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Chapter 1 - Aggregate Production and Prices
1.1 Gross Domestic Product (GDP)
Gross Domestic Product (GDP): Gross Domestic Product is the monetary value of final goods and services
produced in a country during some period.
- Measured in money terms (not physical units) as its easier to compare monetary amounts
Includes only final goods and services
- These are for final use and are not subject to further processing or manufacturing
- Intermediate goods (goods subject to further processing) are excluded to avoid double counting
GDP excludes non-productive transactions
" Two major types of non-productive transactions:
1. Purely financial transactions
- Public transfer payments, private transfer payments, buying or selling of shares.
2. Sales of second-hand goods
" Household production: Unpaid housework (e.g. cooking & cleaning)
- Production of goods and services by households for own consumption using their own labour and
capital.
1.1.1 Monetary Value
The monetary value of final goods and services produced in a country during a given period.
1.1.2 Goods and Services without Market Prices
There are some goods and services that do not have market prices.
Example:
" Police
" Fireman
1.1.3 Intermediate Goods and Value Added
•
INTERMEDIATE GOOD: AN INTERMEDIATE GOOD IS A GOOD THAT IS USED IN THE PRODUCTION OF ANOTHER GOOD OR
SERVICE.
o
LABOUR IS NOT AN INTERMEDIATE INPUT
o Capital is not an intermediate good
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VALUE ADDED: V ALUED ADDED FOR A BUSINESS IS EQUAL TO THE TOTAL VALUE OF ITS SALES LESS THE COST OF
PURCHASING INTERMEDIATE INPUTS.
Value Added = value of sales 3 cost of intermediate inputs
Valued added = sales less cost of intermediate inputs contribution to GDP equals its value added
Production Approach: Production approach to calculating GDP is the summation of value added for all
businesses operating in an economy.
1.1.4 Location and Period of Production
The definition of GDP refers to the production within a country. It measures production within a specific geographic
location 3 a country 3 without regard for whether the economic activity is undertaken by the country9s citizens or by
citizens of other countries. This has two implications (which we investigate later in this chapter):
-
GDP for Australia excludes goods and services that are purchased by Australians, but produced in another
country (i.e. imported goods and services).
Production by non-Australian businesses and workers (e.g. foreign backpackers) that occurs within Australia is
included in Australian GDP.
GDP is a flow variable 3 measured over a period.
1.1.4 Expenditure Approach to GDP
Expenditure Approach: Expenditure approach to calculating GDP entails the summation of expenditures on
domestically produced final goods and services by households, businesses, governments and by the rest of
the world.
Y = C + I + G + (X 2 M)
Main Components of Expenditure
•
•
•
•
•
Expenditure by households is called consumption spending, which we denote by (C).
Expenditure by businesses is called private investment spending and indicated by (I).
Spending by all levels of government (Federal, State and Local) is called government spending or
sometimes public demand and is indicated by (G).
Domestically produced goods and services that are purchased by the rest of the world are
called exports (X), while foreign produced goods that are purchased from the rest of the world are
called imports (M).
Net exports = exports 3 imports (N=X2M)
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National Income Accounting Identity
GDP c Expenditure
Y c C + I + G + NX
YcC+I+G+X3M
Y+McC+I+G+X
Supply of goods and services c Demand for goods and services
1.1.6 Expenditure Sub-Groups
HOUSEHOLD CONSUMPTION
Consumption expenditures by households are can be classified into non-durables, durables and services.
•
Non-durable consumption includes single use items such as food and drinks;
•
Durable consumption refers to long-lived items such as cars or household appliances. In general a
durable consumption item will provide a flow of consumption services over time.
•
Consumption of services includes expenditures such as going to the dentist or to the movies.
Consumption Expenditure b Consumption
Private Investment
Inventories: Inventories are currently unsold stocks of goods held by businesses.
The change in inventories in the economy over some period is counted as a component of investment expenditure.
The change in inventories is calculated as follows,
!"#$%& ($ ($)&$*+,(&- = /$)&$*+,0 1&)&1 (&$3 +4 5&,(+3) 2 /$)&$*+,0 1&)&1 (8&%($$($% +4 5&,(+3)
Note the change in inventories in any period can be positive or negative.
GOVERNMENT EXPENDITURE
Expenditure by the government sector (G) can be classified into current (or consumption spending) and
capital (or investment) spending. This distinction reflects the fact that governments can purchase goods that are
used immediately (e.g. the Prime Minister9s lunch) or undertake investments that provide future consumption (e.g. a
new airport at Badgerys Creek).
1.1.7 Income Approach to GDP
Income Approach: Income approach to measuring GDP is obtained as the sum of payments to labour and
capital plus any net indirect taxes.
GDP also equals the aggregate incomes paid to
• Labour (L)
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Capital (K) in the production of goods and services plus
indirect taxes 3 subsidies
GDP = Labour Income + Capital Income + Net Indirect Taxes
GDP = (W×L) + (R×K) + Net Indirect Taxes
Net indirect taxes = Indirect Taxes 3 Subsidies
GDP = labour income + capital income + indirect taxes 3 subsidies
"
"
"
"
"
"
Labour Income = W×L
Capital Income = R×K
W = wages and salaries
R = return to capital
L = labour
K = capital stock
1.1.8 Gross National Income (GNI)
Gross National Income (GNI): Gross National Income (GNI) equals the income measure of GDP plus any net
factor income receivable from non-residents.
GNI for the March quarter 2016 was ($414.3 - $12.2) = $402.1 billion.
GNI = GDP(labour income + capital income + indirect taxes 3 subsidies) + factor income received from
foreigners 3 factor income paid to foreigners GNI
1.1.9 Nominal and Real GDP
Nominal GDP: values quantities of goods and services produced at their current year (or year of production)
prices
Real GDP: Real (or constant price) GDP uses final goods and services prices for a common base year to value
the quantities produced in other years.
-./0 123 =
45678/0 123 ;3< =/>. ?./@
×
1
;3< 17A.8 ?./@
1.1.10 Nominal, Real GDP and the GDP Price Index
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The following relationship links nominal and real GDP:
45678/0 123 = -./0 123 × 123 3@7B. <8C.D
123 3@7B. <8C.D = 45678/0 123 ÷ -./0 123
Note that sometimes, the index is normalised to 100 in the base year, in which case, the GDP price index is 90 =
0.9*100.)
If we know any 2 variables we can derive the 3 rd
" price level = (nominal GDP)/real GDP
" real GDP = (nominal GDP)/price level
and can be used to compute a price index or deflator for GDP. If we have values for nominal and real GDP we can
use those to compute a price index for GDP as,
123 3@7B. <8C.D (2.F0/G5@) = 45678/0 123 ÷ -./0 123
Real GDP per Capita
Real GDP per-capita: Real GDP per-capita is a country9s real GDP divided by its population and is a measure
of the average volume of final goods and services produced per person.
Real GDP per capita = (Real GDP)/Pop
Pop = population
1.1.11 Growth in Real GDP
Figure 1 presents a graph of annual real GDP for Australia for the financial years 1959-60 to 2014-15.
" The dominant feature of real GDP is its persistent increase over time.
" This steady rise reflects the economic growth that has occurred in the Australian economy.
" Over the period 1960 to 2015, the level of real GDP in Australia increased by a factor of around 6.5.
" Australia9s population in 1960 was about 10.2 million, while in 2015 it had grown to 23.6 million.
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1.1.12 GDP and Economic Welfare
Omissions from GDP that might matter for economic welfare:
" Leisure Time (extra week of holidays)
" Household production (cook at home)
" Environmental Degradation (pollution)
" Quality of Life (happiness)
" Economic Inequality (distribution of income)
1.1.13 Fluctuations in GDP
Figure 1 show the quarterly percentage change in real GDP for the period 1959:4 to 2016:1
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1.1.14 Business Cycles
Business Cycle: The business cycle is used to describe general or widespread variations in the rate of
utilisation of resources in an economy.
•
•
•
•
A period when GDP is increasing is known as an expansion,
A period when GDP is decreasing is called a contraction or more commonly a recession.
The highest level of GDP attained in a period of expansion is called the peak of the cycle
The lowest level of GDP attained in a recession is called the trough.
Fluctuations in the level of real GDP are frequently used as a summary measure of the state of the business
cycle
1.1.15 Technical Recession
Technical Recession: A technical recession is defined by the simple rule of at least two consecutive quarters
of negative growth in real GDP.
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This means the level of GDP has to fall for at least two quarters (occurred in the first half of
2020 in Australia)
The <rule of thumb= definition of a recession is typically stated as <at least two consecutive quarters of
negative growth in real GDP=, but this is equivalent to saying the level of real GDP falls for at least two
consecutive quarters.
1.2 Consumer Price Index (CPI)
1.2.0 Consumer Price Index (CPI)
Consumer Price Index (CPI): For a given period, measures the cost in that period of a given basket of goods
and services relative to their cost in a fixed year 3 called a base year.
HIJ =
HKLM NO PQRRSOM TSUR
HKLM NO VULS TSUR
CPI measures how the cost of purchasing a fixed basket of goods and services has changed relative to the base
year.
Implications:
" Cost of living is 25 percent higher in 2015 than it was in 2000
" Average prices are 25 percent higher in 2015 than in 2000 Australian CPI
" Published quarterly by ABS.
- Household Expenditure Survey used to determine typical basket (known as weights).
- (Historically) Base year weights changed every 5 years.
- From end-2017 weights are updated on an annual basis.
The CPI is based on the use of a fixed basket of goods and services. That basket reflects the average consumption
pattern for various households in some period, let9s say a year. The year for which the consumption basket refers is
known as the base year. The CPI provides a measure of how the cost of purchasing the fixed basket of goods and
services changes in other years 3 relative to the base year.
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BIASES IN THE CPI
"
When improvements in quality are widespread and not taken into account the CPI suffers from quality
adjustment bias and will tend to over-estimate the increase in prices (or the cost of living).
A second type of bias in the CPI arises because the consumption basket is held fixed at its base year level.
