ECON1102

Study Notes Macroeconomics 1

Chapter 1 Measuring Macroeconomic Performance: Output and Prices

Key Issues
Indicators of macroeconomic performance
Measuring output (GDP)
Measuring prices and inflation

Criteria for Evaluating Macroeconomic Performance
1. Rising Living Standards economic growth
Tendency for the level of output (i.e. quantity and quality of goods and services)
to increase over time.
Material wellbeing.
2. Stable Business Cycle
Low volatility in fluctuation of expansionary and contractionary gaps.
3. Relatively Stable Price Level (real currency value) low (positive) rate of Inflation.
Inflation rise in prices.
Deflation - fall in prices.
4. Sustainable Levels of Public and National Debt
Public debt borrowing by public sector from private sector (budget
deficits/surpluses).
National debt borrowing by domestic residents from foreign countries
(Influenced by an economys current account deficits/surpluses).
5. Balance between Current and Future Consumption
Expenditure vs. need to provide resources for future (saving)
6. Full Employment
Provision of employment for all individuals seeking work

Measuring National or Aggregate Output
GDP: the market value of the final goods and services produced in the domestic
market in a given period. It measures aggregate output or production. flow
variable as it is a function of time. Also a lag indicator.
Final goods or services: goods or services consumed by the ultimate user
because they are the end products of the production processes they are counted
as part of GDP. Intermediated goods or services: goods or services used up in
the production of final goods or services and therefore not counted as part of
GDP.

GDP Measurement Methods
Expenditure Method
Expenditure on Final Goods and Services by the ultimate user equals value of
production

Amount consumers spend should equal market value (economic agent)

Computed by adding total amount spent by 4 groups
o Household consumptions (durables and non-durables)
o Firms (Business fixed investment (Capital) and NEW residential
investment, inventory.)
o Government spending (Not government transfers e.g. unemployment
benefits, social security, welfare payments, interest paid of gvt. Debt)
o Net purchases in foreign market
National accounting Identity: Aggregate Expenditure = Y = C + I + G + NX
Production Method
Aggregate Market Value of final goods and services given indirectly by summing
the value added of all firms in the economy.
GDP = Amount x Market value
Note: Intermediate goods and services: G+S used up in production are not
counted in GDP e.g. flour in bread, services provided that only give value to final
product (or)
Value added: market Value of the production less the cost of inputs from other
firms, of each firm (= summation of value of final goods), Allows value to be
accurately distributed over periods.
Represents portion of value to final G+S added by each firm
o Value added = Revenue Market Value
Income Method
GDP is also given by aggregate income paid to capital and labour in production of
Goods and services
Revenue from sales is distributed to worker and owner of capital
GDP = Labour income (wages, salaries, self-employed) + Capital Income (Physical
capital -made to owner of factories, machinery, office building, Intangible
Capitals trademarks, copyrights, patents, interest to bondholder, income to
owners, rent for land, royalties)
Despite a slight statistical discrepancy between these methods in
theory/conceptually all three should produce the same result. GDP is usually
given by the average of these three outcomes

Some items with no observed market prices are included in GDP: national
defence use costs of provisions, whilst some are excluded: unpaid housework.

Nominal GDP: measures current dollar value of production by valuation of

quantities at current market prices. Calculated by the multiplying the quantity of
each good produced in the economy by current year prices and summing
Real GDP: values quantities of goods and services produced at base year prices
measure of the actual physical volume of production. Calculated using Laspeyres
index, Paasche Index or Chain weighted Index.

Real Growth Rate calculates the growth in the physical volume of production
between periods. Real Growth in GDP can be calculated using Laspeyres index,
Paasche Index or Chain weighted Index.
o Lespeyres Index involves calculating the value of GDP in current year
(here, 2006) and base year using a base year prices (here, 2005), by
multiplying the quantities of each good produced in a each year by the
corresponding price in 2005. Then commute the growth rate of real GDP.
o Paasche Index involves calculating the value of GDP in current year
(2006) and pervious year (2005) using current year prices (2006). The
change in GDP, which is the Real GDP in 2006 less the Real GDP is 2005, is
divided by the Real GDP in 2005.
o The Chain Weighted Index averages the percentage growth of GDP given
by the Laspeyres Index and the Paasche Index to accurately determine
GDP.

Is GDP A Good Measure of Economic Wellbeing?
Economic welfare refers to the general economic wellbeing and interests of the
population.
GDP only accounts for the goods and services sold in the market which to some
extent is a general indication of economic wellbeing positive correlation is
expected
The following factors effect economic welfare by are not accounted for in GDP:
Leisure Time
o Having more time to enjoy worthwhile activities like family, friends,
sport, hobbies is a major benefit of wealthy societies.
Non-market/home Production
o No acknowledgment of unpaid house work.
o Particularly in poorer countries where citizens trade and are self
sufficient their economic activity is undervalued.
o Underground economy legal and illegal transactions not recorded in
government data e.g. baby sitting, drug dealing.
Quality of Life
o Factors of life like traffic congestion, crime rate, open space and
public organisations which are not sold in markets but still add to
quality of life.
Inequality and Poverty
o GDP does not convey the distribution of wealth.
o There could be extremes of rich and poor.
Environmental degradation and Pollution
o Despite the difficulty in valuing this intangible factor, decline in air
and water quality (pollution) negatively affect quality of life.

Note: Although, GDP doesnt capture all factors influencing economic wellbeing,
higher GDP per capita is positively related to increased wellbeing. For example
countries have better health care, medicine, driven by technology

Measures of the Price Level
Consumer Price Index: For any period, measures the cost in that period of a
standard basket of goods and services relative to the cost of the same based of
goods and services in a fixed year (called the base year). CPI is a tool used to
measure the price level and inflation in the economy
CPI = Cost of basket in current year / Cost of basket in base year
Rate of inflation: the annual percentage change in price level measured by the
CPI, mathematically represented by:

The change in relative prices is not inflation. They are changes in response to
demand and supply. Recall that inflation is a sustained change the economys
price level not simply a price rise. It must be a general price change, not a
specific one.
Cost of inflation:
Shoe leather costs
o Money functions as a medium of exchange, thus inflation raises cost of
holding money. Inflation reduces the real purchasing power of a given
amount of money - longer it is hold, the larger reduction.
o Insulate this loss by holding money in bank with interest paid, but this is
associated with inconvenience of frequent bank visits. Businesses
employ extra staff to make trips. Bank employ extra staff for increased
transaction.
Menu costs
o Act of changing prices. Publicly lists prices need to change. E.g. change
coins, menu, signs.
Distortion of the tax system
o Taxes are not indexed to rate of inflation they are based on nominal
magnitudes. For example, inflation may raise peoples nominal incomes
(to compensate for rise in cost of living) moving them into higher bracket
even though their real incomes may not have increased
Unexpected redistribution of wealth

o Inflation causes redistribution/transfers wealth between parties
Employers and employees
Borrowers and lenders.
o If inflation is higher than expected, real wages of predetermined wages
will fall workers lose buying power. This is offset buy gain in employers
buying power, since real cost of paying workers has declined. If inflation
is lower than expected, real wages will increase, meaning workers with

have higher purchasing power, and employer will have to pay a higher
real cost.
o High Inflation means real dollar value of loan repayment is less than
expected.
o Associated with this process is fluctuation and volatility which
discourages people from working and saving, in an effort to protect them
against inflation.
Noise in the price system
o Price system functions to allocate resources efficiently establish
equilibrium. However, inflation distorts/ creates static or noise in
interpretation of price system obscuring information creating
inefficiency. Suppliers are unaware if increase in price represents true
increase in prices by increase in demand, or general rise in price caused
by inflation (quantity?) E.g. Asset Price Bubble.
Interference with long-term planning
o Of households and firms, makes it difficult to discern how much funds
need to be saved for future events, projects
Save too little- comprise plan
Save too much sacrificed pervious consumption

Note: evidence suggests inflation causes real consumption, real investment and real
GDP to fall, accompanied by increase in budget deficit.

Deflation is costly and creates unexpected redistributions of wealth. However,

the main cost of deflation is is to force the real rate of inters higher than normal.
This is because the nominal interest rate cannot fall below zero. This acts to
discourage certain types of important expenditure in the economy, most notably
firms investment expenditure.

Nominal Interest rate: percentage change in the nominal value (dollar value) of
a financial asset.
Real interest Rate: percentage change in real purchasing power of a financial
asset, adjusted for inflation.
1 + inom = (1 + ireal)(1+ )
Real interest rate inom inflation rate
Fisher effect: r = i
For borrowing and lending the real interest rate is most relevant. Since, if
nominal interest rates increase but inflation rises by the same amount then the
cost of borrowing has stayed constant. When real (not the nominal) interest rate
is low, borrowers benefit from a lower real cost of borrowing. When real interest
rate is high, lenders benefit from receiving an increase in purchasing power. So,
lenders need to protect themselves from the decline in the real interest rate;
therefore they must raise nominal interest rates in the face of inflation.


Limitation to CPI
Quality Adjustment Bias
o Failure to adjust for Improvement in quality of goods and services, which
results in an increase in prices and consequently inflation.
o For example, if the CPI basket contains monthly rent and during one
period the rent increase because of kitchen renovation, the CPI will
increase and incorrectly display a higher cost of living despite an increase
in price based on quality
o E.g. larger data storage computer has higher price
New Goods Bias (New goods not included)
o Extreme case of quality improvement
o Where a new product is introduced, that was not available in the base
year, creates distortions in comparisons (eg. computers were not
common 50 years ago).
Substitution Bias
o CPI is a fixed basket of goods meaning it does not account for the
substitution affect to relatively cheaper goods and services that are close
replacements for each other. Ignores consumers ability to switch
between products. E.g. Coffee and Tea
Therefore, since CPI fails to account for the above factors, CPI overstates the rate
of inflation and cost of living.






















6

Chapter 2 Saving and Wealth

Key Issues
Definition and Measures of Saving
Saving and Wealth
Motives for Saving
Investment and Capital Accumulation
Saving, Investment and the Real Interest Rate

Flow: a measure that is defined per unit of time.
Stock: a measure that is defined at a point in time.

Savings is a flow variable measure that is defines per unit of time. If saving is
positive then assets are being accumulated. If saving is negative then assets are
being de-cumulated or liabilities (debts) accumulated Note: household saving in
Australia is declining
Saving = current income current spending
Saving rate = savings/income

Capital gains: increases in the value of existing assets. Capital loses: decreases in
values of existing assets.
Wealth = assets liabilities
Change in Wealth = Saving* + Capital gains Capital losses
W = W(-1) + S + Net Capital Gains
A, L, W are stock variables measure defined at a point in time
*current income current spending; not accumulated savings.

