 480
Year
Calculating real GDP (base year 2020)
Real GDP ($)
2020
($7 per burger × 45 burgers) + ($8 per salad × 40 salads) = $635
635
2021
($7 per burger × 60 burgers) + ($8 per salad × 60 salads) = $900
900
2022
($7 per burger × 90 burgers) + ($8 per salad × 100 salads) = $1 430
Year
Calculating the GDP deflator
1 430
GDP deflator
2020
($635/$635) × 100 = 100
100
2021
($1 140/$900) × 100 = 127
127
2022
($2 480/$1 430) × 100 = 173
173
To calculate total spending in this economy, we multiply the quantities of burgers and
salads by their prices. In the year 2020, 45 burgers are sold at a price of $7 per burger, so
expenditure on burgers equals $315. In the same year, 40 salads are sold for $8 per salad and
so expenditure on salads is $320. Total expenditure in the economy – the sum of expenditure
on burgers and expenditure on salads – is $635. This amount, the production of goods and
services valued at current prices, is called nominal GDP.
The table shows the calculation of nominal GDP for these three years. Total spending
rises from $635 in 2020 to $1140 in 2021 and then to $2480 in 2022. Part of this rise is
attributable to the increase in the quantities of burgers and salads, and part is attributable
to the increase in the prices of burgers and salads.
To obtain a measure of the amount produced that is not affected by changes in prices,
we use real GDP, which is the production of goods and services valued at constant prices.
We calculate real GDP by first choosing one year as a base year. We then use the prices of
burgers and salads in the base year to calculate the value of goods and services in all of the
years. In other words, the prices in the base year provide the basis for comparing quantities
in different years.
nominal GDP
the production
of goods and
services valued at
current prices
real GDP
the production
of goods and
services valued at
constant prices
103
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Chapter
WCN 02-200-202
5 Measuring a nation’s income
05_Stonecash_8e_45658_SB_txt.indd 103
24/08/20 4:31 PM
Suppose that we choose 2020 to be the base year in our example. We can then use the
prices of burgers and salads in 2020 to calculate the value of goods and services produced in
2020, 2021 and 2022. Table 5.3 shows these calculations. To calculate real GDP for 2020, we
use the prices of burgers and salads in 2020 (the base year) and the quantities of burgers and
salads produced in 2020. (Thus, for the base year, real GDP always equals nominal GDP.) To
calculate real GDP for 2021, we use the prices of burgers and salads in 2020 (the base year)
and the quantities of burgers and salads produced in 2021. Similarly, to calculate real GDP
for 2022, we use the prices in 2020 and the quantities in 2022. When we find that real GDP
has risen from $635 in 2020 to $900 in 2021 and then to $1430 in 2022, we know that the
increase is attributable to an increase in the quantities produced, because the prices are held
fixed at base-year levels.
To sum up – nominal GDP uses current prices to place a value on the economy’s production
of goods and services; real GDP uses constant base-year prices to place a value on the economy’s
production of goods and services. Because real GDP is not affected by changes in prices,
changes in real GDP reflect only changes in the amounts being produced. Thus, real GDP is
a measure of the economy’s production of goods and services.
Our goal in calculating GDP is to gauge how well the overall economy is performing.
Because real GDP measures the economy’s production of goods and services, it reflects
the economy’s ability to satisfy people’s material needs and desires. Thus, real GDP is a
better gauge of economic wellbeing than is nominal GDP. When economists talk about the
economy’s GDP, they usually mean real rather than nominal GDP. And when they talk about
growth in the economy, they measure that growth using the percentage change in real GDP
from an earlier period.
The GDP deflator
GDP deflator
a measure of the price
level calculated as the
ratio of nominal GDP
to real GDP times 100
From nominal GDP and real GDP, we can calculate a third useful statistic – the GDP deflator.
The GDP deflator measures the current level of prices relative to the level of prices in the base
year. In other words, the GDP deflator tells us the rise in nominal GDP that is attributable to
a rise in prices rather than a rise in the quantities produced.
The GDP deflator is calculated as follows:
GDP deflator =
Nominal GDP
Real GDP
× 100
This formula shows why the GDP deflator measures the level of prices in the economy. A
change in the price of some good or service, without any change in the quantity produced,
affects nominal GDP but not real GDP. This price change, therefore, is reflected in the GDP
deflator.
The GDP deflator in our example is calculated at the bottom of Table 5.3. For the year
2020, nominal GDP is $635 and real GDP is $635, so the GDP deflator is 100. (The GDP
deflator is always 100 in the base year.) For the year 2021, nominal GDP is 1140 and real
GDP is $900, so the GDP deflator is 127. Because the GDP deflator rose in year 2021 from 100
to 127, we can say that the price level increased by 27 per cent.
The GDP deflator is one measure that economists use to monitor the average level
of prices in the economy. We examine another – the consumer price index – in the
next chapter.
104
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 3 The data of macroeconomics
05_Stonecash_8e_45658_SB_txt.indd 104
24/08/20 4:31 PM
Real GDP over recent history
Now that we know how real GDP is
defined and measured, let’s look at what
this macroeconomic variable tells us
about the recent history of Australia.
Figure 5.3 shows annual data on
real GDP for the Australian economy
since 1970.
CASE
STUDY
FIGURE 5.3 Real GDP in Australia
2 000 000
1 800 000
1 600 000
1 400 000
$million
1 200 000
1 000 000
800 000
600 000
400 000
200 000
0
1970
Recessions
1975
1980
1985
1990
1995
Year
2000
2005
Real GDP
2010
2015
This figure shows quarterly data on real GDP for the Australian economy since 1970.
Recessions – periods of falling real GDP – are marked with the red vertical bars.
Source: ABS Data, Cat. 5206, Table 2
The most obvious feature of these
data is that real GDP grows over time.
Real GDP of the Australian economy in
2015 was almost four times its level in
1970. Put differently, the output of goods
and services produced in Australia has
grown on average about 3 per cent per
year. This continued growth in real GDP
enables the typical Australian to enjoy
greater economic prosperity than his or
her parents and grandparents did.
A second feature of the GDP data is
that growth is not steady. The upward
climb of real GDP is occasionally
interrupted by periods of decline, called
recessions. Figure 5.3 marks recessions
with red vertical bars. (Not everyone
agrees about when Australia has had
recessions. We have used the definition
of two consecutive quarters of recession
here.) Recessions are associated not
only with lower incomes but also with
other forms of economic distress – rising
unemployment, falling profits, increased
bankruptcies and so on.
The third thing to notice about GDP
growth in Australia is that we have had
an extremely long, some would say
unprecedented, period of growth in GDP.
For the last 25 years, we have not had
a recession. Even though many other
economies suffered recessions as a result
of the Global Financial Crisis, Australia’s
GDP dipped in only two quarters, in 2000
and 2008. This could be due to good
economic management, to the stimulus
package put in place by the Rudd
government, to the resources boom, to
105
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Chapter
WCN 02-200-202
5 Measuring a nation’s income
05_Stonecash_8e_45658_SB_txt.indd 105
24/08/20 4:31 PM
the demand for our minerals by growing
economies like China and India, and to
the growth in our exports of food and
education. One thing is certain – it won’t
last forever.
Much of macroeconomics is aimed
at explaining these long-run growth and
short-run fluctuations in real GDP. As
we will see in the coming chapters, we
need different explanatory frameworks
or ‘models’ for these two purposes.
Because short-run fluctuations
represent deviations from the long-run
trend, we first examine the behaviour
of the economy in the long run. In
particular, chapters 7 to 13 examine
how key macroeconomic variables,
including real GDP, are determined
in the long run. We then build on this
analysis to explain short-run fluctuations
in chapters 14 to 17.
Source: ABS, Cat. No. 5206.0, 2018
Question
Based on your understanding of
real GDP, briefly list three reasons
why Australia’s real GDP has almost
quadrupled since 1970?
CHECK YOUR UNDERSTANDING
Define real and nominal GDP. Which is a better measure of economic wellbeing? Why?
Given the GDP deflator, if nominal GDP doubles and real GDP remain constant, what
has happened to the price level?
LO5.5 GDP and economic wellbeing
Earlier in this chapter, GDP was called the best single measure of the economic wellbeing of
a society. Now that we know what GDP is, we can evaluate this claim.
As we have seen, GDP measures both the economy’s total income and the economy’s
total expenditure on goods and services. Thus, GDP per person tells us the income and
expenditure of the average person in the economy. Because most people prefer to receive
higher income and enjoy higher expenditure, GDP per person seems a natural measure of
the economic wellbeing of the average individual.
Yet some people dispute the validity of GDP as a measure of welfare. The Kingdom
of Bhutan uses a measure called Gross National Happiness, which measures four broad
areas – good governance, sustainable socio-economic development, cultural preservation,
and environmental conservation. These are broken down into nine subcategories –
psychological wellbeing, health, education, time use, cultural diversity and resilience, good
governance, community vitality, ecological diversity and resilience, and living standards.
The survey isn’t done very often because it takes around seven hours to complete. But it
gives a very different picture of a nation’s wellbeing than just looking at how much output
was produced. For the most part, people in Bhutan were pretty happy!
In Australia, the Australian Bureau of Statistics measures GDP, and has also begun
measuring whether life in Australia is getting better. Look at the chart in Figure 5.4 –
by most of these measures, we’re not doing too badly, but the economy may not be as
resilient as it was and we aren’t looking after the environment as well as we could.
So why do we look at GDP at all?
The answer is that a large GDP does in fact help us to lead enjoyable lives. GDP does not
measure the health of children, but nations with larger GDP can afford better health care
for their children. GDP does not measure the quality of education, but nations with larger
GDP can afford better educational systems. GDP does not measure the beauty of poetry,
106
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 3 The data of macroeconomics
05_Stonecash_8e_45658_SB_txt.indd 106
24/08/20 4:31 PM
FIGURE 5.4 Measures of Australia’s Progress (MAP)
Society
Economy
Health
Opportunities
Close relationships
Jobs
Home
Prosperity
Safety
A resilient economy
Learning and knowledge
Enhancing living standards
Community connections and diversity
Fair outcomes
A fair go
International economic engagement
Enriched lives
Environment
Governance
Healthy natural environment
Trust
Appreciating the environment
Effective governance
Protecting the environment
Participation
Sustaining the environment
Informed public debate
Healthy built environments
People's rights and responsibilities
Working together for a healthy environment
What do these symbols mean?
The headline progress indicator for this
theme has shown progress.
The headline progress indicator for this
theme has shown regress.
The headline progress indicator for this
theme has not changed greatly.
There is a data gap for this theme as there is
currently no headline progress indicator.
Source: ABS, https://www.abs.gov.au/ausstats/abs@.nsf/Lookup/by%20Subject/1370.0~2013~Main%20Features~Homepage~1
107
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Chapter
WCN 02-200-202
5 Measuring a nation’s income
05_Stonecash_8e_45658_SB_txt.indd 107
24/08/20 4:31 PM
but nations with larger GDP can afford to teach more of their citizens to read and to enjoy
poetry. GDP does not take account of our intelligence, integrity, courage, wisdom, or
devotion to country, but all of these laudable attributes are easier to foster when people are
less concerned about being able to afford the material necessities of life. In short, GDP does
not directly measure those things that make life worthwhile, but it does measure our ability
to satisfy material needs, and these are essential ingredients of comfortable, enjoyable and
worthwhile lives.
GDP is not, however, a perfect measure of wellbeing. Some things that contribute to
a good life are left out of GDP. One is leisure. Suppose, for instance, that everyone in the
economy suddenly started working every day of the week, rather than enjoying leisure on
weekends. More goods and services would be produced, and GDP would rise. Yet, despite the
increase in GDP, we should not conclude that everyone would be better off. The welfare loss
from reduced leisure would offset the welfare gain from producing and consuming a greater
quantity of goods and services.
Another item that GDP excludes is the quality of the environment. Imagine that the
government eliminated all environmental regulations. Firms could then produce goods and
services without considering the pollution they create, and GDP might rise. Yet it is most
likely that wellbeing would fall. The deterioration in the quality of air and water would more
than offset the welfare gain from greater production.
Because GDP uses market prices to value goods and services, it also excludes the value
of almost all activity that takes place outside of markets. Child-rearing and volunteer work,
for instance, contribute to the wellbeing of those in society, but GDP does not reflect these
contributions. If parents decided to spend fewer hours at their jobs in order to spend more
time with their children, the economy might produce fewer goods and services, and GDP
might fall, but that change would not necessarily reflect a lower quality of life.
In the end, we conclude that GDP is a good measure of welfare for most – but not all –
purposes. It is important to keep in mind what GDP includes as well as what it leaves out.
CHECK YOUR UNDERSTANDING
Why should policymakers care about GDP? Why should they also consider other measures
of wellbeing?
International differences in GDP and the quality of life
One way to gauge the usefulness of GDP as a measure of economic wellbeing is to examine
international data. Rich and poor countries have vastly different levels of GDP per person. If
a large GDP leads to a higher standard of living, then we should observe GDP to be strongly
correlated with measures of the quality of life. And, in fact, we do.
The Human Development Index was developed nearly 30 years ago to examine how
well countries did at providing the basic human needs. It has captured data on income per
capita, life expectancy, literacy rates and years of schooling. The Human Development
Report also presents four other composite indices to give a more complete picture of how
countries are doing. The Inequality-adjusted HDI discounts the HDI according to the extent
of inequality. The Gender Development Index compares female and male HDI values. The
Gender Inequality Index highlights women’s empowerment. And the Multidimensional
Poverty Index measures non-income dimensions of poverty.
In the latest report on the HDI, released in 2018, the focus is the alleviation of poverty.
Poverty has a big impact on the quality of life. Just one example is life expectancy. The
following chart from the HDI report shows that life expectancy for people in highly
108
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 3 The data of macroeconomics
05_Stonecash_8e_45658_SB_txt.indd 108
24/08/20 4:31 PM
developed economies is nearly 20 years higher than those living in poorer countries. The
second chart shows that gender inequality is also much higher in those countries that are
poorer. (See Figure 5.5.)
FIGURE 5.5 Life expectancy and gender inequality
Life expectancy at birth, by human development group, 2017
Ver y
hig
h
hu
m
an
Lif
d
e
79 exp
.5
y
.8
60
e
ev
w
Lo
nt
lopme
eve
nd
a
m
hu
nt
me
lop
y
nc
ta
ec rs
ea
people
bn
bn
bn
2.733
2. 3
79
1
69.
e
M e d iu m h u m a n d ev
6 m 1.439
92
7
6
ev .0
el
op
nt
me
me
nt
lo p
Hig
h
m
hu
an
d
70
0.2
2
0.31
Gender inequality index
0.386
La
tin
Su
bAm
Sa
er
ha
i
ra
Ea ca
Ar
n
st an
ab
Af
Eu
ric
As d t
S
S
ro
ou
he
a
t
i
a
a
pe
t
t
an
es
h
Ca
an
As
d
r
i
bb
th
d
ia
e
Ce
Pa ean
nt
c
ra
fic
lA
si
a
Gender inequality index, by developing region, 2017
5
51
0.
31
0.5
69
0.5
Source: United Nations Development Program, Human Development Indices and Indicators 2018 Statistical Update (CC BY 3.0 IGO)
109
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Chapter
WCN 02-200-202
5 Measuring a nation’s income
05_Stonecash_8e_45658_SB_txt.indd 109
24/08/20 4:31 PM
CASE
STUDY
Table 5.4 shows 12 countries around
the world, including Australia and New
Zealand, listed in order of their Human
Development Index (HDI) ranking. Note
that GDP and HDI rankings are not
identical, though. (In the table below, we
use gross national income, which is an
alternative measure of GDP.) The USA
has the 2nd-highest GNI ranking of those
countries shown, but a relatively lower
life expectancy, which lowers its overall
HDI ranking. The countries with a HDI
index above 112 are considered to have
high human development, the countries
between 113 and 151 have medium
human development and below 152 are
considered to have a low level of human
development.
TABLE 5.4 GNI, life expectancy and literacy
The table shows GNI per person and two measures of the quality of life for 12 countries for 2017.
Country
Norway
Australia
USA
HDI rank*
1
Real GNI per
person (2011)
Life
expectancy
(years)
Mean years of
schooling (%)
$68 012
82.3
12.6
3
43 560
83.1
12.9
13
54 941
79.5
13.4
UK
14
39 116
81.7
12.9
New Zealand
16
33 970
82.0
12.5
Japan
19
38 986
83.9
12.8
Thailand
83
15 516
75.5
7.6
China
86
15 270
76.4
7.8
Indonesia
116
10 846
69.4
8.0
India
130
6 353
68.8
6.4
Papua New Guinea
153
3 403
65.7
4.6
Niger
189
906
60.4
2.0
*HDI ranking is based on life expectancy, education and income per capita.
Source: United Nations Development Program, Human Development Indices and Indicators 2018 Statistical Update (CC BY 3.0 IGO)
Questions
1
2
Why is it useful to compare the real
GNI per person across different
countries?
Compare and contrast real GNI per
person to the other measures in
Table 5.4. Do you think real GNI per
person a good measure of economic
wellbeing based on your findings?
FYI
Alternative measures of an economy’s wellbeing
Several economists have tried to develop alternative measures of an economy’s
wellbeing. Here are a few alternative measures:
• Measures of Australia’s Progress (MAP). The Australian Bureau of Statistics
developed this measure to answer the question ‘Is life getting better [in Australia]?’
Economic growth brings with it increases in population which can lead to
increased congestion on the roads and in our schools, strains on the environment,
increases in income inequality and crime, and strains on our health system. This
measure looks at four broad categories to answer the question of whether life
110
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 3 The data of macroeconomics
05_Stonecash_8e_45658_SB_txt.indd 110
24/08/20 4:31 PM
is getting better or not: society, economy, environment and government. ABS
Director, Fiona Dowsley said in 2013:
The latest release of MAP shows us that overall, Australia is in pretty good shape
with more progress or little movement, than regress, which is a great result. Progress
was found in the areas of health, learning and knowledge, jobs, living standards and
participation. We have only regressed in the areas of our economy’s resilience and
sustaining the environment.
Source: ABS, https://www.abs.gov.au/ausstats/abs@.nsf/Lookup/by%20Subject/1370.0~2013~Main%20
Features~Homepage~1
•
•
Gross National Happiness. This concept was first developed by the King of Bhutan. He
wanted to ensure that the culture and environment of Bhutan was not lost on its road
to economic development. Other countries have adapted the concept to suit their own
measure of national happiness.
Social Progress Index. Michael Porter, author of Competitive Advantage, has
worked on setting up the Social Progress Index. In this measure, three categories
are measured: Basic Human Needs, Foundations of Wellbeing and Opportunity.
Basic Human Needs include access to nutrition and basic medical care, water and
sanitation, shelter and personal safety. Foundations of wellbeing include access
to basic knowledge, information and communication, health and wellness and
ecosystem sustainability. Opportunity includes personal rights, freedom and choice,
tolerance and inclusion and access to advanced education.
All of these measures say something about how well a society is doing. And those
countries that score well on these measures tend to have higher GDP per capita. So
GDP is not a bad measure of wellbeing. And it has one additional advantage – it can
be easier to capture the data on expenditure and production in an economy.
Source: © Commonwealth of Australia. Released under a Creative Commons Attribution 2.5 Australia licence.
Although data on other aspects of the quality of life are less complete, they tell a similar
story. Countries with low GDP per person tend to have more infants with low birthweight,
higher rates of infant mortality, higher rates of maternal mortality, higher rates of child
malnutrition, and less common access to safe drinking water. In countries with low GDP per
person, fewer school-age children are in school, and those who are in school must learn with
fewer teachers per student. These countries also tend to have fewer radios, fewer televisions,
fewer telephones, fewer paved roads and fewer households with electricity. International data
leave no doubt that a nation’s GDP is closely associated with its citizens’ standard of living.
Conclusion
This chapter has discussed how economists measure the total income of a nation.
Measurement is, of course, only a starting point. Much of macroeconomics is aimed at
revealing the long-run and short-run determinants of a nation’s GDP. Why, for example,
is GDP higher in Australia and Japan than in India and Afghanistan? What can the
governments of the poorest countries do to promote more rapid growth in GDP? Why
does GDP in Australia rise rapidly in some years and fall in others? What can Australian
policymakers do to reduce the severity of these fluctuations in GDP? These are the
questions we will take up shortly.
At this point, it is necessary to acknowledge the importance of just measuring GDP. We
all get some sense of how the economy is doing as we go about our lives. But economists who
study changes in the economy and policymakers who formulate economic policies need
more than this vague sense – they need concrete data on which to base their judgements.
Quantifying the behaviour of the economy with statistics like GDP is, therefore, the first
step in developing a science of macroeconomics.
111
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Chapter
WCN 02-200-202
5 Measuring a nation’s income
05_Stonecash_8e_45658_SB_txt.indd 111
24/08/20 4:31 PM
STUDY TOOLS
Summary
LO5.1 Because every transaction has a buyer and a seller, the total expenditure in the
economy must equal the total income in the economy.
LO5.2 Gross domestic product (GDP) measures an economy’s total expenditure on newly
produced goods and services and the total income earned from the production of
these goods and services. More precisely, GDP is the market value of all final goods and
services produced within a country in a given period of time.
LO5.3 GDP is divided among four components of expenditure – consumption, investment,
government purchases and net exports. Consumption includes spending on goods and
services by households, with the exception of purchases of new housing. Investment
includes spending on new equipment and structures, including households’ purchases
of new housing. Government purchases include spending on goods and services by
local, state and federal governments. Net exports equal the value of goods and services
produced domestically and sold abroad (exports) minus the value of goods and services
produced abroad and sold domestically (imports).
LO5.4 Nominal GDP uses current prices to value the economy’s production of goods and
services. Real GDP uses constant base-year prices to value the economy’s production
of goods and services. The GDP deflator – calculated from the ratio of nominal to real
GDP – measures the level of prices in the economy.
LO5.5 GDP is a good measure of economic wellbeing because higher incomes mean people
can buy more of the things that add to their wellbeing. But it is not a perfect measure
of wellbeing. For example, GDP excludes the value of leisure and the value of a clean
environment, as well as the negative impact of greater levels of income inequality or
crime.
Key concepts
consumption, p. 100
GDP deflator, p. 104
government purchases, p. 100
gross domestic product (GDP), p. 97
gross national product (GNP), p. 98
investment, p. 100
net exports, p. 100
nominal GDP, p. 103
real GDP, p. 103
value added, p. 101
Practice questions
Questions for review
1
2
3
4
5
6
Explain why an economy’s income must equal its expenditure.
Which contributes more to GDP – the production of a tonne of wheat or the production of
a tonne of coal? Why?
A farmer sells milk to a cheesemaker for $2. The cheesemaker uses the milk to make
cheese, which is sold for $6. What is the contribution to GDP?
Over the last three years, Kane paid $5000 buying new parts to restore his vintage car.
Today he sells the car at auction for $20 000. How does this sale affect current GDP?
List the four components of GDP. Give an example of each.
In the year 2020, the economy produces 200 serves of fish and chips for $9.50 each. In the
year 2021, the economy produces 250 serves of fish and chips for $12.75 each. Calculate
nominal GDP, real GDP and the GDP deflator for each year. (Use 2020 as the base year.) By
what percentage does each of these three statistics rise from one year to the next? Why is
it desirable for a country to have a large GDP? Give an example of something that would
raise GDP and yet be undesirable.
112
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 3 The data of macroeconomics
05_Stonecash_8e_45658_SB_txt.indd 112
24/08/20 4:31 PM
Multiple choice
1
2
3
4
5
GDP includes:
a Consumption, Investment, Government Transfers, Exports
b Consumption, Private Investment, Government Investment, Exports and Imports
c Consumption, Private and Government Investment, Government Expenditure and Net
Exports
d Consumption, Investment, Government Revenue and Imports
If the nominal GDP of HobbitLand in 2020 is $2 350 000 and the GDP deflator in 2020 is
103 and the base year for the GDP deflator is 2016, what is real GDP in 2020:
a $2 281 553
b $2 420 500
c $2 350 000
d $1 807 692
Which of the following should not be included in GDP:
a Your purchase of a new pair of pants.
b Qantas’ purchase of a new ticketing kiosk.
c A bank’s purchase of an existing building for a new office.
d The Royal Australian Navy’s purchase of a new patrol boat.
According to the information in Table 5.4, Australia has a higher life expectancy and
higher mean years of schooling and yet Norway is ranked as number 1 on the Human
Development Index and Australia is number 2. Which of the following must be true?
a Australia’s schooling isn’t as good as Norway’s.
b Norway’s real GDP per person is higher.
c Australia’s distribution of income is worse.
d Norway doesn’t treat its old people as well as Australia does.
If Australia is experiencing rising inflation, then
a nominal GDP is growing faster than real GDP.
b nominal GDP is growing faster than the GDP deflator.
c real GDP is growing faster than nominal GDP.
d real GDP is growing faster than the GDP deflator.
Problems and applications
1
2
3
4
5
What components of GDP (if any) would each of the following transactions affect? Explain.
a A family buys a new LED TV.
b Aunt Maria buys a new iPad.
c Kia sells a Rio from its inventory.
d You buy a movie theatre ticket.
e The government of New South Wales creates a new light rail system in Sydney.
f Your parents buy a bottle of South Australian wine.
g Ford Motor Company shuts down its factory in Campbellfield, Victoria.
The ‘government purchases’ component of GDP does not include spending on transfer
payments like welfare benefits. Thinking about the definition of GDP, explain why transfer
payments are excluded.
Why do you think households’ purchases of new housing are included in the investment
component of GDP rather than the consumption component? Can you think of a reason
that households’ purchases of refrigerators should also be included in investment rather
than in consumption? To what other consumption goods might this logic apply?
As the chapter states, GDP does not include the value of volunteer work. Do you think GDP
should include such transactions? Would this make GDP a better measure of economic
wellbeing?
Look on the ABS website to find the base year for real GDP. Why do you think the ABS
updates the base year periodically?
113
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Chapter
WCN 02-200-202
5 Measuring a nation’s income
05_Stonecash_8e_45658_SB_txt.indd 113
24/08/20 4:31 PM
6
Consider the following data on Australian GDP:
Year
Nominal GDP (in
millions)
GDP deflator (base year
2010–11)
2018
$1 687 453
99.5
2019
1 715 321
99
a
7
8
9
10
11
12
13
What was the growth rate of nominal income between 2018 and 2019? (Note: The
growth rate is the percentage change from one period to the next. The ABS calculates
annual GDP on a financial year basis, from July one year to June the next. The GDP
deflator is equal to 100 in the middle of the financial year.)
b What was the growth rate of the GDP deflator between 2018 and 2019?
c What was real income in 2018 measured in 2011 prices?
d What was real income in 2019 measured in 2011 prices?
e What was the growth rate of real income between 2018 and 2019?
f Was the growth rate of nominal income higher or lower than the growth rate of real
income? Explain.
If prices rise, people’s income from selling goods increases. Why do economists prefer
using real GDP as a measure of economic wellbeing rather than using nominal GDP?
Revised estimates of Australian GDP are usually released by the government near the
end of each month. Look it up on the ABS website at http://www.abs.gov.au. Discuss the
recent changes in real and nominal GDP and in the components of GDP.
If a mining company sells less coal than last year, but at a higher price per tonne, its income
may have increased. Can you tell whether the mining company is better off?
A classmate tells you that Japan’s GDP per person in 2017 is roughly half of what Norway’s
was, but life expectancy was slightly higher. Which is a better indicator of economic
wellbeing? What else would you want to look at to gain a deeper understanding of
wellbeing?
Goods and services that are sold in black markets, like illegal drugs, are generally not
included in GDP.
a Does this lead to a misleading comparison between countries, like in the second
column of Table 5.4, comparing Australia and India? Explain.
b Should these activities be included as a positive or negative in GDP?
c According to work done by the Federal Reserve Bank of St Louis in the USA, the
underground economy represents about 13% of GDP for developed economies,
while for developing economies the estimate is 36% of GDP. Do you think these
figures have an impact on the level of wellbeing in these economies? Why or why not?
(Source: https://www.stlouisfed.org/publications/regional-economist/january-2015
/underground-economy.)
Explain the limitations of GDP:
a as a measure of total production in an economy
b as a measure of economic wellbeing
The participation of women in the Australian labour force has risen dramatically since 1965.
a How do you think this rise affected GDP?
b Now imagine a measure of wellbeing that includes time spent working in the home and
taking leisure. How would the change in this measure of wellbeing compare with the
change in GDP?
c Can you think of other aspects of wellbeing that are associated with the rise in women’s
labour-force participation? Would it be practical to construct a measure of wellbeing
that includes these aspects?
d In the last two decades, there has been an increase in the numbers of fathers staying
home to look after their children. How would this affect GDP?
114
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 3 The data of macroeconomics
05_Stonecash_8e_45658_SB_txt.indd 114
24/08/20 4:31 PM
6
Measuring the
cost of living
Learning objectives
After reading this chapter, you should be able to:
LO6.1 learn how the consumer price index (CPI) is constructed
LO6.2 consider why the CPI is an imperfect measure of the cost of living
LO6.3 compare the CPI and the GDP deflator as measures of the overall price level
LO6.4 see how to use a price index to compare dollar amounts from different times
LO6.5 learn the distinction between real and nominal interest rates.
115
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
06_Stonecash_8e_45658_SB_txt.indd 115
24/08/20 4:31 PM
Introduction
In 1930, as the Australian economy was suffering through the Great Depression, famed
racehorse Phar Lap earned £9429 at the Melbourne Cup. At the time, these earnings were
extraordinary, even for great racehorses. The prime minister, James Scullin, received a
parliamentary allowance of about £1000. When Australia switched from pounds to decimal
currency in 1966, a pound was designated to be worth $2, so in dollar terms, these earnings
would have been $19 000 and $2000 respectively. (See the FYI box ‘The change to decimal
currency’.) Phar Lap may be more famous than Prime Minister Scullin, but neither amount
seems much when compared with the winnings for the present-day Melbourne Cup.
In 2018, the Melbourne Cup paid $3.6 million to the winning horse, over 150 times
what Phar Lap won. And Phar Lap is still considered one of the greatest racehorses ever
to have lived. At first, this fact might lead you to think that horseracing has become much
more lucrative over the past seven decades. But, as everyone knows, the prices of goods
and services have also risen. In 1930, an ice-cream would have cost about 2 cents and a
ticket to the local movie theatre about 5 cents. Because these prices were so much lower
in Phar Lap’s day than they are in ours, it is not clear whether Phar Lap’s owners enjoyed a
higher or lower standard of living than today’s horse owners. (See pp. 126–7.)
In the preceding chapter we looked at how economists use gross domestic product
(GDP) to measure the quantity of goods and services that the economy is producing. This
chapter examines how economists measure the overall cost of living. To compare Phar
Lap’s earnings of $19 000 with prize money of today, we need to find some way of turning
dollar figures into meaningful measures of purchasing power. That is exactly the job of
a statistic called the consumer price index. After seeing how the consumer price index is
constructed, we discuss how we can use such a price index to compare dollar figures from
different points in time.
LO6.1 The consumer price index
consumer price
index (CPI)
a measure of the
overall cost of the
goods and services
bought by a typical
consumer
The consumer price index (CPI) is used to monitor changes in the cost of living over
time. When the consumer price index rises, the typical family has to spend more dollars
to maintain the same standard of living. Economists use the term inflation to describe
a situation in which the economy’s overall price level is rising. The inflation rate is the
percentage change in the price level from the previous period. As we will see in the coming
chapters, inflation is a closely watched aspect of macroeconomic performance and is a
key variable guiding macroeconomic policy. This chapter provides the background for
that analysis by showing how economists measure the inflation rate using the consumer
price index.
The consumer price index is a measure of the overall cost of the goods and services
bought by a typical consumer. Each month the Australian Bureau of Statistics (ABS)
calculates and reports the consumer price index. In this section, we discuss how the
consumer price index is calculated and what problems arise in its measurement. We also
consider how this index compares with the GDP deflator, another measure of the overall
level of prices, which we examined in the last chapter.
116
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 3 The data of macroeconomics
06_Stonecash_8e_45658_SB_txt.indd 116
24/08/20 4:31 PM
FYI
The change to decimal currency
Imagine that, instead of the name ‘dollar’, the currency in Australia was called the
‘inflato’. That was one of the names suggested to Prime Minister Holt for the new
decimal currency introduced in 1966. The ‘royal’ was the most favoured name, but
others suggested were ‘austral’, ‘A.B.C.D.’, ‘aborroo’, ‘anzac’, ‘centimate’, ‘deci-cur’,
‘dollauster’, ‘kanoala’, ‘howzat’, ‘macquarie’, ‘oz’ and ‘sheepsback’. It’s hard to imagine a
shopkeeper saying ‘That’ll be five sheepsbacks, please’!
The day Australia changed to decimal currency was 14 February 1966. The currency used
before the change was the pound (£). One pound was worth 20 shillings, and 1 shilling was
worth 12 pence. The conversion rate was $2 for every pound. A shilling became 10 cents,
and 1 penny was equivalent to 5/6 of a cent. This is not an exchange rate, though. It is simply
the rate chosen for converting old currency to new. If you found a pound in your attic, it
would still be equivalent to $2. How much that pound would buy today compared with how
much it would have bought 50 years ago is another matter. What we are discussing in this
chapter is what happens to the purchasing power of a unit of currency over time as a result
of inflation; that is, a rise in the prices of goods and services.
At the time of the conversion, people predicted that inflation would result from
the change. For example, a box of matches sold for 2 pence in the old currency. At the
standard conversion rate of 1 penny to 5/6 of a cent, the price in the new currency
would be 1.67 cents. But because there were no units of currency smaller than a cent,
this would be rounded up to 2 cents, a price increase of roughly 20 per cent. However,
these increases would have occurred only for goods that were very low in price and an
insignificant part of anyone’s budget, so the predicted inflationary effects did not occur.
Other costs of the conversion included changing accounting machines, cash
registers and electronic data processing machines to handle decimal currency. There
was a government compensation scheme to help business people with the costs of
the changeover. Despite concerns that conversion would be costly and inflationary, the
transition to decimal currency was made with relatively little fuss.
How the consumer price index is calculated
When the ABS calculates the consumer price index and the inflation rate, it uses data
on the prices of thousands of goods and services. To see exactly how these statistics are
constructed, let’s consider a simple economy in which consumers buy only two goods –
coffees and muffins.
Table 6.1 shows the five steps that the ABS follows.
1 Fix the basket. The first step in calculating the consumer price index is to determine
which prices are most important to the typical consumer. If the typical consumer buys
more coffees than muffins, then the price of coffees is more important than the price of
muffins and, therefore, should be given greater weight in measuring the cost of living.
The ABS sets these weights by surveying consumers and finding the basket of goods
and services that the typical consumer buys. In the example in the table, the typical
consumer buys a basket of six coffees and eight muffins.
2 Find the prices. The second step in calculating the consumer price index is to find the
prices of each of the goods and services in the basket for each point in time. The table
shows the prices of muffins and coffees for three different years.
3 Calculate the basket’s cost. The third step is to use the data on prices to calculate
the cost of the basket of goods and services at different times. The table shows this
calculation for each of the three years. Notice that only the prices in this calculation
change. By keeping the basket of goods the same (six coffees and eight muffins), we
117
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN
02-200-202
Chapter
6 Measuring the cost of living
06_Stonecash_8e_45658_SB_txt.indd 117
24/08/20 4:31 PM
are isolating the effects of price changes from the effect of any quantity changes that
might be occurring at the same time.
TABLE 6.1 Calculating the consumer price index and the inflation rate: An example
This table shows how to calculate the consumer price index and the inflation rate for a
hypothetical economy in which consumers buy only coffees and muffins.
Step 1: Survey consumers to determine a fixed basket of goods
Six coffees, eight muffins
Step 2: Find the price of each good in each year
Year
Price of coffees
$
Price of muffins
$
2020
5.00
5.00
2021
6.25
6.50
2022
7.50
7.75
Step 3: Calculate the cost of the basket of goods in each year
Year
2020
2021
2022
Cost of basket
($5.00 per coffee × 6 coffees) + ($5.00 per muffin × 8 muffins)
= $70.00
($6.25 per coffee × 6 coffees) + ($6.50 per muffin × 8 muffins)
= $89.50
($7.50 per coffee × 6 coffees) + ($7.75 per muffin × 8 muffins)
= $107.00
Calculations
$70.00
89.50
107.00
Step 4: C
hoose one year as a base year (2020) and calculate the consumer price index
in each year
Year
Consumer price index
2020
($70/$70) × 100 = 100
100
2021
($89.50/$70) × 100 = 128
128
2022
($106/$70) × 100 = 153
153
Step 5: Use the consumer price index to calculate the inflation rate from previous year
inflation rate
the percentage change
in the price index from
the preceding period
118
Year
Inflation rate
2021
(128 − 100)/100 × 100 = 28%
28%
2022
(153 − 128)/128 × 100 = 20%
20%
4 Choose a base year and calculate the index. The fourth step is to designate one year
as the base year, which is the benchmark with which other years are compared. To
calculate the index, the price of the basket of goods and services in each year is divided
by the price of the basket in the base year and this ratio is then multiplied by 100. The
resulting number is the consumer price index.
In the example in the table, the year 2020 is the base year. In this year, the basket of
muffins and coffees costs $70.00. Therefore, the price of the basket in all years is divided by
$70.00 and multiplied by 100. The consumer price index is 100 in 2020. (The index is always
100 in the base year.) The consumer price index is 128 in 2021. This means that the price of
the basket in 2021 is 128 per cent of its price in the base year. Put differently, a basket of goods
that costs $100 in the base year costs $128 in 2021. Similarly, the consumer price index is 153
in 2022, indicating that the price level in 2022 is 153 per cent of the price level in the base year.
5 Calculate the inflation rate. The fifth and final step is to use the consumer price index
to calculate the inflation rate, which is the percentage change in the price index from
the preceding period. In our example, the consumer price index rose by 28 per cent from
2020 to 2021 and by 25 per cent from 2021 to 2022. The inflation rate is said to be 28 per
cent in 2021 and 20 per cent in 2022.
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 3 The data of macroeconomics
06_Stonecash_8e_45658_SB_txt.indd 118
24/08/20 4:31 PM
Although this example simplifies the real world by including only two goods, it shows
how the ABS calculates the consumer price index and the inflation rate. The ABS collects
and processes data on the prices of around 100 000 goods and services at least once each
quarter and, by following the five steps described above, determines how quickly the cost of
living for the typical consumer is rising. When the ABS makes its quarterly announcement
of the inflation rate calculated from the consumer price index, you can usually find the
number on any domestic news website, hear the number on the evening news, see it in the
next day’s newspaper, or look it up on the ABS website.
In addition to the consumer price index for the overall economy, the ABS calculates
several other price indexes. It reports the index for the capital cities (Sydney, Melbourne,
Perth, Adelaide, Brisbane, Hobart, Darwin and Canberra) as well as for some narrow
categories of goods and services (like food, clothing and housing). It also calculates the
producer price index, which measures the cost of a basket of goods and services bought by
firms rather than by consumers. Because firms eventually pass on their costs to consumers
in the form of higher consumer prices, changes in the producer price index are often thought
to be useful in predicting changes in the consumer price index.
producer price index
a measure of the
cost of a basket of
goods and services
bought by firms
FYI
What is in the CPI’s basket?
When constructing the consumer price index, the ABS tries to include all the goods and
services that the typical consumer buys. Moreover, it tries to weight these goods and
services according to how much consumers buy of each item.
Figure 6.1 shows the breakdown of consumer spending into the major categories of
goods and services for the 16th series, last updated in 2017. (It is updated about every
five years, but the ABS is looking at updating it more frequently because of substitution
bias, which is discussed in the following section.)
FIGURE 6.1 The basket of goods and services
Education
4%
Clothing &
footwear
3%
Communication
3%
Health
6%
Insurance &
financial services
6%
Alcohol & tobacco
7%
Furnishings, household
equipment & services
9%
Housing
23%
Food & nonalcoholic
beverages
16%
Transport Recreation
& culture
10%
13%
Housing
Food & non-alcoholic beverages
Recreation & culture
Transport
Furnishings, household
equipment & services
Alcohol & tobacco
Insurance & financial services
Health
Education
Clothing & footwear
Communication
This figure shows how the typical consumer divides his or her spending among various
categories of goods and services. The ABS calls each percentage the ‘relative importance’ of
the category.
Source: ABS Data, Cat. No. 6470.0.55.002
119
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN
02-200-202
Chapter
6 Measuring the cost of living
06_Stonecash_8e_45658_SB_txt.indd 119
24/08/20 4:31 PM
The basics of living are the most significant categories. Housing and household
contents and services make up the largest component of the typical consumer’s
budget, at 32.1 per cent. Housing (23.1 per cent) includes rent, utilities, property rates
and repairs and maintenance. Furnishing, household equipment and services (8.9 per
cent) include furniture, large and small appliances, and household supplies like laundry
soaps and garbage bags. The next largest category at 15.8 per cent is food and nonalcoholic beverages; this includes food at home (just under 10 per cent) and food away
from home (just under 6 per cent). Alcoholic beverages and tobacco products are in a
separate category (7.4 per cent). The next category, at 12.6 per cent, is recreation and
culture. Then comes transport, at 10.5 per cent, which includes spending on cars, petrol,
buses, trains and so on. Next is health, and insurance and financial services, both just
under 6 per cent, then education at just above 4 per cent. Clothing and footwear
(3.3 per cent) and communication (2.6 per cent ) make up the last two segments.
LO6.2 Problems in measuring the cost of living
The consumer price index is a measure of the aggregate price level in the economy. The goal
of the index is to measure changes in the cost of living. In other words, the consumer price
index can be used to gauge how much incomes must rise in order to maintain a constant
standard of living. The consumer price index, however, is not a perfect measure of the cost
of living. Three problems with the index are widely acknowledged but difficult to solve.
The first problem is called substitution bias. When prices change from one year to the next,
they do not all change proportionately – some prices rise by more than others. Consumers
respond to these differing price changes by buying less of the goods whose prices have risen
by large amounts and by buying more of the goods whose prices have risen less or have even
fallen. That is, consumers substitute goods that have become relatively less expensive. Yet
the consumer price index is calculated assuming a fixed basket of goods. By not taking into
account the possibility of consumer substitution, the index overstates the increase in the
cost of living from one year to the next.
IN THE
NEWS
What happens when prices don’t go up very much?
What does it tell us when prices on average are not going up very much? You’d
think this is a good thing, but you might have to think again. Even though it
means households pay less on average for their basic items, it also is a sign that
the economy is slowing down. And that’s not such a good thing.
Inflation undershoots in Australia – why it’s a concern, is the
RBA running out of ammo & what it means for investors?
Dr Shane Oliver, Head of Investment Strategy and Economics and Chief Economist, AMP
Capital Sydney, Australia, 29 April 2019
Introduction
Surprisingly weak Australian inflation has led to expectations the Reserve Bank will soon
cut rates. But what’s driving low inflation? Is it really that bad? Why not just lower the
inflation target? Will rate cuts help? And what does it mean for investors?
Inflation surprises on the downside again
Australian inflation as measured by the CPI was flat in the March quarter and up just
1.3% over the last year. Sure, the zero outcome in the quarter was partly due to a nearly
9% decline in petrol prices and they have since rebounded to some degree. And highprofile items like food, health and education are up 2.3%, 3.1% and 2.9% respectively
120
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 3 The data of macroeconomics
06_Stonecash_8e_45658_SB_txt.indd 120
24/08/20 4:31 PM
FIGURE 6.2 Australian inflation running below target range
7
GST impact
6
Underlying inflation
(avg of mean &
median)
Annual % change
5
4
Target
band
3
2
1
Headline inflation
0
–1
93
95
97
99
01
03
05
07
09
11
13
15
17
19
Source: Dr Shane Oliver/AMP Capital, ABS Data, https://www.ampcapital.com/au/en/insights-hub/articles/2019/
april/inflation-undershoots-in-australia-why-its-a-concern
from a year ago. But against this, price weakness is widespread in areas like clothing,
rents, household equipment & services and communications. [See Figure 6.2.]
But why the focus on ‘underlying inflation’?
The increase in the CPI is the best measure of changes in the cost of living. But it can
be distorted in the short term by often volatile moves in some items that are due to
things like world oil prices, the weather and government-administered prices that
are unrelated to supply and demand pressures in the economy. So, economists and
policymakers like the RBA focus on what is called underlying inflation to get a handle
on underlying price pressures in the economy so as not to jump at shadows. There are
various ways of measuring this ranging from excluding items like food and energy as in
the US version of core inflation, to excluding items whose prices are largely government
administered to statistical measures that exclude items that have volatile moves in each
quarter (as with the trimmed mean and weighed median measures of inflation). Right
now they all show the same thing, i.e. that underlying inflation is low, ranging between
1.2% to 1.6% year on year. The average of the trimmed mean and weighted median
measures is shown in the previous chart and is averaging 1.4%. The common criticism
of underlying inflation that ‘if you exclude everything there is no inflation’ is funny but
irrelevant. The point is that both headline and underlying inflation are below the RBA’s
2–3% target and this has been the case for almost four years now. [See Figure 6.3.]
What is driving low inflation?
The weakness in inflation is evident globally. Using the US definition, core (ex food & energy)
inflation is just 1.8% in the US, 0.8% in the Eurozone, 0.4% in Japan and 1.8% in China.
Several factors have driven the ongoing softness in inflation including: the sub-par
recovery in global demand since the GFC which has left high levels of spare capacity
in product markets and underutilisation of labour; intense competition exacerbated
by technological innovation (online sales, Uber, Airbnb, etc); and softish commodity
prices. All of which has meant that companies lack pricing power & workers lack
bargaining power.
Why not just lower the inflation target?
Some suggest that the RBA should just lower its inflation target. This reminds me of a similar
argument back in 2007–08, when inflation had pushed above 4%, that the RBA should just raise
its inflation target. Such arguments are nonsense. First, the whole point of having an inflation
121
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN
02-200-202
Chapter
6 Measuring the cost of living
06_Stonecash_8e_45658_SB_txt.indd 121
24/08/20 4:31 PM
FIGURE 6.3 Core inflation: US, Japan, Eurozone & China
3
US
China
Annual % change
2
1
Eurozone
0
Japan
–1
–2
00
02
04
06
08
10
12
14
16
18
Source: Dr Shane Oliver/AMP Capital, Bloomberg, https://www.ampcapital.com/au/en/insights-hub/
articles/2019/april/inflation-undershoots-in-australia-why-its-a-concern
target is to anchor inflation expectations. If the target is just raised or lowered each time it’s
breached for a while then those expectations – which workers use to form wage demands and
companies use in setting wages and prices – will simply move up or down depending on which
way inflation and the target moves. And so inflationary or deflationary shocks will turn into
permanent shifts up or down in inflation. Inflation targeting would just lose all credibility.
Second, there are problems with allowing too-low inflation. Most central bank
inflation targets are set at 2% or so because statistical measures of inflation tend to
overstate actual inflation by 1–2% because statisticians have trouble actually adjusting
for quality improvements and so some measured price rises often reflect quality
improvements. In other words, 1.3% inflation as currently measured could mean we are
actually in deflation. And there are problems with deflation.
What’s wrong with falling prices (deflation) anyway?
Deflation refers to persistent and generalised price falls. It occurred in the 1800s,
1930s and the last 20 years in Japan. Most people would see falling prices as good
because they can buy more with their income. However, deflation can be good or bad.
In the period 1870–1895 in the US, deflation occurred against a background of strong
growth, reflecting rapid technological innovation. This can be called ‘good deflation’.
However, falling prices are not good if they are associated with falling wages, rising
unemployment, falling asset prices and rising real debt burdens. For example, in
the 1930s and more recently in Japan. This is ‘bad deflation’. Given high debt levels,
sustained deflation could cause big problems. Falling wages and prices would make
it harder to service debts. Lower nominal growth will make high public debt levels
harder to pay off. And when prices fall people put off decisions to spend and invest,
which could threaten economic growth. This could risk a debt deflation spiral of falling
asset prices and falling incomes leading to rising debt burdens, increasing defaults,
spurring more falls in asset prices, etc.
The problem for RBA credibility?
The problem for the RBA is that inflation has been undershooting its forecasts and
the target for several years now. The longer this persists the more the RBA will lose
credibility, seeing low inflation expectations become entrenched making it harder to
get inflation back to target and leaving Australia vulnerable to deflation in the next
economic downturn. [See Figure 6.4.]
122
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 3 The data of macroeconomics
06_Stonecash_8e_45658_SB_txt.indd 122
24/08/20 4:31 PM
FIGURE 6.4 RBA inflation forecasts risk losing credibility
3.5
3.0
Feb 14
Annual % change
Feb 12
Feb 17
Feb 15
2.5
Feb 16
Feb 13
2.0
Feb 19
Actual
underlying
inflation
1.5
1.0
Mar-10
Mar-12
Mar-14
Mar-16
Feb 18
Mar-18
Mar-20
Source: Dr Shane Oliver/AMP Capital, RBA, Bloomberg, https://www.ampcapital.com/au/en/insights-hub/
articles/2019/april/inflation-undershoots-in-australia-why-its-a-concern
Due to the slowdown in economic growth flowing partly from the housing downturn
we have been looking for two rate cuts this year since last December. We had thought
that the RBA would prefer to wait till after the election is out of the way before starting
to move and coming fiscal stimulus from July also supports the case to wait as does the
still strong labour market. However, with underlying inflation coming in much weaker
than expected the RBA [probably feels] its arguably too risky to wait until unemployment
starts to trend up. And the RBA has moved in both the 2007 and 2013 election
campaigns. So, while it’s a close call our base case is now for the first rate cut to occur at
the RBA’s May meeting. Failing that, then in June.
Source: Dr Shane Oliver/AMP Capital, ABS Data, https://www.ampcapital.com/au/en/insights
-hub/articles/2019/april/inflation-undershoots-in
-australia-why-its-a-concern
Let’s consider a simple example. Imagine that, in the base year, bananas are much
cheaper than coffees and so consumers buy more bananas than coffees. When the ABS
constructs the basket of goods, it will include more bananas than coffees. But think about
what happens when the price of bananas rises dramatically due to storms, like it did in 2007
and 2010. Consumers will naturally respond to the price changes by buying more coffees and
fewer bananas. Yet, when calculating the consumer price index, the ABS uses a fixed basket,
which in essence assumes that consumers continue buying the now-expensive bananas in
the same quantities as before. For this reason, the index will measure a much larger increase
in the cost of living than consumers actually perceive.
The second problem with the consumer price index is the introduction of new goods.
When a new good is introduced, consumers have more variety from which to choose.
Greater variety, in turn, makes each dollar more valuable, so consumers need fewer dollars
to maintain any given standard of living. Yet because the consumer price index is based on
a fixed basket of goods, it does not reflect this change in the purchasing power of the dollar.
Again, let’s consider an example. When streaming services like Spotify and Apple Music
were introduced, consumers could access all kinds of music on their devices without having
to purchase individual albums or songs, no matter where they were. These new services
increased consumers’ wellbeing by expanding their consumption choices. A perfect costof-living index would reflect this change as a decrease in the cost of living. The consumer
123
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN
02-200-202
Chapter
6 Measuring the cost of living
06_Stonecash_8e_45658_SB_txt.indd 123
24/08/20 4:31 PM
price index, however, did not decrease in response to the introduction of streaming services.
The ABS revises the basket of goods to include new services, but the category ‘Audio, visual
and computing media and services’ is only 0.7 percent of the consumer price index, and
streaming services would be a very small part of this category, so reductions in the cost of
living associated with streaming services would not show up in the index.
The third problem with the consumer price index is unmeasured quality change. If the
quality of a good deteriorates from one year to the next, the value of a dollar falls, even
if the price of the good stays the same. (A dollar buys a good of lower quality.) Similarly,
if the quality rises from one year to the next, the value of a dollar rises. The ABS does its
best to account for quality change. When the quality of a good in the basket changes – for
example, when a car model has more horsepower or gets better petrol consumption per
kilometre from one year to the next – the ABS adjusts the price of the good to account for
the quality change. It is, in essence, trying to calculate the price of a basket of goods of
constant quality. Nonetheless, changes in quality remain a problem, because quality is so
hard to measure.
There is still much debate among economists about how severe these measurement
problems are and what should be done about them. The issue is important because many
government programs use the consumer price index to adjust for changes in the overall
level of prices. Some economists have suggested modifying these programs to correct for
the measurement problems. For example, most studies conclude that the consumer price
index overstates inflation by 0.5 to 2.0 percentage points per year. In response to these
findings, the federal government could change benefits programs so that benefits increased
every year by the measured inflation rate minus one percentage point. Such a change would
provide a crude way of offsetting the measurement problems and, at the same time, reduce
benefits outlays significantly.
LO6.3 The GDP deflator versus the consumer price index
In the preceding chapter, we saw another measure of the overall level of prices in the
economy – the GDP deflator. The GDP deflator is the ratio of nominal GDP to real GDP.
Because nominal GDP is current output valued at current prices and real GDP is current
output valued at base-year prices, the GDP deflator reflects the current level of prices
relative to the level of prices in the base year.
Economists and policymakers monitor both the GDP deflator and the consumer price
index to gauge how quickly prices are rising. Usually, these two statistics tell a similar story.
Yet there are two important differences that can cause them to diverge.
The first difference is that the GDP deflator reflects the prices of all goods and services
produced domestically, whereas the consumer price index reflects the prices of all goods and
services bought by consumers. For example, suppose that the price of a ship produced by
Australian shipbuilders and sold to the Navy rises. Even though the ship is part of GDP, it is
not part of the basket of goods and services bought by a typical consumer. Thus, the price
increase shows up in the GDP deflator but not in the consumer price index.
As another example, suppose that Subaru raises the price of its cars. Because Subarus
are made in Japan, the car is not part of Australian GDP. But some Australian consumers do
buy Subarus and so the car is part of the typical consumer’s basket of goods. Hence, a price
increase in an imported consumption good, like a Subaru, shows up in the consumer price
index but not in the GDP deflator.
124
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 3 The data of macroeconomics
06_Stonecash_8e_45658_SB_txt.indd 124
24/08/20 4:31 PM
This first difference between the consumer price index and the GDP deflator is
particularly important if a country imports a significant proportion of its oil. As a result, oil
and oil products like petrol and heating oil are a much larger share of consumer spending
than they are of GDP. When the price of oil rises, the consumer price index rises by much
more than does the GDP deflator. This is more significant in some countries than others.
Australia is a net exporter of oil products, so a change in the price of oil is reflected both in
the GDP deflator and the consumer price index.
The second and more subtle difference between the GDP deflator and the consumer price
index concerns how various prices are weighted to yield a single number for the overall level
of prices. The consumer price index compares the price of a fixed basket of goods and services
with the price of the basket in the base year. The ABS changes the basket of goods once
every four or five years. In contrast, the GDP deflator compares the price of currently produced
goods and services with the price of the same goods and services in the base year. Thus, the
group of goods and services used to calculate the GDP deflator changes automatically over
time. This difference is not important when all prices are changing proportionately. But if
the prices of different goods and services are changing by varying amounts, the way we
weight the various prices matters for the overall inflation rate.
Figure 6.5 shows the inflation rate as measured by both the GDP deflator and the
consumer price index for each year since 1970. You can see that sometimes the two measures
diverge. When they do diverge, it is possible to go behind these numbers and explain the
divergence with the two differences we have discussed. The figure shows, however, that
divergence between these two measures is the exception rather than the rule. In the mid1970s, both the GDP deflator and the consumer price index show high rates of inflation. In
the mid-1980s and mid-1990s, both measures showed low rates of inflation.
FIGURE 6.5 Two measures of inflation
20.0
15.0
% per year
GDP price delfator
10.0
CPI
5.0
0.0
–5
1970
1975
1980
1985
1990
1995
2000
2005
2010
2015
2020
Year
This figure shows the inflation rate – the percentage change in the level of prices – as measured
by the GDP deflator and the consumer price index using annual data since 1970. Notice that the
two measures of inflation generally move together.
Source: ABS Data, Cat Nos 5206.05, 6401.06
125
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN
02-200-202
Chapter
6 Measuring the cost of living
06_Stonecash_8e_45658_SB_txt.indd 125
24/08/20 4:31 PM
Source: B. Rich/Hedgeye https://app.hedgeye.com/insights/37735-cartoon-of-the-day-inflationt-rex?type=cartoons
CHECK YOUR UNDERSTANDING
Explain briefly what the consumer price index is trying to measure. How does the
consumer price index differ from the GDP deflator?
LO6.4 Correcting economic variables for the effects of inflation
The purpose of measuring the overall level of prices in the economy is to permit comparison
between dollar figures from different points in time. Now that we know how price indexes
are calculated, let’s see how we might use such an index to compare a dollar figure from the
past with a dollar figure in the present.
Dollar figures from different times
We first return to the issue of Phar Lap’s winnings. Were his earnings of $19 000 in 1930 high
or low compared with the earnings in today’s race?
To answer this question, we need to know the level of prices in 1930 and the level of
prices today. Part of the increase in prize money just compensates the owners of racehorses
for the higher level of prices today. To compare Phar Lap’s winnings with those of today’s
horses, we need to inflate Phar Lap’s winnings to turn 1930 dollars into today’s dollars. A
price index determines the size of this inflation correction. (Remember that Phar Lap’s
earnings were in pounds, but we are using the equivalent dollar amounts.)
The Reserve Bank of Australia shows a price index of 2.7 for 1930 and 112.9 for 2018.
(The base year is 2012.) Thus, the overall level of prices has risen by a factor of 41.8 (which
126
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 3 The data of macroeconomics
06_Stonecash_8e_45658_SB_txt.indd 126
24/08/20 4:31 PM
equals 112.9/2.7). We can use these numbers to measure Phar Lap’s winnings in 2016
dollars. The calculation is:
Winnings in 1930 × Price level in 2018
Winnings in 2018 =
Price level in 1930
19 000 × 112.9
= 794 730
2.7
We find that Phar Lap’s 1930 winnings are equivalent to winnings today of about
$795 000. That is a lot of money for a horse, but nothing like the Melbourne Cup winner’s
earnings 2018. It is not even as much as what the second-placed horse receives. The
example does show that it is important to make these comparisons using the same dollars.
Over three-quarters of a million dollars looks much better than $19 000.
Let’s also examine Prime Minister Scullin’s 1930 salary of £1000, or roughly $2000. To
translate that figure into 2018 dollars, we again multiply the ratio of the price levels in the
two years. We find that Scullin’s salary is equivalent to $2000 × (112.9.7/2.7), or $83 656 in
2018 dollars. This is well below the current Prime Minister’s salary of $538 460. It seems
that Prime Minister Scullin did not earn very much compared with the famous racehorse or
today’s prime minister.
=
Indexation
As we have just seen, price indexes are used to correct for the effects of inflation when
comparing dollar figures from different times. This type of correction shows up in many
places in the economy. When some dollar amount is automatically corrected for inflation by
law or contract, the amount is said to be indexed for inflation.
For example, for many years, the basic wage in Australia was indexed to the consumer
price index. Such a provision automatically raises the wage whenever the consumer price
index rises.
Indexation is also a feature of many laws. Pension benefits, for example, are frequently
adjusted to compensate the elderly for increases in prices. There are, however, many ways
in which the tax system is not indexed for inflation, even when perhaps it should be. For
example, the brackets of income tax – the income levels at which the tax rates change – are
not indexed for inflation. We discuss these issues more fully when we discuss the costs of
inflation later in this book.
indexation
the automatic
correction of a dollar
amount for the
effects of inflation
by law or contract
LO6.5 Real and nominal interest rates
Correcting economic variables for the effects of inflation is particularly important, and
somewhat tricky, when we look at data on interest rates. When you deposit your savings in
a bank account, you will earn interest on your deposit. Conversely, when you borrow from
a bank to pay for a car, you will pay interest on your loan. Interest represents a payment
in the future for a transfer of money in the past. As a result, interest rates always involve
comparing amounts of money at different points in time. To fully understand interest rates,
we need to know how to correct for the effects of inflation.
Let’s consider an example. Suppose that Sally Saver deposits $1000 in a bank account
that pays an annual interest rate of 10 per cent. After a year passes, Sally has accumulated
$100 in interest. Sally then withdraws her $1100. Is Sally $100 richer than she was when
she made the deposit a year earlier?
The answer depends on what we mean by the word ‘richer’. Sally does have $100 more
than she had before. In other words, the number of dollars has risen by 10 per cent. But if
prices have risen at the same time, each dollar now buys less than it did a year ago. Thus, her
purchasing power has not risen by 10 per cent. If the inflation rate was 4 per cent, then the
127
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN
02-200-202
Chapter
6 Measuring the cost of living
06_Stonecash_8e_45658_SB_txt.indd 127
24/08/20 4:31 PM
nominal interest
rate
the interest rate as
usually reported
without a correction
for the effects
of inflation
real interest rate
the interest rate
corrected for the
effects of inflation
amount of goods she can buy has increased by only 6 per cent. And if the inflation rate was
15 per cent, then the price of goods has increased proportionately more than the number
of dollars in her account. In that case, Sally’s purchasing power has actually fallen by
5 per cent.
The interest rate that the bank pays is called the nominal interest rate, and the interest
rate corrected for inflation is called the real interest rate. We can write the relationship of
the nominal interest rate, the real interest rate and inflation as follows:
Real interest rate = Nominal interest rate − Inflation rate
The real interest rate is the difference between the nominal interest rate and the rate of
inflation. The nominal interest rate tells you how fast the number of dollars in your bank
account rises over time. The real interest rate tells you how fast the purchasing power of
your bank account rises over time.
Figure 6.6 shows real and nominal interest rates in Australia since 1970. The nominal
interest rate is the interest rate on 90-day bank bills. The real interest rate is calculated
by subtracting inflation – the percentage change in the consumer price index – from this
nominal interest rate.
FIGURE 6.6 Real and nominal interest rates
20
Inflation rate
Interest rates
(% per year)
15
Nominal interest rate
10
5
0
Real interest rate
–5
–10
1970
1975
1980
1985
1990
1995
Year
2000
2005
2010
2015
2020
This figure shows nominal and real interest rates using annual data since 1970. The nominal
interest rate is the rate on a 90-day bank bill. The real interest rate is the nominal interest
rate minus the inflation rate as measured by changes in the consumer price index. Notice the
nominal and real interest rates often do not move together.
Source: Reserve Bank of Australia Bulletin, 2018
IN THE
NEWS
Mr Index goes to Hollywood
What was the most popular film of all time? As the following article notes,
answering this question requires an understanding of price indexes.
Winner and still champ
Director James Cameron has directed several well-known movies, including two of the
most successful Hollywood films ever made – Titanic and Avatar. It had been over a
decade since Cameron had directed Titanic, when he told producer Greg Coote about
Avatar. He said ‘[It’s] a science-fiction environmental action film. I’ve been working on the
128
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 3 The data of macroeconomics
06_Stonecash_8e_45658_SB_txt.indd 128
24/08/20 4:31 PM
Getty Images/Bettmann
script since 1994, before I’d even started Titanic. It’s set in the year 2154 on a moon in the
Alpha Centauri system called Pandora.’ Coote apparently responded, ‘What . . . Terminator
vs. Alien? The Sinking of the Lusitania?’ Obviously, he was not impressed. But Cameron’s
Avatar went on to gross nearly US$3 billion.
Surely, that’s the highest grossing movie ever?
Well, not really. It’s a lot of money, but when
you adjust the earnings for inflation, Titanic (#5)
outdoes Avatar (#15), but Gone with the Wind,
released in 1939, outdoes them all. The Box
Office Mojo website lists the top-grossing films
of all time using today’s dollars. In 1939, a ticket
to the movies cost about $0.25. Today a movie
ticket is about $9.00 – an increase of over 3000%!
The chart below lists the all-time highest grossing
movies in dollars of the day and adjusted for
inflation. Notice how few of the movies in the
adjusted list were made since 2000. This list tells
‘Frankly, my dear, I don’t give a
us a lot about the effects of inflation . . . and that
damn about the effects of inflation.’
movies aren’t as popular as they used to be.
