MODULE 1: CONCEPTS ECONOMIC METHODOLOGY & THE ECONOMISING PROBLEM MEASUREMENT - GDP, UNEMPLOYMENT & INFLATION Economic Methodology & the Economising Problem Economics: Foundations and Models - Chapter 1 Choices and Trade-Offs in the Market - Chapter 2 Learning Objectives: 1. 2. 3. 4. 5. 6. Discuss the following important economic ideas: people are rational; people respond to incentives; optimal decisions are made at the margin. Understand the issues of scarcity and trade-offs, and how the market makes decisions on these issues. Understand the role of economics in modern analysis. Distinguish between microeconomics and macroeconomics. Use a production possibility frontier to analyse opportunity costs and trade-offs. Understand the basics of trade. RMIT University School of Economics, Finance and Marketing 2 Economics • A social science concerned with the allocation of scarce/limited resources between unlimited and often competing needs and wants. – Scarcity: The situation in which unlimited wants exceed the limited resources available to fulfill them. – Trade-off: The idea that because of scarcity, producing more of one good or service means producing less of another good or service. RMIT University School of Economics, Finance and Marketing 3 Check Your Understanding What does the adage ‘There is no such thing as a free lunch’ mean? a. To get something we like, we usually have to give up another thing we like. b. Even people on welfare have to pay for food these days. c. The cost of living is always increasing. d. All costs are measured in dollars. RMIT University School of Economics, Finance and Marketing 4 Resource Categories • Resources are divided into 4 main categories. – Land: all natural resources. – Labour: Requires a fundamentally scarce resource TIME. – Capital: – Human capital: knowledge & skills that people develop – Physical Capital: buildings, machinery tools, etc. – Enterprise or entrepreneurial ability RMIT University School of Economics, Finance and Marketing 5 Check Your Understanding We study economics because of a. resources. b. money. c. scarcity. d. economists have convinced universities it is a necessary field of study. RMIT University School of Economics, Finance and Marketing 6 Economics and Individual Decisions Three ideas are primary throughout the course: 1. People (economic agents) are rational. 2. People (economic agents) respond to economic incentives. 3. Optimal decisions are made at the margin. RMIT University School of Economics, Finance and Marketing 7 Check Your Understanding Economists understand that people respond to: a. the wishes of policymakers. b. Incentives. c. threats more than rewards. d. tax breaks, but not tax hikes. RMIT University School of Economics, Finance and Marketing 8 Economic Models • Economics deals with generalities/statements about regularities, concerning economic behaviour. • Models are simplified representations of the real world. • Ceteris Paribus – A hypothesis in an economic model: A statement about an economic variable that may be either correct or incorrect. – Economic variable: Something measurable that relates to resources that can have different values. – In testing hypotheses, economists distinguish between correlation and causality. RMIT University School of Economics, Finance and Marketing 9 Check Your Understanding Economic models are usually composed of: a. plastic. b. beautiful people. c. assumptions only. d. diagrams and equations. RMIT University School of Economics, Finance and Marketing 10 Positive versus Normative • Positive: Claims that attempt to describe the world as it is. Statements of facts. Can be tested empirically. • Normative: Claims that attempt to prescribe how the world should be. Opinions. Cannot be tested empirically. RMIT University School of Economics, Finance and Marketing 11 Check Your Understanding Which of the following is a positive economic statement? a. The government should close income tax loopholes that enable people to avoid paying tax. b. We should redistribute income to reduce poverty. c. Everyone should live at the same standard of living. d. If the price of petrol rises, a smaller quantity of it will be bought. RMIT University School of Economics, Finance and Marketing 12 Macroeconomics versus Microeconomics • Microeconomics: The study of how individuals make decisions. Microeconomics considers how households and firms make choices, how they interact in markets, and how the government attempts to influence their choices. • Macroeconomics: Enables us to better understand the structure and behavior of the entire economy (regional, national or global) and to consider issues associated with measuring performance. Macroeconomics is the study of the economy as a whole and includes topics such as inflation, unemployment, and economic growth. RMIT University School of Economics, Finance and Marketing 13 Check Your Understanding State whether the following issues are microeconomic or macroeconomic. a. The overall unemployment rate b. A tax that affects workers in the automobile industry. c. The inflation rate d. Prices of electronic goods e. Real GDP RMIT University School of Economics, Finance and Marketing 14 Scarcity and Trade-offs 1. What to produce 2. How to produce it 3. Who will receive the products WHO DECIDES? Laissezfaire/Market Economy RMIT University Mixed Economy School of Economics, Finance and Marketing Command Economy 15 Check Your Understanding A market economy rewards people according to: a. their need for goods and services. b. how willing they are to work. c. their ability to produce things of cultural importance. d. their ability to produce things that other people are willing to pay for. RMIT University School of Economics, Finance and Marketing 16 Resource Market Financial Markets Borrowing & Lending Private and Public Firm Household Product Market Government External RMIT University School of Economics, Finance and Marketing 17 Production Possibilities Frontier • How to achieve the greatest possible satisfaction of society’s material wants given scarce resources? – Full employment – Full production – Allocative efficiency – Productive efficiency RMIT University School of Economics, Finance and Marketing 18 Check Your Understanding Which of the following results in production occurring at the lowest possible cost? a. Productive efficiency b. Allocative efficiency c. Dynamic efficiency d. All of these options are correct. RMIT University School of Economics, Finance and Marketing 19 Production Possibilities Frontier Represents the maximum possible combinations of goods & services that can be produced with a given quantity of factors of production and given technology. butter 10 A W Unattainable U Attainable but not desirable E guns 4 RMIT University School of Economics, Finance and Marketing 20 Check Your Understanding An "increase in efficiency" suggests that an economy: a. Has moved from a point outside of, to a point on, its production possibilities curve. b. Has decided to produce more consumer goods and fewer capital goods. c. Is able to get less output from a given amount of input. d. Is able to get more output from a given amount of input. RMIT University School of Economics, Finance and Marketing 21 Opportunity Cost The opportunity cost of any activity is the highest-valued alternative that must be given up to engage in the activity under consideration. butter A 10 Any movement along the PPF involves the concept of opportunity cost. Can only obtain more of one good by having less of the other. B 9 C 7 D 4 E 1 RMIT University 2 3 4 guns School of Economics, Finance and Marketing 22 Check Your Understanding In economics, the cost of something is: a. the out-of-pocket expense of obtaining it. b. what you give up to get it. c. always measured in units of time. d. always higher than people think. RMIT University School of Economics, Finance and Marketing 23 Increasing & Constant Opportunity Costs butter 10 9 pastries 10 A A B B 8 C 7 6 D 4 D 4 C E 2 E 1 2 3 4 guns Scarce resources are not equally suitable in all productive activities. Economic resources are not completely adaptable to alternative uses. RMIT University 1 2 3 4 cakes Scarce resources are equally suitable in all productive activities. Economic resources are completely adaptable to alternative uses. School of Economics, Finance and Marketing 24 Check Your Understanding Increasing opportunity costs will lead to the production possibility frontier being a. bowed inward from the origin. b. bowed outward from the origin. c. a negatively sloped straight line. d. a positively sloped straight line. RMIT University School of Economics, Finance and Marketing 25 Check Your Understanding Assume a firm can produce a combination of 60 units of X together with 80 units of Y but to produce 70 units of X, the firm can only produce 60 units of Y. What is the opportunity cost to produce 10 more units of X? a. Two units of Y b. 10 units of X c. One-half a unit of X d. 20 units of Y RMIT University School of Economics, Finance and Marketing 26 • Trade-offs and disaster relief More funds for one disaster relief means less funds for other charities. RMIT University School of Economics, Finance and Marketing 27 Economic Growth computers (good for the future) • Over time PPF can move outwards. • Achieved through economic growth. • The following will push the PPF out: – Capital accumulation. – Technological progress. – Increased resources pizzas (good for the present) RMIT University School of Economics, Finance and Marketing 28 Check Your Understanding Which of the following would shift the country's production possibility frontier inward? a. An increase in the unemployment rate b. Discovering a cheap way to convert sunshine into electricity c. Producing more capital equipment d. A law requiring workers to retire at age 50 RMIT University School of Economics, Finance and Marketing 29 Check Your Understanding Production possibilities (alternatives) Capital goods Consumer goods A B C D E F 5 4 3 2 1 0 0 5 9 12 14 15 Refer to the above table. As compared to production alternative D, the choice of alternative C would: a. Tend to generate a more rapid growth rate. b. Be unattainable. c. Entail unemployment. d. Tend to generate a slower growth rate. RMIT University School of Economics, Finance and Marketing 30 Check Your Understanding Here is a production possibilities table for watches and bags in Consumer Land. Type of product Watches (in millions) Bags (in millions) a. b. Production Alternatives A B C D 10 9 7 4 0 5 10 15 E 0 20 Draw a PPF that corresponds with the data in the table. Why must Consumer Land sacrifice successively larger amounts of watches to acquire more bags. What type of opportunity costs is it facing? ? RMIT University School of Economics, Finance and Marketing 31 Check Your Understanding c. d. e. f. If the economy is currently at production alternative D: i. What is the opportunity cost of five million more bags? ii. What is the opportunity cost of three million more watches? Where would the economy be operating if a recession in Consumer Land resulted in 2 million people losing their jobs? If the production possibilities frontier for Consumer Land was a straight line, what would it indicate about the country’s opportunity costs? What does this indicate regarding resources? Suppose improvement occurs in the technology of producing watches but not in the production of bags. Illustrate the impact on the original production possibilities frontier. RMIT University School of Economics, Finance and Marketing 32 Trade We can use the production possibility frontier and the concept of opportunity cost to explain the economic gains from specialisation and trade. (ECON1086: International Trade covers the important topic of international trade in more detail). Trade: the act of buying or selling a good or service in a market. RMIT University School of Economics, Finance and Marketing 33 PPF and International Trade • Mercantilism held that countries would grow wealthy by accumulating gold and silver. They would do so by exporting as much as possible, and importing as little as possible. • Adam Smith put forward the idea that the wealth of a nation depends on the incomes of the people in the country and what they are able to consume, not on the gold and silver held by the monarchs and the nobles. • According to Smith, imports rather than exports are the purpose of trade. Imports of goods and services rather than the accumulation of gold and silver improve people’s standard of living. RMIT University School of Economics, Finance and Marketing 34 Trade Absolute and comparative advantage. – Absolute advantage: The ability of an individual, firm or country to produce more of a good or service than competitors using the same amount of resources. – Comparative advantage: The ability of an individual, firm or country to produce a good or service at a lower opportunity cost than other producers. RMIT University School of Economics, Finance and Marketing 35 The Benefits of International Trade • David Ricardo’s theory of comparative advantage (developed in 1817) showed how a country could improve the income of its citizens by allowing them to trade with people in other countries. • International trade allows nations to increase the productivity of their resources through specialisation and thereby to realise a higher standard of living than is possible in the absence of trade. • Trade enables a country and the world to produce and consume more than would be possible without trade. RMIT University School of Economics, Finance and Marketing 36 Trade • The basis for trade is comparative advantage not absolute advantage. • Individuals, firms or countries are better off if they specialise in producing goods and services for which they have a comparative advantage and obtain other desirable goods and services by trading. RMIT University School of Economics, Finance and Marketing 37 Check Your Understanding The basic principle underlying free trade between nations is a. Absolute advantage b. Comparative advantage c. Mercantilism d. Productivity growth RMIT University School of Economics, Finance and Marketing 38 Review Your Understanding Daniel decides to spend an hour swimming rather than working at $6 per hour. His trade-off is: a. nothing, because he enjoys swimming more than working. b. the increase in skill he obtains from swimming for that hour. c. the $6 he could have earned. d. nothing, because he spent $6 for admission into the sports complex to swim. RMIT University School of Economics, Finance and Marketing 39 Review Your Understanding When society requires that firms reduce pollution: a. there is no trade-off, since everyone benefits from reduced pollution. b. there is no trade-off for society as a whole, since the cost of reducing pollution falls only on the firms affected by the requirements. c. there is a trade-off only if some firms are forced to close. d. there is a trade-off to the firms’ owners, workers and customers. RMIT University School of Economics, Finance and Marketing 40 Review Your Understanding When the government prevents prices from adjusting naturally to supply and demand: a. it stabilises the economy. b. it adversely affects the allocation of resources. c. the improvement in equity justifies the reduction in efficiency. d. the reduced uncertainty associated with fixed prices is worth more than the cost in lower efficiency. RMIT University School of Economics, Finance and Marketing 41 Review Your Understanding What is the basic cause of scarcity? RMIT University School of Economics, Finance and Marketing 42 Review Your Understanding Opportunity cost is best defined as a. the cost to producers that results from a failed investment opportunity. b. the additional cost of producing one more unit of output. c. the highest valued alterative that we forego when we make a choice or decision. d. the additional cost of purchasing one more unit of a good. RMIT University School of Economics, Finance and Marketing 43 Review Your Understanding If an economy had production problems which led to inefficiency, but then solved these problems and increased economic efficiency, how would this be shown on a production possibility frontier? a. The slope of the production possibility frontier would become more elastic. b. There would be a movement from a point inside the frontier to a point closer to or on the frontier. c. The slope of the production possibility frontier would become more inelastic. d. The production possibility frontier would shift outwards. RMIT University School of Economics, Finance and Marketing 44 Review Your Understanding The following Production Possibilities Frontier shows the maximum possible combinations of food and clothing that can be produced in a given time period in a particular country. food clothing a. If the country moves upward along the curve and produces more food, does this involve increasing opportunity costs? Why/Why not? b. Under what circumstances would the PPF be a straight line and what type of opportunity costs would exist? c. Under what circumstances would the PPF be bowed out from the origin and what type of opportunity costs would exist? RMIT University School of Economics, Finance and Marketing 45 Review Your Understanding Production possibilities (alternatives) Capital goods Consumer goods A B C D E F 5 0 4 5 3 9 2 1 0 12 14 15 Given the above production possibilities table for an economy, what would be the benefit of producing at production alternative C as compared to production alternative D? RMIT University School of Economics, Finance and Marketing 46 Review Your Understanding Production possibilities (alternatives) Capital goods Consumer goods A B C D E F 5 0 4 5 3 9 2 1 0 12 14 15 Refer to the above table. If the economy is producing at production alternative C, what is the opportunity cost of the tenth unit of consumer goods? RMIT University School of Economics, Finance and Marketing 47 Review Your Understanding Refer to the above diagram. If the economy moves from point C to point B, what is the opportunity cost of each additional baseball? RMIT University School of Economics, Finance and Marketing 48 Measurement : GDP, Unemployment, Inflation Measuring Total Production, Income and Economic Growth - Chapter 4 Economic Growth, The Financial System and Business Cycles – Chapter 5 (pp. 119-120) Unemployment - Chapter 9 ( pp. 246-262) Learning Objectives: Inflation - Chapter 10 (pp. 272-280) 1. Explain how total production in an economy is measured. 