ECON1102 Final Exam Notes

UNSW Semester 2 ECON1102: Macroeconomics 1
ECON1102: MACROECONOMICS 1
1. AGGREGATE PRODUCTION AND PRICES .
1.1 GROSS DOMESTIC PRODUCT (GDP)
• Gross Domestic Product (GDP): Monetary value of final goods and services produced in a
country during a period of time
• Non-market production activities (e.g. household cooking), second-hand or used goods is

not included
1.1.1 MONETARY VALUE

• GDP = (Quantity of A x Good A) + (Quantity of B x Good B) + etc
• Note: Market prices are used in the calculation of GDP
1.1.2 GOODS & SERVICES W/O MARKET PRICES

• National statistical authorities seek to address this issue in 2 ways:
1. Estimate a market value for the good or service
2. Use historical cost e.g. contribution of police is measured by costs of labour + capital
1.1.3 INTERMEDIATE GOODS & VALUE ADDED

• Intermediate Good: Good that is used in the production of another good/service
• Value Added: Total value of a business’s sales — Cost of purchasing intermediate inputs
• 2 Ways to calculate the contribution of the production of a hamburger to GDP:
1. Measure the market price of the hamburger when it is sold to a final consumer ($5)
2. Production Approach: Summation of the value added of each producer who contributes
to the final product
• Quarter: Includes the month in its name + 2 previous months
1.1.4 EXPENDITURE APPROACH TO GDP

• Expenditure Approach: Summation of expenditures on domestically produced final goods
and services by households, businesses, governments and the rest of the world
• Consumption Spending (C): Expenditure by households
• Private Investment Spending (I): Expenditure by businesses
• Government Spending (G): Spending by all levels of govt aka public demand
• Exports (X) and Imports (M)
Y=C+I+G+X—M
1.1.5 STATISTICAL DISCREPANCY
• ABS obtains a single headline figure for quarterly GDP by taking the avg of the 3 measures
(production, expenditure and income)
• Note: Private investment includes ∆ level of inventories that are held by businesses
- ∆ Inventory = Inventory (end of period) — Inventory (beginning of period)
- Inventories: Currently unsold stocks of goods held by businesses
• Government Expenditure: Current/consumption spending and capital/investment spending
1.1.6 SECOND-HAND GOODS

• Domestically produced second-hand goods would have been included in measured GDP at
the time when they were newly produced and sold
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1.1.7 INCOME APPROACH TO GDP
• Income Approach: Sum of payments to labour and capital + net indirect taxes
• Total value added received by businesses must be paid to labour (wages and salaries) or paid
to capital (profits, interest or rents)
• Sum of payments aka GDP at factor cost (i.e. cost of purchasing the factors of production)
Y = LABOUR INCOME + CAPITAL INCOME + (INDIRECT TAXES — SUBSIDIES)

• If we assume net indirect taxes = 0, we can write GDP as: 
 
  Y = (W x L) + (R x K)
 
L = Labour, K = Capital, W = Wage, R = Rate of Return
• Compensation: Measure of total wages and salaries
• Gross Operating Surplus: Measure of payments to capital
• Gross Mixed Income: Payments to labour & capital which ABS is can’t separately identify
1.1.8 GROSS NATIONAL INCOME (GNI)

• Gross National Income (GNI): Income measure of GDP + NPI from Non-Residents
• To calculate GNI, subtract income paid to foreign workers from measured GDP
• Diff btw GDP and GNI in AU b/c foreign ownership of capital used in domestic production
1.1.9 NOMINAL & REAL GDP

• With nominal GDP, final goods are valued using the current period’s market prices
• Real GDP uses final good’s prices for a common base year to value quantities in other years
• Chain Weighting (Chain Weighted GDP)

- Better estimate of growth rate of real GDP is obtained by taking the average of the growth
rates obtained using each year in turn as the base year
1.1.10 NOMINAL, REAL GDP AND THE GDP

NOMINAL GDP = REAL GDP X GDP PRICE INDEX
GDP PRICE INDEX = NOMINAL GDP
REAL GDP
1.1.11 GROWTH IN REAL GDP
• ↑ Population growth has contributed to steady ↑ in real GDP over time
• Real GDP Per-Capita: Real GDP/Population
- Measure of the average volume of final goods and services produced per person
• ↑ Reflects growth in the quantity production, improvements in quality and ↑variety
1.1.12 GDP & ECONOMIC WELFARE

• Economic welfare depends on income levels, distribution of income and income inequality
• GDP may not fully capture quality of life factors e.g. crime rates and social cohesion
• Solutions to persistent criticisms of GDP:
- Adjust GDP to capture more depreciation costs (environmental, natural resource use)
associated with production; and household production
- Augment GDP with other economic and social indicators (e.g. life expectancy)
- Better Life Index (BLI) published by OECD compares well-being across its member
countries based on 11 criteria e.g. household income, education, work-life balance
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1.1.13 FLUCTUATIONS IN GDP
• Real growth rate variation has ↓en since 1970s b/c improved macro policy, greater flexibility
in labour and product market due to structural reforms
1.1.14 BUSINESS CYCLES

• Business Cycle: Short term fluctuations in the
growth rate of real GDP
• Expansion: Period when ↑ GDP
• Recession: Period when ↓ GDP
• Peak: Highest level of GDP
• Trough: Lowest level of GDP
• Australia hasn’t had a Classical recession since

the early 90s
1.1.15 TECHNICAL RECESSION

• Technical Recession: 2+ consecutive quarters of negative growth
1.2 CONSUMER PRICE INDEX (CPI)

• GDP price index provides a broad measure of avg ∆ prices across all econ. sectors
• Consumer Price Index (CPI): Measure of how the cost of purchasing the fixed basket of
goods and services changes relative to the base year
- Basket reflects the average consumption pattern for various households in some period
• Inflation: Situation in which the general price level in an economy is rising
• Deflation: Situation in where the general price level is ↓ing
CPI = COST IN CURRENT YEAR

COST IN BASE YEAR
• Rate of Inflation (%)
𝜋= CPI — CPI-1. x 100

CPI-1
1.2.1 BIASES IN THE CPI
• Quality Adjustment Bias
- When improvements in quality are not taken into account, CPI will over-estimate ↑ prices
- E.g. Selling a renovated house
• Substitution Bias
- Example: Suppose base year consumption basket contains 500 oranges and 500 apples
- Next year, there is severe frost and supply of oranges ↓s, raising their price
- In response households are likely to substitute apples for oranges
- Because substitution by consumers in response to relative price changes is not taken into
account, CPI will tend to overstate what consumers actually spend
1.2.2 TRENDS IN INFLATION & DEFLATION