Domestic grosses: Adjusted for ticket price inflation
Rank
Title
Adjusted gross
Unadjusted gross
Year
1
Gone with the Wind
$1 895 421 694
$200 852 579
1939
2
Star Wars [ep. 4: A New
Hope]
$1 668 979 715
$460 998 507
1977
3
The Sound of Music
$1 335 086 324
$159 287 539
1965
4
E.T.: The Extra-Terrestrial
$1 329 174 791
$435 110 554
1982
5
Titanic
$1 270 101 626
$659 363 944
1997
6
The Ten Commandments
$1 227 470 000
$65 500 000
1956
7
Jaws
$1 200 098 356
$260 000 000
1975
8
Doctor Zhivago
$1 163 149 635
$111 721 910
1965
9
The Exorcist
$1 036 314 504
$232 906 145
1973
$1 021 330 000
$184 925 486
1937
$1 013 038 487
$936 662 225
2015
10
11
Snow White and the Seven
Dwarfs
Star Wars: Episode VII: The
Force Awakens
12
101 Dalmatians
$936 225 101
$144 880 014
1961
13
Star Wars: Episode V: The
Empire Strikes Back
$919 244 787
$290 271 960
1980
14
Ben-Hur
$918 699 453
$74 422 622
1959
15
Avatar
$911 790 952
$760 507 625
2009
16
Avengers: Endgame
$892 669 593
$858 373 000
2019
17
Star Wars: Episode VI:
Return of the Jedi
$881 336 578
$309 306 177
1983
18
Jurassic Park
$858 893 554
$402 828 120
1993
19
Star Wars: Episode I – The
Phantom Menace
$846 224 377
$474 544 677
1999
20
The Lion King
$835 301 768
$422 783 777
1994
Source: Box Office Mojo, http://www.boxofficemojo.com
129
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN
02-200-202
Chapter
6 Measuring the cost of living
06_Stonecash_8e_45658_SB_txt.indd 129
24/08/20 4:31 PM
You can see that real and nominal interest rates do not always move together. For
example, in the mid-1970s, nominal interest rates were high. But since inflation was very
high, real interest rates were low. Indeed, in some years, real interest rates were negative, for
inflation eroded people’s savings more quickly than nominal interest payments increased
them. In contrast, in both 1985 and 1990, even though nominal interest rates were high, low
inflation meant that real interest rates were relatively high. In the coming chapters, when
we study the causes and effects of changes in interest rates, it will be important for us to
keep in mind the distinction between real and nominal interest rates.
CHECK YOUR UNDERSTANDING
If the real interest rate is 3.5 per cent and the nominal interest rate is 5 per cent, then
what is the inflation rate?
Conclusion
When McDonald’s was introduced into Australia, a Big Mac, fries and a Coke cost about a
dollar. Now the same meal costs about $11 (if purchased separately). A dollar’s not worth
what it used to be. Indeed, throughout recent history, the purchasing power of the dollar has
not been stable. Persistent increases in the overall level of prices have been the norm. Such
inflation reduces the purchasing power of each unit of money over time. When comparing
dollar figures from different times, it is important to keep in mind that a dollar today is not
the same as a dollar 20 years ago or, most likely, 20 years from now.
This chapter has discussed how economists measure the overall level of prices in the
economy and how they use price indexes to correct economic variables for the effects of
inflation. This analysis is only a starting point. We have not yet examined the causes and
effects of inflation or how inflation interacts with other economic variables. To do that, we
need to go beyond issues of measurement. Indeed, that is our next task. Having explained
how economists measure macroeconomic quantities and prices in the past chapters, we are
now ready to develop the models that explain long-run and short-run movements in these
variables.
130
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 3 The data of macroeconomics
06_Stonecash_8e_45658_SB_txt.indd 130
24/08/20 4:31 PM
LO6.1 The consumer price index shows the cost of a basket of goods and services relative to
the cost of the same basket in the base year. The index is used to measure the overall
level of prices in the economy. The percentage change in the consumer price index
measures the inflation rate.
LO6.2 The consumer price index is an imperfect measure of the cost of living for three
reasons. First, it does not take into account consumers’ ability to substitute goods that
become relatively cheaper over time. Second, it does not take into account increases
in the purchasing power of the dollar due to the introduction of new goods. Third, it
is distorted by unmeasured changes in the quality of goods and services. Because of
these measurement problems, the consumer price index overstates annual inflation by
about one percentage point.
LO6.3 Although the GDP deflator also measures the overall level of prices in the economy, it
differs from the consumer price index because it includes goods and services produced
rather than goods and services consumed. As a result, imported goods affect the
consumer price index but not the GDP deflator. In addition, whereas the consumer
price index uses a fixed basket of goods, the GDP deflator automatically changes the
group of goods and services over time as the composition of GDP changes.
LO6.4 Dollar figures from different points in time cannot be used to make valid comparisons
of purchasing power. To compare a dollar figure from the past with a dollar figure
today, the older figure should be inflated using a price index. Various laws and private
contracts use price indexes to correct for the effects of inflation. The tax laws, however,
are only partially indexed for inflation.
LO6.5 A correction for inflation is especially important when looking at data on interest rates.
The nominal interest rate is the interest rate usually reported; it is the rate at which the
number of dollars in a savings account increases over time. In contrast, the real interest
rate takes into account changes in the value of the dollar over time. The real interest
rate equals the nominal interest rate minus the rate of inflation.
STUDY TOOLS
Summary
Key concepts
consumer price index (CPI), p. 116
indexation, p. 127
inflation, p. 116
inflation rate, p. 118
nominal interest rate, p. 128
producer price index, p. 119
real interest rate, p. 128
Practice questions
Questions for review
1
2
3
4
5
Which do you think has a greater effect on the consumer price index: An 8 per cent
increase in the price of an iPhone or an 8 per cent increase in the price of electricity? Why?
Explain briefly the three problems associated with measuring the cost of living.
If the price of a Royal Australian Air Force fighter jet rises, is the consumer price index or
the GDP deflator affected more? Why?
If you were a government official deciding to increase the pension age to 70, would you
have to take inflation into account in any way? Explain. If you were a businesswoman trying
to decide on a 10-year investment in a service industry in Australia, would you use the
same measure? Why or why not?
Explain the meaning of nominal interest rate and real interest rate. How are they related?
Multiple choice
1
Housing is just over 20% of the basket of goods contained in the CPI. If the cost of housing
rises, then the CPI will
a rise by the same amount.
b rise by less than the rise in the cost of housing.
131
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN
02-200-202
Chapter
6 Measuring the cost of living
06_Stonecash_8e_45658_SB_txt.indd 131
24/08/20 4:31 PM
2
3
4
5
c rise or fall depending on what happens to the prices of other goods in the basket.
d fall as housing isn’t very important in the CPI.
If you borrow money at 7%, and the inflation rate is on average 4% over the life of your
loan, then the amount you pay back in real terms is:
a 9%
b 6%
c 3%
d greater than what you borrowed.
If Apple doubled the price of Apple Music, it would cause the CPI to
a double.
b go up by less than double.
c remain unaffected because people would shift to Spotify.
d go up by the percentage increase in Apple Music weighted by how significant Apple
music is in the CPI.
Which of the following are reasons why the CPI should not be used to measure the cost of
living in Australia:
a If the price of a good goes up, people look for cheaper substitutes.
b The CPI measures prices in all capital cities in Australia.
c The CPI is updated frequently to account for the introduction of new goods and services.
d The base year changes from time to time.
Uber has been introduced into several cities in Australia. As a result, the price of getting
rides around these cities has fallen. This will have the following impact on the CPI:
a It will cause the CPI to fall as the price of rides has fallen.
b It will have no effect because Uber is not currently counted in the CPI.
c It will increase the CPI as taxi fares will have to rise as a result of fewer passengers in taxis.
d It will have a big impact because it is such a good way to travel.
Problems and applications
1
Suppose that people consume only three goods, as shown in this table:
Computers
Sushi
Boost Juice®
2020 price
$20
$175
$4.50
2020 quantity
100
10
200
2021 price
$24
$240
$5
2021 quantity
100
10
200
a
2
3
Calculate the percentage change in the price of each of the three goods. What is the
percentage change in the overall price level?
b Does sushi become more or less expensive relative to Boost Juice? Does the wellbeing
of some people change relative to the wellbeing of others? Explain.
Suppose that the residents of Veggieland spend all of their income on cauliflower, broccoli
and carrots. In 2020, they buy 75 heads of cauliflower for $100, 50 bunches of broccoli
for $120 and 600 carrots for $90. In 2021 they buy 60 heads of cauliflower for $200, 60
bunches of broccoli for $150 and 600 carrots for $150. If the base year is 2020, what is the
CPI in both years? What is the inflation rate in 2021?
From 1950 to 2016 the consumer price index in Australia rose around 2600 per cent. Use
this fact to adjust each of the following 1950 prices for the effects of inflation. Which items
cost less in 2016 than in 1950 after adjusting for inflation? Which items cost more?
Item
1950 price
2020 price
A day at the footy
$0.25
$76
Woman’s Day magazine
$0.05
$4.40
Orange juice
$0.12
$6.95
$700.00
$42 000.00
$1.28
$11.20
A Holden ‘BT1’ commodore sedan
Sending a package by air from Melbourne to Germany
132
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 3 The data of macroeconomics
06_Stonecash_8e_45658_SB_txt.indd 132
24/08/20 4:31 PM
4
In late 2012, Uber launched in Australia. The price of getting driven around Australia’s
capital cities suddenly got cheaper. But taxis drivers complained that Uber wasn’t as safe as
taking a taxi. If you were the chief statistician for the ABS, how would you change the CPI to
reflect the increased use of Uber? Could you simply say the price of taxi fares went down?
5 Which of the problems in the construction of the CPI might be illustrated by each of the
following situations? Explain.
a the invention of the Fitbit
b the introduction of zero-emission cars
c decreased purchases of beef in response to an increase in its price
d more scoops of sultanas in each package of Sultana Bran®
e increased purchases of the Smart car
6 The Age newspaper cost $0.05 in 1970 and $2.50 in 2016. The average wage in
manufacturing was $3.35 per hour in 1970 and $45 per hour in 2016.
a By what percentage did the price of a newspaper rise?
b By what percentage did the wage rise?
c In each year, how many minutes does a worker have to work to earn enough to buy a
newspaper?
d Did workers’ purchasing power in terms of newspapers rise or fall?
7 For years, British citizens who are resident in Australia have tried to convince the UK
government to index the pensions they receive, just as they would be if they were in the
UK. But the UK government has steadfastly refused to index the pensions of British people
who have settled in Australia for their retirement.
a If you were a British citizen contemplating retirement in the Aussie sunshine, how
would the lack of indexing affect your decisions? What could you do to overcome the
disadvantage of having a pension that wasn’t indexed?
b Suppose Australia’s inflation rate is 2 per cent per year and the UK’s inflation rate is 4
per cent per year. If the UK government indexed all pensions, would British people who
had migrated to Australia be better or worse off than if they’d stayed in the UK (ignoring
the impact of nicer weather in Australia)?
c Now suppose that inflation and indexing are as suggested in part (b), but Australia has
a much higher rate of increase in the price of health care. How does that change your
answer to part (b)?
8 Suppose that a borrower and a lender agree on the nominal interest rate to be paid on a
loan. Then inflation turns out to be higher than they both expected.
a Is the real interest rate on this loan higher or lower than expected?
b Does the lender gain or lose from this unexpectedly high inflation? Does the borrower
gain or lose?
c If you were taking out a mortgage today, how would your expectations about inflation
in the next 10 years affect your decision about whether to fix your mortgage rate or let
it vary?
9 Since the Global Financial Crisis of 2008–09, inflation has actually been much lower than
people expected it to be. How has this impacted on homeowners who are on fixed-rate
mortgages in the mid-2000s? How did it affect the banks that lent them the money?
10 The chapter defines the real interest rate as the nominal interest rate less inflation.
Because, under Australian tax laws, nominal interest income is taxed, we can define the
after-tax real interest rate as the nominal interest rate after taxes, less inflation.
a Suppose that the inflation rate is 1 per cent, the nominal interest rate is 1.5 per cent,
and the tax rate is 37 per cent. What is the real interest rate? What is the after-tax real
interest rate? What is the effective tax rate on real interest income (the percentage
reduction in real interest income due to taxes)?
b Now suppose that the inflation rate rises to 3 per cent, and the nominal interest rate
rises to 3 per cent. What is the real interest rate now? What is the after-tax real interest
rate? What is the effective tax rate on real interest income?
c Some economists argue that because of our tax system, inflation discourages saving.
Use your answers to parts (a) and (b) to explain this view.
11 In Australia, income tax brackets are not indexed. When inflation pushed up nominal
incomes, what do you think happened to real tax revenue? (Hint: This phenomenon is
known as ‘bracket creep’.)
133
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN
02-200-202
Chapter
6 Measuring the cost of living
06_Stonecash_8e_45658_SB_txt.indd 133
24/08/20 4:31 PM
PART
PARTFOUR
ONE
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
07_Stonecash_8e_45658_SB_txt.indd 134
24/08/20 6:12 PM
The real economy
in the long run
Chapter 7 Production and growth
Chapter 8 Saving, investment and the financial system
Chapter 9 The natural rate of unemployment
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
07_Stonecash_8e_45658_SB_txt.indd 135
24/08/20 6:12 PM
7
Production and growth
Learning objectives
After reading this chapter, you should be able to:
LO7.1 understand economic growth around the world
LO7.2 understand the role of productivity and its determinants
LO7.3 examine economic growth and public policy.
136
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
07_Stonecash_8e_45658_SB_txt.indd 136
24/08/20 6:12 PM
Introduction
When you travel around the world, you see tremendous variation in the standard of living.
The average person in a high-income country, like Australia, the United States, or Norway,
has an income more than 20 times as high as the average person in a low-income country,
like Bangladesh, Kenya, or Haiti. Figure 7.1 shows a map that is a visual representation of
these differences, whereby darker colours represent higher income per person (adjusted for
the purchasing power to be comparable across countries).
FIGURE 7.1 Economic prosperity differs substantially across countries
GDP per capita, 2016
No Data
$0
$5000 $10,000 $20,000 $30,000 $40,000 >$50,000
The figure shows 2016 GDP per person across the globe in US dollars (adjusted for differences in
price levels).
Source: Maddison Project Database, version 2018. Bolt, Jutta, Robert Inklaar, Herman de Jong and Jan Luiten van Zanden (2018),
“Rebasing ‘Maddison’: new income comparisons and the shape of long-run economic development”, Maddison Project Working
paper 10 (CC BY 4.0)
These large differences in production and incomes are reflected in large differences in the
quality of life. Richer countries not only have more cars and more televisions, but they also
have better health care and nutrition, higher literacy rates, lower child mortality and longer
life expectancy.
Even within a country, there are large changes in the standard of living over time. In
Australia over the past 100 years, average income as measured by real GDP per person has
grown by about 1.6 per cent per year (using the Maddison project data available at http://
www.ggdc.net/maddison/maddison-project/home.htm). Although 1.6 per cent might
seem a small number, this rate of growth has led to average income today being nearly five
times as high as average income a century ago. As a result, the typical Australian enjoys
much greater economic prosperity today than back in the early twentieth century.
Income growth rates vary substantially from country to country. In some East Asian
countries, like Hong Kong, Singapore, South Korea and Taiwan, average income has risen
around 4 to 7 per cent per year in recent decades. At this rate, average income doubles every
10 to 17.5 years. These countries have, in the length of two generations, gone from being
fairly poor to being among the richest in the world. In contrast, in countries like Venezuela,
North Korea or some in sub-Saharan Africa, average income has been stagnant for several
decades. Zimbabwe has had one of the worst growth experiences: From 1991 to 2014, income
per person fell by a total of 60 per cent.
137
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN Chapter
02-200-202
7 Production and growth
07_Stonecash_8e_45658_SB_txt.indd 137
24/08/20 6:12 PM
economic growth
increases in real
GDP (and prosperity)
over time
The effects of these differences in growth rates can be seen in Australia. Even though
the typical Australian enjoys a greater level of economic prosperity now relative to his or her
ancestors, the standard of living in Australia has not increased as rapidly as it has in some
other countries. For example, in 1870, GDP per capita in Australia was 1.35 times GDP per
capita in the United States. By 1992, Australian GDP per capita was only about 0.74 times
US GDP per capita (although in 2014 it was already 0.85 times). The fact that Australia
slipped in the rankings of GDP per capita is not necessarily cause for concern, but it does
indicate that the Australian economy has not always performed as well as it perhaps could.
What explains these diverse experiences? How can wealthy countries be sure to maintain
their high standard of living? What policies should low-income countries pursue to prosper?
These are among the most important questions in macroeconomics. As economist Robert
Lucas put it (1988, p. 5): ‘The consequences for human welfare in questions like these are
simply staggering: Once one starts to think about them, it is hard to think about anything
else’. (‘On the mechanics of economic development’, Journal of Monetary Economics, 22
(1988), pp. 3–42.)
In the previous two chapters we showed how economists measure macroeconomic
quantities and prices. In this chapter we start studying the forces that determine these
variables. As we have seen, an economy’s gross domestic product (GDP) measures not only
the quantity of goods and services produced in the economy, but also (as you may recall from
the circular-flow diagram) the total income earned and the economy’s total expenditure. We
have also discussed how the level of real GDP per capita is a decent (although not perfect)
measure of a country’s prosperity and people’s wellbeing. Consequently, the growth rate of
real GDP, commonly referred to as economic growth, represents the dynamic perspective:
Improvements in prosperity over time. In this chapter, we focus on the long-run determinants
of both the level and the growth rate of real GDP. Later in this book we will study the shortrun fluctuations of real GDP around its long-run trend.
We proceed here in three steps. First, we examine international data on real GDP per
person. These data will give you some sense of how much living standards vary around
the world and over time. Second, we examine the role of productivity – the amount of
goods and services produced for each hour of a worker’s time. In particular, you will see
that a nation’s standard of living is determined by the productivity of its workers and
consider the factors that determine a nation’s productivity. Third, we explore the link
between productivity and the economic policies that a nation pursues.
LO7.1 Economic growth around the world
As a starting point for our study of long-run economic growth, consider a fact that many
people find surprising: It is a relatively recent phenomenon! Widespread increases in
incomes, that we now take for granted, only started about two and a half centuries ago with
the onset of the Industrial Revolution. Before that, the prosperity of ordinary people was
stagnant for many centuries and possibly millennia (see, for example, the book A Farewell to
Alms: A Brief Economic History of the World by Professor Gregory Clark). While the reasons
for this ‘birth’ of economic growth in the eighteenth century are not fully known, the rest of
the chapter will offer some insights in this respect.
To understand the more recent developments, Table 7.1 shows data on real GDP per
person for 17 selected countries over the past six to seven decades. The second column of
the table presents the time periods, which differ somewhat from country to country because
of differences in data availability. The third and fourth columns show real GDP per person in
the early 1950s and in 2017.
138
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 4 The real economyCopyright
in the long
run
07_Stonecash_8e_45658_SB_txt.indd 138
24/08/20 6:12 PM
Country
Period
Real GDP
per capita at
beginning of
period ($)*
Real GDP per
capita at end
of period*
Average
growth
rate (%)
Botswana
1960–2017
405
14 997
6.5
South Korea
1953–2017
988
36 265
5.8
Japan
1950–2017
2 531
40 374
4.2
China
1952–2017
1 073
13 043
3.9
Malaysia
1955–2017
2 144
22 776
3.9
Indonesia
1960–2017
1 282
10 594
3.8
Brazil
1950–2017
1 510
13 813
3.4
India
1950–2017
841
6 422
3.1
Pakistan
1950–2017
1 268
5 303
2.2
Australia
1950–2017
12 283
47 393
2.0
Canada
1950–2017
11 186
42 907
2.0
United States
1950–2017
14 569
54 795
2.0
New Zealand
1950–2017
10 703
36 538
1.8
Bangladesh
1959–2017
1 356
3 436
1.6
Russia
1990–2017
15 262
22 581
1.5
Venezuela
1950–2017
5 436
7 697
0.5
Niger
1960–2017
1 368
909
–0.7
Source: The Penn World Table (Mark 9.1), Feenstra, R.C., R. Inklaar & M.P. Timmer (2015), ‘The Next
Generation of the Penn World Table’, American Economic Review, 105(10), 3150–3182, available for
download at http://www.ggdc.net/pwt (CC BY 4.0)
TABLE 7.1 The variety of growth experiences across countries
*Real GDP is expressed in 2011 (internationally comparable) dollars.
The data on real GDP per person show that living standards vary widely from country
to country. Income per person in Australia, for instance, is over three and a half times that
in China and seven times that in India. Some countries have average levels of income that
have not been seen in Australia for many decades. The typical Indonesian in 2017 had about
as much real income as the typical New Zealander in 1950. The typical person in Pakistan
in 2017 had roughly the same income as the typical Venezuelan in 1950. You may also be
surprised that the typical person in Niger had higher income than the typical South Korean
in the early 1950s, whereas in 2017 she had nearly 40 times less income.
The last column of the table shows each country’s average annual growth rate over
the whole period. The growth rate measures how rapidly real GDP per person grew in the
typical year. In Australia, for example, real GDP per person was $12 283 in 1950 and $47 393
in 2017 (these amounts can be compared as they are both measured in 2011 dollars). The
average annual growth rate over this period was 2.0 per cent per year. This means that if
real GDP per person, beginning at $12 283, were to increase by 2.0 per cent for each of the
67 years, it would end up at $47 393. Of course, real GDP per person did not actually rise
exactly 2.0 per cent every year – there were short-run fluctuations around the long-run
trend growth rate.
The countries in Table 7.1 are ordered by their GDP per capita growth rate from the most
to the least rapid. Botswana (South Africa’s neighbour) tops the list with an average growth
rate of 6.5 per cent per year. China’s average growth rate was 3.9 per cent over that period,
and double that amount in the past two decades. While it is growing rapidly, it still has a
relatively low per capita GDP. Even at its current growth rates, it would still take many years
before China’s average income is in the world’s top 10.
139
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN Chapter
02-200-202
7 Production and growth
07_Stonecash_8e_45658_SB_txt.indd 139
24/08/20 6:12 PM
Seventy years ago, Japan and South Korea were not rich countries. Their average incomes
were higher than Indonesia’s average incomes, but they were less than half of Venezuela’s
average income. But because of their spectacular growth (during the 1950–90 period in the
case of Japan and during 1965–95 in South Korea), they are today economic superpowers,
with average income almost the same as Australia’s and New Zealand’s. Countries like
Australia, Canada, the US and New Zealand all have similar growth rates (at or close to 2%)
because they were all relatively developed at the start of the period.
At the bottom of the list of countries is Niger, which has experienced hardly any growth
at all over most of the past half-century; the typical resident of Niger lives in poverty similar
to that experienced by his or her great-grandparents. It should, however, be said that the
economic situation of many low-income countries has been improving. For example, Niger
has experienced positive growth in the last few years, and a number of countries in Africa
and Asia like Chad or Afghanistan have had average incomes growing as high as 8 per
cent annually since the start of the twenty-first century. Later in the chapter there is more
discussion on how global poverty has been decreasing over the past three decades.
FYI
The magic of compounding and the rule of 70
It may be tempting to dismiss differences in growth rates as insignificant. If one
country’s real GDP grows at 1 per cent while another’s grows at 3 per cent, so what?
What difference can 2 percentage points make?
The answer is clear: A big difference. Even growth rates that seem small when
written in percentage terms seem large after they are compounded for many years.
Compounding refers to the accumulation of a growth rate over a period of time.
Consider an example. Suppose that two university graduates – Delta and Bec – both
take their first jobs at the age of 22 earning $30 000 a year. Delta lives in an economy
where real incomes grow at 1 per cent per year, whereas Bec lives in one (otherwise
identical) where real incomes grow at 3 per cent per year. Straightforward calculations
show what happens. Forty years later, when both are 62 years old, Delta earns $45 000
a year, and Bec earns $98 000 (you can double-check these numbers using an online
compound growth calculator, for example, at http://www.investo-pedia.com/calculator/
cagr.aspx). Because of that difference of 2 percentage points in the growth rate, Bec’s
salary in real terms will be more than twice Delta’s.
An old rule of thumb, called the rule of 70, is helpful in understanding growth rates
and the effects of compounding. According to the rule of 70, if a variable grows at a rate
of x per cent per year, then that variable doubles in approximately 70/x years. In Delta’s
economy, real incomes grow at 1 per cent per year, so it takes about 70 years for them
to double. In Bec’s economy, real incomes grow at 3 per cent per year, so it takes about
70/3, or 23, years for them to double.
The rule of 70 applies not only to a growing economy but also to a growing savings
account. Here is an example. Suppose that when Governor Phillip left office in 1792, he
gave $5000 to be invested for a period of 200 years to benefit scientific research into early
Australian history. If this money had earned 7 per cent per year (which would, in fact, have
been very possible to do), the investment would have doubled in value every 10 years.
Over 200 years, it would have doubled 20 times. At the end of 200 years of compounding,
the investment would have been worth 220 × $5000, which is about $5 billion.
As these examples show, growth rates compounded over many years can lead to
some spectacular results. That is probably why some people call compounding ‘the
greatest mathematical discovery of all time’.
140
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 4 The real economyCopyright
in the long
run
07_Stonecash_8e_45658_SB_txt.indd 140
24/08/20 6:12 PM
Because of differences in GDP growth rates, the ranking of countries by income changes
substantially over time. Japan is a country that has risen relative to others between 1950 and
1990 and has fallen since then. The rise of China and other South East Asian countries still
continues. Two countries that have fallen behind are New Zealand and Argentina. In 1950,
New Zealand was one of the richest countries in the world, with average income nearly as
high as the United States and well above the United Kingdom. Today, average income in New
Zealand is well below average income in the US and in Australia. In 1950, Venezuela had
almost four times the income of its South American neighbour, Brazil. Today, Venezuela’s
average income is only just over half that of Brazil’s. Australia’s story is somewhere in
between these two. In 1900, Australia had the highest per capita income in the world, but
by 1970 it had fallen to around seventh in the rankings. By 1991, Australia was no longer in
the top 10 and had fallen behind most western European countries in relative terms. Since
then, Australia’s relatively strong economic growth (we have had no recession since 1992)
has seen Australia’s ranking rise, attacking the top 10 again.
These data show that the world’s richest countries have no guarantee that they will
stay the richest and that the world’s poorest countries are not doomed forever to remain in
poverty. But what explains these changes over time? Why do some countries zoom ahead
while others lag behind? These are precisely the questions that we take up next.
CHECK YOUR UNDERSTANDING
What has been the approximate annual growth rate of real GDP per person in Australia
and China over the past half century? Before reading the rest of the chapter, can you
suggest any possible explanations for the differences in economic growth rates between
Australia and China over this period?
LO7.2 Productivity: Its role and determinants
Explaining the large variation in living standards around the world is, in one sense, very
easy. As we will see, the explanation can be summarised in a single word – productivity. But,
in another sense, the international variation is deeply puzzling. To explain why incomes are
so much higher in some countries than in others, we must look at the many (economic as
well as non-economic) factors that determine a nation’s productivity.
Why is productivity so important?
Let’s begin our study of productivity and economic growth by developing a simple model
based loosely on Daniel Defoe’s famous novel, Robinson Crusoe. Robinson Crusoe, as you
may recall, is a sailor stranded on a desert island. Because Crusoe lives alone, he catches his
own fish, grows his own vegetables and makes his own clothes. We can think of Crusoe’s
activities – his production and consumption of fish, vegetables and clothing – as being a
simple economy. By examining Crusoe’s economy, we can learn some lessons that also apply
to more complex and realistic economies.
What determines Crusoe’s standard of living? The answer is obvious. If Crusoe is good
at catching fish, growing vegetables and making clothes, he lives well. If he is bad at doing
these things, he lives poorly. Because Crusoe gets to consume only what he produces, his
living standard is tied to his productive ability.
141
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN Chapter
02-200-202
7 Production and growth
07_Stonecash_8e_45658_SB_txt.indd 141
24/08/20 6:12 PM
The term productivity refers to the quantity of goods and services that a worker can
produce for each hour of work. In the case of Crusoe’s economy, it is easy to see that
productivity is the key determinant of living standards and that growth in productivity is
the key determinant of improvements in living standards. The more fish Crusoe can catch
per hour, the more he can eat at dinner. If Crusoe finds a better place to catch fish or a smarter
way of doing so, his productivity rises. This increase in productivity makes Crusoe better
off – he could eat the extra fish, or he could spend less time fishing and devote more time to
other activities he enjoys.
The key role of productivity in determining living standards is as true for nations as it is
for stranded sailors. Recall that an economy’s gross domestic product (GDP) measures three
things at once – the total production, the total income earned in the economy and the total
expenditure on the economy’s goods and services. The reason GDP can measure these three
things simultaneously is that, for the economy as a whole, they must be equal. Put simply,
workers and owners of capital get paid their income for what they produce and use this
income to purchase the goods and services produced in the economy.
The implication is that Australians are more prosperous than Nigerians mainly because
Australian workers are more productive than Nigerian workers. The Chinese have enjoyed
more rapid growth in living standards than Venezualans primarily because Chinese workers
have experienced more rapidly growing productivity. Indeed, one of the Ten Principles of
Economics in chapter 1 is that a country’s standard of living depends on its ability to produce
goods and services.
The above discussion implies that in order to understand the large differences in living
standards across countries or over time, we must focus on the production of goods and
services. But seeing the link between prosperity and productivity is only the first step. It
leads naturally to the next question: Why are some economies so much better at producing
goods and services than others?
How is labour productivity determined?
Although productivity is uniquely important in determining Robinson Crusoe’s standard of
living, many factors determine Crusoe’s productivity. Crusoe will catch more fish, for instance,
if he has more fishing rods, if he has been trained in the best fishing techniques, if his island
has a plentiful fish supply or if he has figured out the best places and times on his island to
fish. Each of these determinants of Crusoe’s productivity – which we can call physical capital,
human capital, natural resources and technological knowledge – has a counterpart in more
complex and realistic economies. Let’s consider each of these factors in turn.
Physical capital
physical capital
the stock of
equipment and
structures that are
used to produce
goods and services
Workers are more productive if they have tools with which to work. The stock of equipment
and structures that are used to produce goods and services is called physical capital, or
just capital. For example, when woodworkers make furniture, they use saws, lathes and
drill presses. More tools allow work to be done more quickly and more accurately. That is,
a worker with only basic hand tools can make less furniture each week than a worker with
sophisticated and specialised woodworking equipment.
As you may recall from chapter 2, the inputs used to produce goods and services are called
the factors of production. An important feature of physical capital is that, unlike labour, it is a
produced factor of production. That is, capital is an input into the production process that in
the past was an output from the production process. The woodworker uses a lathe to make the
leg of a table. Earlier, the lathe itself was the output of a firm that manufactures lathes. The
lathe manufacturer in turn used other equipment to make its product. Thus, capital is a factor
of production used to produce all kinds of goods and services, including more capital.
142
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 4 The real economyCopyright
in the long
run
07_Stonecash_8e_45658_SB_txt.indd 142
24/08/20 6:12 PM
Human capital
A very important determinant of productivity is human capital. Human capital is the
economist’s term for the knowledge and skills that workers acquire through education,
training and experience. Human capital includes the skills accumulated in early childhood
programs, primary school, secondary school, university and on-the-job training for adults
in the labour force.
Although education, training and experience are less tangible than lathes, bulldozers and
factory buildings, human capital is like physical capital because it raises a nation’s ability to
produce goods and services. Also, like physical capital, human capital is a produced factor of
production. Producing human capital requires inputs in the form of teachers, libraries and
student time. Indeed, students can be viewed as ‘workers’ who have the important job of
producing the human capital that will be used in future production.
human capital
the knowledge and
skills that workers
acquire through
education, training
and experience
Natural resources
Another (although less important) determinant of productivity is natural resources.
Natural resources are inputs into production that are provided by nature, like land, rivers
and mineral deposits. Natural resources take two forms – renewable and non-renewable. A
forest is usually given as an example of a renewable resource. When one tree is cut down,
a seedling can be planted in its place to be harvested in the future (although you may
rightly point out that it sometimes takes a long time). Oil is an example of a non-renewable
resource. Because oil is produced by nature over many thousands of years, there is only a
limited supply. Once the supply of oil is depleted, it is impossible to create more, and we
would have to turn to its natural or human-made alternatives.
Differences in natural resources are responsible for some of the differences in standards of
living around the world. The historical success of Australia was driven in part by the large supply
of land well suited to agriculture. Today, some countries in the Middle East, like Kuwait and Saudi
Arabia, are rich because they are on top of some of the largest pools of oil in the world.
But while natural resources can be beneficial, they are not necessary for an economy
to be productive and to have high economic growth. Singapore, for instance, is one of the
most prosperous countries in the world, despite having few natural resources. International
trade makes Singapore’s success possible. Singapore imports most of the natural resources
it needs and exports its manufactured goods to economies rich in natural resources.
natural resources
the production inputs
provided by nature,
like land, rivers and
mineral deposits
Technological knowledge
An essential determinant of productivity is technological knowledge – the understanding
of the best ways to produce goods and services. A hundred years ago, most Australians
worked on farms, because farm technology required a high input of labour in order to feed
the entire population. Today, thanks to advances in the technology of farming, a small
fraction of the population can produce enough food to feed the entire country.
Technological knowledge takes many forms. Some technology is common knowledge –
after it becomes used by one person, everyone can take advantage of it. For example, once
Henry Ford successfully introduced production in assembly lines, other carmakers quickly
followed suit. A more recent example is the Internet. Other technology is proprietary – it is
known only by the company that discovers it. Only the Coca-Cola Company, for instance,
knows the secret recipe for making its soft drink. Some other technology is proprietary for
a short time. When a drug company discovers a new drug, the patent system gives that
company a temporary right to be the exclusive manufacturer of this particular drug. When
the patent expires, however, other companies are allowed to make the drug.
It is worthwhile to summarise the differences between technological knowledge, human
capital, physical capital and labour. Roughly speaking, physical capital is the quantity of
machines whereas technological knowledge refers to the quality of machines and production
technological
knowledge
society’s
understanding of the
best ways to produce
goods and services
143
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN Chapter
02-200-202
7 Production and growth
07_Stonecash_8e_45658_SB_txt.indd 143
24/08/20 6:12 PM
processes. Similarly, labour relates to the quantity of workers in terms of the number of hours
they supply, while human capital expresses the quality and intellectual capacity of people
with regard to economic activities. To use a relevant metaphor, technological knowledge
is the quality of society’s textbooks, whereas human capital is the zeal and ingenuity with
which individuals write these textbooks and learn from them.
Based on the above discussion, it will probably not surprise you that labour productivity
depends on physical capital and human capital, as well as technological knowledge. You
will, however, soon see that physical capital only has a temporary effect: Ongoing increases
in the number of machines per worker cannot permanently sustain economic growth. This
is in contrast to human capital and technological knowledge, both of which improve the
quality of the production inputs rather than just adding more inputs.
CASE
STUDY
Are natural resources or global warming limits to growth?
The world’s population is far larger today than it used to be (in 1800 it was around one
billion, one-seventh of what it is now), and most people are enjoying a much higher
standard of living. A perennial debate concerns whether this growth in population and
living standards can continue in the future.
Many commentators have argued that natural resources provide a limit to how
much the world’s economies can grow. At first, this argument might seem hard to
ignore. If the world has only a fixed supply of non-renewable natural resources,
how can population, production and living standards continue to grow over time?
Eventually, won’t supplies of oil and minerals start to run out? When these shortages
start to occur, won’t they stop economic growth and, perhaps, even force living
standards to fall?
In the early 1970s, a group of researchers at the Massachusetts Institute of
Technology (MIT) in the US were commissioned to undertake analysis of whether
this would in fact happen. They published a book called The Limits to Growth. They
concluded that by about 2020, we would reach peak production – that we would not be
able to continue to increase our output of goods as we would run out of key inputs of
non-renewable resources. The researchers were criticised – their computer modelling
made simplistic assumptions, they didn’t consider technological advances and so on.
It appears that they weren’t entirely accurate about their predictions … and yet … We
are experiencing changes to our climate that may force us to limit our production to
prevent catastrophic changes to our environment.
Most economists are less concerned about running out of resources as the source
of limits. Technological progress has led to discoveries that have replaced many nonrenewable resources with renewables or that allow us to recycle the non-renewables.
If we compare the economy today with the economy of the past, we see various ways
in which the use of natural resources has improved. Modern cars, particularly hybrids,
require fewer litres of petrol per kilometre. New houses have better insulation and
require less energy to heat and cool them. Recycling allows some non-renewable
resources to be reused. Solar panels on houses and the use of batteries to store
energy generated during the day are now fairly common.
Half a century ago, some people were concerned about the excessive use of tin and
copper. At the time, these were crucial commodities – tin was used to make many food
containers, and copper was used to make telephone wire. Some people advocated
mandatory recycling and rationing of tin and copper so that supplies would be
available for future generations. Today, however, plastic has replaced tin as a material
for making many food containers, and phone calls often travel over fibre-optic cables,
which are made from sand. Technological progress has made once-crucial natural
resources less necessary.
But are all these technological efforts enough to permit continued economic growth?
One way to answer this question is to look at the prices of natural resources. In a market
144
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 4 The real economyCopyright
in the long
run
07_Stonecash_8e_45658_SB_txt.indd 144
24/08/20 6:12 PM
iStockphoto/alantobey
What happens when these wells run dry?
economy, scarcity is reflected in market prices. If the world were running out of natural
resources without any alternatives in sight, then the prices of those resources would
be rising over time. But this does not seem to be the case. The prices of most natural
resources (adjusted for overall inflation) are stable over the long term or even falling.
It appears that our ability to conserve these resources and/or discover new reserves
is growing more rapidly than their supplies are dwindling (for example, reported oil
reserves of the eight main OPEC countries are more than five times larger now than in
1980, although these numbers are disputed). Market prices for most resources give no
reason to believe that natural resources are a hard limit to economic growth.
The same can be said about other main drivers of prosperity: Human capital and
technological progress. Given that human creativity and passion for self-improvement
seem limitless, it is very unlikely that there exists a certain fixed technological frontier
that would bring economic growth to a halt.
Does this mean that all is well and economic growth can continue the same way
we are used to? Not exactly. The IPCC produced a report in 2014 that detailed ways
in which climate change might affect different industries. A couple of examples
highlight how an increase in global temperatures might affect economic growth.
Water resources may be less available, so industries that use a great deal of water
may not experience the same level of growth. Agriculture, a significant export sector
for Australia, is being affected by longer and longer periods of drought, leading to
reduced levels of output. Climate change will certainly affect tourism – whether it be
reduced ski seasons because of warmer weather or greater storm activity and severity
leading to fewer people sitting on beaches. For some tropical economies, these affects
will be significant. (See chapter 10 of Climate Change 2014: Impacts, Adaptation, and
Vulnerability. Part A: Global and Sectoral Aspects. Contribution of Working Group II to
the Fifth Assessment Report of the Intergovernmental Panel on Climate Change for more
detailed descriptions of climate change impacts on various economic sectors.)
Questions
Can technological progress reduce the effects of climate change? (Hint: Think about
how the production process affects climate change.)
145
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN Chapter
02-200-202
7 Production and growth
07_Stonecash_8e_45658_SB_txt.indd 145
24/08/20 6:12 PM
The production function
Economists often use a production function to describe the relationship between the
quantity of inputs used in production and the quantity of output from production. To
formalise our previous discussion, suppose Y denotes the quantity of real output, for the
production of which five inputs are used. Three of them are ‘tangible’ (i.e. quantity-type
inputs) whereas two are ‘non-tangible’ (i.e. quality-type inputs). In terms of the tangible
factors of production, L denotes the quantity of labour, K the quantity of physical capital
and N the quantity of natural resources. In terms of the non-tangible factors, H expresses
human capital (the quality of a typical worker) and A captures technological knowledge
(the quality of the available production technology). Then we might write:
Y = F (L; K; N; H; A)
returns to scale
the effect on output
of increasing all
(tangible) inputs in
the same proportion
where F( ) is some function that shows how the inputs are combined to produce output. The
specific form of this function is not important for our purposes; what matters is that as any
of the five production inputs rises, the economy produces more output.
A common question is whether it is better for productivity to be a small or a large country.
The answer depends on a property of the production function called returns to scale. This
concept describes what happens if all three tangible inputs L, K and N are increased in
the same proportion. For example, assume that you double the number of workers (L), the
number of machines (K) and the amount of natural resources (N), keeping the non-tangible
inputs unchanged. Three scenarios can occur as a consequence. First, if a production
function has constant returns to scale, then a doubling of all the tangible inputs causes the
amount of output to double as well. In such cases it makes no difference if a country is large
or small. Second, if output more than doubles then the production function has increasing
returns to scale, and being a bigger country is better for productivity. Third, if doubling all
tangible inputs results in less than a doubling of output then there are decreasing returns to
scale; i.e. it is better to be a small country.
Do economies have constant, increasing or decreasing returns to scale? A lot of economic
research attempts to answer this question, and the conclusion is not clear-cut. But as we see
both small and large countries among the richest countries as well as among the poorest
countries, it makes sense to focus on the case of constant returns to scale. Mathematically,
a production function has constant returns to scale if, for any positive number x:
xY = F (xL, xK, xN, H, A)
The right-hand side shows the tangible inputs changing in the same proportion; for
example, doubling in the case of x = 2. And the left-hand side shows the output changing in
the same proportion (i.e. doubling) too. Production functions with constant returns to scale
have an interesting implication. To see what it is, set x = 1/L. Then the equation becomes:
Y/L = F (1, K/L, N/L, H, A)
Notice that output per worker (Y/L), which is a measure of labour productivity, does not
depend on the number of workers L. Under constant returns to scale, the L variable disappears
from the right-hand side of the equation. Instead, productivity depends on physical capital
per worker (K/L), natural resources per worker (N/L), as well as society’s technology (A)
and human capital (H). This equation thus provides a mathematical summary of the four
determinants of productivity we have discussed.
You may wonder why productivity depends on A and H rather than A/L and H/L; that
is, why A and H do not have to be increased in proportion with the tangible inputs. The
first reason is that A and H in our production function represent the (average) quality of
technology and workers, not the sum of all technology or knowledge in the society. But more
146
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 4 The real economyCopyright
in the long
run
07_Stonecash_8e_45658_SB_txt.indd 146
24/08/20 6:12 PM
fundamentally, it is because these two non-tangible inputs generate a positive externality.
We will discuss the meaning of this concept in our section on education, but in a nutshell:
A smart person comes up with more efficient ways of doing things, and the benefit from
this accrues not only to that person, but also to many other people who can enjoy the
person’s ideas and technological innovations. Ideas and technologies are (at least partly)
public goods. This is in contrast to a machine (K) or a piece or iron ore (N) that is used in a
certain factory and cannot be utilised by many people at the same time. And this positive
externality is what makes H and A special.
CHECK YOUR UNDERSTANDING
What are the key determinants of labour productivity? Which one do you think is most
important? Explain your reasoning.
LO7.3 Economic growth and public policy
So far, we have determined that a society’s standard of living, at least on the material level,
depends on its ability to produce goods and services, and that its productivity depends
on physical capital, human capital, natural resources and technological knowledge (and
possibly other factors that will be discussed below). Let’s now turn to the question faced by
policymakers around the world: What can government policy do to raise productivity and
living standards?
The importance of saving and investment
Because both physical and human capital are produced factors of production, a society can
change the amount of capital it has. If today the economy produces a large quantity of new
capital goods or invests in people’s education, then tomorrow it will have a larger stock of
capital and be able to produce more of all types of goods and services, or enjoy more leisure
time. Thus, one way to raise future productivity is to invest more current resources in the
production of physical and human capital.
One of the Ten Principles of Economics presented in chapter 1 is that people face tradeoffs. This principle is especially important when considering the accumulation of capital.
Because resources are scarce, devoting more resources to producing capital requires
devoting fewer resources to producing goods and services for current consumption. That is,
for society to invest more in physical or human capital, it must consume less and save more
of its current income. If Robinson Crusoe wants to increase his production of vegetables,
he must spend more time planting them, or come up with more efficient ways of looking
after them, or become smarter about harvesting them. The growth that arises from capital
accumulation is not a free lunch – it requires that society sacrifice consumption of goods
and services in the present in order to enjoy higher consumption in the future.
This implies that encouraging saving and investment is one way that a government can
foster economic growth and, in the long run, raise people’s standard of living.
To see the importance of investment for economic growth, consider Figure 7.2, which
displays data for 17 countries. Panel (a) shows each country’s economic growth rate (on
average) over a 65-year period.
147
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN Chapter
02-200-202
7 Production and growth
07_Stonecash_8e_45658_SB_txt.indd 147
24/08/20 6:12 PM
FIGURE 7.2 The relationship between investment and economic growth
(a)
(b)
Botswana
South Korea
Japan
China
Malaysia
Indonesia
Brazil
India
Pakistan
Australia
Canada
United States
New Zealand
Bangladesh
Russia
Venezuela
Niger
–2
–1
Botswana
South Korea
Japan
China
Malaysia
Indonesia
Brazil
India
Pakistan
Australia
Canada
United States
New Zealand
Bangladesh
Russia
Venezuela
Niger
0
1
2
3
4
5
6
7
8
0%
5%
10%
15%
20%
25%
30%
35%
(a) Average GDP growth rate (%), 1950–2017
(b) Average investment (% of GDP), 1950–2017
Panel (a) shows the average annual growth rate of GDP for 17 countries over the period 1950–2017. Panel (b) shows the
percentage of GDP that each country devoted to investment on average over this period. High GDP growth countries
generally have high rates of investment, although they are some exceptions.
Source: The Penn World Table (Mark 9.1), Feenstra, R.C., R. Inklaar & M.P. Timmer (2015), ‘The Next Generation of the Penn World Table’, American Economic Review,
105(10), 3150–3182, available for download at http://www.ggdc.net/pwt (CC BY 4.0)
The countries are ordered by their growth rates, from most to least rapid. Panel (b) shows
the percentage of GDP that each country devotes to investment. The correlation between
growth and investment, although not perfect, is strong (in this case 0.44). Countries
that devote a large share of GDP to investment, like Korea and China, tend to have high
growth rates. Countries that devote a small share of GDP to investment, like Pakistan and
Bangladesh, tend to have low growth rates. Studies that examine a more comprehensive
list of countries confirm this strong correlation between investment and economic growth.
There is, however, a problem in interpreting these data. As the appendix to chapter 2
discussed, a correlation between two variables does not establish which variable is the cause
and which is the effect. It is possible that high investment causes high economic growth,
but it is also possible that high GDP growth causes high investment. (Or, perhaps, high GDP
growth and high investment are both caused by a third variable that has been omitted from
the analysis.) The data by themselves cannot tell us the direction of causality. Nonetheless,
both economic theory and careful econometric analysis reveals that high investment tends
to lead to more rapid economic growth, at least temporarily.
Diminishing returns to physical capital and the catch-up effect
148
Suppose that a government, convinced by the evidence in Figure 7.2, pursues policies
that raise the nation’s saving rate – the percentage of GDP devoted to saving rather than
consumption. What happens? With the nation saving more, fewer resources are needed
to make consumption goods, and more resources are available to make capital goods. As
a result, the stock of physical capital increases (assume for the time being that there is no
change in H or A). The increase in K leads to rising productivity and more rapid growth in
future GDP (note that GDP temporarily falls due to shifting from consumption to saving,
which is why some short-sighted governments tend not to encourage people to save). But
how long does a higher GDP rate of growth, driven by increases in K, last? Assuming that
the saving rate remains at its new higher level, do both the level of GDP and the growth rate
of GDP stay high indefinitely or only for a limited period of time?
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 4 The real economyCopyright
in the long
run
07_Stonecash_8e_45658_SB_txt.indd 148
24/08/20 6:12 PM
Economic analysis shows that physical capital is subject to diminishing returns – as the
stock of physical capital per worker rises, the extra output produced from an additional unit
of capital falls. In other words, when each worker already has a large quantity of physical
capital to use in producing goods and services, giving them an additional unit (another
machine) increases their production only slightly. The contribution of this additional
machine to output may still be positive, but it is less than the contribution of the previous
machines.
In our Robinson Crusoe example, the first fishing rod he made increased his productivity
substantially – much more than the second rod. The important implication is that because
of diminishing returns to physical capital, a sustained increase in the saving rate leads to
a permanently higher level of GDP, but only to a temporary increase in the growth rate of
GDP. Why is that? The higher saving rate allows more physical capital per worker to be
accumulated, but the benefits from additional capital become smaller as each worker has
to operate an increasing number of machines. Therefore, the growth rate of GDP slows
down. In summary, in the long run a higher saving rate and the resulting greater physical capital
investment lead to a higher level of productivity and income, but not to higher growth in these
variables. Reaching this long run, however, can take quite a while. According to studies of
international data on economic growth, increasing the saving rate can lead to substantially
higher economic growth for a period of several decades.
You should now be able to answer the following question: What is the difference between
the two concepts we discussed, namely returns to scale and returns to an input like physical
capital? Recall that when considering returns to scale we increase all the tangible inputs
L, K and N in the same proportion. In contrast, when considering returns to an input we
only increase the one input (for example, K), but leave all the other inputs unchanged. In
the latter case Robinson Crusoe’s economy would have a second fishing rod, whereas in the
former there would also be another person to operate the rod (you may recall Friday who
appeared on the island one day and became Crusoe’s friend).
Once you understand this difference, it is straightforward to see why we usually
see diminishing returns to physical capital (or other tangible inputs, labour and natural
resources), but at the same time the economy has constant returns to scale. In the first
case we keep adding only one input which creates an imbalance between the inputs. In the
second case we add all of the tangible inputs proportionately so this imbalance does not
occur, and nor does a fall in productivity.
The diminishing returns to physical capital feature have another important implication –
other things being equal, it is easier for a country to grow fast if it starts out relatively poor.
This effect of initial conditions on subsequent growth is sometimes called the catch-up (or
convergence) effect. In poor countries, workers lack even the most rudimentary tools and,
as a result, have low productivity. Small amounts of capital investment would substantially
raise these workers’ productivity. In contrast, workers in high-income countries already
have large amounts of physical capital with which to work, and this partly explains their
high productivity. But in this case additional capital investment has a relatively small effect
on productivity. Studies of international data on economic growth confirm this catch-up
effect. Controlling for other variables, like the percentage of GDP devoted to investment,
human capital or political stability, less-industrial countries do grow faster than moreindustrial countries.
This catch-up effect can help us understand some of the puzzling results in Figure 7.2.
Over this 67-year period, Australia and Japan devoted a similar share of GDP to investment.
Yet Australia experienced only moderate growth of below 2 per cent, whereas Japan
experienced high growth of 4.6 per cent. The explanation is the convergence predicted by
diminishing returns to physical capital. In 1950, Japan had GDP per person around one-fifth
the Australian level, in part because previous investment had been so low. With a small
diminishing returns
the property whereby
the benefit from
each extra unit of
an input declines as
the quantity of the
input increases
catch-up (or
convergence) effect
low-income countries
tend to grow more
rapidly than highincome countries
149
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN Chapter
02-200-202
7 Production and growth
07_Stonecash_8e_45658_SB_txt.indd 149
24/08/20 6:12 PM
initial capital stock, the benefits to capital accumulation were much greater in Japan, and
this gave Japan a higher subsequent growth rate. In the 1960s annual economic growth
in Japan was around 10 per cent, and this rate fell every decade until the 1990s, whereby
growth virtually disappeared. It is almost certain that the high rate of economic growth
in China, which is to a large extent driven by extensive industrialisation, will keep falling
over time for exactly the same reason as Japan’s did – due to diminishing returns to physical
capital. But in the meantime, China’s GDP per capita will be converging to levels observed in
high-income countries.
This catch-up effect shows up in other aspects of life. When a school gives an endof-year award to the ‘most improved’ student, that student is usually one who began the
year with relatively poor performance. Students who began the year not studying find
improvement easier than students who always worked hard. Note that it is good to be
‘most improved’, given the starting point, but it is arguably even better to be ‘best student’.
Similarly, economic growth over the last few decades has been much more rapid in China
than in Australia, but GDP per person is still much higher in Australia.
Investment from abroad
So far, we have discussed how policies aimed at increasing a country’s saving rate can
increase investment and, thereby, long-term economic growth. Yet saving by domestic
residents is not the only way for a country to invest in new capital. The other way is
investment by foreigners.
Investment from abroad takes several forms. An Australian university might build a
campus in Thailand. A capital investment that is owned and operated by a foreign entity
is called foreign direct investment. Alternatively, an Australian might buy shares in a Thai
corporation (that is, buy a share of the ownership of the corporation); the Thai corporation
can use the proceeds from the sale of shares to build a new factory. An investment that is
financed with foreign money but operated by domestic residents is called foreign portfolio
investment. In both cases, Australians provide the resources necessary to increase the stock
of capital in Thailand. That is, Australian saving is being used to finance Thai investment.
When foreigners invest in a country, they do so because they expect to earn a return
on their investment. If an Australian university were to open a Thai campus, that would
increase the Thai stock of capital and, therefore, increase Thai productivity and GDP. Yet,
in this case, the university takes some of this additional income back to Australia in the
form of profit. Similarly, when an Australian investor buys shares in a Thai corporation, the
investor has a right to a portion of the profit that the corporation earns.
Investment from abroad, therefore, affects GDP and GNP differently. Recall that gross
domestic product is the income earned within a country by both residents and non-residents,
whereas gross national product is the income earned by residents of a country both at home
and abroad. If the University of Melbourne opens a campus in Thailand, some of the income
the university generates accrues to people who do not live in Thailand. As a result, this
investment raises Thailand’s GDP more than Thailand’s GNP, and it raises Australia’s GNP
more than Australia’s GDP.
Investment from abroad is one way for a country to increase its stock of capital and grow.
Even though some of the benefits from this investment flow back to the foreign owners,
this investment does increase the economy’s stock of capital, leading to higher productivity
and higher wages. Moreover, investment from abroad is one way for emerging countries
to learn the state-of-the-art technologies and processes used in richer countries. For these
reasons, many economists who advise governments in low-income economies advocate
150
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 4 The real economyCopyright
in the long
run
07_Stonecash_8e_45658_SB_txt.indd 150
24/08/20 6:12 PM
policies that encourage investment from abroad. Often, this means removing restrictions
that governments have imposed on foreign ownership of domestic capital.
An institution that tries to encourage the flow of investment to low-income countries is
the World Bank. This international organisation obtains funds from the world’s advanced
countries, like Australia, and uses these resources to make loans to low-income countries so
that they can invest in roads, sewer systems, schools and other types of capital. It also offers
the countries advice about how the funds might best be used. The World Bank, together
with its sister organisation, the International Monetary Fund, was set up after the Second
World War. One lesson from the war was that economic distress often leads to political
turmoil, international tensions and military conflict. Thus, every country has an interest
in promoting economic prosperity around the world. The World Bank and the International
Monetary Fund aim to achieve that common goal.
Education
Our earlier discussion implies that education – investment in human capital – is no less
important for a country’s long-run economic success than investment in physical capital. In
Australia, each year of schooling raises a person’s wage on average by about 8 per cent, and
some studies indicate as much as 15 per cent at the tertiary level. In low-income countries,
where human capital is especially scarce, the gap between the wages of educated and
uneducated workers is even larger. Thus, one way in which government policy can enhance
the standard of living is to provide good schools and to encourage the population to take
advantage of them.
Investment in human capital, like investment in physical capital, has an opportunity
cost. When students are in school or university, they forgo the wages they could have earned.
In less prosperous countries, children often drop out of school at an early age, even though
the benefit of additional schooling is very high, simply because their labour is needed to
help support the family.
We mentioned that human capital is particularly important for economic growth because
it conveys positive externalities. An externality is the effect of one person’s actions on the
wellbeing of a bystander. An educated person, for instance, might generate new ideas about
how best to produce goods and services. If these ideas enter society’s pool of knowledge
so everyone can use them, then the ideas are an external benefit of education. This ‘public
good’ property of human capital and technology seems to be the reason why these two nontangible production inputs H and A do not have diminishing returns – unlike the tangible
inputs L, K and N. One of the implications of this positive externality is that the return to
schooling is even greater for society than for the individual, which may justify the large
subsidies for human-capital investment that we observe in the form of public education. On
the other hand, it is conceivable that these subsidies partly distort the education market at
the tertiary level, and lead some people to make the wrong decision about whether to study,
and what to study (you may recall a funny line from the movie Gothika: ‘All that education,
but you can’t remember an umbrella?’).
CHECK YOUR UNDERSTANDING
If university education was fully paid for by the Australian government, what could this do
to the level of human capital in Australia? Discuss the pros and cons.
151
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN Chapter
02-200-202
7 Production and growth
07_Stonecash_8e_45658_SB_txt.indd 151
24/08/20 6:12 PM
One problem facing some countries is the brain drain – the emigration of many of
the highly educated workers to richer countries, where these workers can enjoy a higher
standard of living. This is particularly a problem for low-income countries. If human capital
does have positive externalities, then this brain drain makes those people left behind poorer
than they otherwise would be. This problem poses a dilemma for policymakers. On the one
hand, Australia, the United States and other high-income countries have better systems
of higher education, and it would seem natural for low-income countries to send their best
students abroad to earn higher degrees. On the other hand, those students who have spent
time abroad may choose not to return home and this brain drain would reduce the lowincome nation’s stock of human capital even further.
CHECK YOUR UNDERSTANDING
How can a country deal with brain drain? In order for governments of low-income
countries to reduce this problem, some require the recipients of their scholarships in
foreign countries to commit to returning home and working for the government for a
certain number of years. What is your view of this arrangement?
Let us now discuss several additional factors that may be important for prosperity but
have not been included in our production function.
Health and nutrition
The term human capital usually refers to intellectual skills, but the broader concept also
includes a person’s ability to look after their health. There is no doubt that, other things
being equal, healthier workers are more productive. The implication for governments is
that the right investments in the health of the population provide one way for a nation to
increase productivity and raise living standards.
Economic historian Robert Fogel, the recipient of the 1993 Nobel Prize in Economics, has
suggested that a significant factor in long-run economic growth is improved health from
better nutrition. He estimated that in Great Britain in 1780, about one in five people were
so malnourished that they were incapable of manual labour. Among those who could work,
insufficient caloric intake substantially reduced the work effort they could put forth. As
nutrition improved, so did workers’ productivity.
Fogel studies these historical trends in part by looking at the height of the population.
Short stature can be an indicator of malnutrition, especially during gestation and the
early years of life. Fogel finds that as nations develop economically, people eat more and
the population gets taller. From 1775 to 1975, the average caloric intake in Great Britain
rose by 26 per cent and the height of the average man rose by 9.1 cm. Similarly, during
the spectacular economic growth in South Korea from 1962 to 1995, caloric consumption
rose by 44 per cent and average male height rose by 5.1 cm. Of course, a person’s height
is determined by a combination of genetics and environment. But because the genetic
make-up of a population is slow to change, such rapid increases in average height are most
likely due to changes in the environment – nutrition being the obvious explanation. Fogel
concluded that ‘improved gross nutrition accounts for roughly 30 per cent of the growth of
per capita income in Britain between 1790 and 1980’.
Moreover, studies have found that height is an indicator of productivity. Looking at data
on a large number of workers at a point in time, researchers have found that taller workers
tend to earn more. Because wages reflect a worker’s productivity, this finding suggests
that taller workers tend to be more productive. The effect of height on wages is especially
pronounced in poorer countries, where malnutrition is a bigger risk.
152
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 4 The real economyCopyright
in the long
run
07_Stonecash_8e_45658_SB_txt.indd 152
24/08/20 6:12 PM
Today, malnutrition is fortunately rare in high-income nations like Australia, the UK and
the United States. (Obesity is a more widespread problem.) But for people in low-income
nations, poor health and inadequate nutrition remain obstacles to higher productivity
and improved living standards. The United Nations estimates that almost a third of the
population in sub-Saharan Africa is undernourished, although the situation has been
improving as you will find out below.
The causal link between health and wealth runs in both directions. Poor countries are
poor in part because their populations are not healthy, and their populations are not healthy
in part because they are poor and cannot afford adequate health care and nutrition. It is
a vicious circle. But this fact opens the possibility of a virtuous circle: Policies that lead
to more rapid economic growth tend to improve health outcomes, which in turn further
promote economic growth.
And we can indeed see this virtuous circle in the data. Swedish Professor Hans Rosling
has convincingly argued that the standard distinction between ‘developed’ and ‘developing’
countries is no longer appropriate. To show this he created an online application called the
Gapminder (http://www.gapminder.org), which allows anyone to find out more about
economic, social and health trends, and the relationships between many variables. In his
accompanying videos Rosling demonstrates that on many dimensions, for example, child
mortality or the number of children per family in urban areas, low-income countries have
made substantial progress. They are now much more similar to high-income countries than
several decades ago, with this catch-up likely to continue in the future. Rosling therefore
makes a plea for us all to move beyond our prejudices and see the fast transforming world
rather than its outdated caricature.
CHECK YOUR UNDERSTANDING
What are some of the key factors that link health and nutrition to human capital?
Property rights, markets, trust and political stability
Another way in which policymakers can foster economic growth is by protecting property
rights and promoting political stability. As we first noted when we discussed economic
interdependence in chapter 2, production in market economies arises from the interactions of
millions of individuals and firms. When you buy a car, for instance, you are buying the output
of a car dealer, a car manufacturer, a steel company, an iron ore mining company and so on.
This division of production among many firms allows the economy’s factors of production to
be used as effectively as possible. To achieve this outcome, the economy has to coordinate
transactions among these firms, as well as between firms and consumers. Market economies
achieve this coordination through market prices. That is, market prices are the instrument
with which the ‘invisible hand of the marketplace’ brings supply and demand into balance.
(In his 1776 landmark book The Wealth of Nations, economist Adam Smith referred to the
seemingly undirected operation of the marketplace as being guided by an ‘invisible hand’.)
A key prerequisite for the price system to work is an economy-wide respect for property
rights. In fact, Austrian economist Friedrich August Hayek, the 1974 recipient of the
Nobel Prize in Economics, argued that they are ‘the most important guarantee of freedom’.
Property rights refer to the ability of people to exercise authority over the resources they
own. A mining company will not make the effort to mine iron ore if it expects the ore to be
stolen. The company mines the ore only if it is confident that it will benefit from the ore’s
subsequent sale. For this reason, courts serve an important role in a market economy – they
enforce property rights. Through the criminal justice system, the courts discourage theft
and corruption. In addition, through the civil justice system, the courts ensure that buyers
153
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN Chapter
02-200-202
7 Production and growth
07_Stonecash_8e_45658_SB_txt.indd 153
24/08/20 6:12 PM
and sellers live up to their contracts, and that no one can be forced into a contract they do
not wish to make.
Most people do not realise just how costly in terms of productivity various breaches of
property rights and similar rules are. Think about the criminal system. The number of police,
lawyers and judges involved in dealing with people who break the law is very large, and
growing. If individuals refrained from criminal behaviour (ideally for moral reasons rather
than for fear of imprisonment) many of these law enforcement workers could devote their
capacity to another profession. John Maynard Keynes once controversially argued that in a
recession, ‘The government should pay people to dig holes in the ground and then fill them
up’. Crime (including traffic infringements like speeding or drink-diving) is in some sense
similar to digging unnecessary holes, and the law enforcement sector is similar to filling
them up. As valuable as the job of police officers and judges currently is, in the absence
of crime many people in these occupations could switch to some other productive activity,
which would greatly enhance the country’s prosperity.
Although people in high-income countries tend to take property rights and other legal
checks and balances for granted, those living in less prosperous countries see firsthand
how a lack of property rights and weak law enforcement can be a major problem. In many
countries, the system of justice does not work well. Contracts are hard to enforce and fraud
often goes unpunished. In more extreme cases, the government not only fails to enforce
property rights but actually infringes upon them. To do business in some countries, firms are
expected to bribe powerful government officials. Such corruption impedes the coordinating
power of markets. It also discourages domestic saving and investment from abroad (to
find out more, see the Corruption Perceptions Index annually calculated by Transparency
International at http://www.transparency.org/research/cpi/overview).
One threat to property rights is political instability. When revolutions and coups are
common, there is doubt about whether property rights will be respected in the future. If a
revolutionary government might confiscate the capital of some businesses, as was often
true after communist revolutions, domestic residents have less incentive to save, invest
and start new businesses. At the same time, foreigners have less incentive to invest in the
country. Even the mere threat of such a scenario can depress a nation’s standard of living.
Thus, economic prosperity depends in part on political stability. A country with an
efficient court system, honest government officials, well-functioning markets and a stable
political system will enjoy a higher economic standard of living than a country with a
poor legal system, corrupt officials, central planning and frequent revolutions. You may
be interested to see the Index of Economic Freedom (available at http://www.heritage.
org/index/ranking), which shows a strong relationship between economic freedom and
prosperity. Hong Kong, Singapore, New Zealand, Switzerland and Australia were the topranked countries in 2016, whereas North Korea, Cuba, Zimbabwe and Venezuela were at the
bottom of the list, based on economic freedom.
An often-overlooked contributor to prosperity is the degree of social trust within a
nation. Data show that the proportion of people who believe that their fellow citizens can
be trusted is positively associated with economic growth. And it is encouraging to note
that social trust in Australia has been on the rise. In the 2014 wave of the World Values
Survey (http://www.worldvaluessurvey.org), 51.4 per cent believed that ‘Most people can
be trusted’. This is close to the New Zealand’s figure of 55.3 per cent, and much higher than
the 34.8 per cent of Americans, 27.8 per cent of Russians and 7.1 per cent of Brazilians.