2. Discuss whether GDP is a good measure of economic wellbeing. 3. Discuss the difference between real and nominal variables. 4. Understand how the economic growth rate is measured. 5. Define the unemployment rate and the labour force participation rate, and understand how they are calculated. 6. Explain the economic costs of unemployment. 7. Identify the different types of unemployment 8. Define the price level and the inflation rate, and understand how they are calculated. 9. Use price indexes to adjust for the effects of inflation. 10. Distinguish between the nominal interest rate and the real interest rate. 11. Discuss the problems caused by inflation. RMIT University School of Economics, Finance and Marketing 49 GDP • Gross Domestic Product (GDP): The total market value of all final goods and services produced in the economy during a specific period. • Gross National Product (GNP): The total market value of all final goods and services produced by residents of a country (eg. Singaporean residents) during a specific period. – GDP includes only the market value of final goods. – Final good or service: A good or service purchased by a final user. – Intermediate good or service: A good or service that is an input into another good or service, such as a tyre on a truck. – GDP includes only current production. RMIT University School of Economics, Finance and Marketing 50 Check Your Understanding Gross Domestic Product is the total market value of all a. intermediate and final goods and services produced in a time period within a country. b. goods but not services produced in a time period within a country. c. final goods and services produced in a time period within a country. d. final goods and services produced in a time period by citizens of a country, both within the country and by its citizens working overseas. RMIT University School of Economics, Finance and Marketing 51 Methods to Measure GDP Three alternative methods to measure GDP: 1. The Production or Value Added Method: The sum of the value of all goods and services produced by industries in the economy in a year minus the cost of goods and services used in production – leaving the value added. 2. The Expenditure Method: The sum of the total expenditure on goods and services by households, investors, government and net exporters (exports minus imports). 3. The Income Method: The sum of the income generated by resources used in the production of goods and services (includes the sum of wages, salaries and supplements plus rent, interest, profit and dividends). RMIT University School of Economics, Finance and Marketing 52 Resource Market Financial Markets Borrowing & Lending Private and Public Firm Household Value of Production = Value of Resources = Value of Income Generated = Expenditure Undertaken Product Market Government External RMIT University School of Economics, Finance and Marketing 53 Simple Relationships RGDP = Y = AE = C + I + G + NX For a closed economy we simply remove the external sector which makes our income function: Y = C+ I + G We can re-arrange this to derive the investment function: I=Y–C–G Stotal = Sprivate + Spublic Sprivate = Y + TR – C – T and Spublic = T – G – TR, hence Stotal = (Y + TR – C – T) + (T – G – TR) =Y–C–G S=I RMIT University School of Economics, Finance and Marketing 54 Check Your Understanding One bag of flour is sold for $1.50 to a bakery, which uses the flour to bake bread that is sold for $4.00 to consumers. A second bag of flour is sold to a consumer in a grocery store for $2.00. Taking these three transactions into account, what is the effect on GDP? a. GDP increases by $1.50. b. GDP increases by $3.50. c. GDP increases by $6.00. d. GDP increases by $7.50. RMIT University School of Economics, Finance and Marketing 55 Components of GDP • Consumption: Spending by households on goods and services, not including spending on new houses. • Investment: Spending by firms on new factories, office buildings, machinery (planned), and inventories (unplanned), and spending by households on new houses. • Government purchases: Spending by federal, state, and local governments on goods and services. • Net exports: The value of exports minus the value of imports. GDP = C + I + G + NX RMIT University School of Economics, Finance and Marketing 56 Check Your Understanding In the equation GDP = C + I + G + NX, the G component refers to a. the purchases of final goods and services by all levels of government, excluding transfer payments. b. government expenditures plus all transfer payments. c. the taxes and expenditure of all levels of government. d. government expenditures on transfer payments, such as pensions and unemployment benefits. RMIT University School of Economics, Finance and Marketing 57 Issues in the Measurement of GDP: Shortcomings of GDP as a measure of total production GDP does not reflect total current production as production from the following sources are not reflected in its calculation: – Household production: Goods and services people produce for themselves. – The black economy: Buying and selling of goods and services that is concealed from the government to avoid taxes or regulations or because the goods and services are illegal. RMIT University School of Economics, Finance and Marketing 58 Does GDP measure what we want it to measure? Shortcomings of GDP as a measure of wellbeing: – The composition and distribution of GDP is not captured in GDP measures. – The value of leisure is not included in GDP. – The level, quality of and access to health care is not measured in GDP. – GDP does not accurately reflect improvements in the quality of products. – GDP is not adjusted for pollution or other negative effects of production. – GDP does not reveal anything about social problems that also impact on overall societal wellbeing. RMIT University School of Economics, Finance and Marketing 59 Nominal (Money/Current) GDP vs Real GDP • Inflation or deflation complicates the comparison of figures measuring GDP over time, because GDP is a price-timesquantity figure. • Nominal GDP could increase over time because of increased output, increased prices or both. • Suppose the economy had a money GDP of $1,000 in 2008, which results from the production of 1,000 apples that sell at a price of $1 per apple. Would it be better off in the year 2009 with a money GDP of $2,000? – What would be your conclusion if you found out that the $2,000 GDP resulted from the production and sale of 1,000 apples at a price of $2 per apple? RMIT University School of Economics, Finance and Marketing 60 Price and Quantities Year Price of apples 2006 $1 2007 2008 Year Qty. of apples Price of burgers Qty. of burgers 100 $2 50 $2 150 $3 100 $3 200 $4 150 Calculating GDP using current prices 2006 2007 2008 Year Calculating GDP using constant prices (base year 2006) 2006 2007 2008 RMIT University School of Economics, Finance and Marketing 61 Real GDP versus Nominal GDP Calculating Real GDP – Real GDP (RGDP): The value of final goods and services evaluated at base year prices. – Nominal GDP: The value of final goods and services valuated at current year prices. – Nominal GDP can change over time due to changes in either price or output. RGDP shows changes in output only. – GDP statisticians select a base year and use this over a specified period to measure RGDP in order to make meaningful comparisons of GDP over time. – A simple rule: RGDP equals base year prices times current year quantities. nominal GDP RGDP 100 price index RMIT University School of Economics, Finance and Marketing 62 Check Your Understanding Suppose that a very simple economy produces three goods: movies, burgers, and bikes. Suppose the quantities produced and their corresponding prices for 2004 and 2009 are shown in the following table: 2004 2009 Product Quantity Price Quantity Price Movies 20 $6 30 $7 Burgers 100 $2 90 $2.50 Bikes 3 $1000 6 $1100 The base year is 2004. What is nominal GDP in 2009? a. $7035 b. $3690 c. $6360 d. $3320 RMIT University School of Economics, Finance and Marketing 63 Check Your Understanding Given the following information, what can we say has happened in the economy from 2008 and 2009? Nominal GDP Real GDP 2008 $10 000 $9 500 2009 $12 000 $10 500 a. The price level has remained constant. b. The price level has risen. c. The price level has fallen. d. Not enough information is available to determine what has happened to prices. RMIT University School of Economics, Finance and Marketing 64 Calculating Economic Growth The Economic Growth Rate: the rate of change in real GDP from one year to another. Real GDP Current - Real GDP Previous Economic Growth x 100 Real GDP Previous RMIT University Slide 65 School of Economics, Finance and Marketing 65 Measuring Unemployment • Unemployment rate: percentage of the labour force that is unemployed. Number Unemployed Unemployme nt Rate 100 Labour Force • Labour-force Participation rate: percentage of the adult population in the labour force. Labour Force Labour - force Participation Rate 100 Adult Population • Labour force = No. of employed + No. of unemployed RMIT University School of Economics, Finance and Marketing 66 Types of Unemployment • Frictional Unemployment – Includes workers who are in the process of voluntarily switching jobs, workers who are temporarily laid off because of seasonality, and new entrants into the labour force. Largely due to imperfect information. • Structural Unemployment – Unemployment due to fundamental changes in the kinds of jobs that the economy offers. Workers may have inappropriate skills. • Cyclical unemployment – Due to a deficiency in aggregate demand for goods and services. RMIT University School of Economics, Finance and Marketing 67 Full Employment and the Natural Unemployment Rate • When cyclical unemployment is zero, there is full employment. • Full employment is therefore achieved when real GDP is equal to its long-run potential GDP. • At full employment, there will inevitably be some structural and frictional unemployment. • The unemployment rate at full employment is termed the natural rate of unemployment. • The natural rate of unemployment is not forever fixed and will vary as rates of frictional and structural unemployment change. RMIT University School of Economics, Finance and Marketing 68 Issues in the Measurement of Unemployment • Discouraged workers: individuals who have given up looking for work but would like to work. • Underemployment: All part-time workers are classified as employed. Yet many part-time employees may want to work full-time. (Underemployment may also apply to causal workers who work in excess of 1 hour per week and are counted as employed even though they might like to work more hours). • Truthfulness issues RMIT University School of Economics, Finance and Marketing 69 Inflation – Price level: a measure of the average prices of goods and services in the economy. – Inflation rate: The percentage increase in the price level from one year to the next. – Deflation: A decline in the general price level in the economy. PI year 2 PI year 1 100 Inflation Rate PI year 1 RMIT University School of Economics, Finance and Marketing 70 Measuring Inflation – Consumer Price Index (CPI): An average of the prices of the goods and services purchased by the typical urban family of 4 in an economy. – The Market Basket: the Department of Statistics identifies: –A typical or representative household. –The goods and services purchased by the household (this is the “market basket”). RMIT University School of Economics, Finance and Marketing 71 Consumer Price Index • The CPI is the most commonly known price index and is based on changes in the price of a given basket of consumption g&s. Fixed basket of 4 apples and 2 burgers Year Price of apples Price of burgers 2006 $1 $2 2007 $2 $3 2008 $3 $4 Year Cost of basket 2006 2007 2008 Year Consumer price index (2006 is the base year) 2006 2007 2008 RMIT University School of Economics, Finance and Marketing 72 Inflation Inflation rate calculated used the CPI: 2007: 2008: RMIT University School of Economics, Finance and Marketing 73 Check Your Understanding Suppose an economy has only three goods and the typical family purchases the amounts given in the following table. If 2000 is the base year, then what is the CPI for 2008? Product Hair cuts Backpacks Tacos a. b. c. d. Quantity 6 4 100 Price (2000) $50 $25 $1.00 Price(2008) $70 $30 $5.00 40.08 208 180 100 RMIT University School of Economics, Finance and Marketing 74 Check Your Understanding Suppose that the data in the following table reflects the prices in the economy. What is the inflation rate in between 2008 and 2009? Year 2008 2009 a. b. c. d. CPI (1990=100) 175 180 4.6% 7.5% 5% 2.9% RMIT University School of Economics, Finance and Marketing 75 Issues in the Measurement of Inflation – The CPI is the most widely used measure of inflation. – Is the CPI accurate? – Four sources of bias in the CPI may lead to its overstating the inflation rate. • Substitution bias • Increase in quality bias • New product bias • Outlet bias RMIT University School of Economics, Finance and Marketing 76 Check Your Understanding If consumers purchase fewer of those products that increase most in price and more of those products that decrease in price as compared to the CPI basket, then a. changes in the CPI understate the true rate of inflation. b. changes in the CPI are unrelated to the true rate of inflation. c. changes in the CPI accurately reflect the true rate of inflation. d. changes in the CPI overstate the true rate of inflation RMIT University School of Economics, Finance and Marketing 77 Other Measures of Inflation • The GDP Deflator: GDP also allows us to calculate changes in the price level over time. The GDP deflator is a measure of the price level calculated by dividing nominal GDP by real GDP and multiplying by 100. • The Producer Price Index (PPI): an average of the prices received by producers of goods and services at all stages of the production process. RMIT University School of