Suppose that the base year consumption basket for a CPI contains (among other items) 500 oranges and
500 apples. In a subsequent year there is severe frost, and the supply of oranges falls, raising their price
relative to apples. In response households are likely to substitute apples for oranges, consuming much less
than 500 oranges and much more than 500 apples. However, in calculating the CPI, this scope for
substitution is ignored and it is assumed that base year figures for consumption of apples and oranges still
apply in the subsequent year.
"
This will tend to overstate what the consumer actually spends on buying their chosen combination of apples
and oranges. Because substitution by consumers in response to relative price changes is not taken into
account, the CPI will tend to overstate the consumers9 true cost of living.
"
This is known as substitution bias.
Inflation
Inflation: Inflation is a situation in which the general price level in an economy is rising.
Deflation: Deflation (or negative inflation) represents a situation in where the general price level is falling.
Inflation Rate Formula
JOWXUMNKO YUMS =
HQRRSOM JOWXUMNKO 2 IRSZNKQL JOWXUMNKO [\\
×
IRSZNKQL JOWXUMNKO
[
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JOWXUMNKO YUMS =
HIJ("#) 2 HIJ(%#) [\\
×
HIJ(%#)
[
Inflation rate = 0 implies prices are constant
Inflation rate > 0 implies prices are rising
Inflation rate < 0 implies prices are falling 3 known as deflation
1.2.1 Biases in the CPI
CALCULATING THE AUSTRALIAN CPI
Quality Adjustment and New Goods Bias
" Quality improvements may show up as higher prices for goods and services.
" New goods are not included until CPI is re-based. Substitution Bias
" Use of a fixed basket means that no allowance is made for consumers9 substitution toward relatively
less expensive goods. CPI tends to overstate the rate of inflation.
1.2.2 Trends in Inflation and Deflation
•
•
•
•
The trends in the rate of inflation for the developed countries since the end of World War 2 follow similar
patterns.
In the 1950s and 1960s inflation rates were relatively low and stable.
However, in the late 1960s and early 1970s, many countries experienced a sharp rise in their inflation rate,
with annual rates rising above 10 percent. Shows the inflation rate for Australia from 1960 to 2016.
The general pattern for developed countries is evident: relatively low inflation rates in the 1960s; a period of
high inflation rates in 1970s and 1980s and finally a period of relatively low inflation beginning in the 1990s
and continuing to the present day
1.2.15 Costs of Inflation
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Costs of Inflation Important to distinguish between relative price change and a change in the general price
level.
Unexpected Inflation:
" Unexpected re-distributions of wealth: (Borrowers/lenders, fixed nominal incomes)
" Distorts tax systems (if not indexed to inflation).
" Introduces noise into the (relative) price mechanism.
Fully Anticipated Inflation: (full indexation)
Shoe-leather costs
" inflation reduces the real purchasing power of a given amount of money
" requires more frequent <trips to bank=
Menu Costs
" Any real cost associated with changing prices for businesses
1.2.4 Optimal Rate of Inflation
Policymakers generally wish to:
" avoid high and variable inflation
" avoid deflation
View that a low positive inflation rate is helpful for allowing moderate falls in real wages.
Many countries have inflation targets:
" inflation rate of around 1 3 3 % per annum
Chapter 2 - Employment, Unemployment and the
Labour Market
2.1.1
Labour Market Definitions
Summary Classification
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Employed: Typically, a person worked for at least one hour in past week for some form of compensation (or
be on leave).
Unemployed: Person did not work during the past week, but:
" looked for work in previous month, and
" was available to begin work, or
" was waiting to start a new job
UNDEREMPLOYMENT: U NDEREMPLOYMENT ARISES EITHER WHEN A WORKER IS WILLING TO WORK MORE HOURS THAN THEY
ARE CURRENTLY OFFERED OR WHEN THEIR CURRENT JOB DOES NOT REQUIRE THE INDIVIDUAL9S SKILLS OR EXPERIENCE.
• a worker has less paid hours or work than they are willing and able to work (time-related
underemployment); and/or
• a worker9s current position does not make full or suitable use of their level of skills, education or
experience (skill-related underemployment).
FULL-TIME EMPLOYMENT: F ULL - TIME EMPLOYMENT CORRESPONDS TO WORKING AT LEAST 35 HOURS PER WEEK.
PART-TIME EMPLOYMENT: INDIVIDUALS WHO WORK LESS THAN 35 HOURS PER WEEK ARE CLASSIFIED AS BEING IN PART-TIME
EMPLOYMENT.
DISCOURAGED JOBSEEKER: A DISCOURAGED JOBSEEKER HAS GIVEN-UP ACTIVE JOB SEARCH, DESPITE BEING WILLING TO
WORK, BECAUSE THEY BELIEVE THEY HAVE VERY LITTLE CHANCE OF FINDING A SUITABLE JOB.
2.1.2
Labour Market Data
Not in Labour Force: Does not meet requirements to be employed or unemployed. Examples include unpaid
homeworkers, volunteers, unable to work due to disability or illness, voluntarily inactive.
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Working-age Population: Australians who are civilians, usually resident and who are 15 years or older
Participation rate: Participation rate refers to the percentage of the working age population actually in the
labour force (i.e. full time and part time employees plus the unemployed).
3/@G7B7]/G758 @/G. =
^/_5`@ a5@B.
100
×
b5@c78d /d. ]5]`0/G758
1
Labour Force Equals the total number of people employed or unemployed.
Labour Force = Employed + Unemployed
Notation LF = L + U
Unemployment: Unemployed persons refer to people who are within the working age population (15yrs +)
and are actively seeking work but are unable to secure a job.
f8.6]05g6.8G -/G. =
•
•
•
Total Number Unemployed
100
×
Labour force (Employed + Unemployed)
1
Regularly checking advertisements from different sources for available jobs
Be willing to response to job advertisements, apply for jobs with employers and attend interviews
Be registered with an employment agency linked to Job Services Australia
Employment to population rate: The employment to population rate is the number of people in
employment expressed as a percentage of the working-age population.
|6]05g6.8G G5 ]5]`0/G758 @/G. =
|
× 100
3}3
E = is the number of people employed
POP = refers to the working-age population.
Using data from Table 1;
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2.1.3 Economic Types of Unemployment
or Search Unemployment:
" Short-term unemployment (for an individual) that is associated with searching for a suitable job.
" Feature of any dynamic economy.
" Beneficial rather than costly to an economy, as it leads to more efficient matching between workers
and jobs.
Long-Run Frictional:
Simple Model
L + U = LF
In any month:
" Some people find a new job (move from U to L)
" Some people separate from their job (move from L to U)
Define:
f = rate of job finding
s = rate of job separation
&! = " × # 2 $ × !
Structural Unemployment:
" Longer-term unemployment that can arise when the distribution of skills of some workers does not
match the available jobs in the economy.
" Structural change in the economy may result in a loss of jobs for certain types of specialised workers.
" Workers may have a lack of skills or be subject to discrimination and this prevents them from finding
stable long-term employment
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Cyclical Unemployment:
" Cyclical unemployment refers to those persons that have become unemployed due to a downturn in
the business cycle (caused by a contraction in economic activity or aggregate demand).
" Rises in recessions
" Falls during booms.
2.2.4 Natural Rate of Unemployment
Natural rate of unemployment: The natural rate of unemployment is measured as the sum of the frictional
unemployment rate and the structural unemployment rate.
" Frictional and structural unemployment are less sensitive to business cycle than cyclical
unemployment.
" Even if cyclical unemployment is zero, the unemployment rate will still be positive.
" Natural rate of unemployment is the rate of unemployment that arises, even when cyclical
unemployment is zero.
Measures:
u = actual rate of unemployment
u*= natural rate of unemployment
`7 = F@7BG758/0 @/G. + >G@`BG`@/0 @/G.
Cyclical unemployment
;gB07B/0 f8.6]05g6.8G = u 2 `7
Ynr = GDP at natural rate of unemployment
Ynr = Yf 3 Yp
" Yf = GDP at full employment
" Yp = Potential GDP
2.2.5 Okun9s Law
Okun9s law is a quantitative (or empirical) model linking cyclical variations in real GDP and in the rate of
unemployment.
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The output gap for an economy is equal to the actual (or measured) level of real GDP less a measure
of potential output.
The unemployment rate tends to co-move with the output gap in an economy.
" Contractionary gaps are associated with a high unemployment rate
" Expansionary gaps are associated with a low unemployment rate
!"!7
Output gap in percent =
!7
× "##
where Y = real GDP
Y* = potential GDP
Quantitative Relationship
(
"# " 7
"7
) × 100 = 2&(' 2 '7 )
The size of ³ can differ across different countries and over time.
" Current estimate of ³ for Australia is about 2.0
" Natural rate of unemployment: `7 = 5%
An additional percentage point of cyclical unemployment is associated with a ³ percentage point decline in
the output gap
Substituting what is known into Okun9s law, 10 = -³×(-2), implies ³ = 5.
Potential output
Potential Output Definition: Potential output is the level of GDP an economy can produce when using its
resources or factors of production (labour and capital) at normal rates.
Symbol: Potential output = ? 7
Potential output is not the same as maximum output.
Potential output increases over time with growth in:
" labour force
" capital stocks
" growth in technology
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Not necessarily the case that ? = ? 7
Actual output (Y) can vary (expand or contract) due to:
" changes in potential output (? 7 ),
" changes in the utilisation rate of labour and capital.
" For example, in the short-run the utilisation rate of labour and capital can be above (or below) the
normal rate.
Output Gap
Actual output does not always equal potential output.
Difference is called output gap.
Output gap = Actual GDP less Potential GDP
Output gap = ? 2 ? 7
Positive output gap ? > ? 7 : called expansionary gap
Negative output gap ? < ? 7 : called contractionary gap
Output Gap Policymakers generally view both (persistent) contractionary and expansionary as problems.
" Contractionary gaps are associated with capital and labour not being fully utilised (cost in terms of
forgone output).
" Expansionary gaps are associated with firms operating above normal capacity and can lead them to
raise prices (inflationary)
2.2.6
Demand for labour
Marginal Product of Labour
A business combines workers with a given amount of capital (machines and buildings) to produce bikes.
" As the business employs more labour its output rises.
" But we can look at the additional output that is generated by each additional worker. This is the
marginal product of labour.