Free trade
Some of the world’s poorest countries have tried to achieve more rapid economic growth by
pursuing inward-oriented policies. These policies are aimed at raising productivity and living
standards within the country by avoiding interaction with the rest of the world. Domestic
154
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 4 The real economyCopyright
in the long
run
07_Stonecash_8e_45658_SB_txt.indd 154
24/08/20 6:12 PM
firms sometimes claim they need protection from foreign competition in order to grow. This
‘infant industry’ argument, together with a general distrust of foreigners, has at times led
policymakers to impose tariffs and other trade restrictions (we will examine the effect of
these in our chapter on open economies).
Most economists today believe that emerging countries are better off pursuing outwardoriented policies that integrate these countries into the world economy. Chapter 3 showed
how international trade can improve the economic wellbeing of a country’s citizens. Trade
is, in some ways, a type of technology. When a country exports wheat and imports steel, the
country benefits in the same way as if it had invented a technology for turning wheat into
steel. A country that eliminates trade restrictions will, therefore, experience the same kind
of economic growth that would occur after a major technological advance.
The adverse impact of inward orientation becomes clear when one considers the small
size of many less-prosperous economies. The GDP of Finland or Denmark, for instance, is
about that of Sydney. Imagine what would happen if Sydney residents were prohibited from
trading with people living outside the city. Without being able to take advantage of the
gains from trade, Sydney would need to produce all the goods it consumes. It would also have
to produce all its own capital goods, rather than importing state-of-the-art equipment from
other cities. Living standards in Sydney would fall immediately and the problem would be
likely to get worse over time. This is precisely what happens when countries pursue inwardoriented policies, like Argentina did throughout much of the twentieth century, North Korea
did over the past several decades, and the United States may do if President Trump delivers
on his pre-election promises. In contrast, countries pursuing outward-oriented policies, like
South Korea, Singapore and Taiwan, have enjoyed high rates of economic growth.
The amount that a nation trades with others is determined not only by government
policy but also by geography. Countries with good natural seaports find trade easier than
countries without this resource. It is not a coincidence that many of the world’s major
cities, like New York, Shanghai, Tokyo and Hong Kong, are located next to oceans. Similarly,
because landlocked countries find international trade more difficult, they tend to have lower
levels of income than countries with easy access to the world’s waterways.
The United Nation’s development goals
In September 2000, world leaders came together at the United Nations
Headquarters in New York to adopt the United Nations Millennium Declaration.
It committed their nations to specific targets on eight key issues that perpetuate
poverty, with a deadline of 2015. These have become known as the Millennium
Development Goals. In September 2015, nations agreed on a new agenda for
the next 15 years, consisting of 17 Sustainable Development Goals.
Below we provide a summary of the original Development Goals and
outcomes. (See https://www.brookings.edu/blog/future-development/2017/01/11/
how-successful-were-the-millennium-development-goals/ for an assessment of
progress.) While some of the goals have not been fully achieved, progress has
been made in alleviating poverty and improving outcomes of the less fortunate.
The UN also set out Sustainable Development Goals for the period from
2016–2030. These can be seen in the graphic below.
IN THE
NEWS
Millennium Development Goal No 1: Eradicate extreme
poverty and hunger
Poverty has decreased substantially all around the world. The number of people
living below the poverty line (on less than US$1.25 a day, adjusted for the
changes in price levels) was 836 million in 2015, a decline from 1.9 billion in 1990.
155
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN Chapter
02-200-202
7 Production and growth
07_Stonecash_8e_45658_SB_txt.indd 155
24/08/20 6:12 PM
Millennium Development Goal No 2: Achieve universal primary education
Primary school enrolment rate increased from 83 per cent in 2000 to 91 per
cent in 2015. While this shows substantial improvement, the original goal
of achieving universal primary education has not been achieved (yet). Some
geographic areas progressed more than others. For example, primary school
net enrolment rate in sub-Saharan Africa increased from 52 per cent to 80 per
cent between 1990 and 2015.
Millennium Development Goal No 3: Promote gender
equality and empower women
The majority of low-income countries, about two-thirds of them, have seen the
number of girls enrolled in primary education catch up with boy’s enrolment.
For example, in Southern Asia, the number of girls in primary school per 100
boys increased from 74 in 1990 to 103 in 2015.
Millennium Development Goal No 4: Reduce child mortality
The proportion of children who die before they turn 5 has more than halved,
falling from 90 to 43 deaths per 1000 live births between 1990 and 2015.
Millennium Development Goal No 5: Improve maternal health
The global proportion of mothers who die during pregnancy or birth has decreased
by nearly half – falling from 380 per 100 000 births in 1990 to 210 in 2013.
Millennium Development Goal No 6: Combat HIV/AIDS,
malaria and other diseases
The number of new HIV infections declined by approximately 40 per cent
between 2000 and 2013. Nevertheless, the target of reversing the spread of
HIV/ AIDS by 2015 has not been achieved.
FIGURE 7.3 Various measures of improvements in people’s lives.
Millions of lives improved
compared to 1990–2000* trend
500
471
400
300
200
111
100
19
0
–100
(99)
–200
–300
(169)
Water
Primary
school
completion
Extreme
income
poverty
Sanitation Undernourishment
Sub-Saharan Africa
China
India
Rest of developing world
Note: For primary school completion, data do not allow for regional breakdown outside of
Africa. * Years adjusted to account for data availability where needed.
Source: Global Economy and Development program, The Brookings Institution. John W. McArthur, Krista Rasmussen,
Change of Pace: Accelerations and advances during the millennium development goal era, Figure E2, p. v., Authors’
calculations based on World Bank (2016b, c), U.N.-DESA (2015).
156
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 4 The real economyCopyright
in the long
run
07_Stonecash_8e_45658_SB_txt.indd 156
24/08/20 6:12 PM
Millennium Development Goal No 7: Ensure environmental sustainability
Between 1990 and 2015, more than 2.5 billion people have gained access to
improved drinking water. Despite such progress, more than 600 million people
globally still do not have access to drinking water of satisfactory quality.
Millennium Development Goal No 8: Develop a global
partnership for development
Assistance of high-income to low-income countries rose by 66 per cent (in real
terms) during the 2000–2014 period. Most high-income countries are, however,
still below the agreed global target of 0.7 per cent of Gross National Income (GNI).
Unfortunately, Australia and New Zealand are both in this category, with each
spending 0.27 per cent of GNI on official development assistance. This contrasts
with 0.71 per cent in the UK, 1.05 per cent in Norway and 1.4 per cent in Sweden.
FIGURE 7.4 The United Nation’s 17 Sustainable Development Goals for the 2016–30 period
Source: © UNITED NATIONS 2020. The content of this publication has not been approved by the
United Nations and does not reflect the views of the United Nations or its officials
or Member States. https://www.un.org/sustainabledevelopment/
CHECK YOUR UNDERSTANDING
Describe the global trends in poverty over the past several decades. Find out more
about the Sustainable Development Goals for the 2016–2030 period and discuss which
of them you believe are likely to be achieved. Think about some specific ideas for how
environmental sustainability can be enhanced globally.
157
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN Chapter
02-200-202
7 Production and growth
07_Stonecash_8e_45658_SB_txt.indd 157
24/08/20 6:12 PM
Discouraging excessive population growth
A country’s productivity and living standards are determined in part by its population
growth. Obviously, population is a key determinant of a country’s labour force. It is no
surprise, therefore, that countries with large populations (like the United States and
China) tend to produce a greater GDP than countries with small populations (like Australia
and New Zealand). But as you already know, total GDP is not a good measure of economic
wellbeing. For policymakers concerned about living standards, GDP per person is more
important, since it tells us the quantity of goods and services available for a typical
individual in the economy.
How does growth in the number of people affect the amount of GDP per person? Early
nineteenth-century economist Thomas Malthus believed that population growth is
undesirable and likely to lead to famine and poverty – an idea known as the Malthusian
trap. While this idea is generally incorrect, data suggest that excessive population growth
may be associated with some problems.
The most important of them is insufficient education and lack of human capital.
Countries with very high population growth have large numbers of school-age children,
which places a major burden on the educational system. It is not surprising, therefore, that
educational attainment tends to be low in such countries.
The differences in population growth around the world are still large, despite getting
smaller. In high-income countries, like Australia, the United States and countries in western
Europe, the population has risen about 1 per cent per year in recent decades, and it is
expected to rise more slowly (or even shrink) in the future. In contrast, in many African
countries, population growth has been about 3 per cent per year. You can calculate, using
the rule of 70, that at this rate the population doubles every 23 years.
Reducing the rate of population growth is widely thought to be one way that low-income
countries can raise their standards of living. In some countries, this goal is accomplished
directly with laws regulating the number of children families may have. China, for instance,
used to allow only one child per family under most circumstances; couples who violated this
rule were subject to substantial fines. In countries with greater freedom, the goal of reduced
population growth is accomplished less directly by increasing awareness of birth control
techniques.
The final way in which a country can influence population growth is to apply one of the
Ten Principles of Economics – people respond to incentives. Bearing a child, like any decision,
has an opportunity cost. When the opportunity cost rises, people will choose to have smaller
families. In particular, women with the opportunity to receive good education and desirable
employment tend to want fewer children than those with unappealing opportunities outside
the home. Hence, policies that foster equal treatment of women are one way to reduce the
rate of population growth.
And encouraging results can already be seen in the data. Population growth
has decreased in virtually all low- and middle-income countries hand in hand with
improvements in incomes. Let us provide some numbers. Total world fertility has halved
over the past six decades – the average number of children per woman decreased from
about 5 in 1950 to less than 2.5 in 2016, and continues to decrease. For example, in Turkey
the total fertility rate decreased from 7 to just over 2, which is comparable to the current
rate in the United States and New Zealand, and only slightly higher than Australia’s figure
of 1.8. Similarly, Bangladesh’s fertility rate was between 6 and 7 during 1950–80, and since
then has decreased to around 2.3. Even in Yemen, a country which had a fertility rate of
9 as recently as 1980, the average number of children per woman decreased to 3.7, and
keeps falling.
Let us note that it is not just excessively high fertility rates that can cause problems; it
is also excessively low fertility rates. If the number of children per woman falls below the
158
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 4 The real economyCopyright
in the long
run
07_Stonecash_8e_45658_SB_txt.indd 158
24/08/20 6:12 PM
‘replacement rate’ of 2.1, the population starts shrinking (in the absence of immigration).
And most high-income countries are in this category. In fact, many countries have fertility
rates in a dangerous territory of below 1.5: for example, Japan, South Korea, Russia, Germany,
Italy and the Czech Republic. Not to mention Singapore and Macau, whose fertility rates are
the lowest in the world – below 1.
One of the resulting problems of insufficient population growth is ensuring sustainability
of public finances. In most high-income countries, pensions and health care systems are
designed on the pay-as-you-go basis, whereby government expenditure each year is paid for
by the tax revenue from that year. Very low fertility leads to an ageing population with an
increasing number of retirees per worker. This results in an increase in pension and health
care expenditures but a fall in tax revenue, and therefore a growing budget deficit and debt.
You will find out more about this problem in the next chapter.
The link between population growth and technological progress
Some economists have argued that rapid population growth may depress economic
prosperity by reducing the amount of capital each worker has. This view believes that
there are diminishing returns to labour, for the same reason as there are diminishing
returns to physical capital. On the other hand, other economists have suggested that
world population growth has been an engine of technological progress and economic
prosperity, essentially arguing that there are increasing returns to scale and/or positive
externalities from human capital accumulation. The mechanism is simple: If there are
more people, then there are more scientists, inventors and engineers to contribute to
technological advances, which benefits everyone.
Economist Michael Kremer has provided some support for this hypothesis in an
article titled ‘Population Growth and Technological Change: One Million B.C. to 1990’,
which was published in the Quarterly Journal of Economics in 1993. Kremer begins
by noting that over the broad span of human history, world GDP growth rates have
increased with world population. For example, world economic growth was more rapid
when the world population was one billion (which occurred around the year 1800) than
when the population was only 100 million (around 500 BC). This fact is consistent with
the hypothesis that a larger population induces more technological progress.
Kremer’s second piece of evidence comes from comparing regions of the world.
The melting of the polar icecaps at the end of the Ice Age around 10 000 BC flooded
the land bridges and separated the world into several distinct regions that could not
communicate with one another for thousands of years. If technological progress is
more rapid when there are more people to discover things, then larger regions should
have experienced more rapid growth.
According to Kremer, that is exactly what happened. The most successful region
of the world in 1500 (when Columbus re-established technological contact) comprised
the ‘Old World’ civilisations of the large Eurasia–Africa region. Next in technological
development were the Aztec and Mayan civilizations in the Americas, followed by the
hunter-gatherers of Australia, and then the people of Tasmania, who lacked even firemaking and most stone and bone tools.
The smallest isolated region was Flinders Island, a tiny island between Tasmania
and Australia. With a very small population, Flinders Island had few opportunities for
technological advancement and, indeed, seemed to regress. Around 3000 BC, human
society on Flinders Island died out completely. A large population, Kremer concludes, is
a prerequisite for technological advancement.
CASE
STUDY
Questions
1 What do you think are the pros and cons to the economy of having a larger
population?
2 Do you believe Michael Kremer’s prerequisite for having a larger population
is valid?
159
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN Chapter
02-200-202
7 Production and growth
07_Stonecash_8e_45658_SB_txt.indd 159
24/08/20 6:12 PM
CHECK YOUR UNDERSTANDING
What is your view of immigration? How does immigration affect the economy? If you were
the prime minister in your home country, how would you design the immigration system?
Research and development
An important reason that living standards are higher today than they were a century ago
is that technological knowledge has advanced. The mobile phone, the silicon chip and
the solar panel are among the thousands of innovations that have improved our ability to
produce goods and services at a lower cost.
Although most technological advances come from private research by firms and
individual inventors, there is also a public interest in promoting these efforts. We mentioned
that to a large extent, knowledge is a public good – once a person discovers an idea, the idea
enters society’s pool of knowledge, and other people can use it freely. Therefore, just as the
government has a role in providing public goods like national defence, it may also help to
encourage research and development of new technologies.
The Australian government has long played a major role in the creation and
dissemination of technological knowledge. The government funds research in institutions
like the CSIRO (the Commonwealth Scientific and Industrial Research Organisation). It
also provides funding for research in universities across the country through research
grants from the Australian Research Council and the National Health and Medical
Research Council, and tax breaks for firms engaging in research and development.
Yet another way in which government policy has attempted to encourage research is
through the patent system. When a person or firm invents a new product, like a new drug,
the inventor can apply for a patent. The idea is that if the product is deemed truly original,
the government awards the patent, which gives the inventor the exclusive right to make the
product for a specified number of years. In essence, the patent gives the inventor a property
right over the invention, turning the new idea from a public good into a private good. It is
argued that by allowing inventors to profit from their inventions – even if only temporarily –
the patent system enhances the incentive for individuals and firms to engage in research.
This traditional view of the patent system has, however, been forcefully challenged by
recent research. Most notably, Professors Michele Boldrin and David Levine argue that:
‘intellectual property is a government grant of a costly and dangerous private monopoly
over ideas’. In their 2008 book titled Against Intellectual Monopoly they show convincingly
through economic theory, data and numerous historical examples that ‘intellectual
monopoly is not necessary for innovation and as a practical matter is damaging to growth,
prosperity and liberty’. To do what they preach, they make the entire book available on the
internet for free (http://www.dklevine.com/general/intellectual/againstfinal.htm).
Let us summarise their case. Boldrin and Levine argue that patents are not essential for
innovation by showing that technology-heavy industries, like the early software industry,
have flourished without patent protection. The authors then report data on many instances
where patents clearly hindered competition and innovation: for example, James Watt’s
steam engine patents in the second half of the nineteenth century.
The book documents the incredible growth in patents in recent decades (for example,
Microsoft adding more than 1000 patent applications each month!). It then offers three main
reasons for why excessive patent protection is likely to be undesirable. First, attempts to get
patent protection and enforce it are associated with a lot of expensive and unproductive
(primarily legal) actions. The recent Apple vs Samsung patent wars with more than 50 court
cases serve as a telling example. Second, the danger that a rival company patents ‘your’ idea
160
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 4 The real economyCopyright
in the long
run
07_Stonecash_8e_45658_SB_txt.indd 160
24/08/20 6:12 PM
just before you do arguably discourages innovation. As Boldrin and Levine state: ‘Insofar as
innovators have unique ideas, it may make sense to reward them with monopolies to make
sure we get advantage of their unusual talents … As it happens, simultaneous discoveries
tend to be the rule rather than the exception’. Third and most importantly, excessive patent
protection inhibits a key driver of prosperity, namely learning from others. As the authors
argue: ‘Imitation is a great thing. It is among the most powerful technologies humans have
ever developed’.
CHECK YOUR UNDERSTANDING
Why is research and development (R&D) important for long-run economic growth?
IN THE
NEWS
Using experiments to evaluate aid and ignite prosperity
To figure out what policies are effective in low-income nations, economists
are increasingly turning to randomised controlled experiments used in
medical trials.
What it takes to lift families
out of poverty
by Michaeleen Doucleff
15 May 2015
Eighteen years ago, Dean Karlan was a
fresh, bright-eyed graduate student in
economics at the Massachusetts Institute
of Technology. He wanted to answer what
seemed like a simple question:
‘Does global aid work?’ Karlan says.
He was reading a bunch of studies
on the topic. But none of them actually
answered the question. ‘We were tearing
our hair out reading these papers because
it was frustrating,’ he says. ‘[We] never really
felt like the papers were really satisfactory.’
One problem was that no one was
actually testing global aid programs —
methodically — to see if they really
changed people’s lives permanently. ‘They
haven’t been taking the scientific method
to problems of poverty,’ he says.
Take, for instance, a charity that gives
a family a cow. The charity might check on
the family a year later and say, ‘Wow! The
family is doing so much better with this
cow. Cows must be the reason.’
But maybe it wasn’t the cow that
improved the family’s life. Maybe it had
a bumper crop that year or property
values went up in the neighborhood.
Researchers really weren’t doing those
experiments, Karlan says.
So he and a bunch of his colleagues
had a radical idea: Test aid with the same
method doctors use to test drugs (that is,
randomized control trials).
The idea is quite simple. Give some
families aid but others nothing. Then
follow both groups, and see if the
aid actually made a difference in the
long run.
Karlan, who’s now a professor at
Yale University, says many people were
skeptical. ‘I have many conversations with
people who say, ‘You want to do what?
Why would you want to do that?’
One issue is that some families go
home empty-handed, with no aid. So
the idea seems unethical. But Karlan
disagrees. ‘The whole point of this is to
help more people,’ he says. ‘If we find out
what works and what doesn’t, in five years
we can have a much bigger impact.’
So Karlan and collaborators around
the world, including those at the Abdul
Latif Jameel Poverty Action Lab at MIT
and the nonprofit Innovations for
Poverty Action, decided to try out the
idea with one of the toughest problems
out there: helping families get out of
extreme poverty.
An anti-poverty program in
Bangladesh, called BRAC, looked like
it was successful. It seemed to help
nearly 400 000 families who were
living off less than $1.25 each day.
161
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN Chapter
02-200-202
7 Production and growth
07_Stonecash_8e_45658_SB_txt.indd 161
24/08/20 6:12 PM
So Karlan and his colleagues wanted to
test the program and see if it could work
in other countries.
They teamed up with a network
of researchers and nonprofits in six
developing countries. They went to
thousands of communities and found the
poorest families.
Then they divided the families into
two groups. They gave half the families
nothing. And the other half a whole
smorgasbord of aid for one to two years.
They gave them:
1. Some livestock for making money,
such as goats for milk, bees for honey,
or guinea pigs for selling. ‘Depending
on the site, there were different
things specifically appropriate for that
context,’ Karlan says.
2. Training about how to raise the
livestock
3. Food or cash so they wouldn’t eat the
livestock
4. A savings account
5. Help with their health – both physical
and mental
Karlan and his colleagues reported the
results of the massive experiment in the
journal Science this week.
So what did they find? Well, the
strategy worked pretty well in five of the
six countries they tried it in. Families who
got the aid started making a little more
money, and they had more food to eat.
‘We see mental health go up.
Happiness go up. We even saw things like
female power increase,’ Karlan says.
But here’s what sets this study apart
from the rest: Families continued to make
a bit more money even a year after the aid
stopped.
‘People were stuck. They give them
this big push, and they seem to be on
a sustained increased income level,’
says Justin Sandefur, an economist at
the Center for Global Development in
Washington, who wasn’t involved in the
study.
‘What I found exciting and unique
about this study is that the impact of
the aid was durable and sustainable,’ he
added.
The results suggest that the right kind
of aid does help people in multiple places.
It lifted the families up just a little bit
so they could finally start inching out of
extreme poverty.
But we shouldn’t get too excited yet.
These people are still very poor, says
Sarah Baird, an economist at George
Washington University.
The effect of the aid was actually quite
small, she says. Families’ incomes and
food consumption together went up by
only a small amount — about 5 percent,
on average, when compared with the
control group.
And it’s still unknown how long this
bump will last. The researchers looked
at the change only a year after the aid
stopped.
‘Moving poverty is hard,’ Baird
says. ‘The fact that they [Karlan and
colleagues] were able to move it, and it
was sustainable after a year, I think is
important.’
The findings are a leap forward, she
says, because it shows charities and
governments a basic strategy that often
works.
And even a little bit of extra money can
make a huge difference in these peoples’
lives, she says. It can help them send their
kids to school. Or even just give them a
little more hope.
Source: © 2015 National Public Radio, Inc, NPR
news report titled ‘What it takes to lift families out
of poverty’ by Michaeleen Doucleff was originally
published on npr.org on May 15 2015, and is used
with permission of NPR. Any unauthorised duplication
is strictly prohibited.
CHECK YOUR UNDERSTANDING
Refer to the previous article ‘What it takes to lift families out of poverty’. Do you think global
aid works?
162
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 4 The real economyCopyright
in the long
run
07_Stonecash_8e_45658_SB_txt.indd 162
24/08/20 6:12 PM
Conclusion: The importance of long-run growth
In this chapter we have discussed what determines the standard of living in a nation and
how policymakers can endeavour to raise it through policies that promote economic growth.
A part of this chapter is summarised in one of the Ten Principles of Economics – a country’s
standard of living depends on its ability to produce goods and services. Policymakers
who want to encourage improvements in prosperity should aim to increase their nation’s
productive ability by encouraging accumulation of physical and human capital as well as
technological knowledge, and enabling people to use natural resources as effectively and
sustainably as possible.
This chapter argued that there do not seem to be technological limits to economic growth,
but highlighted likely environmental and physical constraints relating to our energy usage.
Our simple economy of Robinson Crusoe offered further insights that refute some people’s
criticisms of economic growth. First, economic growth needs neither inflation nor debt –
Crusoe did not use money on the island, but could still increase his output. Second, it is
possible to improve wellbeing without increases in real GDP – when Crusoe became more
productive, he could enjoy the same output with more leisure. Third, economic growth does
not have to be hostile to the environment. It does not necessarily require an ever-increasing
amount of natural resources since technological progress finds ways of using resources
more effectively. Fourth, excessive focus on high output today may be costly in terms of
future growth. The latter requires investing time and resources into accumulation of capital
and technology – Crusoe taking the time to make better tools that increase his future
productivity rather than only maximising his current harvest.
Economists differ in their views on the role of government in promoting economic
growth. At the very least, the government can lend support to the invisible hand of the
market by maintaining property rights and political stability. A more controversial debate is
whether government should target and subsidise specific industries that might be especially
important for technological progress. There is no doubt that these issues are among the
most important in economics. The success of one generation’s policymakers in learning and
heeding the fundamental lessons about economic growth determines what kind of world
the next generation will inherit.
163
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN Chapter
02-200-202
7 Production and growth
07_Stonecash_8e_45658_SB_txt.indd 163
24/08/20 6:12 PM
STUDY TOOLS
Summary
LO7.1 Economic growth is the result of growth in labour and physical capital as well as human
capital and technological knowledge. Different countries grow at different rates because
they start out with differing levels of these economic variables. Economies get a
particular boost from increases in human capital and technological knowledge.
LO7.2 The accumulation of physical capital is subject to diminishing returns – the more
physical capital each worker has, the less additional output she produces from an extra
unit of it. Because of diminishing returns, higher saving leads to higher economic growth
for a period of time, but growth eventually slows down as the economy approaches a
higher level of capital, productivity and income per person. Also because of diminishing
returns, the return on physical capital is especially high in less industrial countries.
These countries can therefore grow faster and catch up with richer countries.
LO7.3 Government policies can influence the economy’s growth rate in many ways – fostering
education, promoting saving, encouraging investment (both domestic and from abroad),
maintaining property rights and political stability, allowing free trade, discouraging
excessive population growth, and promoting the research and development of new
technologies.
Key concepts
catch-up (or convergence) effect, p. 149
diminishing returns, p. 149
economic growth, p. 138
human capital, p. 143
natural resources, p. 143
physical capital, p. 142
returns to scale, p. 146
technological knowledge, p. 143
Practice questions
Questions for review
1
2
3
4
5
6
What do the level of GDP per person and the growth rate of GDP per person tell us about
the standard of living in a society?
Why is productivity important? Highlight the main determinants of labour productivity.
Which one do you think is most important?
Do you think a country can ‘over-invest’ in physical capital? Do you think a country can ‘overinvest’ in human capital? Explain and highlight the pros and cons.
What are the differences and similarities between returns to scale and returns to an input
(like natural resources)? Why are decreasing returns to scale less likely than diminishing
returns to physical capital? Carefully explain.
How does the rate of immigration influence the level of GDP per person in a country
such as Australia? Does it matter what educational level the immigrants have achieved
before they arrive in the new country? Can you offer any solutions to the recent European
migration crisis?
Describe two ways in which the Australian government tries to encourage advances in
technological knowledge. Try to propose some additional measures.
Multiple choice
1
Over the past century, real GDP per person in Australia has grown about
.
which means it doubles approximately every
a 0.4 per cent per year, 175 months
b 8.7 per cent per year, 8 years
c 1.6 per cent per year, 44 years
d 3.2 per cent per month, 32 years
,
164
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 4 The real economyCopyright
in the long
run
07_Stonecash_8e_45658_SB_txt.indd 164
24/08/20 6:12 PM
2
3
4
Most economists are _______________ that natural resources will eventually limit economic
growth. As evidence, they note that the prices of most natural resources, adjusted for
overall inflation, have tended to_______________over time.
a concerned, rise
b concerned, fall
c not concerned, rise
d not concerned, fall
Because physical capital is subject to diminishing returns, higher saving and investment
do not lead to a higher
a level of income in the long run.
b level of income in the short run.
c growth rate of income in the long run.
d growth rate of income in the short run.
Thomas Robert Malthus believed that population growth would
a lead to food shortages and famine.
b spread the capital stock too thinly across the labour force, lowering each worker’s
productivity.
c promote technological progress, because there would be more scientists and
inventors.
d eventually decline to sustainable levels, as birth control improved and people had
smaller families.
Problems and applications
1
2
3
4
5
Use the data in the table to answer the following questions.
Year
Billions of $AUD
(constant prices)
2015
1185
2016
1230
2017
1270
2018
1285
2019
1310
a Calculate the economic growth rate for each year from 2015 to 2019.
b Calculate the average annual economic growth rate from 2015 to 2019. Comment on
your answer.
Suppose that society decided to permanently increase the saving rate and investment.
a How would this change affect the level of real GDP and the rate of economic growth,
both in the short term and long term?
b Would it matter what type of investment (physical vs human capital) was undertaken?
c What groups in society would benefit from this change? What groups might be hurt?
d Why are politicians often reluctant to encourage people to save, despite this
enhancing the nation’s prosperity in the long term?
Australian (inflation adjusted) income per person today is around five times what it was
a century ago. Many other countries have also experienced significant economic growth
over that period. What are some specific ways in which your standard of living differs from
that of your great-grandparents? Is your standard of living higher in every regard, or can
you think of counter-examples?
Suppose that a computer-manufacturing company owned entirely by Japanese citizens
opens a new factory in Melbourne, Australia.
a What sort of foreign investment would this represent?
b What would be the effect of this investment on Australian GDP? Would the effect on
Australian GNP be larger or smaller? How would it affect Japanese GDP and GNP?
Do you think free trade is good for a country such as Australia? What two factors
determine the amount that nations trade?
165
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN Chapter
02-200-202
7 Production and growth
07_Stonecash_8e_45658_SB_txt.indd 165
24/08/20 6:12 PM
6
7
8
Different governments grant patents for different numbers of years, although the general
trend of the past decades has been to increase the breadth and depth of patent protection
(so that patents not only cover genuine innovations but also some very obvious ‘ideas’).
a How do you think country differences in patent protection affect the decisions of
multinational corporations about where to conduct their research and development?
b Suppose governments everywhere increased the number of years a patent lasts. What
do you think would be the effect of this change on the incentive to do research and on
the growth rate of GDP? Outline the various arguments.
International data show a positive correlation between political stability and economic
growth.
a Through what mechanism could political stability lead to strong economic growth?
b Through what mechanism could strong economic growth lead to political stability?
Why is research and development (R&D) important for long-run economic growth? How has
the Australian government played a role in facilitating R&D?
166
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 4 The real economyCopyright
in the long
run
07_Stonecash_8e_45658_SB_txt.indd 166
24/08/20 6:12 PM
8
Saving, investment and
the financial system
Learning objectives
After reading this chapter, you should be able to:
LO8.1 identify important financial institutions in the Australian and world economy
LO8.2discuss the role of the financial system and its relationship to key
macroeconomic variables
LO8.3analyse how the interest rate is determined, and how market forces and
economic policies impact equilibrium saving and investment
LO8.4examine how government budget deficits and surpluses affect the Australian
and world economy.
167
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
08_Stonecash_8e_45658_SB_txt.indd 167
24/08/20 4:33 PM
Introduction
financial system
the group of
institutions in the
economy that help
to match saving
with investment
Imagine that you have just graduated from university (with a degree in economics, of course) and
you decide to start your own business – a consulting firm. Before you make any money selling
your economic insights to firms, you have to incur substantial costs to set up your business.
You have to buy computer hardware and software with which to make your analysis, as well
as desks and chairs to furnish your new office and a phone to communicate with your clients.
Each of these is a type of capital that your firm will use to produce and sell its services.
How do you obtain the funds to invest in these capital goods? Perhaps you are able to pay
for them out of your past savings. More likely, however, like most entrepreneurs, you do not
have enough money of your own to finance the start of your business. As a result, you have
to get the money you need from other sources.
There are various ways for you to finance these capital investments. You could borrow
the money, perhaps from a bank or from a friend. In this case, you would promise not only to
return the money at a later date but also to pay interest. Alternatively, you could convince
someone to provide the money you need for your business in exchange for a share of your
future profits. In either case, your investment in computers and office equipment is being
financed by someone else’s saving.
The financial system consists of those institutions in the economy that help to match
one person’s saving with another person’s investment. As we discussed in the previous
chapter, saving and investment are key ingredients to economic growth. When a country
saves a good portion of its GDP, more resources are available for investment in capital,
and higher capital generally raises a country’s productivity and living standard. But that
chapter did not explain how the economy coordinates saving and investment. At any time,
some people want to save part of their income for the future and others want to borrow in
order to finance investments in new and growing businesses. How are these two groups of
people brought together? What ensures that the supply of funds from those who want to
save exactly balances the demand for funds from those who want to invest?
This chapter answers these questions by examining how the financial system works.
First, we discuss the large variety of institutions that make up the financial system in our
economy. Second, we discuss the relationship between the financial system and some key
macroeconomic variables – notably saving and investment. Third, we develop a model of
the supply of and demand for funds in financial markets. In the model, the interest rate
is the price that adjusts to balance supply and demand. The model enables us to show
how various economic developments and government policies affect the interest rate and,
thereby, society’s allocation of scarce resources.
LO8.1 Financial institutions in the Australian economy
At the broadest level, the financial system moves the economy’s scarce resources from savers
(people who spend less than they earn) to borrowers (people who spend more than they
earn). Savers save for various reasons – to put a child through university in several years’
time or to retire comfortably in several decades. Similarly, borrowers borrow for various
reasons – to buy a house in which to live or to start a business with which to make a living.
Savers supply their money to the financial system with the expectation that they will get it
back with interest at a later date. Borrowers demand money from the financial system with
the knowledge that they will be required to pay it back with interest at a later date.
The financial system is made up of various financial institutions that help coordinate
the actions of savers and borrowers. As a prelude to analysing the economic forces that drive
the financial system, let’s discuss the most important of them. Financial institutions can be
grouped into two categories – financial markets and financial intermediaries.
168
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 4 The real economyCopyright
in the long
run
08_Stonecash_8e_45658_SB_txt.indd 168
24/08/20 4:33 PM
Financial markets
Financial markets are the institutions through which a person who wants to save can
directly supply funds to a person who wants to borrow. The two most important financial
markets in our economy are the bond market and the stock market.
The bond market
When BHP, the big international resources company, wants to borrow to finance construction
of a new copper mine, it can borrow directly from the public. It does this by selling bonds.
A bond is a certificate of indebtedness that specifies the obligations of the borrower to
the holder of the bond. Put simply, a bond is just an IOU (I owe you). It identifies the time
at which the loan will be repaid, called the date of maturity, and the rate of interest that
will be paid periodically until the loan matures. Buyers of bonds give their money to BHP
in exchange for the promise of interest and eventual repayment of the amount borrowed
(called the principal). Buyers can hold the bonds until maturity or sell them at an earlier date
to someone else.
There are hundreds of different kinds of bonds in the Australian economy. When large
corporations or governments need to borrow to finance the purchase of a new factory or a
new jet fighter, they usually do so by issuing bonds. If you look at the Australian Financial
Review or the Australian Securities Exchange website (http://www.asx.com.au), you will
find a listing of the prices and interest rates on some of the most important bonds. Although
they differ in many ways, three characteristics of bonds are most important.
The first characteristic is a bond’s term – the length of time until the bond matures. Some
bonds have short terms, like a few months, and others have terms as long as 100 years. (The
British government has even issued a bond that never matures, called a perpetuity. This
bond pays interest forever, but the principal is never repaid.) The interest rate on a bond
depends, in part, on its term. Long-term bonds are riskier than short-term bonds because
holders of long-term bonds have to wait longer for repayment of the principal. If a holder of
a long-term bond needs the money earlier than the distant date of maturity, the buyer has
no choice but to sell the bond to someone else, perhaps at a reduced price. To compensate for
this risk, long-term bonds usually pay higher interest rates than short-term bonds.
The second important characteristic of a bond is its credit risk – the probability that the
borrower will fail to pay some of the interest or principal. Such a failure to pay is called
a default. Borrowers default on their loans by declaring bankruptcy. When bond buyers
perceive that the probability of default is high, they demand a higher interest rate to
compensate them for this risk. Therefore, the relationship between risk and returns for
various types of assets is an upward sloping curve; see Figure 8.1.
Because most governments, including Australia’s, are considered safe borrowers with no
or little credit risk, government bonds tend to pay low interest rates. They are in the bottom
left-hand part of the risk-versus-returns curve. In contrast, financially shaky corporations
raise money by issuing junk bonds, which pay very high interest rates. These are in the top
right-hand part of the risk-versus-returns curve of Figure 8.1. Buyers of bonds can judge
credit risk by checking with various private credit-rating agencies that evaluate the credit
risk of different bonds. For example, Standard & Poor’s rates bonds from AAA (the safest) to D
(already in default).
financial markets
financial institutions
through which savers
can directly provide
funds to borrowers
bond
a certificate of
indebtedness
CHECK YOUR UNDERSTANDING
What are the three important characteristics of a bond? Can you construct a diagram for
the saying: ‘the higher risk, the higher the reward’?
169
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole
or in
WCN
02-200-202and the financial system
Chapter
8 part.
Saving,
investment
08_Stonecash_8e_45658_SB_txt.indd 169
24/08/20 4:33 PM
FIGURE 8.1 The trade-off between risk and return
Aggressive
High
Balanced
Real return
Conservative
Low
Cash
Risk
High
When people increase the percentage of their savings that they have invested in shares as
opposed to bonds, they increase the average return they can expect to earn, but they also
increase the risks they face.
The third important characteristic of a bond is its tax treatment – the way in which the
tax laws treat the interest earned on the bond. The interest on most bonds is taxable income,
so the bond owner has to pay a portion of the interest he earns in income taxes. In some
countries, e.g. in the United States, the owners of state and local governments’ bonds, called
municipal bonds, are not required to pay federal income tax on the interest income. Because
of this tax advantage, bonds issued by state and local governments in the United States pay
a lower interest rate than bonds issued by corporations or the federal government. However,
in Australia, interest earned on all bonds is treated as any other type of income and taxed at
the normal rate.
The stock market
shares
a claim to partial
ownership in a firm
Another way for BHP to raise funds to build a new copper mine is to sell shares in the
company. Shares (stocks) represent ownership in a firm and are, therefore, a claim to the
profits that the firm makes. For example, if BHP sells a total of one million shares, then each
share represents ownership of 1/1 000 000 of the business.
The sale of shares to raise money is called equity finance, whereas the sale of bonds is
called debt finance. Although corporations use both equity and debt finance to raise money
for new investments, shares and bonds are very different. The owner of shares in BHP is a
part-owner of BHP; the owner of a BHP bond is a creditor of the corporation. If BHP is very
profitable, the shareholders enjoy the benefits of these profits, whereas the bondholders get
only the interest on their bonds. But if BHP runs into financial difficulty, the bondholders are
paid what they are due before shareholders receive anything at all. Compared with bonds,
shares offer the holder both higher risk and potentially higher return; see this relationship
in Figure 8.1.
CHECK YOUR UNDERSTANDING
How can a firm raise capital to finance investment projects? What are the main differences
between shares and bonds? Highlight and compare.
170
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 4 The real economyCopyright
in the long
run
08_Stonecash_8e_45658_SB_txt.indd 170
24/08/20 4:33 PM
Shutterstock.com/charnsitr
After a corporation sells shares to the public, these shares trade among shareholders
on organised stock exchanges. In these transactions, the corporation itself receives no
money when its shares change hands. The most important stock exchange in the Australian
economy is the ASX (the Australian Securities Exchange Ltd). It makes the top 10 stock
exchanges in the world based on market capitalisation; the value of all the shares issued
and traded there is around $2 trillion with close to 2200 listed companies and issuers (as of
early 2020).
Given the interconnectedness of financial markets, it is no surprise that our stock market
is also influenced by stock markets overseas. Some of the key ones are the New York Stock
Exchange and NASDAQ in the United States, the Tokyo Stock Exchange, the Stock Exchange
of Hong Kong, the Shanghai Stock Exchange and the London Stock Exchange. Most of the
world’s countries have their own stock exchanges on which the shares of local companies
trade.
The share prices observed on stock exchanges are determined by supply and demand.
Because shares represent ownership in a corporation, the demand for a share reflects people’s
perception of the corporation’s future profitability and/or expected future price movements.
When people become optimistic about a company’s future (or for whatever reason believe
that its share price will increase), they raise their demand for its shares and thereby bid up
the price of a share. Conversely, when people expect a company to have little profit or even
losses, the demand falls, reducing the share price.
Various share indexes are available to monitor the overall level of share prices. A share
index is calculated as an average of a group of share prices. The oldest Australian share
index is the All Ordinaries, which is an index of common shares listed on the ASX. The most
widely used Australian index is the S&P/ASX 200 introduced in 2000. Its components are
weighted based on their market value, so larger companies form a greater proportion of the
index than smaller companies.
One of the world’s most famous share indexes is the Dow Jones Industrial Average in
the United States, which has been calculated since 1896. It is now based on the prices of
the shares of 30 major US companies, like Apple, Nike, Visa, Coca-Cola, Boeing, McDonald’s
and Microsoft. Other well-known share indexes include the Nikkei in Tokyo, the Hang Seng
in Hong Kong, the FTSE in London and Standard & Poor’s 500 Index in the United States.
Because share prices reflect expected profitability, these share indexes are watched closely
as possible indicators of future economic conditions.
171
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole
or in
WCN
02-200-202and the financial system
Chapter
8 part.
Saving,
investment
08_Stonecash_8e_45658_SB_txt.indd 171
24/08/20 4:33 PM
CASE
STUDY
Key numbers for stock watchers
When following the stock of any company investors keep an eye on four key numbers.
These numbers are reported on the financial pages of some newspapers, and you can
easily obtain them online as well (like at Yahoo! Finance or the ASX website).
• Price. The single most important piece of information about a share is its price. The
newspaper usually presents several prices. The ‘closing’ price is the price of the last
transaction that occurred before the stock exchange closed the previous day. Many
newspapers also give the ‘high’ and ‘low’ prices over the past day of trading and,
sometimes, over the past year as well.
• Volume. Most newspapers present the number of shares sold during the past
day or week of trading. These figures are called the daily volume and the weekly
volume. A higher volume is generally preferred by investors as it means they can
more easily sell the shares if they need to.
• Dividend. Corporations pay out some of their profits to their shareholders; this
amount is called the dividend. (Profits not paid out are called retained profits and
are used by the corporation for additional investment.) Newspapers often report
the dividend paid over the previous year for each share. They sometimes report the
dividend yield, which is the dividend expressed as a percentage of the share’s price.
• Price–earnings ratio. This ratio, often called the P/E ratio, is the price of a
corporation’s share divided by the amount the corporation earned per share over
the past year. Historically, the typical price–earnings ratio is about 15. A higher
P/E ratio indicates that a corporation’s shares are expensive relative to its recent
earnings; this might mean either that people expect earnings to rise in the future or
that the shares are overvalued. Conversely, a lower P/E ratio may imply the opposite.
You may be interested to know that Warren Buffett, one of the worlds’ richest
people, based his investment strategy on finding such undervalued companies.
According to Investopedia.com, a $10 000 investment in Buffett’s Berkshire Hathaway
in 1965 would have been worth nearly $30 million by 2005, 60 times more than an
investment in the S&P 500 stock market index. But before you break your piggy bank
and rush to invest in the stock market you should know that many have tried Buffett’s
approach – called ‘value investing’ – and were unable to replicate his success.
In the list below, we’ve included one Australian company that is listed on the US
index, NASDAQ. Atlassian is a very successful tech company that has achieved a very
high price by Australian standards – nearly USD120 per share. It hasn’t paid a dividend
yet, so the dividend yield can’t be calculated.
Symbol for
company’s
shares
Name of
company
ASX Code
CBA
WBC
NAB
Commonwealth
Bank of
Australia
Westpac
Banking
Corporation
National
Australia Bank
Market
capitalisation
(total value)
Last
sale
price
in billion $
in $
High
Low
in
million
shares
in %
139.92
79.170
83.990
67.310
1.78
5.44
16.3
97.97
27.420
30.500
23.300
15.0
6.35
13.950
81.94
28.470
30.000
22.520
8.38
5.83
16.60
42.330
Highest and
Price/
Daily Dividend
lowest price over
earnings
volume
yield
the past year
ratio
BHP
BHP
110.03
37.300
29.062
5.70
5.14
16.320
CSL
CSL Limited
118.6
261.340 263.180 173.000
0.369
1.02
43.27
TLS
Telstra
Corporation
41.75
3.510
3.978
2.663
13.56
2.85
19.39
TEAM
Atlassian
USD14.5Bn
118.95
149.80
65.17
1.42
–
2294
Sources: https://www.asx.com.au/asx/share-price-research/company. Prices at 10 Nov 2019. For TEAM (Atlassian, listed on the
US NASDAQ): https://www.nasdaq.com/market-activity/stocks/team
172
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 4 The real economyCopyright
in the long
run
08_Stonecash_8e_45658_SB_txt.indd 172
24/08/20 4:33 PM
Questions
1
2
Based on the data provided in the above table, which company has the lowest
daily volume? What does a lower daily volume generally mean?
Which company has the highest price–earnings ratio? What does a higher
price–earnings ratio generally mean?
Financial intermediaries
Financial intermediaries are financial institutions through which savers can indirectly
provide funds to borrowers. The term intermediary reflects the role of these institutions
in standing between savers and borrowers. Here we consider two of the most important
financial intermediaries – banks and managed funds.
financial
intermediaries
financial institutions
through which savers
can indirectly provide
funds to borrowers
Banks
Chris owns a small grocery store and wants to finance a business expansion. The strategy
taken is probably quite different from that of BHP. Unlike BHP, Chris would find it difficult
to raise funds in the bond and stock markets. Most buyers of shares and bonds prefer to
buy those issued by larger, more familiar companies. Chris is therefore likely to finance his
business expansion with a loan from a local bank.
Banks are the financial intermediaries with which people are most familiar. One of the
main jobs of banks is to take in deposits from people who want to save and use these deposits
to make loans to people who want to borrow. Banks pay depositors interest on their deposits
and charge borrowers slightly higher interest on their loans. The difference between these
rates of interest covers the banks’ costs and returns some profit to the owners of the banks.
Before we proceed it should be noted that the standard process of taking deposits and
then offering loans can run in reverse. In the fractional reserve banking system used around
the world, which we will discuss in a later chapter, commercial banks can decide to give a
loan and only then create a deposit of that value, without waiting for a deposit from one
of their clients. Some economists are critical of the fact that commercial banks can create
money out of thin air and even circumvent the savers (see for example http://en.wikipedia.
org/wiki/The_Chicago_Plan_Revisited).
Besides being financial intermediaries, banks also facilitate purchases of goods and
services by allowing people to write cheques or use debit cards (EFTPOS) against their
deposits. In other words, banks help create a special asset that people can use as a medium
of exchange. A medium of exchange is an item that people can easily use to make payments.
A bank’s role in providing a medium of exchange distinguishes it from many other financial
institutions. Shares and bonds, like bank deposits, are a possible store of value for the wealth
that people have accumulated in past saving, but access to this wealth is not as easy, cheap
and immediate as just writing a cheque or using a debit card. For now, we ignore this second
role of banks, but we will return to it when we discuss the monetary system in a later chapter.
Managed funds
Another financial intermediary is a managed fund. It is a type of financial investment that
allows investors to own a selection, or portfolio, of various types of shares and bonds without
buying them individually. When an individual investor puts money into a managed fund, a
manager or trustee makes the decisions about which shares or bonds to purchase. However,
the individual investor in the managed fund accepts all the risk and return associated with
managed fund
an institution that
allows investors
to own a portfolio
of various types of
shares and/or bonds
173
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole
or in
WCN
02-200-202and the financial system
Chapter
8 part.
Saving,
investment
08_Stonecash_8e_45658_SB_txt.indd 173
24/08/20 4:33 PM
the portfolio. If the value of the portfolio rises, the investor benefits; if the value of the
portfolio falls, the investor suffers the loss.
The main advantage of managed funds is that they allow people with small amounts
of money to diversify risk. Buyers of shares and bonds are well advised to follow the advice
‘don’t put all your eggs in one basket’. Because the value of any single share or bond is tied to
the fortunes of one company, holding a single kind of share or bond is very risky. In contrast,
people who hold a diverse portfolio of shares and bonds face less risk because they have
only a small stake in each company. Managed funds make this risk diversification easy.
With only a few hundred dollars, a person can buy shares in a managed fund and, indirectly,
become the partial owner or creditor of hundreds of major companies. For this service, the
company operating the managed fund charges shareholders a fee, most commonly around
2 per cent of assets each year.
A second advantage claimed by managed fund companies is that managed funds give
ordinary people access to the skills of professional money managers. The managers of
most managed funds are paid to closely monitor the developments and prospects of the
companies in which they buy shares. These managers buy the shares of those companies
that they view as having a profitable future and sell the shares of companies with less
promising prospects. This professional management, it is argued, should increase the return
that managed fund depositors earn on their savings.
Financial economists, however, are often sceptical of the latter argument. With
thousands of money managers paying close attention to each company’s prospects, it is
hard to ‘beat the market’ by buying good shares and selling bad ones. In fact, managed funds
called index funds, which buy all the shares in a given share index and hold them (passive
investing), deliver investors a greater (risk-adjusted) return on average than managed funds
that engage the services of professional money managers and trade frequently (active
investing).
The main explanation for the superior performance of index funds is that they keep
costs low (some charge only 0.05 per cent of assets, which is 40 times less than the
average of 2 per cent mentioned above for active asset management). This saving of
index funds is achieved by buying and selling very rarely and by not having to pay the
salaries of professional money managers (the restaurant conversation between Matthew
McConaughey and Leonardo DiCaprio in the 2013 movie The Wolf of Wall Street offers
some pointers in this regard).
CHECK YOUR UNDERSTANDING
What are the differences between banks and managed funds?
Summing up
The Australian economy contains a large variety of financial institutions. In addition to
the bond market, the stock market, banks and managed funds, there are also credit unions,
insurance companies, superannuation (pension) funds, and even the local loan shark. These
institutions differ in many ways. When analysing the macroeconomic role of the financial
system, however, it is more important to keep in mind the similarities of these institutions
rather than the differences. These financial institutions all help direct the resources of
174
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 4 The real economyCopyright
in the long
run
08_Stonecash_8e_45658_SB_txt.indd 174
24/08/20 4:33 PM
savers into the hands of borrowers. Does this imply that policymakers should treat financial
institutions ‘with extra care’ when they get into trouble? This is discussed in the box below,
and more details follow in our chapter on the 2008 crisis in Chapter 17.
Financial institutions in trouble: To bail or let them sink?
In September 2008, a New York-based financial services company, Lehman
Brothers, went bankrupt. With over US$600 billion in assets it was the largest
bankruptcy in US history (almost five times bigger than the 2009 bankruptcies
of the automobile giants General Motors and Chrysler combined). The failure of
Lehman Brothers was a shock to the financial system, as there had not been a
major financial house bankruptcy since the savings and loan failures of the late
1980s and early 1990s. Many commentators at the time predicted a collapse of
the global financial system.
The US government and the Federal Reserve undertook to stabilise the
situation by providing liquidity to those banks and other financial institutions
that were in danger of failing in late 2008. Similar rescue actions, called
bailouts, were subsequently performed by many European policymakers. There
is ongoing debate about whether or not the governments should have done
this, and whether they should do it again in the future in similar situations.
We briefly outline the ‘bailout is good’ and the ‘bailout is bad’ arguments so
that you can decide whether you think we should bail out financial institutions
or not. Even though these articles refer to something that happened over a
decade ago, these issues are real and current.
Prevent financial panic and
instil confidence
The pro-bailout commentators argue
that because confidence is crucial to
the smooth operation of the economy,
and because major financial institutions
(banks, insurance companies, mutual
funds etc.) are heavily interconnected,
policymakers must not let them go
bankrupt. They are ‘too-big-to-fail’ in the
sense that their collapse would cause
panic in the financial market and lead
to ‘bank runs’ (many people trying to
withdraw all their deposits). Such financial
contagion would damage even healthy
institutions, and impair the ability of the
financial system to serve its purpose of
linking investors with savers. This could
have a detrimental effect on firms, and
lead to increases in unemployment,
declines in the stock market and a
substantial loss of household wealth.
For example, Professor Paul Krugman,
the recipient of the 2008 Nobel Prize in
IN THE
NEWS
Economics, argues that the bailout acts
as the fire brigade of the financial system.
He believes that letting large banks fail ‘is
a bad idea for the same reason that it’s
a bad idea to stand aside while an urban
office building burns. In both cases, the
damage has a tendency to spread.’
Don’t reward excessively
risky behaviour
Those against bailouts argue that such
implicit insurance of the government to
the ‘too-big-to-fail’ financial institutions
creates the wrong incentives. Knowing
that they are not gambling with their
own money but rather with taxpayers’
money encourages financial institutions
to take on excessive risk – the so-called
‘moral hazard’ problem. This increases the
danger of a costly financial crisis in the
future, and the likelihood that bailouts will
indeed be necessary.
Professor Tyler Cowen used the
1998 bailout of the Long-Term Capital
Management hedge fund as an example
175
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole
or in
WCN
02-200-202and the financial system
Chapter
8 part.
Saving,
investment
08_Stonecash_8e_45658_SB_txt.indd 175
24/08/20 4:33 PM
of this problem in the run-up to the
Global Financial Crisis of 2008. He argues
that this bailout set a bad precedent:
‘Creditors came to believe that their loans
to unsound financial institutions would be
made good by the Fed [America’s central
bank] – as long as the collapse of those
institutions would threaten the global
credit system. Bolstered by this sense of
security, bad loans mushroomed’.
We will revisit this topic in chapter 17
on the monetary system, in which you
will learn how to formally show excessive
leverage and bad loans in a bank’s balance
sheet. Chapter 17 discusses the Global
Financial Crisis and how loans to people
who were not good prospects for repaying
their mortgages plus an overheated
property market led to the collapse of
banks and put the financial position of
entire countries at risk.
Source: Paul Krugman, ‘The Fire Next Time’, The New
York Times, 15 April 2010, http://www.nytimes.com/
2010/04/16/opinion/16krugman.html; Tyler Cowen,
‘Bailout of Long-Term Capital: A Bad Precedent?’, The
New York Times, 26 December 2008,
http://www.nytimes.com/2008/12/28/business/
economy/28view.html
CHECK YOUR UNDERSTANDING
Concept Jan Libich © 2017, drawing Veronika Mojžíšová
What is your view of the bailout debate? If you had been in charge of economic policy in
the United States, would you have let Lehman Brothers collapse in September 2008?
How would you deal with the too-big-to-fail problem going forward? (Hint: You can find
some pointers in the following cartoon.)
LO8.2 Saving and investment in the national income accounts
Events that occur within the financial system are central to understanding developments in
the overall economy. As we have just seen, the institutions that make up this system have the
role of coordinating the economy’s saving and investment, which are important determinants
176
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 4 The real economyCopyright
in the long
run
08_Stonecash_8e_45658_SB_txt.indd 176
24/08/20 4:33 PM
of long-run economic growth and living standards. As a result, macroeconomists need to
understand how financial markets work and how various events and policies affect them.
As a starting point for an analysis of financial markets, we discuss the key macroeconomic
variables that measure activity in these markets. Our emphasis here is not on behaviour
but on accounting. Accounting refers to how various numbers are defined and added up. A
personal accountant might help individuals calculate their income and expenses. A national
income accountant does the same thing for the economy as a whole. The national income
accounts include, in particular, GDP and the many related statistics.
The rules of national income accounting include several important identities. Recall that
an identity is an equation that must be true because of the way the variables in the equation
are defined. Identities are useful to keep in mind, for they clarify how different variables are
related to one another. Here we consider some accounting identities that shed light on the
macroeconomic role of financial markets.
national income
accounts
an accounting
system that tracks
an economy’s
performance
Some important identities
Recall that gross domestic product (GDP) for a certain period of time is (i) the total
production of the economy, (ii) the total income that workers and capital owners receive
for this production, and (iii) the total expenditure by households, firms and the government
on the produced goods and services. Focusing on the latter perspective, GDP (denoted as Y )
is made up of four expenditure components: consumption (C ), investment (I ), government
purchases (G ) and net exports (NX ). We can write:
Y = C + I + G + NX
This equation is an identity because every dollar of expenditure that shows up on the
left-hand side also shows up in one of the four components on the right-hand side. Because
of the way each of the variables is defined and measured, this equation must always hold.
In this chapter, we simplify our discussion by examining a closed economy; one that
does not interact with other economies. In particular, a closed economy does not engage
in international trade in goods and services, nor does it participate in international
borrowing and lending. Of course, actual economies, perhaps except North Korea, are open
economies; that is, they interact with other economies around the world. (We will examine
the macroeconomics of open economies later in this book.) Assuming a closed economy is
a useful simplification with which we can learn some lessons that apply to all economies.
Moreover, this assumption applies perfectly to the world economy since interplanetary
trade does not yet exist.
Because a closed economy does not engage in international trade, both imports and
exports are exactly zero. Therefore, net exports (NX ) are also zero. We can therefore simplify
the identity as:
Y=C+I+G
This equation states that each unit of output sold in a closed economy is consumed,
invested, or bought by the government. To see what this identity can tell us about financial
markets, subtract C and G from both sides of this equation:
Y–C–G=I
The left-hand side of this equation (Y – C – G) is the total income in the economy that
remains after paying for consumption and government purchases. This amount is called
national saving, or just saving, and is denoted S. Substituting S for Y – C – G, we can write
the last equation as:
S=I
national saving
(saving)
the total income in
the economy that
remains after paying
for consumption
and government
purchases
177
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole
or in
WCN
02-200-202and the financial system
Chapter
8 part.
Saving,
investment
08_Stonecash_8e_45658_SB_txt.indd 177
24/08/20 4:33 PM
This equation states that saving equals investment. To understand the meaning of
national saving, it is helpful to manipulate the equation a bit more. Let T denote the
amount that the government collects from households in taxes (strictly speaking, it is
taxes minus the amount it pays back to households in the form of transfer payments like
pension benefits or social security payments, but below we will sometimes disregard this
to simplify the language). We can then write national saving in either of two ways:
S=Y–C–G
or
private saving
the income that
households have left
after paying for taxes
and consumption
public saving
the tax revenue that
the government
has left after paying
for its spending
(and transfers)
budget surplus
an excess of tax
revenue over
government spending
budget deficit
government spending
exceeding tax revenue
S = (Y – T – C) + (T – G)
These equations are the same, since the two Ts in the second equation cancel each other,
but each reveals a different way of thinking about national saving. In particular, the second
equation separates national saving into two pieces: Private saving (Y – T – C ) and public
saving (T – G ).
Private saving is the amount of income that households have left after paying their
taxes and paying for their consumption; that is, Y – T – C. Public saving is the amount of tax
revenue that the government has left after paying for its spending. The government receives
T in tax revenue (minus transfers) and spends G on goods and services. If T exceeds G, the
government runs a budget surplus because it receives more money than it spends. This
surplus of T – G represents public saving. If the government spends more than it receives in
tax revenue (as has been the case in most high-income countries over the past few decades),
then G is larger than T. In this case, the government runs a budget deficit, and public saving
T – G is a negative number. The obvious consequence of deficits is an accumulation of public
debt.
Now consider how these accounting identities are related to financial markets. The
equation S = I reveals an important fact – for the economy as a whole, saving must be equal
to investment. Yet this fact raises some important questions. What mechanisms lie behind
this identity? What coordinates those people who are deciding how much to save and
those people who are deciding how much to invest? The answer is the financial system.
The bond market, the stock market, banks, managed funds and other financial markets and
intermediaries stand between the two sides of the S = I equation. They take in the nation’s
saving and channel it to the nation’s investors.
The meaning of saving and investment
The terms saving and investment can sometimes be confusing. Most people use these
terms casually and sometimes interchangeably. In contrast, the macroeconomists who put
together the national income accounts use these terms carefully and distinctly. Consider an
example. Suppose that Mary earns more than she spends and deposits her unspent income
in a bank or uses it to buy a bond or some shares from a corporation. Because Mary’s income
exceeds her consumption, she adds to the nation’s saving. Mary might think of herself as
‘investing’ her money, but a macroeconomist would call Mary’s act ‘saving’ rather than
‘investment’.
In the language of macroeconomics, investment refers to the purchase of new capital,
like equipment or buildings. When Jerry builds himself a new house using money borrowed
from the bank, he adds to the nation’s investment. Similarly, when the Curly Corporation
builds a new factory using proceeds from selling shares, it also adds to the nation’s
investment.
178
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 4 The real economyCopyright
in the long
run
08_Stonecash_8e_45658_SB_txt.indd 178
24/08/20 4:33 PM
Although the accounting identity S = I shows that saving and investment are equal for
the economy as a whole, this does not have to be true for every individual household or
firm. Mary’s saving can be greater than her investment, and she can deposit the excess in
a bank. Jerry’s saving can be less than his investment and he can borrow the shortfall from
a bank. Banks and other financial institutions make these individual differences between
saving and investment possible by allowing one person’s saving to finance another person’s
investment.
LO8.3 The market for loanable funds
Having discussed some of the important financial institutions in our economy and their
role, we are ready to build a model of financial markets. Our purpose in doing so is to explain
how financial markets coordinate the economy’s saving and investment. The model also
gives us a tool with which we can analyse various economic developments and government
policies that influence saving and investment.
To keep things simple, we assume that the economy has only one financial market, called
the market for loanable funds. All savers go to this market to deposit their savings and all
borrowers go to this market to get their loans. In this market there is one interest rate, which
is both the return on saving and the cost of borrowing.
The assumption of a single financial market is, of course, not realistic. We have seen that
the economy has many types of financial institutions and instruments. But, as we discussed
in chapter 2, the art in building an economic model is simplifying the world in order to
explain it. For our purposes here, we can ignore the diversity of financial institutions and
assume that the economy has a single financial market.
market for loanable
funds
a (virtual) place where
those who supply and
demand funds interact
FYI
Present value
Imagine that someone offered to give
you $100 today or $100 in 10 years.
Which would you choose? This is an easy
question. Getting $100 today is clearly
better, because you can always deposit
the money in a bank, still have it in 10
years and earn interest along the way. The
lesson: Money today is more valuable than
the same amount of money in the future.
Now consider a harder question:
Imagine that someone offered you $100
today or $200 in 10 years. Which would you
choose? To answer this question, you need
some way to compare sums of money from
different points of time. Economists do this
with a concept called present value. The
present value of any future sum of money
is the amount today that would be needed,
at current interest rates, to produce that
future sum. To learn how to use the
concept of present value, let’s work through
a couple of simple problems.
Question: If you put $100 in a bank
account (that pays interest) today, how
much money will you have in N years?
That is, what will be the future value of
this $100?
Answer: Let’s use r to denote the
interest rate expressed in decimal form (so
an interest rate of 5 per cent means r =
0.05). If interest is paid each year, and
if this interest paid remains in the bank
account to earn more interest (a process
called compounding, which you learnt
about in an earlier chapter), the $100 will
become (1 + r) × $100 after 1 year, (1 + r) ×
(1 + r) × $100 after 2 years, (1 + r) × (1 + r) ×
(1 + r) × $100 after 3 years and so on. After
N years, the $100 becomes (1 + r)N × $100.
For example, if the interest rate is 5 per
cent, then the value of the $100 in 10 years’
time will be (1.05)10 × $100, which is $163.
Question: Now suppose you are going
to be paid $200 in N years. What is the
present value of this future payment?
179
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole
or in
WCN
02-200-202and the financial system
Chapter
8 part.
Saving,
investment
08_Stonecash_8e_45658_SB_txt.indd 179
24/08/20 4:33 PM
That is, how much would you have to
deposit in a bank right now to yield $200
in N years?
Answer: To answer this question, just
turn the previous answer on its head. In
the last question, we computed a future
value from a present value by multiplying
by the factor (1 + r)N. To compute a present
value from a future value, we divide by the
factor (1 + r)N. Thus, the present value of
$200 deposited today in N years is $200/
(1 + r)N. For instance, if the interest rate is
5 per cent, the present value of $200 in
10 years is $200/(1.05)10, which is $123.
This illustrates the general formula: If
r is the interest rate, then the amount X to
be received in N years has a present value
of X/(1 + r)N.
Let’s now return to our earlier question:
Should you choose $100 today or $200 in
10 years? We can infer from our calculation
of present value that if the interest rate is
5 per cent, you should prefer the $200 in
10 years. The future $200 has a present
value of $123, which is greater than $100.
You are, therefore, better off waiting for
the future sum.
Notice that the answer to our question
depends on the interest rate. If the
interest rate were 8 per cent, then the
$200 in 10 years would have a present
value of $200/(1.05)10, which is only $93. In
this case, you should take the $100 today.
Why should the interest rate matter for
your choice? The answer is that the higher
the interest rate, the more you can earn
by depositing your money at the bank,
so the more attractive getting $100 today
becomes. Using one of the Ten Principles
of Economics introduced in chapter 1,
since a higher (real) interest rate increases
the opportunity cost of spending money
now, it makes people substitute current
consumption for future consumption.
The concept of present value is
useful in many applications, including
the decisions that companies face when
evaluating investment projects. For
instance, imagine that Nissan is thinking
about building a new factory. Suppose
that the factory will cost $100 million
today and will yield the company
$200 million in 10 years. Should Nissan
undertake the project? You can see that
this decision is exactly like the one we
have been studying. To make its decision,
the company will compare the present
value of the $200 million return to the
$100 million cost.
The company’s decision, therefore,
will depend on the interest rate. If the
interest rate is 5 per cent, then the present
value of the $200 million return from the
factory is $123 million, and the company
will choose to pay the $100 million cost. By
contrast, if the interest rate is 8 per cent,
then the present value of the return is only
$93 million, and the company will decide
to forgo the project. Thus, the concept of
present value helps explain why investment
declines when the interest rate rises.
Here is another application of present
value: Suppose you win a million-dollar
lottery, but the prize is going to be paid out
as $20 000 a year for 50 years. How much
is the prize really worth? After performing
50 calculations similar to those above (one
calculation for each payment) and adding
up the results, you would learn that the
present value of this million-dollar prize at
a 7 per cent interest rate is only $276 000.
This is one way that lotteries make money –
by selling tickets in the present and paying
out prizes in the future.
Supply of and demand for loanable funds
supply of loanable
funds
saving from
households and
the government
The market for loanable funds, like other markets in the economy, is governed by supply and
demand. What are the sources of supply and demand in that market?