Economics, Finance and Marketing 78 Using Price Indexes to Adjust for the Effects of Inflation • The purchasing power of the dollar falls over time as prices rise. • Price indexes, such as the CPI, allow us to adjust for the effects of inflation so we can compare dollar values over time. • For example; we can find the 2008 purchasing power equivalent of a $20,000 salary in 1980. We use the following formula: CPI in 1980 Value in 2008 dollars = Value in 1980 dollars CPI in 2008 189 =$ 20,000 $46,098 82 RMIT University School of Economics, Finance and Marketing 79 Hyperinflation • Extremely rapid increases in the general price level. • In periods of hyperinflation, money loses value so rapidly, that firms and households try to avoid holding it. • Hyperinflation is often associated with political instability and usually accompanied by recession. RMIT University School of Economics, Finance and Marketing 80 Real versus Nominal Interest Rates – Nominal interest rate: The stated interest rate on a loan. – Real interest rate: The nominal interest rate minus the inflation rate. – Deflation: A decline in the general price level in the economy. RMIT University School of Economics, Finance and Marketing 81 Check Your Understanding In the country of Hyrkania, the CPI in 2000 was 120 and the CPI in 2001 was 132. Jake, a resident of Hyrkania, borrowed money in 2000 and repaid the loan in 2001. If the nominal interest rate on the loan was 12 percent, what was the real interest rate? RMIT University School of Economics, Finance and Marketing 82 Review Your Understanding Which of the following is a TRUE statement about real and nominal GDP? a. If nominal GDP increases from one year to the next, we know that production of goods and services has risen. b. Increases in average prices do not affect the calculation of nominal GDP. c. If real GDP increases from one year to the next, we know that production of goods and services has risen. d. Nominal GDP is a better measure than real GDP in comparing changes in the production of goods and service year after year. RMIT University School of Economics, Finance and Marketing 83 Review Your Understanding Suppose that a very simple economy produces three goods: movies, burgers, and bikes. Suppose the quantities produced and their corresponding prices for 2004 and 2009 are shown in the following table: 2004 2009 Product Quantity Price Quantity Price Movies 20 $6 30 $7 Burgers 100 $2 90 $2.50 Bikes 3 $1000 6 $1100 What is real GDP in 2009, using 2004 as the base year? a. $3690 b. $7035 c. $6360 d. $3320 RMIT University School of Economics, Finance and Marketing 84 Review Your Understanding In 1995, the Consumer Price Index was 118.5. In 1996, it was 120.3, and in 1997, it was 120.0. Calculate the inflation rate in 1996 and 1997. RMIT University School of Economics, Finance and Marketing 85 Review Your Understanding Using the following table, fill in the missing cells: Nominal GDP GDP Deflator RGDP ($ billion) 1991 1992 1993 1994 361.1 391.4 441.7 632 RMIT University Growth Rate Inflation Rate 103.1 106.4 109.2 116.2 School of Economics, Finance and Marketing 86 Review Your Understanding Suppose dishwashers are part of the market basket used to compute the CPI. Suppose also that the quality of dishwashers improves while the price of dishwashers stays the same. If the Department of Statistics is able to precisely adjust the CPI for the improvement in quality, then, other things equal, should the CPI increase, decrease or remain unchanged? RMIT University School of Economics, Finance and Marketing 87 Review Your Understanding Andrew is offered a job in Adelaide, where the CPI is 80, and a job in Melbourne, where the CPI is 125. Andrew's job offer in Adelaide is for $42,000. How much does the Melbourne job have to pay in order for the two salaries to represent about the same purchasing power? RMIT University School of Economics, Finance and Marketing 88 MODULE 2: MARKETS THE PRICING MECHANISM THE PRODUCT MARKET THE LABOUR MARKET EXCHANGE RATE MARKET FINANCIAL MARKETS MONEY MARKET The Pricing Mechanism Where Prices Come From: The Interaction of Demand and Supply - Chapter 3 Learning Objectives: 1. 2. 3. 4. Understand the factors that influence the demand for goods and services. Understand the factors that influence the supply of goods and services. Explain how equilibrium in a market is reached and use a graph to illustrate equilibrium. Use demand and supply graphs to predict changes in prices and quantities. RMIT University School of Economics, Finance and Marketing 90 The Market for an Individual Good or Service • The market is one method of producing and rationing scarce goods and resources. • A market is when a group of buyers and sellers of a particular good or service interact. • Supply and Demand refer to the behaviour of individual householders (or consumers) and firms as they interact with one another in the market. • A competitive market is a market in which there are many buyers and sellers, so that each has a negligible impact on price. RMIT University School of Economics, Finance and Marketing 91 Individual’s Demand for a Good or Service • A demand schedule shows the various amounts of a product consumers are willing to purchase at each specific price point, ceteris paribus (all other things being equal). • The negative or inverse relationship between price and the quantity demanded is known as the Law of Demand. RMIT University School of Economics, Finance and Marketing 92 Check Your Understanding Demand shows the a. quantity of a good that buyers will buy at a given price. b. quantity of a good that sellers will sell at a given price. c. quantities of a good that sellers will sell at all possible prices. d. quantities of a good that buyers will buy at all possible prices. RMIT University School of Economics, Finance and Marketing 93 Market and Individual Demand When the price is $40, Kate will demand 6 CDs. Kate’s Demand When the price is $40, Paul will demand 4 CDs. The market demand at $40 will be 10 CDs. Paul’s Demand Market Demand Price of CD Price of CD Price of CD 40 40 40 20 20 20 6 12 Quantity of CDs When the price is $20, Kate will demand 12 CDs. 4 8 10 Quantity of CDs Quantity of CDs When the price is $20, Paul will demand 8 CDs. 20 The market demand at $20, will be 20 CDs. The market demand curve is the horizontal sum of the individual demand curves RMIT University School of Economics, Finance and Marketing 94 A Change in Demand versus a Change in the Quantity Demanded • A change in demand occurs if any determinant of demand (other than the price of the good or service itself) changes. This will shift the demand curve. –An increase in demand shifts the demand curve to the right and will result in a new equilibrium (↑P and ↑ Q). –A decrease in demand shifts the demand curve to the left and will result in a new equilibrium (↓P and ↓Q). • A change in the quantity demanded occurs if the price of the good or service itself changes. This is reflected by a movement along an existing demand curve. –An increase in price will lead to a decrease in the quantity demanded. –A decrease in price will lead to an increase in the quantity demanded. RMIT University School of Economics, Finance and Marketing 95 Check Your Understanding A change in demand represents a ________ while a change in quantity demanded is a ________. a. shift to a new demand curve; movement along one demand curve b. movement along one demand curve; movement along another demand curve c. movement along one demand curve; shift to a new demand curve d. shift to a new demand curve; shift to a another new demand curve RMIT University School of Economics, Finance and Marketing 96 Determinants of Demand (Factors that will Shift the Demand Curve) 1. Tastes or Preferences A change in tastes in favour of a product causes an increase in demand. 2. Population and Demographics An increase in the number of consumers in the market represents an increase in demand. 3. Income Normal goods: demand varies directly with income. An increase in income causes an increase in demand. Inferior goods: demand varies inversely with income. RMIT University School of Economics, Finance and Marketing 97 Determinants of Demand (cont.) 4. Prices of Related Goods Substitutes: A good that can be used in place of another good. A decrease in the price of a substitute good causes the demand for the other good to decrease. Complements: Goods that must be used jointly. A decrease in the price of one good causes the demand curve for the other good to shift to the right. 5. Expectations Consumer expectations of higher future prices may result in an increase in demand. RMIT University School of Economics, Finance and Marketing 98 Check Your Understanding If tyres and petrol are complements, then a. an increase in the price of tyres will increase the consumption of petrol. b. an increase in the price of petrol will increase the consumption of tyres. c. an increase in the price of petrol will reduce the consumption of tyres. d. tyres and petrol consumption are unrelated. RMIT University School of Economics, Finance and Marketing 99 Shifts and Movements RMIT University School of Economics, Finance and Marketing 100 Check Your Understanding What effect will each of the following have on the demand for NIKE running shoes? a. NIKE running shoes become more fashionable. b. The price of REBOCK running shoes, a popular substitute, goes down. c. Consumers anticipate that prices on all running shoes will fall next month. d. There is a rapid increase in the population due to increased immigration. RMIT University School of Economics, Finance and Marketing 101 Supply for a Good or Service • A supply schedule shows the various amounts of a product that producers are willing and able to produce at various prices, ceteris paribus (all other things being equal). • Positive or direct relationship between price and quantity supplied is known as the Law of Supply. RMIT University School of Economics, Finance and Marketing 102 Market and Individual Supply • Market supply refers to the sum of all individual supplies for all sellers of a particular good or service. • Graphically, individual supply curves are summed horizontally to obtain the market supply curve RMIT University School of Economics, Finance and Marketing 103 A Change in Supply versus a Change in the Quantity Supplied • A change in supply occurs if any determinant of supply (other than the price of the good or service itself) changes. This will shift the supply curve. –An increase in supply shifts the supply curve to the right and will result in a new equilibrium (↓P and ↑ Q). –A decrease in supply shifts the supply curve to the left and will result in a new equilibrium (↑P and ↓Q). • A change in the quantity supplied occurs if the price of the good or service itself changes. This is reflected by a movement along an existing supply curve. –An increase in price will lead to an increase in the quantity supplied. –A decrease in price will lead to a decrease in the quantity supplied. RMIT University School of Economics, Finance and Marketing 104 Determinants of Supply (Factors that will Shift the Supply Curve) 1. Resource prices: A decrease in price of inputs lowers production costs and increases supply. 2. Technology: Technological improvements lowers production costs and increases supply. 3. Prices of Substitutes in Production 4. Expected Future Prices 5. Number of sellers: The larger the number of suppliers, the greater is market supply. RMIT University School of Economics, Finance and Marketing 105 Shifts and Movements RMIT University School of Economics, Finance and Marketing 106 Market Equilibrium • The intersection of the supply curve and the demand curve for the product indicates the equilibrium price and quantity. • At the equilibrium price: quantity demanded = quantity supplied; • The intentions of both buyers and sellers coincide. • There is no incentive to alter the price. RMIT University School of Economics, Finance and Marketing 107 Check Your Understanding Which of the following describes what occurs at a market equilibrium? a. Everyone who wants to buy at the current price can do so. b. The market is cleared, there is no surplus and no shortage. c. Every seller who is willing to sell at the current price can do so. d. All these correctly describe what happens at a market equilibrium. RMIT University School of Economics, Finance and Marketing 108 Market Disequilibrium: Shortages & Surpluses • A surplus causes a competitive bidding down of price by suppliers. • A shortage causes a competitive bidding up of price by buyers. RMIT University School of Economics, Finance and Marketing 109 Market Clearing Price Price S S A A P0 P0 D0 Q0 RMIT University D0 Quantity Q0 School of Economics, Finance and Marketing Quantity 110 Check Your Understanding In the Figure above, if demand was to increase, then equilibrium a. price falls and quantity rises. b. price and quantity fall. c. price rises and quantity falls. d. price and quantity rise. RMIT University School of Economics, Finance and Marketing 111 Check Your Understanding What will happen to the equilibrium price and quantity of butter in each of the following cases? State whether demand or supply (or both) have shifted and in which direction. a. A rise in the price of margarine; b. A rise in the price of bread; c. A tax on butter production and an increased preference for butter over margarine. RMIT University School of Economics, Finance and Marketing 112 Review Your Understanding If the price of a product increases from $12 to $15, assuming all else remains constant, then the a. demand for the product will decrease. b. quantity demanded for the product will decrease c. demand for the product will increase. d. quantity demanded for the product will increase. RMIT University School of Economics, Finance and Marketing 113 Review Your Understanding The expectation of higher future prices actually causes higher prices now because a. quantity demanded will increase now. b. supply will increase now as firms try to sell before the price rises. c. demand will increase now as people try to buy before price rises. d. quantity supply will decrease now. RMIT University School of Economics, Finance and Marketing 114 Review Your Understanding Pens are normal goods. What will happen to the equilibrium price of pens if the price of pencils rises, consumers experience an increase in income, writing in ink becomes fashionable, people expect the price of pens to rise in the near future, the population increases, fewer firms manufacture pens, and the wages of pen-makers increase? a. Price will rise. b. Price will fall. c. Price will stay exactly the same. d. The price change will be ambiguous. RMIT University School of Economics, Finance and Marketing 115 Review Your Understanding Consider the housing market domestically and assume that due to tax incentives, building and development companies have dramatically increased the amount of new housing available in the country, causing a surplus in the market. Using market demand and supply illustrate the above situation. RMIT University School of Economics, Finance and Marketing 116 Review Your Understanding Using the market for beer, consider the following events and use the demand-supply model to illustrate the effects of each event on quantity and the price. Briefly state the determinant assumption being made for each event. a. Decrease in the price of yeast. b. The legal age for all alcohol consumption increases to 21 in the country. RMIT University School of Economics, Finance and Marketing 117 The Product Market Economic Growth, the Financial System and Business Cycles - Chapter 5 (pp. 117-124) Aggregate Expenditure and Output in the Short-Term Chapter 7 (pp. 174, 177-187) Aggregate Demand and Aggregate Supply Analysis - Chapter 8 (pp. 212-225) Learning Objectives: 1. 2. 3. 