Diminishing Marginal Product
Diminishing Marginal Product: The nature of the production technology is such that each additional worker
produces less output than the existing workers.
Business9s Demand for Labour
Business9s Demand for Labour: In deciding the number of workers to employ a business will compare the
benefit of an additional worker with the cost of that worker.
Benefit to the business of employing an additional worker
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" Value of Marginal Product = p × MPL
Competitive Markets
Competitive Markets Assume that business operates in a competitive market
" It cannot set the wage it pays workers
" It cannot set the price it receives for its product
Business will be willing to employ labour until:
VMPL = money wage
VMPL=W
p×MPL=W
The business employs workers until VMPL = W, where VMPL = p*MPL.
It is optimal for the firm to employ workers until VMPL >= W.
The VMPL is pMPL, so we have pMPL >= W.
Aggregate or Economy-Wide Demand for Labour Apply above model of labour demand to aggregate economy.
P×MPL = W
P = aggregate price level
W = aggregate money wage
Re-arrange as: MPL = W/P
W/P = real wage
Since a and b represent equilibrium outcomes, it must be true that at both points the real wage equals the marginal
product of labour. Since the real wage is lower at b than it is at a, the marginal product of labour must be lower at b
than at a.
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Aggregate Labour Demand Curve
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2.2.7 Supply of Labour
Supply of Labour: Suppliers of labour are workers and potential workers.
" Labour Supply Decision: At any given wage people have to decide if they are willing to work.
" Supply of labour is the total number of people willing to work at each real wage.
" Labour supply is generally assumed to be an increasing function of the real wage (W/P)
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Factors that Shift Labour Supply Curve
" Size of working-age population (influenced by birth rate, retirement ages, immigration rates)
" Participation rate 3 percentage of working age population who seek employment
Frictions in Competitive Model
" In absence of any frictions there is no involuntary unemployment in competitive model.
" Involuntary unemployment arises where the unemployed would be willing to accept a job at the current
market wage, but are not able to find employment.
In the competitive model factors that increase the real wage above the competitive equilibrium are:
" Minimum wage laws
" Unions
" Taxes
Minimum Wage Laws
" Legal minimum hourly wage that business must pay workers
o Known as award wages in Australia
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" Standard labour demand and supply model predicts that setting too high a minimum wage will
produce unemployment.
"
Imposition of a minimum real wage will cause some worker to lose their jobs (so worse off), but those
workers who remain employed will receive a higher real wage (so better off). Even with a minimum real
wage, businesses only employ workers with a marginal product greater than or equal to the real wage. A
minimum real wage causes an excess supply of labour.
" Those workers (Ld.) who are employed at the minimum wage are better-off than at the market"
clearing wage.
The distance (Ls 3 L d) indicates people who are willing to work at the minimum real wage, but who
cannot find jobs. Involuntary unemployment.
Labour Unions Workers may negotiate on an individual basis with a firm over wages and conditions
" Alternatively, workers may form labour unions to bargain collectively with a firm.
" Presence of unions tends to produce a wage outcome that is above the market-clearing wage.
" The figure for a minimum wage can be re-interpreted as the outcome for a unionised industry, where
(b/3)'() = (b/3)*)(+)
CHAPTER 3 - INTEREST RATES, INVESTMENT AND SAVING
3.1 INTEREST RATES
3.1.1 NOMINAL RATE
Nominal interest rate: Nominal interest rate measures return on loan in terms of money.
3.1.2 REAL RATE
Real interest rate: Real interest rate measures return on a loan in terms of goods and services.
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Real rate = nominal rate 3 inflation rate
@=72€
Ex-post and Expected Real Rate
" (Ex-post) r = i - Ã Actual Inflation
" (Expected) r = i 3 Ã e
The inflation rate for Duff over the week is 2.5 percent. So we can calculate the (ex-post) real interest rate as the
nominal interest rate less the rate of inflation. This is just 1% - 2.5%, so the real rate is -1.5%.
The ex-post real interest rate equals r = i 3 Ã. So we can just replace r in the PRF and then re-arrange: i 3 Ã = 0.02 +
0.5 Ã or i = 0.02 + 1.5 Ã.
3.1.4 FISHER EFFECT
Assume the real interest rate is a constant:
7 = @ + €,
Fisher effect implies that nominal interest rate will move one-for-one with changes in expected inflation.
The Fisher effect implies
i = r + expected inflation.
I = nominal interest rate
R = real interest rate
3.1.5 NEGATIVE INTEREST RATES
Nominal interest rates were widely believed (prior to 2008- 09) to be subject to a zero lower bound (ZLB).
Zero lower bound (ZLB)
"
The Zero Lower Bound (ZLB) implies that nominal interest rates must be greater than or equal to zero (i.e.
cannot be negative).
7 g0
Use the expected real interest rate:
(Expected) r = i 3 € ,
If 7 =0
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(Expected) r = 3 € ,
3.2 INVESTMENT
Investment: Investment refers to expenditures that are concerned with the production of future goods and
services.
INVESTMENT AND CAPITAL STOCK
" Investment is flow variable.
Accumulation over time gives capital stock.
Formula:
#1 = #0 + $1 2%×#0
•1 = capital stock at end of period
•0 = capital stock at beginning of period
<1 = gross investment during period
‚ו0= depreciation during period
‚ = depreciation rate (e.g., 0.05 or 5%)
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It is useful to use the formula for the accumulation of the capital stock
K(1) = K(0) + I(1) 3
Depreciation Re-arrange as K(1) - K(0) = I(1) - Depreciation and you can see that
net investment (I(1) - Depreciation) = the change in the capital stock
VALUE OF MARGINAL PRODUCT OF CAPITAL
!"#$ ="#$ × &
Other things equal, marginal product of capital (MPK) is the increase in output due to the use of an additional
unit of capital.
p = sales price of business9s output.
Real interest rate
r=i3Ã
'( = #K[) + *]
SUMMARY
"
"
Other things equal (ceteris paribus) a rise in the real interest rate will make investment less attractive.
Other things equal (ceteris paribus) a rise in the price of capital goods will make investment less attractive
INVESTMENT AND THE REAL INTEREST RATE
Other things equal, an increase in the real interest rate will cause an increase in user cost and this will make less capital
investments worthwhile.
Implies a negative relationship between investment and the real interest rate.
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ECON1102 Macroeconomics
Saanvi Yerawar
Generally, we can write:
9 = 9(:; ;, <=>)
NATIONAL SAVING
In an economy saving is undertaken by:
" Households
" Business
" Government
National saving is a measure of aggregate saving in an economy.
HOUSEHOLD SAVING
(Gross) Household saving = Disposable Income 3 Consumption
S = YD 3 C
Calculation of YD
Income measure of GDP
+ = labour income + capital income + (indirect taxes 3subsidies)
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YD is the income available to households to spend or save.
" Should be after-tax income.
" But some households get transfer payments.
" Households will get interest payments on any government debt they hold.
" Businesses may choose not to pay all their profits to shareholders, but <retain= some of their profits
DISPOSABLE INCOME
"
To obtain household disposable income (YD) from GDP (Y), we subtract taxes and business retained earnings
and add transfer payments and government interest payments.
YD = Y 3 TA + TR + INT 3 RE
Y = GDP
"
"
"
"
TA = taxes (direct and net indirect)
TR = government transfers
INT = government interest payments to households
RE = business retained earnings
SAVING AND WEALTH
Two possible measures of household saving:
"
S = YD 3 C
"
Changes in household wealth is a stock variable.
Wealth
Wealth = Wealth + Saving + Net Capital Gains
CHANGES IN WEALTH
2 things can change Net Wealth
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Saving
"
If saving is positive, then assets are being accumulated.
"
If saving is negative, then assets are being de-cumulated, or liabilities (debts) accumulated.
CAPITAL GAINS AND LOSSES
Fluctuations in the market value of assets:
Change in Wealth = W 3 W(-1) = —W
—W = Saving + Capital gains 3 Capital losses
or
W = W(-1) + S + Net Capital Gains
Assets, liabilities and wealth are stock variables.
GROSS INVESTMENT
It is useful to use the formula for the accumulation of the capital stock K(1) = K(0) + I(1) - Depreciation Re-arrange as
K(1) - K(0) = I(1) - Depreciation and you can see that net investment (I(1) - Depreciation) = the change in the capital
stock. So both options (a) and (d) are correct.
WHY DO HOUSEHOLDS SAVE? (3 STANDARD MOTIVES)
1. Life-Cycle Saving (meet long-term goals)
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2. Precautionary Saving
"
"
Saving can be used as a form of insurance against unexpected declines in income or unexpected increases in
consumption, e.g. temporary unemployment, medical expenses.
Increases with level of uncertainty (or variance of income).
3. Bequest Saving
"
People save to leave a bequest or inheritance for their heirs and dependents.
HOUSEHOLD SAVING AND THE REAL INTEREST RATE
Saving = Disposable Income 3 Consumption
Saving provides a link between today and future.
"
"
Think of the real interest rate r as the relative price of consuming today verses consuming in the future.
A higher real interest rate makes current consumption relatively more expensive and creates an
incentive for people to reduce current consumption 3 this means an increase in saving (today).
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HOUSEHOLD SAVING AND THE REAL INTEREST RATE
BUSINESS SAVING
Profits earned by the business sector are typically paid to owners or shareholders as dividends.
Possible for businesses to save by not distributing all their profits.
Business saving is known as retained earnings (RE).
Government (Public) Saving
Public saving is measured as.
Public Saving = T 3 G
where G is government expenditure and using our previous notation, we can write:
T = TA - TR - INT
"
TA = taxes (direct and net indirect)
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ECON1102 Macroeconomics
"
"
Saanvi Yerawar
TR = government transfers
INT = government interest payments to households
Government (Public) Saving
Alternative name for public saving is the government budget balance (BB), which is called a surplus if positive and a deficit
if negative.
BB = Public Saving = T 3 G
National Accounting Identity
Y = C + I + G + NX
Assume X=M=0 (closed economy)
Y=C+I+G
Definition of Saving
Saving = Current income 3 Current spending
Definition of National Saving
NS = Y 3 C 3 G
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ECON1102 Macroeconomics
"
"
Saanvi Yerawar
Exclude I because, by definition, it is spending that provides for future needs not current ones.