• General Pattern for Developed Countries: Relatively low inflation in 1960s; period of high
inflation in 1970s and 1980s; period of relatively low inflation beginning 1990s until now
• Widely accepted that a relatively low and stable rate of inflation is a desirable outcome
- Evidence: Many developed countries have monetary policy inflation targets of 1-3% p.a.
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1.2.3 COSTS OF INFLATION
• Unexpected inflation transfers resources away from people with fixed incomes or with
incomes that are not fully indexed to the actual inflation rate
• Unexpected inflation causes a transfer from lenders to borrowers
• ∆ relative prices provides a signal to businesses to change their production, while a ∆ the
inflation rate does not
• Policy to minimise costs of inflation → Index all prices and wages to actual inflation rate
- Indexing: All prices and wages are allowed to ↑ at the same rate as inflation
• 2 Costs associated with (positive) inflation: Menu Costs and Shoe-Leather Costs
• Menu Costs: Any real (resource) costs associated with changing prices due to inflation
- Real costs that a↑ b/c prices need to be changed with greater frequency during inflation
- Restaurants need to spend resources to have menus re-printed to reflect new prices
• Currency and transaction accounts required to undertake purchases of goods and services
typical pay zero/very low rates of interest
- During periods of inflation the real value of these types of assets will ↓ and there will be
no compensation in the form of higher interest rates
- When ↑ IR, people have an incentive to economise on their holdings of currency and
transaction accounts and hold more resources in interest-bearing assets
- More frequent switches will be associated with higher transactions costs
- Transactions costs are shoe-leather costs (tend to ↑ with inflation)
‣ Inflation ↓ the real purchasing power of a given amount of money
• Unexpected Inflation
- Unexpected redistribution of wealth due to fixed nominal incomes
- Distorts tax systems (if not indexed to inflation)
- Introduces noise into the price mechanism
1.2.4 OPTIMAL RATE OF INFLATION

• Many countries have inflation targets of 1% to 3%
• Why not target an inflation rate for zero?
- Inflation allows for some flexibility in reducing real wages
- Suppose that to ↑ the economy-wide demand for labour, avg level of real wages should ↓
- Since real wage is W/P (money wage/general price level), it can be ↓ by ↓ W and/or ↑ P
- With zero inflation, only way to ↓ real wage is by ↓ money wage and workers will strongly
resist any reduction in their money wage
• Zero Lower Bound: Constraint that nominal interest rates cannot be negative
- Fisher Effect suggests higher inflation targets and consequently higher actual and
expected inflation would produce higher nominal interest rates
- Would give central banks greater scope to cut policy interest rates – in response to a bad
shock – before they hit the zero lower bound
• Persistent deflationary episodes have been associated with stagnant/negative growth
• Bad deflations are associated with low economic output
• Good deflations are driven by widespread ↑ production which causes a ↓ in general prices
• Policy makers wish to:
- Avoid high and variable inflation
- Avoid deflation
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2. EMPLOYMENT, UNEMPLOYMENT & THE LABOUR MARKET .
2.1 LABOUR MARKET DEFINITIONS & DATA
2.1.1 DEFINITIONS
• Working Age Population: Over 15 years old residing in Australia and not Australian military
• Employed: Minimum 1 paid/compensated hour of work per week (or on leave)
• Unemployed: Actively seeking work within the previous month + available to begin work
• Full-Time: At least 35 hours in all jobs during the previous week
• Not in Labour Force: Doesn’t meet requirements e.g. volunteers, homeworkers
• Underemployment: Working less than willing and able to

- Current position does not make full use of their level of skills/education/experience
• Discouraged Jobseekers:
- Given up active job search (but able to work) b/c they believe they have very little chance
of finding a suitable job
- Want to work and can begin work within 4 weeks
- Reasons: Lack of appropriate skills or training; disability; language difficulties
2.1.2 LABOUR MARKET DATA

• Unemployment Rate: # unemployed persons as % of the labour force
u (%) = UNEMPLOYED (U) x 100

LABOUR FORCE (LF)
• Participation Rate: # people in the labour force as a % of the working-age population
LFPR (%) = LABOUR FORCE x 100

WORKING AGE POPULATION (15+)
- Ageing population may cause a decline in the LF as more workers retire and leave LF
- BUTpeople are living longer and govt is looking to ↑ formal retirement age
- SR changes can affect LFPR e.g. ↑ economic activity may lead discouraged workers to
search for jobs and hence move into the LF
• Employment to Population Rate: # of people in employment expressed as a percentage of

the working-age population
EMPLOYMENT TO POPULATION RATE = E x 100

POP
- Employment rate is an indicator of the overall state of an economy’s labour market
- Provides a direct measure of the proportion of an economy’s economically active

population that is in employment
2.2 ECONOMIC CONCEPTS OF UNEMPLOYMENT

2.2.1 FRICTIONAL/SEARCH UNEMPLOYMENT
• Frictional/Search Unemployment: Unemployed (short period of time) b/c they are in
transition between different jobs
• Beneficial to an economy b/c leads to more efficient matching of workers & jobs
LF = L + U
• ∆ Unemployment:
ΔU = sL - fU
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• Where:
- S = job separation rate
- f = job finding rate
- sL = # people who move from being employed to unemployed
- fU = # people who move from being unemployed to employed during a month
ΔU = sLF - (s+f)U
• Suppose LR→ situation when unemployment is constant so that ΔU = 0
sLF = (s+f)U
• Long run frictional unemployment rate (%):
𝑢̃ = s x 100
s+f
• Frictional unemployment in the LR is determined by job separation and job finding rates
• Policies designed to ↓ frictional unemployment would need to ↓ s and/or ↑ f
2.2.2 STRUCTURAL UNEMPLOYMENT

• Structural Unemployment: Unemployment due to mismatch of skills & jobs
• Policies to reduce structural unemployment may involve re-training programs for workers or
other specific forms of assistance to find new jobs
2.2.3 CYCLICAL UNEMPLOYMENT

• Associated with fluctuations in the level of aggregate production
• If real GDP declines or even slows down (below its previous trend rate of growth) the
unemployment rate tends to ↑
2.2.4 NATURAL RATE OF UNEMPLOYMENT

• Natural Rate of Unemployment: Frictional UR + Structural UR
u* = FRICTIONAL RATE + STRUCTURAL RATE

CYCLICAL UR = u — u*
2.2.5 OKUN’S LAW

• Okun’s Law: Quantitative relationship btw economic activity (output gap) & cyclical
unemployment
• Output Gap = actual (measured) level of real GDP — measure of potential output
Potential Output & Output Gaps