4. Understand what happens during business cycles and their relationship to long-run economic growth. Discuss the determinants of aggregate demand and distinguish between a movement along the aggregate demand curve and a shift of the AD curve. Discuss the determinants of the four components of aggregate expenditure and define the marginal propensity to consume and the marginal propensity to save. Discuss the determinants of aggregate supply, and distinguish between a movement along and a shift of the AS curve. RMIT University School of Economics, Finance and Marketing 118 The Business Cycle • The economy grows over time, but there are irregular fluctuations in its rate of growth from year to year. • The business cycle refers to the periodic but irregular ups and downs in the level of growth in economic activity over a period of time. Real GDP Peak Trough Time RMIT University School of Economics, Finance and Marketing 119 Economic Fluctuations • Irregular and unpredictable. • Most macroeconomic quantities fluctuate together. • Changes in the economy’s output of goods and services are strongly correlated with changes in the economy’s utilisation of its labour force. – Potential real GDP: The level of real GDP attained when all firms are producing at capacity. – Actual real GDP fluctuates around the long-run potential in the Business Cycle. RMIT University School of Economics, Finance and Marketing 120 Check Your Understanding During the expansion phase of the business cycle, a. employment decreases. b. income decreases. c. unemployment increases. d. production increases. RMIT University School of Economics, Finance and Marketing 121 Aggregate Demand • AD curve shows the amounts of goods and services (RGDP) that will be purchased at any given price level. • AD is the relationship between the price level and RGDP. • Overall price level of goods and services – An increase in the price level decreases the value of money because each dollar you have buys less. – When the price level increases how much we can buy with $1 decreases, in other words, the value of money decreases in terms of goods and services purchased. Price level AD = C+I+G+NX = AE RGDP RMIT University Slide 122 School of Economics, Finance and Marketing 122 Aggregate Demand Slopes Downwards Three key factors help explain the downward slope of the AD curve and hence the inverse relationship between the overall price level and the level of RGDP demanded. 1. Wealth Effect – 2. Changes in the price level, with other things remaining the same, change real wealth, thus changing the level of spending. Interest Rate Effect – 3. Higher prices requires more money for purchases. Higher interest rates discourages business investment and reduces consumption expenditure on consumer durables. International Trade Effect – Higher prices causes consumers to spend less on domestically produced goods and services (g&s) and more on imported g&s. RMIT University School of Economics, Finance and Marketing 123 Check Your Understanding Because of the slope of the aggregate demand curve we can say that a. a decrease in the price level leads to a higher level of aggregate spending. b. a decrease in the price level leads to a lower level of aggregate spending. c. a decrease in the price level leads to a higher level of aggregate supply. d. an increase in the price level leads to a higher level of aggregate spending. RMIT University School of Economics, Finance and Marketing 124 Components of AE - Shifts of AD • Changes in consumer spending – Expenditures by households on durable goods, non-durable consumer goods, and on services. • Changes in investment spending – the purchase of capital goods - plant and equipment, residential structures, and changes in inventory - that can be used in the production of other goods and services. • Changes in Government spending – Conduct of fiscal policy: changes in government purchases of goods and services and taxation. • Changes in Net Foreign spending – (Export - Imports) = Net Exports RMIT University School of Economics, Finance and Marketing 125 Consumption Spending If income is considered a primary determinant of consumption then: C S MPC C = CO + cY Y MPS Y C: Total consumption expenditure CO: Autonomous/exogenous consumption. Captures the effect of the non-income factors. MPC: Marginal propensity to consume. Extra consumption associated with an extra dollar of disposable income. MPS: Marginal propensity to save. Extra savings associated with an extra dollar of disposable income. •Based on the principal that Yd = C + S RMIT University School of Economics, Finance and Marketing 126 Check Your Understanding If consumption spending increases from $350 million to $358 million when income increases from $412 million to $432 million it can be concluded that the relevant marginal propensity to consume is: a. 0.2 b. 0.4 c. 0.6 d. 0.8 RMIT University School of Economics, Finance and Marketing 127 Check Your Understanding If the MPC is 0.95, then a $10 million increase in disposable income will a. increase consumption by $5 million. b. increase saving by $9.5 million. c. increase saving by $0.5 million. d. increase consumption by $950 million. RMIT University School of Economics, Finance and Marketing 128 Consumption Spending The level of consumption spending is influenced by: • Wealth • Level of consumer debt • Expectations – e.g. future incomes or prices • Availability and the cost of credit • Age distribution of the population RMIT University School of Economics, Finance and Marketing 129 Investment Spending The level of investment spending is influenced by: • Interest rate • Expectations and business sentiment • Acquisition, operating and maintenance costs • Business taxes • Technological change/innovation • Capital stock RMIT University School of Economics, Finance and Marketing 130 Government Spending The level of government expenditure is influenced by: • Discretionary Fiscal Policy: deliberate changes in government spending and tax revenue used to help stabilise the economy. • Expansionary fiscal policy involves: – Increases in government spending – Lowering of taxes – A combination of the two • Contractionary fiscal policy involves: – Decreases in government spending – Increasing of taxes – A combination of the two RMIT University School of Economics, Finance and Marketing 131 Net Foreign Spending The three most important variables that determine the level of net exports are: • The price level in Singapore relative to the price level in other countries. • The growth rate of GDP in Singapore relative to the growth rates of GDP in other countries. • The exchange rate between the Singaporean dollar and other countries currencies. RMIT University School of Economics, Finance and Marketing 132 Check Your Understanding If countries that imported goods and services from Singapore went into recession, what would be the impact on: a. domestic net exports b. the aggregate demand curve RMIT University School of Economics, Finance and Marketing 133 Aggregate Supply – The short-run aggregate supply curve (SRAS) shows the relationship in the short-run between the price level and the quantity of real GDP supplied by firms. Price level AS RGDP RMIT University School of Economics, Finance and Marketing 134 The Slope of the Short-run Aggregate Supply Slope (SRAS) The SRAS is upward sloping, showing that in the short-run firms will produce more in response to higher prices. The reason for this is that the price of inputs tends to rise more slowly than the price of final products due to wage and price rigidities. • Nominal Wages Rigidities – If the price level falls, real wages rise, production costs increase; firms hire less labour, thus producing a smaller output. • Price Rigidities – Not all firms adjust prices immediately in response to changes in the price level; affecting their competitiveness, sales and thus production. RMIT University School of Economics, Finance and Marketing 135 Short-Run Aggregate Supply The variables that shift the SRAS curve include: 1. Expected changes in the future price level. 2. Adjustments of workers and firms to errors in past expectations about the price level. 3. Unexpected changes in the price of an important natural resource. 4. Plus any factor that shifts the LRAS curve. Note: Factors 1-3 shift only the SRAS curve not the LRAS curve RMIT University School of Economics, Finance and Marketing 136 Long-Run Aggregate Supply (LRAS) – The long-run aggregate supply curve (LRAS) shows the relationship in the long-run between the price level and the quantity of real GDP supplied. – The long-run aggregate supply curve shows that in the long-run increases in the price level do not affect the level of RGDP. RMIT University School of Economics, Finance and Marketing 137 Factors that Shift the LRAS Curve – Shifts in the long-run aggregate supply curve occur because potential GDP increases over time. Anything that shifts the LRAS also shifts the SRAS. – Increases in GDP (or economic growth) which shift the LRAS are due to: 1. An increase in resources. 2. An increase in the capital stock. 3. New technology 4. Changes in government policy (Incentives to work and invest) RMIT University School of Economics, Finance and Marketing 138 Check Your Understanding The level of long run aggregate supply is NOT affected by a. changes in the price level. b. changes in the number size of the labour force. c. changes in the capital stock. d. changes in technology. RMIT University School of Economics, Finance and Marketing 139 Macroeconomic Equilibrium Price Level Price Level LRAS SRAS LRAS SRAS P0 AD Y0 P0 Price Level RGDP Yf LRAS SRAS AD Yf RGDP P0 AD Yf RMIT University School of Economics, Finance and Marketing Y0 RGDP 140 Check Your Understanding Suppose the economy is at full employment and firms become more optimistic about the future profitability of new investment. Which of the following will happen in the short run? a. Prices will decline. b. Unemployment will decline. c. Aggregate demand will shift to the left. d. Output will decline. RMIT University School of Economics, Finance and Marketing 141 Check Your Understanding What effects might each of the following have on aggregate demand and/or aggregate supply and which determinant has changed? a. A widespread fear of depression among consumers. b. A tax leading to a 2% increase in petrol prices. c. A decrease in interest rates. d. A decrease in government spending on higher education. e. The discovery of cheaper energy sources. RMIT University School of Economics, Finance and Marketing 142 Review Your Understanding The interest rate effect is described as an increase in the price level which a. lowers the interest rate thereby reducing government spending. b. lowers the interest rate thereby reducing investment and consumption spending. c. raises the interest rate thereby reducing government spending. d. raises the interest rate thereby reducing investment and consumption spending. RMIT University School of Economics, Finance and Marketing 143 Review Your Understanding The level of real GDP in the long run is called a. potential GDP. b. frictional GDP. c. low capacity GDP. d. short run GDP. RMIT University School of Economics, Finance and Marketing 144 Review Your Understanding In the Figure above, which of the points are possible long run equilibriums? a. A and B b. A and C c. A and D d. B and D RMIT University School of Economics, Finance and Marketing 145 Review Your Understanding Macroeconomic equilibrium always occurs when a. real GDP = potential GDP. b. aggregate income = national savings c. aggregate expenditure = C+ I + G + NX. d. none of the above RMIT University School of Economics, Finance and Marketing 146 Review Your Understanding If disposable income increases by $100 million, and consumption increases by $90 million, then the marginal propensity to consume is a. 0.6 b. 0.9 c. 0.75 d. 0.8 RMIT University School of Economics, Finance and Marketing 147 Review Your Understanding In the Figure above, given the economy is at point A in year 1 and point B in year 2, what is the growth rate in potential GDP between those two years? RMIT University School of Economics, Finance and Marketing 148 Review Your Understanding In each case, specify which of the four components of AE will be impacted, and how: a. Real interest rates increase. b. Two of Singapore’s major trading partners, experience high GDP growth relative to Singapore. c. The business sector becomes pessimistic about future profits. d. Most households believe their income prospects are positive for the foreseeable future. RMIT University School of Economics, Finance and Marketing 149 Review Your Understanding Imagine that the economy is in long-run equilibrium. Then, perhaps because of improved international relations and increased confidence in policy makers, people become more optimistic about the future and stay this way for some time. a. What would be the impact on the AD curve? b. In the short-run, how will this affect the price level and RGDP? c. As a result of the impact on the price level in (b) what happens to the expected price level and what’s the result for wage bargaining? d. How does the change in price expectations in (c) affect the product market? e. Illustrate the entire above scenario, highlighting the final longrun equilibrium RMIT University School of Economics, Finance and Marketing 150 The Labour Market Unemployment - Chapter 9 (pp.262-264) Learning Objectives: 1. 2. 3. 4. Explain what factors determine the unemployment rate. Explain labour market equilibrium and disequilibrium Explain the consequence of labour market disequilibrium Describe the changes that have occurred in the determination of wages and discuss the possible effects on unemployment. RMIT University School of Economics, Finance and Marketing 151 The Labour Market • Through the workings of the supply of labour and demand for labour, the levels of employment and the representative equilibrium wage rate is determined. • The labour market is a resource market meaning that firms are the demanders and householders are the suppliers in this market. • The labour market as presented, can be understood in terms of a representative model (in reality there are many distinct labour markets) Supply of labour: Quantity of labour provided by households at various wage rates. Demand for labour: Quantity of labour hired by firms at various wage rates. RMIT University School of Economics, Finance and Marketing 152 Real Wage Rate • Real wage = nominal wage/overall price level = w/p • Real wage is the amount of purchasing power that each worker receives and which the firm pays for each unit of labour. • The wage rate can be viewed as the opportunity cost of leisure. RMIT University School of Economics, Finance and Marketing 153 Labour Market Equilibrium In a perfectly competitive labour market, the wage rate and level of employment is determined by the intersection of the demand and supply curves. Real wage Real wage SL SL w0 p0 w0 p0 N0 RMIT University DL DL Labour Labour School of Economics, Finance and Marketing 154 Causes of Unemployment • When wages are set above their market-clearing level: – Minimum wage laws – Unions and collective bargaining: Prevent downward wage flexibility – Efficiency wages: Firms may make higher profits by paying above market-clearing wage rates (link between wages and worker effort, worker quality and company turnover) • Government Policies that influence the incentive to work: – Job network & unemployment benefits and unemployment insurance • Deficiency in Aggregate Demand – Cyclical unemployment RMIT University School of Economics, Finance and Marketing 155 Why did Henry Ford pay his workers twice as much as other car manufacturers? RMIT University School of Economics, Finance and Marketing 156 Check Your Understanding Mary Sue is the newly appointed CEO of a company that manufactures CD drives on an assembly line. Her staff has told her that the output the firm produces, given the number of workers employed, indicates that some workers may be shirking. According to efficiency wage theory, what should she do? a. Pay all workers more than the equilibrium wage rate b. Pay all workers below the equilibrium wage rate to make up for the loss from shirking c. Make sure that workers are getting paid exactly the equilibrium wage rate d. None of the above is correct according to efficiency wage theory. RMIT University School of Economics, Finance and Marketing 157 Check Your Understanding When a union bargains successfully with an employer, in that industry a. The unemployment and wages increase. b. Unemployment and wages decrease. c. Unemployment decreases and wages increase. d. Unemployment increases and wages decrease. RMIT University School of Economics, Finance and Marketing 158 Labour Market Regulation and Deregulation Advantages of deregulation: – Numerical and functional labour market flexibility: • Numerical flexibility: ease with which firms can vary the quantity of labour inputs. • Functional flexibility: ease with which the tasks performed by workers can be altered. Disadvantages of deregulation: – Relate primarily to equity, and in particular, the vulnerability of workers in weak bargaining positions. – Such workers are often low paid and low skilled. – Minimum wages may be used to ensure greater equity. RMIT University School of Economics, Finance and Marketing 159 Review Your Understanding Which of the following have a tendency to raise the unemployment rate? a. The establishment of effective trade unions in an economy b. Firms deciding to pay efficiency wages in an economy c. Implementing a minimum wage in an economy d. All of these are correct. RMIT University School of Economics, Finance and Marketing 160 Review Your Understanding Trade unions cause unemployment because the union contract wage is set a. above the market wage, causing a shortage of labour. b. below the market wage, causing a surplus of labour. c. below the market wage, causing a shortage of labour. d. above the market wage, causing a surplus of labour. RMIT University School of Economics, Finance and Marketing 161 Review Your Understanding What is the rationale behind the efficiency wage model? RMIT University School of Economics, Finance and Marketing 162 The Exchange Rate Market Macroeconomics in an Open Economy - Chapter 14 (pp. 404410) Learning Objectives: 1. Explain how exchange rates are determined. 