We are assuming that all government spending is on current consumption (no public investment).
SINCE CLOSED ECONOMY
NS = I
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Decompose NS into its subcomponents:
National Saving (NS) = Household Saving + Business Saving + Government Saving
or
National Saving (NS) = Private Saving + Public Saving
Use definition of NS as:
NS c Y 3 C 3 G
Add and subtract T from the right-hand side of above; then we can decompose NS into private and public saving;
NS c [(Y 3 T) 3 C] + T 3 G
" T 3 G is public saving
" Y - T - C is private saving (by households and businesses).
National saving increases by 3 NS=8+0.5r so the new equilibrium real interest rate is 8+0.5r=10-0.5r r=2 NS=I= 9
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National Saving Schedule
NS = [(Y 3 T) 3 C] + T 3 G
We can do a further decomposition of NS by adding and subtracting RE to both sides of
NS = [(Y 3 T 3 RE) 3 C] + RE + T 3 G
"
"
"
Y 3 RE 3 T 3 C is household saving,
RE is business saving
T 3 G is public saving.
NATIONAL SAVING, INVESTMENT AND REAL INTEREST RATE
In an economy with no access to international capital markets:
National Saving = Investment.
Gi
The supply of saving by HH, businesses, and government and the demand for saving (for investment) by business are
equated by the financial markets.
National Saving = Household Saving + Business Saving + Government
NS = S(r) + RE + (T 3 G)
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MODEL
"
"
NS(r) =Saving is an increasing function of the real interest rate
I(r)= Investment is a decreasing function of the real interest rate
INITIAL EQUILIBRIUM
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CROWDING OUT
"
"
"
An increase in the government budget deficit will reduce private investment spending.
In the above model a larger deficit reduces the supply of saving (savings curve shifts inwards) and drives up the real
interest rate. The higher real interest rate makes investment less attractive and causes a move along the I curve.
A decline in public saving causes a rise in the real interest rate which reduces the level of private investment
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CHAPTER 4 - INCOME-EXPENDITURE MODEL OF GDP
Keynesian Model
Key Assumption (or friction)
Prices of goods are fixed (common to say sticky) in the short run
" Firms do not change prices in response to a change in demand for their product
" Instead, they fix their price and then meet the demand by varying their level of production
In the short-run firms will:
" accommodate a cut in demand by reducing output and employment, not by reducing prices.
" accommodate a rise in demand by increasing output and employment, not by increasing prices.
But, in the long run:
" sustained or persistent changes in demand will eventually lead firms to change their prices and cause
production to return to normal capacity
Menu costs are any real cost of changing prices and are one reason why a business may hold prices fixed and vary
production in response to changes in demand.
Planned Aggregate Expenditure
Planned Aggregate Expenditure: Planned aggregate expenditure (PAE) reflects the desired level of spending on
domestically produced final goods and services by all sectors of an economy.
Planned aggregate expenditure (PAE):
PAE = C+!! +G+X2M
C = Household Expenditure
I = Investment Expenditure
G = Government Expenditure
NX = Net Exports
? = 3ƒ| + `8]0/88.C & <8A.8G5@7.>
Unplanned Inventories
" Planned investment does not include any unplanned or unexpected changes in inventories that may be
experienced by businesses.
" Unplanned changes in inventories will arise when desired purchases of a firm9s output differ from its production
level plus any planned change in inventories.
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# = #! + &#() "
# = actual investment (includes unplanned inventory investment)
#! = Planned investment
Equation states that measured investment equals planned investment plus any unplanned change (i.e., accumulation
or decumulation) in inventories.
Equilibrium and Disequilibrium
Equilibrium Condition:
Two equivalent conditions:
Y = PAE
# = # ! (unplanned)
— Inventories = 0
Equilibrium means there is no tendency for the level of real GDP to change.
Disequilibrium
Y < PAE
Businesses experience:
" unplanned decrease in inventories (goods producers)
" insufficient capacity to meet demand (service producers)
"
Actual investment = planned investment + unplanned change in inventories. If I < Ip, then the unplanned
change in inventories must be negative.
Signal to businesses to increase their level of production (meet higher level of spending, and rebuild
inventories)
GDP will rise
Y > PAE
Businesses experience:
" unplanned increase in inventories (goods producers)
" excess capacity to meet demand (service producers)
Signal to businesses to reduce their level of production (goods are not being sold)
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GDP will fall.
TWO-SECTOR MODEL: HOUSEHOLDS AND BUSINESSES
In the two-sector model PAE is comprised of household consumption and planned business investment.
PAE = C + *#
Planned Investment
# = # ! (unplanned)
Assumed to be:
" Autonomous or exogenous variable
" In the income-expenditure model an autonomous or exogenous variable is determined by factors other
than the level of real GDP.
Household Consumption
C = Consumption
" Non-durable goods (hamburger)
" Durable goods (cars, tv, fridge)
" Services Develop a simple model in which consumption expenditure is a linear function of disposable
income
"
The exogenous components of expenditure C
A MODEL OF CONSUMPTION
Hypothesize a key influence on consumption spending by households is current disposable income.
"
"
"
"
Disposable Income = Y 3 T
Y = national income or GDP
T = taxes (TA) + transfers (TR) 3 interest on government debt (INT)
Assume retained earnings (RE=0)
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"
To obtain household disposable income (YD) from GDP (Y), we subtract taxes and business retained earnings
and add transfer payments and government interest payments.
Consumption Function
; = ;0 + B(?2…)
" Linear relationship
Household consumption depends on:
" a constant ;0, and
" disposable income (?2 …)
; = ;0 + B(?2…)
;0 is exogenous (or autonomous) consumption
" Factors (other than disposable income) that could affect consumption, e.g. wealth, real interest rates.
" The value of an exogenous variable is determined outside of the model under consideration.
c (Y 2 T) captures the effect of disposable income on consumption (sometimes called induced consumption)
" c = marginal propensity to consume (parameter).
Marginal Propensity to Consume: The marginal propensity to consume (out of disposable income) is the
change in consumption due to a change in disposable income.
? = ?0 + A(B2C)
&$
<=? = &(&'() = ?
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A key assumption of the Keynesian consumption function is that the value of the MPC is greater than zero,
but less than one, i.e. 0
<c<1.
Impact of an additional dollar.
Marginal Propensity to consume:
&$
()* = = &(&'() = (
Proportion of income that is used for consumption.
Average Propensity to consume:
!
)*+ = "#$
Relationship between MPC and APC (in linear model)
; = ;0 + B(?2…)
Divide both sides by (Y-T)
ƒ3; =
-
./0
=
%& ' ((*#+)
*#+
=
-.
/#0
+42
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" APC > MPC but approaches MPC (c) as Y-T increases.
EQUILIBRIUM IN TWO-SECTOR MODEL
GRAPHICAL REPRESENTATION
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DIS-EQUILIBRIUM
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In Figure 1 we illustrate the situation in which for a given PAE curve, the level of aggregate output is either YL<Ye
or YH>Ye.
CHANGES IN EQUILIBRIUM GDP
Multiplier: The multiplier in the income-expenditure model is a measure of the change in equilibrium GDP in
response to a given exogenous change in planned expenditure.
An additional dollar of exogenous PAE generates more than a dollar9s worth of GDP
&2
&345
>1
The Multiplier in the 2-Sector Model
Equilibrium GDP
6
?e =6/7 = [;0 + <0]
What is the effect on equilibrium GDP of a change in:
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" Autonomous consumption, C0
-
Consumption for necessities
" Autonomous investment, I0
Multipliers: Write model in terms of changes in induced (endogenous) and autonomous (exogenous) variables.
&?e =
6
6/7
Autonomous consumption: (So set &<0 = 0)
&?e =
= [&;0 + &<0]
6
6/7
&. #
&-$
= [&;0]
6
=6/7
Multipliers:
Autonomous consumption:
&* !
=
,
&+" ,'-
Autonomous planned investment:
&* !
&."
>1
=
,
,'-
>1
Must be greater than one, since MPC: 0 < B < 1
MPC =
$/0123 41 $516789:451
$/0123 41 ;1<583
=
&$
&&
The Multiplier (Diagram)
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In this case the multiplier is the change in GDP for a given change in planned investment. It is the distance DE (which
measures the change in GDP) divided by the distance AB (which measures the change in planned investment).
‰QXMNŠXNSR =
&‹8
&IΥ
Since the two countries are otherwise identical, the only thing that determines the relative size of the
multiplier is the marginal propensity to consume. Since the MPC determines the slope of the consumption
function, and Beta has the steeper slope, it has the larger multiplier.
SAVING AND PLANNED INVESTMENT IN TWO-SECTOR MODEL
Alternative way to represent the 2-sector model.
In the 2-sector model there are two equivalent conditions for equilibrium:
(i) Y = PAE (and C + Ip = PAE in the 2-sector model) and (ii) S = Ip, saving equal to planned investment.
Equilibrium Condition
Re-write
Y = PAE
, = + + -=
, 2 + = -=
. = -=
Equivalent Equilibrium Condition
Consumption Function
; = ;0 +BY
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Definition of Saving
Saving Function
Planned Investment (exogenous)
S=Y3C
Ž = ? 2 ;0 2B?
Ž = 2;0 + (1 2B)Y
< 3 = <0
Equilibrium Condition:
Planned Investment equals Saving
<3=S
PARADOX OF THRIFT
What is the paradox?
" While any individual household may be able to increase its own level of saving (and wealth)
" The attempt by all households to increase their saving does not lead to an increase in the aggregate level
of saving (and aggregate wealth)
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Fallacy of composition
New Equilibrium
" Prediction: The level of GDP will fall
" Prediction: The aggregate amount of saving is unchanged
" The upward shift in the saving function represents an exogenous increase in saving and hence must correspond
to an exogenous decrease in consumption.
OPEN ECONOMY MODEL
Include international trade in goods and services in the two sector model.