The supply of loanable funds comes from those people who have some extra money
they want to save and lend out, and from the government when its tax revenue (net of
transfers) is in excess of its expenditures.
This lending can occur directly, like when a household buys a bond from a firm. Or it can
occur indirectly, when a household makes a deposit in a bank which then uses the funds to
make loans. In both cases, saving is the source of the supply of loanable funds.
180
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 4 The real economyCopyright
in the long
run
08_Stonecash_8e_45658_SB_txt.indd 180
24/08/20 4:33 PM
The demand for loanable funds is driven by the need to finance investments.
It is composed primarily of firms borrowing to buy new equipment or build factories.
Nevertheless, it also includes households taking out mortgages to buy homes (recall that
all other purchases by households, for example, getting a car, are classified as consumption
not investment).
The interest rate expresses the price of a loan. It represents the amount that borrowers
pay for loans and the return that lenders receive on their saving. Because a high interest
rate makes borrowing more expensive, the quantity of loanable funds demanded falls as
the interest rate rises. Similarly, because a high interest rate makes saving more attractive,
the quantity of loanable funds supplied rises as the interest rate rises. In other words, the
demand curve for loanable funds slopes downwards and the supply curve for loanable funds
slopes upwards. (In the figures below, we plot them as linear for simplicity; in the real world
they may not be straight lines, but the same intuition still applies.)
Recall that economists distinguish between the real interest rate and the nominal interest
rate. The nominal interest rate is the monetary return to saving and the monetary cost of
borrowing. It is the interest rate as usually reported. The real interest rate is the nominal
interest rate corrected for inflation; it equals the nominal interest rate minus the inflation
rate. Which one do you think better reflects the actual return on saving and the cost of
borrowing that households and firms are interested in? Because inflation erodes the value
of money over time, it is the real interest rate. Therefore, in our model, the supply of and
demand for loanable funds will depend on the real (rather than nominal) interest rate, which
features on the vertical axis of Figure 8.2. For the rest of this chapter, when you see the term
interest rate, you should remember that we are talking about the real interest rate.
Figure 8.2 shows the real interest rate that balances the supply of and demand for
loanable funds. The adjustment of the interest rate towards the equilibrium level occurs
for the usual reasons. If the interest rate is lower than the equilibrium level, the quantity of
loanable funds supplied is less than the quantity of loanable funds demanded. The resulting
shortage of loanable funds encourages lenders to raise the interest rate they charge.
Intuitively, you can think of it as an auction in which there are a lot of potential buyers who
bid up the price.
demand for loanable
funds
demand from firms
looking to invest
and households
buying real estate
FIGURE 8.2 The market for loanable funds
Interest
rate
Supply
5%
Demand
0
$120
Loanable funds
(in millions of dollars)
The (real) interest rate in the economy adjusts to clear the market for loanable funds, i.e. to
balance the supply and demand. Here, the equilibrium interest rate is 5 per cent at which
$120 million of loanable funds are supplied and demanded.
181
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole
or in
WCN
02-200-202and the financial system
Chapter
8 part.
Saving,
investment
08_Stonecash_8e_45658_SB_txt.indd 181
24/08/20 4:33 PM
Conversely, if the interest rate is higher than the equilibrium level, the quantity of
loanable funds supplied exceeds the quantity of loanable funds demanded. As lenders
compete for the scarce borrowers, interest rates are driven down. This is similar to an auction
in which there are currently no buyers so the seller needs to drop the price to attract them.
In this way, the interest rate approaches the equilibrium level at which the supply of and
demand for loanable funds exactly balance.
This model of the supply of and demand for loanable funds shows that financial markets
work much like other markets in the economy. In the market for milk, for instance, the price
of milk adjusts so that the quantity of milk supplied balances the quantity of milk demanded
and the market reaches its equilibrium. In this way, the ‘invisible hand’ coordinates the
behaviour of dairy farmers and the behaviour of milk drinkers. Once we realise that saving
represents the supply of loanable funds and investment represents the demand, we can see
how the invisible hand helps coordinate saving and investment.
You may have heard some critiques of the concept of equilibrium and the invisible hand,
jokes like ‘The invisible hand was nowhere to be seen’. While entertaining, they are often
based on an incorrect interpretation of these concepts. The invisible hand does not imply
that the market allocation will always be efficient (recall the discussion of market failure in
earlier chapters), and equilibrium does not mean that the market will remain there all the
time. Because market conditions change frequently, the equilibrium does too. So you should
think of it in a dynamical sense as the direction in which market forces are moving prices
and quantities, not in a static sense as some fixed outcomes. It is about the adjustment
process itself.
CHECK YOUR UNDERSTANDING
What are loanable funds? Why do firms demand loanable funds? Who supplys
loanable funds?
LO8.4 How government policies can affect saving and investment
We can now use the analysis of the market for loanable funds to examine various
government policies that affect the economy’s saving and investment, following the three
steps discussed in chapter 4. First, we decide whether the policy shifts the supply curve or
the demand curve. Second, we determine the direction of the shift. Third, we use the supplyand-demand diagram to see how the equilibrium changes.
Policy 1: Taxes and saving
In 2017, Australian families saved 3.51 per cent of their disposable income according to
OECD data. This is a smaller proportion than their counterparts in some other countries; for
example, in China it was close to 36 per cent and in Sweden and Switzerland between 15 and
19 per cent. But Australian households still saved more than families in other countries like
Japan (nearly 3 per cent) or New Zealand (where the savings rate was actually negative).
Although all the reasons for these large international differences are not fully understood,
and although the saving rate of Australians increased in recent years (from 1 per cent in
2005), many Australian policymakers view inadequate Australian saving as a problem.
They also point out that the saving rate is likely to decline in the future due to demographic
trends of an ageing population. One of the Ten Principles of Economics in chapter 1 is that
a country’s standard of living depends on its ability to produce goods and services. And,
as we discussed in the previous chapter, saving is an important long-run determinant of a
182
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 4 The real economyCopyright
in the long
run
08_Stonecash_8e_45658_SB_txt.indd 182
24/08/20 4:33 PM
nation’s productivity. If Australia could somehow raise its saving rate, more resources would
be available for investment and capital accumulation, GDP would grow more rapidly and,
over time, Australians would enjoy a higher standard of living.
Another of the Ten Principles of Economics is that people respond to incentives. Many
economists have used this principle to suggest that the relatively low saving rate in
Australia is at least partly attributable to tax laws that discourage saving. The Australian
government collects revenue by taxing income, including interest and dividend income. To
see the effects of this policy, consider a 25-year-old who saves $1000 and buys a 30-year
bond that pays an interest rate of 9 per cent. In the absence of taxes, the $1000 grows to
$13 268 when the individual reaches age 55. Yet if that interest is taxed at a rate of, say,
33.3 per cent, then the after-tax interest rate is only 6 per cent. In this case, the $1000 grows
to only $5743 after 30 years.
The tax on interest income substantially reduces the future pay-off from current saving
and, as a result, reduces the incentive for people to save. Following the Global Financial
Crisis, the returns have generally been much lower than in the past: for example, the yield
on a 30-year US government bond was just above 2 per cent and on a 15-year Australia bond
it was around 1.3 per cent in early 2020. While this reduces the quantitative impact of taxes
on people’s returns from saving, their thinking at the margin implies that incentives and
decisions will still be affected by tax legislation.
In response to this problem, some economists and lawmakers have attempted to change
the tax laws to encourage greater saving. For instance, under the 10 per cent consumption
tax that John Howard introduced in 2000 (commonly known as goods and services tax,
GST), money spent effectively gets taxed more than money saved. Most countries have
something similar to a GST; in Europe it is referred to as a VAT or value-added tax, and its
value is usually higher (between 17 and 25 per cent).
More recent proposals have included reduced taxes on contributions to superannuation
funds that allow people to shelter some of their saving from taxation. Let’s consider the
effect of such a saving incentive on the market for loanable funds in Figure 8.3. First, which
FIGURE 8.3 A tax incentive to save
Interest
rate
5%
Supply, S1
A
4%
B
C
2. ... which
reduces the
equilibrium
interest rate ...
S2
1. Tax incentives for
saving increase the
supply of loanable
funds by $60 million
for any interest rate ...
Demand
0
$120
$160 $180
Loanable funds
(in millions of dollars)
3. ... and raises the equilibrium
quantity of loanable funds,
but by less than $60 million.
A change in the tax laws encouraging people to save more shifts the supply of loanable funds
to the right from S1 to S2. As a consequence, the equilibrium real interest rate must fall and the
new equilibrium quantity of loanable funds saved and invested rises.
183
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole
or in
WCN
02-200-202and the financial system
Chapter
8 part.
Saving,
investment
08_Stonecash_8e_45658_SB_txt.indd 183
24/08/20 4:33 PM
curve does this policy affect? Because this tax change alters the incentive for households
to save at any given interest rate, it affects the quantity of loanable funds supplied at each
interest rate. Thus, the supply of loanable funds shifts. The tax change does not directly
affect the amount that borrowers want to borrow at any given interest rate, so the demand
for loanable funds is largely unchanged.
Second, which way does the supply curve shift? If saving is taxed less heavily than
under current law, households increase their saving by consuming a smaller fraction of their
income. Households use this additional saving to increase their deposits in banks or to buy
more bonds. The supply of loanable funds therefore increases and the supply curve shifts to
the right from S1 to S2, as shown in Figure 8.3.
Finally, we compare the new equilibrium (point C in the figure) with the old equilibrium
(point A). We can see that if a change in the tax laws encouraged greater saving, the result
would be lower interest rates and greater investment. However, we can also see that the
increase in the equilibrium quantity of loanable funds saved and invested, in our example
from $120 million to $160 million, is smaller than the initial increase (horizontal shift) in
private saving of $60 million. Can you think of an explanation for that?
The story is as follows. For all the new saving to be absorbed in the market it must
become cheaper. That is, the equilibrium interest rate must fall (from 5 per cent to 4 per
cent). This leads to two other movements in Figure 8.3 – along the demand and supply
curves. Specifically, the lower interest rate attracts additional investment as households
and firms have an incentive to borrow more. This is represented by a movement along the
demand curve from point A to C. At the same time, some households are no longer willing to
save at the lower interest rate, and there is a movement along the supply curve from point B
to C. This partly offsets the initial increase in private saving, and means that the equilibrium
change of loanable funds saved and invested is less than what it would be under the original
interest rate of 5 per cent. In Figure 8.3 the equilibrium increase is only $40 million rather
than $60 million.
Although this analysis of the effects of increased saving is widely accepted among
economists, there is less consensus about what kinds of tax changes should be enacted.
Many economists endorse tax reform aimed at increasing saving in order to stimulate
investment and economic growth. Yet others are sceptical that these tax changes would
have much effect on national saving. These sceptics also doubt the equity of the proposed
reforms. They argue that, in many cases, the benefits of the tax changes would accrue
primarily to the wealthy, who are least in need of tax relief.
Policy 2: Taxes and investment
Suppose that federal parliament passed a law giving a tax reduction to any firm building a
new factory. In essence, this is what happens when government institutes an investment tax
credit, which policymakers do from time to time. Let’s consider the effect of such a law on
the market for loanable funds in Figure 8.4.
First, does the law affect supply or demand? Because the tax credit alters the incentive of
firms to borrow and invest in new capital, it alters the demand for loanable funds. Because
the tax credit does not directly affect the amount that households save at any given interest
rate, it leaves the supply of loanable funds largely unaffected.
Second, which way does the demand curve shift? Because firms have an incentive to
increase investment at any interest rate, the quantity of loanable funds demanded is higher
at any given interest rate. Thus, the demand curve for loanable funds shifts to the right from
D1 to D2 in Figure 8.4.
Third, consider how the equilibrium changes. The increased demand for loanable funds
raises the equilibrium interest rate from 5 per cent to 6 per cent and the equilibrium quantity
of loanable funds supplied and demanded from $120 million to $140 million. Note that this
184
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 4 The real economyCopyright
in the long
run
08_Stonecash_8e_45658_SB_txt.indd 184
24/08/20 4:33 PM
FIGURE 8.4 A tax incentive to invest
Interest
rate
Supply
C
6%
5%
B
A
2. ... which
raises the
equilibrium
interest rate ...
1. An investment
tax credit
increases the
demand for
loanable funds by
$50 million for any
interest rate ...
D2
Demand, D1
0
$120
$140 $170
Loanable funds
(in millions of dollars)
3. ... and raises the equilibrium
quantity of loanable funds, but by
less than $50 million.
An investment tax credit encourages firms to invest more, increasing the demand for loanable
funds from D1 to D2. As a result, the equilibrium interest rate rises and the equilibrium quantity
of loanable funds saved and invested rises too.
increase of $20 million is less than the horizontal shift of $50 million. This is because the
higher interest rate discourages some investors — there is a movement along the new
demand curve from point B to C. On the other hand, due to the higher interest rate some
households are willing to save more, which causes a movement along the supply curve from
point A to C. In summary, if a change in the tax laws encouraged greater investment, the result
would be higher interest rates and greater saving.
Policy 3: Government budgets – surplus or deficit?
One of the most widely discussed issues of macroeconomic policy is the government
budget balance. When the government takes in more revenue than it spends, the excess
is called the budget surplus. When the government spends more than it receives in tax
revenue, the shortfall is called the budget deficit. The accumulation of past budget deficits
is called government debt. When a government runs a budget surplus, it can reduce the size
of the accumulated government debt. Up until the Global Financial Crisis, the Australian
government had run budget surpluses for a decade and had retired almost all of its debt
(the public debt to GDP ratio was below 10 per cent in 2007). It was therefore, unlike many
countries with high public debt, in a good position to stimulate the economy with increased
government expenditure when the crisis hit.
During national elections in Australia, there is always much debate about which party
is more fiscally responsible. To see why this debate may be relevant, imagine that the
government starts with a balanced budget and then, because of an increase in government
spending, starts running a budget deficit. We can analyse the effects of such a newly
created budget deficit by following our three steps in the market for loanable funds, which
is illustrated in Figure 8.5.
First, which curve shifts when the budget moves into a deficit? Recall that national
saving – the source of the supply of loanable funds – is composed of private saving and
public saving. A change towards a (greater) deficit represents a change in public saving and,
185
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole
or in
WCN
02-200-202and the financial system
Chapter
8 part.
Saving,
investment
08_Stonecash_8e_45658_SB_txt.indd 185
24/08/20 4:33 PM
FIGURE 8.5 The effect of a government budget deficit
Interest
rate
S2
C
6%
5%
A
B
Supply, S 1
1. A budget deficit
decreases the
supply of loanable
funds by $70 million
for any interest rate ...
2. ... which
raises the
equilibrium
interest rate ...
Demand
0
$50 $80
$120
Loanable funds
(in millions of dollars)
3. ... and reduces the equilibrium
quantity of loanable funds, but by
less than $70 million.
When the government spends more than it receives, the resulting budget deficit lowers national
saving – compared to a balanced budget situation. The supply of loanable funds decreases from
S1 to S2 and, as a consequence, the equilibrium interest rate rises and the quantity of loanable
funds saved and invested falls.
crowding out effect
a decrease in private
investment resulting
from government
borrowing
thereby, in the supply of loanable funds. Because the budget deficit does not, in a major way,
influence the amount that households and firms want to borrow to finance investment at
any given interest rate, it does not alter the demand for loanable funds.
Second, which way does the supply curve shift? When the government moves from
a balanced budget to a budget deficit, public saving becomes negative and this reduces
national saving. In other words, when the government borrows to finance its budgetary
shortfall, it reduces the supply of loanable funds available to finance investment by
households and firms. Intuitively, the deficit sucks up some of the funds that would
otherwise be available for investment. Thus, a budget deficit shifts the supply curve for
loanable funds to the left from S1 to S2 in Figure 8.5.
Third, we compare the old equilibrium with the new one. In the figure, when the budget
deficit reduces the supply of loanable funds, the interest rate rises from 5 per cent to 6
per cent. This higher interest rate then alters the behaviour of the households and firms
that participate in the loan market. In particular, some demanders of loanable funds are
discouraged by the higher interest rate. Fewer families buy new homes and fewer firms
choose to build new factories.
This fall in private investment due to government borrowing is called the crowding out
effect. It is represented in the figure by the movement along the demand curve between
points A and C from a quantity of $120 million to $80 million. That is, when the government
borrows to finance its budget deficit, it crowds out private borrowers who are trying to
finance investment. But it should be noted that the higher interest rate leads to an inflow of
additional saving in the market (a movement along the new supply curve from point B to C),
which partly offsets the drop in public saving.
186
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 4 The real economyCopyright
in the long
run
08_Stonecash_8e_45658_SB_txt.indd 186
24/08/20 4:33 PM
Thus, one of the basic lessons about budget deficits follows directly from their effects on
the supply of and demand for loanable funds – when the government reduces national saving
by running a budget deficit, the real interest rate rises and investment falls. Because private
investment is important for long-run economic growth, frequent and large government
budget deficits tend to reduce the economy’s growth rate. It should, however, be said
that while most economists would agree with this conclusion under normal economic
circumstances, they would argue that in some situations the economy may respond
differently. For example, some economists point to the post-Global Financial Crisis period
of 2008–16, in which budget deficits in countries like the United States, Japan and Australia
did not lead to higher interest rates. Likewise, with the stimulus to the economy during the
coronavirus crisis – most economists agree that this will not lead to an increase in interest
rates. You will find out why this may be the case in chapter 7, which discusses the so-called
‘liquidity trap’.
FYI
Why, you might ask, does a budget deficit affect the supply of loanable funds, rather
than the demand for them? After all, the government finances a budget deficit by selling
bonds, thereby borrowing from the private sector. Why does increased borrowing from
the government shift the supply curve, while increased borrowing by private investors
shifts the demand curve? The model as presented here takes the term ‘loanable funds’
to mean the flow of resources available to fund private investment; thus, a government
budget deficit reduces the supply of loanable funds. If, instead, we had defined the term
‘loanable funds’ to mean the flow of resources available from private saving, then the
government budget deficit would increase demand rather than reduce supply. Changing
the interpretation of the term would cause a semantic change in how we described
the model, but the bottom line from the analysis would be the same. In either case, a
budget deficit increases the interest rate, thereby crowding out private borrowers who
are relying on financial markets to fund private investment projects.
CHECK YOUR UNDERSTANDING
Assume the Australian government wants to increase human capital by providing an
additional $1.5 billion dollars to fund tertiary education. Assuming there is no change in
tax revenues, what happens to the demand for and supply of loanable funds? How will this
affect the real interest rate and the quantity of investment? Is the change in equilibrium
investment the same, more or less than the initial change (horizontal shift) in government
spending? Why? Demonstrate your answers using a diagram.
So far, we have examined a budget deficit that results from an increase in government
spending, but a budget deficit that results from a tax cut has similar effects. A tax cut reduces
public saving, T − G. Private saving, Y − T − C, might increase because of lower T. But as long
as households respond to the lower taxes by consuming more, C increases, private saving
rises by less than public saving and their sum, national saving (S = Y − C − G), declines. Once
again, the budget deficit reduces the supply of loanable funds, drives up the interest rate
and crowds out borrowers trying to finance investments.
187
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole
or in
WCN
02-200-202and the financial system
Chapter
8 part.
Saving,
investment
08_Stonecash_8e_45658_SB_txt.indd 187
24/08/20 4:33 PM
CASE
STUDY
public debt
the amount owed by a
country’s government
Government debt and the sustainability of public finances
The word ‘debt’ has recently become one of the most commonly used economic terms.
Many observers argue that excessive debt of households, banks and governments
was one of the causes of the 2008 Global Financial Crisis, possibly the main one. The
subsequent debt crises in several European countries and the ‘fiscal cliff’ or the ‘debt
ceiling’ negotiations in the US all attracted the attention of the media and were closely
watched by investors. Has all this attention been justified?
Yes and no. Yes, because too much debt creates economic imbalances, and can
thus cripple an economy with dire consequences for the wellbeing of individuals. No,
because much of the debt focus has been misplaced, with policymakers putting out
current ‘debt fires’ rather than implementing reforms that prevent future ‘debt blazes’.
Earlier in this chapter we discussed the danger of excessively risky behaviour and
indebtedness on the part of banks and other financial institutions. Let’s now focus on
public debt, which is the amount of money that a country’s government officially owes
to its creditors. Obviously, as the government does not have any money of its own, the
country’s taxpayers are ultimately liable for this debt.
Let’s first look at the ‘yes’ part, using Greece as a recent example of damaging public
debt. Due to three decades of excessive government spending (and indirectly also
the effects of the introduction of the euro), the public debt of Greece in 2013 reached
175 per cent of its gross domestic product. (Contrast this with Australia, where we
had a debt level of 18.9% of GDP or around $326bn.) This is despite repeated financial
support from other European Union countries and international organisations.
Excessive public debt has led to low confidence of investors and households, and a
need for sudden drastic expenditure cutbacks (the so-called ‘austerity measures’).
These in turn have greatly contributed to a deep economic downturn with
unemployment rates above 24 per cent, and even 50 per cent among young people in
2016. The financial and social burden of these outcomes on Greek citizens and society
is enormous and long-lasting.
Now turn to the ‘no’ part. What many people do not realise is that most advanced
countries may follow in Greece’s footsteps and experience a debt crisis within one or
two generations if they do not adjust their current policies. You may be hesitant to
believe this claim, so let us support it with numbers. Figure 8.6 shows public debt for
selected countries as a proportion of GDP. We can see that for many countries, debt
is high – close to, or more than, 100 per cent of GDP. Economic theory explains why
there is no universal threshold debt level above which a country goes bankrupt; there
are many specific factors at play. But the examples of Russia in 1998 and Argentina
in 2001, both experiencing solvency crises with public debt of less than 80 per cent of
GDP, suggest policymakers would be ill-advised to ignore accelerating public debt.
Unfortunately, this is exactly what has been happening. What Figure 8.6 does not
show is that most countries are predicted to see sizable increases in their public debt
in the next few decades. What is the reason for such pessimistic debt projections? A
large part of the story is the observed demographic trend of ‘ageing populations’. It is
well documented that increases in incomes and prosperity are associated with people
having fewer children and higher life expectancy. These trends, however, lead to
decreases in the ratio of workers per retiree. Half a century ago this ratio was between
6 and 7 in high-income countries, whereas now it is about half that, and within the next
40 years this ratio is predicted to fall below 2 in most rich countries. To appreciate this,
Figure 8.7 presents the old-age dependency ratios – the proportion of population aged
65 or more relative to population aged 15–64. It shows the predicted trend towards an
older population.
By itself, such demographic shifts would not pose a major problem since labour
and capital markets can adapt to expected trends. The problem lies in the pay-as-yougo system of public finances where government expenditures are paid for by the tax
revenues in the same year. A reduction in the worker-per-retiree ratio means higher
expenditures on pensions and health care, but lower tax revenues. This makes it
188
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 4 The real economyCopyright
in the long
run
08_Stonecash_8e_45658_SB_txt.indd 188
24/08/20 4:33 PM
FIGURE 8.6 Gross public debt – selected countries (% of GDP, estimate for 2017)
Gross Public Debt - selected countries (% of DGP, estimate for 2017)
Japan
237.6
Greece
181.8
Lebanon
146.8
Italy
131.8
Congo, Republic of the
130.8
Singapore
111.1
Jamaica
101
Belize
99
France
96.8
Syria
94.8
Canada
89.7
United States
78.8
Vietnam
58.5
Fiji
48.9
Australia
40.8
New Zealand
31.7
Saudi Arabia
17.2
Country
0
0
50
100
150
200
250
Source:Data: CIA The World Factbook
FIGURE 8.7 Ageing populations: old-age dependency ratios for selected countries
80
Old-age dependency ratio (in %)
70
60
China
Japan
50
India
40
Italy
Germany
30
United States
20
Australia
10
19
5
19 0
5
19 5
6
19 0
6
19 5
7
19 0
7
19 5
8
19 0
8
19 5
9
19 0
9
20 5
0
20 0
0
20 5
1
20 0
1
20 5
2
20 0
2
20 5
3
20 0
3
20 5
4
20 0
4
20 5
5
20 0
5
20 5
6
20 0
6
20 5
70
20
7
20 5
8
20 0
8
20 5
9
20 0
9
21 5
00
0
Each line shows the proportion of the population aged 65 and above, relative to population
aged 15–64; the 1960–2014 period shows actual data, years from 2015 show predicted data.
Source: Data: United Nations, http://data.un.org
harder for the government to balance its books. The demographic trends thus imply
growing budget deficits and public debt in the next several decades, and increasing
likelihood of a future debt crisis.
In this context, many economists, most notably Professor Laurence Kotlikoff from
Boston University and his co-authors, have argued that the official measures of public
189
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole
or in
WCN
02-200-202and the financial system
Chapter
8 part.
Saving,
investment
08_Stonecash_8e_45658_SB_txt.indd 189
24/08/20 4:33 PM
debt are misleading. They underestimate the true extent of the debt problem by
omitting many future items to which governments have committed, like future public
pension liabilities. These authors therefore advocate a more comprehensive debt
measure, the so-called ‘fiscal gap’, which is the present value difference between all
projected future government spending and revenue.
For example, in the United States as of 2015, the authors calculate the fiscal gap to
be around US$210 trillion, which is much higher than the official government debt of
around US$19 trillion! And the fiscal gap tends to rise rapidly as the large cohort of ‘baby
boomers’ approaches retirement. In addition, uncertainty about the future of public
finances may lead to many related problems: for example, higher and more variable
inflation resulting from excessive money printing (see the 1981 study by Tom Sargent
and Neil Wallace or research by Eric Leeper). For all these reasons, 17 Nobel Laureates
and many others endorse the INFORM Act, a bipartisan bill which would require key
public institutions in the US to report fiscal gap accounting annually.
In summary, the above developments call for a major reform of public finances
in most high-income countries that would put them (especially their pension and
health care systems) on a sustainable path. Nevertheless, for political reasons only a
handful of countries have attempted to seriously and conceptually tackle this longterm problem. Kotlikoff compares the situation to ‘a cancer patient whose tumour is
growing, but whose doctors are too afraid to operate because the patient doesn’t like
pain’. Instead, politicians have engaged in short-sighted austerity measures in the form
of arbitrary budget cuts that increase economic uncertainty and often turn out to be
counter-productive by undermining economic growth.
This is reflected in the reputable Global Risks Reports by the World Economic
Forum, whereby over 500 experts evaluate the main risks facing the world. Out of the
several dozen economic, geopolitical, societal, environmental and technological risks,
‘fiscal crises’ were ranked the no. 1 global risk in terms of the predicted financial losses
as recently as 2014! Australia is in a much better situation than most other high-income
countries, due to a lower level of existing debt, the pension reform in the early 1990s,
and relatively high fertility and immigration. However, it is still likely to face some fiscal
challenges in the future due to an ageing population.
Like most policy debates, the debate over government budgets and debt has
many facets. But the basic elements of this debate should already be clear. Whenever
policymakers consider the government’s budget and its impact on the economy,
foremost in their minds should be saving, investment and interest rates, as well as the
long-term sustainability of public finances.
Sources: Laurence Kotlikoff, ‘America’s Hidden Credit Card Bill’, The New York Times, 31 July 2014,
http://www. nytimes.com/2014/08/01/opinion/laurence-kotlikoff-on-fiscal-gap-accounting.html;
http://www.theinformact.org
Questions
1 Why is rising public debt a risk to the economy?
2 Why are demographic trends important for understanding a country’s debt
level? Explain.
CHECK YOUR UNDERSTANDING
Watch the video-interview of Dr Jan Libich with Dr Stephen Kirchner titled ‘The Public Debt
Crisis and Fiscal Solutions’ (http://youtu.be/4XW4J3oTCig). Summarise the debt problem
facing advanced countries, and suggest some possible solutions.
190
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 4 The real economyCopyright
in the long
run
08_Stonecash_8e_45658_SB_txt.indd 190
24/08/20 4:33 PM
Conclusion
‘Neither a borrower nor a lender be’, Polonius advises his son in Shakespeare’s Hamlet. If
everyone followed this advice, this chapter would have been unnecessary. Few economists
would agree with Polonius. In our economy, people borrow and lend often, and usually for
good reason. You may borrow one day to start your own business or to buy a home. And
people may lend to you in the hope that the interest you pay will allow them to enjoy a
more prosperous future, e.g. retirement. The financial system has the important job of
coordinating all this borrowing and lending activity.
In many ways, financial markets are like other markets in the economy. The price of
loanable funds – the interest rate – is governed by the forces of supply and demand, just as
other prices in the economy are. When financial markets bring the supply of and demand
for loanable funds into balance, they help allocate the economy’s scarce resources to their
most efficient uses.
In one way, however, financial markets are special. Financial markets, unlike most
other markets, serve the important role of linking the present and the future. Those who
supply loanable funds – savers – do so because they want to convert some of their current
income into future purchasing power. Those who demand loanable funds – borrowers – do so
because they want to invest today in order to have additional capital in the future to produce
goods and services. Thus, financial markets are important not only for current generations,
but also for future generations who will inherit many of the resulting benefits.
But the Global Financial Crisis of 2008 gave arguments to those economists and
policymakers who see ‘something wrong’ with the incentives and behaviour of certain
financial institutions. Our discussion of government bailouts mentioned excessive risktaking and gambling with taxpayers’ money. Given the importance of financial markets for
the running of the economy, we will revisit these issues in later chapters.
191
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole
or in
WCN
02-200-202and the financial system
Chapter
8 part.
Saving,
investment
08_Stonecash_8e_45658_SB_txt.indd 191
24/08/20 4:33 PM
STUDY TOOLS
Summary
LO8.1 The Australian financial system is made up of many types of financial institutions, like
the bond market, the stock market, banks and managed funds. All these institutions act
to direct the resources of households who want to save into the hands of households
and firms who want to borrow.
LO8.2 National income accounting identities reveal some important relationships among
macroeconomic variables. In particular, for a closed economy, national saving must
equal investment. Financial institutions are the mechanism through which the economy
matches one person’s saving with another person’s investment.
LO8.3 The real interest rate is determined by the supply of and demand for loanable funds.
The supply of loanable funds comes from households who want to save some of their
income. The demand for loanable funds comes from households and firms who want to
borrow for investment. To analyse how any policy or event affects the interest rate, one
must consider how it affects the supply of and demand for loanable funds.
LO8.4 National saving equals private saving plus public saving. A government budget deficit
represents negative public saving and, therefore, reduces national saving and the
supply of loanable funds available to finance private investment. This usually crowds out
private investment and reduces the growth of GDP and productivity.
Key concepts
bond, p. 169
budget deficit, p. 178
budget surplus, p. 178
crowding out effect, p. 186
demand for loanable funds, p. 181
financial intermediaries, p. 173
financial markets, p. 169
financial system, p. 168
managed fund, p. 173
market for loanable funds, p. 179
national income accounts, p. 177
national saving (saving), p. 177
private saving, p. 178
public debt, p. 188
public saving, p. 178
shares, p. 170
supply of loanable funds, p. 180
Practice questions
Questions for review
1
2
3
4
5
6
Highlight the importance of the financial system. Why is it crucial for a country’s long-run
economic growth? Describe two types of financial intermediaries.
What is national saving? What is private saving? What is public saving? Why must S = I
(savings equals investment) in a closed economy?
How does an economist’s definition of investment differ from the ordinary usage of
the term?
Describe a change in the tax laws that might decrease private saving. If this policy were
implemented, how would it affect the market for loanable funds?
What are the differences between (government) budget surplus and budget deficit? How do
these affect interest rates, investment and economic growth?
Consider an increase in the supply for loanable funds. What will happen to the equilibrium
quantity of national saving and investment? Will these quantities change by more or by less
than the initial change (horizontal shift) in the supply? Carefully explain.
Multiple choice
1
Tony wants to buy and operate an ice-cream truck but doesn’t have the financial resources
to start the business. He borrows $20 000 from his brother Terry, to whom he promises
a nominal interest rate of 6.5 per cent. He further gets another $10 000 from his friend
Travis, to whom he promises a third of his profits. What best describes this situation?
a Terry is a stockholder, and Tony is a bondholder.
b Terry is a stockholder, and Travis is a bondholder.
192
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 4 The real economyCopyright
in the long
run
08_Stonecash_8e_45658_SB_txt.indd 192
24/08/20 4:33 PM
c Travis is a stockholder, and Tony is a bondholder.
d Travis is a stockholder, and Terry is a bondholder.
2 If the government collects more in tax revenue than it spends, and households consume
more than they get in after-tax income, then
a private and public saving are both positive.
b private and public saving are both negative.
c private saving is positive, but public saving is negative.
d private saving is negative, but public saving is positive.
3 A closed economy has income of $1100, government spending of $300, taxes of $250 and
investment of $350. What is private saving?
a $200
b $300
c $400
d $500
4 If a popular TV show on personal finance convinces Australians to save more for retirement,
the ___________ curve for loanable funds would shift, driving the equilibrium interest rate
___________ .
a supply, up
b supply, down
c demand, up
d demand, down
5 If the business community becomes more optimistic about the profitability of capital,
the _________ curve for loanable funds would shift, driving the equilibrium interest
rate __________.
a supply, up
b supply, down
c demand, up
d demand, down
6 After the Global Financial Crisis of 2008, the ratio of government debt to GDP in Australia
and most other countries
a increased markedly.
b decreased markedly.
c was stable at a historically high level.
d was stable at a historically low level.
Problems and applications
1
2
3
4
For each of the following pairs, which bond would you expect to pay a higher interest rate?
Explain.
a A bond of the Australian government or a bond of a government in a war-torn country
b A bond that repays the principal in the year 2030 or a bond that repays the principal in
the year 2040
c A bond from the Coles Group or a bond from a software company your friend runs in
his garage
d A bond issued by the federal government or a bond issued to finance the construction
of a new airport for Brisbane
Using some online sources, find information on the main credit rating agencies. Are they
public or private? What was the controversy regarding their role in the lead-up to the
2008 Global Financial Crisis? Has there been any reforms of the rating agencies? Can you
propose some?
Following the collapse of Lehman Brothers in September 2008, banks in Australia did not
lower the interest they charged for home loans to the same extent that the Reserve Bank
of Australia lowered its cash rate target. They argued that their cost of capital – that is, what
they had to pay to borrow money on the world’s financial markets – had increased. Use the
loanable funds model to explain why banks may have been justified in doing this.
Using some online data, compare the return on an actively managed mutual fund with
the return on a passive index fund (to minimise the effect of luck, it is better to compare a
longer time period). What could explain the differences?
193
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole
or in
WCN
02-200-202and the financial system
Chapter
8 part.
Saving,
investment
08_Stonecash_8e_45658_SB_txt.indd 193
24/08/20 4:33 PM
5 Many workers hold large amounts of shares issued by the firms at which they work. Why do
you suppose companies encourage this behaviour? Can you see any problems with that?
6 Two investors are discussing their investment strategies. One says she always looks for
companies that seem to have good prospects, but have low price–earnings ratios. The
other says he only invests in shares of companies that are in strongly growing industries.
What are the merits of each investment strategy? What are the pitfalls?
7 Explain the difference between saving and investment as used by a macroeconomist.
Which of the following situations represent investment? And which saving? Explain.
a Your family refinances their mortgage to buy a new car.
b You use your $350 pay cheque to buy shares in Apple Inc.
c Your sister earns $150 and deposits it in her bank account.
d You borrow $1500 from a bank to buy a scooter to use as an Uber Eats delivery driver.
8 If more Australians adopted a ‘live for today’ approach to life, and borrowed heavily to
finance higher consumption (or purchases of investment properties), how would this affect
saving, investment and the real interest rate?
9 Suppose the government borrows $7 billion more next year than this year (for example,
they move from a balanced budget to a $7 billion deficit or from a $10 billion deficit to a
$17 billion deficit).
a Use a supply-and-demand diagram to analyse this policy. What happens to the interest
rate?
b What happens to investment? To private saving? To public saving? To national saving?
Compare the size of the equilibrium changes with the $7 billion of extra borrowing. Is it
the same, less or more? Carefully explain why and distinguish the various movements in
the diagram.
c How do the elasticities of supply of and demand for loanable funds (i.e. the slopes of
the curves) affect the size of these changes? (Hint: See chapter 2 to review the definition
of elasticity.)
d Suppose households believe that greater government saving today implies lower future
taxes since there will be little government debt. What does this belief do to private
saving and the supply of loanable funds today? Does it increase or decrease the effects
you discussed in parts (a) and (b)?
10 What are the reasons behind the demographic trend of an ageing population? What are
its economic implications? Can you think of some political implications as well? In terms
of the latter, Lenten and Libich propose (Australian Financial Review, 19 February 2016)
a slight deviation from Australia’s compulsory voting by making it optional for those
reaching retirement age. What do you think motivates the proposal? Can you think of some
alternative policies that may achieve a similar outcome?
194
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 4 The real economyCopyright
in the long
run
08_Stonecash_8e_45658_SB_txt.indd 194
24/08/20 4:33 PM
9
The natural rate
of unemployment
Learning objectives
After reading this chapter, you should be able to:
LO9.1find out what unemployment means, what the natural rate of unemployment is,
and discuss its various types and causes
LO9.2how ‘classical’ unemployment can result from the real wage being too high due
to minimum-wage laws, union wage bargaining, or efficiency wages
LO9.3get to know how ‘frictional’ unemployment is driven by the process of job search
LO9.4discover how ‘structural’ unemployment arises in the labour market from a
mismatch between the skills that workers have and the skills that employers need.
195
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
09_Stonecash_8e_45658_SB_txt.indd 195
24/08/20 4:33 PM
Introduction
natural rate of
unemployment
unemployment
accounted for by
longer-term (not
cyclical) factors
cyclical
unemployment
the short-term
deviations of
unemployment from
its natural rate due
to the business cycle
196
Losing a job can be the most distressing economic event in a person’s life. Most people
rely on their work not only to maintain their standard of living and make their monthly
mortgage repayments, but also to get a sense of personal accomplishment. A job loss means
a lower level of prosperity in the present, anxiety about the future and possibly reduced selfesteem. It is not surprising, therefore, that politicians, campaigning for office, often speak
about how their proposed policies will help create jobs.
In the last two chapters, we have seen some of the forces that determine the growth of
a country’s GDP and the standard of living. For instance, a country that saves and invests
a good fraction of its income enjoys more rapid growth in its physical and human capital,
and subsequently in its GDP, than a similar country that saves and invests less. An even
more obvious determinant of a country’s standard of living is the amount of unemployment
it typically experiences. People who would like to work but cannot find a job are not
contributing to the economy’s production of goods and services. Although some degree of
unemployment is inevitable in a complex economy with thousands of firms and millions of
workers searching for their dream job, the amount of unemployment varies substantially
over time and across countries.
When a country’s workers are fully employed, the country achieves a higher level of GDP
than if many of its workers stood idle. On the other hand, you know from the chapter on
economic growth that not all jobs are created equal, and the workers’ productivity matters
a great deal for their prosperity. In countries, like Cuba, United Arab Emirates and Kuwait,
where over 80 per cent of the nationals work in the public sector, labour productivity tends
to be lower than in countries with a much smaller share of public sector jobs. For example,
Australia’s figure is 18 per cent, New Zealand is 12 per cent, and Singapore, Japan and South
Korea have less than 10 per cent public sector employment.
Given the importance of employment for prosperity, this chapter provides some insights
into the labour market with a focus on the driving forces behind unemployment. They
can be separated into two broad categories – long term and short term. The economy’s
natural rate of unemployment relates to the long-term perspective and describes the
amount of unemployment that the economy normally experiences. Conversely, cyclical
unemployment refers to the short-run fluctuations in unemployment around its natural
rate and it is closely associated with the short-run ups and downs of economic activity
during the business cycle. Cyclical unemployment has its own explanations, which we defer
until we study short-run economic fluctuations later in the book.
In this chapter we discuss the determinants of an economy’s natural rate of
unemployment. It is often referred to as the ‘non-accelerating-inflation rate of
unemployment’ (NAIRU), or the level at which the economy is at ‘full employment’.
As we will see, the designation ‘natural’ does not in any way imply that this rate of
unemployment is desirable or inevitable. It just means that this natural unemployment
does not go away on its own, even in the long run. So, it is important to keep in mind that the
term full employment does not mean that all people willing to work actually have a job.
We begin the chapter by looking at some of the relevant facts that describe
unemployment. In particular, we examine three questions: How do we measure
the economy’s rate of unemployment? What problems arise in interpreting the
unemployment data? How long are the unemployed typically without work? We then
turn to the reasons why economies always experience some unemployment and the
ways in which policymakers attempt to reduce the number of people without jobs.
We discuss three components of the natural rate of unemployment: structural, frictional
and classical. Structural unemployment arises from a skill mismatch: The skills some workers
have differ from those employers need. Frictional unemployment occurs when workers are
searching for a new job and are temporarily unemployed in the meantime. Finally, classical
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 4 The real economyCopyright
in the long
run
09_Stonecash_8e_45658_SB_txt.indd 196
24/08/20 4:33 PM
unemployment arises when the real wage in the labour market is too high for employers to
be able to hire all the workers willing to work at that wage. We examine three reasons for
why the real wage may be too high and not adjusted to balance labour supply and demand,
namely minimum-wage laws, unions and efficiency wages.
You will see that long-run unemployment does not arise from a single problem. Instead,
it reflects a variety of underlying causes. As a result, there is no easy way for policymakers
to eliminate the economy’s natural rate of unemployment and to alleviate the hardships
experienced by the unemployed.
LO9.1 Identifying unemployment
We begin this chapter by examining more precisely what the term unemployment means.
How is unemployment measured?
Measuring unemployment in Australia is the job of the Australian Bureau of Statistics
(ABS). Every month the ABS produces data on unemployment and on other aspects of
the labour market, like types of employment, length of the average working week and the
duration of unemployment. These data come from a regular survey of around 0.33 per cent
of the civilian population aged 15 years and over, called the Labour Force Survey. Based on
the answers to the survey questions, the ABS places each such individual in each surveyed
household into one of three categories:
• employed
• unemployed
• not in the labour force.
A person is considered employed if he or she spent at least one hour of the previous week
working at a paid job (including self-employment) or family business. For a person to be
classified as unemployed a key criterion is that he or she is actively looking for a job; not
having a job is insufficient. The exceptions are people who are on a temporary layoff and
waiting to start a new job. A person who is neither employed nor unemployed falls in the
third category with a somewhat odd name, not in the labour force. This includes groups
inactive in the labour market like full-time students, stay-at-home parents, the disabled and
retirees. Figure 9.1 shows this breakdown for October 2019.
Once the ABS has placed all the individuals covered by the survey in a category, it
calculates various statistics to summarise the state of the labour market. Let us consider the
key ones. The ABS defines the labour force as the sum of the employed and the unemployed:
Labour force = Number of employed + Number of unemployed
The ABS defines the unemployment rate as the proportion of the labour force (not the
entire adult population) that falls in the unemployed category:
Unemployment rate =
Number of unemployed
× 100
Labour force
The ABS calculates unemployment rates for the entire adult population and for more
narrow groups – men, women, youth and so on. The ABS uses the same survey to produce
data on labour-force participation. The labour-force participation rate is the percentage of
the total adult population that is either employed or unemployed:
Labour-force participation rate =
Labour force
× 100
Adult population
labour force
the total number of
workers, including
both the employed
and the unemployed
unemployment rate
the percentage of
the labour force that
is unemployed
labour-force
participation rate
the proportion of the
adult population that
is in the labour force
This statistic tells us the fraction of the population that has chosen to participate in
the labour market, so its numerator includes the unemployed as well. The labour-force
participation rate, like the unemployment rate, is calculated both for the entire adult
population and for more narrow groups.
197
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or inChapter
part. WCN
02-200-202
9 The
natural rate of unemployment
09_Stonecash_8e_45658_SB_txt.indd 197
24/08/20 4:33 PM
FIGURE 9.1 The breakdown of the adult population in terms of the labour market (October 2019)
Employed
(12 935 693)
Labour force
(13 658 083)
Adult
population
(20 680 657)
Unemployed (722 390)
Not in labour force
(7 022 574)
The ABS divides the adult population into three categories – employed, unemployed, and not in
the labour force.
Source: Based on statistical data from the ABS, Cat. No. 6202.0
To see how these data are calculated, consider the figures for October 2019. The adult
population was about 20.68 million, out of which about 12.94 million people were employed
and 0.72 million people were unemployed. These numbers imply the following:
Labour Force participation rate =
13.66
× 100 = 66.1
20.68
Labour Force = 12.94 + 0.72 = 13.66
0.72
Unemployment rate =
× 100 = 5.3%
13.66
Hence, in October 2019, about two-thirds of the Australian adult population were
participating in the labour market and one in 19 of them (5.3 per cent) was unemployed.
Table 9.1 shows the statistics on unemployment and labour-force participation for various
groups within the Australian population. Three comparisons are most apparent. First, women
have lower rates of labour-force participation than men (although as you will see later, the
difference has been getting smaller and it is reversed in the youth cohort). Second, once
in the labour force women and men have similar rates of unemployment. Third, migrants
to Australia have slightly higher unemployment and participation rates than the overall
population. Fourth, teenagers have much lower rates of labour-force participation and much
higher rates of unemployment than the overall population. More generally, these data show
that labour-market experiences vary widely among groups within the economy.
It should be mentioned that the basic labour market statistics summarise the situation
in a given point in time (i.e. they are stock variables); they do not show the dynamic story
of people moving between the three main categories (i.e. the flows). For example, even if the
number of employed and unemployed people remains unchanged, there are always people
who get a new job. This may be either within the employed category (people changing
between jobs) or from the unemployed category (formerly unemployed people replacing
some formerly employed people).
198
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 4 The real economyCopyright
in the long
run
09_Stonecash_8e_45658_SB_txt.indd 198
24/08/20 4:33 PM
Demographic group
Unemployment rate (in %)
Labour-force participation
rate (in %)
Adults (aged 15 and over)
Total
5.3
66.1
Male
5.4
71.1
Female
5.2
61.3
Recent migrants and
temporary residents *
7.4
69.8
Total
17.7
55.0
Male
19.7
53.4
Female
15.7
56.6
Teenagers (aged 15–19)
Source: ABS DATA, cat. 6202.0, Tables 1, 17, Cat. 6250.0, Table 5
TABLE 9.1 The labour-market experiences of various demographic groups (May 2016)
*denotes June 2017 data
In recent years, economists and policymakers have become concerned about how many
hours employed people are working and whether the labour force is underutilised – that is,
people working less than they could or would like to. They attempt to explain the seemingly
contradictory phenomenon of the past three decades whereby both full-time and parttime workers work longer hours than before, but the average number of hours worked per
employed person has trended downwards. How can it be?
Essentially, more and more people are working part-time rather than full-time,
which more than offsets the fact that both full-time and part-time workers are working
longer hours. ABS surveys suggest that while most part-time workers are happy with
their reduced workload, about a quarter of them would prefer to work more hours. These
workers are classified as underemployed. ABS data show a worrying trend, namely that the
underemployment rate increased from 2.6 per cent in early 1978 to 8.5 per cent in October
2019. As Professor Jeff Borland documents in his 2016 survey of the Australian labour market
(Labour market snapshot #25, March 2016), the largest increases in underemployment have
occurred among young workers aged 15–24 years, from about 3 per cent in 1978 to 17 per cent
in 2015. The underemployment rate for this age group in October 2019 was 20.7 per cent. He
also reports that ‘the incidence of part-time employment has grown particularly among the
least educated’.
The ABS also reports the labour underutilisation rate, which is the number of unemployed
plus the underemployed, as a percentage of the labour force. This rate for all the total
work force has stayed fairly constant for the last decade, from 13.2 per cent in 2009 to
13.8 per cent in 2019. If you are in the 15–24 age bracket, though, the news isn’t so good –
the underutilisation rate for this group rose from 25.7 in 2009 to 30.2 in 2019.
Policymakers and economists monitor the data on the various measures of employment
and unemployment as a way to see how the economy is performing over time. We mentioned
the natural rate of unemployment at the start of the chapter – this rate is important because
it tells us whether we are likely to see wages increase as more people find work. The RBA has
estimated that the NAIRU has declined from 6 per cent in 2003 to around 5 per cent in 2017.
What this means in practice is that more people finding jobs won’t necessarily put pressure
on wages to increase. Quoting Jeff Borland again, ‘The decline of trade unions, changes in
bargaining power suggests, if anything, you may be able to push the rate of unemployment
lower without causing a big breakout in wage inflation.’ (https://www.theguardian.com/
australia-news/2018/mar/02/who-is-to-blame-for-australias-stalled-wages)
Even though many economists think the NAIRU may be lower, this isn’t spread evenly
across all states. Figure 9.2 shows the unemployment rate for each state, along with
199
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or inChapter
part. WCN
02-200-202
9 The
natural rate of unemployment
09_Stonecash_8e_45658_SB_txt.indd 199
24/08/20 4:33 PM
an estimate of its NAIRU. Those states that have an unemployment rate close to its NAIRU
are more likely to see wages growth as employment increases.
FIGURE 9.2 Estimate of NAIRU, 2016–17 (%)
Oct 2017 unemployment rate
7
6
5
4
3
NSW
Vic
Qld
WA
SA
Tas
NT
ACT
Source: Goldman Sachs, reprinted in Australian Financial Review, ‘“Natural” unemployment rate may be lower than
Reserve Bank estimates, say economists’, 8 February 2018
Labour-force participation of men and women in the Australian
economy
The role of women in Australian society has changed dramatically over the past century.
In part, the change is due to new technologies, like the washing machine, clothes dryer,
refrigerator, freezer and dishwasher, which have reduced the amount of time required
to complete routine household tasks. In part, the change is attributable to improved
birth control, which was one of the factors behind a reduction in the number of children
born to the typical family. And, of course, the change in a woman’s role is also partly
attributable to changing political and social attitudes; for example, university degrees
becoming widely accessible to women. Together, these developments have had a
profound impact on society in general and on the economy in particular.
Nowhere is that impact more obvious than in data on labour-force participation. Just
after the Second World War, men and women had very different roles in society. Only
around 30 per cent of women were working or looking for work, in contrast to over
85 per cent of men. This is apparent
in Figure 9.3 showing the labour-force
participation rates of men and women
in Australia since 1978. Over the
past several decades, the difference
between the participation rates
of men and women has gradually
diminished as growing numbers of
women have entered the labour force
and some men have left it.
At the end of 2019, 61.3 per cent of
women and 71.1 per cent of men were
More women are working now than ever before.
in the labour force. So while labourforce participation rates are still higher
for men than women, they have been converging over time. It is most apparent in the
55–64 age category in which the participation rate for women increased from 38.3 per cent
to 59.9 per cent between 2002 and 2018.
Source: Shutterstock.com/Jacob Lund
CASE
STUDY
200
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 4 The real economyCopyright
in the long
run
09_Stonecash_8e_45658_SB_txt.indd 200
24/08/20 4:33 PM
FIGURE 9.3
Labour-force participation rates in Australia for men and women since 1978
90.0
80.0
70.0
60.0
50.0
40.0
30.0
20.0
Feb-2018
Feb-2016
Feb-2014
Feb-2012
Feb-2010
Feb-2008
Feb-2006
Feb-2004
Feb-2002
Feb-2000
Feb-1998
Feb-1996
Feb-1992
Feb-1990
Feb-1988
Feb-1986
Feb-1984
Feb-1982
Feb-1980
Feb-1978
0.0
Feb-1994
Participation rate; > Males; Percent Trend PERCENT Month
Participa0on rate; > Females; Percent Trend PERCENT Month
10.0
Over the past several decades, the proportion of Australian women who enter the labour
force has been increasing, and the proportion of such men decreasing.
Source: ABS DATA, Cat. No. 6202.0, Table 1
The increase in women’s labour-force participation is easy to understand, but the
fall in men’s may seem puzzling. There are several reasons for this decline. First, young
men now stay in school longer than their fathers and grandfathers did. Second, with
more women employed, more fathers now stay at home to raise their children (some
companies in Australia now allow men to take parental leave). Third, as the average
age in the Australian population grows due to increases in life expectancy and declines
in fertility (a trend towards an ageing population discussed in an earlier chapter), more
men move into higher age brackets where labour-force participation rates are lower. In
fact, the latter seems to be the main explanation for the recent declines in the overall
labour-force participation rate of Australian men, because over the past decade the
participation rate has increased for every individual age group.
In summary, the increases in the proportion of full-time students, stay-at-home
fathers and retirees, all of whom are counted as not in the labour force, imply a drop in
the labour-force participation rate.
Questions
1 What factors have led to the fall in men’s labour-force participation rate?
2 Will this have an impact on median income? Explain.
Is unemployment measured correctly?
Measuring the amount of unemployment in the economy is not as straightforward as it
might seem. Although it is easy to distinguish between a person with a full-time job and a
person who is not working at all, it is much harder to distinguish between a person who is
unemployed and a person who is not in the labour force.
Movements in and out of the labour force are, in fact, very common. More than one third
of the unemployed are recent entrants into the labour force. These entrants include young
201
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or inChapter
part. WCN
02-200-202
9 The
natural rate of unemployment
09_Stonecash_8e_45658_SB_txt.indd 201
24/08/20 4:33 PM
discouraged workers
individuals who
would like to work
but have given up
looking for a job
IN THE
NEWS
workers looking for their first jobs, like recent university graduates. They also include older
workers who had previously left the labour force but have now returned to look for work.
Moreover, not all unemployment ends with the job seeker finding a job. Almost half of all
spells of unemployment end when the unemployed person leaves the labour force.
Because people move in and out of the labour force so often, statistics on unemployment
are difficult to interpret. On the one hand, some of those who report being unemployed
may not, in fact, be trying very hard to find a job. They may be reporting themselves as
unemployed to qualify for one of the government programs that provide financial assistance
for the unemployed. It would be more realistic to view some of these individuals as not in
the labour force. On the other hand, some of those who are classified as not in the labour
force may, in fact, want to work. These individuals may have tried to find a job but have
given up after an unsuccessful search. Such individuals, called discouraged workers, do
not show up in unemployment statistics, even though they are truly workers without jobs.
This is a non-trivial problem in Australia. For the last five years, Australia has had over
one million people who the ABS designate as having ‘… marginal attachment to the labour
force’. These are people who are employed part-time and would like more work and have
applied for jobs, registered with job agencies and so forth. Of the one million in this category,
around 90 000 (in 2019) were designated ‘discouraged workers’ – they wanted to work but
had given up looking. For example, the total number of discouraged workers in Switzerland,
Denmark and Austria was less than 10 000 in that year – despite their combined population
being comparable to Australia’s. Even the United Kingdom, with triple the population, has
had fewer than 50 000 discouraged workers in for the last five years, with only 34 000 in
2019. One of the implications is that if all Australian discouraged workers were put into
the unemployed category, the unemployment rate would increase significantly, from 5.3 to
over 5.9 per cent as of December 2019. As the following box discusses, some believe that the
labour market situation in Australia is even worse than the OECD statistics show.
Is true Australian unemployment double the official rate?
Roy Morgan Research has conducted weekly labour market surveys in the
form of face-to-face interviews since 2007. Their estimates imply that official
unemployment statistics by the ABS may underestimate the real unemployment
rate. For example, Roy Morgan Research estimated the unemployment rate to
be 10.9 per cent in March 2019, which was over double the rate calculated by
the ABS. Roy Morgan Research further reported 9.7 per cent of the workforce to
be underemployed – working part-time but attempting to find additional work.
Using Roy Morgan Research’s methodology implies over 20 per cent of workingage Australians are either unemployed or underemployed.
Roy Morgan Research estimates are considered controversial by many, and
their accuracy disputed by the government. Nevertheless, they suggest that
various labour market statistics should be examined carefully and broadly to
get an accurate picture of employment conditions. Unfortunately, there is no
generally agreed-upon way to adjust the unemployment rate as reported by
the ABS to make it a more reliable indicator. In the end, it is best to view the
reported unemployment rate as a useful but imperfect measure of joblessness,
and use various sources for comparison.
Source: Roy Morgan Research, http://www.roymorgan.com/findings/7948-roy-morganaustralian-unemployment-march-2019-201904160632
202
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 4 The real economyCopyright
in the long
run
09_Stonecash_8e_45658_SB_txt.indd 202
24/08/20 4:33 PM
CHECK YOUR UNDERSTANDING
How do we measure the unemployment rate? Can it overstate or understate the true
amount of joblessness?
How long are the unemployed without work?
In judging how serious the problem of unemployment is, one question to consider is whether
unemployment is typically a short-term or long-term condition. If unemployment is short
term, one might conclude that it is not a big problem. Workers may require a few weeks
between jobs to find the openings that best suit their skills and tastes. Yet if unemployment
is long term, one might conclude that it is a serious problem. Workers unemployed for
many months are more likely to suffer economic shortages, skill deterioration, isolation or
psychological hardship. Research even shows that they are less likely to get married and
more likely to get divorced.
Because the duration of unemployment can affect our view about how costly
unemployment is, economists have devoted much energy to studying data on the duration
of unemployment spells. In this work, they have uncovered a result that is important, subtle
and seemingly contradictory – most spells of unemployment are short, but most unemployment
observed at any given time is long term.
To see how this statement can be true, consider an example. Suppose that you visited
an unemployment office every month for a year to survey the unemployed. Each month
you find that there are four unemployed workers. Three of these workers are the same
individuals for the whole year, whereas the fourth person changes every month. Based on
this experience, would you say that unemployment is typically short term or long term?
Some simple calculations help answer this question. In this example, you meet a total of
15 unemployed people – 12 of them are unemployed for one month and three are unemployed
for the full year. Thus, 12/15, or 80 per cent, of unemployment spells end in one month. That
is, most spells of unemployment are short. Yet consider the total amount of unemployment
at some given month. Out of the four unemployed people, three are unemployed for a full
year. This means that 75 per cent of unemployment observed at any given time is long term.
This subtle conclusion implies that economists and policymakers must be careful when
interpreting data on unemployment and when designing policies to help the unemployed.
Most people who become unemployed will soon find jobs, and they generally need little
help. Yet most of the economy’s unemployment problem is attributable to the relatively few
workers who are jobless for long periods of time.
Why is there unemployment?
Now that you have a good idea about what unemployment is and how it is measured, let us
explain why economies experience unemployment. In most markets in the economy, prices
and product features adjust to bring the quantity supplied and demanded into balance. In
an ideal labour market, wages and workers’ skills would adjust to balance the quantity of
labour supplied and the quantity of labour demanded. This adjustment of wages and skills
would ensure that all workers are always fully employed.
Of course, reality does not resemble this ideal. There are always some workers without
jobs, even when the overall economy is doing well. In other words, the natural unemployment
rate never falls to zero; instead, it fluctuates around the natural rate of unemployment.
Three types of unemployment help explain why natural unemployment never falls to zero.
203
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or inChapter
part. WCN
02-200-202
9 The
natural rate of unemployment
09_Stonecash_8e_45658_SB_txt.indd 203
24/08/20 4:33 PM
One is frictional unemployment. This is unemployment associated with job search – people
being temporarily unemployed while they look for a new job. This type of unemployment
is usually of a short duration for the individual, but from the society’s point of view it is a
long-term phenomenon as there are always such workers in between jobs.
Another type of unemployment is called structural unemployment. This is unemployment
that results from a mismatch between the skills that businesses require and the skills that
workers have. Austrian-American economist Joseph Schumpeter called the dynamic process
within markets ‘creative destruction’, whereby new ideas, products and jobs constantly
replace the old ones. Structural unemployment tends to be longer in duration because it
takes time for people to acquire new skills that the labour market demands.
The third type of unemployment is called classical unemployment. It arises because the
real wage in the labour market is above the market clearing level that equates supply of and
demand for labour. In the next section we will examine three reasons for such high wage
unemployment, namely minimum-wage laws, unions and efficiency wages.
LO9.2 Classical unemployment
The real wage that occurs in the labour market may sometimes be too high to equate
supply of and demand for labour. For example, Guy Debelle and James Vickery estimated for
Australia that ‘slower real wage growth of 2 per cent below trend for one year could result
in a permanent reduction in the unemployment rate of about one percentage point’ (RBA
Conference 1998, ‘The Macroeconomics of Australian unemployment’, https://www.rba.
gov.au/publications/confs/1998/debelle-vickery.html). The following sections present
three main reasons for an above-equilibrium wage, and show how they lead to what is called
classical (or real-wage) unemployment.
Minimum-wage laws
We begin by reviewing how unemployment arises from minimum-wage laws. It is a natural
place to start because, as we will see, it can be used to understand some of the other reasons
for unemployment. Figure 9.4 reviews the basic economics of a minimum wage. When
a minimum-wage law forces the wage to remain above the level that balances supply
and demand, it raises the quantity of labour supplied and reduces the quantity of labour
demanded compared with the equilibrium level. There is a surplus of labour, that is, classical
type unemployment. There are more workers willing to work than there are jobs, and some
workers are therefore unemployed.
Minimum-wage laws create a gap between supply and demand for labour. We focus here
on their effect in the labour market. Before doing so, it is however important to note that
minimum-wage laws are not a predominant reason for unemployment. It is because most
workers in the economy earn higher wages. Minimum-wage laws are binding most often for
the least skilled and least experienced members of the labour force so it is only among these
workers that minimum-wage laws may explain the existence of unemployment.
Although Figure 9.4 was drawn to show the effects of a minimum-wage law, it
demonstrates a more general lesson – if the wage is kept above the equilibrium level for any
reason, the result is classical unemployment. Minimum-wage laws are just one reason that
wages may be ‘too high’.
We can break down the quantity LS into the following three categories. First, the quantity
of labour LD are workers who have kept their jobs and now enjoy a higher wage than before.
Due to a higher income these workers are better off. Second, the quantity LE – LD are workers
204
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 4 The real economyCopyright
in the long
run
09_Stonecash_8e_45658_SB_txt.indd 204
24/08/20 4:33 PM
FIGURE 9.4 Unemployment resulting from minimum wage legislation forcing wages above
the equilibrium level
Wage
Labour
supply
Surplus of labour classical unemployment
Minimum
wage
WE
Labour
demand
0
LD
LE
LS
Quantity of
labour (in hours)
In this labour market, the (real) wage at which supply and demand balance is WE. At this
equilibrium wage, the quantity of labour supplied and the quantity of labour demanded both
equal LE. In contrast, if the wage is forced to remain above the equilibrium level, perhaps
because of a minimum-wage law, the quantity of labour supplied rises to LS, and the quantity
of labour demanded falls to LD. The resulting excess supply of labour, LS–LD, represents classical
unemployment.
who had a job before the minimum wage was implemented, but lost it as a consequence of
this law. They are undoubtedly worse off than before. Third, the quantity LS – LE are new
entrants. These workers were not in the labour force at the equilibrium wage WE, but were
attracted by the higher minimum wage. Nevertheless, given the surplus of labour they are
unable to find a job at this wage so they are also arguably worse off than before.
Australia has a system of minimum wages that take the form of awards. These are
minimum wage levels that are set for certain jobs in broad industry categories. So, in
contrast to a simple minimum wage, the award system affords some flexibility to take into
account differences in industry conditions and job skills.
In the next two sections, we consider two other reasons that may keep wages above the
equilibrium level – unions and efficiency wages. The basic economics of unemployment
in these cases is the same as that shown in Figure 9.4, but these explanations of
unemployment can apply to many more of the economy’s workers.
CHECK YOUR UNDERSTANDING
Keynesian economists stress the fact that recipients of the higher minimum wage will
spend more, which increases demand for products and services and makes firms hire
more labour. How could you incorporate this argument into Figure 9.4? Can you think
of some other arguments and important factors not captured in the simple model
of Figure 9.4 (including those that could justify minimum wage legislation not only on
equity grounds but also on efficiency grounds)? If the level of minimum wages rises, what
happens to labour demand, labour supply and the unemployment level? Based on your
answer, do you think minimum wages should rise?
205
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or inChapter
part. WCN
02-200-202
9 The
natural rate of unemployment
09_Stonecash_8e_45658_SB_txt.indd 205
24/08/20 4:33 PM
Unions and collective bargaining
union
a worker association
that bargains with
employers over
wages and working
conditions
collective bargaining
the process by which
unions and firms
agree on the terms
of employment
In some industries, labour markets do not operate according to the simple principles of
supply and demand. In industries like transport, teaching and mining, wages are determined
by negotiations between unions and employers. A union is a type of cartel. Like any cartel,
a union is a group of sellers acting together in the hope of exerting their joint market power.
Many workers in the economy discuss their wages, benefits and working conditions with
their employers as individuals. In contrast, workers in a union do so as a group. The process
by which unions and firms agree on the terms of employment is called collective bargaining.
The role of unions has been the source of considerable debate in Australia. Every year
it seems that workers and employers in some industry, whether it be air transport, meat
processing, or the waterfront, are in a dispute. Unionisation was partly a response to very
poor working conditions in those industries. There was a time when being a member
of a union was seen as very important to achieving better work conditions. However, as
depicted in Figure 9.5, both trade union membership as a proportion of the workforce and
the numbers of workers in unions have declined over the past three decades. Young workers
are less likely to join a union, and union membership is no longer compulsory. There has
also been a decline in the sectors that have traditionally been heavily unionised, such as
car manufacturing and clothing, textile and footwear workers. There have been increases in
union membership among police, nursing and midwifery and education.