2. The difference between the direct and indirect quotations of exchange rates. 3. How changes in exchange rates affect the prices of imports and exports. 4. The exchange rate market model. RMIT University School of Economics, Finance and Marketing 163 Nominal Exchange Rate • The rate at which one currency is exchanged for another. Direct: Singapore dollars required to purchase a unit of foreign currency: $SGD 1.46 SGD e 1.46 1 Foreign Currency 1USD RMIT University School of Economics, Finance and Marketing 164 Nominal Exchange Rate • Depreciation: the SGD is worth less in terms of another currency. i.e. is less valuable. So, it takes more SGD to purchase a unit of foreign currency. Exchange rate increases. • Appreciation: means the SGD is worth more in terms of another currency. So, it takes less SGD to purchase a unit of foreign currency. Exchange rate decreases. RMIT University School of Economics, Finance and Marketing 165 Check Your Understanding When the dollar weakens, each dollar buys a. more foreign currency, and so buys more foreign goods. b. more foreign currency, and so buys fewer foreign goods. c. less foreign currency, and so buys more foreign goods. d. less foreign currency, and so buys fewer foreign goods. RMIT University School of Economics, Finance and Marketing 166 Exchange Rate Market • Market forces in the form of supply and demand determine the level of the foreign exchange rate. e SFX DFX Quantity – SFX is derived from any transaction which involves a payment from nonresidents to residents. Converting foreign currency to domestic currency. – DFX is derived from any transaction which involves a payments from residents to non-residents. Converting domestic currency to foreign currency. RMIT University School of Economics, Finance and Marketing 167 Exchange Rate Market • Importing: • Exporting – Demand for FX. – Supply of FX. – Supply of SGD. – Demand for SGD. RMIT University School of Economics, Finance and Marketing 168 Changes in Net Exports Increased Exports Decreased Imports Exchange rate Exchange rate SAUD SAUD0 e0 e0 DAUD0 Q0 RMIT University Quantity School of Economics, Finance and Marketing DAUD Q0 Quantity 169 Shifts in demand and supply 1. Changes in demand for Singapore-produced goods and services and changes in the demand for foreignproduced goods and services. 2. Changes in the desire to invest in Singapore and changes in the desire to invest in foreign countries. 3. Changes in the expectations of currency traders about the likely future value of the dollar and the likely future value of foreign currencies. – Speculators: Currency traders who buy and sell foreign exchange in an attempt to profit by changes in exchange rates RMIT University School of Economics, Finance and Marketing 170 Check Your Understanding a. b. c. d. If domestically produced goods increased in price relative to foreign produced goods, exports would increase and imports would decrease resulting in an appreciation. exports would decrease and imports would increase resulting in an appreciation. exports would decrease and imports would increase resulting in a depreciation. exports would increase and imports would decrease resulting in a depreciation. RMIT University School of Economics, Finance and Marketing 171 Check Your Understanding A rise in domestic interest rates relative to interest rates in other countries may lead to a. an exchange rate depreciation and an increase in net exports. b. an exchange rate appreciation and a fall in net exports. c. an exchange rate depreciation and a fall in net exports. d. an exchange rate appreciation and an increase in net exports. RMIT University School of Economics, Finance and Marketing 172 Review Your Understanding Exchange rates are 120 yen per dollar, 0.8 euro per dollar, and 10 pesos per dollar. A bottle of beer in Singapore costs 6 dollars, 1,200 yen in Tokyo, 7.2 euro in Munich, and 50 pesos in Cancun. Where is the most expensive and the cheapest beer? RMIT University School of Economics, Finance and Marketing 173 Review Your Understanding Ceteris paribus, assume the exchange rate changes from 115 yen per dollar to 125 yen per dollar. Has the dollar appreciated or depreciated and what may be the impact for the consumption of Singaporean and Japanese goods. RMIT University School of Economics, Finance and Marketing 174 Review Your Understanding Singapore’s major trading partners experience a severe recession. Illustrate the impact on the exchange rate market and state whether the currency has appreciated or depreciated as a result. RMIT University School of Economics, Finance and Marketing 175 The Financial Market Economic Growth, the Financial System and Business Cycle Chapter 6 (pp. 125-133) Learning Objectives: 1. 2. 3. 4. Discuss the role of the financial system in facilitating economic growth. Understand the link between savings and investment and how these are facilitated by the financial system. To introduce the loanable funds model and understand the sources of demand and supply in this market. To understand the significance of the real long term rate of interest in driving investment decisions. RMIT University School of Economics, Finance and Marketing 176 Saving, Investment and the Financial System • The Financial system: The system of financial markets and financial intermediaries through which firms acquire funds from households. • Financial intermediaries include banks and non-bank financial institutions. • Financial markets include the share and bond markets. ― Shares: financial securities that represent partial ownership of a firm. ― Bonds: financial securities that represent promises to repay a fixed amount of funds. RMIT University School of Economics, Finance and Marketing 177 The Role of the Financial System – Financial intermediaries, such as banks, mutual funds, pension funds, and insurance companies, act as go-betweens for borrowers and lenders. – Financial markets enable firms to raise funds by selling financial securities (shares or bonds directly to savers). – As well as facilitating the channeling of funds from savers to borrowers the financial system provides three key additional services for savers and borrowers: 1. risk sharing, 2. liquidity, and 3. information. RMIT University School of Economics, Finance and Marketing 178 Loanable Funds Market Model – The demand for loanable funds is determined by the willingness of firms to borrow funds to engage in new investment projects. – The supply of loanable funds is determined by the willingness of households to save, and by the extent of government saving or dissaving (borrowing / budget deficit). – Equilibrium in the market for loanable funds determines the real interest rate and the quantity of loanable funds exchanged. RMIT University School of Economics, Finance and Marketing 179 Loanable Funds Market RMIT University School of Economics, Finance and Marketing 180 Explaining Movements in Savings, Investment and Interest Rates An increase in the demand for loanable funds RMIT University School of Economics, Finance and Marketing 181 Explaining Movements in Savings, Investment and Interest Rates The effect of a budget deficit on the market for loanable funds RMIT University School of Economics, Finance and Marketing 182 Ebenezer Scrooge: Accidental promoter of Economic growth? – Who was better for economic growth: Scrooge the saver or Scrooge the spender? RMIT University School of Economics, Finance and Marketing 183 Review Your Understanding Equilibrium in the loanable funds market determines a. the current interest rate b. the real interest rate c. the expected interest rate d. the nominal interest rate RMIT University School of Economics, Finance and Marketing 184 Review Your Understanding Some economists have suggested that interest on savings should be subject to a lower tax rate than is currently being paid. Use the market for loanable funds model to analyse the impact of a policy change of this nature on savings, investment, the interest rate and economic growth. Illustrate the impact on the loanable funds market. RMIT University School of Economics, Finance and Marketing 185 The Money Market Money, Banks and the Monetary Authority of Singapore Chapter 11 Learning Objectives: 1. 2. 3. 4. Define money and discuss its functions. Discuss the definition of the money supply used. Explain how financial institutions create money. Illustrate and discuss the money market. RMIT University School of Economics, Finance and Marketing 186 What is Money and Why do we Need it? – Money: Assets that people are willing to accept in exchange for goods and services or for payment of debts. – Asset: Anything of value owned by a person or firm. – Barter: exchange of goods or services for other goods or services. – Barter requires a double coincidence of wants. – Commodity money: A good used as money that also has value independent of its use as money. – Fiat money: Money such as paper currency that is authorised by the central bank and has no intrinsic value except in its function as money. RMIT University School of Economics, Finance and Marketing 187 Check Your Understanding Money is a. the income a person earns over a period of time. b. a person's assets net of liabilities at any point in time. c. a liability that people are willing to accept in exchange for goods and services. d. an asset that people are generally willing to accept in exchange for goods and services. RMIT University School of Economics, Finance and Marketing 188 Check Your Understanding The problem with barter economies is that they require a. that there be a double coincidence of wants. b. a banking system for trade to occur. c. that there be a single coincidence of wants. d. less time and trouble to trade as compared with a money economy. RMIT University School of Economics, Finance and Marketing 189 Money in a World War II prisoner of war camp. – During World War II cigarettes were used as money in some prisoner of war camps. RMIT University School of Economics, Finance and Marketing 190 Check Your Understanding In World War II, cigarettes were used as money in some prisoner of war camps. Given this, we would expect to see a. prices of other goods expressed in terms of cigarettes. b. people bartering instead of using cigarettes as money. c. only government-issued cigarettes being accepted as money. d. no one ever smoking cigarettes in the prisoner of war camps. RMIT University School of Economics, Finance and Marketing 191 What is Money and Why do we Need it? • • What can serve as money? What makes a good suitable to use as a medium of exchange? There are five criterion: 1. 2. 3. 4. 5. The good must be acceptable to most traders It should be a standardised quality It should be durable It should be valuable relative to its weight It should be divisible RMIT University School of Economics, Finance and Marketing 192 Functions of Money 1. Medium of exchange – Buying and selling goods and services – Money eliminates need for a coincidence of wants required for trade to occur in a barter economy. 2. Unit of account – Assist the measurement of the relative worth of various goods, services and resources. 3. Store of value – A form in which to store wealth due to its liquidity and convenience 4. Standard of deferred payment RMIT University School of Economics, Finance and Marketing 193 Check Your Understanding The statement 'a Dell laptop costs $2500' illustrates which function of money? a. Store of value b. Medium of exchange c. Standard of deferred payment d. Unit of account RMIT University School of Economics, Finance and Marketing 194 How do we Measure Money Today? • • • M1: The narrowest definition of the money supply which includes all the paper money and coins that are in circulation – meaning what is not held by the banks or the state and federal governments – plus the value of all demand deposits with banks. M3: M1, plus all other deposits with domestic and foreign owned banks operating in Singapore. Broad Money: M3, plus deposits into non-bank deposit-taking institutions less holdings of currency and deposits of non-bank depository corporations, such as finance companies, money market corporations and cash management trusts. RMIT University School of Economics, Finance and Marketing 195 Financial Institutions and the Creation of Money • Reserves: Deposits that a bank keeps as cash in its vault or on deposit with the Central Bank. • Reserve Ratio: A bank’s ratio of reserves to deposits. • Excess Reserves: Reserves above the normal ratio of reserves to deposits. • Financial institutions such as banks are able to create money through the simple deposit multiplier process. RMIT University School of Economics, Finance and Marketing 196 Check Your Understanding The portion of ________ that a bank does not loan out or spend on securities is known as ________. a. loans; reserves b. loans; securities c. deposits; reserves d. deposits; securities RMIT University School of Economics, Finance and Marketing 197 Banks and Money Creation • Assume the required reserve ratio is 10% and $1,000 is deposited into Bank A. Bank A Assets ($1,000) Liabilities ($1,000) Bank B Assets ($900) RMIT University School of Economics, Finance and Marketing Liabilities ($900) 198 Banks and Money Creation Bank C Assets ($810) Liabilities ($810) From the original deposit a new loan is created that result in further deposits into the financial system Bank A = $1,000 Bank B = $900 Bank C = $810 Bank D = $729 Bank…… Total change in demand account deposits = $10,000 RMIT University School of Economics, Finance and Marketing 199 Check Your Understanding If Thrifty Bank receives a $10 000 deposit, and keeps 10% of its deposits in reserve, how much will the bank loan out? a. $1000 b. $9000 c. $11 000 d. $10 000 RMIT University School of Economics, Finance and Marketing 200 The Simple Deposit Multiplier – The simple deposit/credit/money multiplier: The ratio of the amount of deposits created by banks to the amount of new reserves. 