• Potential output ↑ over time with growth in labour force, capital stocks and technology
• Utilisation Rate: Rate at which its workers and machines are used by a business
• High utilisation rate = workers and machines are “working long and hard” (e.g. workers have
lots of overtime hours and machines are being used around the clock)
• Normal utilisation rate: Rate that can to be sustained by a business in the LR w/o any
excessive/undue costs
• Potential GDP/Output: Real GDP that could be produced when labour & capital are utilised
at their normal rates
OUTPUT GAP = Y — Y*
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• Where:
- Y = Real (Actual) Output
- Y* = Real Potential Output
• Positive output gap (Y > Y*) = Expansionary gap
• Negative output gap (Y* > Y) = Contractionary gap
• Contractionary gap → Capital and labour not being fully utilised
• Expansionary gap → firm operating above normal capacity + can lead to raised prices
• Methods of estimating potential output: Assume potential output grows at a constant rate
• Output gap as a % of potential output:
OUTPUT GAP (%) = Y — Y* x 100
Y*
Okun’s Law
Y — Y* x 100 = - 𝜷 (u — u*)
Y*
• 𝜷 = Okun’s law coefficient
• According to Okun’s law, output gap is negatively related (-𝜷) to cyclical unemployment
• Australia’s 𝜷 is approx 2 → Figure of 2 implies that a 1% ↑ in the cyclical unemployment rate
will be associated with a 2% decline in the output gap
• Negative cyclical unemployment → measured rate of unemployment < NRU
• Since Okun’s law implies that negative cyclical unemployment = positive output gap, it reflects
unemployment ↓ing below what would be considered the usual/normal NRU
• Individuals who would normally be frictionally or structurally unemployed are temporarily
drawn into employment due to the relatively high level of real economic production
2.3 COMPETITIVE MODEL OF THE LABOUR MARKET

2.3.1 DEMAND FOR LABOUR BY A BUSINESS
• Marginal Product of Labour: Additional output produced by an additional unit of labour, with
all other factors of productions held fixed
• Value of Marginal Product of Labour: Marginal (physical) product of labour x output price
VMPL = MPL x p
• Diminishing Marginal Product: Each additional worker produces less output than the
existing workers
• Money (nominal) wage: Wage received by workers measured in units of currency
• Real wage: Measures ability of money wage to purchase real goods and services
• In deciding whether to employ a worker → VMPL ≥ W
• For a demand curve, # of workers is horizontal axis; VMPL is vertical axis
• ↑ (↓) money wage will cause ↓ (↑) number of workers employed
• 2 Factors affecting VMPL:
1. Product Price: ↑ p = ↑ incentive to produce = ↑ labour demand = shifts right
2. MPL: Changes in a firm’s capital/technology
- ↑ Capital and improvements in technology = ↑ MPL = VMPL shift right
• Factors that ↑ workers’ marginal productivity will ↑ the demand for labour
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2.3.2 LABOUR DEMAND IN AN ECONOMY
• Condition: Labour will be employed up to the point where the value of its marginal product =
economy-wide money wage
P x MPL = W
• P = Index of general price level (e.g. CPI or GDP price index)
• MPL = Aggregate marginal product of labour
• W = Index of general wage levels
• Aggregate level of employment is determined by MPL = real wage
• Changes in real wage will result in changes in amount of labour (either number of workers or  
hours worked) demanded in an economy
• ↑ real wage will be associated w/ ↓ quantity of labour being demanded
• Shifts in aggregate labour demand curve will occur if the firm’s output price ↑ or economy-
wide MPL changes e.g. due to changes in the aggregate capital stock/tech
2.3.3 LABOUR SUPPLY OF AN ECONOMY

• Economy-wide labour supply curve
• Supply of labour = total number of peoplewilling to work at each real wage
• Assumption: Supply of labour ↑ w/ real wages
• Shifts in labour supply curve a↑ from changes in working age pop & participation rate
• Causes of shifts in supply:
- Demographic changes e.g. changing birth or immigration rates, higher productivity
- Changes in preferences for work v leisure or for market v non-market work (volunteering)
- ↑ Longevity rates and inadequate levels of retirement income = ↑ labour supply
W/P
2.3.4 EQUILIBRIUM IN A COMPETITIVE  
LABOUR MARKET
• Le = Aggregate employment
Supply
• Innovation → ↑ in marginal productivity of  
workers → shift labour demand curve right
(W/P)
• ↑ Real wage & employment
(W/P)e
• Note: New tech will benefit some  
workers (↑ their marginal productivity)  
and hinder other workers
Demand
= VMPL
• Historically, tech change = long term ↑  
in aggregate real wages & employment
Q
Ld Le Ls
2.3.5 FRICTIONS IN THE COMPETITIVE LABOUR MARKET
• If Le < LF, there will be some level of unemployment (U = LF — Le) but this will be voluntary
• Involuntary unemployment: Situation where an unemployed individual would be willing to

accept a job at the current market wage but are not able to find employment
• Assuming some mechanism or institution causes the aggregate real wage in the economy to
be fixed at level > competitive level
• Since real wage (W/P) > equilibrium wage (W/P)e, labour demanded ↓ & labour supplied ↑
• Ls — Ld = People willing to work at real wage rate but are unable to find employment
• Ld = People employed at the min. wage are better off than at the market-clearing wage
• Factors leading to real wages being above equilibrium:
- Minimum wage laws (min. hourly wage aka award wages)
- Labour unions
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2.3.6 TAXES P
• Taxes (e.g. income taxes, payroll taxes)  
can shift level of employment
• Example: Lump-sum tax levied on workers
Supply
• Introduction of tax causes an upward  
shift of the initial labour supply curve, by  
the amount of tax per worker
W/Pemployer
• New labour supply curve (Labour supply   W/Pe
+ tax) intersects the initial labour demand  
curve at a higher real wage W/Pemployer and   W/Pworker
lower employment level Ltax
Demand
• Tax causes real wage by the employer  
to ↑ and real wage received by the worker to ↓
Q
Ltax Le
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3. INTEREST RATES, INVESTMENT & SAVINGS .
3.1 INTEREST RATES
3.1.1 NOMINAL RATE
• Interest Rate: Return/earned paid on a loan
• Nominal IR: Return on a loan measured in monetary terms (e.g. measured in dollars) 
• Net IR:
• Gross IR: 
i = CURRENT — PREVIOUS 1 + i = CURRENT

PREVIOUS PREVIOUS
3.1.2 REAL RATE

• Real Interest Rate: Return on the loan measured in terms of real goods and services
• Using the values of CPI, we first calculate the annual rate of inflation (𝜋)
𝜋= CPI — CPI-1. x 100

CPI-1
3.1.3 EX-POST & EXPECTED REAL RATE
• If we are using past or historical data then we can calculate the actual (ex-post) real IR
• Best lenders/borrowers can do is have an expected value for CPI/inflation over the next year
• 2 Measures of the real IR:
(EX-POST) r
≈i—𝜋
(EXPECTED) r ≈ i — 𝜋e
• Where 𝜋 = actual inflation rate, 𝜋e = expected inflation rate
• For economic decision making, expected real interest rate is relevant
3.1.4 FISHER EFECT