" Exports (X) and
" Imports (M)
Assume no government sector (G=T=0)
Definition of PAE
3ƒ| = ; + < 3 + • 2M
Model for Exports
Key influences on exports(X):
" World demand
" Exchange rate
Assume exports are exogenous:
• = •9
Model for Imports
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Key influence on imports (M) is domestic GDP
Simple model
• =6?
Imports are a linear function of domestic GDP
m = marginal propensity to import
&•
=6
&?
3ƒ| = ; + < 3 + • 2•
; = ;0 +B? <
3 = <0
• = •0
• = 6?
Equilibrium Condition: ? = 3ƒE
Final Equation for PAE
3ƒ| = [;0 + <0 + •0 ] + (B 2 6)?
" The first term is independent of output and is called exogenous (or autonomous) expenditure
" The second term is called induced expenditure since it depends on output
Short-Run Equilibrium Output
Equilibrium is when firms produce a level of output that just equals planned aggregate expenditure
? =3ƒE
Diagram of Equilibrium Output
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Income-expenditure diagram the 45-degree line represents
- A situation where S= Ip
- A situation where unplanned changed in inventories equal zero
PAE and the Output Gap
" Output gap = Actual output less Potential output
" Output gap = Y 3 Y*
We can use our model to understand contractionary (negative) and expansionary (positive) output gaps.
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How Does the Keynesian Model Explain Fluctuations in GDP?
!3 =
/
[5 + -> + 7> ]
/ 2 (( 2 2) >
2 possibilities
" A change in one of the exogenous variables: ;0, <0,•0
" A change in one of the parameters: c, m
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CHAPTER 5 - GOVERNMENT SECTOR AND FISCAL POLICY
Fiscal Policy in response to COVID
"
"
"
"
"
One-off $750 payment to persons receiving social assistance
$550 fortnightly payments to recipients of income support
Early access to superannuation, up to $20k for people experiencing financial hardship
JobKeeper wage subsidy of $1,500 per fortnight per eligible employee for up to six months and was later
extended
Plus: loan guarantees for small and medium businesses; investment incentives; cash-flow assistance.
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Instruments of Fiscal Policy
"
"
"
Government expenditure: current goods and services, investment and infrastructure (G)
Taxes (direct, indirect) 3 income taxes, consumption taxes (GST) (T)
Transfer payments 3 unemployment benefits, pensions (T)
Fiscal Policy in Income-Expenditure Model
Government decisions about G and T can affect the level of output in the economy.
Assume (for now) a closed economy (X = M =0)
3ƒ| =; + <+ +1
" Direct role for government expenditure G to affect PAE.
" What about taxes T? Indirect role via consumption.
; = ;0 + B(? 2 …)
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Tax Function
What determines the level of tax revenue?
Role for GDP
… = …0 + G?
" Autonomous component to taxes given by …0
" Induced component that depends on Y " t = marginal tax rate. Assume 0<t<1
&T
=G
&Y
The average tax rate T/Y
Gives the change in tax receipts for a change in national income.
Consumption Function and Tax Function
; = ;0 + B(? 2…)
… = …0 +G?
Substitute
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Three Sector Model
"
"
"
"
"
3ƒ| =; + <+ +1
; = ;0 + B(? 2 …)
<] = <0
1 =10
… = …0 + G?
Assume government spending is autonomous/exogenous
Equilibrium in Three Sector Model
"
"
"
"
"
3ƒ| =; + <+ +1
; = ;0 2 B…0 + B(1 2G)?
<] = <0
1 =10
3ƒ| = [;0 2 B…0 + <0 + 10] + B(1 2G)?
" Y = PAE
Equilibrium in Three Sector Model
1
!! =[1 2 B ( 1 2 G ) ] ×[%02()0++0+,0]
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Fiscal Multipliers in 3-Sector Model
We have derived equilibrium GDP as;
?, =
× [;0 2 B…0 + <0 + 10]
Re-write in changes:
&?, =
× [&;0 2 B&…0 + &<0 +&10]
&?, =
× [&;0 2 B&…0 + &<0 +&10]
Fiscal Multipliers in 3-Sector Model
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CHANGE IN G
& ?
& 1
,
0
1
= [1
2
B ( 1
2
G ) ]
2
G) ]
>
0
<
0
CHANGE IN T
& ?
,
2 B
=
& …
0
[1
2
B ( 1
Larger Effect on GDP?
" Exogenous Tax Cut or
" Increase in Government Spending
" Equal size changes in G and T.
Increase G by 100 and cut T by 100.
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Government purchases of goods and services are a component of
PAE
3ƒ| = ; + <- +1
Have a direct effect on PAE and consequently on Y.
Taxes and transfer payments affect the level of disposable income (Y 3 T) received by the private sector.
Exogenous changes in taxes and transfers only have an indirect effect on PAE.
3ƒ| = [;0 2 B…0 + <0 + 10] + B(1 2G)?
Weighted by the Marginal Propensity to Consume (c).
Taxes and transfer payments affect the level of disposable income (Y 3 T) received by the private sector.
Exogenous changes in taxes and transfers only have an indirect effect on PAE.
3ƒ| = [;0 2 B…0 + <0 + 10] + B(1 2G)?
Weighted by the Marginal Propensity to Consume (c).
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Balanced Budget Multiplier
Definition: Government Budget Balance
BB = T 3 G
Suppose a government wanted to undertake a fiscal policy that affected the level of GDP but didn9t change the
initial value of the budget deficit.
Consider equal changes in G and T so that (initial) level of budget surplus is unchanged.
" Increase government spending by 100 (and simultaneously).
" Increase exogenous taxes by 100.
(Initial) BB = T 3 G
BB = (T+100) 3 (G+100)
No change on initial value.
Nowset:
&;0 = &<0 = 0
For the following 3-sector economy:
C=80+0.8(Y-T)
Ip=200
G=100
T=100+0.4Y
calculate the (approximate) size of the budget balance when economy is in equilibrium.
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PAE = 80 3 0.8*100 + 200 + 100 + 0.8*(1-0.4)*Y
*PAE = 300 + 0.8(1-0.4)Y
•
Y = PAE
•
Ye =1/[1 3 0.8(1-0.4)] [300] = 1.923*300 = 577
•
T = 100 + 0.4(577) = 331
BS = T - G = 331 3 100 = 231
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Balanced Budget Multiplier
× [2B&…0 +&10]
&?, =
But we can set &…0 = &10
&?, =
× [2B&…0 +&10]
But we can set &…0 = &10 (Why?)
1 2
& ?
,
B
=
×
[1
2
B ( 1
2
G ) ]
& 1
0
Even though we matched the increase in G with an equal increase in T, the overall effect is to increase Y.
In the 3-sector model, BBM is positive but less than one in value.
For the following 3-sector economy:
C = 100 + 0.8(Y-T)
Ip = 200
G = Go
T = To
calculate the size of the balanced budget multiplier.
PAE = 100 3 0.8T + 200 + G + 0.8Y
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Balanced Budget Multiplier
PAE = 300 3 0.8T + G + 0.8Y
Y = PAE
Y = 300 3 0.8T + G + 0.8Y
Ye = 5*[300 3 0.8T + G]
Since BBM sets —T = —G,
—Ye = 5*[-0.8—G + —G]
—Ye = 5* 0.2 —G
—Ye/—G = 1
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How large are Fiscal Multipliers in Practice?
International Monetary Fund (IMF), 2014, Review Paper.
34 empirical studies since 2000.
Government Spending Multipliers
"
Plausible Range: 0.5 to 0.9
Tax/Transfer Multipliers
"
Plausible Range: 0.1 to 0.3
Estimates tend to smaller than what is implied by our IncomeExpenditure Model.
Fiscal Policy and Output Gaps
Previously introduced concepts of:
"
"
Potential GDP (Y*)
Output gap (Y 3 Y*) or 100[(Y-Y*)/Y*)] in percent
Y* = the level of real GDP produced if labour and capital inputs are utilised at their normal rates.
Income-expenditure model has no automatic mechanism to ensure Y = Y*
However, the model does imply exogenous changes in G and T
can be used to close output gaps, i.e. to ensure Y = Y*
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Increasing G to Eliminate a Negative (Contractionary) Output Gap
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The Role of Fiscal Policy in Stabilising the Economy
Effects of fiscal policy occur in 2 ways:
AUTOMATIC STABILISERS
" tendency for a system of taxes and transfers which are related to the level of income to
automatically reduce the size of GDP fluctuations.
DISCRETIONARY FISCAL POLICY
" refers to deliberate changes in the level of government spending, transfer payments or in tax rates
(e.g. one-off cash payments).
Automatic Stabilisers
System of taxes and transfer payments that act as automatic stabilisers for the economy:
"
"
… = …0 +G?
As GDP declines, the level of taxes paid falls and the level of transfer payments (e.g.
unemployment benefits) will increase.
BB = (T 3 G), so fall in T, other things equal, implies BB declines (i.e. smaller surplus or bigger
deficit).
Process is automatic (without any government action) and makes contractions and expansions in GDP smaller
than they would have been otherwise.
Impact of Automatic Stabilisers
" To reduce the size of the multiplier
" A tax or form of government expenditure that has the effect of reducing the size of the multiplier
Discretionary Fiscal Policy
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Prior to 2007-08 Global Financial Crisis (GFC), the importance of fiscal policy as a (discretionary) policy
instrument for stabilizing the economy had been declining.
Fiscal policy seen as less flexible and less timely than monetary policy.
Time Lags with Fiscal Policy
RECOGNITION LAG
" recognize 3 by monitoring the state of the economy 3 the need for some form of policy action
Decision lag
" decide on an appropriate policy action
IMPLEMENTATION LAG
" implementation of fiscal policy generally requires legislation (needs to be approved by parliament)
Time Lags with Fiscal Policy
EFFECT LAG
" time required for policy to have a significant effect on economy
Ideally, macroeconomic policy should be forward-looking, e.g. fiscal policy changes made today should be
designed to influence future (forecast) levels of output
What was different about GFC?
" Falls in GDP were preceded by a financial/credit crisis (provided advanced warning for
"
governments).
Many countries (not Australia) have had relatively large and persistent falls in GDP.
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" Concerns about the ability of monetary policy to provide sufficient stimulus to economies. In some
countries policy interest rates were at the zero lower bound.