1 Simple deposit multiplier = RR – Change in deposits = initial deposit x multiplier ($1,000 x 10 = $10, 000) – Change in the money supply = change in demand account deposits – initial deposit ($10,000 - $1,000 = $9,000) RMIT University School of Economics, Finance and Marketing 201 Check Your Understanding If the reserve ratio is 0.05 then the simple deposit multiplier is a. 20 b. 10 c. 2 d. 5 RMIT University School of Economics, Finance and Marketing 202 Check Your Understanding a. b. c. d. Other things the same if reserve requirements are decreased, the reserve ratio? decreases, the money multiplier increases, and the money supply decreases increases, the money multiplier increases, and the money supply increases decreases, the money multiplier increases, and the money supply increases increases, the money multiplier increases, and the money supply decreases RMIT University School of Economics, Finance and Marketing 203 Check Your Understanding Suppose Colin deposits $3000 into ABC Bank. Assume ABC Bank has no excess reserves at the time of this deposit, and the bank’s reserve ratio is 0.20 a. Show the initial impact of Colin’s deposit on the bank’s balance sheet, and the maximum amount ABC Bank can now lend as a result of this deposit. b. What is the maximum increase in deposits that can result from Colin’s initial deposit? What is the increase in the money supply? RMIT University School of Economics, Finance and Marketing 204 Check Your Understanding Imagine that the banking system receives additional deposits of $100 million and that all the individual banks wish to retain their current liquidity ratio of 20 per cent. a. How much will banks choose to lend out initially? b. What will happen to banks' liabilities when the money that is lent out is spent and the recipients of it deposit it in their bank accounts? c. How much of these latest deposits will be lent out by the banks? d. By how much will the money supply eventually have risen, assuming that none of the additional liquidity is held outside the banking sector? e. What is the size of the bank multiplier? RMIT University School of Economics, Finance and Marketing 205 Money Supply • Notes and Coins; Bank deposits and Non-Bank Financial Institution deposits • Ms determined exogenously r Ms Quantity of Money RMIT University School of Economics, Finance and Marketing 206 The Money Market The Demand for Money RMIT University School of Economics, Finance and Marketing 207 Check Your Understanding The money demand curve is downward sloping because a. lower interest rates cause households and firms to switch from money to financial assets. b. lower interest rates cause households and firms to switch from financial assets to money. c. lower interest rates cause households and firms to switch from money to bonds. d. lower interest rates cause households and firms to switch from money to shares. RMIT University School of Economics, Finance and Marketing 208 The Money Market Shifts in the Money Demand Curve RMIT University School of Economics, Finance and Marketing 209 Money Market and Equilibrium r MS r0 MD Quantity of Money RMIT University School of Economics, Finance and Marketing 210 Check Your Understanding A decrease in real GDP can a. increase money demand and increase the interest rate. b. decrease money demand and increase the interest rate. c. decrease money demand and decrease the interest rate. d. increase money demand and decrease the interest rate. RMIT University School of Economics, Finance and Marketing 211 Check Your Understanding The money market model is concerned with ________ and the loanable funds market model is concerned with ________. a. short-term real interest rates; long term real interest rates b. short-term nominal interest rates; long term nominal interest rates c. short-term real interest rates; long term nominal interest rates d. short-term nominal interest rates; long term real interest rates RMIT University School of Economics, Finance and Marketing 212 Review Your Understanding When a grocery store accepts your $10 note in exchange for bread and milk, this illustrates that the $10 note is serving as a a. store of value. b. standard of deferred payment. c. unit of account. d. medium of exchange. RMIT University School of Economics, Finance and Marketing 213 Review Your Understanding Suppose you deposit $2000 into a bank that has a reserve ratio of 0.01. How does this affect the bank's balance sheet? a. Reserves rise by $200. b. Excess reserves rise by $1800. c. Required reserves rise by $2000. d. Deposits rise by $1000. RMIT University School of Economics, Finance and Marketing 214 Review Your Understanding Mia puts money into a piggy bank so she can spend it later. What function of money does this illustrate? School of Economics, Finance and Marketing 215 Review Your Understanding What will be the impact on the bank multiplier of a decision by the banks to hold a higher liquidity ratio? RMIT University School of Economics, Finance and Marketing 216 Review Your Understanding An increase in real GDP a. decreases the buying and selling of goods and decreases the demand for money as a medium of exchange. b. increases the buying and selling of goods and decreases the demand for money as a medium of exchange. c. increases the buying and selling of goods and increases the demand for money as a medium of exchange. d. decreases the buying and selling of goods and increases the demand for money as a medium of exchange. RMIT University School of Economics, Finance and Marketing 217 MID-SEMESTER TEST RMIT University School of Economics, Finance and Marketing 218 MODULE 3: INFLATION, UNEMPLOYMENT, GOVERNMENT POLICY, DEVELOPMENT AND GROWTH MONETARY POLICY FISCAL POLICY RECESSION, INFLATION & THE LONG-RUN DEVELOPMENT & GROWTH Monetary Policy Monetary Policy - Chapter 12 Learning Objectives: 1. Define monetary policy and describe the main goal of monetary policy. 2. Describe how the Central Bank affects interest rates. 3. Use aggregate demand and aggregate supply graphs to show the effects of monetary policy on real GDP and the price level. 4. Discuss the Central Bank’s use of monetary policy. 5. Discuss the role of the MAS. RMIT University School of Economics, Finance and Marketing 220 What Is Monetary Policy? – Monetary policy: The actions taken by the Central Bank of a nation to affect interest rates and/or exchange rates. – The main goals of Monetary policy in Singapore • Price Stability • Sustainable Economic Growth. RMIT University School of Economics, Finance and Marketing 221 Monetary Authority of Singapore (MAS) • Mission: promote sustained non-inflationary economic growth, and a sound and progressive financial centre. • Main functions: – – – – – Conduct of monetary and exchange rate policy Banker and financial agent of the Government Banker to financial institutions Regulation and supervision of the financial sector Promotion and development of the financial sector RMIT University School of Economics, Finance and Marketing 222 Monetary Authority of Singapore (MAS) • “Central banks in most developed economies usually describe their aims in terms of the pursuit of non-inflationary growth. • Today, there’s a consensus that price stability should be the overriding objective of monetary policy. • In 1981, MAS moved to an exchange rate centred monetary policy”. RMIT University School of Economics, Finance and Marketing 223 External Balance • When there is an increase in the demand for Singapore dollars and the market exchange rate strengthens and the exchange rate moves to the lower end of the established band, the MAS sells Singapore dollars to banks and/or buys government securities from banks. • The money base (supply) will increase, pushing down Singapore dollar interest rates. Lower domestic interest rates relative to foreign interest rates restrain capital inflows into the nation, encouraging outflows. • Supply of foreign currency (FX) decreases and demand for foreign currency increases, weakening the currency to restore stability. RMIT University School of Economics, Finance and Marketing 224 External Balance p AS Sell S$ Increase in the money supply Lower domestic interest rates p0 AD0 Y0 RGDP Exchange rate SFX0 e0 DFX0 Quantity RMIT University School of Economics, Finance and Marketing 225 External Balance • When there is a decrease in the demand for Singapore dollars and the currency weakens; the exchange rate moves to the upper end of the established band, the MAS purchases Singapore dollars from banks and/or sells government securities to banks. • The money base (supply) will decrease, pushing up Singapore dollar interest rates. Higher domestic interest rates relative to foreign interest rates induce capital inflows into the nation and reduce outflows. • Supply of foreign currency (FX) increases and demand for foreign currency decreases, strengthening the currency and restoring stability. RMIT University School of Economics, Finance and Marketing 226 External Balance p AS p0 Buy S$ Decrease in the money supply Increase domestic interest rates AD0 Y0 RGDP Exchange rate SFX0 e0 DFX0 Quantity RMIT University School of Economics, Finance and Marketing 227 Internal Balance • Goal: Maintain the inflation rate within a particular band. • Sale and purchase of government securities changes bank reserves and thus their ability to extend credit, thus changing the money supply and the interest rate. • The Monetary Authority targets interest rates by affecting system liquidity. • Monetary policy influences the size of bank reserves. This influences: – The size of the money supply. – The interest rate and the availability of credit. – Investment spending, interest-sensitive consumption spending thus output, employment and the price level. RMIT University School of Economics, Finance and Marketing 228 Open Market Operations • Monetary Authority actions designed to change interest rates by changing system liquidity to change the cost of credit and thus economic activity and the price level. • Easy Money: Authority announces its decision to reduce interest rates – it buys government securities to maintain the lower interest rates; expanding the money supply and reducing the cost of credit. • Tight Money: Authority announces its decision to increase interest rates – it sells government securities to maintain the higher interest rates; reducing the money supply and increasing the cost of credit. RMIT University School of Economics, Finance and Marketing 229 Internal Balance – Contractionary Policy Decrease in the money supply Increase domestic interest rates Exchange rate SFX0 e0 p AS DFX0 p0 Q0 Quantity AD0 Y0 RMIT University RGDP School of Economics, Finance and Marketing 230 Internal Balance – Expansionary Policy Increase in the money supply Lower domestic interest rates SFX0 Exchange rate e0 p DFX0 AS Q0 Quantity p0 AD0 Y0 RMIT University RGDP School of Economics, Finance and Marketing 231 Check Your Understanding If the interest rate is below the Central Bank's target, the Central Bank would: a. buy bonds to increase the money supply. b. buy bonds to decrease the money supply. c. sell bonds to increase the money supply. d. sell bonds to decrease the money supply. RMIT University School of Economics, Finance and Marketing 232 Check Your Understanding If the Central Bank pursues expansionary monetary policy then interest rates will a. fall and GDP will fall. b. rise and GDP will rise. c. fall and GDP will rise. d. rise and GDP will fall. RMIT University School of Economics, Finance and Marketing 233 Equilibrium in the Money Market – With interest rate targeting, the money supply curve is a horizontal line at the Central Bank’s target interest rate. RMIT University School of Economics, Finance and Marketing 234 Monetary Policy Effectiveness • Responsiveness of capital flows, consumption and investment to changes to changes in interest rates. • Phase of the business cycle • Private decisions of lenders and borrowers. • Size of the expenditure multiplier RMIT University School of Economics, Finance and Marketing 235 Check Your Understanding Suppose you are the monetary policy adviser for the government. The economy is experiencing a large and prolonged inflationary trend. What change in open market operations would you recommend? RMIT University School of Economics, Finance and Marketing 236 Check Your Understanding If the MAS buys bonds and securities in the open market, this is likely to lead to a. a rise in interest rates and a depreciation of the Singaporean dollar. b. a fall in interest rates and a depreciation of the Singaporean dollar. c. a fall in interest rates and an appreciation of the Singaporean dollar. d. a rise in interest rates and an appreciation of the Singaporean dollar. RMIT University School of Economics, Finance and Marketing 237 Why Does The Share Market Care about Monetary Policy? – The share market reacts when the Central Bank implements policy to either raise or lower interest rates. RMIT University School of Economics, Finance and Marketing 238 Review Your Understanding Explain the process by which an easy money policy affects equilibrium output and employment. RMIT University School of Economics, Finance and Marketing 239 Review Your Understanding How may the business cycle impact on the effectiveness of monetary policy? RMIT University School of Economics, Finance and Marketing 240 Review Your Understanding If the stock market crashes and aggregate demand decreases, what can the Central Bank do to offset this decrease in aggregate demand? RMIT University School of Economics, Finance and Marketing 241 Review Your Understanding a. If the Central Bank sells financial instruments in the open market, what may happen to net exports – analyse the impact via the product market. b. If the Central Bank sells financial instruments in the open market, what may happen to net exports – analyse the impact via the exchange rate market. RMIT University School of Economics, Finance and Marketing 242 Fiscal Policy Aggregate Expenditure and Output in the Short Run - Chapter 7 (pp. 195-200) Fiscal Policy - Chapter 13 Learning Objectives: 1. Define the multiplier effect and use it to calculate changes in equilibrium GDP. 2. Define fiscal policy. 3. Explain how fiscal policy affects AD and how the government can use fiscal policy to stabilise the economy. 4. Explain how the multiplier process works with respect to fiscal policy. 5. Discuss the difficulties that can arise in implementing fiscal policy. 6. Explain how the federal budget can serve as an automatic stabiliser. 