• Fisher Effect links interest rates and inflation rates
i = r0 + 𝜋e
• Implies nominal interest rate will move one-for-one with changes in expected rate of inflation
• We measure nominal IR on vertical axis and expected inflation on horizontal axis
• If 𝜋e < 0 we have expected deflation
• When 𝜋e = 0, nominal IR = real IR (i = r0)
• If expected deflation is not too far below zero, it ↓ value of nominal IR below real IR
- Example: Suppose r0 = 2% and 𝜋e = -1%, nominal IR = 1%
3.1.5 NEGATIVE INTEREST RATES

• Nominal IR was thought to be constrained by the Zero Lower
Bound (ZLB)
• Once expected deflation exceeds 2% (i.e. 𝜋e < 2), nominal IR

cannot ↓ any further
• Any further ↑ deflation rate will ↑ real IR
• As deflation ↑ (𝜋e becomes more negative), real IR ↑
• Note: Only occurs once nominal IR has ↓en to 0 and can’t ↓

any lower
• Possible for some nominal IR to be negative (e.g. Japan) 
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3.2 INVESTMENT
• Investment: Expenditures concerned w/ future production (not intermediate consumption)
3.2.1 PRIVATE INVESTMENT

• Undertaken by businesses and households
• Major categories of private business investment include:
- Purchases of new machines and equipment
- Investment in non-residential buildings and structures (e.g. engineering construction)
- Investment in cultivated biological resources (e.g. agricultural livestock, plantations)
- Investment in intellectual property (e.g. computer software, R&D expenditures)
• For the household sector purchases of new housing (+ renovations to existing dwellings) are
included in investment expenditure as dwelling construction
• Private Gross Fixed Investment = Private business investment + dwelling construction
3.2.2 PUBLIC INVESTMENT

• Govt undertakes investment at all levels and through publicly owned corporations
• Investment by govt sector is called public investment/public infrastructure investment
• Largest component is business investment and ↑s + ↓s greatly as a share of GDP
3.2.3 INVENTORY INVESTMENT

• Total inventory investment = ∆ the level of inventory holdings
• Reduced volatility of inventory investment since 1970s reflects better mgmt strategies for
planned inventory investment + decline in share of manufacturing production in total output
• Inventory investment = planned + unplanned changes in inventory investment
3.2.4 INVESTMENT & THE CAPITAL STOCK

• Investment expenditure is a flow variable and is measured over some period of time
• Standard formula for the accumulation of capital: 

 
  K1 = K0 + I1 - 𝛿K0
Where:
- K0 = Stock of capital at the beginning of the period
- I1 = (Gross) Investment over the period
- 𝛿K0 = Physical depreciation on the existing capital stock (𝛿 = depreciation rate)
- K1 = Stock of capital at the end of the period
• Gross investment is what is included in the expenditure approach to calculating GDP
NET INVESTMENT = I - 𝛿K
• Net investment is what adds/subtracts from capital stock in a period
3.2.5 ECONOMIC INFLUENCES ON INVESTMENT

• Business decisions to invest in new capital = demand for capital/investment
• Marginal Product of Capital (MPK): ↑ output due to the use of an additional unit of capital
• Assume MPK is positive but declines with each additional unit of capital added
• Value of MPK (benefit):
VMPK = MPK x p
• Where p = Sales price of business’s output
• VMPK measures the marginal benefit to the business from investing in new capital
- Needs to be compared to the marginal cost of the investment
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3.2.6 USER COST OF CAPITAL
• Goods purchased for investment will typically last for more than a single period of time
• Example: Business that purchased a new capital good for $1 million, could decide to re-sell
that good after using it for one period
- Cost to the business of using the capital good is less than the original $1 million purchase
• Where
- Interest cost of the good over one year = i x Pk
- Physical depreciation rate = 𝛿
- Amount of the good that remains at the end of the year = 1 — 𝛿
- Year-end market price = Pk + ∆Pk (∆Pk = ∆ price of the good over the year)
USER COST = PURCHASE PRICE + INTEREST PAYMENTS — MARKET PRICE OF

DEPRECIATED PLANE (YEAR-END)
UC = Pk + I x Pk — (1— 𝛿)(Pk + ∆Pk)

• 2 important influences on investment decisions: Price of Capital Goods + Real IR
- ↑ IR or price of capital goods would make investment less attractive
• Firm should compare UC to expected value of the marginal product of the good over the next
year → undertake investment if VMPK ≥ UC
3.2.7 AN APPROXIMATION
• Approx. user cost ($):
UC ≈ Pk (i + 𝛿 — 𝜋)
• Since real rate (r) = i - 𝜋, 
 
  UC ≈ Pk (r + 𝛿)

• Divide both sides by initial price:
UC = r + 𝛿
• Initial eqn implies that in situations where the depreciation rate is reasonably stable, we can
use real IR as an approximation to the user cost (at aggregate level)
3.2.8 INVESTMENT DEMAND CURVE

• ↑ Real IR will ↑ UC ∴ Less likely that value of the  
marginal product of a new investment > user cost
REAL RATE
• ↑ Real rate is associated with a movement   (W/P)
up the curve and ↓ aggregate investment
• Any factor influencing expected marginal product  

of capital can shift the investment schedule
• Example: Discovery of new tech with widespread  

application might result in ↑ investment (shifts right)
• Expectations about future economic state will affect   I(R; 𝛿, MPK)

(expected) marginal product of capital
- Shift curve right if optimistic (↑ MPK)

INVESTMENT (I)
- Shift curve left if pessimistic (↓ MPK) 
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3.3 NATIONAL SAVINGS
• Saving: Income — current consumption
3.3.1 HOUSEHOLD SAVING

• Household Savings = Household Disposable Income — Consumption Expenditure
• Household Disposable Income: Income available to households to spend/save
Y = LABOUR INCOME + CAPITAL INCOME + (INDIRECT TAXES — SUBSIDIES)

• Transfer Payments: Govt payments made to households (e.g. age pensions, unemployment
benefits) for no goods/services in exchange
• Govt Interest Payments: Paid to households on their holdings of govt bonds
• Most capital income is paid to households as rents, interest or dividends
YD = Y — TA + TR + INT — RE
• Where:
- YD = Household disposable income
- TA = Taxes (direct and net indirect)
- TR = Govt transfers
- INT = Govt interest payments to households
- RE = Business retained earnings
S = YD — C
• Where: S = Gross Household Saving
• Net Savings = YD — Depreciation
3.3.2 SAVING AND WEALTH
NET WEALTH = ASSETS — LIABILITIES

• Note: Wealth are stock variables and hence need to be measured at a point in time
• Standard to measure assets + liabilities at current market prices
• Household wealth can be affected by changes in the price of assets or capital gains/losses
• To consider changes in net wealth over time, write current stock of net wealth W1 as:
W1 = W0 + S + (NET) CAPITAL GAINS