Motives For Saving (why do people save?)
Life-cycle saving - Saving to meet long term objectives. Saving during working life
for future consumption E.g. University fees, retirement, home or car purchase.
Precautionary Saving - Resources put aside for protection/self assurance against
unexpected circumstances. E.g. loss of job, recession, medical emergency.
Bequest Saving - Desire to leave family heirs or dependents an inheritance or
bequest. Often by people in higher income ladder. E.g. children or charity.

Saving and the Real Interest Rate
Represent reward for saving increase in r increases opportunity cost of not
saving. However, small negative relationship since increase interest rate means
people need to save less to reach target saving level in future years. Net effect:
Other things equal (ceteris paribus) saving to increase with real interest rate
Saving is also influenced by cultural factors and neighborhood expectations

o Lack of sufficient self-control or will power to undertake optimal savings

level. The consumptions benefits are in the future, whilst the costs are
immediate.
o Availability of consumer credit eg. Home equity loans.
o Demonstration effects conspicuous spending by others encourages
conspicuous spending by households.
o Government provision of welfare may reduce private saving for
retirement.

National Saving
Measures aggregate saving in an economy by private and public sectors
(households, business, governments).
Y = C + I + G + NX
S = Y C G
NX is assumed to be zero and note that saving is current income current
spending, therefore I (investment) and is for future needs. Note: not all G and C
are current good (durable Goods e.g. cars, furniture, appliances, roads, bridges,
schools, other infrastructure). Hence, the equation above tends to overstates
current spending and understates national saving.
S = Y C G
S = Y C G + T T
S = (Y T C) + (T G)
S = Private saving + public saving
o Where: T = T Q = net taxes = taxes paid by private sector to government
transfer payments from government to private sector interest
payments from government to private sector bond holders.
o Transfer payments: (Q) payments the government makes to the public
for which it receives no current goods or services in return
Government budget deficit: T < G [Receipts < Expenditures]
Government budget surplus: T > G
Government balanced budget: T = G
National savings, not household savings, determines the capacity of an economy
to invest in new capital goods and to achieve continued improvement in living
standards. Australias national saving has showed slightly upward trends in
recent years, despite a lower household savings rate.
Investment and Capital Formation - National saving provides the resources for
investment. Investment is the purchase of new capital goods. New capital goods
increase productivity. Influences on the level of Investment:
o Cost of capital:
Nominal interest rate (i)
The dollar price/cost of the new plane (Pk)
Physical depreciation rate on capital ()

Over time the price of the plane may rise or fall (capital gain or
capital loss) (change in Pk)
Cost of capital = price of capital (begin year) + interest cost - price
of (depreciated) capital (end year)
Most important influences on investment decision are price of capital
good and real interest rate.
Rise in the real interest rate will make investment less attractive.
Rise in the price of capital goods will make investment less attractive.
Cost vs. Benefit Investment decision: Value of marginal product of
capital (benefit net of expenses and taxes) Cost of capital

o
o
o
o

Saving, Investment and Financial Markets
Economy with no access to international capital markets: National Saving =
Investment.
S = Y C T = I
Saving is increasing function of real interest rate supply of saving, therefore it is
upward sloping.
Investment is a decreasing function of the real interest rate demand for saving.
Downward sloping because rates link to WACC.








New Technology increased productivity increase marginal product
(investment more profitable) increase investment shift right increase in
r higher real interest rate makes saving attractive move along the S curve.
Increase in Budget Deficit/ Increase in Budget Deficit decrease in national
savings decrease saving shift left increase r higher real interest rate
makes investment less attractive and causes a move along the I curve.
An increase in the government budget deficit will reduce private investment
spending. A larger deficit reduces the supply of saving (savings curve shifts
inwards) and drives up the real interest rate. The higher real interest rate makes
investment less attractive and causes a move along the I curve. The tendency of
a government budget deficit to reduce investment is called the crowding out
effect.
Note: change in real interest rate is a movement ALONG curve.
In a closed economy NS = I.
Chapter 3 Unemployment and the Labour Market

Key Issues
Demand for labour
Supply and demand model of the labour market
Types of unemployment
Impediments to full employment

Demand for Labour
Diminishing returns to labour: if the amount of capital and other inputs in use is
held constant, then the greater the quantity of labour already employed, the less
each additional worker adds to production.
Marginal Product of Labour (MPL): additional output associate with additional
labour unit.
Firm combines workers with a given amount of capital (machines and buildings)
to produce output.
Based on Low-hanging fruit principle and increasing opportunity cost firm will
assign worker to most productive jobs.
Error! Not a valid embedded object.

[P is general price level]
Firm will compare benefit (Value MPL) of an additional worker with cost of
worker (Wage = W) [cost-benefit principle]. Note: Model assumes that firm
operates in a competitive market therefore cannot set the wage it pays workers
or price it receives for its product.
Firms will continue to employ labour until (value of MPL = money wage)
Since MPL decreases as firm employs more workers, real wage also has to fall (as
more workers are employed). This implies that a firms demand for labour is a
decreasing function of the real wage.
Error! Not a valid embedded object.

Shifts in Demand for Labour
Higher relative price for firms output (e.g. due to increased demand). Workers
production is more valuable, and therefore value of marginal product increases
(shifts right).
Higher marginal productivity of labour (e.g. large increase of capital stock or
new technology) as this leads to an increase in the value of marginal product.

Supply of Labour
At any given wage people decide if they are willing to work by reservation price
(minimum payment that leaves you indifferent between working and not
working) cost-benefit principle application. Supply of labour is the
total number of people willing to work at each real wage, Wi/P.

Shifts in Supply of labour
Size of working-age population (influenced by birth rate, retirement ages,
immigration rates).

10

Participation rate/Social changes percentage of working age population who

seek employment e.g. women working more.

Real Unit Labour Costs = Real average labour cost / Average labour productivity

Increasing Wage inequality: Globalisation and Technological change.
Globalisation
Globalisation is the process of breaking down national barriers:
o Free trade agreements
o Deregulation
o Reduced tariffs/taxes
Open up economies to international market and encourages specialization.
Demand for workers in industries with comparatives disadvantage experience
lower real wages and employment (shift demand left). This is due to suffering
from increased foreign competition, consumers purchase overseas (cheaper or
higher quality), which leads to a decrease in the value of marginal product and
therefore a decrease in demand for workers.
Demand for workers in industries with comparatives advantage experience
higher real wages and employment (shift demand right). This is because there is
a greater demand for exports and therefore there is an increase in the value of
marginal product and an increase in the demand for workers.
Note: countries employing higher skilled worker do better in international trade
heightening the inequality
Technological Change
Technological change increases worker productivity and is the basic source of
rising living standards. However, technological change affects different workers
in different ways. Note worker mobility counteracts trends of wage inequality. A
policy of providing transition aid in training workers with obsolete skills is useful
response to problem.

11

Skill-biased technical change (replaces or assists):

o Raises marginal product of high-skill workers increase in productivity
increase in demand rise in real wages and employment.
o Reduces marginal product of low-skill workers (no longer required)
decrease in productivity decrease demand fall in real wages and
employment.

Unemployment
Labour Force: total number of people available for work.
Labour Force = Employed + Unemployed
o Employed: Person worked full-time or part-time during the past week (or
was on leave from a regular job)
o Unemployed: Person did not work during the preceding week and made
some effort to find work.
o Not in Labour Force: Person did not work in the past week and was not
actively seeking work (e.g. retirees, unpaid homemakers, full-time
student).
Unemployment Rate = (Unemployed/Labour Force)*100
Participation Rate = (Labour Force/Working-age (15+) Population)*100
Working-age (15+) Population = Labour force + Not in Labour force

Costs of Unemployment
Economic costs: output that is foregone since workforce is not fully utilised.
Psychological costs: long periods of unemployment can lead to loss of self-
esteem, unhappiness and depression.
Social costs: high unemployment can lead to increased crime and associated
social problems e.g. crime, violence, alcoholism, drug abuse
Discouraged Workers: People who have given up looking for work (and so a not
counted as unemployed)

Types of Unemployment
Natural rate of employment: the part of the total unemployment rate that is
attributable to frictional and structural unemployment; equivalently, the

12

employment rate when cyclical is zero; i.e. the economy is not in an

expansionary or contracitonary gap.
Frictional unemployment: the short-term unemployment associated with the
process of workers searching for the right job.
Labor market is dynamic driven by changes in technology, globalization and
changing consumer tastes. This means new products and companies (and thus
jobs) are always being created.
Cyclical unemployment can improve efficiency of market bring together those
seeking and offering employment (e.g. left school or change careers).
Cost are low (short-term physiological and direct economic affects low)
Can be economically beneficial/essential negative costs (better fit of workers
into job positions higher productivity higher output in long run).
Structural unemployment: the long-term and chronic unemployment that exists
when the skills or aspirations of workers are not matched to jobs available in the
economy.
Refers to availability and distribution of jobs and can be caused by: lack of skills,
language barriers or discrimination. Also unions and minimum wage laws can
cause structural unemployment.
Cyclical unemployment: the extra unemployment that occurs during periods of
economic contractions and especially recessions. Cyclical unemployment is
costly in terms of foregone output and underutilization of labour resources.

Factors that affect the rate of unemployment
Minimum wage: legal minimum hourly rate firms can pay employees (Award
wages).
o Despite minimum wages raising the unemployment rate it benefits those
workers who are lucky enough to receive a job in this market (0 ND) as
they will receive higher than normal wages. Of course, those who are
shut out of the market lose and are left jobless.
o Taxpayers are worse off pay for unemployment insurance and support
and higher prices.
o Consumers are worse off, lower output
o When minimum wage laws are below equilibrium the market is not
affected, and will continue to operate in equilibrium.

13

Labour union workers may negotiate on an individual basis with a firm over
wages and conditions. Alternatively may form labour unions to bargain
collectively. Unions tend to produce higher than normal wage outcomes (above
equilibrium clearing). Outcome wmin=wunion.
Unemployment Benefits Government transfer payment paid to the
unemployed. This is a basic income to workers who are unemployed and
searching for work. Can have a disincentive effect on a workers search effort
prolong period before individual accepts employment.
Other government regulations OH&S or Anti-discrimination.