7. Discuss the long-run supply side effects of fiscal policy. RMIT University School of Economics, Finance and Marketing 243 Fiscal Policy • Fiscal Policy: Changes in federal taxes and purchases that are intended to achieve macroeconomic policy objectives, such as full employment, price stability, and healthy sustainable rates of economic growth. RMIT University School of Economics, Finance and Marketing 244 Rules (Automatic Approach) versus Discretionary Action There are two key approaches to fiscal policy; following rules implied by automatic stabilisers or else implementing a discretionary fiscal policy. – Automatic stabilisers: Government spending and taxes that automatically increase or decrease along with the business cycle. –Discretionary fiscal policy: when the government is taking actions to change spending or taxes to achieve its objectives. RMIT University School of Economics, Finance and Marketing 245 Check Your Understanding Discretionary fiscal policy is when a. existing taxation policy automatically smoothes out business cycle fluctuations in the economy. b. politicians are discrete about policy changes, and do not advise consumers or producers of new policies. c. policy is left to the discretion of the MAS. d. the government changes the levels of expenditure or taxation. RMIT University School of Economics, Finance and Marketing 246 Using Fiscal Policy to Influence Aggregate Demand Expansionary fiscal policy – Increasing government expenditure, or decreasing taxes, or both. The goal is to shift aggregate demand to the right. –Appropriate when the economy is in a below full-employment equilibrium. Contractionary fiscal policy –Decreasing government expenditure, or increasing taxes, or both. The goal is to shift aggregate demand to the left. –Appropriate when the economy is at an above fullemployment equilibrium. RMIT University School of Economics, Finance and Marketing 247 Check Your Understanding Fiscal policy refers to the a. government's ability to regulate the functioning of financial markets. b. spending and taxing policies used by the government to influence the level of economy activity. c. techniques used by firms to reduce its tax liability. d. the policy by the MAS to affect the cash rate. RMIT University School of Economics, Finance and Marketing 248 The Government Purchases (Expenditure) and Tax Multipliers – The multiplier effect: The series of induced increases in consumption spending that results from an initial increase in autonomous expenditures. The process by which an increase in autonomous expenditure leads to a larger increase in real GDP. – Autonomous expenditure: Expenditure that does not depend on GDP. – Multiplier: The increase in equilibrium real GDP divided by the increase in autonomous expenditure. RMIT University School of Economics, Finance and Marketing 249 The Government Purchases or Expenditure Multiplier in Action Figure 14.6 The multiplier effect and aggregate demand – An initial increase in autonomous government spending, such as building new railway lines, will increase aggregate demand by an amount that is more than the initial amount of new spending. RMIT University School of Economics, Finance and Marketing 250 Check Your Understanding The government decides to fund the building of a new bridge. The owner of the company that builds the bridge pays her workers. The workers increase their spending. Firms that the workers buy goods from increase their output. This type of effect on spending illustrates a. the multiplier effect. b. the crowding-out effect. c. None of the above is correct. d. the Fisher effect. RMIT University School of Economics, Finance and Marketing 251 The Multiplier Effect Change in equilibrium real GDP Expenditur e Multiplier Change in autonomous expenditur e 1 Expenditur e Multiplier 1 - MPC – – – – The multiplier effect occurs both when autonomous expenditure increases and when it decreases. The multiplier effect makes the economy more sensitive to changes in autonomous expenditure than it would otherwise be. The larger the MPC, the larger the value of the multiplier. Our formula for the multiplier is very simplified, but nevertheless serves to illustrate the process. RMIT University School of Economics, Finance and Marketing 252 The Government Purchases (Expenditure) and Tax Multipliers Change in equilibriu m real GDP Government Purchases Multiplier Change in government purchases 1 1 k e or 1 MPC MPS Change in equilibrium real GDP Tax Multiplier Change in taxes MPC kT MPS Y ke G RMIT University Y kT T School of Economics, Finance and Marketing 253 Check Your Understanding Suppose the MPC is .75. If the government increases expenditures by $200 billion how far does the economy grow? If the government decreases taxes by $200 billion how far does the economy grow? RMIT University School of Economics, Finance and Marketing 254 Check Your Understanding The tax multiplier a. is negative b. only works when taxes are cut c. is larger in absolute value as compared to the d. is less than one RMIT University School of Economics, Finance and Marketing 255 Check Your Understanding Assume the consumption function for a closed economy is C=50+0.8Y and that investment is equal to $30bn. a. Calculate the equilibrium level of income/output for this economy. b. Calculate what will happen to equilibrium income and output if the government undertakes expansionary policy of $15bn. RMIT University School of Economics, Finance and Marketing 256 Multiplier Effectiveness Fixed Price Variable Price Price Level AS P AD2 AD Y RMIT University Y Quantity of Output School of Economics, Finance and Marketing 257 Crowding Out Effect Price Level P1 AS A AD Y1 RMIT University RGDP School of Economics, Finance and Marketing 258 Check Your Understanding If crowding out occurs, an increase in government spending a. decreases the interest rate and consumption and investment spending rise. b. decreases the interest rate and consumption and investment spending decline. c. increases the interest rate and consumption and investment spending rise. d. increases the interest rate and consumption and investment spending decline. RMIT University School of Economics, Finance and Marketing 259 Goals of Fiscal Policy Recessionary Gap Price Level Inflationary Gap Price Level LRAS LRAS SRAS SRAS P2 P1 AD GDP Gap Y Yf AD Quantity of Output Recessionary Gap = GDP Gap ke RMIT University GDP Gap Yf Y Quantity of Output Inflationary Gap = GDP Gap ke School of Economics, Finance and Marketing 260 Putting Everything Together Y k e G GDP Gap k e G GDP Gap G ke GDP Gap Recessiona ry Gap ke GDP Gap Inflationa ry Gap ke RMIT University School of Economics, Finance and Marketing 261 Check Your Understanding If the MPS is 0.25 and the economy has a recessionary gap of $5 billion, what is the size of the GDP Gap? RMIT University School of Economics, Finance and Marketing 262 Successful Fiscal Policy Real GDP Time RMIT University School of Economics, Finance and Marketing 263 Case Against Intervention • FiscalLags • Recognition • Administrative/Legislative • Operational/Implementation – Expansionary bias leading to a Political business cycle RMIT University School of Economics, Finance and Marketing 264 Deficits, Surpluses and Government Debt – Budget deficit: The situation in which the government’s spending is greater than its tax revenue. – Budget surplus: The situation in which the government’s expenditures are less than its tax revenue. – The budget can serve as an automatic stabiliser. • Federal government deficits increase automatically during recessions because: 1. Tax revenues fall. 2. Unemployment benefits increase. • Federal government deficits decrease or surpluses increase automatically during expansions because: 1. Tax revenues increase. 2. Unemployment benefit payments decrease. RMIT University School of Economics, Finance and Marketing 265 Check Your Understanding Which of the following is an automatic stabiliser? a. Reductions in nominal wages as inflation rates rise b. Unemployment benefit payments to the unemployed c. Interest rate changes d. Increases in government spending on schools RMIT University School of Economics, Finance and Marketing 266 Check Your Understanding To counteract the effect of automatic stabilisers during a recession and keep the budget balanced, the federal government must ________ government spending, or ________ taxes, and which will ________ aggregate demand. a. decrease; increase; reduce b. increase; decrease; increase c. increase; increase; reduce d. decrease; decrease; increase RMIT University School of Economics, Finance and Marketing 267 Deficits, Surpluses and Government Debt – Should the federal budget always be balanced? – Is government debt a problem? – These questions are related and the answer is not always clear-cut. – Economists examine the debt, and the interest on the debt in proportionate terms to determine if it is a problem. RMIT University School of Economics, Finance and Marketing 268 The Effects of Fiscal Policy in the LongRun Supply side policies: –Fiscal policies that have long-run effects by expanding the productive capacity of the economy and increasing the rate of economic growth. –These policy actions primarily affect aggregate supply, by shifting the long-run aggregate supply curve to the right. RMIT University School of Economics, Finance and Marketing 269 The Effects of Fiscal Policy in the LongRun RMIT University School of Economics, Finance and Marketing 270 The Effects of Fiscal Policy in the LongRun The long-run effects of tax policy: – We can look at the effect on aggregate supply of each of the following taxes: 1. Individual income tax 2. Company income tax 3. Taxes on capital gains RMIT University School of Economics, Finance and Marketing 271 The Effects of Fiscal Policy in the LongRun Tax simplification: – There are also potential gains to be derived from simplifying the tax law. – Resources diverted to tax compliance and tax minimisation can be put to more productive use. – Tax simplification may improve the efficiency of firm and household decision making. RMIT University School of Economics, Finance and Marketing 272 Long Run Implications of Supply Side Policies Supply side policies can increase long run aggregate supply, thereby reducing the upward pressure on prices following an increase in aggregate demand RMIT University School of Economics, Finance and Marketing 273 Review Your Understanding Expansionary fiscal policy ________ the price level and ________ equilibrium real GDP. a. increases; increases b. increases; decreases c. decreases; decreases d. decreases; increases RMIT University School of Economics, Finance and Marketing 274 Review Your Understanding To try to combat inflation, the government could a. conduct expansionary fiscal policy. b. lower interest rates. c. decrease taxes. d. decrease government spending. RMIT University School of Economics, Finance and Marketing 275 Review Your Understanding If crowding out occurs, an increase in government spending a. decreases the interest rate and consumption and investment spending rise. b. decreases the interest rate and consumption and investment spending decline. c. increases the interest rate and consumption and investment spending rise. d. increases the interest rate and consumption and investment spending decline. RMIT University School of Economics, Finance and Marketing 276 Review Your Understanding Refer to the figure above. If the economy moves from A to B, which of the following would be the appropriate fiscal policy to achieve potential GDP? a. Increase taxes b. Decrease interest rates c. Contractionary fiscal policy d. Increase government spending RMIT University School of Economics, Finance and Marketing 277 Review Your Understanding Increases in government spending will lower the long term growth rate of GDP, if it lowers ________ spending and the government purchases ________ and not ________ goods. a. net export spending; investment; consumption b. investment; consumption; investment c. net export spending; consumption; investment d. consumption; investment; consumption RMIT University School of Economics, Finance and Marketing 278 Review Your Understanding Use the information in the table to answer the questions. a. At what level of RGDP does the market clear? b. What is the MPC? c. Suppose government purchases increase by $500 billion. What will be the new equilibrium level of real GDP? Use the multiplier formula to determine your answer. RMIT University School of Economics, Finance and Marketing 279 Review Your Understanding Given the above data what actions might the government take to move the economy to the fullemployment level of output? RMIT University School of Economics, Finance and Marketing 280 Recession, Inflation and the Long-Run Aggregate Demand and Aggregate Supply Analysis - Chapter 8 (pp. 226-234) Unemployment - Chapter 9 (pp. 256-257) Inflation - Chapter 10 (pp. 280-287) Learning Objectives: 1. Use the aggregate demand and aggregate supply model to illustrate the difference between short-run and long-run equilibrium. 2. Use the dynamic aggregate demand and aggregate supply model to analyse macroeconomic conditions. 3. Understand the difference between demand-pull and cost-push inflation. 4. Explain the quantity theory of money and use it to explain how high rates of inflation can occur. RMIT University School of Economics, Finance and Marketing 281 Macroeconomic Equilibrium in the Long Run and the Short Run The short-run and the long-run effects of a decrease in aggregate demand RMIT University School of Economics, Finance and Marketing 282 The Costs of Unemployment Costs to the economy as a whole: – – – – Loss of gross domestic product. Loss of human capital. Net drain on the budget. The opportunity cost of funds directed towards welfare payments. Costs to the unemployed: – – – – Loss of income. Loss of skills. Loss of self esteem. Unemployment may contribute to family break-ups, health problems, mental illness, crime and political unrest. RMIT University School of Economics, Finance and Marketing 283 Costs of Inflation • In general, wages rise with inflation. Inflation can, however, affect the distribution of income. The extent of redistribution depends partly on the degree to which inflation was anticipated or unanticipated. • The problem with anticipated inflation: – Menu costs – the costs to firms of changing prices. – Risk – particularly for contracts with a ‘time’ element • The problem with unanticipated inflation: – There are winners and losers, depending on whether inflation is higher or lower than anticipated. – For example: those on fixed incomes, such as aged pensions, will lose if inflation is higher than anticipated. – Borrowers may gain and lenders lose when inflation is higher than anticipated. RMIT University School of Economics, Finance and Marketing 284 Causes of Inflation • Monetary growth greater than growth in RGDP • Demand-pull inflation ― Increases in AD • Cost-push inflation ― Supply Shocks ―Stagflation: a combination of inflation and recession, usually resulting from a supply shock. RMIT University School of Economics, Finance and Marketing 285 The Quantity Theory of Money – Connecting money and prices: The equation of exchange. The connection between money and prices is expressed in the following equation. MxV PxY – Velocity of money: The average number of times each dollar in the money supply is used to purchase goods and services included in GDP. PxY V M RMIT University School of Economics, Finance and Marketing 286 Check Your Understanding a. b. c. d. According to the assumptions of quantity theory, if the money supply increases 5% then at full employment nominal and real GDP would rise by 5%. nominal GDP would rise by 5%; real GDP would be unchanged. nominal GDP would be unchanged; real GDP would rise by 5%. neither nominal GDP nor real GDP would change. RMIT University School of Economics, Finance and Marketing 287 The Quantity Theory of Inflation – The quantity equation is transformed to: Growth rate of money supply + growth rate of velocity = growth rate of the price level + growth rate of real output – Which we can rearrange as: Inflation rate = growth rate of money supply + growth rate of velocity - growth rate of real output – If Irving Fisher is correct and velocity is constant, then the growth rate of velocity is zero, so we can rewrite the equation as: Inflation rate = growth rate of the money supply – growth rate of real output RMIT University School of Economics, Finance and Marketing 288 Check Your Understanding a. b. c. d. According to the quantity theory of money, inflation is caused by GDP growing faster than the money supply. GDP growing at the same rate as the money supply. the money supply growing faster than GDP. the money supply growing slower than GDP. RMIT University School of Economics, Finance and Marketing 289 Check Your Understanding Suppose the money supply is currently growing at 4 % per year, while real GDP is growing at 2%, calculate the inflation rate assuming Irving Fisher is correct in his assumption regarding the velocity of money. RMIT University School of Economics, Finance and Marketing 290 Macroeconomic Equilibrium in the Long Run and the Short Run The short-run and long-run effects of an increase in aggregate demand - Demand-pull inflation and a price-wage spiral RMIT University School of Economics, Finance and Marketing 291 Check Your Understanding a. b. c. d. An increase in aggregate demand causes an increase in ________ only in the short run, but causes an increase in ________ in both the short run and the long run. the price level; real GDP real GDP; real GDP real GDP; the price level the price level; the price level RMIT University School of Economics, Finance and Marketing 292 A Dynamic AD and AS Model – We can create a dynamic aggregate demand and aggregate supply model by making three changes to the basic model: 1. Potential real GDP increases continually, shifting the long-run aggregate supply curve to the right. 2. During most years the aggregate demand curve will be shifting to the right. 