• Where:
- W0 = Net household wealth at the beginning of the period
- S = Household saving over the period
- Net Capital Gains = Effect of market price changes on household’s assets + liabilities
W1 — W0 = ∆W = S + (NET) CAPITAL GAINS

• ∆ net wealth = Household saving + Net capital gains on existing assets
• Note: Property & superannuation = main household assets; mortgages = largest liability
3.3.3 WHAT IS “TRUE” SAVING

• 2 Measures:
1. Gross (Net) Savings from national accounts
2. Derived directly from household wealth
• Income-expenditure or Keynesian model uses the national accounting definition of saving
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3.3.4 ECONOMIC INFLUENCES ON HOUSEHOLD SAVING
Life-Cycle Saving (Meet long term goals)
• Households can use saving/borrowing to smooth their consumption in the face of expected
variations in their income aka consumption smoothing
• Example: Savings for a vacation
- Expected income may be zero so you will need to use saving to fund consumption
• Pattern of saving for a household over a lifetime aka life cycle saving
• Red line = Desired level of consumption; Blue line = Life-time income path
• In early life, individual has no income and relies on transfers (e.g. family) to fund consumption
• Once they begin working, income > consumption and the individual will save
• Saving might be for large anticipated expenditures e.g. buying a house, funding retirement
• In retirement, individual’s income < desired consumption and they finance the difference by
dis-saving (i.e. drawing on previously accumulated assets)
Bequest Saving
• Saving to leave an inheritance for their descendants
Precautionary Saving
• Saving as a form insurance (self-insurance) against hard to predict future events
- ↑ Uncertainty leads to ↑ precautionary saving
- Precautionary saving caused rapid ↑ household saving in Australia around GFC 2007-08
REAL IR (r)
3.3.5 ROLE OF THE REAL INTEREST RATE
• Saving allows for the moving of resources over time
S(r)
• When households are making decisions about  
consumption and saving decisions the real  
interest rate (r) plays the role of a relative price
• If real interest rate is low, (opportunity)  

cost of consuming more today is relatively low
HOUSEHOLD
- By forgoing $1 of consumption today you are   SAVING (S)
able to consume $1(1+r) tomorrow
• If r is high and you consume $1 today, you forego more additional consumption tomorrow
• ∴↑ Real IR will create an incentive to ↓ current consumption & ↑ saving out of current income
3.3.6 BUSINESS SAVING

• Profits earned by the business sector are typically paid to shareholders as dividends
• Possible for businesses to save by not distributing all their profits aka retained earnings 
Page 14 of 51
3.3.7 GOVERNMENT SAVING
PUBLIC SAVING = T — G

• Where G = Govt Expenditure
T = TA — TR — INT
• Where:
- TA = Taxes (direct and net indirect)
- TR = Govt transfers
- INT = Govt interest payments to households
• Public Saving aka Govt Budget Balance (BB) (surplus if positive, deficit if negative)
BB = PUBLIC SAVING = T — G
• Budget Surplus → Positive; indicates public saving
• Budget Deficit → Negative; indicates dis-saving by the govt sector
3.3.8 NATIONAL SAVING
NATIONAL SAVING = HOUSEHOLD SAVING + BUSINESS SAVING + GOVT SAVING

= PRIVATE SAVING + PUBLIC SAVING
NS(r) = S(r) + RE + (T — G)
•
• Assume all govt expenditure is for current consumption:
• Where:
- Y — RE — T — C = Household Saving
NS = Y — C — G
- RE = Business Saving
=Y—C—G+T—T
- T — G = Public Saving
= [(Y — T) — C] + T — G
=[(Y — T — RE) — C] + RE + T — G
• ↑ Real IR will ↑ national saving as we assume   REAL IR (r)

NS’(r)
that ↑ r leads to ↑ household saving
• Since business saving and public saving are   NS(r)

treated as exogenous, ∆ either of those  
variables will shift the NS curve
• Example: ↓ Public Saving (i.e. ↑ in size of budget  

deficit) will shift NS curve left
NS
REAL IR
3.3.9 NATIONAL SAVING & INVESTMENT   (r)
IN EQUILIBRIUM
• Combine aggregate investment & national saving   NS(r)
schedules for a closed economy (no access to  
international capital markets) to determine re
• Equilibrium for closed economy: Real IR will adjust  (r)e

to ensure National Saving = Investment holds
I(r)
Page 15 of 51 NS, I
NSe = Le
3.3.10 CROWDING OUT REAL IR
• Crowding Out: ↑ Budget deficit (or ↓ public   (r)
saving) can cause ↓ private investment
• Diagram: ↑ Budget deficit shifts NS curve left

NS’(r)
• ↓ in the national saving curve results in   NS(r)
an ↑ in the real interest rate (from r0 to r1)  
and this causes a shift up along the I(r)   r1
curve and hence a lower level of investment
• It is the reduction in private investment   r0

which is the key of crowding out
• ↑ in the budget deficit has led to a crowding  

out of some private investment
I(r)
NS, I
NS1 = I1 NS0 = I0
3.3.11 INVESTMENT SLUMPS REAL IR

• Exogenous shifts in I(r) curve can a↑ due to   (r)
changes in business confidence or general  
changes in productivity
• If future prospects look relatively poor,   NS(r)

economy-wide investment by businesses may ↓
• ↓ Business confidence causes I(r) to shift left

r1
• ↓ Real IR from r1 to r0 and ↓ investment  
& national saving  r0
I(r)
I’(r)
NS1 = I1 NS0 = I0 NS, I
Page 16 of 51
4. INCOME-EXPENDITURE MODEL OF GDP .
• Key assumption of Income-Expenditure Model: In the SR, businesses respond to
variations in demand for their output by changing their production
• If businesses face any menu costs in changing prices, they will find it profitable to keep
prices fixed and respond to ↑ (↓) in demand by ↑ (↓) production
• Short Run: Prices are fixed/sticky
• Long Run: Variations in aggregate expenditure affects inflation rather than level of real GDP
• Income-expenditure model is a model of income determination in the SR
4.1 AGGREGATE EXPENDITURE: ACTUAL & PLANNED

• Planned Aggregate Expenditure (PAE): Desired level of spending on domestically produced
final goods & services by all sectors of an economy
PAE = C + Ip + G + X — M
• PAE differs from actual aggregate expenditure by its inclusion of planned investment Ip
• Unplanned changes in inventories a↑ when desired purchases of a firm’s output differ from its
production level plus any planned ∆ inventories
I = Ip + ∆Invu
• Measured Investment = Planned Investment + Unplanned ∆ Inventories
4.1.1 EQUILIBRIUM & DISEQUILIBRIUM