Provided greater scope for governments to use fiscal policy in a timely manner.
BUDGET DEFICITS AND PUBLIC DEBT
Budget Balance (BB) = T 3 G
Four main components:
" Government purchases of goods and services = G
" Tax receipts (TA)
" Transfer payments (TR)
" Interest payments on government debt (INT)
Chapter 3 (Notation)
T = TA - TR - INT
BUDGET BALANCE
BB = T 3 G
The budget balance is equal to T 3 G, where T = Taxes 3 Transfers 3 Interest payments.
" Budget surplus/deficit is a flow variable.
" Budget deficits need to be financed in some manner.
" A standard source of financing is to borrow from the private sector.
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PUBLIC DEBT
The outstanding stock of government borrowing is called public debt.
Public debt equals the sum of all past deficits less any surpluses.
2t = 2 t - 1 2 ==t
" D = stock (or level) of public debt
" 2t = stock of debt at end of periodt
" 2 t - 1 = stock of debt at end of periodt-1
PUBLIC DEBT
2t = 2 t - 1 2 ==t
For a given value of 2 t - 1 :
" a budget deficit ==t < 0, adds to the stock of debt, while
" a budget surplus ==t > 0 reduces the stock of public debt
Budget Deficits and (Gross) Public Debt (% GDP)
GOVERNMENT BUDGET CONSTRAINT
Government expenditures (purchases, transfer payments and interest payments) in any period need to be
funded by taxes or by borrowing.
A government can fund its outlays in 3 ways:
" Taxes
" Borrowing (i.e. it can sell a government security)
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" Printing Money
Last approach has bad reputation 3 associated with hyperinflation
(Monthly inflation greater than 50%).
Printing Money
" Suppose that a government is unable to raise enough revenue to cover its expenditure and runs a budget
"
deficit.
(In addition) the government finds it cannot borrow enough from public or from abroad to finance its
deficit.
Government Budget Constraint: Notation
1t + …-t + @2 t - 1 = TAt + 2t 2 2 t - 1
Use of Funds
Funding Sources
Suppose 2t 2 2 t - 1 = 0. No new borrowing.
1t + …-t + @2 t - 1 >…At
Only other source of funds is the central bank, and these are provided in the form of new currency (printing
money). Inflation/Hyper-inflation
Hyper-inflation in Germany 1920s
Log of German Price Level
German Inflation Rate
GOVERNMENT BUDGET CONSTRAINT
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Assume government does not use money finance.
Means of relating government outlays (purchases, transfer and interest payments) to their method of
financing is via the government budget constraint.
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Government Budget Constraint (Notation)
Budget Balance
==t = …t 2 1t
Stock of Debt
2t = 2 t - 1 2 ==t
Substitute and re-arrange
2(…t 2 1t) = 2t 2 2 t - 1
Decompose T
…t = …t 2 …-t 2 @2t-1
" …t = tax receipts
" …-t= transfer payments
@2 t - 1 = real interest payments on publicdebt r = real interest rate on debt (assumed constant)
…t = …t 2 …-t 2 @2 t - 1
Substitute for T
2(…t 2 1t) = 2t 2 2t-1
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GOVERNMENT BUDGET CONSTRAINT
1t + …-t + @2 t - 1 = …t + 2t 2 2 t - 1
Use of Funds
"
"
"
"
"
Funding Sources
G = government purchases
TR = transfer payments
…= taxes
Dt-1 = stock of government securities (i.e. public debt) at the end of period (t-1) (or beginning
of period t)
rDt-1 = real interest payments on public debt
GOVERNMENT BUDGET CONSTRAINT: TRADE-OFFS
In any period, a government has a choice of how to pay for their expenditures.
" One option is to raise just enough revenue through taxes and not borrow. This is equivalent to running a
"
balanced budget.
Or government can fund some of its expenditures by borrowing.
Trade-off:
" Raising taxes has economic (and political) costs.
" Governments to defer some of these costs by borrowing.
" But, higher government debt means relatively higher taxes on future generations.
PUBLIC DEBT AND THE ECONOMY
There is a temptation for a government to continually defer raising taxes or reducing government
expenditures and allow a growing level of public debt.
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One response is for government to follow a fiscal policy rule.
•
Balance budget over the business cycle.
•
Golden rule for pubic investment.
GOVERNMENT BORROWING AND THE BUSINESS CYCLE
One rule for fiscal policy is that governments should seek to balance their budgets over the business cycle.
•
•
During recessions, governments would borrow to finance temporarily larger budget deficits
During periods of economic expansion, governments would reduce the level of public debt by running
budget surpluses.
Acts to stabilize the level of public debt and would prevent a persistently rising level of public debt over time.
A GOLDEN RULE FOR PUBLIC INVESTMENT
Alternative rule for fiscal policy draws a distinction between:
• government spending for current consumption, and
• for investment in public capital (or public infrastructure).
The basic principle underlying the rule is one of <pay-as-you-use=.
Government consumption expenditures only provide benefits to the current generation, so they should be
paid for current taxes.
Government investments are long-lived and provide benefits not only for the current generation, but also for
future generations.
A GOLDEN RULE FOR PUBLIC INVESTMENT
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Since future generations share in the benefits of government investment, there is a case on equity grounds
that they should contribute to the cost of the investment.
This will occur if governments borrow to fund their investment spending, as the higher taxes required to repay the debt will fall on future generations.
Under the Golden Rule, government investment 3 since it provides benefits to future generations 3 should be
funded by borrowing (i.e. deferred taxes).
The golden rule implies governments should borrow for public infrastructure investments.
COSTS OF PUBLIC DEBT
Emphasizes three issues:
•
•
•
consequences of high levels of public debt for economic growth;
possible crowding-out of private investment due to higher real interest rates and;
intergenerational equity.
Public Debt and Economic Growth
Implication:
Other things equal, if a country9s debt to GDP ratio were 50 percent rather than 40 percent its annual real
growth rate would be 1.8 percent rather than 2 percent.
Crowding Out of Investment
One mechanism by with higher public debt might act to reduce economic growth is through crowding out.
Closed economy NS and I model (Chapter 3) predicted an increase in the government deficit would tend to
increase the real interest rate and reduce (or <crowd out=) the level of private investment.
Over time a persistently lower level of private investment would result in a lower private capital stock in an
economy and this could lead to a lower level of real economic growth. (We will see how this can occur in
Chapter 10).
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•
•
•
Borrowing because of deficit budgets cannot be sustained forever, and eventually surpluses would be
required to reduce debt.
Intergenerational equity means we should not enjoy the benefits of budget deficits now and pass on the
costs of those deficits to future generations.
As noted above, high levels of public debt that are not matched by high levels of productive public
infrastructure tend to be inequitable from an intergenerational perspective.
Intergenerational Equity
" Borrowing because of deficit budgets cannot be sustained forever, and eventually surpluses would be
required to reduce debt.
" Intergenerational equity means we should not enjoy the benefits of budget deficits now and pass on the
costs of those deficits to future generations.
" As noted above, high levels of public debt that are not matched by high levels of productive public
infrastructure tend to be inequitable from an intergenerational perspective.
Sustainability of Public Debt
In evaluating sustainability, we use the debt to real GDP ratio;
C=
2
?
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Factors will cause d to rise and fall
" Growth in D relative to the growth in Y.
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ECON1102: Macroeconomics
Saanvi Yerawar
CHAPTER 6 - FINANCIAL ASSETS, MONEY AND PRIVATE BANKS
Financial System
What happens to Private Saving?
S=Y-T-C
•
•
•
•
•
Currency
Bank deposits
Stocks/shares/equities
Bonds
Other assets
Lenders
(Saver)
Financial System
{Intermediation}
Asset Prices and Yields
The yield or return on a financial asset is inversely related to the asset9s price.
Return =
Other things equal:
3:(7,(;+<+::+=)>3?@+AA
3:(7, (0+C?@)
±Price(today) implies ³Return
Bonds
Definition: Legally enforceable promise to re-pay a debt:
•
•
Government bonds
Corporate bonds
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Borrower
(Investor)
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ECON1102: Macroeconomics
Saanvi Yerawar
4 Elements of a Bond
Term of bond = length of time before bond has to be repaid (terms can range from 24 hours to 30 years)
(called maturity)
Principal = amount that needs to be repaid at maturity
Coupon payment = regular dollar payment of interest on the bond
Coupon rate =
!%&'%( *+,-.(/
*01(1'+2
Bond Prices and Interest Rates
Market interest rates and bond prices are inversely related.
Bonds do not have to be held until maturity, but can be bought and sold (traded) on the bond market.
What determines the price of a bond?
•
•
Consider a two-year bond with a face value of $1,000.
The annual coupon rate is 5%, implying there are two annual coupon payments of $50.
Gross Rate of Return = (1 + interest rate/100)
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ECON1102: Macroeconomics
Saanvi Yerawar
PV = C/i
C = Coupon Payment + Principal
Consider a bond with a term of two years, a principal or face value of $2,000 and that pays an
end-year coupon of $50.
If the market interest rate on similar bonds is 2%, what is the (approximate) initial price of the
bond?
Price = PV = 50/1.02 + 2,050/[(1.02)*(1.02]
What is Money?
" Currency and transaction deposits at banks
Functional Definition of Money
• Medium of exchange
• Unit of account
• Store of value
Medium of Exchange
•
Good or asset whose primary purpose is to purchase other goods.
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ECON1102: Macroeconomics
Saanvi Yerawar
goods ³ money ³ goods
•
Medium of exchange increases efficiency of trade.
With a medium of exchange each person:
•
•
Sells their goods for medium of exchange
Uses medium of exchange to buy goods they want
Unit of Account
•
•
•
Good that is used to compare the value of all other goods and services.
Standard to use medium of exchange as the unit of account.
Its use in measuring prices of goods and services and assets
Store of Value
•
•
•
Good or asset that serves as a means of holding (or transferring) wealth over time.
Transfer purchasing power from today into some future period.
Many goods and assets can serve as a store of value (e.g. land, bonds, stocks) but do not possess the
medium of exchange or unit of account functions of money.