Chapter 4 - Short-run Economic Fluctuations

Key Issues
What is a recession?
Business cycle fluctuations
Output gaps and cyclical unemployment

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Natural rate of unemployment

Okuns law

Business Cycle
The business cycle refers to the fluctuations in economic activity/GDP associated
with periods of expansion (strong economic performance) and contraction
(weaker economic performance).
Contraction: period where GDP falls, moves from a peak to a trough
Expansion: period when GDP rises, moves from a trough to a peak
Peak is the beginning of a contraction, end of expansion high point prior to a
downturn
Trough is the end of a contraction, beginning of expansion low point prior to a
recovery











Note: Rule of Thumb for a recession is at least two quarters of negative economic
growth i.e. level of GDP has to fall for at least two quarters.

Potential Output (y*)
Amount of output (real GDP) an economy can produce when using its resources
(labour and capital) at normal rates.
Not the maximum output.
Grows over time with growth in labour, capital inputs and growth in technology.
Actual output (y)
Actual level of GDP produced in the economy
Vary (expand or contract) due to:
o Changes in potential output ( y*) e.g. extreme weather conditions
decrease actual output contractionary gap recession
o Changes in utilization rate of labour and capital e.g. immigration, new
technologies increase actual output expansionary gap / boom.

Output gap = y y* at a point in time.
Occurs when utilization of labor and capital is above or below normal rate. Thus,
y <> y*

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Expansionary gap: y* < y (Positive output gap)

Contractionary gap: y* > y (Negative output gap)

Natural Rate of Unemployment (u*): the part of the total unemployment rate
that is attributable to frictional and structural unemployment; equivalently, the
unemployment rate that prevails when there is no cyclical unemployment.
Unemployment rate (u) tends to co-move with the output gap in economy.
Contractionary gaps link to high unemployment rate
Expansionary gaps low unemployment rate
Unemployment = (frictional + structural) + cyclical
Cyclical unemployment = u u*
Okuns law is systematic, quantitative relationship between output gap and
cyclical unemployment. Implies, an extra percentage point of cyclical
unemployment is associated with an specific percentage point increase in the
output gap.
For Australia, the percentage point in approximately 1.5.
Okuns law implies negatively proportionality, meaning:
o Positive output gap (expansionary) causes a reduction in cyclical
unemployment.
o Negative output gap (contractionary) cause an increase in cyclical
unemployment
o When output gap = 0, there is no cyclical unemployment.

- opportunity cost
- inflation

Policymakers generally view both, a persistent contractionary or expansionary as

problems.
Contractionary gaps are associated with capital and labour not being fully
utilised (cost in terms of forgone output).
o Reduced total economic value higher unemployment reduced
livings standards.
o In order to reduce cyclical unemployment levels, policy makers must
attempt to create an expansionary output gap. This can be achieved by
using resources at greater than normal rates. For example, creating new
infrastructure projects is new capital investment, while using resources
such as labour at higher rates than normal.
o Implies that it is possible for an economy to suffer from jobless
recoveries, that is, output growth resumes however employment does
not grow. An increase in labour productivity can mean that real net
output grows leading to an expansionary gap without net unemployment
rates falling, as there is no strict relationship between the two as a
variable is involved. It is this variable that changes in such situations.
Expansionary gaps are associated with firms operating above normal capacity to
meet demand. This can lead them price increase (inflationary), leading to
inefficient market.

16



Chapter 5 Spending and Output in the Short-Run

Key Issues
A model of output determination Keynesian Model
Planned verses actual expenditure
A consumption function
Equilibrium output in the short-run

Keynesian Model
Key Assumption: Prices of goods are fixed/sticky in the short-run. Firms do not
change prices in response to a change in demand for their products. Fix their
price and meet demand at this preset price by varying their level of production
(labour and output). The implication: changes in spending yield a change in
output above or below potential. Thus spending determines aggregate output.
If prices where fully flexible, in theory prices would be changing instantaneously
with changes in demand menu costs. Also, there will never be excess
production because firms will cut prices to sell it and never be persistent
unemployment because workers will cut their wages to keep and get jobs.
Fluctuations in demand will be accommodated by flexible prices and wages
without changes in output and employment.
In long-run, sustained changes in demand will eventually lead firms to change
their prices and cause production to return to normal capacity.

Aggregate Expenditure
The actual expenditure in the economy is equivalent to production/GDP since
aggregate output is determined by spending. Thus: AE = C + I + G + NX. (Note, I =
real investment not financial).
PAE is the total level of planned spending on goods and services and may differ
from the actual level of production. PAE = C + IP + G + NX.
Since firms are meeting demand at preset prices they cannot control how much
they sell. Consequently, differences arise when firms sell more or less than
expected. When firms sell less output than planned, it adds more than planned
to its inventory stocks (investment) and hence actual investment will exceed
planned (I>Ip). When firms sell more output than planned, it adds less than
planned to its inventory stocks (investment) and hence actual investment will be
below planned (I<Ip).
When output differs from desired spending (i.e. demand) there is a change in the
inventory investment accounting for the difference in AE and PAE:
o I IP = Inventories
o Inventories + AE = PAE

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A Model of Consumption Expenditure

Current disposable income is an important influencer of household consumption
aggregate income less net taxes (Y T).
Consumption Function: Error! Not a valid embedded object.
o C-bar is exogenous (or autonomous) consumption. Factors (other than
disposable income) that could affect consumption, e.g. wealth, real
interest rates (external factors).
o Wealth Effect: changes in asset prices that affect spending.
o c(Y-T) Captures the effect of disposable income on consumption (induced
consumption). c is the marginal propensity to consume (parameter), or
the change in consumption when disposable income changes by a dollar.
[0<c<1]
Error! Not a valid embedded object.

Error! Not a valid embedded object.
o 1st term is independent of output and is called exogenous expenditure.
o 2nd term is called induced expenditure and is dependent on output.

Short-Run Equilibrium Output
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- 2 Sector model

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- 4 Sector model

Injections and withdrawals short-run equilibrium
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Error! Not a valid embedded object.











Injection: all sources of exogenous expenditure in the economy (All exogenous
spending).
Withdrawals: That part of income not used for consumption purposes.
Circular flow of income: the economys national income, which can be
equivalently measured using the production expenditure or income approach.

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Disequilibrium
o PAE > Y and INJP>WD; PAE < Y and INJP<WD.
o In Keynes model, short-run equilibrium output is defined as the level of
output at which Actual output (Y) = Planned Aggregate Expenditure
(PAE), and clearly, Y= PAE for all points on the 45 degree line, and thus
equilibrium occurs when the PAE curve crosses the 45 degree diagram, at
actual output Ye. Further, when Y=PAE, this means that Y= C + Ip.
Subtracting C from both sides, Y-C=Ip, that is, the economy is in
equilibrium when withdrawals (income that is not consumed) is equal to
total planned injections (total exogenous spending in the economy).
o Suppose that at a point in time, the economys actual output than Ye.
Hence, planned expenditure falls short of the actual level of production
(Y>PAE and WD>INJ) in the economy, and thus, firms find an increase in
their inventory (unsold stock), such that their actual investment, which
includes inventories, is greater than their planned investment. This
situation is also known as excess supply. As there are costs involved with
carrying unsold stock, less income is consumed so that withdrawals
exceed injections. Firms attempt to remove this excess inventory,
however, in the short term, prices do not change, such that the firm
cannot dump their inventory and instead revise their production levels
downward in order to avoid these costs. Subsequently, GDP will fall until
it reaches equilibrium level. The reverse is also true firms cannot raise
prices to satisfy excess demand, and therefore the only option is to
increase production, resulting in GDP rising to its equilibrium level.
[REVIESE GRAPHS]

The Paradox of Thrift
Consider a savings function given by and investment function IP where
equilibrium is initially at Y0e, that is where savings equals investment
Suppose there is an exogenous increase in an agents desire to save (). That is, at
every level of income there is an increase in savings by a constant amount.
Resulting in a parallel shift in savings function to S1.
Since the actions of saving reduce economic activity, the aggregate amount of
savings actually remains unchanged, but the level of GDP will fall. Hence, an
attempt to increase savings results in the economy being worse off.
This decline in exogenous consumption can be explained using the Y=PAE
diagram. Essentially, the decrease in PAE means there is less actual expenditure
(Y) and lower levels of income to ensure that savings again match planned
investments.

Four Sector Model

19

PAE = C + IP + G + NX
Consumption Function:Error! Not a valid embedded object.
Tax Function: Error! Not a valid embedded object.
Import Function: Error! Not a valid embedded object.
Error! Not a valid embedded object.

The Multiplier
Multiplier is the effect of a one-unit increase in exogenous expenditure on short
run equilibrium output. The multiplier suggests that an additional dollar of
exogenous PAE results in more than a dollars worth of GDP.
For example, if the multiplier is 5 and increase of 10 units in exogenous
expenditure results in a 50 units increase in output.
In general, a change in exogenous expenditure produces a larger change in
short-run output since actions to spend by one party, results in successive
rounds of changes in income and spending for others which results in a larger
change in short-run output.
For example, if consumers increase spending this increases sales directly, but
also inadvertently increases the income of workers and firm owners. This
enables workers and owners to increase their own spending, which results in a
recursive process.
As the marginal propensity to consume is typically less than 1, the
income/expenditure benefit of each round decreases as less of diminishing
proportion transfers between parties.
2-sector Model
Multiplier = 1 / 1 c [M>1 since 0<c<1]
Error! Not a valid embedded object.
4-Sector Model
Error! Not a valid embedded object.
To eliminate output gaps and restore full employment, the government employs
stabilisation policies. The two major types are fiscal and monetary. Stabilisation
policies work by changing the PAE and hence short-run equilibrium output.
o Expansionary Policy increase PAE and output.

20

o Contractionary Policies decrease PAE and output.

Recall, an increase in real output raises planned aggregate expenditure, since
higher output (and, equivalently, higher income) encourages households to
consume more (and firms too).

Chapter 6 - Fiscal Policy

Key Issues
Fiscal policy and output gaps
Effects of different fiscal instruments
Limitations of fiscal policy
Fiscal policy and demographics
Public debt and government budget constraint

Fiscal Policy Introduction
Components of Fiscal policy:
o Government expenditure (G): current goods & services, investment and
infrastructure.
o Taxes (T - direct, indirect) income taxes, consumption taxes.
o Transfer payments (Q) benefits, pensions. Note that transfer payments
are not part of G because the government does not receive any goods or
services in return.
Government decisions about these variables can affect the level of output in the
economy.
G spending has a direct effect on PAE. T and Q have an indirect effect.
Government Spending and Output Gaps
o Government purchases component of PAE exogenous G shift PAE
(parallel).