FIGURE 9.5 Unionisation rate in Australia
50
2.5
40
2.0
30
1.5
20
1.0
10
0.5
0
0
Union membership–Million
3.0
Union members (RHS)
Union density (LHS)
1976
1982
1986
1988
1990
1992
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2016
Trade union density–per cent
60
Source: Parliament of Australia, Geoff Gilfillan and Chris McGann Statistics and Mapping Section, Trends in union membership
in Australia, 15 October 2018. Based on 1976–1993: ABS, Trade Union Members, cat. no. 6325.0; 1994–2013: ABS, Employee
Earnings Benefits and Trade Union Membership, cat. no. 6310.0; 2014–2016: ABS, Characteristics of Employment, cat.
no. 6333.0[1] https://www.aph.gov.au/About_Parliament/Parliamentary_Departments/Parliamentary_Library/pubs/rp/rp1819/
UnionMembership#_Toc527380727
Unionisation varies greatly across countries. For example, in 2017–18, Scandinavian
countries such as Sweden (66%) and Denmark (67%) had high rates of unionisation,
whereas Germany (16.5%) and the United States (10.1%) had much lower rates.
The economics of unions
When a union bargains with a firm, it asks for higher wages, greater benefits and better
working conditions than the firm would offer in the absence of a union. If the union and the
firm do not reach agreement, the union can organise a withdrawal of labour from the firm,
206
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 4 The real economyCopyright
in the long
run
09_Stonecash_8e_45658_SB_txt.indd 206
24/08/20 4:33 PM
called a strike. Because a strike reduces production, sales and profit, a firm facing a strike
threat is more likely to agree to pay higher wages than it otherwise would.
When a union raises the wage above the equilibrium level, it raises the quantity of labour
supplied and reduces the quantity of labour demanded, resulting in classical unemployment.
The graphical representation is identical to the one in Figure 9.4. Those workers who remain
employed are better off, but those who were previously employed and are now unemployed
are worse off. Indeed, unions are sometimes thought to cause conflict between different
groups of workers – the insiders who benefit from high union wages and the outsiders who
do not get the better paid jobs.
The outsiders can respond to their status in one of two ways. Some of them remain
unemployed and wait for the chance to become insiders and earn the high union wage.
Others take jobs in firms that are not unionised. Thus, when unions raise wages in one part
of the economy, the supply of labour increases in other parts of the economy. This increase in
labour supply, in turn, generally reduces wages in industries that are not unionised. In other
words, it is believed that workers in unions often reap the benefit of collective bargaining,
whereas workers not in unions bear some of the cost.
The end result is that the existence of unions can cause wages to be higher in some
industries and, hence, some workers to be unemployed. However, the ability of unions to
exert this control depends on their specific goals. Many unions are explicitly concerned
about unemployment levels and are willing to negotiate wage arrangements that promote
existing employment levels. Let us give two Australian examples. During the 1980s, these
negotiations were assisted by the Hawke government, which offered workers tax cuts in
order to preserve their after-tax real incomes. Similarly, in 1992 the Keating government
introduced a pension reform and the unions agreed that a 3 per cent reduction in the pay rise
was to be put into the workers’ individual superannuation accounts.
strike
organised temporary
withdrawal of
labour from a firm
FYI
Why do strikes occur?
Strikes are costly to both firms and workers. To firms they represent lost output; to
workers lost income. The longer the strike, the costlier it is to both parties. So why do
they occur?
In reality, strikes occur because negotiations do not always run smoothly.
Negotiations break down. During times of disagreement, unions wish to demonstrate
their resolve by striking and being willing to forgo income. Management also wants
to demonstrate to the union that it can weather a strike and hold out as well. In this
case, disagreements are the result of ‘brinkmanship’ – an attempt by both parties to
temporarily use threats to demonstrate the value of their work to the firm.
If both unions and management had a better understanding of the costs of strike
action, brinkmanship might not occur. In this way, strikes can be seen as the result of
a lack of information. Unions might believe that a company does not appreciate their
full value. Management might believe that unions do not appreciate the competitive
pressures of the market and the risks inherent in the economy.
Nonetheless, in the past – whether because of simple misunderstanding or
differences in information – many workdays were lost to industrial action. To
reduce the problem, Australia has had government involvement in the resolution of
industrial disputes. At its core is a dispute resolution body – the Fair Work Commission
(previously the Industrial Relations Commission performed the role). Whenever a union
contemplates strike action, the commission’s task was to step in and arbitrate the
dispute. Its rulings are binding.
207
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or inChapter
part. WCN
02-200-202
9 The
natural rate of unemployment
09_Stonecash_8e_45658_SB_txt.indd 207
24/08/20 4:33 PM
The strengthening of the arbitration system, together with the Accord between the
government and the trade unions regarding wage restraint, resulted in a substantial
reduction in workdays lost due to industrial disputes. This is apparent in Figure 9.6.
Such reduction occurred in most high-income countries, but some, for example, France
and Denmark, still experience much more frequent strikes than Australia.
FIGURE 9.6 Industrial disputes in Australia
Working 120
days lost
per 1000 100
employees
80
60
40
20
Mar-15
Dec-13
Jun-11
Sep-12
Mar-10
Dec-08
Jun-06
Sep-07
Mar-05
Dec-03
Jun-01
Sep-02
Mar-00
Dec-98
Jun-96
Sep-97
Mar-95
Dec-93
Jun-91
Sep-92
Mar-90
Dec-88
Jun-86
Sep-87
Mar-85
0
Year
Source: Based on statistical data from the ABS, various years, Cat. No. 6321.0.55.001, http://www.abs.gov.au/AUSSTATS/
abs@.nsf/DetailsPage/6321.0.55.001Mar%202013?OpenDocument#Time
The theory of efficiency wages
efficiency wage
above-equilibrium
wages paid by firms
in order to increase
worker productivity
Our third and final explanation for an above-equilibrium wage and the resulting classical
unemployment comes from practices designed to improve workplace performance. Firms
may set wages high so as to motivate workers to perform well in their jobs. This wage is
called an efficiency wage. Since it exceeds the level under which supply equals demand,
it can potentially explain unemployment; the same way as minimum wages in Figure 9.4.
Why should firms want to keep wages high? In some ways, this decision seems odd,
for wages are a large part of firms’ costs. Normally, we expect profit-maximising firms to
want to keep costs – and therefore wages – as low as possible. If a firm pays a wage above
the equilibrium, workers employed by that firm will want to work harder to keep that job
as moving to another firm will lower their wages. The novel insight of efficiency-wage
theory is that paying above-equilibrium wages might be profitable because it might raise
the efficiency of a firm’s workers by more than it costs.
There are several types of the efficiency-wage theory, each suggesting a different
explanation for why firms may want to pay high wages. Let’s consider four of these theories.
Worker health
The first type of efficiency-wage theory dates back to the 1920s and emphasises the link
between wages and worker health. Better paid workers can afford to eat a more nutritious
diet and should therefore be healthier and more productive.
This type of efficiency-wage theory is not relevant for firms in high-income countries like
Australia where the equilibrium wage for most workers is well above the level needed for an
adequate diet. Paying higher wages to raise worker health is more relevant for firms in less
prosperous countries where inadequate nutrition is a more common problem. In such countries,
health concerns may explain why firms do not cut wages despite a surplus of labour.
208
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 4 The real economyCopyright
in the long
run
09_Stonecash_8e_45658_SB_txt.indd 208
24/08/20 4:33 PM
Worker turnover
A second type of efficiency-wage theory focuses on the link between wages and worker
turnover. Workers quit jobs for many reasons – to take jobs in other firms, to move to other
parts of the country, to leave the labour force and so on. The frequency with which they quit
depends on the entire set of incentives they face, including the benefits of leaving and the
benefits of staying with their current employer. The more a firm pays its workers, the less
often its workers choose to leave. Thus, a firm can reduce turnover among its workers by
paying them a higher wage.
Why do firms care about turnover? The reason is that it is costly for firms to hire and
train new workers. Moreover, even after they are trained, newly hired workers are not as
productive as experienced workers. Firms with higher turnover, therefore, tend to have
higher production costs. Firms may therefore find it profitable to pay wages above the
equilibrium level in order to reduce worker turnover.
Henry Ford and the generous $5-a-day wage
Henry Ford was an industrial visionary. As founder of the Ford Motor Company, he was
responsible for introducing modern techniques of production. Rather than building
cars with small teams of skilled craftsmen, Ford built cars on assembly lines in which
unskilled workers were taught to perform the same simple tasks over and over again.
The output of this assembly process was the Model T Ford, one of the most famous
early cars.
In 1914, Ford introduced another innovation – the $5 workday. This might not
seem like much today, but back then $5 was about twice the going wage (using your
knowledge from an earlier chapter, you should be able to tell what information is
needed to work out that the $5 amount in 1914 corresponds to roughly $300 in 2019
dollars). It was also far above the wage that balanced supply and demand. When the
new $5-a-day wage was announced, long lines of job seekers formed outside the Ford
factories. The number of workers willing to work at this wage far exceeded the number
of workers Ford needed.
Ford’s high-wage policy had many of the effects predicted by efficiency-wage
theory. Turnover fell, absenteeism was halved and productivity rose by more than 50
per cent according to the company’s calculations. Workers were so much more efficient
that Ford’s production costs were lower even though wages were much higher. Thus,
paying a wage above the equilibrium level was profitable for the firm. Henry Ford
himself called the $5-a-day wage ‘one of the finest cost-cutting moves we ever made’.
Why did it take Henry Ford to introduce this efficiency wage? Why were other firms
not already taking advantage of this seemingly profitable business strategy? According
to some analysts, Ford’s decision was closely linked to his use of the assembly line.
Workers organised in an assembly line are highly interdependent. If one worker is
absent or works slowly, other workers are less able to complete their own tasks. Thus,
while assembly lines made production more efficient, they also raised the importance
of low worker turnover, high worker quality and high worker effort. As a result, paying
efficiency wages may have been a more appropriate strategy for the Ford Motor
Company than for other businesses at the time.
CASE
STUDY
Questions
1 Do you think Ford’s high wage was a good predictor of efficiency-wage theory?
2 Do you think the $5 workday improved Ford’s production efficiency?
209
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or inChapter
part. WCN
02-200-202
9 The
natural rate of unemployment
09_Stonecash_8e_45658_SB_txt.indd 209
24/08/20 4:33 PM
Worker effort
A third type of efficiency-wage theory highlights the link between wages and worker effort.
In many jobs, workers have some discretion over how hard to work. As a result, firms monitor
the efforts of their workers, and workers caught shirking their responsibilities are fired. But
not all shirkers are caught immediately because monitoring workers is costly and imperfect.
A firm can respond to this problem by paying wages above the equilibrium level. Higher
wages make workers more eager to keep their jobs and, thereby, give workers an incentive
to put forward their best effort.
In a high unemployment economy, the threat of unemployment can, in principle, be used
by employers to reduce wages. In a low unemployment environment, however, employers
cannot use this ‘stick’, and they therefore use the ‘carrot’ by paying wages above the
equilibrium level. This causes classical unemployment while providing an incentive for
workers not to shirk their responsibilities.
Worker quality
A fourth type of efficiency-wage theory emphasises the link between wages and worker
quality. When a firm hires new workers, it cannot perfectly observe the quality of the
applicants. By paying a high wage, the firm attracts a better pool of workers to apply for
its jobs.
To see how this might work, consider a simple example. Waterwell Company owns one
well and needs one worker to pump water from the well. Two workers, Bill and Ben, are
interested in the job. Bill, a proficient worker, is willing to work for $30 per hour. Below that
wage, he would rather start his own lawn-mowing business. Ben, a complete incompetent,
is willing to work for $10 per hour. Below that wage, he would rather sit on the beach.
Economists say that Bill’s reservation wage – the lowest wage he would accept – is $30, and
Ben’s reservation wage is $10.
What wage should the firm set? If the firm were interested in minimising labour costs,
it would set the wage at $10 per hour. At this wage, the quantity of workers supplied (one)
would balance the quantity demanded. Ben would take the job and Bill would not apply for
it. Yet suppose Waterwell knows that only one of these two applicants is competent, but
it does not know whether it is Bill or Ben. If the firm hires the incompetent worker, he will
damage the well, causing the firm huge losses. In this case, the firm has a better strategy
than paying the equilibrium wage of $10 and hiring Ben. It can offer $30 per hour, inducing
both Bill and Ben to apply for the job. By choosing between these two applicants, the firm
has at least a 50–50 chance of hiring the competent worker (probably higher since it can
infer the quality of the workers from their résumés and interviews). In contrast, if the firm
offers any lower wage, it is sure to hire the incompetent worker.
This story illustrates a general phenomenon. When a firm has an excess supply of
workers, it might seem profitable to reduce the wage it is offering. But by reducing the wage,
the firm would induce an adverse change in the mix of its workers and job applicants.
CHECK YOUR UNDERSTANDING
Why might firms pay wages to employees that are above equilibrium wage?
210
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 4 The real economyCopyright
in the long
run
09_Stonecash_8e_45658_SB_txt.indd 210
24/08/20 4:33 PM
FYI
The economics of asymmetric information: Adverse selection
and moral hazard
In many situations in life, information is asymmetric – one person in a transaction knows
more about what is going on than the other person. This possibility raises a variety of
interesting problems for economists. We have just seen some of these problems raised
in the context of the theory of efficiency wages. These problems, however, go beyond
the study of unemployment.
The worker-quality variant of the efficiency-wage theory illustrates a general
phenomenon called adverse selection. Adverse selection arises when one person
knows more about the attributes of a good or service than another and, as a result,
the uninformed person runs the risk of being sold a good or service of low quality. In
the worker-quality story of Bill and Ben, for instance, workers have better information
about their own abilities than firms do. When a firm cuts the wage it pays to below $30,
the selection of workers changes in a way that is adverse to the firm – only the less
competent remains.
Adverse selection arises in many other circumstances. Here are two examples:
• Sellers of used cars know their cars’ defects whereas buyers often do not. Because
owners of the worst cars are more likely to sell them than are the owners of the best
cars, car buyers are correctly apprehensive about getting a low-quality car, a ‘lemon’.
As a result, many people avoid buying cars in the second-hand market.
• Buyers of private health insurance know more about their own health problems
than do health funds. Because people with greater hidden health problems are
more likely to buy private health insurance than are other people, the price of health
insurance reflects the costs of a sicker-than-average person. As a result, relatively
healthier people are discouraged from buying private health insurance.
In each case, the market for the product – used cars or private health insurance –
does not work as well as it might because of the problem of adverse selection. Can
you think of some solutions to the problem? To give one example, a common way of
reducing the adverse selection problem in the second-hand car market is to offer a
warranty. If it is sufficiently comprehensive, it sends a strong signal to the buyer that
the product is not a lemon, and increases the buyer’s willingness to purchase it at a
higher price.
The worker-effort variant of efficiency-wage theory illustrates a different
phenomenon called moral hazard. Moral hazard arises when one person, called the
agent, is performing some task on behalf of another person, called the principal.
Because the principal cannot perfectly monitor the agent’s behaviour, the agent tends
to undertake less effort than the principal considers desirable. The term ‘moral hazard’
refers to the risk of dishonest or otherwise inappropriate behaviour by the agent. In
such a situation, the principal tries various ways to encourage the agent to act more
responsibly.
In an employment relationship, the firm is the principal and the worker is the agent.
The moral-hazard problem is the temptation of imperfectly monitored workers to
shirk their responsibilities. According to the worker-effort variant of efficiency-wage
theory, the principal can encourage the agent not to shirk by paying a wage above the
equilibrium level because then the agent has more to lose if caught shirking. In this way,
high wages reduce the problem of moral hazard.
211
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or inChapter
part. WCN
02-200-202
9 The
natural rate of unemployment
09_Stonecash_8e_45658_SB_txt.indd 211
24/08/20 4:33 PM
Moral hazard arises in many other situations. Here are some examples:
A homeowner with fire insurance buys too few fire extinguishers. The reason is that
the homeowner bears the cost of the extinguisher whereas the insurance company
receives much of the benefit.
• A babysitter allows children to watch more television than the parents of the children
prefer. The reason is that more educational activities are beneficial for the children,
but require more effort from the babysitter.
• A family lives near a river with a high risk of flooding. The reason it continues to live
there is that the family enjoys the scenic views and the government will bear part of
the cost when it provides disaster relief after a flood.
Can you identify the principal and the agent in each of these situations? How do
you think the principal in each case might solve the problem of moral hazard? For
example, the insurance company may offer the homeowner a ‘no claim discount’, which
encourages her to increase the number of fire extinguishers to a level that is optimal to
the insurance company.
It is important to understand the key difference between the two asymmetric
information problems. Adverse selection relates to uncertainty about the type of good
or worker (e.g. competence of job applicants), and this information asymmetry occurs
before the economic transaction (hiring a worker) takes place. In contrast, moral hazard
refers to the incentives and behaviour of one party, and occurs after the transaction has
been completed (e.g. shirking after the job contract was signed).
•
LO9.3 Frictional unemployment
job search
the process by
which workers find
appropriate jobs
All three reasons we have just discussed that cause classical unemployment have one thing
in common: They lead to the real wage being too high to support jobs for all willing workers.
But we can observe some unemployment even if the real wage is at its ‘correct’ level. One
reason for this is the time it takes for workers to find a new job. Job search is the process of
matching workers with appropriate jobs. If all workers and all jobs were the same, so that
all workers were equally well suited for all jobs, job search would not be a problem. Laid-off
workers would quickly find new jobs that were well suited to them. But, in fact, workers
differ in their tastes and skills, jobs differ in their attributes, and information about job
candidates and job vacancies is disseminated with varying speed among the many firms
and households in the economy.
The inevitability of frictional unemployment
Search unemployment is often the result of changes in the demand for labour among
different firms. When consumers decide that they prefer Samsung phones over BlackBerrys,
Samsung increases employment and BlackBerry Limited lays off workers. Its former
workers must now search for new jobs and Samsung must decide which new workers to
hire for the various jobs that have opened up. The result of this transition is temporary
unemployment.
Similarly, because different regions of the country produce different goods, employment
can rise in one region and fall in another. Consider, for instance, what happens when the
world price of coal falls (due to people switching to cleaner fuels). Coal mines in Western
Australia respond to the lower price by decreasing production and employment. At the
same time, cheaper coal decreases electricity costs, so aluminium refineries in Queensland
that are electricity-intensive increase production and employment. Changes in the
composition of demand among industries or regions are called sectoral shifts. Because it
takes time for workers to search for jobs in the new sectors, sectoral shifts temporarily
cause unemployment.
212
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 4 The real economyCopyright
in the long
run
09_Stonecash_8e_45658_SB_txt.indd 212
24/08/20 4:33 PM
Public policy and job search
Even if some search unemployment is inevitable, public policy can nonetheless affect its
prevalence. To the extent that policy can reduce the time it takes unemployed workers to find
new jobs, it can reduce search unemployment. Government programs try to facilitate job finding
in various ways. The main way is through government-sponsored employment agencies, which
give out information about job vacancies in order to match workers and jobs more quickly.
Critics of these programs question whether the government should get involved with the
process of job search. They argue that it is better to let the market match workers and jobs. In
fact, most job searches in the economy take place without intervention by the government.
Newspaper advertisements, job newsletters, university placement offices, head-hunters
and word of mouth all help spread information about job openings and job candidates.
Furthermore, the Internet has improved information flows and greatly simplified the job
search process. In Australia, the government largely outsources these services through the
Jobactive platform (which replaced the Jobs Services Australia network in mid-2015). It
pools together a number of both for-profit and non-profit organisations that have a contract
with the Australian government to offer employment services.
Unemployment benefits
One government program that increases the amount of search unemployment, without
intending to do so, is the provision of unemployment benefits. This program is designed to
offer workers partial protection against income loss. Any permanent resident who becomes
unemployed is eligible for such benefits. The length of eligibility in Australia has changed
over time, and is currently about one year if a person does not undertake reasonable efforts
to regain employment. Regardless, unemployment benefits are usually only a fraction of a
worker’s previous wage.
Although unemployment benefits reduce the hardship of unemployment, they also
increase the amount of unemployment. The explanation is based on one of the Ten Principles
of Economics in chapter 1 – people respond to incentives. Because unemployment benefits
stop when a worker takes a new job, the unemployed devote less effort to job search and
are more likely to turn down less attractive job offers. In addition, because unemployment
benefits make unemployment less onerous, workers are less likely to seek guarantees of job
security when they negotiate with employers over the terms of employment.
Many studies by labour economists have explored the incentive effects of unemployment
benefits, usually finding their adverse effect on employment. For example, a 2013 research
paper by Marcus Hagedorn and co-authors examined US labour market data in the aftermath
of the Global Financial Crisis. It found that extending the duration of unemployment
benefits (from 26 to 99 weeks in some states) led to a marked reduction in employment,
with the long-term effect being stronger than the short-term effect.
Many studies confirm that the design of the unemployment benefits system influences
the effort that some of the unemployed devote to job search. Professor Jeff Borland provided
another piece of evidence. According to the 1997 time use data, only 15 to 20 per cent of the
unemployed people in Australia reported job search activity on any given day. The average
time spent searching among those people was 80–100 minutes per day. The average time
spent job searching across all unemployed people was only 16 minutes per day (less than
two hours per week).
Despite all these findings, we cannot automatically conclude that providing unemployment
benefits is a bad policy overall. The program does achieve its primary goal of reducing the income
uncertainty and threat of poverty that workers face. In addition, when workers turn down
unattractive job offers, they have the opportunity to look for jobs that better suit their tastes
and skills. Some economists have argued that unemployment benefits improve the ability of the
economy to match each worker with the most appropriate job.
unemployment
benefits
a government
program that
partially protects
workers’ incomes
against job loss
213
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or inChapter
part. WCN
02-200-202
9 The
natural rate of unemployment
09_Stonecash_8e_45658_SB_txt.indd 213
24/08/20 4:33 PM
Therefore, while most economists agree that eliminating unemployment benefits
would reduce the amount of unemployment, there is disagreement on whether economic
wellbeing would be enhanced or diminished by this policy change.
LO9.4 Structural unemployment
The third and final component of the natural rate is structural unemployment. It arises if
the skills demanded in the labour market by employers are not matched by the skills that
workers possess. For example, the late 1990s saw a boom in the ICT industry (the dotcom
bubble), with a sudden decline in the early 2000s. Soon after, most countries experienced
a surge in the construction sector (the housing bubble) which culminated in the Global
Financial Crisis. It is not surprising that some of the computer specialists and programmers
that became redundant in the early 2000s struggled to re-train and become builders to shift
to the newly booming industry. Such cases, which are larger sectoral shifts, are captured as
part of structural unemployment.
Like frictional unemployment, some structural unemployment is inevitable simply
because the economy is always changing. A century ago, the sectors with the largest
employment in Australia were primary industries like agriculture and mining. Today, the
largest employers are in services including retail trade and health care. As this transition took
place, jobs were created in some firms and destroyed in others, the above-mentioned process
of ‘creative destruction’. The end result of this process has been greater productivity and
higher living standards. But, along the way, workers in declining industries found themselves
out of work, some unable to find a new job for a long time due to a skill mismatch.
IN THE
NEWS
The Terminator’s move from the big screen to the labour market
near you
Many people worry that technological progress characterised by automation
of the production process and the use of robots will lead to growing
unemployment. Laurence Kotlikoff from Boston University and Jan Libich
from La Trobe University explored the relevance of these concerns in their
November 2016 article in the Sydney Morning Herald.
Will robots eat our lunch or serve us our dinner?
18 November 2016
The outcome of the U.S. presidential election is widely seen as a protest vote; people
showing discontent with their economic situation. Central to this are subpar labour market
outcomes of most Americans and growing income inequality over the past three decades.
Let us therefore explore what the future holds, and why it is important what kind
of employment policies global leaders pursue. Economic research shows that the main
challenges to American (low-skilled) workers may not be coming from Mexico or China, but
from continued technological progress leading to increased automation and use of robots.
Many associated questions have been carefully examined, for example: Does
technological progress lead to growing unemployment? Are ever improving robots and
machines pushing people out of jobs? Should we fight back by destroying them the way
the Luddite movement did in England two centuries ago?
The idea that ongoing automation wipes out jobs is most commonly associated with
Karl Marx, who in his 1867 book Das Kapital discussed the struggle between workers and
machines and the resulting reserve army of labour. Rather than considering whether
Marx actually claimed that industrialisation would lead to ever-rising unemployment, let
us consider this popular hypothesis at face value.
214
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 4 The real economyCopyright
in the long
run
09_Stonecash_8e_45658_SB_txt.indd 214
24/08/20 4:33 PM
Looking back, data strongly reject this hypothesis. Following Ludd and Marx,
industrialisation and automation continued at a very high pace, and technological
advances led to the substitution of workers by machines in most areas. But
unemployment generally remained at very low levels. For example, a century after
Das Kapital was published the unemployment rate in advanced countries was around
one or two per cent despite real GDP increasing by more than 500% – largely due to
technological progress. And countries with the fastest rate of industrialisation generally
saw lower, not higher unemployment levels.
Economists have carefully examined why the hypothesis failed to eventuate in the past.
In short, the economy is a dynamically evolving process of ‘creative destruction’ where new
jobs constantly arise and replace old jobs. People whose jobs get taken over by machines
simply do different jobs, often in newly emerging industries. In line with this explanation
we have seen major shifts away from agriculture to manufacturing and later into services,
and importantly into research and development. In essence, the more machines and
robots help us with existing jobs, the more time we have to invent new ones.
Does this mean that all is well and human labour is safe from automation and
robotisation going forward? Not necessarily. There are three important qualifications to
the above discussion.
First, major sectoral shifts require workers’ re-training and thus may be associated with
structural unemployment, a mismatch between the skills available and required in the
labour market. Its extent depends on the quality and flexibility of the education system,
i.e. whether it produces people capable of adapting to technological change. If education
doesn’t keep up with technology, the share of workers who can’t find work could grow.
Second, even if automation does not lead to higher unemployment, it may still
change the nature of the jobs left to humans and their compensation. Recent research
shows that this may partly explain the rise in inequality in most high-income countries
(especially the United States) over the past three decades.
If humans go from having high- to low-paying jobs, an ironic possibility arises.
They may become too poor to purchase the products produced by robots. As
Benzell, Kotlikoff, LaGarda and Sachs show in their recent paper, this can under some
circumstances produce what Marx predicted, a situation in which capitalism sows the
seeds of its own destruction or, at least, a long-run decline in output and economic
wellbeing. The dynamic involves young, poorly paid workers unable to save as much as
their parents’ generation. This spells lower national investment.
Over time, the economy ends up with better technology (smarter robots), but less
physical capital available to help produce output. Whether this grim view prevails
remains to be seen unless governments ensure that the advent of smart machines
benefits all generations, not just those who are old enough to temporarily control the
means of production.
Third, it is conceivable that the future of robotics will represent a fundamentally
different era of technological progress. For example, consider the scenario of
some science-fiction movies such as the Terminator franchise. Artificial intelligence
progresses greatly and robots do not just assemble themselves but are capable of selfimprovement, of inventing a technologically more advanced type.
In such a futuristic scenario it may indeed be the case that human labour input
becomes largely redundant in production. But if the crystal ball of the Terminator creators
is more accurate than that of the Luddites movement, lack of jobs would be the least
of people’s worry. In such case humans would be ‘occupied’ with trying to control such
hyper-intelligent robots and ward off their dominance over humankind. As we know from
the big screen, Arnold Schwarzenegger needs help to avert the Judgement day.
Source: Laurence Kotlikoff and Jan Libich, Canberra Times, http://www.canberratimes.com.au/comment/willrobots-eat-our-lunch-or-serve-us-our-dinner-20161117-gsrdn7.html
215
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or inChapter
part. WCN
02-200-202
9 The
natural rate of unemployment
09_Stonecash_8e_45658_SB_txt.indd 215
24/08/20 4:33 PM
You should now be able to contrast structural unemployment with the two other
types of unemployment we discussed. In the case of classical unemployment arising from
minimum-wage laws, unions and efficiency wages, the real wage is above the equilibrium
level, so the quantity of labour supplied exceeds the quantity of labour demanded. Workers
are unemployed because they are essentially waiting for jobs to open up.
In the case of frictional and structural unemployment, real wages are not excessive –
workers are simply searching for jobs. The difference is that frictional unemployment is
temporary; there is a suitable job for each worker and it is just a matter of time for their
search to be successful. However, structural unemployment is a more serious and longer
lasting condition. While there are jobs available in the economy, some workers will remain
unemployed as there are no suitable jobs for them in their geographical area. Sometimes
a distinction is made between two interconnected drivers of structural unemployment –
occupational immobility (skill mismatch) and geographical immobility (location mismatch).
Spain offers an example of the latter. The natural rate of unemployment for the country as a
whole approached 25 per cent in the aftermath of the Global Financial Crisis, but the south
of the country generally featured rates above 35 per cent whereas the north only half that.
One similarity of structural and frictional unemployment is that various government
programs attempt to reduce both of them, and help people get suitable jobs. Most countries
offer public training programs, which aim to ease the transition of workers from declining
to growing industries and to help disadvantaged groups escape poverty. Again, there exist
critics. They argue that most worker education is done privately, either through schools or
through on-the-job training, and that the government is no better – and most likely worse –
at deciding what kinds of worker training would be most valuable. They claim that these
decisions are best made privately by workers and employers. What is your view on that?
CASE
STUDY
The differences in unemployment within Australia and across countries
Popular discussions of unemployment rarely consider the composition of the
unemployed. Even though unemployment in certain groups is sometimes targeted
(for instance, youth or ethnic minority), there is still a tendency to view unemployment
in the aggregate around the country. But the data show that this is a mistake. Table 9.2
reports the unemployment rate for Australian states and territories.
It shows large differences across the states. While the ACT, New South Wales
and the Northern Territory feature a low rate of unemployment, South Australia’s
and Tasmania’s rates are much higher. Looking more deeply within states reveals
even larger differences, with the official unemployment rate being higher in regional
Australia than in the cities. To give one example, in outback Queensland it was around
13 per cent in 2019, over double the national average.
Unemployment rates across countries show an even greater variation, which
may not surprise you given the large differences in economic growth we saw in an
earlier chapter. In 2019, unemployment rates below 3 per cent could be found in, for
example, Switzerland, Japan, Singapore and the Czech Republic. Still fairly low rates of
around 5 per cent were reported from the United States, Russia, New Zealand and the
Philippines. At the other end of the spectrum, South Africa, Namibia and Palestine had
unemployment rates between 25 and 45 per cent. Similar differences can be observed
in youth unemployment. For example, based on OECD data, Greece and Spain had
over 30 per cent youth unemployment and South Africa over 60 per cent in 2019.
In contrast, Japan, Kazakhstan and Switzerland had less than 10 per cent.
Source: US Bureau of Labour Statistics, Eurostat, OECD
216
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 4 The real economyCopyright
in the long
run
09_Stonecash_8e_45658_SB_txt.indd 216
24/08/20 4:33 PM
Labour force region
Unemployment rate (%)
Australian Capital Territory
4.1
Northern Territory
4.4
New South Wales
4.3
Western Australia
6.1
Australia-wide average
5.0
Victoria
4.6
Queensland
5.9
Tasmania
6.5
South Australia
5.9
Source: ABS DATA, Cat 6202.0, Table 12, March 2019
TABLE 9.2 Differences in unemployment between Australian states and territories
Questions
1 What do you think explains the differences in Australian state and territory
unemployment?
2 If global demand for coal falls, will that have an impact on the employment level
in Western Australia, which heavily relies on its coal export industry?
CHECK YOUR UNDERSTANDING
How would a tax on carbon emissions impact the amount of search unemployment? Is this
unemployment necessarily undesirable? What public policies might affect the amount of
unemployment caused by this price change?
Conclusion
In this chapter, we discussed the measurement of unemployment and the reasons why
economies always have people without jobs. You could see the many driving forces behind
classical, frictional and structural types of unemployment. Which of these explanations for
the natural rate of unemployment are the most important? Unfortunately, there is no easy
way to tell, and the answer differs across countries and time.
Unemployment is not a simple problem with a simple solution. Instead, it has various
explanations and is affected by a number of public policies. When policymakers debate the
minimum wage, the laws regulating collective bargaining, unemployment benefits, or job
matching and re-training programs, they should always carefully consider the impact of
these policies on the economy’s natural rate of unemployment.
217
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or inChapter
part. WCN
02-200-202
9 The
natural rate of unemployment
09_Stonecash_8e_45658_SB_txt.indd 217
24/08/20 4:33 PM
STUDY TOOLS
Summary
LO9.1 The unemployed are those who would like to work but do not have jobs. The ABS
calculates the unemployment rate statistics monthly, based on a survey of thousands of
households.
LO9.2 One explanation for the existence of ‘classical’ unemployment is a real wage kept at
a level that is too high. This can be due to minimum-wage laws, which raise the wage
of unskilled and inexperienced workers and thus lead to excess supply of labour over
demand.
LO9.3 Frictional unemployment does not require wages to be too high. It relates to the
process of workers’ searching for jobs where there is no skill mismatch, and it is just a
matter of time for each worker to find a job that best suits their skills and tastes.
LO9.4 Structural unemployment also does not require wages to be too high and relates to
the process of workers searching for jobs. However, an occupational or geographical
mismatch exists, and therefore some workers are unable to find jobs despite vacancies
being available.
Key concepts
collective bargaining, p. 206
cyclical unemployment, p. 196
discouraged workers, p. 202
efficiency wage, p. 208
job search, p. 212
labour force, p. 197
labour-force participation rate, p. 197
natural rate of unemployment, p. 196
strike, p. 207
unemployment benefits, p. 213
unemployment rate, p. 197
union, p. 206
Practice questions
Questions for review
1
2
3
4
5
6
7
Explain the three categories into which the ABS divides the population. How does it
calculate the labour force, the unemployment rate and the labour-force participation rate?
What factors determine whether unemployment is short term or long term? Explain.
Are minimum-wage laws a better explanation for unemployment among teenagers or
among university graduates? Why?
Why should economists and policymakers be careful when interpreting data on
unemployment?
Why does the level of unemployment vary widely from region to region within Australia and
across countries? If you were advising the government, what would you suggest to reduce
the regional differences in unemployment?
Explain four ways in which a firm might increase its profits by raising the wages it pays.
What are the main differences between frictional and structural unemployment? Are there
ways in which the government can reduce search unemployment?
Multiple choice
1
Consider a country with a population of 110 people: 40 work full-time, 20 work part-time
but would prefer to work full-time, 10 are looking for a job, 10 would like to work but are
so discouraged they have given up looking, 10 are not interested in working because they
are full-time students, 10 are children below 15 years of age, and 10 are retired. What is the
official number of the unemployed?
a 10
b 20
c 30
d 40
218
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 4 The real economyCopyright
in the long
run
09_Stonecash_8e_45658_SB_txt.indd 218
24/08/20 4:33 PM
2
3
4
5
6
Using the labour market data in question 1, what is the size of the country’s labour force?
a 50
b 60
c 70
d 80
Using the labour market data in question 1, what is the rate of unemployment?
a 10
b 20
c 30
d 40
Using the labour market data in question 1, what is the labour-force participation rate?
a 50
b 60
c 70
d 80
The main policy goal of unemployment benefits is to reduce the
a search effort of the unemployed.
b income uncertainty that workers face.
c role of unions in wage setting.
d amount of frictional unemployment.
Which of the following is more likely to raise the unemployment rate?
a Establishing more effective trade unions in an economy
b Introducing a minimum wage in the economy
c Firms are willing to pay efficiency wages in an economy
d All of the above
Problems and applications
1
2
The ABS reported in December 2019 that of all adult Australians 12 976 300 were
employed, 703 600 were unemployed, and the participation rate was 66.0 per cent. The
civilian population over 15 years of age was 20 701 918. How many people were not in the
labour force? How big was the labour force? What was the unemployment rate?
The following table shows the underemployment rate for men, women and all people aged
25–34 over the 1978 to 2015 period. Why is this information useful for policymakers?
Men 25–34
3
4
Women 25–34
All people 25–34
1978
1.3%
5.4%
2.7%
2015
9.3%
13.2%
11.1%
Draw a diagram of the labour market with the wage being at the equilibrium level.
a Draw a minimum wage that is above the equilibrium level. Show the effect of its
introduction on the number of workers supplied and demanded as well as the amount
of unemployment. Discuss the intuition behind the effect.
b Draw a minimum wage that is below the equilibrium level and answer the questions in
part a.
During the mining boom, it was suggested that Australia had a two-speed economy – that
is, some sectors that were doing really well and some sectors that weren’t.
a If we had perfectly flexible labour markets, what would you expect to happen to wages
in the two sectors? Explain.
b What government policies would you recommend to overcome the two-speed
economy?
219
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or inChapter
part. WCN
02-200-202
9 The
natural rate of unemployment
09_Stonecash_8e_45658_SB_txt.indd 219
24/08/20 4:33 PM
5
6
7
8
9
The following situations involve moral hazard. In each case, identify the principal and the
agent, and explain why there is asymmetric information. How does the action described
reduce the problem of moral hazard?
a Landlords require tenants to pay security deposits.
b Firms compensate top executives with options to buy company shares at a given price
in the future.
c Car insurance companies offer discounts to older drivers or those who have had fewer
accidents.
Suppose that the Live-Long-and-Prosper Health Fund charges $8000 annually for family
health cover. The fund’s managing director suggests that the firm raise the annual price to
$10 000 in order to increase its profits. If the firm followed this suggestion, what economic
problem might arise? Would the firm’s pool of customers tend to become more or less
healthy on average? Would the firm’s profits necessarily increase? Explain.
How will the following affect the supply of labour? Illustrate your answer with a diagram.
a The retirement age has increased from 67 to 68 years.
b Australia experiences a productivity increase causing real wages to rise.
c Social security benefits are decreased.
d Australians decide to have more children (you need to consider both short-run and
long-run effects).
(This problem is challenging, in your answers try to be quantitative when you can, but even
an intuitive discussion is fine.) Suppose that the federal government passes a law requiring
employers to provide employees some benefit (like private health care) that raises the cost
of an employee by $6 per hour.
a What effect does this legal requirement have on the demand for labour?
b If employees place a value on this benefit exactly equal to its cost, what effect does this
legal requirement have on the supply of labour?
c If the wage is free to balance supply and demand, how does this legal requirement
affect the wage and the level of employment? Are employers better or worse off? Are
employees better or worse off?
d If a minimum-wage law prevents the wage from balancing supply and demand, how
does the legal requirement affect the wage and the level of unemployment? Are
employers better or worse off? Are employees better or worse off?
e Now suppose that workers do not value the benefit at all. How does this alternative
assumption change your answers to parts (b), (c) and (d)?
For each of the following scenarios, identify whether the unemployment is frictional or
structural.
a Alex lost his job when the car manufacturing company closed down. He does not have
the skills to work in another industry and thus has been unemployed for more than a
year.
b Lauren had a job as a primary school teacher but quit when her husband was
transferred to another state. She was only unemployed for a month before she found a
new job that she liked.
c Ethan completed his bachelor’s degree and has been looking for work over the last five
weeks. He turned down a few offers because they did not allow him to apply the skills
he gained at university, but now he has a job in his field of study.
220
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 4 The real economyCopyright
in the long
run
09_Stonecash_8e_45658_SB_txt.indd 220
24/08/20 4:33 PM
221
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
WCN 02-200-202
Chapter
9 Application: International trade
09_Stonecash_8e_45658_SB_txt.indd 221
24/08/20 4:33 PM
PART FIVE
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
10_Stonecash_8e_45658_SB_txt.indd 222
24/08/20 4:34 PM
Money and prices
in the long run
Chapter 10 The monetary system
Chapter 11 Inflation: Its causes and costs
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
10_Stonecash_8e_45658_SB_txt.indd 223
24/08/20 4:34 PM
10
The monetary system
Learning objectives
After reading this chapter, you should be able to:
LO10.1 explain what money is and what functions money has in the economy
LO10.2 discuss the Reserve Bank of Australia and the tools it uses to influence liquidity
conditions in the economy
LO10.3 examine how the banking system influences the amount of money in the
economy.
224
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
10_Stonecash_8e_45658_SB_txt.indd 224
24/08/20 4:34 PM
Introduction
When you walk into a restaurant to buy a meal, you get something of value – your hunger
satisfied. To pay for this service, you might hand the restaurateur several worn-out pieces
of coloured plastic decorated with strange symbols, government buildings and the portraits
of famous dead Australians. Or you might tap your watch or phone to electronically access
your cheque or savings account. Whether you pay by cash or through a mobile payment app,
the restaurateur is happy to work hard to satisfy your gastronomical desires in exchange for
these internet transfers, which, in and of themselves, are worthless.
To anyone who has lived in a modern economy, this social custom is not at all odd. Even
though plastic money has no intrinsic value, the restaurateur is confident that, in the future,
some third person will accept it in exchange for something that the restaurateur does value.
And that third person is confident that some fourth person will accept the money, with the
knowledge that yet a fifth person will accept the money … and so on. To the restaurateur and
to other people in our society, your cash represents a claim to goods and services in the future.
The social custom of using money for transactions is extraordinarily useful in a large,
complex society. Imagine, for a moment, that there was no item in the economy widely
accepted in exchange for goods and services. People would have to rely on barter – the
exchange of one good or service for another – to obtain the things they need. To get your
restaurant meal, for instance, you would have to offer the restaurateur something of
immediate value. You could offer to wash some dishes, clean the floor, or help with the
restaurant’s accounts. An economy that relies on barter will have trouble allocating its scarce
resources efficiently. In such an economy, trade is said to require the double coincidence of
wants – the unlikely occurrence that two people each have a good or service that the other
wants at the same time.
The existence of money makes trade easier. Our restaurateur, George, does not care
whether you can produce a valuable good or service for him. He is happy to accept your
money, knowing that other people will do the same for him. Such a convention allows trade to
be roundabout – a coincidence of desires to trade is not required. George accepts your money
and uses it to pay Eleni, his chef; Eleni uses her pay cheque to send her child to day care; the
day care centre uses these fees to pay Vinh, a teacher; and Vinh hires you to mow his lawn. As
money flows from person to person in the economy, it facilitates production and trade, thereby
allowing people to specialise in what they do best and raising everyone’s standard of living.
In this chapter, we begin to examine the role of money in the economy. We discuss what
money is, the various forms that money takes, how the banking system helps create money
and how the government influences the quantity of money in circulation. Because money
is so important in the economy, we devote much effort in the rest of this book to learning
how money is linked to various economic variables, including inflation, interest rates,
production and employment. Consistent with our long-run focus in the last three chapters,
we will examine the long-run effects of changes in monetary policy in the next chapter.
The short-run effects of monetary changes are a more complex topic, which we take up
later in the book. This chapter provides the background for all of this further analysis.
LO10.1 The meaning of money
What is money? This might seem like an odd question. When you read that billionaire Gina
Rinehart has a lot of money, you know what that means – she is so rich that she can buy
almost anything she wants. In this sense, the term money is used to mean wealth.
Economists, however, use the word in a more specific sense. Money is the set of assets
in the economy that people regularly use to buy goods and services from other people.
The cash in your wallet is money because you can use it to buy a meal at a restaurant or a
money
the set of assets in an
economy that people
regularly use to buy
goods and services
from other people
225
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN Chapter
02-200-202
10 The monetary system
10_Stonecash_8e_45658_SB_txt.indd 225
24/08/20 4:34 PM
shirt at a clothing shop. In contrast, if you happened to be a major shareholder in Hancock
Prospecting, as Gina Rinehart is, you would be wealthy, but this asset is not considered a
form of money. You could not buy a meal or a shirt with this wealth without first obtaining
some money. According to the economist’s definition, money includes only those few types
of wealth that are regularly accepted by sellers in exchange for goods and services.
The functions of money
medium of exchange
an item that buyers
give to sellers when
they want to purchase
goods and services
unit of account
the yardstick people
use to post prices
and record debts
store of value
an item that people
can use to transfer
purchasing power
from the present
to the future
liquidity
the ease with which
an asset can be
converted into the
economy’s medium
of exchange
Money has three functions in the economy – it is a medium of exchange, a unit of account and
a store of value. These three functions together distinguish money from other assets.
A medium of exchange is an item that buyers give to sellers when they purchase
goods and services. When you buy a shirt at a clothing shop, the shop gives you the shirt
and you give the shop your money. This transfer of money from buyer to seller allows the
transaction to take place. When you walk into a shop, you are confident that the shop will
accept your money for the items it is selling because money is the commonly accepted
medium of exchange.
A unit of account is the yardstick people use to post prices and record debts. When you
go shopping, you might observe that a shirt costs $40 and a meat pie costs $4. Even though
it would be accurate to say that the price of a shirt is 10 meat pies and the price of a meat pie
is 1/10 of a shirt, prices are never quoted in this way. Similarly, if you take out a loan from a
bank, the size of your future loan repayments will be measured in dollars, not in a quantity
of goods and services. When we want to measure and record economic value, we use money
as the unit of account.
A store of value is an item that people can use to transfer purchasing power from the
present to the future. When a seller accepts money today in exchange for a good or service,
that seller can hold the money and become a buyer of another good or service at another
time. Of course, money is not the only store of value in the economy. A person can also
transfer purchasing power from the present to the future by holding shares, bonds, real
estate, art, or even old stamps. The term wealth is used to refer to the total of all stores of
value, including both money and non-monetary assets.
Economists use the term liquidity to describe the ease with which an asset can be
converted into the economy’s medium of exchange. Because money is the economy’s
medium of exchange, it is the most liquid asset available. Other assets vary widely in their
liquidity. Most shares and bonds can be sold easily at little or no cost, so they are relatively
liquid assets. In contrast, selling a house, a Rembrandt painting or a 1948 Don Bradman
cricket bat requires more time and effort, so these assets are less liquid.
When people decide in what form to hold their wealth, they have to balance the liquidity
of each possible asset against the asset’s usefulness as a store of value. Money is the most
liquid asset, but it is far from perfect as a store of value. When prices rise, the value of money
falls. In other words, when goods and services become more expensive, each dollar in your
wallet can buy less. This link between the price level and the value of money will turn out to
be important for understanding how money affects the economy.
Kinds of money
commodity money
money that takes the
form of a commodity
with intrinsic value
When money takes the form of a commodity with intrinsic value, it is called commodity
money. The term intrinsic value means that the item would have value even if it were not
used as money.
One example of commodity money is gold. Gold has intrinsic value because it is used in
industry and in the making of jewellery. Although today we no longer use gold as money,
historically gold has been a common form of money because it is relatively easy to carry,
measure and verify for impurities. And in times of great uncertainty, like in the Global
226
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 5 Money and pricesCopyright
in the long
run
10_Stonecash_8e_45658_SB_txt.indd 226
24/08/20 4:34 PM
fiat money
money without
intrinsic value
that is used as
money because of
government decree
Source: Cartoon by Steve Nease/neasecartoons.com
Financial Crisis of 2008, people hold gold because it is seen as a safer asset. When an
economy uses gold as money (or uses plastic or paper money that is convertible into gold
on demand), it is said to be operating under a gold standard. Another example of commodity
money is cigarettes. In prisoner-of-war camps during the Second World War, prisoners
traded goods and services with one another using cigarettes as the store of value, unit of
account and medium of exchange. Similarly, as the Soviet Union was breaking up in the late
1980s, cigarettes started replacing the rouble as the preferred currency in Moscow. In both
cases, even non-smokers were happy to accept cigarettes in an exchange, knowing that they
could use the cigarettes to buy other goods and services. In the early days of the Australian
colonies, rum was used as commodity money. Workers were paid in gallons of rum and they
then used this as a medium of exchange. It didn’t serve as much of a store of value, though –
you could say it was a very liquid asset!
Money without intrinsic value is called fiat money. A fiat is simply an order or decree,
and fiat money is established as money by government decree. For example, compare the
plastic dollars in your wallet (printed by the Reserve Bank of Australia) and the paper
dollars from a game of Monopoly® (printed by the Parker Brothers game company). Why can
you use the first to pay your bill at a restaurant but not the second? The answer is that the
Australian government has decreed its dollars to be valid money. Each note in your wallet
reads ‘This Australian note is legal tender throughout Australia and its territories’.
Although the government is central to establishing and regulating a system of fiat
money (like by prosecuting counterfeiters), other factors are also required for the success of
such a monetary system. To a large extent, the acceptance of fiat money depends as much
on expectations and social convention as on government decree. The Soviet government
in the 1980s never abandoned the rouble as the official currency yet the people of Moscow
preferred to accept cigarettes (or even American dollars) in exchange for goods and services,
because they were more confident that these alternative monies would be accepted by
others in the future. The same thing happened in Indonesia in the 1990s, where the value of
the rupiah dropped dramatically in a short period of time. Some places in Indonesia would
accept only American dollars in payment for goods or services.
227
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN Chapter
02-200-202
10 The monetary system
10_Stonecash_8e_45658_SB_txt.indd 227
24/08/20 4:34 PM
Money in the Australian economy
money supply
the quantity of
money available
in the economy
currency
the plastic notes and
metal coins in the
hands of the public
current deposits
balances in bank
accounts that
depositors can
access on demand
by using a debit card
or writing a cheque
IN THE
NEWS
As we will see, the quantity of money circulating in the economy, called the money
supply, has a powerful influence on important economic variables. We will find out in the
next chapter how closely money supply and the level of inflation are linked. But before we
consider why that is true, we need to ask a preliminary question. What is the quantity of
money? In particular, suppose you were given the task of measuring how much money there
is in the Australian economy. What would you include in your measure?
The most obvious asset to include is currency – the plastic notes and metal coins in the
hands of the public. Currency is clearly the most widely accepted medium of exchange in
our economy. There is no doubt that it is part of the money supply.
Yet currency is not the only asset that you can use to buy goods and services. Most shops
today also accept debit cards, or offer EFTPOS facilities. (EFTPOS stands for ‘electronic
funds transfer at point of sale’.) There is a distinction between the plastic card itself and
the funds in savings or cheque accounts that the card allows consumers to access. (See the
FYI box ‘Credit cards, debit cards, smart cards and money’.) Some shops also accept personal
cheques. Wealth held in your savings or cheque account is almost as convenient for buying
things as wealth held in your wallet. To measure the money supply, therefore, you might
want to include current deposits – balances in bank accounts that depositors can access
on demand simply by using a debit card or writing a cheque.
Ever heard the expression ‘cold, hard cash’? In times gone by, some people
would only accept gold coins in exchange for their goods. They didn’t trust
any other sort of payment. Now we have online exchanges that accept virtual
money – bitcoin. And it’s making some governments nervous. They worry that
bitcoin use will mean they won’t be able to control their monetary policy. As the
following articles argue, it may be too late to stop the tide of virtual money.
Banning Bitcoin is stupid. Non-state digital currencies will
soon sweep away our monopoly money
The winner of this week’s King Canute prize for attempting to hold back the tide goes to
the government of Thailand. Why? They have just decided to ban Bitcoin, the new digital
currency.
Bitcoin – which exists only as a string of computer source code, and in so far as
people are willing to exchange ownership of it for other things – cannot lawfully be used
to buy and sell in Thailand.
Monetary authorities in Bangkok fear that this upstart currency cannot be subject to
capital controls. And they are right. It can’t. But banning Bitcoin won’t end a very 21stcentury conundrum for governments everywhere.
A digital tide is coming in, and it will sweep away the post-Bretton Woods system of
monopoly money.
No government, in Thailand, or elsewhere, will ultimately be able to stop it.
Personally, I am a bit of a Bitcoin sceptic. I suspect it might be to the future of private
currencies what the ZX Spectrum was to the future of personal computing. Much hyped,
we can all sense it might just be the start of something big. Yet for all that, no one seems
entirely sure what to do with it.
To catch a glimpse of our monetary future, perhaps we should look not to Bitcoin,
but to Africa. No, not the half-baked idea of an East African monetary union, but to the
success of something called Mpesa.
Ostensibly a way of paying for things using mobile phone credits, Mpesa allows
tens of millions of Africans to do so without a costly banking system attached. Payment
without banking!
228
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 5 Money and pricesCopyright
in the long
run
10_Stonecash_8e_45658_SB_txt.indd 228
24/08/20 4:34 PM
Yep. But that’s only the start. Imagine if a mobile phone company were to decouple
the value of its credits from the local official currency. With monopoly money inflation
in double digits, it would only be a matter of time before folk used a virtual payment
system to store wealth, not just buy stuff. Money without a government!
Try to imagine what might happen here in the West if we were to have 1970s levels
of inflation, combined with 2019 rates of internet usage? We might not have to wait too
long to find out.
A generation ago, the last time our monopoly money currency was seriously
debauched, there were – as the Thai authorities would appreciate – capital controls.
Only very rich people could safeguard their wealth by buying old masters paintings, or
other such assets.
Thanks to the internet, today ordinary folk can not just shop around. They can do
so in all sorts of currencies. Whatever the law says in Thailand or elsewhere – unless
the authorities plan on monitoring every online transaction – we’ll be able to store
wealth online in all kinds of ways. Currency competition and non-state-issued money
is only a matter of time.
Far from being a product of deliberate design, I suspect the successful non-state
currencies of the future might be almost accidental; an online supermarket voucher
scheme, perhaps, which retains its worth better than the Bank of England alternative?
The whole point about King Canute trying to hold back the tide is that he knew at
the outset that he couldn’t. He was, so the story goes, trying to demonstrate to his
underlings the limits of a ruler’s power. A thousand years on, it seems many have still
not learned the lesson.
Source: © Telegraph Media Group Limited,
13 July 2013
How safe is Bitcoin?
In a lot of ways, bitcoin is safer than ‘real’ money. It is based on blockchain technology,
which ‘In essence … is a shared, trusted, public ledger that everyone can inspect, but which
no single user controls. The participants in a blockchain system collectively keep the ledger
up to date: it can be amended only according to strict rules and by general agreement.
Bitcoin’s blockchain ledger prevents double-spending and keeps track of transactions
continuously. It is what makes possible a currency without a central bank.’ According to The
Economist, the technology underlying bitcoin is even more interesting than the currency. It
could replace institutions that trade in trust – banks, clearing houses and other government
agencies that facilitate our transactions – because it is based on a secure (and therefore
trustworthy) technology. Like a lot of things in the digital economy, no one is quite sure
where it could take us, but it will most certainly transform how we conduct our transactions.
Based on: The trust machine, The Economist, 31 October 2015, http://www.economist.com/ news/
leaders/21677198-technology-behind-bitcoin-could-transform-how-economy-works-trust-machine
Once you start to consider balances in savings or cheque accounts as part of the money
supply, you are led to consider the large variety of other accounts that people hold at banks
and other financial institutions. Bank depositors usually cannot write cheques against the
balances in their savings accounts, but they can easily transfer funds from other accounts
into cheque accounts or use debit cards to access their funds. Thus, these accounts should
plausibly be part of the Australian money supply.
In a complex economy like ours, it is not easy to draw a line between assets that can
be called ‘money’ and assets that cannot. The coins in your pocket are clearly part of the
money supply and the Sydney Opera House clearly is not, but there are many assets in
between these extremes for which the choice is less clear. Therefore, various measures of
the money supply are available for the Australian economy. Table 10.1 shows the three most
important monetary aggregates – currency, M3 and broad money. Each of these measures
uses a slightly different criterion for distinguishing monetary from non-monetary assets.
229
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN Chapter
02-200-202
10 The monetary system
10_Stonecash_8e_45658_SB_txt.indd 229
24/08/20 4:34 PM
Measure
Currency
M3
Amount in 2019
($ million)
76 200
2 149 500
What’s included
Notes and coins
Current deposits with banks
Travellers cheques
Savings deposits
Certificates of deposit
Broad money
2 163 000
Everything in M3
Deposits in non-bank financial institutions and
bank deposits by non-bank financial institutions
Source: Reserve Bank of Australia Bulletin
TABLE 10.1 Three measures of the money supply for the Australian economy
Source: Rod Clement, The Economic Rationalist’s
Guide to Sex, Harper Collins, Australia 1997.
Reproduced with permission of Harper Collins
Publishers
For our purposes in this book, we need not dwell on the differences between the various
measures of money. The important point is that the money supply for the Australian
economy includes not just currency but also deposits in banks and other financial
institutions that can be readily accessed and used to buy goods and services.
CASE
STUDY
Whose currency is the fairest in
the land?
For over 50 years, the US dollar has
been the currency that everyone wants.
People around the world have been
willing to accept US dollars in payment
for goods and services in preference to
their own currencies. In fact, in 1960,
it was estimated that half of all US
currency in circulation was held outside
the US. Today, it is estimated that up
to 70 per cent of US currency is held
overseas. So what function is the US
dollar serving? Why would foreigners
want to hold so much US currency?
And will the US dollar continue to be so
desirable? This question has been asked
a lot more since the Global Financial
Crisis showed the US economy to be
more vulnerable than most people
thought.
The US dollar has been used outside
the US for several purposes – as a reserve
currency (held by foreign governments
as a store of value), as a medium of
exchange in countries that don’t have a
stable monetary system, and as a store
of value for tax evaders, drug dealers and
other criminals.
For most people in the US economy,
currency is not a particularly good way
to hold wealth. Currency can be lost or
stolen. Moreover, currency does not
earn interest, whereas money in a bank
account does.
Thus, most people in the US hold only
small amounts of currency. In contrast,
criminals may prefer not to hold their
wealth in banks. A bank deposit would
230
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 5 Money and pricesCopyright
in the long
run
10_Stonecash_8e_45658_SB_txt.indd 230
24/08/20 4:34 PM
give police a paper trail with which to
trace their illegal activities. For criminals,
currency may be the best store of value
available.
But why would other governments
hold US dollars? It’s not because
someone decreed that they should. It’s
because the US economy is the largest in
the world (at least for the time being), it
is important in world trade, it has open
financial markets, its currency is easily
convertible and several countries peg
their currency to the US dollar. All of
these things make it a good store of value
for other governments.
In the 1980s, the Japanese yen was a
threat to the dominance of the US dollar,
as was the euro throughout most of the
2000s. However, most economists don’t
see a decline in the significance of the US
dollar in the global market any time soon.
Even though China is closing in on the US
position as the dominant economy in the
world, the Chinese government still fixes
the rate at which its currency, the yuan
or renminbi, is traded, so it is not likely
to replace the US dollar as the preferred
reserve currency.
Questions
1 Why is the US dollar used outside
of the United States?
2 What factors make the US dollar a
store of value?
CHECK YOUR UNDERSTANDING
List the three functions of money. Why are they important?.
LO10.2 The Reserve Bank of Australia
Whenever an economy relies on a system of fiat money, as the Australian economy does,
some agency must be responsible for regulating the system. In Australia, that agency is the
Reserve Bank of Australia (RBA). If you look at an Australian note, you will see that it is
signed by the Secretary to the Treasury and the Governor of the Reserve Bank of Australia.
The RBA is an example of a central bank – an institution designed to oversee the banking
system and financial conditions of the economy. Other major central banks around the
world include the Federal Reserve System of the United States, the Bank of England, the
Bank of Japan and the European Central Bank.
Reserve Bank of
Australia (RBA)
the central bank
of Australia
central bank
an institution designed
to oversee the banking
system and regulate
the quantity of money
in the economy
FYI
Shutterstock.com/Marie C Fields
Credit cards, debit cards, smart cards and money
Is this money?
It might seem natural to include credit
cards as part of the economy’s supply of
money. After all, people use credit cards
to make many of their purchases. Aren’t
credit cards, therefore, a medium of
exchange?
Although at first this argument
may seem persuasive, credit cards
are excluded from all measures of the
quantity of money. The reason is that
credit cards are not really a method
231
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN Chapter
02-200-202
10 The monetary system
10_Stonecash_8e_45658_SB_txt.indd 231
24/08/20 4:34 PM
of payment but a method of deferring payment, like taking out a short-term loan.
When you buy a meal with a credit card, the bank that issued the card pays the
restaurant what is due. At a later date, you will have to repay the bank (perhaps
with interest). When the time comes to pay your credit card bill, you will probably
do so by transferring funds from your savings or cheque account electronically or
through phone banking. The balance in your savings or cheque account is part of the
economy’s supply of money.
Notice that credit cards are very different from debit cards, which automatically withdraw funds from a bank account to pay for items bought. Rather than allowing the user
to postpone payment for a purchase, a debit card allows the user immediate access to
deposits in a bank account. In this sense, a debit card is more similar to a cheque than to a
credit card. The account balances that lie behind debit cards are included in measures of
the quantity of money.
Smart cards are similar to debit cards in that they aren’t a form of loan like credit
cards – they either access your cheque or savings account balances or are ‘topped
up’ with transfers from your accounts or with cash. They usually have a set amount
transferred to them and then can be used until these balances are drawn down. So,
they aren’t ‘money’ either because you can’t use them unless you have money to
transfer to them.
Even though credit cards are not considered a form of money, they are
nonetheless important in analysing the monetary system. People who have credit
cards can pay many of their bills all at once at the end of the month, rather than
sporadically as they make purchases. As a result, people who have credit cards
probably carry less money on average than people who do not have credit cards.
Thus, the introduction and increased popularity of credit cards may reduce the
amount of money that people choose to carry.
Organisation of the RBA
232
The origins of the RBA are in the Commonwealth Bank of Australia, which was established
in 1911 in response to the banking crisis of the 1890s. It combined the roles of a commercial
bank and a central bank. Central bank functions developed gradually until the Second
World War when the powers of the central banking arm were increased to include control
over exchange rates and administration of monetary and banking policy. In 1945, these
powers were formalised in the Commonwealth Bank Act and the Banking Act. The RBA was
created in its current form by the Reserve Bank Act of 1959, when it was separated from the
Commonwealth Bank and given its own board.
The Reserve Bank Board is responsible for determining the bank’s monetary and banking
policy. The board consists of nine members, including the Governor and Deputy Governor
and the Secretary to the Treasury. The Governor and Deputy Governor are appointed by the
Governor-General on the recommendation of the government. The remaining members of
the board are drawn from industry, universities and, in the past, the trade union movement.
Individuals who are employed by banks are not eligible to be members of the board as this
would represent a conflict of interest.
The Reserve Bank Board determines monetary policy after advice from the various
departments within the RBA. The Economic Group is responsible for economic analysis of
international and domestic markets, forecasting and research relevant to the framing of
monetary policy. The Financial Markets Group is responsible for implementation of policy
decisions. The RBA operates independently of the government of the day, but in cases of
irreconcilable differences over policy, legislation provides for the government to be able to
overrule the RBA. However, this is clearly a measure of last resort. The procedures required
to do this are politically demanding and thus reinforce the RBA’s independence. For the
most part, the RBA and the government interact on a consultative basis.
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 5 Money and pricesCopyright
in the long
run
10_Stonecash_8e_45658_SB_txt.indd 232
24/08/20 4:34 PM
Changes in the RBA’s role
The RBA has, historically, had three related jobs. The first is to monitor individual banks
and ensure their stability. The RBA monitors each bank’s financial condition and makes
recommendations to the bank if it is experiencing financial difficulties and is unable to meet
depositors’ demands. This is known as prudential supervision. (This role has been shifted
to APRA, the Australian Prudential Regulation Authority, discussed below.) A related role
is acting as a guarantor of stability in the banking system. As part of this role, the RBA
also facilitates bank transactions by clearing cheques. This helps ensure that the banking
system has sufficient liquidity at any one time.
Unlike the Federal Reserve in the United States, the RBA does not act as a lender of last
resort. In the United States, when financially troubled banks find themselves short of cash,
the Federal Reserve acts as a lender to those who cannot borrow anywhere else – in order to
maintain stability in the overall banking system. In Australia, the RBA has not specifically
acted in this capacity, although under a new agreement between the former Treasurer,
Wayne Swan, and the Reserve Bank, the bank will provide liquidity to the system if not to
a specific bank. It will continue to monitor liquidity in the system and assist troubled banks
to find a solution to their problems. For instance, the RBA has played a role in facilitating
mergers and acquisitions of troubled banks by other banks.
The RBA’s third job is to determine monetary policy. Monetary policy is the management
by the central bank of liquidity conditions in the economy. Liquidity conditions refers to
the price and availability of funding for the economy’s expenditure. According to the RBA’s
charter, the objectives of monetary policy are to ‘contribute to stability of the currency …,
the maintenance of full employment, and the economic prosperity and welfare of the people
of Australia’. The RBA’s main contribution to these objectives is to control inflation. It has an
announced target for monetary policy of keeping inflation to around 2–3 per cent over time.
The long-run objective of monetary policy is to influence the rate of growth in the
economy and the level of prices. When overall economic growth is too fast and the
economy is overheating, this puts upward pressure on prices. The RBA will implement a
tightening of monetary policy to slow the economy. On the other hand, when the economy
is experiencing slow growth, the RBA will implement expansionary monetary policy. This
process is described in detail next.