Money as a Store of Value
Disadvantage
•
Low (or zero) nominal return compared to other assets
Advantages
•
•
Money as medium of exchange is perfectly liquid.
Nominal price of money is fixed, so no possibility of capital loss (or gain).
Measuring Money
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ECON1102: Macroeconomics
Saanvi Yerawar
In modern economies money is provided by:
" Government (currency 3 notes and coin)
" Banking system (deposits 3 accounting)
Standard Measures of Money for Australia
"
"
"
"
Currency = notes and coin on issue (less what is held by RBA and banks)
M1 = Currency + Current deposits at banks
M3 = M1 + all other bank deposits of non-bank private sector
Broad Money = M3 + borrowings from private sector by non-bank depository corporations (less what
these non-banks hold with banks)
Demand for Money
" Focus on transactions demand for money (M).
" Demand to hold a particular level or stock of money.
What factors are likely to influence the quantity of money demanded for making transactions?
" Value of transactions (i.e. volume × price)
" (Opportunity) cost of holding money
" Transactions technology
The money demand curve for an economy is given by the following equation.
Md = P*(1.5Y 3 5i)
Suppose the price level for the economy is fixed at P = 1.0. If real GDP is 100 and the nominal
interest rate equals 10 percent (i.e. i=10). What is the quantity of money demanded in the
economy?
Md = 1*(1.5100 3 510) = 150 3 50 = 100.
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ECON1102: Macroeconomics
Saanvi Yerawar
Value of Transactions
2 components:
Real GDP (Y) as a proxy for volume of transactions.
" Other things equal, an increase in Y will increase demand for money (M)
Aggregate Price Level (P)
" Other things equal, an increase in P will increase the demand for M
Opportunity Cost
" Money that is held to make transactions (currency and transactions deposits) pays zero or low interest
"
rate.
Holding money incurs an (opportunity) cost, which is the nominal interest rate you could have earned
by holding a bond.
PRICE LEVEL (P)
Other things equal, an increase in the price level p would be expected to lead to a proportionate increase in the
demand for money (md). For example, if the price of all goods and services in an economy were to double, the value
of m would also need to double in order for individuals to undertake the same real volume of transactions.
REAL GDP (Y)
Other things equal, an increase in real gdp y is expected to cause an increase in the demand for money. The
percentage increase in the demand for money in response to a 1 percent increase in real gdp is called the income
elasticity of money demand.
NOMINAL INTEREST RATE (I)
Other things equal, an increase in the nominal interest on non-monetary assets is expected to result in a fall in the
demand for money. The percentage decrease in the demand for money in response to a 1 percent increase in the
nominal interest rate is called the interest elasticity of money demand.
We can represent the demand from money md using the following equation.
Nominal interest rate (i)
"
Other things equal, an increase in i will reduce the demand for m
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ECON1102: Macroeconomics
Saanvi Yerawar
Changes in either the price level or real income will cause a shift in the money demand curve. Figure 2
illustrates an increase (or outward shift) in the money demand curve. For a given nominal interest rate i0,
either an increase in P or in Y will produce an outward shift and a consequent increase in the quantity of
money demanded (i.e. from M0 to M1).
FINANCIAL INNOVATION (AND REGULATION)
Effects on composition of M
" Tap and Pay will reduce demand for currency, but still need bank deposits for transfer or to pay credit
card account.
Decline in Currency
Increase in Deposits
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ECON1102: Macroeconomics
Saanvi Yerawar
Effects on demand for M
" Transactions technology that is a substitute for M?
" Bitcoin and other e-currencies (Not measured in M).
" Very small effect at present.
SUPPLY OF MONEY
" Main component of money in Australia is bank deposits.
" Value of current deposits is about 4 times the value of currency.
" How are bank deposits produced?
Private Banks provide:
" Financial intermediation
" Key role in payments system
MODEL OF A BANK
Initial Balance Sheet of New Bank
Assets
Loans
Reserves
Liabilities
0
100
Deposits
Equity
0
100
" Bank owners (shareholders) need to provide some initial equity or what is known as bank capital.
" Funds provided by equity, enter balance sheet as an asset, which are called reserves.
Model of a Bank
" New bank is solvent but has no revenue.
" Make loans to earn interest.
" When the bank makes a loan it simultaneously creates a deposit to provide the funds to the
borrower.
" By creating a deposit, bank has created money.
Model of a Bank
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(jayden.lei6@gmail.com)
Bank can earn revenue by chargingDownloaded
a higher by
interest
rate
on its loans, than it pays on its deposits.
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ECON1102: Macroeconomics
Saanvi Yerawar
Loan rate (iL) > Deposit rate (iD)
CONSTRAINTS ON A BANK
Suppose $500 in deposits are withdrawn.
Balance Sheet of New Bank with Lending
Assets
Loans
1,000
Liabilities
Deposits
1,000 -500
Reserves
100
Equity
100
-500
Bank only has 100 in reserves, and will be short 400 to meet withdrawals. (What are its options?)
CONSTRAINTS ON A BANK
Bank could try and make borrowers repay their loans.
" Likely to be costly
" Likely to cause increased withdrawal of deposits
2 options
" Attract additional deposits
" Borrow the necessary funds
NEW DEPOSITS
If the bank can attract new deposits of 500, it can re-pay existing depositors who wish to withdraw
deposits.
BORROW FUNDS
Bank can borrow to obtain the funds needed to repay the deposits.
A THIRD OPTION
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ECON1102: Macroeconomics
Saanvi Yerawar
Banks have a third option for obtaining the funds (or reserves) needed to meet payment on their liabilities.
This involves borrowing reserves from other banks or from the central bank. This option is examined in
Chapter 7.
SUMMARY
Banks are special in their ability to fund a loan by simultaneously creating a deposit (i.e. creating money,
money supply).
However, banks are required to convert their deposits into currency on demand or to transfer resources to
another bank if their deposit is used to make a transaction.
Consequently, banks need to actively manage both the asset side (loans and reserves) and the liability side
(deposits, borrowing and equity) of their balance sheet.
Banks9 Balance Sheets and Leverage
Two ratios used to measure riskiness of bank:
" Leverage ratio
" Reserve-deposit ratio (or liquidity coverage ratio)
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ECON1102: Macroeconomics
Saanvi Yerawar
Leverage Ratio
Definitions
Assets = Liabilities
Loans + Reserves = Debt + Equity
Equity = Loans + Reserves 3 Debt
The leverage ratio is the ratio of loans to equity
Leverage ratio = Loan/Equity
Leverage Ratio and Insolvency
" Equity provides a buffer to bank becoming insolvent or bankrupt in the case of default on loans.
" Suppose a negative economic shock reduces the value of bank loans.
2 Cases
" Bank 1 has leverage ratio = 10
" Bank 2 has leverage ratio = 20
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ECON1102: Macroeconomics
Saanvi Yerawar
Reserve-deposit ratio
Reserves as a proportion of deposits. R/D
Historically governments imposed some minimum required reserve-deposit ratio on banks.
Today reserve requirements have been abolished in many countries (e.g. Australia and Canada)
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ECON1102: Macroeconomics
Saanvi Yerawar
Even where they remain (e.g. United States); reserve requirements do not play an important role in the
regulation of banks.
Bank Runs and Liquidity
Banks typically <borrow short= and <lend long.=
Miss-match in maturity structure of bank loans compared to bank liabilities (i.e. deposits).
Maturity transformation undertaken by banks makes them susceptible to bank runs and liquidity crises.
Bank Runs and Liquidity
Bank run arises when depositors seek to withdraw their deposits precisely because they expect that other
deposit-holders to do the same.
To meet the sudden and unexpected demand to withdraw deposits, banks will need:
"
"
to borrow from other sources or " try to sell their marketable assets or
call-in loans.
If banks cannot meet the demand for withdrawals they may be forced to suspend the ability of depositors
to withdraw their funds.
Bank Runs and Liquidity
Liquidity crisis:
Occurs when a bank is solvent (Assets > Debt Liabilities), but has insufficient liquid assets to meet demand
for withdrawals.
Policy Responses:
"
"
Central bank lending
Deposit insurance
Central Bank Lending
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ECON1102: Macroeconomics
Saanvi Yerawar
Suppose banks have insufficient reserves or liquid assets to meet demand to convert bank liabilities into
currency.
Central bank can supply currency/reserves at zero cost.
Can lend banking system necessary liquid assets to meet demand.
A general rule is that the central bank should lend to banks that are solvent but short of liquid assets.
Deposit Insurance
Government (or agency) provide insurance to depositors.
Since depositors are assured of being able to receive payment in currency regardless of the bank9s
financial situation, they have less incentive to participate in a bank run.
In Australia, the Federal Government guarantees deposits of up to $250,000 that are held with banks,
building societies and credit unions.
Governments will typically charge banks a fee for deposit insurance.
Regulation of Banks
Banks are susceptible to economic shocks.
Systemic shocks can have big negative consequences for the macro-economy (Global Financial Crisis 200708)
Consequently, banks are subject to various types of regulation.
"
Australian Prudential Regulation Authority (APRA) regulates all domestic financial institutions.
"
Internationally many countries (including Australia) adhere to the Basel Accords.
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Regulation of Banks (prudential regulation)
"
Capital ratios require banks to maintain a certain ratio of equity capital to a risk weighted measure
of their assets.
Assets
Liabilities
Reserves
Deposits
Gov. Securities
Borrowing
Loans
Equity
Regulation of Banks (prudential regulation)
"
Liquidity coverage ratios require a certain fraction of bank assets are relatively liquid and can be
easily used to meet potential deposit outflows and re-payment of short-term borrowings.
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Assets
Liabilities
Reserves
Deposits
Gov. Securities
Borrowing
Loans
Equity
Regulation of Banks (prudential regulation)
"
Net stable funding ratios focus on the sources of bank funding; deposits, borrowing and equity and
their relative stability (i.e. the ease with which the type of funding can be withdrawn).
Assets
Reserves
Liabilities
Gov. Securities
Deposits
Long-term fundin
Borrowing
Loans
Equity
Regulation of Banks (prudential regulation)
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Restrictions on loan-to-value ratios provide limits on the amount that an individual can borrow to
purchase an asset. Eg. a loan-to-value ratio of 80 percent implies the bank can only lend up to 80
percent of the market value of the asset.