21

Taxes, Transfers and PAE

o Indirect effect on PAE affect disposable income (Y-T)
o Tax cuts and increases in transfer payments (decrease T) increase
disposable income PAE increases.
o Tax increases and decreases in transfer payments (increase T) decrease
disposable income PAE decreases.
o Thus, slope of PAE curve and depends on t.
Larger t - flatter PAE (decrease PAE)
Smaller t steeper PAE (increase PAE)
Governments can change the exogenous part of T, T-bar or the tax rate t.
Taxes on labour Income rate rates and structure of government payments can
influence labour supply decisions
Taxes on capital Company tax rates can influence firms investment decisions
and affect the level of private capital

Fiscal Multipliers in the 4-Sector Model
Total change in GDP is given by the change in variable multiplied by multiplier
value.
Error! Not a valid embedded object.
A proportion of tax cuts may be saved and not fully spent, therefore the tax
multiplier is lower.
Balanced Budget Multiplier: the short-run effect of equilibrium GDP of an equal
change in government expenditure and net taxes. The initial government budget
surplus/deficit is T G. Hence, the initial deficit is kept constant when there is
equal change in T and G components. The balanced budget multiplier
determines the change in output that results from an equivalent change in T and
G. Note budget surplus/deficit is a flow variable.
Hence, output will change by less than one for every unit change in G as c and m
are < 1. Hence, output will change by less than one for every unit change in G.
Graphically since an increase in G will shift the PAE upwards by increase in G
(PAE1), simultaneously an increase in T will shift the PAE curve downwards
(PAE2) by less than increase in G since (c-m) < 1. The net effect of these
operations will be an overall increase in PAE at every level of output and
consequently a net increase in equilibrium output from Y to Y2.

22


The Role of Fiscal Policy in Stabilising the Economy

Problems with fiscal policy
Supply side
o The model doesnt take into account that fiscal policy influences both
PAE and the economys productive capacity, through affecting the supply
factors of the economy. E.g. investments in roads, airports, schools, lead
to growth in potential output
o Whilst taxes and transfer payments affect saving and investment. E.g. tax
cuts could motivate people to work harder as they are able to keep a
larger proportion of their earnings, hence increasing potential output.
(Taxes on labour and capital affects labour and investment supply
decision).
o The multiplier effect is also not instantaneous.
Problem of Deficits
o Expansionary fiscal policy in attempt to close contractionary gaps may
lead to large sustained budget deficit, which reduce national savings
o When government spending is above tax revenue, reduction in national
saving will in turn, reduce investments in new capital good an
important source of long-term economic growth.
Inflexibility of Fiscal policy (lags)
o Model assumes discretionary changes in fiscal policy are made in a timely
manner/instantaneously in response to output gaps.
o However, in reality changes in government spending and taxes involve
lengthy legislative processes
o The model does not also consider non-output focused government
objectives such as including national defense and income support to the
poor.
Due to these factors, and time lag issues, ideally, macroeconomic policy should
be used as a forward looking tool, e.g. fiscal policy changes made today should
be designed to influence future (forecast) levels of output

Discretionary fiscal policy refers to deliberate changes in the level of government
spending, transfer payments or taxation. Includes spending items such as health
and defense, or fiscal stimulus such The Education Revolution, or NBN.
Automatic stabilizers are provisions in law that imply automatic increase in
government spending and decrease in taxes when real output declines. Refers to
the tendency for a system of taxes and transfers which are related to the level of
income to automatically reduce the size of GDP fluctuations. e.g. when the
economy is booming, GDP rising, there will be high tax receipts due to the
progressive tax system and lower transfer payments reduces PAE. Or when

23

the economy is in recession, GDP declines, income taxes decline and transfer
payments increase increases PAE
o Called automatic because responses to contractions/expansions occur
without legislative process
Discretionary fiscal policy is equated with structural changes in the budget where
there are direct decisions amount the amount of government spending, tax
collections and transfer payments. Called structural deficit because this deficit
exists even when the economy is at potential it is a fundamental expenditure >
receipts scenario.
Whereas Automatic stabilizers drive cyclical fiscal changes and is dependent on
the economic conditions.

Budget Constraint, Public Debt and Fiscal Policy
The budget constraint refers to concept that government spending in any period
has to be financed by taxes or government borrowing.
The budget constraints relates government outlays (purchases (G) and transfer
payments (Q)) to their sources of financing:
o Taxes (T)
o Borrowing (through issuing security like bonds). Denote Bt as borrowings
at period t.
o Printing Money inflationary.
The outstand stock of government borrowing is called public debt. Public debt is
the sum of past deficits minus any surpluses. Public debt = past deficits
surpluses.
Since interest must be paid on loans government spending also includes interest
payments of rBt-1 Hence,
Gt + Qt + rBt-1 = Tt + Bt Bt-1 Gt + Qt + rBt-1 - Tt = Bt Bt-1
When the government runs a deficit budget, the LHS is positive (G+Q+rB>T), and
the level of public debt grows (implies Bt > Bt-1). Conversely, public debt falls with
a government surplus.
Since fiscal policy involves decisions about G, Q, T the government budget
constraint demonstrates how these choices influence the level of public debt.

Costs of Public Debt
Crowding Out: High levels of government borrowing may raise real interest rates
crowd-out private investment and capital formation (S & I model). Thus one
reason a government may drop debt is to encourage investment expenditure by
the private sector.
Intergenerational Equity: the concept that the current generation should not
impose an unfair burden on future generations. Borrowing because deficit
budgets cant be sustained forever surpluses required in order to reduce
debt. Thus, we should not enjoy benefits of budget deficits now and pass on
costs of those deficits to future generations. Recent budget surplus and sales of

24

assets such as Telstra have allowed the government to help pay off debts
accumulated as a result of past budget deficits the GFC has forced the
government budget back into deficit.

Benefits of Public Debt
One use of public debt is to finance the provision of public infrastructure. Where
infrastructure has the characteristics of a public good it will be under-supplied by
the private sector.
Some estimates suggest that the returns to investment in infrastructure are
relatively high.
Thus it is possible that public debt may have a net benefit for the economy, even
when allowing for crowding out and intergenerational equity effects.

Fiscal Policy Challenges Demographic Change
Demographic changes are alterations to structure of population.
Australias population is expected to increase from 20.5m in 2006 to 24.5m in
2048.
Declining fertility rates and increases longevity means that people 65 and over
are likely to go from 13% of population to 22% in that time.
This has implications for government expenditure, as health, aged care and
pension spending will increase over that time.
Government budget deficits are predicted from 2025 onwards based on
government revenue being about 22% of GDP.
Coincidently, senior citizen typically pay minimal tax, therefore the Australian
government must borrow more in order to finance expenditure as per the
budget constraint. Recall, that the budget constraint refers to concept that
government spending in any period has be financed by taxes or government
borrowing. Additional measures to address this issue include raising the
retirement age, increasing taxes, or encouraging younger people to being
working earlier rather than study for longer there is a cost-benefit trade-off
here.
Tax smoothing: a theory that states that the government should run a budget
surplus now if it anticipates higher government spending in the future.

Distribution of Income
Key function of fiscal policy - influence distribution of income changing
disposable income available to households, through net taxes.
Net taxes = tax paid by a household less transfer payments received.
Progressive Taxes: a system of taxation that levies higher tax rates on additional
dollars earned as income increases less unequal distribution of income.
Government transfer payments are also targeted toward low-income earners as
they are means tested.
Gini Coefficient: summary measure of income inequality.

25

Error! Not a valid embedded object.

Lorenz curve: graphical representation of income inequality.
A Gini coefficient of 0 implies perfect income equality and larger coefficients
imply higher income inequality.

Note: Fiscal policy is not often used these days to stablise the economy. This is
because of supply side issues (undesirable long-run consequences), excessive
national debt, and is relatively inflexible as discretionary changes to the budget
take time to approve.
Fiscal policy is not often used as a stablisation tool. However, fiscal policy does
have important roles in the economy. Three of these roles are:
1. To influence the distribution of disposable income across households.
2. The management of the likely pressures on government expenditure implied by
the ageing of the population.
3. The management of the governments public debt.

Chapter 7 - Money, Prices and the Reserve Bank

Key Issues
Money and its uses
Private banks and money creation
Money and prices
Reserve Bank of Australia
Cash rate and exchange settlement funds

Money: an asset that can be used in making purchases.
Functions of money:
o Medium of exchange (asset used in purchases) money removes the
problem associated with barter (direct trade) by eliminating the double
coincidence of wants problem. Thus money significantly reduces search
costs.
o Unit of account (basic measure of economic value) standardized value
comparisons.
o Store of Value (means of holding or transferring wealth. Many assets hold
this property but do not posses the first 2 functions e.g. stock, loans and
bonds).

Currency = notes and coin on issue (less what is held by banks and RBA).
M1 = Currency + Current deposits with banks (cheque and savings accounts).
M3 = M1 + all other bank deposits of non-bank private sector
Broad Money = M3 + borrowings from private sector by non-bank depository
corporations less what these non-banks hold with banks.

26

The sources of money in a modern economy are governments (currency) and the
banking system (deposits).

Banks as Creators of Money
Households and firms deposit all currency in banking system
Bank reserves: reserves of cash kept by banks to meet their customers deposit
withdrawal demands. A 100 % reserve banking system means all deposits are
kept in form of cash reserves.

Assets

Liabilities

Reserves = $100m Deposits = $100m

Reserve-deposit ratio: the ratio of reserves to total deposits held by a bank.
Fractional-reserve banking system: a banking system in which the reserve
deposit ratio is less than 100%. Some reserves are left for regular withdrawals;
the rest (excess over R/D) can be loaned to households and firms that demand
additional currency. Banks are now intermediaries. E.g. R/D=10%; reserves =
10M, loans = 90M and deposits = 100M.

Assets

Liabilities

Reserves = $10m Deposits = $100m
Loans = $90m

Assume that private citizen prefer bank deposits to cash for making transactions,
therefore loans will ultimately be redeposited into the banking system again
after each round.

Assets

Liabilities

Reserves = $100m Deposits = $190
Loans = $90m

Here, after re-deposits, R/D = 0.53 (too high, so more lending rounds occur to
get R/D = 0.10). Thus, banks make additional loans and they re-deposited.