The functions of the RBA have changed in the last two decades. An inquiry into the
financial sector, known as the Wallis Inquiry, recommended the separation of these three
roles. A new regulatory body, the Australian Prudential Regulation Authority (APRA),
was created in 1998. APRA performs many of the functions of prudential supervision of
banks – as well as other financial institutions, like insurance companies – that the RBA had
previously performed, and the RBA has been left in charge of monetary policy and operation
of the payments system, or the settlement of cheques between banks. In the past, the RBA
used its instruments of monetary policy to exercise prudential control over the banking
system, but with changes in the implementation of monetary policy and innovations
in the financial sector in the last two decades, these controls were no longer considered
useful. Under the new regulatory structure, the RBA no longer has an obligation to protect
the interests of bank depositors, nor does it supervise any individual financial institution.
Instead, it concentrates more broadly on the overall stability of the financial system.
We discuss later in this chapter how the RBA actually influences the amount of cash in
the economy, but it is worth noting here that the RBA’s main policy target is the cash rate –
the interest rate that financial institutions can earn on overnight loans of their currency
or reserves. The process that the RBA uses to change the cash rate is explained below. The
cash rate is important because it signals whether the Reserve Bank thinks the economy
needs stimulating (indicated by a drop in the cash rate) or slowing down (indicated by an
increase in the cash rate).
monetary policy
the management by
the central bank of
liquidity conditions
in the economy
liquidity conditions
the price and
availability of funding
for the economy’s
expenditure
233
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN Chapter
02-200-202
10 The monetary system
10_Stonecash_8e_45658_SB_txt.indd 233
24/08/20 4:34 PM
IN THE
NEWS
What does ‘money’ mean?
Are we kidding ourselves? Does money really exist? We certainly spend a lot
of time and effort trying to get more of it, but the next article suggests that it’s
all an illusion. So if people will accept Bitcoin, or any other cryptocurrency, in
payment for a good or service, then it’s money.
You Don’t Understand Bitcoin Because You Think Money
Is Real
U.S. dollars is just an illusion more widely and fiercely believed
1 December 2017
Bitcoin is an illusion, a mass hallucination, so one hears. It’s just numbers in
cyberspace, a mirage, insubstantial as a soap bubble. Bitcoin is not backed by anything
other than the faith of the fools who buy it and of the greater fools who buy it from
these lesser fools. And you know? Fair enough. All this is true.
What may be less easy to grasp is that U.S. dollars are likewise an illusion. They too
consist mainly of numbers out there in cyberspace. Sometimes they’re stored in paper
or coins, but while the paper and coins are material, the dollars they represent are not.
U.S. dollars are not backed by anything other than the faith of the fools who accept it
as payment and of other fools who agree in turn to accept it as payment from them.
The main difference is that, for the moment at least, the illusion, in the case of dollars,
is more widely and more fiercely believed.
In fact, almost all of our U.S. dollars, about 90 percent, are purely abstract – they
literally do not exist in any tangible form. James Surowiecki reported in 2012 that ‘only
about 10 percent of the U.S. money supply – about $1 trillion of the roughly $10 trillion
total – exists in the form of paper cash and coins.’ (The number now appears to be
about $1.5 trillion out of $13.7 trillion.) There is nothing stopping our banking system
from creating more dollars whenever the mood strikes. Of the $13.7 trillion in the M2
money supply as of October 2017, $13.5 trillion was created after 1959 – or, to put it
another way, M2 has expanded by almost 50 times.
The U.S. dollar is what is known as a ‘fiat’ currency. Fiat is Latin for ‘let there be,’
as in fiat lux, let there be light; hence, fiat denarii, let there be lire, bolivars, dollars,
and rubles. The temptation for leaders of nation-states to manufacture money has
historically been practically irresistible. One evident result of this wantonness is
inflation: The purchasing power of $1 in 1959 is now a little under 12 cents.
The bitcoin blockchain was created, in part, to address this historical weakness.
After the 21 millionth bitcoin is mined, in around 2140, the system will produce
no more.
Charlatans and thieves will forever try to game the various structures put in place
to control and/or account for any monetary system and, indeed, any store of value
(see: the crooks of the Panama and Paradise Papers, Bernies Cornfeld and Madoff,
the London Whale, LTCM and BCCI, the clever and quiet thieves of treasures from the
Gardner Museum in Boston, the 2008 financial crisis and associated bailouts, and the
thefts at Mt. Gox, the DAO, and Tether). All stores of value are targets. And using any
system of exchange – through fair means or foul – fortunes can and will be made and
lost. And yet, surprising as it may sometimes seem, there are enough people acting in
good faith to prevent monetary systems from collapsing entirely.
There are a few radical differences between cryptocurrencies and U.S. dollars.
For example, the transactions conducted in the bitcoin system are recorded in an
unfalsifiable ledger that relies not on the authority of banks or governments, but on the
strength of a public computer network that (theoretically, at least) anyone is free to join.
Also, again, the supply of bitcoins is ultimately fixed. The anonymity of cryptocurrency is
not, perhaps, quite as bulletproof as the anonymity of (unmarked) cash.
234
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 5 Money and pricesCopyright
in the long
run
10_Stonecash_8e_45658_SB_txt.indd 234
24/08/20 4:34 PM
Money itself is an illusion, a mass hallucination. You’re working hard to make it, grow
it, and keep it, but even so, the only real thing about it is its symbolic power. Which is
indeed awesome, considered from a certain angle.
Our shared understanding of the value of that green-tinted piece of paper,
that Krugerrand, ether token, or pound coin, is all that counts. And that shared
understanding has no fixed meaning; it’s in eternal flux. The ‘value’ of all money, all
stores of exchange, is unstable and abstract, even in the face of every attempt to secure
it – say, with a set rate of exchange against various assets – or to regulate its flow by
setting interest rates. Money is only a shifting network of agreements made in and on
behalf of the hive, and that’s all it has ever been – a fragile thread in a web of human
trust.
Consider the ‘flight capital’ that refugees are forced to trade at a huge loss in order
to cross a hostile border. That is money, but exactly what does it have in common with
the invisible money that is your paycheck, a string of numbers colliding in the ether
with the string of numbers that is your bank account? Maybe the price of avocados
or coffee goes up or down between the time of the electronic collision in your bank
and the day you go to the market. There are natural disasters in which people must
suddenly become willing to pay vastly inflated sums for a few gallons of clean water.
What, then, is ‘the value of a dollar’?
All the common arguments against cryptocurrencies such as bitcoin, and the
blockchain technology that undergirds them, invariably fail to take this fact – the
provisional and fragile nature of ordinary money – into account. Cryptocurrencies
cannot be understood even a little bit by anyone who thinks money is real, solid, or
‘backed by’ anything other than human trust in institutions whose stability is always
uncertain. A U.S. dollar is ‘backed by’ ‘the full faith and credit of the United States.’ But
what exactly does this mean?
It means that if you take one dollar to the U.S. Treasury and ask them to redeem it,
they will: They’ll give you … one dollar. Or four quarters, if you want, probably.
The unfortunate fact is that monetary crises in unstable governments like those of
Greece, Venezuela, and Spain have already precipitated a number of spikes in the crypto
markets. When the Cypriot government sought to resolve the country’s 2013 banking crisis
by subjecting its citizens’ bank deposits to a nearly 7 percent haircut, the price of bitcoin
shot up, likely because, at that point, many southern European holders of euros with
debt-ridden governments surmised that bitcoin might represent a more reliable home for
their money than the Cypriot banks could provide. Spanish bank depositors must have
wondered: Would their own banks be next?
Our existing financial institutions are deeply flawed, in short, and permanently
prone to corruption, and this was so long before bitcoin was a gleam in its mysterious
inventor’s eye. Satoshi Nakamoto made a point of stating it plain as day in the so-called
genesis block that started bitcoin rolling: ‘The Times 03/Jan/2009 Chancellor on brink of
second bailout for banks.’ Bitcoin was a politically motivated project from the first, a new
system explicitly built to provide a tamperproof digital means of exchange on which a
better alternative to our existing banking systems might be based.
The theory behind all cryptocurrencies, including bitcoin, is that the records
produced by a distributed computer network can be made tamperproof, thus
theoretically guaranteeing the soundness of a currency better than governments can.
And so far, despite some substantial bumps in the road, the blockchain system on which
bitcoin is built has at least partially proved this theory. A million or more bitcoins have
been stolen since 2009, but the underlying system’s distributed ledger, the accounting
system on which bitcoin is based, has so far remained stable and incorruptible.
The many thefts and ripoffs that occurred in the early days of bitcoin call to mind
the movie The Treasure of Sierra Madre, a fine drama of greed and corruption set during
the 1920’s. There can be no question that the prospect of instantaneous wealth, almost
close enough to touch, can drive people insane. Note, however, that the propensity of
greed to produce crime and insanity did not cause the value of gold to evaporate.
235
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN Chapter
02-200-202
10 The monetary system
10_Stonecash_8e_45658_SB_txt.indd 235
24/08/20 4:34 PM
The real caveat here is that the incorruptibility of the bitcoin ledger survived, not
only because of the system’s distribution, not only because of its clever cryptographic
safeguards, but because of the good faith and good sense of individual developers
who shepherded the project through its wobbly-legged infancy. Without the sangfroid
of Gavin Andresen, who was effectively bitcoin’s sole steward during many of its early
moments of crisis, the project might easily have died. Even today, the various forks and
growing pains still bedeviling the bitcoin system are providing a kind of stress test. At
present (this is just my opinion) the relative untrustworthiness of bitcoin’s core devs,
who are thought by many to be strategizing for their own benefit, may be inflicting
lasting damage not only to the cause of bitcoin, but also to the promise of blockchain
technology in general.
Source: Maria Bustillos/popula.com https://medium.com/s/the-crypto-collection/you-dont-understand-bitcoinbecause-you-think-money-is-real-5aef45b8e952
Read more about bitcoin at: https://www.rba.gov.au/publications/bulletin/2019/jun/
cryptocurrency-ten-years-on.html
The RBA is an important institution because changes in monetary policy can
profoundly affect the economy. One of the Ten Principles of Economics in chapter 1
is that prices rise when the government prints too much money. Another of the Ten
Principles of Economics is that society faces a short-run trade-off between inflation and
unemployment. The power of the RBA rests on these principles. For reasons we discuss
more fully in the coming chapters, the RBA’s policy decisions have an important influence
on the economy’s rate of inflation in the long run and the economy’s employment and
production in the short run.
CHECK YOUR UNDERSTANDING
Historically, what were the RBA’s functions? Why have they changed in the last
two decades?
LO10.3 Banks and the money supply
So far, we have introduced the concept of ‘money’ and will discuss later in the chapter how
the RBA influences the liquidity or cash in the system by buying and selling government
securities in open-market operations. But as we saw in Table 10.1, the amount of ‘money’ in
the system is much greater than the amount of ‘cash’. How does this work? We explain this
by examining the role that banks play in the monetary system through their acceptance of
deposits and issuing of loans.
Recall that the amount of money you hold includes both currency (the notes in your
wallet and coins in your pocket) and deposits at banks (the balances in your savings and
cheque accounts). Because deposits are held in banks, the behaviour of banks can influence
the quantity of deposits in the economy and, therefore, the money supply. This section
examines how banks affect the money supply and how they complicate the job of controlling
the interest rate and thus the money supply.
The simple case of 100 per cent reserve banking
To see how banks influence the money supply, it is useful to imagine first a world without
any banks at all. In this simple world, currency is the only form of money. To be concrete, let’s
suppose that the total quantity of currency is $100. The supply of money is, therefore, $100.
236
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 5 Money and pricesCopyright
in the long
run
10_Stonecash_8e_45658_SB_txt.indd 236
24/08/20 4:34 PM
Now suppose that someone opens a bank, called First State Bank. First State Bank is
only a depository institution. That is, the bank accepts deposits but does not make loans.
The purpose of the bank is to give depositors a safe place to keep their money. Whenever
people deposit some money, the bank keeps the money in its vault until the depositors come
to withdraw it or write cheques against their balances. Deposits that banks have received
but have not loaned out are called reserves. In this imaginary economy, all deposits are held
as reserves, so this system is called 100 per cent reserve banking.
We can express the financial position of First State Bank with a T-account, which is a
simplified accounting statement that shows changes in a bank’s assets and liabilities. Here
is the T-account for First State Bank if the economy’s entire $100 of money is deposited in
the bank:
reserves
deposits that banks
have received but
have not lent out
First State Bank
Assets
Reserves
Liabilities
$100.00 Deposits
$100.00
On the left-hand side of the T-account are the bank’s assets of $100 (the reserves it holds
in its vaults). On the right-hand side of the T-account are the bank’s liabilities of $100 (the
amount it owes to its depositors). Notice that the assets and liabilities of First State Bank
exactly balance.
Now consider the money supply in this imaginary economy. Before First State Bank
opens, the money supply is the $100 of currency that people are holding. After the bank
opens and people deposit their currency, the money supply is the $100 of current deposits.
(There is no longer any currency outstanding, for it is all in the bank vault.) Each deposit
in the bank reduces currency and raises current deposits by exactly the same amount,
leaving the money supply unchanged. Thus, if banks hold all deposits in reserve, banks do not
influence the supply of money.
Money creation with fractional-reserve banking
Eventually, the bankers at First State Bank may start to reconsider their policy of 100 per
cent reserve banking. Leaving all that money sitting idle in their vaults seems unnecessary.
Why not use some of it to make loans? Families buying houses, firms building new factories
and students paying for university would all be happy to pay interest to borrow some of that
money for a while. Of course, First State Bank has to keep some reserves so that currency is
available if depositors want to make withdrawals. But if the flow of new deposits is roughly
the same as the flow of withdrawals, First State needs to keep only a fraction of its deposits
in reserve. Thus, First State adopts a system called fractional-reserve banking.
Let’s suppose that First State decides to keep 10 per cent of its deposits in reserve and
to lend the rest. Banks may hold reserves because people may want to withdraw some cash
from their accounts. We say that the reserve ratio – the fraction of total deposits that the
bank holds as reserves – is 10 per cent. Now let’s look again at the bank’s T-account:
First State Bank
Assets
Reserves
Loans
Liabilities
$10.00 Deposits
fractional-reserve
banking
a banking system in
which banks hold
only a fraction of
deposits as reserves
reserve ratio
the fraction of
deposits that banks
hold as reserves
$100.00
90.00
First State still has $100 in liabilities because making the loans did not alter the bank’s
obligation to its depositors. But now the bank has two kinds of assets – it has $10 of reserves
in its vault and it has loans of $90. (These loans are liabilities of the people taking out the
237
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN Chapter
02-200-202
10 The monetary system
10_Stonecash_8e_45658_SB_txt.indd 237
24/08/20 4:34 PM
Source: REALITY CHECK © 2008 Dave Whamond.
Reprinted by permission of ANDREWS MCMEEL
SYNDICATION for UFS. All rights reserved
loans but they are assets of the bank making the loans, because the borrowers will later
repay the bank.) In total, First State’s assets still equal its liabilities.
Once again consider the supply of money in the economy. Before First State makes any loans,
the money supply is the $100 of deposits in the bank. Yet when First State makes these loans, the
money supply increases. The depositors still have current deposits totalling $100, but now the
borrowers hold $90 in currency. The money supply (which equals currency plus current deposits)
equals $190. Thus, when banks hold only a fraction of deposits in reserve, banks create money.
At first, this creation of money by fractional-reserve banking may seem too good to
be true because it appears that the bank has created money out of thin air. To make this
creation of money seem less miraculous, note that when First State Bank lends some of its
reserves and creates money, it does not create any wealth. Loans from First State give the
borrowers some currency and thus the ability to buy goods and services. Yet the borrowers
are also taking on debts, so the loans do not make them any richer. In other words, as a bank
creates the asset of money, it also creates a corresponding liability for its borrowers. At the
end of this process of money creation, the economy is more liquid in the sense that there is
more of the medium of exchange, but the economy is no wealthier than before.
The money multiplier
The creation of money does not stop with First State Bank. Suppose the borrower from
First State uses the $90 to buy something from someone who then deposits the currency in
Second State Bank. Here is the T-account for Second State Bank:
Second State Bank
Assets
Liabilities
Reserves
$9.00 Deposits
Loans
81.00
$90.00
After the deposit, this bank has liabilities of $90. If Second State also has a reserve ratio
of 10 per cent, it keeps assets of $9 in reserve and makes $81 in loans. In this way, Second
State Bank creates an additional $81 of money. If this $81 is eventually deposited in Third
State Bank, which also has a reserve ratio of 10 per cent, this bank keeps $8.10 in reserve
and makes $72.90 in loans. Here is the T-account for Third State Bank:
Third State Bank
Assets
Liabilities
Reserves
$8.10 Deposits
Loans
72.90
$81.00
238
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 5 Money and pricesCopyright
in the long
run
10_Stonecash_8e_45658_SB_txt.indd 238
24/08/20 4:34 PM
The process goes on and on. Each time that money is deposited and a bank loan is made,
more money is created. The ‘money’ in the system is in the form of currency plus deposits,
which are considered to be part of the money supply. Remember that there is still only $100
of currency in the system.
How much money is eventually created in this economy? Let’s add it up:
Original deposit
First State lending
Second State lending
Third State lending
•
•
•
Total money supply
= $ 100.00
=
90.00 [= 0.9 × $100.00]
=
81.00 [= 0.9 × $90.00]
=
72.90 [= 0.9 × $81.00]
•
•
•
= $1000.00
It turns out that even though this process of money creation can continue forever, it
does not create an infinite amount of money. If you laboriously add the infinite sequence of
numbers in the foregoing example, you find the $100 of reserves generates $1000 of money.
The amount of money the banking system generates with each dollar of reserves is called
the money multiplier. In this imaginary economy, where the $100 of reserves (the currency
deposited originally in First State Bank) generates $1000 of money ($900 of which is in the
form of deposits), the money multiplier is 10.
What determines the size of the money multiplier? It turns out that the answer is
simple – the money multiplier is the reciprocal of the reserve ratio. If all banks in the economy
had the same reserve ratio, R, then each dollar of reserves generates 1/R dollars of money.
In our example, R = 1/10, so the money multiplier is 10.
This reciprocal formula for the money multiplier makes sense. If a bank holds $1000 in
deposits, then a reserve ratio of 1/10 (10 per cent) means that the bank must hold $100 in
reserves. The money multiplier just turns this idea around – if the banking system holds a
total of $100 in reserves, it can have only $1000 in deposits. Similarly, if the reserve ratio were
1/5 (20 per cent), the banking system must have five times as much in deposits as in reserves,
implying a money multiplier of 5. The higher the reserve ratio, the less of each deposit banks
lend, and the smaller the money multiplier. In the special case of 100 per cent reserve banking,
the reserve ratio is 1, the money multiplier is 1 and banks do not create money.
money multiplier
the amount of money
the banking system
generates with each
dollar of reserves
Bank capital, leverage and the Global Financial Crisis of 2008
In the previous sections, we have seen a very simplified explanation of how banks work.
The reality of modern banking, however, is a bit more complicated and this complex reality
played a leading role in the Global Financial Crisis of 2008. Before looking at that crisis, we
need to learn a bit more about how banks actually function.
In the bank balance sheets you have seen so far, a bank accepts deposits and uses those
deposits either to make loans or to hold reserves. More realistically, a bank gets financial
resources not only from accepting deposits but also, like other companies, from issuing equity
and debt. The resources that a bank obtains from issuing equity to its owners are called bank
capital. A bank uses these financial resources in various ways to generate profit for its owners. It
not only makes loans and holds reserves but also buys financial securities, like stocks and bonds.
Here is a more realistic example of a bank’s balance sheet:
More Realistic National Bank
Assets
Liabilities and owners’ equity
Reserves
$200 Deposits
$800
Loans
$700 Debt
$150
Securities
$100 Capital (owners’ equity)
$50
239
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN Chapter
02-200-202
10 The monetary system
10_Stonecash_8e_45658_SB_txt.indd 239
24/08/20 4:34 PM
On the right side of this balance sheet are the bank’s liabilities and capital (also known
as owners’ equity). This bank obtained $50 of resources from its owners. It also took in $800
of deposits and issued $150 of debt. The total of $1000 was put to use in three ways; these
are listed on the left side of the balance sheet, which shows the bank’s assets. This bank
held $200 in reserves, made $700 in bank loans and used $100 to buy financial securities,
like government or corporate bonds. The bank decides how to allocate its resources among
asset classes based on their risk and return, as well as on any regulations (like reserve
requirements) that restrict the bank’s choices.
By the rules of accounting, the reserves, loans and securities on the left side of the
balance sheet must always equal, in total, the deposits, debt and capital on the right side
of the balance sheet. There is no magic in this equality. It occurs because the value of the
owners’ equity is, by definition, the value of the bank’s assets (reserves, loans and securities)
minus the value of its liabilities (deposits and debt). Therefore, the left- and right-hand sides
of the balance sheet always sum to the same total.
Many businesses in the economy rely on leverage, the use of borrowed money to
supplement existing funds for investment purposes. Indeed, whenever anyone uses debt
to finance an investment project, he or she is applying leverage. Leverage is particularly
important for banks, however, because borrowing and lending are at the heart of what they
do. To fully understand banking, therefore, it is crucial to understand how leverage works.
The leverage ratio is the ratio of the bank’s total assets to bank capital. In this example,
the leverage ratio is $1000/$50, or 20. A leverage ratio of 20 means that for every dollar of
capital that the bank owners have contributed, the bank has $20 of assets. Of the $20 of
assets, $19 are financed with borrowed money – either by taking in deposits or issuing debt.
You may have learned in a science class that a lever can amplify a force: A boulder that
you cannot move with your arms alone will move more easily if you use a lever. A similar
result occurs with bank leverage. To see how this works, let’s continue with this numerical
example. Suppose that the bank’s assets were to rise in value by 5 per cent because, say,
some of the securities the bank was holding rose in price. Then the $1000 of assets would
now be worth $1050. Because the depositors and debt holders are still owed $950, the bank
capital rises from $50 to $100. Thus, when the leverage rate is 20, a 5 per cent increase in the
value of assets increases the owners’ equity by 100 per cent.
The same principle works on the downside, but with troubling consequences. Suppose
that some people who borrowed from the bank default on their loans, reducing the value of
the bank’s assets by 5 per cent, to $950. Because the depositors and debt holders have the
legal right to be paid before the bank owners, the value of the owners’ equity falls to zero.
Thus, when the leverage ratio is 20, a 5 per cent fall in the value of the bank assets leads to
a 100 per cent fall in bank capital. If the value of assets were to fall by more than 5 per cent,
the bank’s assets would fall below its liabilities. In this case, the bank would be insolvent and
it would be unable to pay off its debt holders and depositors in full.
Bank regulators require banks to hold a certain amount of capital. The goal of such a
capital requirement is to ensure that banks will be able to pay off their depositors. The amount
of capital required depends on the kind of assets a bank holds. If the bank holds safe assets
like government bonds, regulators require less capital than if the bank holds risky assets like
loans to borrowers whose credit is of dubious quality. In Australia, the Australian Prudential
Regulation Authority (APRA) requires institutions that accept deposits, like banks, to hold
8 per cent of their assets in high-quality, safe form. This is called the prudential capital ratio.
In 2008, many banks in the US found themselves with too little capital after they had
incurred losses on some of their assets – specifically, mortgage loans and securities backed
by mortgage loans. The shortage of capital induced the banks to reduce their lending,
a phenomenon sometimes called a credit crunch, which in turn contributed to a severe
downturn in economic activity. To address this problem, the US Treasury, working together
with the Federal Reserve (the US central bank), put many billions of dollars of public funds
240
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 5 Money and pricesCopyright
in the long
run
10_Stonecash_8e_45658_SB_txt.indd 240
24/08/20 4:34 PM
into the banking system to increase the amount of bank capital. As a result, it temporarily
made the US taxpayer a part owner of many banks. The goal of this unusual policy was to
recapitalise the banking system so that bank lending could return to a more normal level,
which in fact occurred by late 2009.
Monetary policy in Australia today
We can see from our discussion of fractional-reserve banking that banks have a significant
influence on the amount of money in the economy – how much the banks decide to keep
as reserves and how much they loan out determines the overall level of deposits in the
economy. Since deposits are considered to be part of the money supply, banks have a big
impact on the money supply. Does this mean the RBA can simply change the amount of
reserves banks are required to keep to change the money supply? Not exactly.
Up until 1993, the RBA required banks to keep a fixed percentage of their deposits as
reserves, so the RBA could exercise control over the money supply through the money
multiplier. (The RBA also used other direct controls over banks prior to 1993.) But APRA
no longer requires all banks to have the same level of reserves for prudential purposes. The
amount of reserves each bank keeps depends on the riskiness of their loans and their projected
demand for cash. In our example in the previous section, all banks kept 10 per cent of their
deposits as reserves. But today they are neither required to do so nor do they choose to do so.
So how does the RBA conduct monetary policy if they can’t control the money supply?
Instead of focusing on the amount of money in the system, the RBA targets the cash rate,
as we indicated earlier in this chapter. The RBA uses the cash rate to influence the level of
economic activity rather than attempting to control the money supply. The RBA announces
a cash rate and then either injects cash or removes cash from the short-term money market,
the overnight market for cash, to ensure that the target rate is the equilibrium rate in the
market. Thus, the RBA allows the money supply to adjust to money demand to ensure that
the targeted rate is the actual rate. The cash rate is then used as a benchmark rate from
which other interest rates in the economy are determined.
Each bank keeps deposits with the Reserve Bank to facilitate their transactions with each
other and with the government. These deposits are called exchange settlement (ES) accounts.
The banks use these accounts to resolve any imbalances they have with each other or with the
government at the end of the day. This market is known as the overnight money market. The
deposits in the ES accounts earn a rate of interest from the RBA just below the cash rate and
banks can borrow from the RBA at just above the cash rate if they are short of deposits. This
band, or channel, around the cash rate ensures that the target cash rate announced by the
RBA is the actual cash rate in the overnight money market, where banks can borrow and lend
to each other on a short-term basis. The following examples illustrate how this works:
Suppose Matt gets a notice from the Australian Tax Office (ATO) that he owes them
$100. He has an account with the ABC Bank. He does an electronic funds transfer from his
account at ABC to the ATO. Since the ATO is a government organisation, its bank is the
RBA. So the ATO’s account at the RBA goes up by $100.
Now suppose Margie pays for her trip to Bali using her account with the ANB Bank. She
does an electronic funds transfer of $500 from her account at the ANB to her travel agent’s
account at the ABC Bank. These transfers are all handled through the banks’ exchange
settlement accounts at the RBA.
What’s the result of these transactions at the end of the day? The ABC’s ES account at
the RBA has gone up by $400 – which is equal to the $500 transferred from Margie’s account
with the ANB minus the $100 that Matt owes to the ATO. The ANB’s ES account has gone
down by $500. And the ATO’s account has gone up by $100.
Suppose that ANB doesn’t have the $500 in its ES account. But it ‘owes’ the money to the
ABC. If it is short of money at the end of the day, it can borrow money from the overnight
cash
the amount of
currency and
bank reserves in
the economy
241
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN Chapter
02-200-202
10 The monetary system
10_Stonecash_8e_45658_SB_txt.indd 241
24/08/20 4:34 PM
money market to make up the shortfall. And the rate that it pays for borrowing this money
overnight is essentially the cash rate.
This overnight money market facility gives the RBA great control over the cash rate.
If the RBA supplies more funds to the exchange settlement funds than the banks want to
hold, they will lend this money out in the overnight money market. This increase in funds
leads to a decrease in the cash rate. If the RBA removes funds from the overnight money
market, the cash rate will increase, as banks who want to borrow money bid up the rate.
Thus, the cash rate, sitting within the channel, is determined in the money market as a
result of the interaction between the demand for and supply of overnight funds.
Open-market operations
open-market
operations
the purchase and
sale of Australian
government securities
by the RBA
cash rate
the interest rate that
financial institutions
can earn on overnight
loans of their
currency or reserves
The last piece of this picture is how the RBA adds funds to the market or withdraws funds
from the market. The RBA uses something called open-market operations to guarantee
that its target rate is the equilibrium interest rate in the short-term money market. An openmarket operation is the purchase or sale of Australian government securities. If the RBA
sees that there is an excess supply of funds in the overnight market at the target interest
rate, it will withdraw funds from the market by selling government securities. When it
sells government securities, it takes in cash from the financial institutions purchasing the
government securities by reducing their ES funds, thus reducing the cash in the system. If
there is an excess demand for funds at the target interest rate, the RBA will buy government
securities, increasing the ES funds of the financial institutions selling the securities, thus
increasing the cash in the system. When the RBA increases or decreases the amount of
cash in the system, this changes the price of cash – the cash rate. In essence, the RBA is
setting the ‘price’ of money, and allowing the quantity to adjust to achieve that price. (This
is explained in greater detail in chapter 15.) In this way, the RBA can ensure that its target
cash rate is the actual cash rate in the market.
In practice, the RBA often uses something called a repo, or repurchase agreement, to
affect the level of exchange settlement funds. These repos are agreements between the RBA
and a commercial financial institution that the securities that have been bought or sold
will be resold or repurchased, effectively reversing the transaction, at an agreed date and
price in the future. Repos increased in use during the late 1990s and 2000s as the number
of government securities issued declined due to reductions in government debt and the
reduced need of government to borrow from the public to fund its expenditures.
Figure 10.1 shows that the actual cash rate nearly always equals the target rate.
The RBA determines the target cash rate by examining several factors that bear directly
on the rate of inflation and the level of economic activity in the short run. These include
aggregate demand, the rate of jobs growth, the change in the level of unemployment,
capacity levels in the economy and the impact of international economic conditions. The
board makes a judgement about whether current economic conditions are likely to produce
an increase in inflation or whether the economy is slowing down. For example, when the
RBA Board announces that the cash rate won’t change in a particular month, it puts out a
statement to explain its decision. Go to the RBA website, look for its media release about the
latest board decision and read the Governor’s reasoning.
The cash rate is significant because it is the interest rate that is the foundation for all
other interest rates in the economy. The cash rate is like a wholesale rate that financial
institutions charge one another for borrowing and lending. When financial institutions
then decide to lend to businesses or private individuals, they use the cash rate as a basis for
determining the interest rates they will charge.
How does the change in the cash rate affect the level of economic activity throughout
the economy? If the economy is growing too fast, the RBA will announce a higher target
242
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 5 Money and pricesCopyright
in the long
run
10_Stonecash_8e_45658_SB_txt.indd 242
24/08/20 4:34 PM
FIGURE 10.1 The target cash rate and the actual cash rate
Chart Title
16.00
Target cash rate
14.00
Inter bank rate
12.00
10.00
8.00
6.00
4.00
2.00
0.00
May-1990
Oct-1995
Apr-2001
Oct-2006
Apr-2012
Sep-2017
The graph shows the cash rate the RBA targets and the overnight rate actually obtained.
Source: Reserve Bank of Australia
for the cash rate. The RBA will undertake open-market operations to ensure that the cash
rate moves up to the higher target level. The higher cash rate tends to push up deposit
and borrowing rates at financial institutions in general. For some borrowers, it will now
not make sense to borrow money for previously intended purposes, whether it be an
investment project, a consumer item, or the acquisition of financial assets. Hence there
are fewer opportunities for banks and other financial institutions to profitably expand
their balance sheets by making more loans. The pace of money and credit creation slows
as a result. In addition, the demand for real goods and services falls or grows more slowly
and pressure on resource usage in the economy lessens, resulting in a fall in prices or in
their rate of increase. This process will be described in more detail in chapter 15 but this
brief explanation helps us understand how the RBA’s actions in the short-term money
market affect the short-run position of the economy.
Open-market operations are easy to conduct. In fact, the RBA’s purchases and sales of
government securities in the nation’s bond markets are similar to the transactions that
individuals might undertake for their own portfolios. (Of course, when an individual buys or
sells a security, money changes hands, but the amount of money in circulation remains the
same.) In addition, the RBA can use open-market operations to effect small or large changes
in the cash rate on any day without major changes in laws or banking regulations. (For
more information on monetary policy operations, see: https://www.rba.gov.au/monetarypolicy/)
Problems in controlling the money supply
The RBA uses the cash rate as its policy instrument because it cannot control the money
supply for two reasons, each of which arises because much of the money supply is created
by our system of fractional-reserve banking.
The first problem is that the RBA does not control the amount of money that households
choose to hold as deposits in banks. The more money that households deposit, the more
reserves banks have and the more money the banking system can create. The less money
that households deposit, the less reserves banks have and the less money the banking
243
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN Chapter
02-200-202
10 The monetary system
10_Stonecash_8e_45658_SB_txt.indd 243
24/08/20 4:34 PM
system can create. To see why this is a problem, suppose that one day people begin to lose
confidence in the banking system and, therefore, decide to withdraw deposits and hold more
currency. When this happens, the banking system loses reserves and creates less money.
The money supply falls, even without any RBA action.
This problem is confounded by innovations in the way that people pay for their goods
and services. As we’ve seen, people don’t need to have cash to pay for the things that they
buy. They can use credit cards, debits cards and smart cards and there are probably even
more methods on the way. All of this means that it is harder to predict how much cash
people will actually need and how much they will leave as deposits.
The second problem of monetary control is that the RBA does not control the amount
that bankers choose to lend. Once money is deposited in a bank, it creates more money only
when the bank lends it out. Yet banks can choose the amount of reserves they wish to hold.
To see why variations in the amount of reserves complicate control of the money supply,
suppose that one day bankers become more cautious about economic conditions and decide
to make fewer loans and hold greater reserves. In this case, the banking system creates
less money than it otherwise would. Because of the bankers’ decision, the money supply
falls. We saw this during the Global Financial Crisis, particularly in the US and in Europe, in
financial systems that were more affected by the GFC than Australia.
Hence, in a system of fractional-reserve banking, the amount of money in the economy
depends in part on the behaviour of depositors and bankers. Because the RBA cannot control
or perfectly predict this behaviour, it cannot perfectly control the money supply. Partly
for this reason, the RBA chose to shift its emphasis from controlling the money supply to
targeting interest rates. The RBA still collects data on deposits and reserves from banks and
non-bank financial institutions (NBFIs) every week, so it is quickly aware of any changes
in depositor or banker behaviour. However, it has much more control over the cash rate and
can implement changes in the cash rate fairly quickly. This can be seen in Figure 10.1 where
the target cash rate is graphed against the actual cash rate. This graph shows that when the
RBA sets a target cash rate, it is able to achieve this rate fairly precisely.
CASE
STUDY
Bank runs and the money supply
Although bank runs are infrequent
occurrences, they do happen
occasionally. There were bank runs in
Victoria in 1990–91. A bank run occurs
when depositors suspect that a bank may
go bankrupt and, therefore, ‘run’ to the
bank to withdraw their deposits.
Bank runs are a problem for banks
under fractional-reserve banking.
Because a bank holds only a fraction
of its deposits in reserve, it cannot
satisfy withdrawal requests from all
depositors. Even if the bank is in fact
solvent (meaning that its assets exceed its
liabilities), it will not have enough cash on
hand to allow all depositors immediate
access to all of their money. When a run
occurs, the bank is forced to close its
doors until some bank loans are repaid
or until some arrangement is made by
the RBA to provide it with the currency it
needs to satisfy depositors.
Bank runs complicate the control of
the money supply. An important example
of this problem occurred during the Great
Depression in the early 1930s. After a
wave of bank runs and bank closures,
households and bankers became more
cautious. Households withdrew their
deposits from banks, preferring to hold
their money in the form of currency.
This decision reversed the process of
money creation, as bankers responded to
falling reserves by reducing bank loans.
At the same time, bankers increased
their reserve ratios so that they would
have enough cash on hand to meet their
depositors’ demands in any future bank
runs. The higher reserve ratio reduced
the money multiplier, which also reduced
the money supply. This contraction in
money supply occurred even though
244
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 5 Money and pricesCopyright
in the long
run
10_Stonecash_8e_45658_SB_txt.indd 244
24/08/20 4:34 PM
there was no deliberate action by the
Commonwealth Bank of Australia.
However, the effects of the
contraction in deposits were less severe
in Australia than in other countries. Many
economists nonetheless point to this fall
in the money supply to explain the high
unemployment and falling prices that
prevailed during this period. (In later
chapters we examine the mechanisms by
which changes in the money supply affect
unemployment and prices.)
Today, bank runs are not a major
problem for the banking system or
the RBA. Even though the RBA and
APRA do not specifically guarantee the
safety of deposits at specific banks,
they discourage bank runs through
ensuring stability of the financial
system. (In October 2008, after the
collapse of Lehman Brothers in the
US, the Australian government issued
a guarantee of bank deposits up to $1
million. This guarantee came from the
government, not the RBA.) As a result,
most people see bank runs only in films.
In some other countries, though, other
means are used to prevent people from
making runs on banks. During the 2008–
09 Global Financial Crisis, authorities in
different countries imposed controls on
various types of financial transactions to
prevent people from withdrawing their
deposits from the banking system. And
we’ve seen a major bailout of banks in the
United States precisely because of fears
of runs on the banks in the US.
Questions
1 Why are bank runs an issue under
fractional-reserve banking?
2 How do bank runs affect the
supply of money?
CHECK YOUR UNDERSTANDING
How does the RBA ensure that the target rate is in equilibrium? Explain briefly.
Conclusion
Several years ago, a book made the bestseller list in the United States with the title Secrets
of the Temple: How the Federal Reserve Runs the Country. Although no doubt an exaggeration,
this title highlights the important role of the monetary system in our daily lives. Whenever
we buy or sell anything, we are relying on the extraordinarily useful social convention called
‘money’. Now that we know what money is and what determines its supply, we can discuss
how money supply and money demand interact to affect interest rates and hence the level
of economic activity. We begin to discuss that topic in the next chapter.
245
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN Chapter
02-200-202
10 The monetary system
10_Stonecash_8e_45658_SB_txt.indd 245
24/08/20 4:34 PM
STUDY TOOLS
Summary
LO10.1
The term money refers to assets that people regularly use to buy goods and services.
Money serves three functions. As a medium of exchange, it provides the item used to
make transactions. As a unit of account, it provides the way in which prices and other
economic values are recorded. As a store of value, it provides a way of transferring
purchasing power from the present to the future. Commodity money, like gold, is
money that has intrinsic value – it would be valued even if it were not used as money.
Fiat money, like plastic dollars, is money without intrinsic value – it would be worthless
if it were not used as money. In the Australian economy, money takes the form of
currency and various types of bank deposits, like cheque accounts.
LO10.2
The Reserve Bank of Australia, Australia’s central bank, is responsible for regulating
the Australian monetary system. The RBA sets interest rates to reach a target range of
inflation. It does this through open-market operations – the purchase of government
securities increases the amount of cash in the economy, thus lowering the interest
rate, and the sale of government securities decreases the amount of cash in the
economy, thus increasing the interest rate.
LO10.3
When banks lend some of their deposits, they increase the quantity of money in the
economy. Because of this role of banks in determining the money supply, the RBA’s
control of the money supply is imperfect.
Key concepts
cash, p. 241
cash rate, p. 242
central bank, p. 231
commodity money, p. 226
currency, p. 228
current deposits, p. 228
fiat money, p. 227
fractional-reserve banking, p. 237
liquidity, p. 226
liquidity conditions, p. 233
medium of exchange, p. 226
monetary policy, p. 233
money, p. 225
money multiplier, p. 239
money supply, p. 228
open-market operations, p. 242
Reserve Bank of Australia (RBA), p. 231
reserve ratio, p. 237
reserves, p. 237
store of value, p. 226
unit of account, p. 226
Practice questions
Questions for review
1 What distinguishes money from other assets in the economy?
2 What is the difference between commodity money and fiat money? Which is more often
used and why?
3 Why should current deposits be included in the supply of money?
4 What are the three measures of money supply for the Australian economy? Where would
Bitcoin (a cryptocurrency currency) fall into these measures?
5 What is the cash rate? What happens to the money supply when the RBA raises the
cash rate?
6 How do changes in the cash rate affect all other interest rates in the economy?
7 Why would financial institutions say they no longer strictly follow movements in the
cash rate to determine the interest rates that they charge people who borrow money
from them?
8 What are reserve requirements? Why are some commentators calling for a reintroduction
of reserve requirements?
9 How will an increase in Bitcoin use affect the ability of the RBA to administer monetary
policy?
10 What is meant by ‘prudential supervision’? Which agency is now responsible for this
function in the Australian financial system?
246
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 5 Money and pricesCopyright
in the long
run
10_Stonecash_8e_45658_SB_txt.indd 246
24/08/20 4:34 PM
Multiple choice
1
2
3
4
5
Which of the following are not good to use as a medium of exchange?
a a car you own
b gold
c coins
d plastic notes from the RBA
Which of the following are good to use for a store of value?
a very expensive caviar
b a very rare painting by a Dutch master
c currency from a country with a very high inflation rate
d iTunes songs
If banks had to keep 100% of their deposits as reserves, what would happen to the supply
of money in the economy?
a It would go down as people would deposit more money in the bank.
b It would stay the same as people don’t use banks as much as they used to.
c It would go down as banks couldn’t loan out money any more.
d It wouldn’t matter as money is printed by the RBA.
If Bitcoin becomes more acceptable, what effect will it have on the effectiveness of
monetary policy?
a It will increase it because people will have more ways to purchase goods and services.
b It will decrease it because people will use Australian currency only for buying Australian
goods.
c It will have no effect because Bitcoin requires people to have internet accounts.
d It will decrease effectiveness because it gives people an alternative to the official
Australian currency.
Which of the following is not the job of the Reserve Bank of Australia?
a to ensure the stability of the banking system
b to set the inflation rate
c to set monetary policy
d to monitor economic conditions in the economy
Problems and applications
1
2
3
4
5
6
Which of the following is money in the Australian economy? Which is not? Explain your
answers by discussing each of the three functions of money.
a an Australian dollar coin
b a euro (the currency of the European Union)
c a Lamborghini
d Apple Pay
Suppose the RBA decided to decrease the cash rate. How will this affect all other interest
rates in the economy? Explain the process of how the RBA will achieve this.
Most people think their house is their biggest asset. Consider the three functions of money.
Does your family home perform these three functions well?
Consider how the following situations would affect the economy’s monetary system.
a Suppose that more shops start accepting Bitcoin in payment. What would this do to the
RBA’s ability to influence interest rates in the economy? Explain.
b Suppose that someone in Australia discovered an easy way to counterfeit Bitcoin. How
would this development affect the Australian monetary system? Explain.
Your aunt repays a $100 loan from Third State Bank (TSB) by writing a $100 cheque on her
TSB cheque account. Use T-accounts to show the effect of this transaction on your aunt
and on TSB. Has your aunt’s wealth changed? Explain.
Iron Bank (IB) holds $350 million in deposits and maintains a reserve ratio of 10 per cent.
a Show a T-account for IB.
b Now suppose that IB’s largest depositor withdraws $10 million from her account in cash.
If IB decides to restore its reserve ratio by reducing the amount of loans outstanding,
show its new T-account.
c Explain what effect IB’s action will have on other banks.
247
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN Chapter
02-200-202
10 The monetary system
10_Stonecash_8e_45658_SB_txt.indd 247
24/08/20 4:34 PM
7
8
9
d Why might it be difficult for IB to take the action described in part (b)? Discuss another
way for IB to return to its original reserve ratio.
What would be the impact on the money supply, bank reserves and interest rates if the
RBA announced that from tomorrow coins would no longer be accepted as legal tender
(and the RBA did not issue any new notes)?
Happy Bank starts with $200 in bank capital. It then takes in $800 in deposits. It keeps 8
per cent (1/12th) of deposits in reserve. It uses the rest of its assets to make bank loans.
a Show the balance sheet of Happy Bank.
b What is Happy Bank’s leverage ratio?
c Suppose that 10 per cent of the borrowers from Happy Bank default and these bank
loans become worthless. Show the bank’s new balance sheet.
d By what percentage do the bank’s total assets decline? By what percentage does the
bank’s capital decline? Which change is larger? Why?
Suppose that the T-account for First State Bank (FSB) is as follows:
First State Bank
Assets
Reserves
Loans
Liabilities
$100 000 Deposits
$1 000 000
900 000
a
10
11
12
13
Suppose a borrower from FSB pays off their loan and no one else wants to take out a
loan. (Suppose they had a $200 000 loan from FSB.) How does this affect their balance
sheet?
b If people aren’t taking out loans, how does this affect the money supply?
Suppose that banks hold reserves of 5 per cent against cheque account deposits.
a If the RBA sells $1 million of government securities, what is the effect on the economy’s
reserves and money supply?
b Suppose banks decide to increase their reserves to 10 per cent. Why might banks
choose to do so? What effect does this have on the money supply?
Suppose MacroComp, a major software company, buys PCGames, a small Australian
company that produces computer games. They draw a cheque on their account at Which
Bank for $100 million. The owners of PC Games deposit this cheque in their account at
That Bank.
a Show what happens to the balance sheet of both Which Bank and That Bank.
b Show the balance sheet of their exchange settlement accounts at the RBA.
c If the sale of the software company is the largest transaction of the day, which of the
two banks is more likely to have to borrow money on the short-term money market?
(This problem is challenging.) The economy of the Seven Kingdoms contains 3000 $1 notes.
If people hold all money as currency, what is the quantity of money?
a If people hold all money as current deposits and banks maintain 100 per cent reserves,
what is the quantity of money?
b If people hold equal amounts of currency and current deposits and banks maintain 100
per cent reserves, what is the quantity of money?
c If people hold all money as current deposits and banks maintain a reserve ratio of 10
per cent, what is the quantity of money?
d If people hold equal amounts of currency and current deposits and banks maintain a
reserve ratio of 10 per cent, what is the quantity of money?
What are the two problems in controlling the supply of money? Explain them.
248
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 5 Money and pricesCopyright
in the long
run
10_Stonecash_8e_45658_SB_txt.indd 248
24/08/20 4:34 PM
11
Inf lation: Its causes
and costs
Learning objectives
After reading this chapter, you should be able to:
LO11.1 discuss the causes of inflation and hyperinflation, and explain the
principle of monetary neutrality
LO11.2 discuss the various costs that inflation imposes on society.
249
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
11_Stonecash_8e_45658_SB_txt.indd 249
24/08/20 4:34 PM
Introduction
Although today you need more than a dollar or two to buy yourself an ice-cream, life was
very different 50 years ago. If you were walking along Bondi Beach on a hot summer’s day
and wanted to buy an ice-cream, it would have cost you about 5 cents.
You are probably not surprised at the increase in the price of ice-cream. In our economy,
most prices tend to rise over time. This increase in the overall level of prices is called
inflation. Earlier in the book we examined how economists measure the inflation rate as the
percentage change in the consumer price index, the GDP deflator, or some other index of the
overall price level. These price indexes show that, over the past 50 years, prices have risen
on average about 5 per cent per year. Accumulated over so many years, a 5 per cent annual
inflation rate leads to almost a 15-fold increase in the price level.
Inflation may seem natural and inevitable to a person who grew up in Australia during the
second half of the twentieth century, but in fact it is not inevitable at all. There were long periods
in the nineteenth century during which most prices fell – a phenomenon called deflation. The
average level of prices in the Australian economy was 20 per cent lower in 1898 than in 1889.
Farmers who had accumulated large debts suffered when the fall in crop prices reduced their
incomes and thus their ability to pay off their debts. It was a time of great turmoil in the colonies.
Although inflation has been the norm in more recent history, there has been substantial
variation in the rate at which prices rise. From 1990 to 2016, prices rose at an average rate
of about 2.7 per cent per year, with inflation dropping below 2 per cent from 2015–16. In
contrast, in the 1970s, prices rose by almost 11 per cent per year, which meant the price level
increased by more than 2½ times over the decade. The public often views such high rates
of inflation as a major economic problem. In fact, when Malcolm Fraser led the Coalition
to victory in the 1975 election, high inflation was one of the major issues of the campaign.
Fraser promised to ‘fight inflation first’.
International data show an even broader range of inflation experiences. Germany after
the First World War experienced a spectacular example of inflation. The price of a newspaper
rose from 0.3 of a mark in January 1921 to 70 000 000 marks less than two years later. Other
prices rose by similar amounts. An extraordinarily high rate of inflation like this is called
hyperinflation. New Zealand had such high inflation in the 1970s and 1980s that the central
bank made low inflation its number one priority in the 1990s. In 1996, the Reserve Bank of
New Zealand announced an inflation target of between 0 per cent and 3 per cent per year.
Other countries, like Japan, have experienced very low rates of inflation. In 2010, Japan had
negative inflation – that is, prices declined by 1.4 per cent on average.
What determines whether an economy experiences inflation and, if so, how much?
This chapter answers the question by developing the quantity theory of money. Chapter 1
summarised this theory as one of the Ten Principles of Economics – prices rise when the
government prints too much money. This insight has a long and venerable tradition
among economists. The quantity theory was discussed by the famous eighteenth-century
philosopher David Hume and has been advocated more recently by the prominent economist
Milton Friedman. This theory of inflation can explain both moderate inflations, like those
we have experienced in Australia, and hyperinflations, like those experienced in interwar
Germany and, more recently, in some Latin American and African countries.
After developing a theory of inflation, we turn to a related question: Why is inflation
a problem? At first glance, the answer to this question may seem obvious – inflation is a
problem because people don’t like it. In the 1970s, when Australia experienced relatively
high rates of inflation, opinion polls placed inflation as one of the most important issues
facing the nation. This sentiment was echoed in other countries as well. In the United
States, President Ford called inflation ‘public enemy number one’. Ford briefly wore a ‘WIN’
button on his lapel – for Whip Inflation Now.
But what, exactly, are the costs that inflation imposes on a society? The answer may
surprise you. Identifying the various costs of inflation is not as straightforward as it first
appears. As a result, although all economists decry hyperinflation, some economists argue
that the costs of moderate inflation are not nearly as large as the general public believes.
250
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 5 Money and pricesCopyright
in the long
run
11_Stonecash_8e_45658_SB_txt.indd 250
24/08/20 4:34 PM
LO11.1 The causes of inf lation
We begin our study of inf lation by developing the quantity theory of money. Most
economists rely on this theory for explaining the long-run determinants of the price level
and the inflation rate.
The level of prices and the value of money
Suppose we observe over some period of time the price of an ice-cream rising from 5 cents
to a dollar. What conclusion should we draw from the fact that people are willing to give
up so much more money in exchange for an ice-cream? It is possible that people have come
to enjoy ice-cream more (perhaps because some celebrity chef has developed a miraculous
new flavour). Yet that is probably not the case. It is more likely that people’s enjoyment
of ice-cream has stayed roughly the same and that, over time, the money used to buy icecream has become less valuable. Indeed, the first insight about inflation is that it is more
about the value of money than about the value of goods.
This insight helps point the way towards a theory of inflation. When the consumer price
index and other measures of the price level rise, commentators are often tempted to look at
the many individual prices that make up these price indexes: ‘The CPI rose by 3 per cent last
month, led by a 20 per cent rise in the price of coffee and a 30 per cent rise in the price of petrol’.
Although this approach does contain some interesting information about what’s happening
in the economy, it also misses a key point – inflation is an economy-wide phenomenon that
concerns, first and foremost, the value of the economy’s medium of exchange.
The economy’s overall price level can be viewed in two ways. So far, we have viewed
the price level as the price of a basket of goods and services. When the price level rises,
people have to pay more for the goods and services they buy. Alternatively, we can view
the price level as a measure of the value of money. A rise in the price level means a lower
value of money because each dollar in your wallet now buys a smaller quantity of goods
and services.
It may help to express these ideas mathematically. Suppose P is the price level as measured,
for instance, by the consumer price index or the GDP deflator. Then P measures the number of
dollars needed to buy a basket of goods and services. Now turn this idea around – the quantity
of goods and services that can be bought with $1 equals 1/P. In other words, if P is the price of
goods and services measured in terms of money, 1/P is the value of money measured in terms
of goods and services. Thus, when the overall price level rises, the value of money falls.
Money supply, money demand and monetary equilibrium
What determines the value of money? The answer to this question, like many in economics,
is supply and demand. Just as the supply of and demand for bananas determine the price of
bananas, the supply of and demand for money determine the value of money. Thus, our next
step in developing the quantity theory of money is to consider the determinants of money
supply and money demand.
First consider money demand. There are many determinants of the quantity of money
demanded, just as there are many determinants of the quantity demanded of other goods
and services. How much money people choose to hold in their wallets, for instance, depends
on how much they rely on credit cards and on whether an automatic teller machine is easy to
find. And, as we will emphasise in a later chapter, the quantity of money demanded depends
on the interest rate that a person could earn by using the money to buy an interest-bearing
bond rather than leaving it in a wallet or low-interest cheque account.
Although many variables affect the demand for money, one variable stands out in
importance – the average level of prices in the economy. People hold money because it is
the medium of exchange. Unlike other assets, like bonds or shares, people can use money to
251
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
WCN 02-200-202
Chapter
11 Inflation: Its causes and costs
11_Stonecash_8e_45658_SB_txt.indd 251
24/08/20 4:34 PM
buy the goods and services on their shopping lists. How much money they choose to hold
for this purpose depends on the prices of those goods and services. The higher prices are, the
more money the typical transaction requires and the more money people will choose to hold
in their wallets and cheque accounts. That is, a higher price level (a lower value of money)
increases the quantity of money demanded for transaction purposes.
Now consider the money supply. In the last chapter, we discussed how the Reserve Bank
of Australia (RBA), together with the banking system, influences the supply of money. The
RBA no longer sets a target for the level of the money supply. Some central banks still do,
though. In the following explanation, we begin to see why modern central banks focus on
interest rates and inflation rather than targeting the level of the money supply.
To help us understand the relationship between the level of prices and the value of money,
let’s consider an economy called Zoobooloo. In the land of Zoobooloo, the Central Bank sets
the level of money supply. What ensures that the quantity of money the Zoobooloo Central
Bank (ZCB) supplies balances the quantity of money people demand? The answer, it turns
out, depends on the time horizon being considered. Later in this book we will examine the
short-run answer and we will see that interest rates play a key role. In the long run, however,
the answer is different and much simpler. In the long run, the overall level of prices adjusts
to the level at which the demand for money equals the supply. If the price level is above the
equilibrium level, people will want to hold more money than the ZCB has created, so the
price level must fall to balance supply and demand. If the price level is below the equilibrium
level, people will want to hold less money than the ZCB has created and the price level must
rise to balance supply and demand. At the equilibrium price level, the quantity of money
that people want to hold exactly balances the quantity of money supplied by the ZCB.
Figure 11.1 illustrates these ideas. The horizontal axis of this graph shows the quantity
of money. The left-hand vertical axis shows the value of money and the right-hand vertical
FIGURE 11.1 H
ow the supply of and demand for money in Zoobooloo determine the
equilibrium price level
Value of
money
(High)
Price
level
Money supply
1
1
/
1.33
3 4
/
1 2
Equilibrium
value of
money
(Low)
A
(Low)
2
Equilibrium
price level
4
/
1 4
Money
demand
0
Quantity fixed
by the ZCB
Quantity of
money
(High)
The horizontal axis shows the quantity of money. The left vertical axis shows the value of money
and the right vertical axis shows the price level. The supply curve for money is vertical because
the quantity of money supplied is fixed by the ZCB. The demand curve for money is downwardsloping because people want to hold a larger quantity of money when each dollar buys less.
At the equilibrium, point A, the value of money (on the left axis) and the price level (on the
right axis) have adjusted to bring the quantity of money supplied and the quantity of money
demanded into balance.
252
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 5 Money and pricesCopyright
in the long
run
11_Stonecash_8e_45658_SB_txt.indd 252
24/08/20 4:34 PM
axis shows the price level. Notice that the price level axis is inverted – when the value of
money is high (as measured on the left axis), the price level is low (as measured on the right
axis). The supply curve for money in this figure is vertical, indicating that the ZCB has
fixed the quantity of money available. The demand curve for money is downward-sloping,
indicating that when the value of money is low, people demand a larger quantity of it to
buy goods and services. At the equilibrium, shown in the figure as point A, the quantity
of money demanded balances the quantity of money supplied. This equilibrium of money
supply and money demand determines the value of money and the price level.
The effects of a monetary injection
Let’s see what happens to the value of the Zoobooloo dollar (Z$) when the ZCB increases
the money supply. To do so, imagine that the economy is in equilibrium and then, suddenly,
the ZCB does as economist Milton Friedman suggested and doubles the supply of money
by printing some more and dropping it around the country from helicopters. (Or, less
dramatically and more realistically, the ZCB could inject money into the economy by buying
some government bonds from the public in open-market operations.) What happens after
such a monetary injection? How does the new equilibrium compare with the old one?
Figure 11.2 shows what happens. The monetary injection shifts the supply curve to
the right from MS1 to MS2, and the equilibrium moves from point A to point B. As a result,
the value of money (shown on the left axis) decreases from ½ to ¼ and the equilibrium
price level (shown on the right axis) increases from 2 to 4. In other words, when an increase
in the money supply makes dollars more plentiful, the result is an increase in the price level
that makes each dollar less valuable.
FIGURE 11.2 An increase in the money supply
Value of
money
(High)
2. … decreases
the value of
money …
MS1
Price
level
MS2
1
1
1. An increase
in the money
supply ...
/
3 4
/
1 2
1.33
A
2
B
/
1 4
(Low)
3. … and
increases
the price
level.
4
Money
demand
(Low)
(High)
0
M1
M2
Quantity of
money
When the ZCB increases the supply of money, the money supply curve shifts from MS1 to MS2.
The value of money (on the left axis) and the price level (on the right axis) adjust to bring supply
and demand back into balance. The equilibrium moves from point A to point B. Thus, when an
increase in the money supply makes dollars more plentiful, the price level increases, making
each dollar less valuable.
253
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
WCN 02-200-202
Chapter
11 Inflation: Its causes and costs
11_Stonecash_8e_45658_SB_txt.indd 253
24/08/20 4:34 PM
CASE
STUDY
IN THE
NEWS
This explanation of how the price level is determined and why it might change over time
is called the quantity theory of money. According to the quantity theory, the quantity of
money available in the economy determines the value of money, and growth in the quantity
of money is the primary cause of inflation. As Milton Friedman once put it: ‘Inflation is
always and everywhere a monetary phenomenon’.
The long-lasting effect of
printing money
Our example of Zoobooloo shows what
happens when a central bank prints more
money. Most Western central banks now
focus more on interest rates rather than
money supply, but the dangers of printing
too much money are still very present
today. According to Steve Hanke of
Forbes magazine, in Zimbabwe inflation
was estimated at 6.5 quindecillion
novemdecillion per cent (65 followed by
107 zeros) in December 2008 because the
Zimbabwean Reserve Bank printed too
much money. It’s hard to even imagine
what that means. As Hanke said, it means
prices double nearly every 24 hours.
There were signs in public toilets that said
Zimbabwe Dollar Returns,
a Decade After It Became
Worthless
By Antony Sguazzin and Ray Ndlovu
24 June 2019
Zimbabwe has brought back its own
currency, the Zimbabwe dollar, just
over a decade after its usefulness was
destroyed by hyperinflation.
The central bank said that effective
immediately, currencies including the
U.S. dollar and the South African rand,
in use since 2009, will no longer be
accepted as legal tender. A local quasi
currency known as bond notes, which
was introduced in 2016 but can’t trade
outside the country, and their electronic
equivalent, the RTGS dollar, will now be
known as the Zimbabwe dollar.
The authorities had abandoned the
Zimbabwe dollar after inflation reached
an estimated 500 billion percent in 2008,
according to the International Monetary
the Zim dollar wasn’t even good for toilet
paper! More than a decade later, the Zim
dollar has returned, but it’s still being
discounted on the street, as Figure 11.3
shows.
Getty Images/EFP/Desmond Kwande
quantity theory of
money
a theory asserting that
the quantity of money
available determines
the price level and
that the growth rate in
the quantity of money
available determines
the inflation rate
Fund. While the country has since
used a basket of currencies from the
continent and abroad as well as bond
notes and the RTGS$, some government
departments and agencies have until
recently demanded payment in the
greenback.
The central bank made it clear in
its announcement that money held in
foreign-currency accounts will not be
affected, but the step will be greeted with
alarm and memories of the lives wrecked
and pensions and savings lost in 2008.
Recollections of what effectively became
a barter economy in a country where a
suitcase full of bank notes was needed to
purchase a pair of jeans will be hard to
erase.
The central bank also announced
a series of other measures, including
raising the rate on its overnight window
to 50% from 15%, to buttress the
currency.
254
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 5 Money and pricesCopyright
in the long
run
11_Stonecash_8e_45658_SB_txt.indd 254
24/08/20 4:34 PM
something backing the currency. There’s
no way that something like this will be
maintained. People will not trust the
currency. It will promote more off-market
activity even more if that’s possible.’
‘Any attempt by the officials to bring a
new currency would require confidence,’
said Jee-A van der Linde, an economist
at NKC African Economics in Paarl, South
Africa. ‘People aren’t sure that there’s
FIGURE 11.3 Zimbabwe dollar vs US dollar
14
RTGS$ per U.S. dollar
12
Interbank rate for RTGS$
RTGS$ parallel exchange rate
10
8
6
4
2
0
Mar 29
Apr 15
Apr 30
May 15
May 31
Jun 14
Source: Reserve Bank of Zimbabwe, Bloomberg
In February, the central bank
introduced the RTGS$ and said it and
bond notes would no longer be pegged
to the U.S. currency. This precipitated
a rapid depreciation in both the newly
introduced interbank rate and the blackmarket value. Inflation, at 97.9%, is now
at its highest since at least 2008.
This ‘will worsen the situation,’ said
Christopher Mugaga, the chief executive
officer of the Zimbabwe National Chamber
of Commerce. Companies ‘with real dollars
will simply go underground,’ he said.
Finance Minister Mthuli Ncube
said Monday’s announcement gives
the central bank ‘flexibility’ to conduct
monetary policy. The authorities in
Zimbabwe have previously said the
central bank plans to establish a
Monetary Policy Committee.
‘We can also expect the creation of
a monetary policy committee as part
of the micro institutions that are going
towards stabilizing the value of the
currency,’ he said on state television.
Source: Used with permission of Bloomberg L.P.
Copyright©2020. All rights reserved.
Question
How does the quantity theory of
money relate to Zimbabwe over the
last two decades?
A brief look at the adjustment process
So far, we have compared the old equilibrium and the new equilibrium after an injection
of money. How does the economy get from the old to the new equilibrium? A complete
answer to this question requires an understanding of short-run fluctuations in the economy,
which we examine later in this book. Yet, even now, it is instructive to consider briefly the
adjustment process that occurs after a change in money supply.
The immediate effect of a monetary injection is to create an excess supply of money.
Before the injection, the economy was in equilibrium (point A in Figure 11.2). At the
prevailing price level, people had exactly as much money as they wanted. But after the
255
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
WCN 02-200-202
Chapter
11 Inflation: Its causes and costs
11_Stonecash_8e_45658_SB_txt.indd 255
24/08/20 4:34 PM
helicopters drop the new money and people pick it up in the streets, people have more dollars
in their wallets than they want. At the prevailing price level, the quantity of money supplied
now exceeds the quantity demanded.
People try to get rid of this excess supply of money in various ways. They might buy
goods and services with their excess holdings of money. Or they might use this excess
money to make loans to others by buying bonds or by depositing the money in a bank
savings account. These loans allow other people to buy goods and services. In either case,
the injection of money increases the demand for goods and services.
Because the economy’s ability to produce goods and services has not changed, this
greater demand for goods and services causes the prices of goods and services to increase.
The increase in the price level, in turn, increases the quantity of money demanded.
Eventually, the economy reaches a new equilibrium (point B in Figure 11.2) at which the
quantity of money demanded again equals the quantity of money supplied. In this way, the
overall price level for goods and services adjusts to bring money supply and money demand
into balance.
The classical dichotomy and monetary neutrality
nominal variables
variables measured
in monetary units
real variables
variables measured
in physical units
classical dichotomy
the theoretical
separation of nominal
and real variables
We have seen how changes in the money supply lead to changes in the average level of
prices of goods and services. How do these monetary changes affect other important
macroeconomic variables, like production, employment, real wages and real interest rates?
This question has long intrigued economists. Indeed, the great philosopher David Hume
wrote about it in the eighteenth century.
Hume and his contemporaries suggested that economic variables should be divided into
two groups. The first group consists of nominal variables – variables measured in monetary
units. The second group consists of real variables – variables measured in physical units. For
example, the income of corn farmers is a nominal variable because it is measured in dollars,
whereas the quantity of corn they produce is a real variable because it is measured in bushels.
Nominal GDP is a nominal variable because it measures the dollar value of the economy’s
output of goods and services; real GDP is a real variable because it measures the total quantity
of goods and services produced and is not influenced by the current prices of those goods and
services. The separation of real and nominal variables is now called the classical dichotomy.