Assets
Liabilities
Reserves
Deposits
Gov. Securities
Less Risky
Loans
Borrowing
Equity
Velocity
How fast does a dollar circulate?
What is average value of transactions that a dollar can be used for (in a given period of time)?
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Velocity of Circulation in Australia
Nominal GDP in March quarter 2014 = $400 billion
Nominal GDP over 12 months to March quarter 2014 = $1,586 billion
$ billion
V
(end-March 2014)
Currency
(qtr)
V
(annual)
57.6
6.9
27.5
M1
295.8
1.4
5.4
M3
1,634.9
0.24
0.97
Broad Money
1,642.0
0.24
0.97
Quantity Theory (is what we care about)
The quantity theory makes two economic assumptions:
" Velocity is constant, and
" Output is constant
Quantity Equation
Quantity Theory
• × –0 = 3 × ?0
Quantity Theory of Prices
Quantity Theory
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• × –0 = 3 × ?0
Re-write as
3 = –0 ו
?0
3 = — ו
—=
Price level is proportional to the money stock
D$
.$
Quantity theory states that changes in M cause (proportional) changes in P.
Inflation and Money Growth
Re-write levels model
3=—ו
as one in growth rates
%—3 = %—— + %—•
Inflation rate = growth rate of money + growth of —
According to the growth rate version of the quantity theory Ã%=—M%
Inflation and Money Growth
%—3 = %—— +%—•
Assume:
Remember — is ratio of constants
" %—— =0
Let %—3 =€
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=% M
Inflation rate = growth rate of money
Fiat Currency
A fiat currency has no intrinsic value.
it has no fundamental value other than as a medium of exchange
Gross return on an asset
Return = Initial share price + paid a dividend (income)/ new share price
CHAPTER 7 - CENTRAL BANKS AND MONETARY POLICY
Central Banks (CB)
" Make operational decisions about monetary policy.
" Often have a considerable degree of autonomy or independence in implementing monetary policy.
Examples:
United States - Federal Reserve System (Fed)
Euro Area - European Central Bank (ECB)
China - People9s Bank of China (PBC)
Monetary policy:
" Actions taken by a central bank (CB) to influence short-run macroeconomic outcomes.
Targets:
" Final variables that CBs seek to influence:
" Inflation rate.
" Level of resource utilisation (e.g. output gap or cyclical unemployment rate).
Targets and Instruments
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CBs do not have direct control over ultimate targets.
Instrument:
Monetary policy instrument:
" Variable which the central bank can directly control.
" Eventually has a predictable effect on policy targets.
Most CBs currently use a (very) short-term interest rate as their policy instrument.
RESERVE BANK OF AUSTRALIA (RBA)
Main functions:
" stability and efficiency of financial markets.
" promoting efficiency of payments system.
" responsible for operation of monetary policy.
AUSTRALIA9S (CURRENT) MONETARY POLICY TARGET(S)
RBA has an explicit inflation target (2-3 % per annum)
Both the Reserve Bank and the Government agree that a flexible medium-term inflation target is the
appropriate framework for achieving medium-term price stability. They agree that an appropriate goal is
to keep consumer price inflation between 2 and 3 per cent, on average, over time. This formulation allows
for the natural short-run variation in inflation over the economic cycle and the medium-term focus
provides the flexibility for the Reserve Bank to set its policy so as best to achieve its broad objectives,
including financial stability. (2016)
HEADLINE INFLATION VERSES CORE INFLATION
Headline = measured CPI (no adjustments).
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Core or Underlying Inflation
" Use some procedure to try and remove the volatile, temporary fluctuations in inflation.
" Measure the longer-term (underlying) trends in inflation rate.
CORE OR UNDERLYING INFLATION MEASURES
2 basic approaches:
" remove historically volatile components of headline inflation such as energy prices.
o US Fed uses (urban CPI less food and energy)
" eliminate a proportion of items with the highest and lowest rates of price change.
o RBA uses trimmed mean inflation measure
MONETARY POLICY FRAMEWORK
Transmission
Mechanism
PolicyInstrument
RBA
Inflation
Targets
Output
Statements by RBA indicate it is has a <flexible= Inflation Target. Takes output into account in setting
policy.
RBA9s Operating Procedures
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Announces target value for the Cash rate
Intervenes in Cash market to ensure:
Actual Cash rate = Target Cash rate
Monetary Policy Process
11 monthly decisions on target Cash rate per year.
Raise, lower or leave unchanged.
Size of change is usually 25 basis points (100 bp = 1%).
" Increasing Cash rate = contractionary policy.
" Decreasing Cash rate = expansionary policy.
"
How does the RBA achieve its Target for the Cash Rate?
What is <Cash= and why does it have an interest rate?
" Cash is <colloquial= name for Exchange Settlement Funds.
Exchange Settlement Funds are held in accounts by Australian banks at the RBA. Accounts are
called Exchange Settlement Accounts (ESAs).
Role of Exchange Settlement Accounts and Exchange Settlement Funds (or Cash)
Banks hold reserves at RBA in Exchange Settlement Accounts (ESAs).
Banks not allowed to overdraw their
ESA
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Role of ESAs in Payments Clearing (Settling)
Banks use ESAs to clear debts (or credits) with other banks.
If ANZ owes $20m to Westpac, then funds are simply transferred between their ESAs.
" ANZ ESA (-$20m)
" Westpac ESA (+$20m)
Inter-bank transfers will change the distribution of Cash, but will not affect the overall level of Cash in the
system.
Overnight Cash Market
Suppose ANZ finds its level of Cash holdings at the end of the day to be undesirably low?
Overnight Cash market
" Specialised market where banks can trade Cash.
" Borrowing and lending for periods up to 24 hours.
" ANZ could borrow Cash from some other bank which might find itself with more than it wants to hold.
" Interest rate in inter-bank market = Cash rate.
Summary (so far)
"
"
"
"
"
Banks hold ESAs with RBA.
Use ES accounts to settle (or clear) debts.
Funds held in ESA are called <Cash=.
Banks can borrow and lend ES funds in Cash market at Cash rate.
RBA sets a target value for the Cash rate.
How Does the RBA Set its Cash Rate Target?
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Mechanisms:
" Channel system.
" Open market operations.
A Channel for the Cash Rate
RBA provides banks with two automatic facilities for overnight lending and borrowing. Called standing
facilities.
Interest on Reserves (IOR)
" The RBA pays interest on funds held in ESAs at rate which is 0.25% below its Cash rate target. Since the
cash rate is now 0.1% the RBA is paying no interest on reserves. Lower bound for actual Cash rate.
<Re-discount rate= (term is not used by RBA)
" Banks can, at any time, borrow Cash (using bonds as security) from the RBA at a rate that is 0.25%
above the target Cash rate (at present this would be 0.35%).
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Supply of Cash (Exogenous Changes)
Banks cannot change the total quantity (supply) of Cash available.
On any given day the supply of cash is affected by transactions between private sector and Federal
Government.
" Private sector payments to government (taxes) reduce the supply of Cash
" Government payments to private sector (transfer payments) increase the supply of Cash.
Supply of Cash (OMO)
" RBA can change the supply of cash by undertaking open market operations (OMO) with the banks.
" Open market operations are where central banks buy or sell government bonds with the private
"
sector.
In practice, the RBA only conducts OMO with banks holding an ESA.
Supply of Cash (OMO)
The RBA9s OMO have the following effects.
" If the RBA buys bonds from the banks it will pay for the bonds by crediting their ESAs and, other things
equal, this will increase the total supply of ES funds available.
" If the RBA sells bonds to the banks it will receive payment by debiting their ESAs and, other things
equal, this will decrease the total supply of ES funds available.
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Summary
1. Exchange Settlement Accounts (ESA)/ Exchange Settlement Funds (called Cash)
2. Banks borrow and lend Cash on short-term basis. There is a market for Cash.
3. RBA intervenes in Cash market:
" Sets interest rates at which it will borrow and lend to banks.
" Conducts open market operations with banks.
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RBA is very successful at achieving its desired target.
The Cash Rate and Longer-Term Interest Rates
" Under its current operating procedures, the RBA has little difficulty achieving its target for the Cash
"
"
rate.
However, the Cash market is highly specialised and the Cash rate is for very short-term borrowing and
lending.
Not clear how the Cash rate is relevant to the consumption and investment decisions of households
and firms. Likely to be influenced
by longer-term
rates.
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Arbitrage
While RBA targets a very short interest rate, changes in Cash rate eventually lead to changes in longerterm interest rates.
Cash rate90-day180-dayLong rates
In practice:
Market Rates = Cash Rate + Premium
Implications for Transmission of Monetary Policy
" Provides a link from changes in short-term rates (e.g. Cash rate) to long-term interest rates in the
"
economy.
RBA9s ability to change long-term interest rates, depends not just on the current value of the Cash rate,
but also on people9s expectations about the future path for the Cash rate.
Nominal and Real Rates
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" RBA has direct control of nominal interest rates.
" But it is the real rate that matters for saving and investment decisions.
" Fisher Effect links nominal and real rates
9 = : + ;+
" A change in i could affect either r or €,
Sticky Inflation and Inflation Expectations
9 = : + ;+
Conventional view among monetary policy makers is in the short-run expected (and actual) inflation is
fixed or sticky and not immediately affected by a change in i.
In the short run (at least) a change in i will tend to influence r (in the same direction).
± 7 =± @ + €,
Monetary Policy Rules
What are key influences on the value a central bank (like RBA) sets for its policy rate?
Conventional Targets
" Inflation
" Measure of resource utilisation (e.g. output gap)
Monetary policy rules are simple models of the behaviour of central banks.
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Taylor Rule
. =(
! 3 !7
%
) × 344
" i = policy rate (%)
" Ã = inflation (%)
" ? = output gap (%)
Well-known example of a policy reaction function.
9 = 1.0 + 1.5; + 0.5,
Indicates how central bank will respond to the level of:
" Inflation
" output gap
Implies that central bank will increase its policy rate in response to higher inflation and/or an increasing
output gap.
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