Assets

Liabilities

Reserves = $19m Deposits = $100
+ $ 81m
+ $90m
Loans = $90m
+ $81m

27

+ $81m



Here, after reserves = $100m and deposits = $271m, thus R/D = 0.37 (too high,
so more lending rounds occur to get R/D = 0.10). Thus, Banks Make Additional
Loans and they Re-Deposited.
Continue process expanding loans and deposits until R/D = required ratio
Thus, the banking system creates money through the process of holding deposits
and lending out excess, which affects the money Supply. An increase in deposits
driving ratio downwards.
To solve for total deposits (D) recall that, Money supply = currency held by public
+ bank deposits. When the public withdraws cash from the banks, the overall
money supply declines. Deposit multiplier:
Error! Not a valid embedded object.

Money and Prices
The long run supply of money and the general price level are closely linked.
Velocity: a measure of the amount of expenditure that can be financed from a
given amount of money over a particular time period (What is the average value
of transitions that a dollar can be used for in a given period of time? How fast
does currency circulate?). This is only approximate recall second hand sales are
not included in GDP yet these have some effect on velocity.
V = P x Y/M = nominal GDP/money stock
Quantity theory derives the relationship between price level and the amount of
money circulating the economy. The quantity theory is based on the quantity
equation (M x V = P x Y), which states that the money stock times velocity equals
nominal GDP which is true by definition (M (money stock), V (velocity of money
circulation), P x Y (nominal GDP)).
Key assumptions: velocity is constant and output is constant, i.e. current
payment methods and production technologies are fixed.
Therefore, quantity theory equation is:
Error! Not a valid embedded object.
This can be algebraically manipulated to:
Error! Not a valid embedded object.
This implies that price level is proportional to the money stock.
Therefore, a specific percentage increase in money stock yields the same
percentage increase in price level and thus, growth rate of money supply equals
rate of inflation. Although, this relationship is only approximate and does not
always hold.
Implications: quantity theory links the growth rate of money to price levels (the
inflation rate). Intuitively this make sense, since an increase in the supply of

28

money with a relatively fixed supply of goods and services will bid up in prices,
hence resulting in a higher price, that is inflation.
The central banks is responsible for the operation of monetary policy and
stability and efficiency of the financial markets. In Australia, the RBA Act (1959
Cmwlth), stated that the RBAs operations should contribute to the stability of
the Australian currency, maintenance of full employment and economic
prosperity and welfare of the people of Australia.
RBA has a 2-3% target inflation band.

The Reserve Banks action of buying and selling bonds is known as Open Market
Operations (OMO). OMO provides a means by which the RBA can influence the
overall level of cash (via exchange settlement funds) and provides a means by
which the RBA can ensure the overnight cash rate is equal to its target rate
Each commercial bank has an exchange settlement account with the RBA, which
is used to manage flow of funds with other commercial banks generated by
commercial activities of their customers. ESA must always be in credit and can
never be overdrawn.
The financial system that helps manage and maintain exchange settlement
accounts by facilitating borrowing and lending of funds for periods of less than
24 hours is called the overnight cash market. The interest rate on these loans is
called the overnight cash rate.
Note: government spending and private sector tax payments also have an effect
on overall level of exchange settlement funds.
Open market purchase: the purchase of government bonds from the public by
the Reserve Bank for the purpose of increases the balances in the banks
exchange settlement accounts. [Cr ESA]
Open market sale: the sale by the Reserve Bank of government bonds to the
public for the purpose of reducing the balances in banks exchange settlement
accounts. [Dr ESA]
Bank with exchange settlement account surplus or deficits can borrow and lend
money between each other in the overnight cash market, at the overnight cash
rate. The return on ESA funds are quite low so there is incentive to not
accumulate too many funds, however they must also never be overdrawn.
If there is excess cash in the system so that there is pressure for the cash rate to
fall below targets, RBA will sell bonds and this will reduce the supply of cash.
If there is a shortage of cash in the system so that there is pressure for the cash
rate to rise above the target, RBA will buy bonds and this will increase the supply
of cash.
These conditions hold because the level of funds held in the exchange
settlement accounts affect the supply and demand of borrowing the overnight
cash market, and therefore the cash rate.
Since the money supply is given by currency held by public + bank reserves /
desired reserve-deposit ratio, the level of bank reserves directly influences the

29

money supply that is an increase in bank reserves, increases by a greater

amount the money supply and a decrease in bank reserves, decreases by a
greater amount the money supply.
In its OMO the RBA rarely buys and sells government securities outright. Rather
it uses repurchase agreements (repos). Here purchases and sales of securities
are only for a certain period (say a week), after which the original transaction is
reversed.

Channel Cash Rate
RBA pays interest in funds held in ESA accounts at rate which is 0.25% below its
cash rate target. Lower bound.
Banks can, at any time, borrow cash from the RBA at a rate that is 0.25% above
target cash rate Upper bound.
Demand for Cash and the Target cash rate At any interest above 4.75 banks
have zero demand for a stock of cash, since they can always get what they
require from the RBA for 4.75%. At any interest rate below 4.25 banks will
demand an infinite amount of cash, since they can always earn 4.25% from their
exchange settlement accounts. Between 4.75 and 4.25 we just assume banks
demand for cash is negatively related to the cash rate.













Note cash rates are annual effective rates.









30











Chapter 8: The Reserve Bank and the Economy

Key Issues
Demand for money
Bond prices and yields
Money Market
Cash Rate and Bond Rates
PAE and the Real Interest Rate
Policy Reaction Function

Demand for Money is the amount of wealth an individual chooses to hole in
form of money. Risk vs. Expected Return: Risky assets need to pay a higher
expected return to induce individuals to hold them.

Benefits and Costs of Holding Money:
Main benefit from holding money is its usefulness in making transactions
medium of exchange function. Transactions demand for money can be affected
by financial innovation e.g. credit cards, ATM reduced need to hold money
Cost - many forms of money pay zero interest (currency) or very low rates of
interest (transactions accounts) opportunity cost of holding money - return
earned by holding wealth in the form of other assets e.g. Bonds pay a fixed
amount of interest each period, Equities pay dividends, capital gain
Assume:
o Money pays a zero nominal interest rate.
o Nominal expected return on other assets is positive.
o Nominal interest rate is represented as i.
Demand for money by households and firms is affected by:
o Nominal interest rate, (i) - negatively related to i. Increasing nominal
interest rate, increase the opportunity cost of holding money and reduce
the amount demanded.
o Real output (or GDP), (y) - positively related to y. Larger GDP means
higher incomes and greater transactions volumes are likely to lead to
increased demand more money.

31

o Price level, (P) - positively related to P. Inflation means the dollar value of
general G+S increase, require more money for transactions

Money Demand Curve
Nominal Demand [Link shape to opportunity costs of money]
Error! Not a valid embedded object.
Real Demand
Error! Not a valid embedded object.


Shifts in the Demand for Money
Real income (y)
Price level (P) (only if we measure nominal money on horizontal axis)
Technological Change and Financial Innovation (E.g. Development and spread of
ATMs decrease demand shift left)
Stock market volatility can increase demand for safer assets.
Political instability can lead people to worry about inflation and hoard currency.

Supply of Money
The supply curve for money is vertical - position is determined by the actions of
the RBA (OMO), independent of i. No change in money supply.
Or, the supply curve for money is horizontal - RBA supplies money on demand
(at a given i).
Recall, RBA is able to control the money supply (currency and deposits) by OMO
with the public.

Asset Prices and Yields
Yield or return on a financial asset is inversely related to the assets price.
Bond: type of financial asset, issued by someone seeking to borrow money.
Principal amount: amount of money lent by purchaser of bond.
Coupon rate: the interest rate attached to a bond (= Coupon Payment/Principal).
Coupon payment: the dollar amount of interest payments on a bond.

Consider, RBA reduces Ms which to raise interest rates:

(Vertical Ms is exogenous?)
32

 OMO: RBA sells bonds to the public in exchange for M (reduces M)

[!] D is downward sloping because a low interest rate would not promote lending
between banks, so banks are more inclined to leave money in their ESA, thus
reducing the demand for base money. Supply is controlled by RBA OMO, and
inelastic wrt. cash rate. Higher target cash rate shifts demand to the right
(expands demand).
At the initial (old equilibrium) interest rate there will be an excess demand for
money and an excess supply of bonds as bond will be over-valued at this lower
interest rate.
The excess supply of bonds will put downward pressure on bond prices, which
raises the interest rate. This process will continue until the demand for money
has been reduced to equal the lower supply.

Consider, endogenous money supply: Interest Rate Target












Given the demand for money function, the RBA will supply whatever
quantity of money that is required to achieve its target value for the
interest rate. Thus at any time, the RBA can either control the money
supply or set a target value for the interest rate.

Monetary Policy and the Money Market
Recall, RBA targets the very short-term interest rate (overnight interbank rate)
and undertakes its OMO mainly with banks. What are the implications of the
cash rate on longer-term interest rates?
Consider maker for Market for 90-Day Bills.

33

Supply curve indicates the willingness of firms to supply/issue bills (ie. to borrow
for 90-days). Recall that when bill price is high, the interest rate on bills is low so
firms want to supply more bills (ie. borrow more). Cost is lower.
Demand curve indicates the willingness to lend to firms (ie. demand for 90-day
bills). Recall that when bill price is high, the interest rate on bills is low, so no one
is willing to lend much (ie. demand for bills is relatively low) Return is poorer.
Effect of an Increase in the Cash Rate on the 90-Day Bill Market RBA raises its
target level for the cash rate. Assume banks (and some other financial
institutions) are able to participate in both the overnight cash market and in the
commercial bill market.
o [DEMAND] Lenders leave the bill market in favour of higher returns in the
overnight cash market Demand for commercial bills (willingness to
lend to firms) will fall: Demand curve shift left. HIGH PRICE = LOW
INTEREST RATE = LOW RETURN = LOW D!
o [SUPPLY] Borrowers in cash market will now seek funds in the 90-day bill
market, due to the higher cash rate supply of commercial bills
(demand for 90-day loans) will rise: Supply curve shift outwards. HIGH
PRICE = LOW INTEREST RATE = LOW COST = LOW S!
[KEY IDEA: if the RBA increases the funds in the overnight cash market, then
investors who previously dealt in the 90-day bill market now seek higher returns
in the overnight cash market, and borrowers who obtained funds from the
overnight cash market restructure their financing plans and move to longer-
maturity loans with a comparatively lower interest rate. Think as if the two
markets were mutually exclusive. RBAs targeting has an indirect effect on
longer-term interest rates].

The price of bills falls and the interest rate rises.