3. Except during periods when workers and firms expect high rates of inflation, the short-run aggregate supply curve will be shifting to the right. RMIT University School of Economics, Finance and Marketing 293 A Dynamic AD and AS Model RMIT University School of Economics, Finance and Marketing 294 Check Your Understanding The simple static aggregate demand and aggregate supply model assumes a. potential real GDP increases continuously. b. the economy experiences continuing inflation. c. the economy's aggregate demand curve shifts to the right in most periods. d. the economy does not experience long run growth. RMIT University School of Economics, Finance and Marketing 295 Macroeconomic Equilibrium in the Long Run and the Short Run The short-run and long-run effects of a supply shock - Cost-push inflation RMIT University School of Economics, Finance and Marketing 296 Check Your Understanding a. b. c. d. Which of the following is considered a supply shock? The increasing investment in the economy causing the capital stock to rise A decline in wages An improvement in technology An unexpected large increase in the price of natural gas RMIT University School of Economics, Finance and Marketing 297 Supply Shocks and Policy Choices Policy Options: 1. Do nothing 2. Do something a.↓AD ↓INF but further ↑UNE b.↑AD ↓UNE but further ↑INF Price Level SRAS0 A P0 AD Y0 RMIT University School of Economics, Finance and Marketing RGDP 298 Fighting Inflation – Reducing AD Price Level LRAS SRAS0 A P0 AD0 Yf RMIT University School of Economics, Finance and Marketing RGDP 299 Check Your Understanding a. b. c. d. Why might the short run aggregate supply curve shift to the right in the long run, following a decrease in aggregate demand? Workers and firms adjust their expectations of wages and prices downward and they push for higher wages and prices. Workers and firms adjust their expectations of wages and prices upward and they accept lower wages and prices. Workers and firms adjust their expectations of wages and prices upward and they push for higher wages and prices. Workers and firms adjust their expectations of wages and prices downward and they accept lower wages and prices. RMIT University School of Economics, Finance and Marketing 300 Review Your Understanding The level of real GDP in the long run is called a. potential GDP. b. frictional GDP. c. low capacity GDP. d. short run GDP. RMIT University School of Economics, Finance and Marketing 301 Review Your Understanding Because of a supply shock, in the short run a. the aggregate supply curve shifts to the left. b. equilibrium real GDP rises. c. unemployment falls. d. the price level falls. RMIT University School of Economics, Finance and Marketing 302 Review Your Understanding Which of the following is NOT an assumption made by the dynamic model of aggregate demand and aggregate supply? a. Aggregate demand shifts to the right during most periods. b. Aggregate supply shifts to the right except during periods when workers and firms expect higher wages. c. Aggregate demand and potential real GDP decrease continuously. d. Potential real GDP increases continuously. RMIT University School of Economics, Finance and Marketing 303 Review Your Understanding Which of the following can cause cost-push inflation if the economy is currently in equilibrium at fullemployment GDP? a. A decrease in personal income tax rates, which increases after tax income b. A flood which destroyed much of the country's crops c. An increase in the size of the labour force d. An increase in the capital stock in the country RMIT University School of Economics, Finance and Marketing 304 Review Your Understanding If a supply shock occurs in the economy, what is the likely impact for inflation and unemployment? RMIT University School of Economics, Finance and Marketing 305 Review Your Understanding What are the policy options available to the government to combat a supply shock and what are the costs of each policy option? RMIT University School of Economics, Finance and Marketing 306 Review Your Understanding Illustrate and explain the implications for the inflation/unemployment trade-off if we persist in undertaking expansionary policy in an attempt to reduce the unemployment rate below the natural rate of unemployment. RMIT University School of Economics, Finance and Marketing 307 Economic Development and Growth Economic Growth, the Financial System and Business Cycles - Chapter 5 (pp. 110-117) Long-Run Economic Growth: Sources and Policies Chapter 6 Learning Objectives: 1. Explain the basic idea of how a market system works. 2. Understand why property rights are necessary for a well-functioning economy. 3. Discuss the importance of economic growth and its impact on living standards. 4. Describe the trends in economic growth in the world. 5. Use the economic growth model to explain why economic growth rates differ between countries. 6. Discuss why many poor countries have not experienced rapid economic growth. RMIT University School of Economics, Finance and Marketing 308 Long-Run Economic Growth is the Key to Rising Living Standards – Long-run economic growth: The process by which rising productivity increases the average standard of living. – Real GDP per capita is used to measure changing living standards over time. Real GDP Real GDP per capita = population RMIT University School of Economics, Finance and Marketing 309 Calculating Economic Growth Rates Recall: economic growth is calculated using the following equation: Real GDP Current - Real GDP Previous Economic Growth x 100 Real GDP Previous – For longer periods we look at ‘average annual growth rates’. Note: the long-term could be 50 or 100 years or more. – An approximation of average annual growth for shorter periods is a simple average. 3.1% + 2.4% + 3.2% = 2.9% 3 RMIT University School of Economics, Finance and Marketing 310 Check Your Understanding Use the table below to answer the following questions: – Calculate the growth rate of real GDP for each year from 2004 – 2007. – Calculate the average annual growth rate over the same period. Year Real GDP, $ (billions in 2004 prices) 2004 790 2005 810 2006 825 2007 850 RMIT University School of Economics, Finance and Marketing 311 Calculating Economic Growth Rates and the Rule of 70 – One way to judge how rapidly real GDP per person is growing is to calculate the number of years it would take to double. 70 Number of years to double = Growth rate – This rule shows small differences in growth compound over time. – This leads to large differences in the number of years it takes for real GDP to double. RMIT University School of Economics, Finance and Marketing 312 Check Your Understanding The rule of 70 states that a. the number of years it takes an economy to double is the growth rate times 70. b. the number of years it takes an economy to double is 70 divided by the growth rate. c. it takes an economy 70 years to double in size. d. the number of years it takes an economy to double is the growth rate divided by 70. RMIT University School of Economics, Finance and Marketing 313 Check Your Understanding Use the table below to answer the following questions: a. How long will it take China to double its real GDP? b. How long will it take the UK to double its real GDP? RMIT University GDP growth (annual %) China UK 2004 10.1 2.7 2005 10.7 2.5 2006 10.4 2.8 School of Economics, Finance and Marketing 314 Economic Growth Over Time Around the World Average annual growth rates for the world economy Source: J. Bradford DeLong (1998), Estimating World GDP, One Million B.C. – Present, working paper, University of California, Berkley. RMIT University School of Economics, Finance and Marketing 315 Economic Growth Over Time Around the World Why do growth rates matter? • An economy that grows too slowly fails to raise living standards. • In the 1980s and 1990s, a small group of Asian countries, such as Taiwan and Singapore, achieved high rates of growth. These are sometimes referred to as the newly industrialising countries. RMIT University School of Economics, Finance and Marketing 316 Economic Growth Over Time Around the World GDP per capita, 2007 RMIT University School of Economics, Finance and Marketing 317 What Determines How Fast Economies Grow? – Labour productivity: The quantity of goods and services that can be produced by one worker or by one hour of work. Two key factors determine labour productivity. 1. Increases in Capital per Hour Worked – Capital: Manufactured goods that are used to produce other goods and services; examples are computers, factory buildings, and machine tools. – Human capital: The accumulated knowledge and skills that workers acquire from education and training, or from their life experiences. RMIT University School of Economics, Finance and Marketing 318 What Determines How Fast Economies Grow? 2. Technological Change: Change in the ability of a firm to produce a given level of output with a given quantity of inputs. Accumulating more inputs such as labour, capital, and raw materials will not ensure that an economy experiences economic growth unless technological change also occurs. Three main sources of technological change: –Better machinery and equipment. –Increases in human capital. –Better means of organising and managing production. RMIT University School of Economics, Finance and Marketing 319 What Determines How Fast Economies Grow? – Which is more important for economic growth: More capital or technological change? – Technological change is the key to sustaining economic growth. – Endogenous growth theory: a model of long-run economic growth that emphasises that technological change is influenced by economic incentives, and so is determined by the working of the market system. RMIT University School of Economics, Finance and Marketing 320 Check Your Understanding Endogenous growth theory a. states that the rate of technological change is caused by economic incentives. b. does not adequately explain the factors that determine productivity. c. states that the rate of technological change is unaffected by economic incentives. d. states that the rate of technological change is determined outside the working of the market system. RMIT University School of Economics, Finance and Marketing 321 Check Your Understanding a. Which of the following will result in an increase in labour productivity? A decline in the capital stock per hour worked b. A decline in the amount of human capital per worker c. An increase in technology d. A decrease in the number of people attending institutions of higher education RMIT University School of Economics, Finance and Marketing 322 The Market System and Economic Growth – Free Market: A market with few government restrictions on how a good or service can be produced or sold, or on how a factor of production can be employed. – Adam Smith argued the benefits of a free market system in his famous book – The Nature and Causes of the Wealth of Nations (published in 1776). – Smith assumed individuals act in a rational, self-interested way. – If not restricted by government, then firms would be led by the invisible hand of the market to provide consumers with what they wanted. – The price mechanism in the free market leads producers to change supply in accordance with consumer demand. RMIT University School of Economics, Finance and Marketing 323 Property Rights – Private property rights provide the legal basis of a free market system. – Property rights: The rights individuals or firms have to the exclusive use of their property, including the right to buy or sell it. RMIT University School of Economics, Finance and Marketing 324 Check Your Understanding A well established and legally enforced system of property rights a. encourages investment growth but reduces entrepreneurial activity. b. reduces economic efficiency which reduces the rate of economic growth. c. encourages economic growth by increasing the incentive to be innovative. d. discourages economic growth by discouraging innovation. RMIT University School of Economics, Finance and Marketing 325 What Determines How Fast Economies Grow? – Government policy can increase the accumulation of knowledge and capital in three ways: 1. Protecting intellectual property rights with patents and copyrights. Patent: the exclusive right to a product for a period of time from the date the product was invented. 2. Subsidising research and development. 3. Subsidising education. RMIT University School of Economics, Finance and Marketing 326 Check Your Understanding What is the ultimate purpose of patents and copyrights? a. To provide owners with large profit forever. b. To encourage the expenditure of funds on research and development to create new products. c. To protect firms from being taken advantage of by producing firms. d. To do all of these things. RMIT University School of Economics, Finance and Marketing 327 What Determines How Fast Economies Grow? Joseph Schumpeter and Creative Destruction. – To Schumpeter, the entrepreneur is central to economic growth: –The function of entrepreneurs is to reform or revolutionise the pattern of production by exploiting an invention or, more generally, an untried technological possibility for producing new commodities or producing an old one in a new way. RMIT University School of Economics, Finance and Marketing 328 Why Isn’t the Whole World Rich? – ‘Catch Up’: the prediction that the level of GDP per capita in poor countries will grow faster than in rich countries. – Some poorer countries have experienced rapid growth rates, but many have not. RMIT University School of Economics, Finance and Marketing 329 Why Isn’t the Whole World Rich? Figure 7.8 The rule of law and growth Source: Based on David Dollar and Aart Kraay (2000), Property Rights, Political Rights, and the Development of Poor Countries in the Post-Colonial Period, World Bank Development Research Group Working Paper, October RMIT University School of Economics, Finance and Marketing 330 Why Isn’t the Whole World Rich? There is no one answer to the question as to why all countries do not experience economic growth. Most economists identify 5 key factors: 1. Failure to enforce the rule of law: • Rule of Law: the ability of a government to enforce the laws of a country, particularly with respect to protecting private property and enforcing contracts. 2. Wars and revolutions: • Many countries that were poor in 1960 have experienced extended periods of violent changes of government during the years since. Eg. Afghanistan, Angola and Ethiopia. RMIT University School of Economics, Finance and Marketing 331 Why Isn’t the Whole World Rich? 3. Poor public education and health: • Many low-income countries have weak public school systems, so many workers are unable to read and write. People who are sick work less, and are less productive when they do work. 4. Slow technological development: • The economic growth model shows the technological change. importance of 5. Low rates of saving and investment: • The low savings rates in developing countries contribute to a vicious cycle of poverty. RMIT University School of Economics, Finance and Marketing 332 Check Your Understanding Which of the following is a reason why low income countries might experience economic growth? a. The country has endured extended periods of war. b. The country fails to enforce a rule of law. c. The country has a high rate of savings and investment. d. The country suffers from poor health infrastructures. RMIT University School of Economics, Finance and Marketing 333 Check Your Understanding Globalisation is defined as the process of countries becoming ________ open to foreign trade and ________ open to foreign investment. a. less; less b. more; less c. more; more d. less; more RMIT University School of Economics, Finance and Marketing 334 Globalisation The benefits of globalisation: – Foreign Direct Investment: The purchase or building by a corporation of a facility in a foreign country. –Foreign Portfolio Investment: The purchase by an individual or firm of stock or bonds issued in another country. –Globalisation: The process of countries becoming more open to foreign trade and investment. RMIT University School of Economics, Finance and Marketing 335 Globalisation Criticisms of Globalisation – Globalisation undermines distinctive cultures. – Multi-national firms exploit low wages and poor health, safety and environmental regulations in the developing world. – Economic growth contributes to global warming, deforestation and other environmental problems. RMIT University School of Economics, Finance and Marketing 336 REVISION OF MODULES 1, 2 & 3 RMIT University School of Economics, Finance and Marketing 337