(A dichotomy is a division into two groups, and classical refers to the earlier economic thinkers.)
Applying the classical dichotomy is tricky when we turn to prices. Most prices are quoted
in units of money and, therefore, are nominal variables. When we say that the price of corn
is $2 a bushel or that the price of wheat is $1 a bushel, both prices are nominal variables. But
what about a relative price – the price of one thing compared with another? In our example,
we could say that the price of a bushel of corn is 2 bushels of wheat. This relative price is not
measured in terms of money. When comparing the prices of any two goods, the dollar signs
cancel and the resulting number is measured in physical units. Thus, while dollar prices are
nominal variables, relative prices are real variables.
This lesson has many applications. For instance, the real wage (the dollar wage adjusted
for inflation) is a real variable because it measures the rate at which people exchange
goods and services for a unit of labour. Similarly, the real interest rate (the nominal interest
rate adjusted for inflation) is a real variable because it measures the rate at which people
exchange goods and services today for goods and services in the future.
Why separate variables into these groups? The classical dichotomy is useful because
different forces influence real and nominal variables. According to classical analysis,
nominal variables are influenced by developments in the economy’s monetary system,
whereas money is largely irrelevant for explaining real variables.
This idea was implicit in our discussion of the real economy in the long run. In
previous chapters, we examined how real GDP, saving, investment, real interest rates
256
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 5 Money and pricesCopyright
in the long
run
11_Stonecash_8e_45658_SB_txt.indd 256
24/08/20 4:34 PM
and unemployment are determined without mentioning the existence of money. In that
analysis, the economy’s production of goods and services depends on productivity and
factor supplies, the real interest rate balances the supply and demand for loanable funds,
the real wage balances the supply and demand for labour and unemployment results when
the real wage is for some reason kept above its equilibrium level. These conclusions have
nothing to do with the quantity of money supplied.
Changes in the supply of money, according to classical analysis, affect nominal variables
but not real variables. When the central bank doubles the money supply, the price level
doubles, the dollar wage doubles and all other dollar values double. Real variables, like
production, employment, real wages and real interest rates, are unchanged. This irrelevance
of monetary changes for real variables is called monetary neutrality.
An analogy sheds light on the meaning of monetary neutrality. Recall that, as the unit of
account, money is the yardstick we use to measure economic transactions. When a central
bank doubles the money supply, all prices double and the value of the unit of account falls
by half. A similar change would occur if the government were to reduce the length of a metre
from 100 cm to 50 cm – as a result of the new unit of measurement, all measured distances
(nominal variables) would double, but the actual distances (real variables) would remain
the same. The dollar, like the metre, is merely a unit of measurement, so a change in its value
should not have important real effects.
Is this conclusion of monetary neutrality a realistic description of the world in which
we live? The answer is ‘not completely’. A change in the length of a metre from 100 cm to
50 cm would not matter much in the long run, but in the short run it would certainly lead to
confusion and various mistakes. Similarly, most economists today believe that over short
periods of time – within the span of a year or two – there is reason to think that monetary
changes do have important effects on real variables. Hume himself also doubted that
monetary neutrality would apply in the short run. (We will turn to the study of short-run
non-neutrality in a later chapter.)
Yet most economists today accept the classical analysis’ conclusion as a description of
the economy in the long run. Over the course of a decade, for instance, monetary changes
have important effects on nominal variables but only negligible effects on real variables.
When studying long-run changes in the economy, the neutrality of money offers a good
description of how the world works.
monetary neutrality
the proposition
that changes in the
money supply do not
affect real variables
Velocity and the quantity equation
We can obtain another perspective on the quantity theory of money by considering the
following question: How many times per year is the typical dollar coin used to pay for a
newly produced good or service? The answer to this question is given by a variable called
the velocity of money. In physics, the term velocity refers to the speed (and direction) at
which an object travels. In economics, the velocity of money refers to the speed at which the
typical note or coin travels around the economy from wallet to wallet.
To calculate the velocity of money, we divide the nominal value of output (nominal GDP)
by the quantity of money. If P is the price level (the GDP deflator), Y the quantity of output
(real GDP) and M the quantity of money (notes and coins), then velocity is:
V=
velocity of money
the rate at which
money changes hands
(P × Y )
M
To see why this makes sense, imagine a simple economy that produces only pizza. Suppose
that the economy produces 100 pizzas in a year, that a pizza sells for $10, and that the quantity
of money in the economy is $50, consisting of 50 dollar coins. Then the velocity of money is:
($10 × 100)
$50
= 20
V=
257
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
WCN 02-200-202
Chapter
11 Inflation: Its causes and costs
11_Stonecash_8e_45658_SB_txt.indd 257
24/08/20 4:34 PM
In this economy, people spend a total of $1000 per year on pizza. For this $1000 of
spending to take place with only $50 of money, each dollar coin must change hands 20 times
per year.
With slight algebraic rearrangement, this equation can be rewritten as:
M×V=P×Y
quantity equation
the equation M × V =
P × Y, which relates
the quantity of money,
the velocity of money
and the dollar value of
the economy’s output
of goods and services
CASE
STUDY
This equation states that the quantity of money (M) times the velocity of money (V )
equals the price of output (P) times the amount of output (Y ). It is called the quantity
equation because it relates the quantity of money (M) to the nominal value of output (P × Y ).
The quantity equation shows that an increase in the quantity of money in an economy must
be reflected in one of the other three variables – the price level must rise, the quantity of
output must rise, or the velocity of money must fall.
If we assume that the velocity of money is relatively stable, we have a clear relationship
between money and prices in the long run. We now have all the elements necessary to
explain the equilibrium price level and inflation rate. Here they are:
1 Assume the velocity of money is relatively stable over time.
2 Because velocity is stable, if a central bank were to change the quantity of money (M ),
it would cause proportionate changes in the nominal value of output (P × Y ).
3 The economy’s output of goods and services (Y ) is primarily determined by factor
supplies and the available technology. In particular, because money is neutral,
money does not affect output.
4 With output (Y ) determined by factor supplies and technology, if the central bank
alters the money supply (M ) and induces parallel changes in the nominal value of
output (P × Y ), these changes are reflected in changes in the price level (P).
5 Therefore, if the central bank increases the money supply rapidly, the result is a high
rate of inflation.
Money and prices during four
hyperinflations
The five steps discussed above are the
essence of the quantity theory of money.
Although earthquakes can wreak havoc
on a society, they have the beneficial
by-product of providing much useful
data for seismologists. These data can
shed light on alternative theories and,
thereby, help society predict and deal with
future threats. Similarly, hyperinflations
offer monetary economists a natural
experiment they can use to study the
effects of money on the economy.
Hyperinflations are interesting in
part because the changes in the money
supply and price level are so large. Indeed,
hyperinflation is generally defined as
inflation that exceeds 50 per cent per month.
This means that the price level increases
more than 100-fold over the course of a year.
The data on hyperinflation show a clear
link between the quantity of money and the
price level. Figure 11.4 graphs data from four
classic hyperinflations that occurred during
the 1920s in Austria, Hungary, Germany
and Poland. Each graph shows the quantity
of money in the economy and an index of
the price level. The slope of the money line
represents the rate at which the quantity
of money was growing and the slope of the
price line represents the inflation rate. The
steeper the lines, the higher the rates of
money growth or inflation.
Notice that in each graph the quantity
of money and the price level are almost
parallel. In each instance, growth in the
quantity of money is moderate at first
and so is inflation. But over time, the
quantity of money in the economy starts
growing faster and faster. At about the
same time, inflation also takes off. Then
when the quantity of money stabilises,
the price level stabilises as well. These
episodes illustrate well one of the Ten
Principles of Economics – prices rise when
the government prints too much money.
Question
What can explain the almost perfectly
synchronised pattern between the price
level and money supply in Figure 11.4?
258
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 5 Money and pricesCopyright
in the long
run
11_Stonecash_8e_45658_SB_txt.indd 258
24/08/20 4:34 PM
FIGURE 11.4 Money and prices during four hyperinflations
(a) Austria
(b) Hungary
Index
(Jan. 1921 = 100)
Index
(July 1921 = 100)
100 000
100 000
Price level
Price level
10 000
10 000
Money supply
1 000
100
Money supply
1 000
1921
1922
1923
1924
1925
100
1921
1922
1924
1925
(d) Poland
(c) Germany
Index
(Jan. 1921 = 100)
Index
(Jan. 1921 = 100)
100 000 000 000 000
1 000 000 000 000
10 000 000 000
100 000 000
1 000 000
10 000
100
1
1923
10 000 000
Price level
Money
supply
Price level
1 000 000
Money
supply
100 000
10 000
1 000
1921
1922
1923
1924
1925
100
1921
1922
1923
1924
1925
This figure shows the quantity of money and the price level during four hyperinflations. (Note that these variables
are graphed on logarithmic scales. This means that equal vertical distances on the graph represent equal
percentage changes in the variable.) In each case, the quantity of money and the price level move closely together.
The strong association between these two variables is consistent with the quantity theory of money, which states
that growth in the money supply is the primary cause of inflation.
Source: Adapted from Thomas J. Sargent, ‘The end of four big inflations’ in Robert Hall (ed.),
Inflation (Chicago: University of Chicago Press, 1983), pp. 41–93
The inf lation tax
If inf lation is so easy to explain, why do countries experience hyperinflation? That is, why
do the central banks of these countries choose to print so much money that its value is
certain to fall rapidly over time?
The answer is that the governments of these countries are using money creation as a
way to pay for their spending. When the government wants to build roads, pay salaries
to police officers, or give transfer payments to the poor or elderly, it first has to raise the
necessary funds. Normally, the government does this by levying taxes, like income and sales
taxes, and by borrowing from the public by selling government bonds. Yet the government
can also pay for spending by simply printing the money it needs.
When the government raises revenue by printing money, it is said to levy an inflation tax.
The inflation tax is not exactly like other taxes, however, because no one receives a bill from
the government for this tax. Instead, the inflation tax is more subtle. When the government
prints money, the price level rises, and the dollars in your wallet are less valuable. Thus, the
inflation tax is like a tax on everyone who holds money.
The importance of the inflation tax varies from country to country and over time. In
Australia in the 1970s, the inflation tax was a significant source of revenue. However, one of
inflation tax
the revenue the
government raises
by creating money
259
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
WCN 02-200-202
Chapter
11 Inflation: Its causes and costs
11_Stonecash_8e_45658_SB_txt.indd 259
24/08/20 4:34 PM
the most striking examples was the German hyperinflation after the First World War. The
German government was required to pay war reparations to the Allies, but it was unable to
collect sufficient tax revenue to meet the debt. It financed the debt by borrowing freshly
minted money from the Reichsbank, the German central bank. By 1922, prices were 1475
times their pre-war level.
Almost all hyperinflations follow the same pattern as the hyperinflation following the
First World War in Germany. The government has high spending, inadequate tax revenue
and limited ability to borrow. As a result, it turns to the printing press to pay for its spending.
The massive increases in the quantity of money lead to massive inflation. The inflation
ends when the government institutes fiscal reforms – like cuts in government spending –
that eliminate the need for the inflation tax.
The Fisher effect
According to the principle of monetary neutrality, an increase in the rate of money growth
raises the rate of inflation but does not affect any real variable. An important application
of this principle concerns the effect of money on interest rates. Interest rates are important
variables for macroeconomists to understand because they link the economy of the present
and the economy of the future through their effects on saving and investment.
To understand the relationship between money, inflation and interest rates, recall the
distinction between the nominal interest rate and the real interest rate. The nominal interest
rate is the interest rate you hear about at your bank. If you have a savings account, for
instance, the nominal interest rate tells you how fast the number of dollars in your account
will rise over time. The real interest rate corrects the nominal interest rate for the effect of
inflation in order to tell you how fast the purchasing power of your savings account will rise
over time. The real interest rate is the nominal interest rate minus the inflation rate:
Real interest rate = Nominal interest rate − Inflation rate
For example, if the bank posts a nominal interest rate of 7 per cent per year and the
inflation rate is 3 per cent per year, then the real value of the deposits grows by 4 per cent
per year.
We can rewrite this equation to show that the nominal interest rate is the sum of the real
interest rate and the inflation rate:
Nominal interest rate = Real interest rate + Inflation rate
This way of looking at the nominal interest rate is useful because different economic
forces determine each of the two terms on the right-hand side of this equation. As we
discussed in an earlier chapter, the supply of and demand for loanable funds determine the
real interest rate. And, according to the quantity theory of money, growth in the money
supply determines the inflation rate.
IN THE
NEWS
Fighting the war … on inflation?
Of all of the devastating effects of war, the one that is least mentioned is the
impact on the economy, prices in particular. In Syria, the war effort has led
to spikes in the prices of most essential items. When governments resort to
printing money to fund their war efforts, its citizens inevitably suffer, through
higher prices of food, as well as the destruction of infrastructure and basic
economic interactions. The article lists the sometimes forgotten implications of
war – the economic consequences.
260
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 5 Money and pricesCopyright
in the long
run
11_Stonecash_8e_45658_SB_txt.indd 260
24/08/20 4:34 PM
The Cost of Conflict
Middle East strife is exacting a heavy
toll on regional economies.
Nowhere in the world has conflict been
as frequent or as violent over the past
50 years as in the Middle East and North
Africa. On average, countries in this region
have experienced some form of warfare
every three years. Today, rarely a day
passes without media reports of violence,
large-scale human suffering, and major
destruction in such countries as Iraq,
Syria, and Yemen.
These conflicts have enormous human
and economic costs, both for countries
directly involved and for their neighbors.
Libya, Syria, and Yemen experienced deep
declines in their economies with sharp
increases in inflation between 2010 and
2016. Iraq’s economy remains fragile owing
to the conflict with the Islamic State (ISIS)
and the fall in oil prices since 2014. Clashes
have also spilled over to other countries,
causing problems that are expected to
persist—such as economic pressures
from hosting refugees. Violent conflict
has worsened conditions for a region
already facing structural deficiencies, low
investment, and, more recently, the oil
price drop, which has had a substantial
impact on oil-producing economies.
Girls washing clothes at Atmeh
displaced persons camp, Syria
Key channels
There are four major channels through
which conflict affects economies.
First, death, injury, and displacement
seriously erode human capital. While the
figures are difficult to verify, half a million
civilians and combatants are estimated to
Getty Images Plus/iStock Unreleased/Joel Carillet
Phil de Imus, Gaëlle Pierre and Björn Rother
December 2017
have died from the conflicts in the region
since 2011. Moreover, as of the end of
2016, the region accounted for almost
half of the world’s population of forcibly
displaced people: 10 million refugees and
20 million internally displaced people
from the region have had to abandon
their homes. Syria alone has nearly
12 million displaced people, the largest
number of any country in the region.
Conflict also reduces human capital
by spreading poverty. Poverty in conflict
countries, even outside regions directly
affected by violence, tends to rise as
employment declines. The quality of
education and health services also
deteriorates, a problem that deepens the
longer a conflict continues. Syria provides
a dramatic example. Unemployment
jumped from 8.4 percent in 2010 to more
than 50 percent in 2013, school dropout
rates reached 52 percent, and estimated
life expectancy fell from 76 years before
the conflict to 56 years in 2014. Since then,
the situation has deteriorated even more.
Second, physical capital and
infrastructure are damaged or destroyed.
Houses, buildings, roads, bridges, schools,
and hospitals – as well as the water,
power, and sanitation infrastructure –
have been hit hard. In some areas, entire
urban systems were virtually wiped out.
In addition, infrastructure related to key
economic sectors such as oil, agriculture,
and manufacturing has been seriously
degraded, with significant repercussions
for growth, fiscal and export revenues,
and foreign reserves. In Syria, more than
a quarter of the housing stock has been
destroyed or damaged since the war’s
onset, while in Yemen, infrastructure
damage has exacerbated drought
conditions and contributed to severe
food insecurity and disease. The country’s
agricultural sector, which employed more
than half the population, was hit hard,
experiencing a 37 percent drop in cereal
production in 2016 from the previous fiveyear average.
Third, economic organization and
institutions are hurt. The deterioration
in economic governance has been
particularly acute where institutional
quality was already poor before the
261
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
WCN 02-200-202
Chapter
11 Inflation: Its causes and costs
11_Stonecash_8e_45658_SB_txt.indd 261
24/08/20 4:34 PM
outbreak of violence, as was the case in
Iraq, Libya, Syria, and Yemen. This damage
has led to reduced connectivity, higher
transportation costs, and disruptions in
supply chains and networks. Institutions
can also become corrupt as the warring
parties try to exert control over political
and economic activity. Fiscal spending and
credit, for example, might be redirected
to the constituencies of those in power.
More broadly, many critical economic
institutions – central banks, ministries of
finance, tax authorities, and commercial
courts – have seen their effectiveness
diminish because they have lost touch
with the more remote parts of their
countries. The World Bank estimates that
disruptions to economic organization
were about 20 times costlier than capital
destruction in the first six years of the
Syrian conflict.
Lastly, the stability of the region and
its longer-term development through its
impact on confidence and social cohesion
are threatened. The conflicts in the Middle
East and North Africa have heightened
insecurity and reduced confidence,
manifested by declining foreign and
domestic investment, deteriorating
financial sector performance, higher
security spending, and shrinking tourism
and trade. Social trust has also weakened,
negatively affecting economic transactions
and political decision making.
Direct and indirect effects
The macroeconomic damage can be
staggering. Syria’s 2016 GDP, for example,
Fisher effect
the one-for-one
adjustment of the
nominal interest rate
to the inflation rate
is estimated to be less than half its 2010
preconflict level. Yemen lost an estimated
25 to 35 percent of its GDP in 2015 alone,
while in Libya – where dependence on
oil has made growth extremely volatile –
GDP fell by 24 percent in 2014 as violence
picked up. The West Bank and Gaza offers
a longer-term perspective on what can
happen to growth in a fragile situation: its
economy has been virtually stagnant over
the past 20 years in contrast with average
growth of nearly 250 percent in other
countries of the region during that period.
Furthermore, these conflicts have
led to high inflation and exchange rate
pressures. In Iraq, inflation peaked at
more than 30 percent during the mid2000s; in Libya and Yemen it rose above
15 percent in 2011, on the back of a
collapse in the supply of critical goods
and services combined with strong
recourse to monetary financing of the
budget. Syria is an even more extreme
case, with consumer prices rising by
about 600 percent between 2010 and late
2016. Such inflation dynamics are usually
accompanied by strong depreciation
pressure on local currencies, which the
authorities may try to resist through heavy
intervention and regulation of crossborder flows. These forces have clearly
been at work in Syria: the Syrian pound,
which floated freely in 2013, officially
trades at about one-tenth its prewar value
against the US dollar.
Source: IMF, Finance & Development, December 2017,
Vol. 54, No. 4, https://www.imf.org/external/pubs/ft/
fandd/2017/12/imus.htm
Let’s go back to Zoobooloo to consider how the growth in the money supply affects
interest rates. In the long run, over which money is neutral, a change in money growth
should not affect the real interest rate. The real interest rate is, after all, a real variable. For
the real interest rate not to be affected, the nominal interest rate must adjust one-for-one
to changes in the inflation rate. Thus, when the ZCB increases the rate of money growth, the
result is both a higher inflation rate and a higher nominal interest rate. This adjustment of the
nominal interest rate to the inflation rate is called the Fisher effect, after economist Irving
Fisher (1867–1947), who first studied it.
The Fisher effect is, in fact, crucial for understanding changes over time in the nominal
interest rate. Figure 11.5 shows the nominal interest rate and the inflation rate in the
Australian economy since 1976. The close association between these two variables is clear.
The nominal interest rate rose from 1980 to 1990 because inflation was also rising during
this time. Similarly, the nominal interest rate fell from the early to mid-1990s due to the
1991 recession and because the RBA finally got inflation under control.
262
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 5 Money and pricesCopyright
in the long
run
11_Stonecash_8e_45658_SB_txt.indd 262
24/08/20 4:34 PM
FIGURE 11.5 The nominal interest rate and the inflation rate
20
90-day bank bill
18
CPI
16
14
12
10
8
6
4
2
0
–2
1976 1981
1986
1991
1996
2001
2006
2011
2016
This figure uses annual data since 1976 to show the nominal interest rate on 90-day bank bills
and the inflation rate as measured by the consumer price index. The close association between
these two variables is evidence for the Fisher effect – when the inflation rate rises, so does the
nominal interest rate.
Source: The Reserve Bank of Australia
CHECK YOUR UNDERSTANDING
If a government of a country increases the growth rate of the money supply from 10 per
cent per year to 50 per cent per year, what happens to the price level? What happens to
nominal interest rates? Why might a government choose this course of action?
LO11.2 The costs of inflation
In the early 1980s, when the Australian inflation rate was above 10 per cent per year,
inflation dominated debates over economic policy. Even though inflation dropped
significantly during the first half of the 1990s, inflation remained a closely watched
macroeconomic variable. One 1996 study found that inflation was the economic term
mentioned most often in Australian newspapers and magazines.
Inflation is closely watched and widely discussed because it is thought to be a
serious economic problem; in fact, its importance has led to a profound change in the
way most central banks, including the RBA, manage monetary policy. But is that true?
And if so, why?
263
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
WCN 02-200-202
Chapter
11 Inflation: Its causes and costs
11_Stonecash_8e_45658_SB_txt.indd 263
24/08/20 4:34 PM
Source: PEANUTS © 1984 Peanuts
Worldwide LLC. Distributed by ANDREWS
MCMEEL SYNDICATION. Reprinted with
permission. All rights reserved
A fall in purchasing power? The inflation fallacy
If you ask ordinary people why inflation is bad, they will tell you that the answer is obvious –
inflation robs them of the purchasing power of their hard-earned dollars. When prices rise,
each dollar of income buys fewer goods and services. Thus, it might seem that inflation
directly lowers living standards.
Yet further thought reveals a fallacy in this answer. When prices rise, buyers of goods
and services do pay more for what they buy. At the same time, however, sellers of goods and
services get more for what they sell. Because most people earn their incomes by selling their
services, like their labour, inflation in incomes goes hand in hand with inflation in prices.
Thus, inflation does not in itself reduce people’s real purchasing power.
People believe the inflation fallacy because they do not appreciate the principle of
monetary neutrality. Workers who receive an annual wage increase of 10 per cent tend to
view it as a reward for their own talents and efforts. When an inflation rate of 6 per cent
reduces the real value of that wage increase to only 4 per cent, workers might feel that
they have been cheated of what is rightfully their due. In fact, as we discussed in previous
chapters, real incomes are determined by real variables, like physical capital, human capital,
natural resources and the available production technology. Nominal incomes are determined
by those factors and the overall price level. If the RBA were to lower the inflation rate from
6 per cent to zero, workers’ annual wage increase would fall from 10 per cent to 4 per cent.
They might feel less robbed by inflation, but their real income would not rise more quickly.
But if nominal incomes tend to keep pace with rising prices, why then is inflation a
problem? It turns out that there is no single answer to this question. Instead, economists
have identified several costs of inflation. Each of these costs shows some way in which
persistent growth in the money supply does, in fact, have some effect on real variables.
Shoeleather costs
shoeleather costs
the resources wasted
when inflation
encourages people
to reduce their
money holdings
As we have discussed, inflation is like a tax on the holders of money. The tax itself is not
a cost to society – it is only a transfer of resources from households to the government.
Yet most taxes give people an incentive to alter their behaviour to avoid paying the tax
and this distortion of incentives causes efficiency losses for society as a whole. Like other
taxes, the inflation tax also causes efficiency losses, as people waste scarce resources
trying to avoid it.
How can a person avoid paying the inflation tax? Because inflation erodes the real value
of the money in your wallet, you can avoid the inflation tax by holding less money. One way
to do this is to go to the bank more often. For example, rather than withdrawing $200 every
four weeks, you might withdraw $50 once a week. By making more frequent trips to the
bank, you can keep more of your wealth in your interest-bearing savings account and less in
your wallet, where inflation erodes its value.
The cost of reducing your money holdings is called the shoeleather costs of inflation
because making more frequent trips to the bank causes your shoes to wear out more quickly.
Of course, this term is not to be taken literally – the actual cost of reducing your money
264
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 5 Money and pricesCopyright
in the long
run
11_Stonecash_8e_45658_SB_txt.indd 264
24/08/20 4:34 PM
holdings is not the wear and tear on your shoes but the time and convenience you must
sacrifice to keep less money on hand than you would if there were no inflation.
The shoeleather costs of inflation may seem trivial. And, in fact, they are in the
Australian economy, which has had only moderate inflation in recent years. But this cost
is magnified in countries experiencing hyperinflation. Here is a description of one person’s
experience in Bolivia during its hyperinflation (as reported in the 13 August 1985 issue of
the Wall Street Journal, p. 1):
When Edgar Miranda gets his monthly teacher’s pay of 25 million pesos, he hasn’t
a moment to lose. Every hour, pesos drop in value. So, while his wife rushes to
market to lay in a month’s supply of rice and noodles, he is off with the rest of the
pesos to change them into black-market dollars.
Mr Miranda is practising the First Rule of Survival amid the most out-of-
control inflation in the world today. Bolivia is a case study of how runaway
inflation undermines a society. Price increases are so huge that the figures build
up almost beyond comprehension. In one six-month period, for example, prices
soared at an annual rate of 38 000%. By official count, however, last year’s inflation
reached 2000%, and this year’s is expected to hit 8000% – though other estimates
range many times higher. In any event, Bolivia’s rate dwarfs Israel’s 370% and
Argentina’s 1100% – two other cases of severe inflation.
It is easier to comprehend what happens to the thirty-eight-year-old
Mr Miranda’s pay if he doesn’t quickly change it into dollars. The day he was paid
25 million pesos, a dollar cost 500 000 pesos. So he received $50. Just days later,
with the rate at 900 000 pesos, he would have received $27.
Source: © Reprinted by permission of the Wall Street Journal,
© 1985 Dow Jones & Company, Inc. All Rights Reserved Worldwide
As this story shows, the shoeleather costs of inflation can be substantial. With the high
inflation rate, Mr Miranda does not have the luxury of holding the local money as a store of
value. Instead, he is forced to convert his pesos quickly into goods or into US dollars, which
offer a more stable store of value. The time and effort that Mr Miranda expends to reduce his
money holdings are a waste of resources. If the monetary authority pursued a low-inflation
policy, Mr Miranda would be happy to hold pesos, and he could put his time and effort to
more productive use. In fact, shortly after this article was written, the Bolivian inflation rate
was reduced substantially with more restrictive monetary policy.
Menu costs
Most firms do not change the prices of their products every day. Instead, firms often
announce prices and leave them unchanged for weeks, months or even years. One survey
found that the typical Australian firm changes its prices about once a year. One very visible
exception to this is petrol prices, which are often changed several times during the week.
Firms change prices infrequently because there are costs of changing prices. Costs of
price adjustment are called menu costs, a term derived from a restaurant’s cost of printing
a new menu. Menu costs include the cost of printing new price lists and catalogues, the
cost of sending these new price lists and catalogues to dealers and customers, the cost of
advertising the new prices, the cost of deciding on new prices and even the cost of dealing
with customer annoyance over price changes. (Of course, for some methods of selling, like
Internet-based sales, the cost of price changes is relatively low, so they can change much
more frequently.)
Inflation increases the menu costs that firms must bear. In the current Australian
economy, with its low inflation rate, annual price adjustment is an appropriate business
strategy for many firms. But when high inflation makes firms’ costs rise rapidly, annual
price adjustment is impractical. During hyperinflations, for example, firms must change
their prices daily or even more often just to keep up with all the other prices in the economy.
menu costs
the costs of
changing prices
265
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
WCN 02-200-202
Chapter
11 Inflation: Its causes and costs
11_Stonecash_8e_45658_SB_txt.indd 265
24/08/20 4:34 PM
Relative-price variability and the misallocation of resources
Suppose that the Eatabit Eatery prints a new menu with new prices every January and then
leaves its prices unchanged for the rest of the year. If there is no inflation, Eatabit’s relative
prices – the prices of its meals compared with other prices in the economy – would be
constant over the course of the year. In contrast, if the inflation rate is 12 per cent per year,
Eatabit’s relative prices will automatically fall by 1 per cent each month. The restaurant’s
prices will be relatively high in the early months of the year, just after it has printed a new
menu, and relatively low in the later months. And the higher the inflation rate, the greater
this automatic variability. Thus, because prices change only once in a while, inflation causes
relative prices to vary more than they otherwise would.
Why does this matter? The reason is that market economies rely on relative prices to
allocate scarce resources. Consumers decide what to buy by comparing the quality and
prices of various goods and services. Through these decisions, they determine how the
scarce factors of production are allocated among industries and firms. When inflation
distorts relative prices, consumer decisions are distorted and markets are less able to
allocate resources to their best uses.
Inflation-induced tax distortions
Almost all taxes distort incentives, cause people to alter their behaviour and lead to a less
efficient allocation of the economy’s resources. Many taxes, however, become even more
problematic in the presence of inflation. The reason is that lawmakers often fail to take
inflation into account when writing the tax laws. Economists who have studied the tax laws
conclude that inflation tends to raise the tax burden on income earned from savings.
One example is the tax treatment of interest income. Income tax treats the nominal
interest earned on savings as income, even though part of the nominal interest rate merely
compensates for inflation. To see the effects of this policy, consider the numerical example
in Table 11.1. The table compares two economies, both of which tax interest income at a
rate of 25 per cent. In Economy 1, inflation is zero, and the nominal and real interest rates are
both 4 per cent. In this case, the 25 per cent tax on interest income reduces the real interest
rate from 4 per cent to 3 per cent. In Economy 2, the real interest rate is again 4 per cent,
but the inflation rate is 8 per cent. As a result of the Fisher effect, the nominal interest rate
is 12 per cent. Because the income tax treats this entire 12 per cent interest as income, the
government takes 25 per cent of it, leaving an after-tax nominal interest rate of only 9 per
cent and an after-tax real interest rate of only 1 per cent. In this case, the 25 per cent tax on
interest income reduces the real interest rate from 4 per cent to 1 per cent. Because the aftertax real interest rate provides the incentive to save, saving is much less attractive in the
economy with inflation (Economy 2) than in the economy with stable prices (Economy 1).
TABLE 11.1 How inflation raises the tax burden on saving
In the presence of zero inflation, a 25 per cent tax on interest income reduces the real interest
rate from 4 per cent to 3 per cent. In the presence of 8 per cent inflation, the same tax reduces
the real interest rate from 4 per cent to 1 per cent.
Economy 1
(price stability) %
Economy 2
(inflation) %
Real interest rate
4
4
Inflation rate
0
8
Nominal interest rate (real interest rate + inflation rate)
4
12
Reduced interest due to 25% tax (0.25 × nominal interest rate)
1
3
After-tax nominal interest rate (0.75 × nominal interest rate)
3
9
After-tax real interest rate (after-tax nominal interest rate –
inflation rate)
3
1
266
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 5 Money and pricesCopyright
in the long
run
11_Stonecash_8e_45658_SB_txt.indd 266
24/08/20 4:34 PM
The taxes on nominal interest income are one example of how tax laws interact with
inflation. There are many others. Because of these inflation-induced tax changes, higher
inflation tends to discourage people from saving. Recall that the economy’s saving provides
the resources for investment, which in turn is a key ingredient of long-run economic growth.
Thus, when inflation raises the tax burden on saving, it tends to depress the economy’s
long-run growth rate. There is, however, no consensus among economists about the size of
this effect.
One solution to this problem, other than eliminating inflation, is to index the tax system.
That is, the tax laws could be rewritten to take account of the effects of inflation. This is
already done in the case of capital gains. A capital gain is the profit made by selling an asset
for more than its purchase price. For example, if you purchased shares in XYZ Company in
1980 for $10 and then sold the same shares in 1998 for $50, you would have made a capital
gain of $40. But if the overall price level had doubled between 1980 and 1998, then the
increase in the value of your asset was really only $20. If the tax laws did not take into
account the effects of inflation, you would pay tax on the profit of $40 instead of $20. The
tax laws in Australia adjust the purchase price using a price index and assess the tax only
on the real gain.
In the case of interest income, the government could tax only real interest income by
excluding that portion of the interest income that merely compensates for inflation. To
some extent, the tax laws have moved in the direction of indexation, as demonstrated above
with capital gains. However, the income levels at which marginal income tax rates change
are not adjusted automatically for inflation.
In an ideal world, the tax laws would be written so that inflation would not alter anyone’s
real tax liability. In the world in which we live, however, tax laws are far from perfect. More
complete indexation would probably be desirable, but it would further complicate tax laws
that many people already consider too complex.
Confusion and inconvenience
Imagine that we took a poll and asked people the following question: ‘This year the metre
is 100 cm. How long do you think it should be next year?’ Assuming we could get people to
take us seriously, they would tell us that the metre should stay the same length – 100 cm.
Anything else would just complicate life needlessly.
What does this finding have to do with inflation? Recall that money, as the economy’s
unit of account, is what we use to quote prices and record debts. In other words, money is
the yardstick with which we measure economic transactions. The job of the RBA is a bit
like the job of Standards Australia – to ensure the reliability of a commonly used unit of
measurement. When inflation occurs, it erodes the real value of the unit of account. The
RBA’s response, as we will see in later chapters, is to limit this erosion.
It is difficult to judge the costs of the confusion and inconvenience that arise from
inflation. Earlier we discussed how the tax laws incorrectly measure real incomes in the
presence of inflation. Similarly, accountants incorrectly measure firms’ profits when prices
are rising over time. Because inflation causes dollars at different times to have different real
values, calculating a firm’s profit – the difference between its revenue and costs – is more
complicated in an economy with inflation. Therefore, to some extent, unexpected inflation
makes investors less able to sort out successful from unsuccessful firms, which in turn
impedes financial markets in their role of allocating the economy’s saving to alternative
types of investment.
A special cost of unexpected inflation: Arbitrary redistributions of wealth
So far, most of the costs of inflation we have discussed occur even if inflation is steady
and predictable. Inflation has an additional cost, however, when it comes as a surprise.
267
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
WCN 02-200-202
Chapter
11 Inflation: Its causes and costs
11_Stonecash_8e_45658_SB_txt.indd 267
24/08/20 4:34 PM
Unexpected inflation redistributes wealth among the population in a way that has nothing
to do with either merit or need. These redistributions occur because many loans in the
economy are specified in terms of the unit of account – money.
Consider an example. Suppose that Sam Student takes out a $20 000 loan at a 7 per cent
interest rate from Bigbank to attend university. In 10 years, the loan will come due. After
his debt has compounded for 10 years at 7 per cent, Sam will owe Bigbank $40 000. The real
value of this debt will depend on inflation over the decade. If Sam is lucky, the economy will
have hyperinflation. In this case, wages and prices will rise so high that Sam will be able to
pay the $40 000 debt out of small change. In contrast, if the economy goes through a major
deflation, then wages and prices will fall and Sam will find the $40 000 debt a greater burden
than he anticipated.
This example shows that unexpected changes in prices redistribute wealth among
debtors and creditors. Hyperinflation enriches Sam at the expense of Bigbank because it
diminishes the real value of the debt; Sam can repay the loan in dollars that are less valuable
than he anticipated. Deflation enriches Bigbank at Sam’s expense because it increases
the real value of the debt; in this case, Sam has to repay the loan in dollars that are more
valuable than he anticipated. If inflation were predictable, then Bigbank and Sam could
take inflation into account when setting the nominal interest rate. (Recall the Fisher effect.)
But if inflation is hard to predict, it imposes risk on Sam and Bigbank that both would prefer
to avoid.
This cost of unexpected inflation is important to consider together with another fact –
inflation is especially volatile and uncertain when the average rate of inflation is high. This
is seen most simply by examining the experience of different countries. Countries with low
average inflation, like Germany in the late twentieth century, tend to have stable inflation.
Countries with high average inflation, like many countries in Latin America, tend also
to have unstable inflation. There are no known examples of economies with high, stable
inflation. This relationship between the level and volatility of inflation points to another
cost of inflation. If a country pursues a high-inflation monetary policy, it will have to bear
not only the costs of high expected inflation but also the arbitrary redistributions of wealth
associated with unexpected inflation.
CASE
STUDY
The Wonderful Wizard of Oz and
the free-silver debate
As a child, you may have seen the film The
Wizard of Oz, based on a children’s book
written in 1900. The film and book tell
the story of a young girl, Dorothy, who
finds herself lost in a strange land far
from home. You probably did not know,
however, that the story is actually an
allegory about US monetary policy in the
late nineteenth century.
From 1880 to 1896, the price level
in the US economy fell by 23 per cent.
Because this event was unanticipated, it
led to a major redistribution of wealth.
Most farmers in the western part of the
country were debtors. Their creditors
were the bankers in the east. When the
price level fell, it caused the real value of
these debts to rise, which enriched the
banks at the expense of the farmers.
According to populist politicians of the
time, the solution to the farmers’ problem
was the free coinage of silver. During this
period, the United States was operating
with a gold standard. The quantity of
gold determined the money supply and,
thereby, the price level. The free-silver
advocates wanted silver, as well as
gold, to be used as money. If adopted,
this proposal would have increased
the money supply, pushed up the price
level and reduced the real burden of the
farmers’ debts.
The debate over silver was heated
and it was central to the politics of the
1890s. A common election slogan of the
populists was ‘We are mortgaged; all but
our votes’. One prominent advocate of
268
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 5 Money and pricesCopyright
in the long
run
11_Stonecash_8e_45658_SB_txt.indd 268
24/08/20 4:34 PM
free silver was William Jennings Bryan, the
Democrat nominee for president in 1896.
He is remembered in part for a speech
at the Democratic Party’s nominating
convention in which he said: ‘You shall
not press down upon the brow of labor
this crown of thorns. You shall not crucify
mankind upon a cross of gold’. Rarely
since then have politicians waxed so
poetic about alternative approaches to
monetary policy. Nonetheless, Bryan
lost the election to Republican William
McKinley, and the United States remained
on the gold standard.
DOROTHY:
TOTO:
SCARECROW:
L. Frank Baum, the author of The
Wonderful Wizard of Oz, was a midwestern
journalist. When he sat down to write a
story for children, he made the characters
represent protagonists in the major
political battle of his time. Although
modern commentators on the story
differ somewhat in the interpretation
they assign to each character, there is
no doubt that the story highlights the
debate over monetary policy. Here is how
economic historian Hugh Rockoff, writing
in the August 1990 issue of the Journal of
Political Economy, interprets the story:
Traditional American values
Prohibitionist party, also called the
Teetotallers
Farmers
TIN WOODSMAN: Industrial workers
COWARDLY LION: William Jennings Bryan
[Democrat nominee for president in 1896]
MUNCHKINS: Citizens of the east
WICKED WITCH OF THE EAST: Grover Cleveland [Democrat president
1893–97]
WICKED WITCH OF THE WEST: William McKinley
[Republican president 1897–1901]
WIZARD: Marcus Alonzo Hanna
[chairman of the Republican party at the time]
OZ:
Abbreviation for ounce of gold
Source: Alamy Stock Photo/World History Archive
YELLOW BRICK ROAD: Gold standard
An early debate over monetary policy
In the end of Baum’s story, Dorothy
does find her way home, but it is not by
just following the yellow brick road. After
a long and perilous journey, she learns
that the wizard is incapable of helping her
or her friends. Instead, Dorothy finally
discovers the magical power of her silver
slippers. (When the book was made
into the film The Wizard of Oz, in 1939,
Dorothy’s slippers were changed from
silver to ruby. Apparently, the Hollywood
filmmakers were not aware that they were
telling a story about nineteenth-century
monetary policy.)
Although the populists lost the debate
over the free coinage of silver, they did
eventually get the monetary expansion
and inflation that they wanted. In 1898,
269
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
WCN 02-200-202
Chapter
11 Inflation: Its causes and costs
11_Stonecash_8e_45658_SB_txt.indd 269
24/08/20 4:34 PM
prospectors discovered gold near the
Klondike River in Alaska. Increased
supplies of gold also arrived from the
Canadian Yukon and the gold mines
of South Africa. As a result, the money
supply and the price level started to rise
in the United States and other countries
operating on the gold standard. Within
15 years, prices in the United States were
back to the levels that had prevailed in
the 1880s, and farmers were better able
to handle their debts.
IN THE
NEWS
Questions
1 How did the unexpected
fall in the price level cause a
redistribution of wealth during
the 1880s?
2 What factors in the early
twentieth century led to the price
level being restored to the prices
prevailing in the 1880s? How did
this affect the supply of money?
If inflation is bad, then deflation must be good … right?
This chapter has discussed the causes and impact of inflation, but sometimes
economies experience deflation. Given everything we’ve said about inflation
being a concern, deflation must be good, right? Well, not exactly. Deflation
means an economy is experiencing a lack of demand and as we will see
in chapter 14 that’s not necessarily better than having inflation. And when
deflation persists for long periods, it can have negative effects on consumer
confidence as well, as the following article discusses.
Forget inflation.
We should be concerned
about deflation
By Robert J. Samuelson
May 1, 2019
There are times when it seems we’re
worrying about things that aren’t worth
worrying about. A good example these
days is inflation. Amazingly, the complaint
is that it’s not rising fast enough. In
March, the consumer price index, or
CPI, had increased 1.9 percent over the
past year. The gain of another inflation
indicator, the ‘deflator’ of the personal
consumption expenditures, or PCE, was
1.5 percent.
What’s not to like?
Despite criticism from President
Trump, all this qualifies as good news.
Prices have hardly risen. Indeed, technical
difficulties in measuring inflation —
for example, how to account for new
products, such as smartphones —
suggest that actual inflation could be
close to zero. Some prices go up (new
vehicles, 0.7 percent over the past
year); other prices go down (televisions,
19 percent).
The PCE is the Federal Reserve’s
preferred inflation indicator. For workers,
this means that if their wages and fringe
benefits rose by more than 1.5 percent
over the year, they would’ve received
a modest boost to their ‘real’ (inflationadjusted) incomes. And yet, some
respected economists worry that inflation
is too low.
To those of us, including me, old
enough to have lived through the
double-digit inflation of late 1970s
and early 1980s, this is crazy. High and
uncontrolled inflation (annually, it peaked
at 13 percent in 1979) was a scourge. It
sowed almost-universal anxiety and was
wildly unpopular. People felt they had
lost control of their lives. Government
seemed powerless to stop it.
Why would anyone want to re-create
this anarchy?
Three reasons are typically given. For
starters, critics complain that the Fed
isn’t hitting its own inflation target, which
is 2 percent on the PCE. This suggests
incompetence. If the Fed can’t hit its
target, the assumption goes, what else
can’t it do? Frankly, this is fearmongering;
the Fed simply isn’t powerful enough to
270
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 5 Money and pricesCopyright
in the long
run
11_Stonecash_8e_45658_SB_txt.indd 270
24/08/20 4:34 PM
hit a precise target. As long as reported
inflation stays between zero and
2 percent, the Fed is delivering a crude
price stability.
A more realistic concern involves the
Fed’s ability to respond to a recession.
Typically, the Fed cuts interest rates to
reverse an economic downturn. But
interest rates, reflecting inflation, are
already low. The fear is that the Fed won’t
be able to cut rates enough to prevent a
recession from getting worse.
Consider. The fed funds rate — the
rate on overnight loans and the rate
most influenced by the Fed — is now set
at about 2.5 percent. By contrast, it was
5.25 percent in 2007, the start of the last
recession, and higher earlier. If the Fed
can only cut rates modestly before they
hit zero, then the next recession could
be lengthy and stubborn. That’s the
argument.
This brings us to the most serious
of inflation’s alleged shortcomings.
Paradoxically, it’s ‘deflation’ — or falling
prices. Of course, some prices are falling
even when the overall price level is rising.
To take an obvious example: Computers
and other tech products have experienced
massive price cuts.
No one is against these. By contrast,
deflation signifies declines in most prices,
and this prospect can do enormous
economic damage. The most terrifying
example is the Great Depression of the
1930s, when the wholesale price index
fell a staggering 33 percent from 1929
to 1933.
The result was to prolong the
Depression. Deflation causes people to
delay major purchases — they think that
prices will go even lower. Deflation also
makes it harder for debtors to repay
their loans. The economy gets caught in a
vicious circle of deflation, weak consumer
spending and more loan defaults. In the
1930s, annual unemployment peaked at
around 25 percent.
Higher inflation is cast as the antidote
to deflation. It’s an extra cushion of
protection. This sounds sensible, but
it overlooks the likely reality that the
transition to higher inflation would
create a new set of problems, involving
interest rates, exchange rates, consumer
and business uncertainty and the stock
market, to name just a few.
Moreover, it presumes that deflation
would quickly attain Depression-like
proportions, when a more likely outcome
would be modest deflation. Probably
many Americans wouldn’t notice slight
price declines; others might seize on
them as an opportunity to go bargainhunting. Indeed, the combination of rigid
wages and falling prices would enhance
consumer purchasing power and could
stimulate an economic recovery.
We have a case study in the
probabilities: Japan. It’s been grappling
with deflation for years, but price declines
have been puny. From 2001 to 2010, the
average annual decline was 0.3 percent
(that’s one-third of 1 percent), says the
International Monetary Fund.
Millions of Americans are unaware of
our disastrous experience with doubledigit inflation. They have either forgotten
or weren’t yet born. The Fed says it won’t
abandon its current inflation target of
2 percent. That’s a promise the Fed needs
to keep.
Source: Reproduced by permission of the Washington
Post. Robert J. Samuelson, May 1, 2019 https://
www.washingtonpost.com/opinions/do-we-have-adeflation-problem/2019/05/01/8541daac-6c41-11e98f44-e8d8bb1df986_story.html?noredirect=on
CHECK YOUR UNDERSTANDING
Briefly describe the six costs of inflation.
271
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
WCN 02-200-202
Chapter
11 Inflation: Its causes and costs
11_Stonecash_8e_45658_SB_txt.indd 271
24/08/20 4:34 PM
Conclusion
This chapter discussed the causes and costs of inflation. The main cause of inflation
is simply growth in the quantity of money. When a central bank creates money in large
quantities, the value of money falls quickly over time. To maintain stable prices, the central
bank must maintain strict control over interest rates or the money supply.
The costs of inflation are more subtle. They include shoeleather costs, menu costs,
increased variability of relative prices, unintended changes in tax liabilities, confusion and
inconvenience, and arbitrary redistributions of wealth. Are these costs, in total, large or
small? All economists agree that they become huge during hyperinflation. But their size
for moderate inflation – when prices rise by less than 10 per cent per year – is more open to
debate.
Although this chapter presented many of the most important lessons about inflation,
the discussion is incomplete. When a central bank reduces the rate of money growth, prices
rise less rapidly, as the quantity theory suggests. Yet as the economy makes the transition
to this lower inflation rate, the change in monetary policy will have disruptive effects on
production and employment. That is, even though monetary policy is neutral in the long run,
it has profound effects on real variables in the short run. Later in this book we will examine
the reasons for short-run monetary non-neutrality in order to enhance our understanding of
the causes and costs of inflation.
272
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 5 Money and pricesCopyright
in the long
run
11_Stonecash_8e_45658_SB_txt.indd 272
24/08/20 4:34 PM
LO11.1
If a central bank increases the supply of money, it causes the price level to rise.
Persistent growth in the quantity of money supplied leads to continuing inflation.
The principle of monetary neutrality asserts that changes in the quantity of money
influence nominal variables but not real variables. Most economists believe that
monetary neutrality approximately describes the behaviour of the economy in the
long run. One application of the principle of monetary neutrality is the Fisher effect.
According to the Fisher effect, when the inflation rate rises, the nominal interest
rate rises by the same amount, so that the real interest rate remains the same.
A government can pay for some of its spending simply by printing money. When
countries rely heavily on this ‘inflation tax’, the result is hyperinflation. Many people
think that inflation makes them poorer because it raises the cost of what they buy.
This view is a fallacy, however, because inflation also raises nominal incomes.
LO11.2
Economists have identified six costs of inflation: shoeleather costs associated with
reduced money holdings; menu costs associated with more frequent adjustment of
prices; increased variability of relative prices; unintended changes in tax liabilities
due to non-indexation of the tax laws; confusion and inconvenience resulting from a
changing unit of account; and arbitrary redistributions of wealth between debtors and
creditors. Many of these costs are large during hyperinflation, but the size of these
costs for moderate inflation is less clear.
Key concepts
classical dichotomy, p. 256
Fisher effect, p. 262
inflation tax, p. 259
menu costs, p. 265
monetary neutrality, p. 257
nominal variables, p. 256
STUDY TOOLS
Summary
quantity equation, p. 258
quantity theory of money, p. 254
real variables, p. 256
shoeleather costs, p. 264
velocity of money, p. 257
Practice questions
Questions for review
1
2
3
4
5
6
7
8
Explain how an increase in the price level affects the real value of money.
According to the quantity theory of money, what is the effect of a decrease in the quantity
of money? What happens if a central bank increases the money supply rapidly?
What is the difference between nominal and real interest rates? Suppose the nominal
interest rate is 8 per cent and the real interest rate is 3.5 per cent. What is the
inflation rate?
The quantity equation is given by M × V = P × Y. Solve this equation for Y and explain in words:
What happens to Y if the numerator rises faster than the denominator, and vice-versa?
In what sense is inflation like a tax? How does thinking about inflation as a tax help explain
hyperinflation?
According to the Fisher effect, how does an increase in the inflation rate affect the real
interest rate and the nominal interest rate?
What are the costs of inflation? Which of these costs do you think are most important for
the Australian economy?
If inflation is greater than expected, who benefits – debtors or creditors? Explain.
Multiple choice
1
A fall in inflation
a hurts retirees.
b benefits lenders.
c benefits borrowers.
d makes wage increases more likely.
273
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
WCN 02-200-202
Chapter
11 Inflation: Its causes and costs
11_Stonecash_8e_45658_SB_txt.indd 273
24/08/20 4:34 PM
2
3
4
5
6
A new form of payment, like Apple Pay, does what to the velocity of money?
a It decreases it because people need less cash.
b It increases it because people buy more because they don’t realise they are spending
money.
c It decreases it because people don’t need as much cash when they travel overseas.
d It increases it because each note or coin supports more transactions.
If the interest rate is 6% and the inflation rate is –1%, then the real interest rate is
a 5%.
b 7%.
c –1%.
d 6%.
If the Australian government keeps the income tax brackets the same from year to year, but
the inflation rate rises, are people being taxed
a more in real terms.
b less in real terms.
c about the same in real terms.
d less in nominal terms.
Suppose the Australian government is worried about money laundering, and so they decide
to take $100 out of circulation. What would have to happen to velocity to handle the same
level of nominal income?
a It would have to increase.
b It would have to decrease.
c It would stay the same.
d It wouldn’t have any bearing on the velocity of money.
Individuals who take out mortgages with fixed rates of interest will most likely
a suffer a loss if the inflation rate is higher than anticipated.
b benefit if the inflation rate is lower than anticipated.
c experience a rise in their real interest rate.
d benefit if the inflation rate is higher than anticipated.
Problems and applications
1
2
3
4
5
6
Central banks around the world, including the United States’ Federal Reserve Bank, do not
have inflation targeting as a monetary policy objective. Can you build a case for why the
US Fed could switch to inflation targeting?
The previous chapter showed that there are several different measures of the money stock,
with the larger measures including more types of assets than the smaller ones. How can
the quantity equation hold for all of these measures?
The economist John Maynard Keynes wrote: ‘Lenin is said to have declared that the best
way to destroy the capitalist system was to debauch the currency. By a continuing process
of inflation, governments can confiscate, secretly and unobserved, an important part of the
wealth of their citizens’. Justify Lenin’s assertion.
Suppose that a country’s inflation rate increases sharply. What happens to the inflation tax
on the holders of money? Why is wealth that is held in savings accounts not subject to a
change in the inflation tax? Can you think of any way in which holders of savings accounts
are hurt by the increase in the inflation rate?
In the lead-up to the last federal election, some political parties made the case for
increased direction of RBA monetary policy by the government of the day so that monetary
policy and fiscal policy were better coordinated. Do you agree or not? If you were writing a
policy paper for your political party, which would you argue for – independence of the RBA
or direction of monetary policy by the government? Be sure to explain your conclusions
thoroughly – the leader of your party wants to make a credible case to the public.
Suppose that Nick is a potato farmer and Aneta is a carrot farmer. Nick and Aneta are the
only people in the economy and both always consume equal amounts of potatoes and
carrots. In 2014 the price of potatoes was $5 and the price of carrots was $3.
a Suppose that in 2015 the price of potatoes was $6 and the price of carrots was $7.50.
What was inflation? Was Nick better off, worse off, or unaffected by the changes in
prices? What about Aneta?
274
2021
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 5 Money and pricesCopyright
in the long
run
11_Stonecash_8e_45658_SB_txt.indd 274
24/08/20 4:34 PM
b Now suppose that in 2015 the price of potatoes was $6 and the price of carrots stayed
at $3. What was inflation? Was Nick better off, worse off, or unaffected by the changes
in prices? What about Aneta?
c Finally, suppose that in 2015 the price of potatoes was $4 and the price of carrots was
$2.50. What was inflation? Was Nick better off, worse off, or unaffected by the changes
in prices? What about Aneta?
7 Most companies no longer produce ‘books’ of prices, but have put all of their prices
on computer. (Think of companies that produce a wide range of products in different
specifications, like a steel company that produces steel pipes and tubes in a large variety
of lengths, diameters and thicknesses.) How does this computerisation affect menu costs?
Does computerisation of price lists make firms more or less likely to respond to changes in
input prices by changes in their prices? How has this affected inflation?
8 If you lived in an economy which experienced rising inflation over the years, would you hold
your wealth in cash or gold or buy some other asset, like paintings? Explain.
9 Suppose that Lauren is a savvy investor and expects inflation to equal 7 per cent in 2020,
but, in fact, prices rise by only 4 per cent. How would this unexpectedly low inflation rate
affect her in the following circumstances?
a The federal government cuts income tax.
b She has a fixed-rate mortgage home loan.
c She is a casual worker with no labour contract in place.
d She has invested in Treasury bonds.
10 Explain one harm associated with unexpected inflation that is not associated with expected
inflation. Then explain one harm associated with both expected and unexpected inflation.
11 Explain whether the following statements are true, false, or uncertain.
a ‘Inflation hurts borrowers and helps lenders, because borrowers must pay a higher rate
of interest.’
b ‘If prices change in a way that leaves the overall price level unchanged, then no one is
made better or worse off.’
c ‘Inflation does not reduce the purchasing power of most workers.’
275
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
WCN 02-200-202
Chapter
11 Inflation: Its causes and costs
11_Stonecash_8e_45658_SB_txt.indd 275
24/08/20 4:34 PM
PART SIX
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
12_Stonecash_8e_45658_SB_txt.indd 276
24/08/20 4:35 PM
The macroeconomics
of open economies
Chapter 12 Open-economy macroeconomics: Basic concepts
Chapter 13 A macroeconomic theory of the open economy
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
12_Stonecash_8e_45658_SB_txt.indd 277
24/08/20 4:35 PM
12
Open-economy
macroeconomics:
Basic concepts
Learning objectives
After reading this chapter, you should be able to:
LO12.1define net exports and net foreign investments, and explain how they measure
the international flow of goods and capital
LO12.2 explain the meaning of the nominal exchange rate and the real exchange rate
LO12.3 examine purchasing-power parity as a theory of how exchange rates are
determined.
278
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
12_Stonecash_8e_45658_SB_txt.indd 278
24/08/20 4:35 PM
Introduction
When you graduate from university and decide to buy a car, you may compare the latest
models offered by Ford and Hyundai. When you take your next holiday, you may consider
spending it on a beach in Queensland or in Tahiti. When you get a job and begin to save for
your retirement, you may choose between a managed fund that buys shares in Australian
companies and one that buys shares in foreign companies. In all of these cases, you will be
participating not just in the Australian economy but in economies around the world.
There are clear benefits to an economy that is open to international trade – trade allows
people to produce what they produce best and to consume the great variety of goods
and services produced around the world. Indeed, one of the Ten Principles of Economics
highlighted in chapter 1 is that trade can make everyone better off. Chapter 3 examined
the gains from trade more fully – that international trade can raise living standards in all
countries by allowing each country to specialise in producing those goods and services in
which it has a comparative advantage.
So far, our development of macroeconomics has largely ignored the economy’s
interaction with other economies around the world. For some economies, like that of the
United States, many questions in macroeconomics can be discussed without considering
international issues. However, for some economies, like the Australian economy, the effects
of international trade are very important. We ignored the effects of international trade when
we discussed topics like the natural rate of unemployment and the causes of inflation to keep
our exposition simple and focused. Indeed, to keep their analysis simple, macroeconomists
often assume a closed economy – an economy that does not interact with other economies.
To build a complete picture of the economy, though, we need to examine an open
economy – an economy that interacts freely with other economies around the world.
This chapter and the next one, therefore, provide an introduction to open-economy
macroeconomics. We begin in this chapter by discussing the key macroeconomic variables
that describe an open economy’s interactions in world markets. You may have noticed
mention of the variables exports, imports, the trade balance and exchange rates in
newspapers or news bulletins. Our first job is to understand what these data mean. In the
next chapter we develop a model to explain how these variables are determined and how
they are affected by various government policies.
closed economy
an economy that
does not interact
with other economies
in the world
open economy
an economy that
interacts freely with
other economies
around the world
LO12.1 The international flows of goods and capital
An open economy interacts with other economies in two ways – it buys and sells goods and
services in world product markets, and it buys and sells financial assets in world financial
markets. Here we discuss these two activities and the close relationship between them.
The flow of goods: Exports, imports and net exports
As noted in chapter 3, exports are domestically produced goods and services that are sold
abroad, and imports are foreign-produced goods and services that are sold domestically.
When Airbus, the European aircraft manufacturer, builds a plane and sells it to Qantas, the
sale is an export for France and an import for Australia. When Arnott’s in Australia makes
Tim Tams and sells them to a US resident, the sale is an import for the United States and an
export for Australia.
The net exports of any country are the value of its exports minus the value of its imports.
The Tim Tams sale raises Australian net exports and the Airbus purchase reduces Australian
net exports. Because net exports tell us whether a country is, in total, a seller or a buyer in
279
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated,
in whole
or in part. WCN 02-200-202
Chapter
12 Open-economy
macroeconomics: Basic concepts
12_Stonecash_8e_45658_SB_txt.indd 279
24/08/20 4:35 PM
trade balance (net
exports)
spending on
domestically produced
goods by foreigners
(exports) minus
spending on foreign
goods by domestic
residents (imports)
trade surplus
an excess of exports
over imports
trade deficit
an excess of imports
over exports
Fairfax Syndication/Matt Golding
balanced trade
a situation in which
exports equal imports
world markets for goods and services, net exports are also called the trade balance. If net
exports are positive, exports are greater than imports, indicating that the country sells more
goods and services abroad than it buys from other countries. In this case, the country is said
to run a trade surplus. If net exports are negative, exports are less than imports, indicating
that the country sells fewer goods and services abroad than it buys from other countries. In
this case, the country is said to run a trade deficit. If net exports are zero, its exports and
imports are exactly equal, and the country is said to have balanced trade.
In the next chapter, we develop a theory that explains an economy’s trade balance, but
even at this early stage it is easy to think of many factors that might influence a country’s
exports, imports and net exports. Those factors include:
• the tastes of consumers for domestic and foreign goods
• the prices of goods at home and abroad
• the rates at which people can exchange domestic currency for foreign currencies
• the cost of transporting goods from country to country
• the policies of the government towards international trade.
As these variables change over time, so does the amount of international trade.
CASE
STUDY
The importance of trade in the
Australian economy
International trade has always been
a significant part of the Australian
economy. Figure 12.1 shows the total
value of goods and services exported to
other countries and imported from other
countries expressed as a percentage
of gross domestic product. In the early
1950s, exports of goods and services
averaged around 20 per cent of GDP. In
the mid-1950s, they levelled off to around
13 per cent and stayed around that level
until the mid-1990s, when they began
to rise. Imports of goods and services
have followed a similar pattern. After
the Second World War, the fledgling
Australian economy began to develop
a manufacturing base, so more goods
were produced in the domestic economy
for domestic production. But trade
has remained an important part of the
national economy.
Because Australia is a small economy,
it has always relied on goods produced
overseas for both investment and
consumption. Many of the goods that
Australians need to produce other goods
or that Australians like to consume are
not produced in the domestic economy.
So we import these goods. Since
Australia is physically a large country,
well endowed with natural resources, for
280
Copyright
2021economies
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 6 The macroeconomics
of open
12_Stonecash_8e_45658_SB_txt.indd 280
24/08/20 4:35 PM
FIGURE 12.1 The openness of the Australian economy
30.0
Exports % GDP
Imports % GDP
25.0
% of GDP
20.0
15.0
10.0
5.0
0.0
Mar-1960
Dec-1973
Aug-1987
Apr-2001
Dec-2014
This figure shows exports and imports of the Australian economy as a percentage of
Australian gross domestic product since 1960. Trade has always been important to the
Australian economy, and has become even more so in recent times.
Source: Reserve Bank of Australia
years our most important exports have
been minerals and primary products,
particularly wool, hence the expression
‘riding on the sheep’s back’.
Even though trade has always been
important for Australia, trade has
increased in importance globally. This
increase in international trade is partly
due to improvements in transportation.
In 1950, the average merchant ship
carried less than 10 000 tonnes of cargo;
today, many ships carry more than
100 000 tonnes. The long-distance jet was
introduced in 1958 and the wide-bodied
jet in 1967, making air transport far
cheaper. Because of these developments,
goods that once had to be produced and
consumed locally can now be traded
around the world. Cut flowers, for
instance, are now grown in Israel and
flown to the United States to be sold.
Fresh fruits and vegetables that can grow
only in summer can now be eaten by
consumers in the Northern Hemisphere
in winter as well, because they can be
shipped from countries in the Southern
Hemisphere, like Australia.
The increase in international trade
has also been influenced by advances
in telecommunications, which have
allowed businesses to reach overseas
customers more easily. Australia’s first
intercontinental telephone connection
was created in 1902 when a submarine
cable was laid across the Pacific,
linking Australia with Canada. The first
transatlantic telephone cable was not
laid until 1956, though. As recently
as 1966, the technology allowed only
138 simultaneous conversations between
North America and Europe. Today,
communications satellites permit more
than 1 million conversations to occur at
the same time.
281
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated,
in whole
or in part. WCN 02-200-202
Chapter
12 Open-economy
macroeconomics: Basic concepts
12_Stonecash_8e_45658_SB_txt.indd 281
24/08/20 4:35 PM
Technological progress has also
fostered international trade by changing
the kinds of goods that economies
produce. When bulky raw materials (like
steel) and perishable goods (like wheat)
were a large part of the world’s output,
transporting goods was often costly
and sometimes impossible. In contrast,
goods produced with modern technology
are often light and easy to transport.
Consumer electronics, for instance, have
low weight for every dollar of value,
which makes them easy to produce in
one country and sell in another. A more
extreme example is the film industry.
Once Fox Studios in Sydney makes a film,
it can send copies of the film around the
world at almost zero cost. Indeed, films
are an export of many countries including
Australia, the United States and India.
The government’s trade policies
have also been a factor in increasing
international trade. As discussed
in chapter 3, economists have long
believed that free trade between
countries is mutually beneficial. Over
time, policymakers around the world
have come to accept these conclusions.
International agreements, like the North
American Free Trade Agreement (NAFTA)
and the General Agreement on Tariffs
Questions
1 After the Second World War, what
factor(s) contributed to increased
international trade globally? How did
these factor(s) change the composition
of international trade? Explain.
IN THE
NEWS
and Trade (GATT), now governed by the
World Trade Organization (WTO), have
gradually lowered trade barriers, like
tariffs and import quotas. Australia is a
leader both in lowering trade barriers
and in encouraging other countries to
do likewise. In fact, since 2000, Australia
has signed free trade agreements with
China, Japan, Korea, Malaysia, Chile,
Thailand, Singapore and the USA. In
2016, the Trans Pacific Partnership
(TPP) was signed, but ultimately never
ratified as the United States pulled
out of the agreement in 2017. This
agreement would reduce trade barriers
between Australia, Brunei, Canada,
Chile, Japan, Malaysia, Mexico, Peru,
New Zealand, Singapore, the United
States and Vietnam. However, a new
agreement was signed in 2018 by all
countries, except the United States, and
it was renamed the Comprehensive and
Progressive Agreement for Trans-Pacific
Partnership (CPTPP). As trade has always
been a significant part of Australia’s
economy, political parties of all stripes
are concerned about what appears to be
a shift towards protectionist policies in
the USA as well as in the UK, with the UK
exiting from the European Union (known
as Brexit).
2
Economists believe that free trade
agreements (FTAs) are mutually
beneficial for the global economy.
Provide examples of FTAs and
briefly explain them. Can you think
of arguments against FTAs?