34

Thus, changes in cash rate eventually lead to changes in longer-term interest

rates.
Market Rates = Cash Rate + Premium (for risk or liquidity factors)
Recall, Error! Not a valid embedded object.. Thus, if inflation is sticky in the
short-run, RBA can control nominal and real interest rates (in SR). Note: r can be
negative if nominal inflation is below inflation.
Real interests move in a direction of real cash rates however this is no exact
relationship.
The RBA controls the nominal interest rate thought its targeting of the overnight
cash interest rate. Because inflation is slow to adjust, in the short-run the reserve
bank can control the real interest rate as well. In the long run, however, the real
interest rate is determined by the balance of savings and investment.

PAE and the Real Interest Rate
Higher real interest rates will lead households to defer current consumption
(positive effect on saving and borrowing costs are higher). Thus, Error! Not a
valid embedded object.
Higher real interest rates will raise the cost of capital and reduce investment by
firms. Thus, Error! Not a valid embedded object.
(Assume G, T and X (N-X-bar, not NX-bar) are exogenous) Therefore,
Error! Not a valid embedded object.
The implication of this is that PAE will rise and fall with the real interest rate (as
set by the RBA when inflation is sticky) since exogenous expenditure now
depends on the real interest rate. The RBA now has a mechanism by which
monetary policy can affect PAE and equilibrium output.












[CHECK EXAMPLE 8.4 & 8.5]

Policy Reaction Function: mathematical representation of how central banks
adjust interest rates in light of the state of the economy.

35

The model assumes that RBA will set level of real interest rate as a function of
the state of the economy. Policy reaction functions characterise the central
banks behaviour.
Taylor Rule: [Output gap affects level of interest rates]
Error! Not a valid embedded object.
Simplified policy reaction function: [Primarily depends on inflation. R-bar is
interest when inflation zero. G is how many percentage points the interest rate
rises with inflation].
Error! Not a valid embedded object.
Simplified policy reaction function with inflation target: [Target could be 2.5, or
the mid-point of their target range].
Error! Not a valid embedded object.
o Positive slope RBA raises the real rate as inflation rises (Inflation is
associated with an expansionary gap.
In practice, the reserve banks information about the level of potential output
and the size and speed of the effects of its actions is imprecise. Thus monetary
policymaking is as much an art as a science.

36










Chapter 9: Aggregate Demand and Aggregate Supply

Key Issues
Aggregate Demand (AD) Curve
Slope and Shifts in the AD Curve
Inflation: Inertia and the Output Gap
Aggregate Supply (AS) Curve
AD-AS Model
Applications

Aggregate Demand (AD) Curve: Shows the relationship between short-run
equilibrium output, (y), and the rate of inflation (); the name of the curve that
reflects the fact that short-run equilibrium output is determined by, and equals,
total planned spending in the economy; increases in inflation reduce planned
spending and short-run equilibrium output, so he aggregate demand curve AD, is
downward sloping.
There is a NEGATIVE relationship between output and inflation (logic behind
negative slope):
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This relation occurs due to the actions of the reserve bank to match planned
spending with capacity, otherwise there will be changes to the general price
level. When inflation is high, the reserve bank responds by raising the real
interest rate. The increase in the real interest rate reduces consumption and
investment spending, hence reduces equilibrium output.
Other reasons for the slope include net wealth (inflation distorts asset prices and
affects peoples spending patterns) especially true for money and the
purchasing power of money. Inflation also affects wealth/income distribution,
inflation tends to affects those on lower incomes more, who spend a greater
proportion of their income. Inflation also crates greater uncertainty amongst
households and firms, reducing their spending. Also, the price of domestic good
and services changes on the international market, leading to a decline in exports.

37

Shifts in AD Curve:
Changes in spending caused by factors other than interest rates (exogenous
spending).
Exogenous change in the RBAs policy reaction function, r-bar component
change in r at every level of AD.












Note: a change in inflation corresponds to movement along AD curve, provide
interest rate are consistent with policy reaction function. CHANGES TO THE REAL
INTERST OR INFLATION RATE DO NOT SHIFT THE AD CURVE - CHANGES TO THE
POLICY REACTION FUNCTION DO!
Why does inflation move slow? Inflation expectations and long-term wage price
contracts (think of the employer bargaining future wages). The cycle: low
inflation expectations, slow increase in wage and projection costs, and low
inflation.

Inflation and Aggregate Supply (AS)
AD curve contains two endogenous variables the output gap and Inflation
shocks.
Inflation Inertia refers to the notion that inflation is sticky or inertial. This is
because the rate of inflation tends to change relatively slowly each year in the
absence of adverse stocks. Reflects the influence of:
o Inflation expectations become a self-fulfilling prophecy. If a firm
expects inflation to rise, they will charge more to shield themselves from
the higher that is expect.
o Long-term nominal wage and price contracts. For example, a union
negotiating in a high-inflation environment is much more likely to
demand a rapid increase in nominal wages over the life of the contract
that it would in a price stable economy.

Output Gap
Inflation
Expansionary (y>y*)
Rising
-Sales exceed normal production rate.

38

-Increase prices to cut excess demand.

Contractionary (y<y*)
-Selling less than capacity.
-Cut prices to sell more.

Zero (y=y*)

Falling slower rate of pricing increases

Constant change in price level is zero. No
inflation pressures for change.

Aggregate Supply: Short-Run and Long-Run + Aggregate Demand Equilibrium
Long-run aggregate supply (LRAS): a vertical line showing the economys
potential output (y*).
Short-run aggregate supply (SRAS): a horizontal line showing the current rate of
inflation, as determined by price expectations and pricing decisions.
Short-run equilibrium: a situation in which inflation equals a value determined
by past expectations and pricing decisions, and output equals the level of short-
run equilibrium output that is consistent with that inflation rate; graphically,
SRAS intersects AD.
Long-run equilibrium: a situation in which actual output equals potential output
and the inflation rate is stable; graphically, AD intersects with SRAS intersects
with LRAS.
o Contractionary output gap (negative output gap)












Recall that in a contractionary gap firms are not selling as much as they
planned to, so they slow down the rate at which prices increase. This
leads to lower inflation and an increase in aggregate demand, pushing
the economy to the long run equilibrium where there is no output gap.
o Adjustment to an Expansionary Gap

39

Note: this implies the economy is self-correcting, however, this speed of return
to LR equilibrium may be unacceptably slow. The greater the initial gap the
longer correction period. This is in contrast to Keynesian economics, which
assumes sticky prices.
This self-correction process means SRAS moves to bring the economy into long-
run equilibrium.

Shocks to AD Curve (by fiscal or monetary policy)
Increase in PAE results in expansionary shifts in AD curve (right shift). When the
economy is already at potential, any increases in exogenous PAE will put upward
pressure on inflation and shift up SRAS (e.g. military spending which increases
G).

Note: In the long run, y = y* (the increase in output is only temporary) but higher
inflation occurs. BUT by increasing (contractionary monetary policy) and shifting
its policy reaction function upwards, the RBA can decrease PAE and move AD
curve to left. This will offset the positive spending shock.

40



Shocks to Aggregate Supply - Inflation shocks (SRAS) and potential output shocks (LRAS).
Inflation shocks shift in the SRAS curve. Inflation shocks are unrelated to the
nations output gap. E.g. examples rising energy/oil costs. Creates stagflation
(recession + higher inflation)
o Sudden change in the rate of inflation that is unrelated to output gap I.e.
LRAS is unchanged. Examples: Large increases in economy-wide wages, or
large falls in manufactured goods prices (China) e.g. large change in oil
prices.
























Potential output Shock: shifts the LRAS curve.
o Fall in Potential Output e.g. smaller capital stock due to sharp rise in oil
as less energy efficient equipment is retired.







41

o Note: because this is a fall in potential output, decline in output is
permanent and inflation rate is higher. This is costly in terms of forgone
output.

Anti-inflationary monetary policy
Shift AD left by increasing r-bar (upward shift in PRF). This reduces the level of
inflation. In the short run, output falls. In the long run, output returns to
potential but at a lower inflation rate. In the short run there is lower output and
higher unemployment and little to no reduction in inflation as it is sticky,
benefits are long term.









Disinflation: a substantial reduction in the rate of inflation. Once a country has
attained a low inflation rate it may introduce institutional arrangement to help
ensure that the lower rate is sustained. Also peoples expectations may be
anchored to lower inflation. Disinflation is costly because it has recessionary
short-term effects.


















42




Chapter 14 Exchange Rates and the Open Economy

Key Issues
Nominal and real exchange rates
Purchasing Power Parity (PPP)
Supply and Demand Model of the Exchange Rate
Fixed Exchange Rates

Nominal Exchange Rate: the rate at which two currencies can be traded for each
other. Units of foreign currency per (one) unit of domestic currency; $F/$D. The
asset is in the denominator.
Nominal exchange rates are the price of one currency in terms of another one.
e = number of units of foreign currency that one unit of the domestic currency
will buy = $F/$D.
o Hence an appreciation (deprecation) of e is an appreciation
(depreciation) of $D. This means D has changed values relative to other
countries purchasing power.
The trade-weighted exchange rate is an average of one countrys exchange rtes
with all of its trading partners, where relatively important trading partners are
accorded a relatively larger rate.
Fixed vs. floating exchanger rate systems.
Real Exchange Rate: the price of the average domestic good or service relative
to the price of the average foreign good or service, when prices are expressed in
terms of a common currency.
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Real exchange rates measures the price of average domestic goods relative to
the price of average foreign goods (when prices are expressed in common
currency).
A rise in the real exchange rate implies that domestic goods are becoming more
expensive relative to foreign goods. Other things equal, this tends to reduce
exports and encourage imports; with the overall effect of reducing the level of
net exports.
A fall in the real exchange rate implies that domestic goods are becoming
cheaper relative to foreign goods. Other things equal, this tends to increase
exports and discourage imports. This leads to a rise in net exports.

Determination of the exchanger rate (PPP and S/D for currencies)
Law of one price: if transport costs are relatively small, the price of an
internationally traded commodity must be the same in all locations. Otherwise
arbitrage opportunities exist.