• Unplanned changes in inventories are a signal to businesses to change production levels
• Equilibrium: Aggregate Production (GDP) = Planned Aggregate Expenditure:
Y = PAE
• At equilibrium GDP, there are no unplanned changes in inventories (∆Invu = 0)
• Disequilibrium occurs when businesses set their production levels but are uncertain abt PAE
4.2 TWO-SECTOR MODEL: HOUSEHOLDS & BUSINESSES
PAE = C + Ip
4.2.1 PLANNED INVESTMENT
• We assume that Ip is an autonomous/exogenous variable ∴Ip = Io
• Autonomous/Exogenous Variable: Determined by factors other than real GDP
4.2.2 HOUSEHOLD CONSUMPTION

• Considerably less volatile/variable than business investment
• 3 Basic types of consumption:
- Non-Durable Consumption: Goods for immediate consumption e.g. food
- Durable consumption: Goods that provide consumption flows over a relatively long
period of time e.g. cars and household appliances
- Consumption of Services: Expenditures such as going to the movies and education fees
4.2.3 MODEL OF CONSUMPTION

• Factors affecting households: Household income, wealth, IR, consumer confidence
• Keynesian Consumption Function assumes aggregate household consumption depends

upon current household disposable income
C = C0 + c(Y — T)
Page 17 of 51
• Where:
- C: Real Consumption Expenditure
- Y — T: Real Household Disposable Income
- Y: Real National Income (GDP)
- T: Total (Direct and Net Indirect) Taxes (TA) — Transfer Payments (TR) — Interest
Payments on Public Debt (INT)
• 2 Parameters in the Model:
- C0: What aggregate consumption will be if aggregate disposable income = zero
‣ Conventional that C0 > 0
- c: Marginal Propensity to Consume (MPC)
∆C = c ∆(Y — T)
- Assume ∆C0 = 0
c= ∆C
∆(Y — T)
• Key assumption of the Keynesian consumption function is 0 < MPC < 1
• Marginal Propensity to Consume (MPC): ∆ Consumption due to ∆ Disposable Income
C = C0 + c
Y—T Y—

T
• Average Propensity to Consume (APC): Ratio of consumption to disposable income
• For our Keynesian consumption function, APC > MPC
4.2.4 EQUILIBRIUM IN 2 SECTOR MODEL
Ye = 1 (C0 + I0)
1—C
4.2.5 GRAPHICAL REPRESENTATION
• Line is known as the 45 degree line
• Represents all possible cases where Y = PAE
• 45 degree line is not sufficient to indicate equil. GDP
• Consumption has autonomous component C0  

(vertical intercept) and component that depends on Y  
(induced consumption)
- Upward slope = MPC (assume < 1)
- PAE line is obtained by (vertically) summing values for

C and Ip for each level of Y
• Equilibrium GDP obtains at the level of Y for which the

PAE line cuts the 45-degree line
4.2.6 DIS-EQUILIBRIUM
• Suppose level of output produced = YL
- Planned aggregate expenditure is PAEL → PAEL > YL
- Since desired level of expenditure > level of output, business sector will experience
unplanned ↓ level of inventories (and excess demand for services)
- Business sector will respond by ↑ output production to above YL and will move GDP
towards Ye
Page 18 of 51
- For any output level below Ye, businesses will
experience unplanned inventory decumulation and will
have an incentive to ↑ production until Y = Ye
• When production is at YH (PAE < YH), business sector will

experience an unplanned ↑ level of inventories which will
signal businesses to cut back on their level of production
- Output will ↓ below YH and move closer to Ye
- For any output level above Ye, businesses will

experience unplanned inventory accumulation and will
↓ production until Y = Ye
4.2.7 CHANGES IN EQUILIBRIUM GDP

• Suppose election of a new govt leads businesses to be
more pessimistic about future profits and ↓ their current
level of planned investment
- Assume no effect from the new govt’s election on

autonomous consumption expenditure
- ↓ Planned investment from I0 to I1 will shift PAE

downwards
- ↓ PAE will ↓ equilibrium level of real GDP to Ye1
• ∆ Y is larger than ∆ Ip
• Multiplier: Measure of ∆ equilibrium GDP as a result of a

given exogenous ∆ planned expenditure
∆Ye = k = 1 .
∆C0 1—c
4.2.9 SAVING & PLANNED INVESTMENT IN 2 SECTOR MODEL

• For equilibrium GDP, savings = planned investment:
S = -C0 + (1 + c)Y
S = Ip
-C0 + (1 + c)Y = Ip
Ye = C0 + I0
1-c
4.2..10 PARADOX OF THRIFT

• Paradox of Thrift: While an individual household can
↑ its own savings, the attempt by all households to ↑
savings doesn’t lead to ↑ aggregate saving
• It just leads to a ↓ in consumption and output
• ↓acy of Composition: ↓acy of assuming what is true

for an individual is also true for the whole
• Attempt by all households to ↑ autonomous saving

results in ↓ real GDP which ↓ by just enough to ↓
induced saving so that it exactly offsets the
autonomous ↑
• Aggregate saving is unchanged
Page 19 of 51
4.3 OPEN MODEL ECONOMY
• Assume no govt in this economy
• Planned aggregate expenditure is given by:
PAE = C + Ip + X — M
• Expenditure on a country’s exports is likely to depend on the real income levels of its main
trading partners + relative price
• Treat exports as an exogenous variable → key influences are world demand + exchange rate
• Domestic real income or GDP is an important determinant of imports:
• Coefficient ‘m’ is the marginal/average propensity to import:
M = mY
∆Ye = m
∆Y0
- m indicates the ∆ imports for a ∆ real national income
PAE = (C0 + I0 + X0)+ Y(c — m)

• Independent of output (exogenous expenditure) and induced expenditure
• Equilibrium GDP:
Y= 1 (C0 + I0 + X0)
1 — (c — m)
• Equilibrium GDP depends on (planned investment + exports + autonomous consumption)
times multiplier for our open economy
• In the open economy, multiplier depends on MPC and marginal propensity to import
• Multiplier for the open economy is smaller than for closed economy (m >0):
1 < 1 .
(1 — c) + m 1—c
• Represent equilibrium for the open economy model using the 45-degree diagram
• PAE line will be flatter, with a slope of (c — m) but intercept will be a larger number due to
inclusion of exports
• Equilibrium output = where PAE curve (for the open economy) cuts the 45-degree line
Page 20 of 51
5. GOVT SECTOR & FISCAL POLICY .
5.1 GOVT SECTOR IN AUSTRALIA
• Macroeconomic activities of govt sector:
1. Spending on final goods and services
2. Raising revenue through taxes
3. Making transfer payments: Unemployment benefits, old age pensions, etc
• Govt spending can be split into:
1. Consumption (current) spending (main component)
2. Capital (investment) spending
5.2 GOVT IN THE INCOME-EXPENDITURE MODEL