Australia’s trade balance – good news, but not on every front
Australia continues to benefit from China’s demand for minerals to fuel their
growing economy. And when countries like Brazil can’t export as much iron
ore, Australia benefits again. Our imports have also gone down, contributing to
the trade surplus, but this is not necessarily a good thing. It may mean people
are lacking confidence in the economy, and as a result, are spending less and
firms are buying less (imported) capital equipment. With a looming trade war
between China and the US, Australia’s economic prospects are uncertain, so
let’s enjoy the surplus while we can.
282
Copyright
2021economies
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 6 The macroeconomics
of open
12_Stonecash_8e_45658_SB_txt.indd 282
24/08/20 4:35 PM
Trade surplus record papers over Australia’s worrying
domestic economic trends
Source: Getty Images/Ron D҆Raine/Bloomberg
By Michael Janda
6 August 2019
A 5 per cent increase in metal ore sales was the biggest contributor to the rising exports.
Australia has posted its biggest trade
surplus on record and is on track to post
its first current account surplus since
Gough Whitlam was prime minister.
In June, Australia sold $8 billion
more goods and services to the rest of
the world than it imported. That is a
whopping $1.8 billion higher than the
previous month, which was itself a record
trade surplus.
Over the quarter, the trade surplus
widened to just under $20 billion, more
than $5 billion above the March quarter,
and over the year Australia accumulated
surpluses totalling almost $50 billion.
As Westpac economist Andrew Hanlan
pointed out, the March quarter current
account deficit was only $2.9 billion — the
lowest in many years — meaning there is
a very good chance Australia will post its
first current account surplus since the June
quarter of 1975, when the June quarter
figures come out in a few weeks.
A current account surplus basically
means the nation is earning more from
overseas than it is paying out.
But, even if it eventuates, Australia’s
stay in the black as against the rest of the
world looks set to be fleeting.
‘Given the terms of trade has only
limited upside from here and the income
account remains in structural deficit, our
expectation is for the current account to
return to deficit in the medium term,’ JP
Morgan’s Tom Kennedy warned.
Although, in the short term, the record
trade surplus is likely to stave off any risk
that Australia’s economy shrank in the
June quarter, with analysts agreeing it will
contribute more to GDP than they had
previously expected.
Iron and coal boost exports
There are no prizes for guessing how
Australia is posting record trade surpluses,
with surging iron ore prices and shipments
of LNG contributing much of the
improvement so far this year.
Again in June, iron ore and other
mineral exports rose 5 per cent, adding a
further $554 million to the positive trade
balance.
283
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated,
in whole
or in part. WCN 02-200-202
Chapter
12 Open-economy
macroeconomics: Basic concepts
12_Stonecash_8e_45658_SB_txt.indd 283
24/08/20 4:35 PM
While iron ore prices have slumped
more than 20 per cent in recent weeks,
they were higher than June levels for most
of July, meaning there is a chance of an
even bigger contribution to the next set of
trade figures before this effect eases off.
The other big export contributors to
the improvement that month were coal
(up by 4 per cent, or $232 million) and
metals (excluding gold, up 21 per cent,
adding $230 million).
The biggest fall in exports was in rural
goods, which dropped 4 per cent, led by a
36 per cent ($207 million) slump in grains,
due to the drought conditions persisting
across much of the country.
As Citi’s economists noted, this export
growth has come despite a trade war
raging between China and the US.
‘The record run of Australian trade
surpluses has occurred despite Australia’s
largest export partner and most important
strategic partner engaging in a trade war,’
Citi’s Josh Williamson said.
‘Australia is also exporting more to
both nations. In original terms, exports to
China increased by 5.9 per cent month-onmonth and 35 per cent year-on-year, while
exports to the US increased by 9.9 per
cent and 15 per cent, respectively.’
JP Morgan believes the trade
war has actually boosted Australia’s
export performance, with this the 18th
consecutive monthly trade surplus.
‘Since the first round of tariffs was
implemented in March 2018 Australia’s
external sector has strengthened,’ Mr
Kennedy said.
‘With local government infrastructure
likely to be an important part of any further
stimulus offset, we retain the view that the
US–China trade conflict will have only a
limited impact on the external sector.’
Concerning import fall
However, while a 1.4 per cent rise in
exports overall boosted the surplus, a
3.6 per cent slump in imports contributed
more than twice as much to the
improvement in the trade balance.
On the one hand, the decline in
imports may be a sign that the lower
dollar is causing people to buy Australian.
The other more concerning, and more
likely, explanation is that the import slump
simply reflects the fact that Australians are
cutting back on spending in general.
That is reflected in a 5 per cent
drop in consumption good imports,
which boosted the trade surplus by
$450 million.
According to the Bureau of Statistics,
more than half of this decline in imports
was due to ‘non-industrial transport
equipment’ — cars and bikes — which fell
13 per cent, or $260 million.
This is further confirmation of a very
weak trend in new car sales that has
persisted for many months.
It is terrible news for car dealers, but
not necessarily so bad for the economy
now that all the nation’s cars are imported.
Much more concerning was a
9 per cent ($600 million) slump in capital
goods imports.
This is the machinery and equipment
that firms import to assist in their
businesses and a fall in this category
can signal weakness in investment and
expansion, ultimately meaning lower
economic and employment growth.
The good news in the June figures was
that the very volatile (because each one
is so expensive) civil aircraft sector fell
46 per cent, accounting for $307 million
of the drop, with industrial transport
equipment accounting for most of the rest
($213 million).
The volatile nature of some of these
factors also means it is possible that
June 2019 was as good as Australia’s
trade surplus gets for quite a while, but
while it lasts it is a welcome fillip for an
economy that is generally otherwise
spluttering.
Source: Reproduced by permission of the Australian
Broadcasting Corporation – Library Sales Michael
Janda © 2019 ABC https://www.abc.net.au/news/
2019-08-06/trade-surplus-record-masks-grimeconomic-trends/11387872
284
Copyright
2021economies
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 6 The macroeconomics
of open
12_Stonecash_8e_45658_SB_txt.indd 284
24/08/20 4:35 PM
The flow of financial resources: Net foreign investment
So far we have been discussing how residents of an open economy participate in world
markets for goods and services. In addition, residents of an open economy participate in
world financial markets. An Australian resident with $20 000 could use that money to buy
a car from Hyundai, but she could instead use that money to buy shares in the Hyundai
corporation. The first transaction would represent a flow of goods, whereas the second
would represent a flow of capital.
The term net foreign investment (sometimes referred to as net capital outflow) refers to
the purchase of foreign assets by domestic residents minus the purchase of domestic assets
by foreigners. When an Australian resident buys shares in British Telecom, the British
phone company, the purchase raises Australian net foreign investment. When a Japanese
resident buys a bond issued by the Australian government, the purchase reduces Australian
net foreign investment.
Recall that foreign investment takes two forms. When the Australian Pie Company
opens up a bakery in Moscow, that is an example of foreign direct investment. Alternatively,
if an Australian buys shares in a Russian corporation, that is an example of foreign portfolio
investment. In the first case, the Australian owner is actively managing the investment,
whereas in the second case the Australian owner has a more passive role. So the distinction
is the degree of control. In both cases, Australian residents are buying assets located in
another country, so both purchases increase Australian net foreign investment.
We develop a theory to explain net foreign investment in the next chapter. Here, let’s
consider briefly some of the more important variables that influence net foreign investment:
• the real interest rates being paid on foreign assets
• the real interest rates being paid on domestic assets
• the perceived economic and political risks of holding assets abroad
• the government policies that affect foreign ownership of domestic assets.
For example, consider Australian investors deciding whether to buy Japanese government
bonds or Australian government bonds. (Recall that a bond is, in effect, an IOU of the issuer.)
To make this decision, Australian investors compare the real interest rates offered on the
two bonds. The higher a bond’s real interest rate, the more attractive it is. While making this
comparison, however, Australian investors must also take into account the risk that one
of these governments might default on its debt (that is, not pay interest or principal when
it is due), as well as any restrictions that the Japanese government has imposed, or might
impose in the future, on foreign investors in Japan.
Globalisation of the food supply chain can lead to
much benefit … but we should be aware of the costs as well
The next time you’re enjoying that chocolate bar while you study or having
a hot chocolate on a cold winter’s night, think of where that chocolate came
from. The cocoa it’s made from might well have been harvested by child labour.
Despite global companies like Mars, Nestlé and Hershey pledging to stop using
cocoa from child labour, there is evidence they are still doing so.
The following article is extracted from an investigative report done by The
Washington Post. To read the rest of the article, and find out in detail what
the major companies are doing to combat this issue, go to: https://www.
washingtonpost.com/graphics/2019/business/hershey-nestle-mars-chocolatechild-labor-west-africa/
net foreign
investment
the purchase of
foreign assets by
domestic residents
minus the purchase
of domestic assets
by foreigners
IN THE
NEWS
285
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated,
in whole
or in part. WCN 02-200-202
Chapter
12 Open-economy
macroeconomics: Basic concepts
12_Stonecash_8e_45658_SB_txt.indd 285
24/08/20 4:35 PM
Cocoa’s child laborers
By Peter Whoriskey and Rachel Siegel
June 5, 2019
GUIGLO, Ivory Coast — Five boys are
swinging machetes on a cocoa farm, slowly
advancing against a wall of brush. Their
expressions are deadpan, almost vacant,
and they rarely talk. The only sounds in
the still air are the whoosh of blades slicing
through tall grass and metallic pings when
they hit something harder.
Each of the boys crossed the
border months or years ago from the
impoverished West African nation of
Burkina Faso, taking a bus away from
home and parents to Ivory Coast, where
hundreds of thousands of small farms
have been carved out of the forest.
These farms form the world’s most
important source of cocoa and are the
setting for an epidemic of child labor that
the world’s largest chocolate companies
promised to eradicate nearly 20 years ago.
‘How old are you?’ a Washington Post
reporter asks one of the older-looking
boys.
‘Nineteen,’ Abou Traore says in a
hushed voice. Under Ivory Coast’s labor
laws, that would make him legal. But as
he talks, he casts nervous glances at the
farmer who is overseeing his work from
several steps away. When the farmer is
distracted, Abou crouches and with his
finger, writes a different answer in the
gray sand: 15.
Then, to make sure he is understood,
he also flashes 15 with his hands. He
says, eventually, that he’s been working
the cocoa farms in Ivory Coast since he
was 10. The other four boys say they are
young, too — one says he is 15, two are 14
and another, 13.
Abou says his back hurts, and he’s
hungry.
‘I came here to go to school,’ Abou
says. ‘I haven’t been to school for five
years now.’
The world’s chocolate companies
have missed deadlines to uproot child
labor from their cocoa supply chains in
2005, 2008 and 2010. Next year, they face
another target date and, industry officials
indicate, they probably will miss that, too.
As a result, the odds are substantial
that a chocolate bar bought in the United
States is the product of child labor.
About two-thirds of the world’s cocoa
supply comes from West Africa where,
according to a 2015 U.S. Labor Department
report, more than 2 million children were
engaged in dangerous labor in cocoagrowing regions.
When asked this spring,
representatives of some of the biggest and
best-known brands — Hershey, Mars and
Nestlé — could not guarantee that any of
their chocolates were produced without
child labor.
‘I’m not going to make those claims,’
an executive at one of the large chocolate
companies said.
286
Copyright
2021economies
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 6 The macroeconomics
of open
12_Stonecash_8e_45658_SB_txt.indd 286
24/08/20 4:35 PM
One reason is that nearly 20 years
after pledging to eradicate child labor,
chocolate companies still cannot identify
the farms where all their cocoa comes
from, let alone whether child labor was
used in producing it. Mars, maker of
M&M’s and Milky Way, can trace only
24 percent of its cocoa back to farms;
Hershey, the maker of Kisses and Reese’s,
less than half; Nestlé can trace 49 percent
of its global cocoa supply to farms.
To succeed, the companies would
have to overcome the powerful economic
forces that draw children into hard labor
in one of the world’s poorest places. And
they would have to develop a certification
system to assure consumers that a bag
of M&M’s or a Reese’s Peanut Butter Cup
did not originate with the swinging of a
machete by a boy like Abou.
In all, the industry, which collects an
estimated $103 billion in sales annually,
has spent more than $150 million over
18 years to address the issue.
But when the businesses initially
made the promise to eradicate child
labor, according to industry insiders and
documents, the companies had little
idea of how to do so. Their subsequent
efforts have been stalled by indecision
and insufficient financial commitment,
according to industry critics.
Their most prominent effort — buying
cocoa that has been ‘certified’ for ethical
business practices by third-party groups
such as Fairtrade and Rainforest Alliance,
has been weakened by a lack of rigorous
enforcement of child labor rules. Typically,
the third-party inspectors are required to
visit fewer than 10 percent of cocoa farms.
‘The companies have always done just
enough so that if there were any media
attention, they could say, “Hey guys, this is
what we’re doing”,’ said Antonie Fountain,
managing director of the Voice Network,
an umbrella group seeking to end child
labor in the cocoa industry. ‘It’s always
been too little, too late. It still is.’
Source: Reproduced by permission of the Washington
Post. Peter Whoriskey and Rachel Siegel, June 5, 2019
https://www.washingtonpost.com/graphics/2019/
business/hershey-nestle-mars-chocolate-child-laborwest-africa/
The equality of the current account and the capital and financial accounts
We have seen that an open economy interacts with the rest of the world in two ways – in
world markets for goods and services and in world financial markets. The current account
and the capital and financial accounts (usually considered together) each measure a type
of imbalance in these markets. The current account measures an imbalance between a
country’s exports and its imports of goods and services – its net exports (NX) – as well as
the flow of income and current transfers. Income and current transfers are important to the
Australian economy because many Australians own property overseas or earn income from
overseas companies and many foreigners own property in Australia or earn income from
Australian companies. The net flow of income to and from Australia is referred to as net
income (NY). Current transfers include items like Australian aid to other countries (like food
aid provided to the victims of the 2013 cyclone in the Philippines) or pensions paid to foreign
citizens now resident in Australia. We call the net flow of transfers net transfers (NT).
We can now write our current account balance (CAB) as:
CAB = NX + NY + NT
The capital and financial accounts measure an imbalance between the amount of
foreign assets bought by domestic residents and the amount of domestic assets bought
by foreigners. Following international convention, Australia separates this into capital
transfers (which happen when Australia gives aid to another country to build a bridge) and
financial transactions that represent a transfer of ownership of Australia’s assets between
Australians and foreigners. (You might have noticed a similarity between current transfers
and consumption expenditure in GDP – both are for current consumption and not for longer
term investments. Just as investment in GDP is a measure of how much of national income
is used to build things that help us produce more in the future, so are capital transfers –
they represent Australia’s contribution to investment in other countries.) To simplify our
287
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated,
in whole
or in part. WCN 02-200-202
Chapter
12 Open-economy
macroeconomics: Basic concepts
12_Stonecash_8e_45658_SB_txt.indd 287
24/08/20 4:35 PM
analysis, we will combine the capital and financial accounts together and refer to them as
net foreign investment.
An important but subtle fact of accounting states that, for an economy as a whole, these
two imbalances must offset each other. That is, net foreign investment (NFI) always equals
the current account balance (CAB):
NFI = CAB
This equation holds because every transaction that affects one side of this equation
must also affect the other side by exactly the same amount. This equation is an identity –
an equation that must hold by the way the variables in the equation are defined and
measured.
To see why this accounting identity is true, consider an example. Suppose that Fisher &
Paykel, the New Zealand whitegoods manufacturer, sells some refrigerators to a Japanese
hotel. In this sale, a New Zealand company gives fridges to a Japanese company, and a
Japanese company gives yen to a New Zealand company. Notice that two things have
occurred simultaneously. New Zealand has sold to a foreigner some of its output (the
refrigerators), and this sale increases New Zealand net exports. In addition, New Zealand
has acquired some foreign assets (the yen) and this acquisition increases New Zealand’s net
foreign investment.
Although Fisher & Paykel most likely will not hold onto the yen it has acquired in this
sale, any subsequent transaction will preserve the equality of net exports and net foreign
investment. For example, Fisher & Paykel may exchange its yen for New Zealand dollars
with a New Zealand stockbroker that wants the yen to buy shares in Sony Corporation,
the Japanese maker of consumer electronics. In this case, Fisher & Paykel’s net export of
refrigerators equals the stockbroker’s net foreign investment in Sony shares. Hence, NX and
NFI rise by an equal amount.
Alternatively, Fisher & Paykel may exchange its yen for New Zealand dollars with
another New Zealand company that wants to buy computers from Toshiba, the Japanese
computer maker. In this case, New Zealand imports (of computers) exactly offset New
Zealand exports (of refrigerators). The sales by Fisher & Paykel and Toshiba together affect
neither New Zealand net exports nor New Zealand net foreign investment. That is, NX and
NFI are the same as they were before these transactions took place.
The equality of the current account and net foreign investment follows from the fact
that every international transaction is an exchange. When a seller country transfers a
good or service to a buyer country, the buyer country gives up some asset to pay for this
good or service. The value of that asset equals the value of the good or service sold. When
we add everything up, the net value of goods and services sold by a country and the net
income it earns from overseas (CAB) must equal the net value of assets acquired (NFI). The
international flow of goods and services and income and the international flow of capital are
two sides of the same coin.
Saving, investment and their relationship to the international flows
288
A nation’s saving and investment are, as we have seen in previous chapters, crucial to its
long-run economic growth. Let’s therefore consider how these variables are related to the
international flows of goods and capital, as measured by the current account and net foreign
investment. We can do this most easily with the help of some simple mathematics.
As you may recall, when we discussed the components of gross domestic product earlier
in the book, we didn’t account for the fact that not only do we earn income from our exports
and spend some of that income on imports, but we also earn income from our overseas
investments. We need to adjust our definition of income to reflect this. If you recall, the
economy’s gross domestic product (Y ) is divided among four components: consumption (C),
investment (I ), government purchases (G) and net exports (NX ). To take account of our
Copyright
2021economies
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 6 The macroeconomics
of open
12_Stonecash_8e_45658_SB_txt.indd 288
24/08/20 4:35 PM
earnings from overseas investments, we define our gross national disposable income, GNDY,
(what we have to spend or save) as:
GNDY = GDP + NY + NT
Total income available for expenditure on the economy’s output is the sum of gross
domestic product (GDP) and what we earn from investments overseas (net income, NY) and
gifts and grants from overseas (net transfers, NT). Recall that ‘national saving’ is the income
of the nation that is left after paying for current consumption and government purchases.
Gross national saving (S) equals GNDY – C – G. If we rearrange the equation to reflect this
fact, we obtain:
S = GNDY − C − G
If we substitute in our definition of disposable income, we find:
S = C + I + G + NX + NY + NT − C − G
= I + NX + NY + NT
= I + CAB
Because our current account balance (CAB) also equals net foreign investment (NFI), we
can also write this equation as:
S = I + NFI
Saving = Domestic investment + Net foreign investment
This equation shows that a nation’s saving must equal its domestic investment plus
its net foreign investment. In other words, when Australian citizens save a dollar of their
income for the future, that dollar can be used to finance accumulation of domestic capital or
it can be used to finance the purchase of capital abroad.
This equation should look somewhat familiar. Earlier in the book, when we analysed
the role of the financial system, we considered this identity for the special case of a closed
economy. In a closed economy, net foreign investment is zero (NFI = 0), so saving equals
investment (S = I). In contrast, an open economy has two uses for its saving – domestic
investment and net foreign investment.
As before, we can view the financial system as standing between the two sides of this
identity. For example, suppose the Barnes family decides to save some of its income for
retirement. This decision contributes to national saving, the left-hand side of our equation. If
the Barnes family deposits their saving in a managed fund, the managed fund may use some
of the deposit to buy shares issued by BHP, which uses the proceeds to build a processing
factory in Victoria. In addition, the managed fund may use some of the Barnes family’s
deposit to buy shares issued by Toyota, which uses the proceeds to build a factory in Osaka.
These transactions show up on the right-hand side of the equation. From the standpoint of
Australian accounting, the BHP expenditure on a new factory is domestic investment and
the purchase of Toyota shares by an Australian resident is net foreign investment. Thus, all
saving in the Australian economy shows up as investment in the Australian economy or as
Australian net foreign investment.
Saving, investment and net
foreign investment of Australia
Since the late 1970s, Australia has relied
in part on foreign investment to fund its
domestic investment. We can use our
macroeconomic accounting identities
to help us understand why this would
be so. In panel (a) of Figure 12.2, we
show national saving and domestic
investment for the Australian economy
as a percentage of GDP since 1960. Panel
(b) shows net foreign investment as a
percentage of GDP. Notice that, as the
identities require, domestic investment
plus net foreign investment always equals
national saving.
CASE
STUDY
289
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated,
in whole
or in part. WCN 02-200-202
Chapter
12 Open-economy
macroeconomics: Basic concepts
12_Stonecash_8e_45658_SB_txt.indd 289
24/08/20 4:35 PM
FIGURE 12.2 National saving, domestic investment and net foreign investment
a
Chart Title
40 %
35 %
Gross Inv % GDP
30 %
25 %
20 %
15 %
Gross saving % GDP
10 %
5%
0%
1960
b
1970
1980
1990
2000
2010
2000
2010
NFI % GDP
3
2
1
0
−1
−2
−3
−4
−5
−6
−7
−8
1960
1970
1980
1990
Panel (a) shows national saving and domestic investment as a percentage of GDP. Panel
(b) shows net foreign investment as a percentage of GDP. You can see from the figure that
national saving has been lower since 1976 than it was before 1976. This fall in national
saving has been reflected mainly in reduced net foreign investment rather than in reduced
domestic investment.
Source: ABS DATA, catalogue 5204.08
The figure shows a change beginning
in the late 1970s. Before 1975, national
saving and domestic investment were
very close and so net foreign investment
was small. After 1976, however, national
saving fell dramatically. (This decline was
due in part to increased government
budget deficits and in part to a fall
in private saving.) Yet the Australian
economy did not experience a similar
fall in domestic investment. As a result,
net foreign investment became a
large negative number, indicating that
foreigners were buying more assets in
Australia than Australians were buying
abroad.
One of the consequences of having
a high level of foreign investment in
Australia is that Australia must then
pay interest and dividend payments on
that investment. Australians pay much
more in dividends and interest than they
290
Copyright
2021economies
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 6 The macroeconomics
of open
12_Stonecash_8e_45658_SB_txt.indd 290
24/08/20 4:35 PM
receive in dividends and interest from
overseas. This difference, what we’ve
called net income and net transfers, is
Questions
1 Why did net foreign investment
(NFI) become such a large negative
number after 1976?
2 If the value of exports and imports
were $3978 million and $8751
added to net exports to come up with the
current account (CAB in our model).
million, respectively, and income
and transfers were –$88 072, what is
the current account balance (CAB)?
What does it mean if the CAB is
negative?
CHECK YOUR UNDERSTANDING
Define net exports and net foreign investment. Explain how they are related.
LO12.2 The prices for international transactions: Real and
nominal exchange rates
So far, we have discussed measures of the flow of goods and services and the flow of capital
across a nation’s border. In addition to these quantity variables, macroeconomists also study
variables that measure the prices at which these international transactions take place. Just
as the price in any market serves the important role of coordinating buyers and sellers in
that market, international prices help coordinate the decisions of consumers and producers
as they interact in world markets. Here we discuss the two most important international
prices – the nominal and real exchange rates.
Nominal exchange rates
The nominal exchange rate is the rate at which a person can trade the currency of one
country for the currency of another. For example, if you go to a bank, you might see a posted
exchange rate of 80 yen per dollar. If you give the bank one Australian dollar, it will give you
80 Japanese yen; and if you give the bank 80 Japanese yen, it will give you one Australian
dollar. (In reality, the bank will post slightly different prices for buying and selling yen. The
difference gives the bank some profit for offering this service. For our purposes here, we can
ignore these differences.)
An exchange rate can always be expressed in two ways. If the exchange rate is 80 yen per
dollar, it is also 1/80 (0.0125) dollar per yen. Throughout this book, we always express the
nominal exchange rate as units of foreign currency per Australian dollar, like 80 yen per dollar.
If the exchange rate changes so that a dollar buys more foreign currency, that change
is called an appreciation of the dollar. If the exchange rate changes so that a dollar buys
less foreign currency, that change is called a depreciation of the dollar. For example, when
the exchange rate rises from 80 to 90 yen per dollar, the dollar is said to appreciate. At the
same time, because a Japanese yen now buys less of the Australia currency, the yen is said
to depreciate. When the exchange rate falls from 80 to 70 yen per dollar, the dollar is said to
depreciate and the yen is said to appreciate.
At times you may have heard the media report that the dollar is either ‘strong’ or ‘weak’.
These descriptions usually refer to recent changes in the nominal exchange rate. When a
nominal exchange
rate
the rate at which a
person can trade
the currency of
one country for the
currency of another
appreciation
an increase in the
value of a currency
as measured by the
amount of foreign
currency it can buy
depreciation
a decrease in the
value of a currency
as measured by the
amount of foreign
currency it can buy
291
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated,
in whole
or in part. WCN 02-200-202
Chapter
12 Open-economy
macroeconomics: Basic concepts
12_Stonecash_8e_45658_SB_txt.indd 291
24/08/20 4:35 PM
currency appreciates, it is said to strengthen because it can then buy more foreign currency.
Similarly, when a currency depreciates, it is said to weaken.
For any country, there are many nominal exchange rates. The Australian dollar can be
used to buy Japanese yen, British pounds, euros, Thai baht and so on. When economists
study changes in the exchange rate, they often use indexes that average these many
exchange rates. Just as the consumer price index turns the many prices in the economy into
a single measure of the price level, an exchange rate index turns these many exchange rates
into a single measure of the international value of the currency. So when economists talk
about the dollar appreciating or depreciating, they often are referring to an exchange rate
index that takes into account many individual exchange rates.
Real exchange rates
real exchange rate
the rate at which a
person can trade the
goods and services
of one country
for the goods and
services of another
The real exchange rate is the rate at which a person can trade the goods and services of one
country for the goods and services of another. For example, suppose that you go shopping
and find that a case of German beer is twice as expensive as a case of Australian beer. We
would then say that the real exchange rate is a ½ case of German beer per case of Australian
beer. Notice that, like the nominal exchange rate, the real exchange rate is expressed as
units of the foreign item per unit of the domestic item. But in this instance the item is a good
rather than a currency.
Real and nominal exchange rates are closely related. To see how, consider an example.
Suppose that a tonne of Australian rice sells for $100, and a tonne of Japanese rice sells
for 18 000 yen. What is the real exchange rate between Australian and Japanese rice? To
answer this question, we must first use the nominal exchange rate to convert the prices
into a common currency. If the nominal exchange rate is 90 yen per dollar, then a price for
Australian rice of $100 per tonne is equivalent to 9000 yen per tonne. Australian rice is half
as expensive as Japanese rice. The real exchange rate is a ½ tonne of Japanese rice per tonne
of Australian rice.
We can summarise this calculation for the real exchange rate with the following formula:
Real exchange rate =
Nominal exchange rate × Domestic price
Foreign price
Using the numbers in our example, the formula applies as follows:
Real exchange rate =
(90 yen per dollar) × ($100 per tonne of Australian rice)
18 000 yen per tonne of Japanese rice
=
9 000 yen per tonne of Australian rice
18 000 yen per tonne of Japanese rice
=
1
tonne of Japanese rice per tonne of Australian rice
2
Thus, the real exchange rate depends on the nominal exchange rate and on the prices of
goods in the two countries measured in the local currencies.
Why does the real exchange rate matter? As you might guess, the real exchange rate is a
key determinant of how much a country exports and imports. When Woolworths is deciding
whether to buy Australian rice or Japanese rice to put on its shelves, for example, it will ask
which rice is cheaper. The real exchange rate gives the answer. As another example, imagine
that you are deciding whether to take a seaside holiday in Cairns in Queensland or in Phuket
in Thailand. You might ask your travel agent the price of a hotel room in Cairns (measured
in dollars), the price of a hotel room in Phuket (measured in baht), and the exchange rate
between baht and dollars. If you decide where to holiday by comparing costs, you are basing
your decision on the real exchange rate.
292
Copyright
2021economies
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 6 The macroeconomics
of open
12_Stonecash_8e_45658_SB_txt.indd 292
24/08/20 4:35 PM
When studying an economy as a whole, macroeconomists focus on overall prices rather
than the prices of individual items. That is, to measure the real exchange rate, they use price
indexes, like the consumer price index. By using a price index for Australia (P), a price index
for prices abroad (P*), and the nominal exchange rate between the Australian dollar and
foreign currencies (e), we can calculate the overall real exchange rate between Australia and
other countries as follows:
Real exchange rate =
(e × P)
P*
This real exchange rate measures the price of a basket of goods and services available
domestically relative to a basket of goods and services available abroad.
As we will see more fully in the next chapter, a country’s real exchange rate is a
key determinant of its net exports of goods and services. A depreciation (fall) in the
Australian real exchange rate means that Australian goods have become cheaper relative
to foreign goods. This change encourages consumers both at home and abroad to buy
more Australian goods and fewer goods from other countries. As a result, Australian
exports rise, and Australian imports fall, and both of these changes raise Australian net
exports. Conversely, an appreciation (rise) in the Australian real exchange rate means
that Australian goods have become more expensive compared with foreign goods, so
Australian net exports fall.
CHECK YOUR UNDERSTANDING
Define nominal exchange rate and real exchange rate, and explain how they are related.
If the nominal exchange rate goes from 100 yen to 80 yen per dollar, has the dollar
appreciated or depreciated?
LO12.3 A first theory of exchange-rate determination:
Purchasing-power parity
Exchange rates vary substantially over time. In 1974, an Australian dollar could be used to
buy 1.49 US dollars, 402 Japanese yen, 0.579 of a British pound or 618 Indonesian rupiah.
In 2014, an Australian dollar bought 0.89 of a US dollar, 90 Japanese yen, 0.579 of a British
pound or 10 367 Indonesian rupiah. In other words, over this period the value of the dollar
fell by 40 per cent compared with the US dollar. The value of the Australian dollar fell by
almost 80 per cent relative to the Japanese yen. And yet it appreciated by over 1580 per cent
compared with the Indonesian rupiah.
What explains these large changes? Economists have developed many models to explain
how exchange rates are determined, each emphasising some of the many forces at work.
Here we develop the simplest theory of exchange rates, called purchasing-power parity.
This theory states that a unit of any given currency should be able to buy the same quantity
of goods in all countries. Many economists believe that purchasing-power parity describes
the forces that determine exchange rates in the long run. We now consider the logic on
which this long-run theory of exchange rates is based, as well as the theory’s implications
and limitations.
purchasing-power
parity
a theory of exchange
rates whereby a unit
of any given currency
should be able to buy
the same quantity of
goods in all countries
The basic logic of purchasing-power parity
The theory of purchasing-power parity is based on a principle called the law of one price.
This law asserts that a good must sell for the same price in all locations. Otherwise, there
293
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated,
in whole
or in part. WCN 02-200-202
Chapter
12 Open-economy
macroeconomics: Basic concepts
12_Stonecash_8e_45658_SB_txt.indd 293
24/08/20 4:35 PM
would be opportunities for profit left unexploited. For example, suppose that coffee beans
sold for less in Brisbane than in Perth. A person could buy coffee in Brisbane for, say, $20 a
kilo and then sell it in Perth for $30 a kilo, making a profit of $10 per kilo from the difference
in price. The process of taking advantage of differences in prices in different markets is
called arbitrage. In our example, as people took advantage of this arbitrage opportunity,
they would increase the demand for coffee in Brisbane and increase the supply in Perth. The
price of coffee would rise in Brisbane (in response to greater demand) and fall in Perth (in
response to greater supply). This process would continue until, eventually, the prices were
the same in the two markets, ignoring transaction costs.
Now consider how the law of one price applies to the international marketplace. If a
dollar (or any other currency) could buy more coffee in Australia than in Japan, international
traders could profit by buying coffee in Australia and selling it in Japan. This export of coffee
from Australia to Japan would drive up the Australian price of coffee and drive down the
Japanese price. Conversely, if a dollar could buy more coffee in Japan than in Australia,
traders could buy coffee in Japan and sell it in Australia. This import of coffee into Australia
from Japan would drive down the Australian price of coffee and drive up the Japanese price.
In the end, the law of one price tells us that a dollar must buy the same amount of coffee in
all countries.
This logic leads us to the theory of purchasing-power parity. According to this theory,
a currency must have the same purchasing power in all countries. That is, an Australian
dollar must buy the same quantity of goods in Australia and Japan, and a Japanese yen must
buy the same quantity of goods in Japan and Australia. Indeed, the name of this theory
describes it well. Parity means equality, and purchasing power refers to the value of money.
Purchasing-power parity states that one unit of every currency must have the same real
value in every country.
Implications of purchasing-power parity
What does the theory of purchasing-power parity say about exchange rates? It tells us that
the nominal exchange rate between the currencies of two countries depends on the price
levels in those countries. If a dollar buys the same quantity of goods in Australia (where
prices are measured in dollars) as in Japan (where prices are measured in yen), then the
number of yen per dollar must reflect the prices of goods in Australia and Japan. For example,
if a kilo of coffee costs 1500 yen in Japan and $20 in Australia, then the nominal exchange
rate must be 75 yen per dollar (1500 yen/$20 = 75 yen per dollar). Otherwise, the purchasing
power of the dollar would not be the same in the two countries.
To see more fully how this works, it is helpful to use just a bit of mathematics. Suppose
that P is the price level in Australia (measured in dollars), P* is the price level in Japan
(measured in yen), and e is the nominal exchange rate (the number of yen a dollar can
buy). Now consider the quantity of goods a dollar can buy at home and abroad. At home,
the price level is P, so the purchasing power of $1 at home is 1/P. Abroad, a dollar can
be exchanged into e units of foreign currency, which in turn have purchasing power e/P*.
For the purchasing power of a dollar to be the same in the two countries, it must be the
case that:
1/P = e/P*
With rearrangement, this equation becomes:
1 = eP/P*
Notice that the left-hand side of this equation is a constant, and the right-hand side is
the real exchange rate. Thus, if the purchasing power of the dollar is always the same at
294
Copyright
2021economies
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 6 The macroeconomics
of open
12_Stonecash_8e_45658_SB_txt.indd 294
24/08/20 4:35 PM
home and abroad, then the real exchange rate – the relative price of domestic and foreign
goods – cannot change. To see the implication of this analysis for the nominal exchange
rate, we can rearrange the last equation to solve for the nominal exchange rate:
e = P*/P
That is, the nominal exchange rate equals the ratio of the foreign price level (measured in
units of the foreign currency) to the domestic price level (measured in units of the domestic
currency). According to the theory of purchasing-power parity, the nominal exchange rate
between the currencies of two countries must reflect the different price levels in those countries.
A key implication of this theory is that nominal exchange rates change when price levels
change. As we saw in the preceding chapter, the price level in any country adjusts to bring
the quantity of money supplied and the quantity of money demanded into balance. Because
the nominal exchange rate depends on the price levels, it also depends on the money supply
and money demand in each country. When a central bank in any country increases the
money supply and causes the price level to rise, it also causes that country’s currency to
depreciate relative to other currencies in the world. In other words, when the central bank
prints large quantities of money, that money loses value both in terms of the goods and
services it can buy and in terms of the amount of other currencies it can buy.
Purchasing-power parity and the Big Mac
In 1986, The Economist devised an ingenious way to evaluate whether a currency
is valued at the level predicted by the theory of purchasing-power parity. Their
approach was to divide the price of a Big Mac in 120 countries by the American
price and compare the result with the actual exchange rate. According to the
burgernomic approach, the price of a Big Mac in Australia looks pretty good.
You can go online and see which currencies are overvalued, which ones
undervalued and which ones are about right. Go to http://www.economist.com
and search for ‘the Big Mac index’.
IN THE
NEWS
While the Big Mac is a good that can be found worldwide and therefore useful for
comparing exchange rates, many economists object to the index because burgers aren’t
really tradeable goods. An alternative was created by UBS, a Swiss bank. It uses the same
burger to measure the purchasing power of local wages. It divides the price of a Big Mac by
the average net hourly wage in cities around the world. A worker from Jakarta must toil for
almost 2½ hours to buy a Big Mac, but a Moscow wage buys the burger in 21 minutes, a
Tokyo salary buys one in just 12 minutes, and in Sydney it takes 14 minutes’ work to buy a
Big Mac.
Purchasing-power parity and the iPod
In 2007, the Commonwealth Bank’s online trading company, CommSec, devised
an alternative to the Big Mac index – the iPod index (now the iPad/iPhone
indexes). This index does the same thing that the Big Mac index does, but uses
a good that is tradeable.
You can go to the CommSec website to see what the current iPad and
iPhone index is telling us about purchasing power in Australia. Here’s an
example from September 2018. (See Table 12.1.)
IN THE
NEWS
295
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated,
in whole
or in part. WCN 02-200-202
Chapter
12 Open-economy
macroeconomics: Basic concepts
12_Stonecash_8e_45658_SB_txt.indd 295
24/08/20 4:35 PM
CommSec iPhone index:
Australia 4th cheapest
by Craig James, Chief Economist, CommSec
Economic trends
•
•
•
•
•
•
Do we have a Goldilocks Aussie dollar –
not too hot, not too cold, just about
right? According to CommSec iPhone
index Australia is now the 4th cheapest
country in the world (of 51 nations)
to buy an Apple iPhone 8 in US dollar
terms.
This time last year, Australia was the
25th cheapest country in the world to
buy an Apple iPhone 7 (Aussie dollar
US80 cents). In 2016 Australia was the
17th cheapest to buy the iPhone 6 Plus
(Aussie dollar US76 cents) and in 2015
Australia was fourth cheapest to buy
an iPhone (Aussie dollar US69 cents).
An iPhone 8, 4.7 inch, 64GB is $1,079
in Australia (US$775.56 at exchange
rates sourced on September 5). In
the US, the same phone is US$699
(US$765.41 in Los Angeles with state
and local taxes) – around 1.3 per cent
cheaper. (The Aussie dollar has fallen
further since all the data was compiled
on September 5.)
Apple is expected to release a new
model of the iPhone on Wednesday
and Australian consumers will be
closely watching the local pricing of the
must-have device.
Turning to the CommSec iPad index.
Australia is now the 3rd cheapest
country in the world (of 51 nations) to
buy an Apple iPad 2018; 9.7-inch tablet
device, 32GB in US dollar terms. This
time last year, Australia was the 17th
cheapest country to buy an Apple iPad
Pro 10.5-inch tablet device in US dollar
terms. (2016: 20th cheapest; 2015: 2nd
cheapest).
In January 2007 CommSec launched
its iPod index as a modern way of
•
looking at purchasing power theory.
That is, the theory that the same good
should be sold for the same price
across the globe once taking into
account exchange rates. On current
iPad & iPhone pricing the Aussie dollar
could be regarded as, at best, as a little
‘expensive’. Last year we thought the
currency was slightly ‘over-valued’.
On current pricing, Aussie tourists
would only save $11 by buying an iPad
in the cheapest country (Hong Kong)
rather than in Australia. When the
currency falls Aussie consumers may
be better off buying goods locally, and
that’s great news for Aussie retailers.
…
Purchasing power parity:
In theory only
•
•
•
While the concept of purchasing power
parity is good in theory, unfortunately
there are complications in practice.
As noted above, one of the biggest
complications is tax with differing
consumption tax rates applied across
the globe.
The other complication with
purchasing power parity is freight or
shipping cost. If the local price was
relatively high and shipping costs
weren't overly exorbitant then a
buyer may decide to source goods
from another country. If enough
buyers were to source goods abroad,
presumably it would force local
retailers to re-assess pricing.
On current exchange rates Australian
consumers probably wouldn’t be
tempted to buy their iPads and
iPhones from abroad while on
personal or business trips. For
instance an Aussie traveller may
save just $16 to buy an iPhone in Los
Angeles or save $11 to buy an iPad in
Hong Kong.
296
Copyright
2021economies
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 6 The macroeconomics
of open
12_Stonecash_8e_45658_SB_txt.indd 296
24/08/20 4:35 PM
Highest
Lowest
Brazil
$600.50
South Africa
$363.26
Argentina
$495.13
Singapore
$360.87
Iceland
$488.64
New Zealand
$356.95
Greece
$473.60
Taiwan
$353.67
Serbia
$472.13
Thailand
$351.24
Slovenia
$438.87
Japan
$339.56
Denmark
$434.80
Australia
$337.10
Romania
$432.64
Malaysia
$331.55
Finland
$427.28
Hong Kong
$329.68
Portugal
$427.28
Table source: CommSec Economics
TABLE 12.1 Apple iPad 2018, 9.7 inch, 32GB, $US
Source: Craig James, Chief Economist, CommSec Economics. https://www.commsec.com.au/content/dam/
EN/ResearchNews/2018Reports/September/ECO_Insights_110918_iPhone.pdf
The nominal exchange rate during hyperinflation
Macroeconomists cannot conduct controlled experiments. Instead, they must glean
what they can from the natural experiments that history gives them. One natural
experiment is hyperinflation – the high inflation that arises when a government turns
to the printing press to pay for large amounts of government spending. Because
hyperinflations are so extreme, they illustrate some basic economic principles with
clarity.
Consider the German hyperinflation of the early 1920s. Figure 12.3 shows the
German money supply, the German price level and the nominal exchange rate
(measured as US cents per German mark) for that period. Notice that these series
move closely together. When the supply of money starts growing quickly, the price level
also takes off, and the German mark depreciates. When the money supply stabilises, so
does the price level and the exchange rate.
The pattern shown in this figure appears during every hyperinflation. It leaves
no doubt that there is a fundamental link between money, prices and the nominal
exchange rate. The quantity theory of money discussed in the previous chapter
explains how the money supply affects the price level. The theory of purchasing-power
parity discussed here explains how the price level affects the nominal exchange rate.
CASE
STUDY
Question
Briefly explain why the price level and nominal exchange rate move together.
297
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated,
in whole
or in part. WCN 02-200-202
Chapter
12 Open-economy
macroeconomics: Basic concepts
12_Stonecash_8e_45658_SB_txt.indd 297
24/08/20 4:35 PM
FIGURE 12.3 Money, prices and the nominal exchange rate during the German
hyperinflation
Indexes
(Jan. 1921 = 100)
1 000 000 000 000 000
Money supply
10 000 000 000
Price level
100 000
1
Exchange rate
0.00001
0.0000000001
1921
1922
1923
1924
1925
This figure shows the money supply, the price level and the exchange rate (measured as
US cents per mark) for the German hyperinflation from January 1921 to December 1924.
Notice how similarly these three variables move. When the quantity of money started
growing quickly, the price level followed, and the mark depreciated relative to the dollar.
When the German central bank stabilised the money supply, the price level and exchange
rate stabilised as well.
Source: Adapted from Thomas J. Sargent, ‘The end of four big inflations’ in Robert Hall, ed., Inflation (Chicago: University
of Chicago Press, 1983), pp. 41–93
We can now answer the question that began this section: Why has the Australian dollar
lost value compared with the US dollar and gained value compared with the Indonesian
rupiah? The answer is that the US has pursued a less inflationary monetary policy than
Australia, and Indonesia has pursued a more inflationary monetary policy. From 1970 to
2014, inflation in Australia was 5.5 per cent per year. In contrast, inflation was 4 per cent
in the United States and over 13 per cent in Indonesia. As Australian prices rose relative
to US prices, the value of the Australian dollar fell relative to the US dollar. Similarly, as
Australian prices fell relative to Indonesian prices, the value of the Australian dollar rose
relative to the rupiah.
Limitations of purchasing-power parity
Purchasing-power parity provides a simple model of how exchange rates are determined.
For understanding many economic phenomena, the theory works well. In particular, it can
explain many long-term trends, like the depreciation of the Australian dollar against the US
dollar and the appreciation of the Australian dollar against the Indonesian rupiah. It can
also explain the major changes in exchange rates that occur during hyperinflations.
Yet the theory of purchasing-power parity is not completely accurate. That is, exchange
rates do not always move to ensure that a dollar has the same real value in all countries all
298
Copyright
2021economies
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 6 The macroeconomics
of open
12_Stonecash_8e_45658_SB_txt.indd 298
24/08/20 4:35 PM
the time. There are two reasons that the theory of purchasing-power parity does not always
hold in practice.
The first reason is that many goods are not easily traded. Imagine, for instance, that
haircuts are more expensive in Paris than in Sydney. International travellers might avoid
getting their haircuts in Paris and some hairdressers might move from Sydney to Paris. Yet
such arbitrage would probably be too limited to eliminate the differences in prices. Thus, the
deviation from purchasing-power parity might persist and a dollar (or euro) would continue
to buy less of a haircut in Paris than in Sydney.
The second reason that purchasing-power parity does not always hold is that even
tradeable goods are not always perfect substitutes when they are produced in different
countries. For example, some consumers prefer German beer and others prefer Australian
beer. Moreover, consumer tastes for beer change over time. If German beer suddenly becomes
more popular, the increase in demand will drive up the price of German beer. As a result, a
dollar (or a euro) might then buy more beer in Australia than in Germany. But despite this
difference in prices in the two markets, there might be no opportunity for profitable arbitrage
because consumers do not view the two beers as equivalent.
Thus, both because some goods are not tradeable and because some tradeable goods are
not perfect substitutes with their foreign counterparts, purchasing-power parity is not a
perfect theory of exchange-rate determination. For these reasons, real exchange rates do in
fact fluctuate over time. Nonetheless, the theory of purchasing-power parity does provide
a useful first step in understanding exchange rates. The basic logic is persuasive – as the
real exchange rate drifts from the level predicted by purchasing-power parity, people have
greater incentive to move goods across national borders. Even if the forces of purchasingpower parity do not completely fix the real exchange rate, they do provide a reason to expect
that changes in the real exchange rate are most often small or temporary. As a result, large
and persistent movements in nominal exchange rates typically reflect changes in price
levels at home and abroad.
CHECK YOUR UNDERSTANDING
If the Reserve Bank of Australia (RBA) decreases the money supply, what happens to the
price level? What happens to Australia’s currency relative to the other countries in the
world? Use the equation, e = P*/P to help answer these questions.
Conclusion
The purpose of this chapter has been to develop some basic concepts that macroeconomists
use to study open economies. You should now understand why a nation’s net exports must
equal its net foreign investment and why national saving must equal domestic investment
plus net foreign investment. You should also understand the meaning of the nominal and
real exchange rates, as well as the implications and limitations of purchasing-power parity
as a theory of how exchange rates are determined.
The macroeconomic variables defined here offer a starting point for analysing an open
economy’s interactions with the rest of the world. In the next chapter, we develop a model
that can explain what determines these variables. We can then discuss how various events
and policies affect a country’s trade balance and the rate at which nations make exchanges
in world markets.
299
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated,
in whole
or in part. WCN 02-200-202
Chapter
12 Open-economy
macroeconomics: Basic concepts
12_Stonecash_8e_45658_SB_txt.indd 299
24/08/20 4:35 PM
STUDY TOOLS
Summary
LO12.1
Net exports are the value of domestic goods and services sold abroad minus the
value of foreign goods and services sold domestically. Net foreign investment is the
acquisition of foreign assets by domestic residents minus the acquisition of domestic
assets by foreigners. Because every international transaction involves an exchange of
an asset for a good or service, an economy’s net foreign investment always equals its
net exports. An economy’s saving can be used either to finance investment at home
or to buy assets abroad. Thus, national saving equals domestic investment plus net
foreign investment.
LO12.2
The nominal exchange rate is the relative price of the currency of two countries and
the real exchange rate is the relative price of the goods and services of two countries.
When the nominal exchange rate changes so that each dollar buys more foreign
currency, the dollar is said to appreciate or strengthen. When the nominal exchange
rate changes so that each dollar buys less foreign currency, the dollar is said to
depreciate or weaken.
LO12.3
According to the theory of purchasing-power parity, a dollar (or a unit of any other
currency) should be able to buy the same quantity of goods in all countries. This
theory implies that the nominal exchange rate between the currencies of two
countries should reflect the price levels in those countries. As a result, countries
with relatively high inflation should have depreciating currencies, and countries with
relatively low inflation should have appreciating currencies.
Key concepts
appreciation, p. 291
balanced trade, p. 280
closed economy, p. 279
depreciation, p. 291
net foreign investment, p. 285
nominal exchange rate, p. 291
open economy, p. 279
purchasing-power parity, p. 293
real exchange rate, p. 292
trade balance (net exports), p. 280
trade deficit, p. 280
trade surplus, p. 280
Practice questions
Questions for review
1
2
3
4
Consider the equation, S = I + NFI. Solve this equation for NFI (i.e. so that NFI is the variable
of interest). If S > I, what happens to NFI? If S < I, what happens to NFI?
If Australia decided to save more than it invests domestically, what must be true of its net
foreign investment (NFI)?
Describe the economic logic behind the theory of purchasing-power parity. What are the
problems with the theory?
If the Reserve Bank of Australia reduced printing quantities of Australian dollars (i.e. a
decrease in the money supply), what would happen to the number of Japanese yen a
dollar could buy? The number of US dollars an Australian dollar could buy? The number of
Chinese RMB an Australian dollar could buy?
Multiple choice
1
If an Australian resident invests in shares in Apple, which is listed on the US stock exchange,
what does this do to net capital flows?
a It increases capital outflow.
b It increases capital inflow.
c It has no effect because it is not a physical exchange of goods or services.
d It causes a deficit in our capital account.
300
Copyright
2021economies
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 6 The macroeconomics
of open
12_Stonecash_8e_45658_SB_txt.indd 300
24/08/20 4:35 PM
2
3
4
5
If the real exchange rate rises, but inflation in Australia and our trading partner’s country is
the same, what is happening to the nominal exchange rate?
a It is increasing.
b It is staying the same.
c It is falling.
d It depends on what is happening to our GDP.
According to the Big Mac index, a currency is overvalued if
a it costs more to buy a Big Mac in that currency than it does in other currencies.
b it costs less to buy a Big Mac in that currency than it does in other currencies.
c it costs the same – it doesn’t matter what a Big Mac costs.
d it is rising relative to other currencies.
Suppose the exchange rate between the dollar and the yen is ¥70 = $1, and then changes
to ¥110 = $1. What is likely to happen next?
a Australian exports will decrease and Australian imports will increase.
b Australian exports will increase and Australian imports will increase.
c Australian exports will decrease and Australian imports will decrease.
d Australian exports will increase and Australian imports will decrease.
Suppose that the US dollar (USD) depreciates against the Australian dollar (AUD). Assuming
ceteris paribus, the real exchange rate of USD to AUD will
a decrease.
b increase.
c remain the same.
d decrease and then increase.
Problems and applications
1
2
3
4
5
How would the following transactions affect Australian exports, imports and net exports?
a An Australian chef spends the summer touring restaurants in Asia.
b Department stores in Milan buy clothes designed by Australian designer Toni
Maticevski.
c Your older brother buys a Nissan GT-R.
d Drake sells a million CDs in Australia.
e A Chinese citizen shops at a store in Melbourne to avoid the Chinese goods and
services tax (assuming that they can get their Australian GST rebated on departure from
Australia).
Based on the following, provide reasons as to why international trade has increased globally
since the post-Second World War period:
a abundant natural resources (such as iron ore and minerals in Australia)
b transportation and telecommunications
c technological progress
d free trade agreements (FTAs)
How would the following transactions affect Australian net foreign investment? Also, state
whether each involves direct investment or portfolio investment.
a An Australian mobile phone company establishes an office in Macedonia.
b British pension funds buy shares in Rio Tinto.
c Toyota closes its factory in Altona.
d A Westpac mutual fund sells its News Ltd shares to a Chinese investor.
Holding national saving constant, does an increase in net foreign investment increase,
decrease, or have no effect on a country’s accumulation of domestic capital?
The Australian Financial Review contains a table showing Australian exchange rates or
you can find exchange rates on the Internet. Use either source to answer the following
questions.
a Does this table show nominal or real exchange rates? Explain.
b What are the exchange rates between Australia and the United States and between
Australia and Japan? Calculate the exchange rate between the United States and Japan.
c If Australian inflation exceeds US inflation over the next year, would you expect the
dollar to appreciate or depreciate relative to the US dollar?
301
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated,
in whole
or in part. WCN 02-200-202
Chapter
12 Open-economy
macroeconomics: Basic concepts
12_Stonecash_8e_45658_SB_txt.indd 301
24/08/20 4:35 PM
6
Would each of the following groups be happy or unhappy if the Australian dollar
depreciated? Explain.
a Australian cattle growers who export beef to China
b Australian companies who buy raw materials overseas
c Australian students planning a study year in London
d An Australian firm trying to purchase a plant located overseas that will produce goods
to be sent back to Australia
7 What is happening to the Australian real exchange rate in each of the following situations?
Explain.
a The Australian nominal exchange rate is unchanged, but prices rise faster in overseas
countries than in Australia.
b The Australian nominal exchange rate is unchanged, but prices rise slower abroad than
in Australia.
c The Australian nominal exchange rate declines, and prices are unchanged in Australia
and abroad.
d The Australian nominal exchange rate declines, and prices rise faster abroad than in
Australia.
8 List three goods for which the law of one price is likely to hold and three goods for which it
is not. Justify your choices.
9 If a Japanese car costs 6 000 000 yen, if a similar Australian car costs $20 000, and if a dollar
can buy 1000 yen, what are the nominal and real exchange rates? Does purchasing-power
parity hold?
10 As the value of the Australian dollar rises, more and more people are buying goods
from overseas on the Internet and having them shipped to Australia. Does this mean
purchasing-power parity is more or less likely to hold for these goods?
11 Assume that Australian coal sells for $320 per tonne, Chinese coal sells for 1800 RMB
(yuan) per tonne, and the nominal exchange rate is 6 RMB (yuan) per dollar.
a Explain how you could make a profit from this situation. What would be your profit per
tonne of coal? If other people exploit the same opportunity, what would happen to the
price of coal in China and the price of coal in Australia?
b Suppose that coal is the only commodity in the world. What would happen to the real
exchange rate between Australia and China?
c What would prevent the exchange rate from adjusting?
12 As you can see from The Economist website, the international news magazine regularly
collects data on the price of a McDonald’s Big Mac hamburger in different countries in
order to examine the theory of purchasing-power parity.
a Why might the Big Mac be a good product to use for this purpose?
b Based on the Big Mac data, purchasing-power parity appears to hold roughly across
some countries, though not across others. Why might the assumptions underlying the
theory of purchasing-power parity not hold exactly for Big Macs?
c Do you think the UBS index on minutes worked required to buy a Big Mac would be
a better measure of purchasing-power parity than the simple Big Mac index? Why or
why not?
d Why would the iPod index be a better measure than either Big Mac index?
302
Copyright
2021economies
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 6 The macroeconomics
of open
12_Stonecash_8e_45658_SB_txt.indd 302
24/08/20 4:35 PM
13
A macroeconomic
theory of the open
economy
Learning objectives
After reading this chapter, you should be able to:
LO13.1build a model to explain an open economy’s trade balance and exchange rate
LO13.2 use the model to analyse the effects of government budget deficits
LO13.3 use the model to analyse the macroeconomic effects of trade policies
LO13.4 use the model to analyse political instability and capital flight.
303
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
13_Stonecash_8e_45658_SB_txt.indd 303
24/08/20 6:52 PM
Introduction
Since the 1970s, Australia’s trade balance has swung between surplus and deficit.
Sometimes we export more goods and services than we import. Sometimes we import
more than we export. Despite periods of trade surplus, economists debate whether the
trade deficits are a problem for the Australian economy. The nation’s business community,
however, has a strong opinion. Many business leaders claim that the trade deficits reflect
unfair competition – foreign firms are allowed to sell their products in Australian markets,
they contend, while foreign governments impede Australian firms selling Australian
products abroad.
Imagine that you are the prime minister and you want to end these trade deficits. What
should you do? Should you try to limit imports, perhaps by increasing tariffs on the import
of water heaters from China? Or should you try to influence the nation’s trade deficit in
some other way?
To understand what factors determine a country’s trade balance and how government
policies can affect it, we need a macroeconomic theory of the open economy. The preceding
chapter introduced some of the key macroeconomic variables that describe an economy’s
relationship with other economies – including net exports, net foreign investment and the
real and nominal exchange rates. This chapter develops a model that shows what forces
determine these variables and how these variables are related to one another.
To develop this macroeconomic model of an open economy, we build on our previous
analysis in two important ways. First, the model takes the economy’s GDP as given.
The economy’s output of goods and services, as measured by real GDP, is assumed to be
determined by the supplies of the factors of production and by the available production
technology that turns these inputs into output. Second, the model takes the economy’s
price level as given. The price level is assumed to adjust to bring the supply and demand
for money into balance. In other words, this chapter takes as a starting point the lessons
learned in previous chapters about the determination of the economy’s output and
price level.
The goal of the model in this chapter is to highlight those forces that determine the
economy’s trade balance and exchange rate. In one sense, the model is simple – it merely
applies the tools of supply and demand to an open economy. Yet the model is also more
complicated than others we have seen because it involves looking simultaneously at
two related markets – the market for loanable funds and the market for foreign-currency
exchange. After we develop this model of the open economy, we use it to examine how
various events and policies affect the economy’s trade balance and exchange rate. We
will then be able to determine the government policies that are most likely to reverse the
trade deficits that the Australian economy has experienced from time to time over the past
few decades.
LO13.1 Supply of and demand for loanable funds
and foreign-currency exchange
To understand the forces at work in an open economy, we focus on supply and demand in
two markets. The first is the market for loanable funds, which coordinates the economy’s
saving and investment (including its net foreign investment). The second is the market for
foreign-currency exchange, which coordinates people who want to exchange the domestic
currency for the currency of other countries. In this section we discuss supply and demand
in each of these markets. In the next section we put these markets together to explain the
overall equilibrium for an open economy.
304
Copyright
2021economies
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 6 The macroeconomics
of open
13_Stonecash_8e_45658_SB_txt.indd 304
24/08/20 6:52 PM
The market for loanable funds
When we first analysed the role of the financial system earlier in this book, we made the
simplifying assumption that the financial system consists of only one market, called
the market for loanable funds. All savers go to this market to deposit their savings and all
borrowers go to this market to get their loans. In this market, there is one interest rate,
which is both the return on saving and the cost of borrowing.
To understand the market for loanable funds in an open economy, the place to start is the
identity discussed in the preceding chapter:
S = I + NFI
Saving = Domestic investment + Net foreign investment
Whenever a nation saves a dollar of its income, it can use that dollar to finance the
purchase of domestic capital or to finance the purchase of an asset abroad. The two sides of
this identity represent the two sides of the market for loanable funds. The supply of loanable
funds comes from national saving (S). The demand for loanable funds comes from domestic
investment (I) and net foreign investment (NFI). Note that the purchase of a capital asset
adds to the demand for loanable funds, regardless of whether that asset is located at home or
abroad. Because net foreign investment can be either positive or negative, it can either add to
or subtract from the demand for loanable funds that arises from domestic investment.
As we learned in our earlier discussion of the market for loanable funds, the quantity of
loanable funds supplied and the quantity of loanable funds demanded depend on the real
interest rate. A higher real interest rate encourages people to save and, therefore, raises the
quantity of loanable funds supplied. A higher interest rate also makes borrowing to finance
capital projects more costly; thus, it discourages investment and reduces the quantity of
loanable funds demanded.
In addition to influencing national saving and domestic investment, the real interest
rate in a country affects that country’s net foreign investment. To see why, consider two
managed funds – one in Australia and one in Canada – deciding whether to buy an Australian
government bond or a Canadian government bond. The managed funds would make this
decision in part by comparing the real interest rates in Australia and Canada. When the
Australian real interest rate rises, the Australian bond becomes more attractive to both
managed funds. Thus, an increase in the Australian real interest rate discourages Australians
from buying foreign assets and encourages foreigners to buy Australian assets. For both
reasons, a high Australian real interest rate reduces Australian net foreign investment.
We represent the market for loanable funds on the familiar supply-and-demand diagram
in Figure 13.1. As in our earlier analysis of the financial system, the supply curve slopes
upwards because a higher interest rate increases the quantity of loanable funds supplied and
the demand curve slopes downwards because a higher interest rate decreases the quantity
of loanable funds demanded. Unlike the situation in our previous discussion, however, the
demand side of the market now represents the behaviour of both domestic investment and
net foreign investment. That is, in an open economy, the demand for loanable funds comes
not only from those who want to borrow funds to buy domestic capital goods but also from
those who want to borrow funds to buy foreign assets.
The interest rate adjusts to bring the supply of and demand for loanable funds into
balance. If the interest rate were below the equilibrium level, the quantity of loanable funds
supplied would be less than the quantity demanded. The resulting shortage of loanable
funds would push the interest rate upwards. Conversely, if the interest rate were above
the equilibrium level, the quantity of loanable funds supplied would exceed the quantity
demanded. The surplus of loanable funds would drive the interest rate downwards. At
the equilibrium interest rate, the supply of loanable funds exactly balances the demand.
305
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated,
in whole
part. WCN 02-200-202
Chapter
13orAinmacroeconomic
theory of the open economy
13_Stonecash_8e_45658_SB_txt.indd 305
24/08/20 6:52 PM
FIGURE 13.1 The market for loanable funds
Real
interest
rate
Supply of loanable funds
(from national saving)
Equilibrium
real interest
rate
Demand for loanable
funds (for domestic
investment and net
foreign investment)
Equilibrium
quantity
Quantity of
loanable funds
The interest rate in a large, open economy, as in a closed economy, is determined by the supply
of and demand for loanable funds. National saving is the source of the supply of loanable
funds. Domestic investment and net foreign investment are the sources of the demand for
loanable funds. At the equilibrium interest rate, the amount that people want to save exactly
balances the amount that people want to borrow for the purpose of buying domestic capital
and foreign assets.
That is, at the equilibrium interest rate, the amount that people want to save exactly balances
the desired quantities of domestic investment and net foreign investment.
The market for foreign-currency exchange
The second market in our model of the open economy is the market for foreign-currency
exchange. Participants in this market trade Australian dollars in exchange for foreign
currencies. To understand the market for foreign-currency exchange, we begin with another
identity from the last chapter:
Net foreign investment = Current account balance
This identity states that the imbalance between the purchase and sale of capital assets
abroad (NFI) equals the imbalance between exports and imports of goods and services and
the net flow of income and transfers (CAB). When the current account balance is negative,
for instance, we are buying more foreign goods and services than foreigners are buying
Australian goods and services, and we are sending more income and transfers overseas
than foreigners are sending to Australia. What are foreigners doing with the Australian
currency they are getting from this net sale of goods and services and net receipt of income
and transfers from Australia? They must be using it to add to their holdings of Australian
assets. These purchases of assets abroad are reflected in a negative value of net foreign
investment.
We can view the two sides of this identity as representing the two sides of the market
for foreign-currency exchange. A positive value for net foreign investment represents the
quantity of dollars supplied for the purpose of buying assets abroad. For example, when an
Australian managed fund wants to buy a Japanese government bond, it needs to change
306
Copyright
2021economies
Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Part 6 The macroeconomics
of open
13_Stonecash_8e_45658_SB_txt.indd 306
24/08/20 6:52 PM
dollars into yen, so it supplies dollars in the market for foreign-currency exchange. The
current account balance represents the quantity of dollars demanded for the purpose of
buying Australian net exports of goods and services and sending income and transfers
back to Australia. For example, when a Japanese steel mill wants to buy Australian coal, it
needs to change its yen into dollars, so it demands dollars in the market for foreign-currency
exchange. (This view is a simplification of the way foreign exchange markets actually work.
We discuss this in greater detail below.)
What is the price that balances the supply and demand in the market for foreign-currency
exchange? The answer is the real exchange rate. As we saw in the preceding chapter, the
real exchange rate is the relative price of domestic and foreign goods and, therefore, is a key
determinant of net exports. When the Australian real exchange rate appreciates, Australian
goods become more expensive relative to foreign goods, making Australian goods less
attractive to consumers both at home and abroad. As a result, exports from Australia fall
and imports into Australia rise. For both reasons, net exports fall. Hence, an appreciation of
the real exchange rate reduces the quantity of dollars demanded in the market for foreigncurrency exchange.
Figure 13.2 shows supply and demand in the market for foreign-currency exchange.
The demand curve slopes downwards for the reason we just discussed – a higher real
exchange rate makes Australian goods more expensive and reduces the quantity of
dollars demanded to buy those goods. The supply curve is vertical because the quantity
of dollars supplied for net foreign investment does not depend on the real exchange rate.
(As discussed earlier, net foreign investment depends on the real interest rate. When
discussing the market for foreign-currency exchange, we take the real interest rate and
net foreign investment as given.)
FIGURE 13.2 The market for foreign-currency exchange
Real
exchange
rate
Supply of dollars
(from net foreign investment)
Equilibrium
real exchange
rate
Demand for dollars
(for current account balance)
Equilibrium
quantity
Quantity of dollars exchanged
into foreign currency
The real exchange rate is determined by the supply of and demand for foreign-currency
exchange. The supply of dollars to be exchanged into foreign currency comes from net foreign
investment. Because net foreign investment does not depend on the real exchange rate, the
supply curve is vertical. The demand for dollars comes fr