43

Purchasing Power Parity (PPP): the theory that nominal exchange rates are
determined as necessary if the law of one price holds; Pf/P=e. Implications:
o Exchange rates are determined by relative price levels.
o Exchange rate adjusts so that price levels in two countries are equal
(when measured in a common currency).
o Countries that experience relatively high inflation will tend to have
depreciating currencies.
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Limitations of PPP
o Stronger support for PPP in the long run (i.e. over decades), than short-
run.
o Non-traded goods - goods difficult to trade internationally e.g. haircut.
o Trade barriers such as tariffs and quotas - raise costs of transporting
goods internationally.
o Some goods are not identical and cannot be compared. E.g. Japanese cars
are unique to American cars.
Supply and Demand Model for currencies (Explains short run behaviour better
than PPP).
o Note: model determined with respect to domestic country
o Supply of AUD - Australian (domestic) households and firms who want to
purchase foreign goods, services or financial assets. Such purchases
require foreign currency so households and firms supply Australian
dollars in exchange for foreign currency (Yen). SLOPE: An increase in the
number of JPY offered per AUD, makes Japanese goods and services
more attractive for Australians. SLOPE: An increase in the number of JPY
offered per AUD, makes Japanese goods/services more attractive.
o Demand for AUD - Foreign/Japanese households and firms who want to
purchase Australian goods, services or financial assets. Such purchases
require $A so Japanese households and firms supply Yen in exchange
for $A. SLOPE: The more JPY that must be offered for per AUD, the less
attractive Australian goods and services are for the Japanese.

Shifts in the Supply Curve
Increase in Supply Curve as the AUD Depreciates e falls (Shift right).

44

o Increased preference for Japanese goods

o Increase in Australian GDP (income effect). Allows for greater
consumption, part of which will be from imports.
o (Expected) increase in the real return on Japanese assets, greater return
(given risk held constant). This attracts savers in Japan who leave the
Australian markets.

Shifts in the Demand Curve (Exogenous shift in the desire of Japanese to purchase
Australian GS/Assets)
Increase in Demand Curve as the AUD Appreciates e rises (Shift right).
o Increased preference for Australian goods.
o Increase in Japanese GDP (income effect).
o (Expected) increase in the real return on Australian assets.

Monetary Policy and the Exchange Rate

In open economies like Australia, the exchange rate provides an additional
channel by which monetary policy can influence the level of aggregate demand
and GDP.
If the RBA tightens monetary policy (by raising the real interest rates), this will
increase demand for the dollar and produce an appreciation of the exchange
rate. But, the supply curve may also shift (inwards) as Australians buy less
foreign assets.
The higher e or appreciation of the AUD should reduce net export and increase
imports, which decreases overall economic activity as measured by AD. Thus the
strong dollar reduces net exports and higher interest rate reduce consumption
and investment.
[!] Note: monetary policy is more effective in open economy with flexible
exchange rate.

A Real Appreciation and NX
Recall, real exchange rate = eP/Pf.
Then if domestic and foreign prices are sticky in the short-run, the nominal
appreciation will lead to an appreciation of the real exchange rate.
Thus, the higher value of the dollar will tend to reduce the level of next exports,
reducing aggregate demand and the level of output.

Fixed Exchange Rates
An exchange rate whose value is set officially by government policy. Country
fixes the value of its currency against some other currency (or a basket of
currencies). The value of a fixed exchange rate may deviate from its fundamental
value due to supply and demand in the FX market.
Devaluation: decrease in official value of currency.

45

Revaluation: increase in official value of currency.

Under fixed exchange rate a currencys value can differ from its fundamental
value (intersection of supply and demand curves actual exchange rate)
Overvalued exchange rate: an exchange rate that has an officially fixed value
greater than its fundamental value.

Central bank buy back the extra supply of domestic currency and become a
demander of the currency. Overvalued currencies can also be maintained by
restricting international trade/transactions (imports/quotas/tarrifs).
Undervalued exchange rate: an exchange rate that has an officially fixed value
less than its fundamental value.
International Reserves: foreign currency assets held by a government for the
purpose of purchasing the domestic currency in the foreign exchange market.
There is obviously a limit to reserves, and a fixed exchange rate can collapse in
this case.
o Balance of payments deficit: net decline in a countrys stock of
international reserves over one year.
o Balance of payments surplus: the net increase in a countrys stock of
international reserves over a year.
Note: devaluation means everything in domestic currency is now worth less

Fixed Exchange Rates are Subject to Speculative Attacks
Speculative Attack: massive selling of domestic currency assets by financial
investors (domestic and foreign). Driven by fear of (expected) devaluation
(currency is overvalued, and reserves could be low). Increases supply of domestic
currency and leads to a fall in the fixed currencys fundamental value. Central
bank needs to buy a greater value of domestic currency, which increases the
further increases reserves deficit. Devaluation may eventually be required. Thus,
fear of devaluation causes devaluation self-fulfilling prophecy.

46















Monetary Policy to Defend an Overvalued Exchange Rate

Currency is overvalued so central bank tights monetary policy. Higher domestic
interest rates should also shift the supply curve left and reduce quantity
demanded!
If currency is undervalued, central banks should adopt expansionary monetary
policy, which reduces the real interest rate and decreases demand. The Demand
curve shifts left and the supply curve shifts right.

Conflict for Policymakers - Stabilize the currency, vs. Stabilise the domestic
economy. Actions to stablise the currency and stop speculative attacks may have
a contracitonary effect on the domestic economy.
Pegged/fixed exchange rates provide potential benefits to countries who are
poor monetary policy managers who have high inflation.
Note: Overvalued currencies have the fixed line ABOVE equilibrium Undervalued
currencies have the fixed line BELOW equilibrium. In undervalued, excess
demand is met by central banks who obtain foreign currency in exchange for
47

domestic currency (loose domestic currency reserves). In overvalued cases,

foreign currency is depleted to purchase domestic currency and inflate the price
this is very risk and creates risk of speculative attacks.

Advantages/Disadvantages of a Flexible Regime
[FOCUS] Countries can use monetary policy for domestic stabilization
strengthens impact of aggregate demand (independent monetary policies)
[AUTOMATIC] Automatic adjustment to equilibrium in the foreign exchange
market
Volatility negative impact on trade

Advantages/Disadvantages of Fixed Regime
(Potentially) stable exchange rate, may promote trade (less volatility and
financial risk). However, speculative attacks threaten the long-term predictability
of a fixed exchanged rate
Countries cannot use monetary policy for domestic stabilization [MAJOR
DISADVANTAGE!]



























48

Chapter 15 The Balance of Payments: Net Exports and International Capital Flows

Key Issues
Balance of payments
Relationship between the capital and the current accounts
Determinants of international capital flows
Saving, investment and capital inflows

Balance of Payments: Record of transactions between residents of a country and
non-residents.
o Current Account: Transactions leading to a change of ownership of
commodities or a direct flow of income [G/S + interest payment/income
payment on foreign investment].
o Capital Account: Transactions involving the purchase or sale of assets
[Bonds and equity].

Current Account:
Balance on merchandise trade (exports imports of goods)
+ Net services (difference between total service credit and debit)
= Balance on good and services
+ Net income (includes labour and property income; interest, dividend and
royalty payments. CR is an inflow, DR is an outflow)
+ Current transfers (migrant funds, foreign aid)
= Balance on Current Account
Current account deficit, when DR>CR. Current account surplus when CR>DR.

Account
Debit
Credit
Merchandise
Domestic purchase of Japanese Sale of wheat to Russia
trade
car
Services
Domestic buyer pays freight
Overseas buyer pays freight
cost on imports
costs on exports
Income
Domestic company pays
Foreign company pays
foreign employee
domestic employee
Transfer
Domestic relative sends cash
Over relative send cash gift to
gift to overseas resident
domestic resident.

Capital Account:
o Transactions between domestic and foreign residents that involve the
acquisition of an asset or a liability
o New liabilities are recorded as credits (as they bring in foreign exchange)
like exports of goods and services

49

o Acquisition of assets are recorded as debits (as they require foreign

exchange to be given up by domestic residents) like imports of goods
and services
o Balance on capital account is difference between total credit items (sales
of domestic assets/acquisitions of a liability by a domestic resident) and
total debit items (purchase of foreign assets/discharge of a liability by a
domestic resident) in the capital account of the balance of payments.
The capital account is divided between two sectors.
o The official sector records the transactions of the government sector and
the Reserve Bank.
o The non-official sector records the transactions of private sector firms,
financial institutions and households.
Balance on Financial Account:
The important part of the capital account is the balance on the financial account,
which records:
o Direct and portfolio investment balances of net foreign investment in
Australia and Australian investment abroad.
o Plus changes in the RBAs holdings of foreign exchange and gold.
A smaller part of the capital account is the balance on the capital account, which
records:
o The cancellation of debts of poor countries and funds taken in and out by
migrants.
o Plus, the net acquisition/disposal of non-produced, non-financial assets,
e.g. records sales of embassy land or patents and copyrights.
Capital Account:
Net capital transfers
+ Net acquisition/disposal of non-produced, non-financial assets
= Balance on capital account
+ Balance on financial account (foreign investment)
= Balance on Capital and Financial Account

International capital flows: flows of financial capital between countries as a
result of the sale or purchase of one countrys assets by other countries. Capital
inflows: when financial capital flows into a country as the result of a sale of a
domestic asset. This is equivalent to a domestic resident acquiring a liability to
an overseas agent. Capital outflows: when financial capital flows out of a country
as the result f a purchase of a foreign asset. This is equivalent to a foreign
resident acquiring a liability to a domestic agent.
International Capital Flows Purchases and sales of real and financial assets
across international borders are called international capital flows. From the
perspective of a particular country:
o Purchases of domestic assets by foreigners are called capital inflows,

50

o Purchases of foreign assets by domestic households and firms are called

capital outflows.
Difference = net capital inflow/outflow
Capital Flows, Saving and Investment International capital flows allow
countries to invest in more productive investment opportunities than would be
possible relying only on national savings. In a closed economy, national saving
and investment are equal. In an open economy, where capital flows are possible,
savings from other countries can finance investments.
Current and Capital Accounts: the balance on the capital (and financial) account
will be the same value as the balance on the current account, though have the
opposite sign. This implies that (subject to recording errors):
CAB + KAB = 0
CAB = -KAB
Note that the above condition always hold for a flexible exchange rate, however
for a fixed exchange rate, it is possible to have surplus and deficits in the CAB
and KAB account due to the purchase/sale of currency by the central bank.
Why Does CAB=-KAB?
Suppose an Australian purchases a $40,000 Japanese car, and writes a cheque
for $40,000. The Japanese company has three options with the money:
1. They could use the $40,000 to buy Australian goods Australian import =
exports so CAB = 0.
2. Could buy a real or financial Australian asset or simply leave the money in the
bank (an asset acquired by foreigners). The import would not be offset by an
export so CAB = -$40,000, and there is a capital inflow of $40,000, so KAB
= +$40,000.
3. They could swap the $40,000 with a third party for another currency (e.g.
yen), but the third party would only have the preceding two choices.
The supply of the Australian currency is related to Australian residents demand
for either foreign goods (DR current account) or foreign financial assets (DR
capital account). The demand for Australian currency depends on the demand
for Australian exports (CR current account) or demand for Australian financial
assets (CR capital account).