• Assume 3 sector economy is closed (households, businesses & govt)
PAE = C + Ip + G
• Where:
- G = Govt purchases of goods & services
• Note: Taxes affect PAE indirectly through their effect on aggregate consumption expenditure
• Assume consumption depends on disposable income (Y — T)
C= C0 + c(Y — T)
5.2.1 TAX FUNCTION
• Assume tax revenues are comp↑d of an exogenous component T0 and an endogenous
component which depends on the level of Y:
T = T0 + tY
• Think of t as the marginal propensity to tax i.e. marginal tax rate:
∆T = t
∆Y
• Marginal Tax Rate: ∆ Tax revenues from a dollar ∆ national income (0 < t < 1)
• Tax function can be substituted into the consumption function to yield:
C = C0 — cT0 + cY(1 — t)
5.2.2 EQUILIBRIUM IN THE THREE-SECTOR MODEL
Y = PAE = C + Ip + G
• Sub C into the equation
PAE = [C0 — cT0 + I0 + G0] + cY(1 — t)

• Note: Variables in [ ] brackets are exogenous components of PAE; final term is induced
Ye = 1 x [C0 — cT0 + I0 + G0]

[1 — c(1—t)
• States that equilibrium = fraction x total autonomous expenditure
Page 21 of 51
5.2.3 GOVT EXPENDITURE & TAX MULTIPLIERS
• Govt expenditure and tax multipliers are called fiscal multipliers
• To isolate the effect on one variable, let the rest = 0
• Tax Multiplier:
∆Ye = —c
∆T0 1 — c(1—t)
• 2 Observations about Tax Multiplier:
- Negative Sign: ↑ Exogenous taxes or ↓ transfers will ↓ PAE and hence ↓ GDP
- Tax and transfer multiplier is smaller than govt expenditure multiplier (Kt = cKG)
• Reason for difference in effects lies with how they affect the level of PAE
- ∆ G has an immediate effect on GDP
- ∆ taxes affects GDP indirectly through dispoable income & consumption
• Dollar ∆ T0 only changes C by MPC times the ∆ T0
• Sine c < 1, effect of a tax change (of a dollar) on PAE will be less than one dollar
5.2.4 BALANCED BUDGET MULTIPLIER

• Balanced Budget Multiplier:
∆Ye = 1—c
∆G0 [1 — c(1—t)]
• Let:
kBB = 1—c
1 — c(1—t)
kBB = kG + kT
• Which states that balanced budget multiplier = govt expenditure — exogenous tax (and
transfer) multiplier
• Balanced budget multiplier = unity (only holds true if marginal tax rate t = 0)
5.2.5 OUTPUT GAPS & FISCAL POLICY

• In the model, there is no mechanism that
automatically ensues actual GDP (Y) = potential
GDP (Y*) in the short run
• In short run equilibrium:
- Y < Y* → Contractionary Gap
- Y > Y* → Expansionary Gap
• We can use the 45-degree diagram to illustrate

situations of contractionary and expansionary gaps
• Steps:
1. Potential output Y* (black vertical line); assume

potential output is independent of PAE
2. If PAE is given by PAEc, Yc < Y* and economy

will be experiencing a contractionary gap
3. If PAE is given by PAEE, YE > Y* and economy

will be experiencing an expansionary gap
Page 22 of 51
• With a contractionary gap, fiscal policy can be used to
↑ short run equilibrium Y from Yc to Y*
- From 3 sector model, PAE can be ↑d by either a

cut in T0 or an ↑ in G0
- Given the size of the negative output gap Yc — Y*

we could use our fiscal multipliers to calculate the
required ∆ the fiscal instruments
- Diagram shows ↑ in PAE required to close the

output gap & set equilibrium Y = Y*
5.2.6 AUTOMATIC STABILISERS

• With transfers, value of unemployment benefits paid is
higher during recessions and lower during booms
• Tax receipts ↑ during economic growth and ↓ during

economic downturn
• We allow dependence of net taxes (taxes — transfers) on GDP via the tax function
• Degree of feedback from real GDP to net tax revenue is determined by marginal tax rate t
• Automatic Fiscal Stabiliser: Tax/transfer system that acts to reduce the effects of
exogenous changes in expenditure on the magnitude of business cycle fluctuations
• Role of ’t’ as a stabiliser is seen through its effect on the size of the multiplier
- ↑ t will ↓ magnitude of the impact of exogenous changes
5.2.7 DISCRETIONARY FISCAL POLICY

• Discretionary Fiscal Policy: Deliberate ∆ fiscal policy instrument in response to economy
• To undertake any type of discretionary policy action, policy makers have to:
- Determine the need for some form of policy action (recognition lag)
- Decide on an appropriate policy action (design lag)
- Implement the policy action (implementation lag)
• When the policy has been implemented it may take some time before the policy has a
significant effect on the economy (effect lag)
• Due to these lags, discretionary policy’s largest effects on the economy may occur after the
effects of a shock have passed & it will act to destabilise the economy
• Believed to face much longer implementation lags b/c of their need to be legislated
5.3 BUDGET DEFICITS & PUBLIC DEBT

• 4 Main components of the government budget
1. Govt purchases of goods and services
2. Tax revenue
3. Transfer payments
4. Interest payments on public debt
BB = T — G
• G = Govt Purchases; T = Tax Revenue — Transfer Payments — Interest on Public Debt
• If T > G then BB > 0 ∴ Budget Surplus
• Budget deficits (surpluses) are associated with ↑ (↓) levels of public debt
• If govt runs a budget deficit, it will borrow an amount = size of the deficit
• Govt borrows by selling new government bonds
- New bonds will add to existing stock of govt bonds and lead to ↑ public debt
Page 23 of 51
5.3.1 GOVT BUDGET CONSTRAINTS
Dt = Dt—1 — BBt
• Govt Budget Constraint: Expenditures = Funding Sources
~
Gt + TRt + rDt—1 = T + Dt — Dt—1
• Where:
- G = Govt Expenditure
- D = Level/Stock of govt debt
- Dt = Stock of debt at the end of period t
- D t—1 = Stock of debt at the end of period t — 1 

~
- T = Tax Revenue
- TR = Transfer Payments
- rDt—1 = Real interest payments on govt debt
• Budget deficit BBt < 0 adds to the stock of debt
• Budget surplus BBt >0 ↓ the stock of public debt
• In any period a government faces a choice of how to pay for their expenditures
- Raise revenue through taxes (equivalent to running a balanced budget)
- Borrow funds (allows govt to defer some economic and political costs)
• Who does the government borrow from?
- Domestic private sector (households and businesses)
- Sometimes from international capital markets
• Borrowing from the country’s central bank to finance a budget deficit
- Equivalent to financing the budget deficit by printing money

- Aka overt money financing
- More likely to cause inflation and hyper-inflation (50+% monthly inflation)
5.3.2 PUBLIC DEBT & THE ECONOMY