Determinants of Capital Flows Why would foreigners want to acquire
Australian assets, and conversely, Australians want to acquire assets abroad?
The factors that determine attractiveness of any asset are: return and risk. Other
things equal (i.e. foreign real returns and the degree of risk) a higher domestic
real interest rate will tend to increase capital inflows, as foreigners buy more
domestic assets and domestic residents buy less foreign assets.

51

Capital Flows and Risk: risk has the opposite effect on capital flows. For a given
real interest rate, an increase in the riskiness of the domestic assets reduces the
net capital inflows, as domestic assets become less attractive to domestic and
foreign purchasers. This shifts the capital inflow curve to the left for any given
real interest rate [Relatively higher returns increase capital inflows, risk
reduce capital inflow].
Small Open Economies: In small open economies (SOE) like Australia, large
capital flows would tend to eliminate any sustained differences in the interest
rates between the domestic and foreign interest rates: r=r*

The domestic interest rate can deviate form the world interest rate if either the
domestic economy is perceived to have some level or risk or there is an
expectation that the exchange rate is likely to change over some point in time.
Saving, Investment and Capital Flows: In a closed economy, national saving (NS =
private + public saving) and investment (I) are equal.
NS = I
In an open economy, where capital flows (KI) are possible, savings from other
countries can finance domestic investments.
NS + KI = I

Implies that shift in national savings does no affect r or r*. The Australian
economy is a net capital importer, hence KI is below equilibrium. In a country
like Japan, where net savings < capital outflows, the KI line is above the
equilibrium as there is net capital outflow.
52

Although capital inflows are generally beneficial to countries that receive them,
they are not costless. Prospects of higher interest and dividends unstable debt
crisis result in returns from capital investments going abroad rather than
accruing to domestic savers.
Capital inflows can augment the pool domestic saving. This means that in an
open economy investment need not be confirmed to the size of the available
supply of domestic savings.
Saving, Investment and Net Exports: national accounting identity to show the
relationship between these variables.
Y=C+I+G+NX
But recall, Y-C-G = NS
NS-I=NX
Implies that low national savings (NS<I) may be the primary cause of trade
deficits since NX will be negative.
In summary, the higher real interest rate and lower risk combination increase
capital inflows. The availability of capital inflows expands a countrys pool of
saving, allowing more domestic investment and increased growth. A drawback to
using capital inflows to finance domestic capital formation is that the returns to
capital (interest and dividends) accrue to foreign financial investors rather than
domestic residents.

53





Chapter 10 and 11 The Economy in the Long Run: Economic Growth

Key Issues
Real GDP per capita
The production function Cobb-Douglas
Growth accounting

Recall that over long run, prices are no longer sticky. Macroeconomic analysis of
economic growth essentially studies how long-run forces affect potential
output.
Aggregate demand has no influence on long-run growth of potential GDP.
Over the past centuries, economic growth has increased significantly, however
not equally distributed. Asian Tiger countries, good; Sub-Saharan Africa, bad.
This is the effect of compounding growth rates, magnifying minor differences.
Conventional a to use real GDP per capital as measure of countrys living
standard.

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However GDP is not a perfect measure of economic wellbeing, although is
positively related to quality of life.
Growth Rates Have Big Level Effects [(1 + g)t] power of compound interest.

[Where N is employed workers]

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Therefore GDP per capita is average labour productivity (GDP/N) times share of
population in employment (N/population).
Thus, Real GDP per capita can only grow if labour productivity grows, and/or the
employment share grows (i.e. increasing women in work force). Not that large
this participation factor is unlikely to continue growing as we have seen in past
decades as many women are already employed, and Australias population ages
and enters retirement.
Labour productivity is the biggest source of output per person.
Influences on Labour Productivity
o Human capital
Talents, Skills, knowledge, education, training of worker.
Note there is an opportunity cost with studying and getting paid
to do work, but benefit of higher pay potentially.
o Physical capital per worker (quantity of machines)

54

Tools, machines and equipment (e.g. computers, earthmovers,

assembly lines) and buildings (e.g. factories, office building).
Sometimes too much capital is not good if there are not enough
workers to use them Diminishing returns to capital applies
here [hold all other variables and increase capital, the less an
additional unit of capital adds to production].
o Land and natural resources (energy and raw materials)
Beneficial but not 100% necessary. Productivity is more
important.
Sometimes there is a resource curse (higher resources with low
productivity).
o Technology (Stock of ideas, quality of machines)
Transportation, computer technology - IT and Internet, more
efficient farming or construction machines than competitors.
Building on these ideas can lead to discuss comparative
advantage.
o Management and Entrepreneur (organisation of production)
People who create new economic enterprise.
Management, financial analysis and marketing skills can be
taught, but society needs a way to channel energy into an
economic productive way e.g. flexible regulation and non-
burdensome taxation.
Business leaders run businesses, obtain funds, delegate jobs,
motivate. Entrepreneurship is a spirit/personality.
o Political and Legal Environment (property rights)
Encourage population to behave in economical productive ways
(intellectual property).
Well-defined property rights private owners incentive [help
determine and allocate resource to people also provide
incentive to work, this is why communism failed partly].
Bankruptcy laws can encourage people to have a go.
Political instability detrimental to economic growth.
Government is unstable, struggle for power war, terrorism civil
unrest.
Free and open exchange of idea promotes development.
Costs and Limits to Economic Growth can GDP grow indefinitely without
depleting natural resource and affecting the global environment?

55

o High investment can force people to consume less and save more there
is a trade-ff between consumption today vs. future. This is because of the
scarcity principal.
o Growth in real GDP can be in the form of new or higher quality products
with may not require more input materials.
o Pollution (quality of life)
o Depletion of natural resources (enrivonemnt)
o Market prices can adjust for shortages in resources scarcity principles
application of cost-benefit principles.
o Reduced leisure time
Recall, scarcity principle means having more of one good usually means having
less of another.
Promoting Economic growth
o Policies to increase human capital (better education through policy focus,
HECS, apprenticeship)
o Policies to promote saving and investment public investment, private
saving (infrastructure spending, compulsory superannuation)
o Policies that support research and development.
o Legal and political framework taxation, regulations, structure.
Limits to growth are poor legal and political systems, where corruption and
nepotism exists.
Limit to growth
o The finite supply of natural resources had led many to conclude that
there must be a limit on the extent of economic growth.
o Economic growth can still occur through more efficient use of existing
resources and through development of new technologies.
o The price system will continue to allocate resources efficiently in a
growing economy and will allow necessary adjustments to be made in the
way that scare resources are used.
o Real GDP vs. Pollution is U shaped, air pollution increase to a point a then
decline.
Industrialised manufacturing.
Developed service clean sector + sophisticated and cost-
effective anti- pollution solutions.

Production Functions: representation of relationship between primary (labour
and capital) and secondary factors (aka Total factor Production (TTF) - i.e.
technology, managerial expertise, skills, infrastructure roads, rail, intangibles -
political stability) of production and aggregate output (GDP).

56

Error! Not a valid embedded object.

Level of real output (Y) depends upon three things:
o Aggregate labour input (L)
o Aggregate capital stock (K)
o The state of technology (A)
Property: Constant Returns to Scale

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Property: diminishing marginal product

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Note: these are diminishing because the second derivative is positive.
Recall, marginal product of capital MPK is the incremental output from a 1-unit
increase in the capital stock, holding all other factors constant. MRPK is the extra
revenue received by a firm from selling the output obtained from an extra unit of
capital (MRPK=P-bar*MPK). Diminishing marginal productivity laws apply to
capital. This is another application of the low-hanging-fruit principle. Capital
equipment should be assigned to area where it will be most productive. Too
much capital is wasteful since limited workers cannot use it all at once. Optimal
capital stock is the capital stock at which the benefits form adding another unit
of capital are exactly offset by the costs of adding another unit of capital.
MRPL is the extra revenue received by a firm from selling the output obtained
from an extra unit of labour (MRPL=P-bar*MPL=W firms expand until they reach
the optimal labour stock MPL = W/P).

Demand for Labour
o L is total number of hours supplied.
o W/P = real wage.
o Marginal product of labour extra output that result from employing
additional unit of labour
o Labour will be used up to the point where MPL = W/P. I.e. extra benefit =
cost (real wage)

57







o Shift right workers more skilled, higher P.
o Shift left lower prices (higher real wage).

Demand for Capital

o Marginal product of capital (MPK) extra output that results from one-
unit increase in capital marginal product of capital declines as size of
capital stock increases .
o Capital will be used up to the point where MPK = r, where r is the cost of
capital. I.e. extra benefit = opportunity cost / real cost on loan borrowing.









o Shift right - ^ P, technology makes K more productive.
o Increase K - ^r.
(Specific production function) Cobb-Douglas production function:
Properties: constant returns to scale, and diminishing marginal productivity.

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Suppose labour and capital are paid t heir marginal products:
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58

Cobb-Douglas function suggests growth comes from only changes in labour,

capital or technology.
Growth accounting: a method of dividing a countrys historical growth
experience between growth in primary and growth in secondary factors of
production. Reveals factor productivity and labour growth have been the most
important factors underlying Australians economic growth. For Asian Tigers,
capital accumulation has been more important.
Recall,

Error! Not a valid embedded object.

Thus,
Yt = At K t L1t becomes :

Yt Yt1 At At1
K K t1
L Lt1
=
+ t
+ (1 ) t
Yt1
At1
K t1
Lt1
Yt At
K t
L

or :
=
+
+ (1 ) t
Yt1 At1
K t1
Lt1
A Y & K t
L )
t = t (
+ (1 ) t +
At1 Yt1 ' K t1
Lt1 *

Note that the LHS is the change in TFP (total factor productivity) is a residual turn
meaning it cannot be explained by capital/labour levels.
Thus, in any period, out is due to:
o Growth in technology At/At-1
o Growth in capital (weighted by ) Kt/Kt-1
o Growth in labour (weighted by 1-) Lt/Lt-1
Note: 0<<1.
Weighting means that if capital grows X% per period, then output grows X% per
period.
Estimating growth rate in technology (a residual term growth that cannot be
explained by labour or capital). However,
MPK = Y/K.
Thus, = MPK*K/Y
If capital is paid its marginal project,
r*K / Y = = payments to capital/Y
2 key assumptions: constant returns to scale and capital is paid its marginal
product.
59

o Recall that CRS implies a proportionate change in primary factors of

production leads to a proportioned change in output.

60