Government Borrowing & the Business Cycle
• Govt should seek to balance its budgets over the business cycle (not necessarily year)
• During recessions, governments may borrow to finance temporarily larger budget deficits
associated with endogenous effects of automatic stabilisers and discretionary fiscal policy
• ↑ taxes and/or ↓ govt spending would ↑ contractionary gap and lead to a deeper recession
• During boom periods, govt limits borrowing and ↓ public debt by running budget surpluses
• Deficits arising from recessions should be offset by budget surpluses during expansions
• Such a rule for fiscal policy acts to stabilise the level of public debt and prevent a persistently
rising level of public debt over time
Golden Rule for Public Investment

• Basic principle is one “pay-as-you-use”
• Golden rule for fiscal policy: Govt should borrow to fund investments that benefit future
generations, but fund consumption expenditures by current taxes
• B/c future generations share in the benefits of government investment spending, govt should
borrow as the higher taxes required to re-pay the debt will ↓ on future generations
Page 24 of 51
Cost of Public Debt
• Analysis of potential costs of public debt emphasise 3 issues:
1. Consequences of high levels of public debt for economic growth
- Reinhart and Rogoff (2010) suggested a public debt to GDP ratio greater than 90% is
associated with a ↓ in economic growth
- Kumar and Woo (2010) estimate that a 10% ↑ in initial debt to GDP ratio is associated
with ↓ annual real growth rate of about 0.2% per year
- If a country’s debt to GDP ratio were 50% rather than 40% its annual growth rate
would be 1.8% rather than 2%
2. Possible crowding out of private investment due to higher interest rates
- ↑ Government deficit would ↑ real IR and ↓ (“crowd out”) private investment
- Persistently lower level of private investment would result in a lower private capital
stock in an economy and this could lead to ↓ real economic growth
3. Intergenerational equity
- We should not enjoy the benefits of budget deficits now and pass on the costs of those
deficits to future generations
Sustainability of Public Debt

• In evaluating sustainability, we use the debt to GDP ratio:
• Where:
- r = Real Interest Rate on Public Debt
- g = Growth Rate of Real GDP

d=D
- pbb = PBB/Y
- PBB = Primary Budget Balance (BB excluding   Y

interest payments)
dt = (r — g)dt—1 - pbbt
• 2 Factors act to ↑ the debt to GDP ratio:
1+g
- Primary Budget Deficit i.e. pbb < 0
- If real IR exceeds growth rate i.e. r > g
5.4 FOUR-SECTOR MODEL

PAE = C + Ip + G + X —M
= C — cT0 + I0 + G0 + X0 + cY(1 — t) — mY
= [C0 — cT0 + I0 + G0 + X0] + Y[c(1 — t) — m]
Ye = 1 x [C0 — cT0 + I0 + G0 + X0]

1 — [c(1—t) — m]
• Multiplier depends on MPC, marginal tax rate and  

marginal propensity to import
• PAE line will be flatter, with slope [c(1-t) — m], but  

intercept will be a larger number due to the  
inclusion of exports
Page 25 of 51
6. FINANCIAL ASSETS, MONEY & PRIVATE BANKS .
6.1 ASSET RETURNS AND PRICES
• Where:
- P = Price of asset in current year

RETURN = P’ + I’
- P’ = Price of asset in next year
P
- I’ = Any payoff to the asset in the next year
• Payoff: Periodic payment that is made to the owner of the asset
• If the next year’s price and payoff are uncertain, formula gives us expected return
• For given values of P’ and I’, the return on the asset is inversely related to current price
6.1.1 BONDS
• Principal: Amount of money that needs to be repaid at maturity
• Coupon Rate: Coupon payment as a % of the principal
• If coupon rate = market IR, price of the bond is its principal
• Value of a bond ↓s when IR ↑s
6.2 DEFINITION OF MONEY

• Functional Definition of Money:
- Medium of Exchange
- Unit of Account
- Store of Value
6.2.1 MEDIUM OF EXCHANGE

• Medium of exchange is a commodity that is used to ↑ efficiency of exchange/trade
• Barter: Form of trade where 2+ individuals directly exchange commodities
• Limitation: Barter requires a double coincidence of wants i.e. both people must want to
- Cost of searching for suitable trading partners in a barter economy is likely to be high
• Economies that primarily rely on a medium of ex∆ making transactions are called monetary
economies
• Commodity Currencies: Gold, silver
• If the medium of exchange can be converted into a physical commodity (e.g. gold) on
demand, it is a commodity-backed money
• Where a medium of exchange is not backed by any physical commodity and is declared to
be legal tender by the govt, it is called a flat money
- Flat Money (Currency): Has no intrinsic value and is not convertible into any other non-
monetary commodity on demand
6.2.2 UNIT OF ACCOUNT

• Means prices of all other goods in an economy are measured in terms of money e.g. AUD
6.2.3 STORE OF VALUE

• Refers to money’s ability to transfer purchasing power from today into some future period
• Advantages of Money:
- Perfectly Liquid: If I hold my savings in the form of money, when the time comes to make
purchases, I can do so directly
- Not Subjected to Risk of Capital Loss: Converting non-monetary asset into money
exposes you to the possibility that the price of the asset may have ↓en over time
• Disadvantages of Money: Typically pays a relatively low expected nominal IR
Page 26 of 51
6.2.4 MONETARY AGGREGATES
• Stock of Money:
M = Cu + D
• Standard Measures of Money:
- Currency: Notes & coins held by the non-bank private sector
- M1: Currency + current deposits at banks
- M3: M1 + all other (non-current) deposits at banks from the private non-ADI sector +
deposits with non-bank ADIs
- Broad Money: M3 + other borrowings from private sector by AFIs
• Definitions:
- Current Deposit: Bank account w/o restrictions on deposits and withdrawals
- ADI: Autho↑d deposit-taking institution incl. banks, building societies and credit unions
- AFI: Financial Intermediaries
6.3 DEMAND FOR MONEY

6.3.1 TRANSACTIONS DEMAND
• Value of transactions is the combination of price level and real volume of transactions
• Use an aggregate price index (e.g. GDP deflator (P)) to measure transactions
• Nominal IR on other financial assets (e.g. bonds) is the opportunity cost of holding money
- When IR ↑ so does the implicit cost of holding money ∴ incentive to hold less money
6.3.2 PRICE LEVEL (P)

• ↑ Price level (P) would lead to a proportionate ↑ demand for money (MD)
• Example: If the price of all goods and services in an economy were to double, the value of M
would need to double for individuals to undertake the same real volume of transactions
6.3.3 REAL GDP (Y)

• ↑ Real GDP Y → ↑ Demand for money
• Income Elasticity of Demand: % ↑ Demand for money in response to a 1% ↑ real GDP
6.3.4 NOMINAL INTEREST (i)

• ↑ Nominal interest on non-monetary assets would ↓ demand for money
• Interest Elasticity of Demand: % ↓ Demand for money in response to a 1% ↑ nominal IR
• Demand for money (MD):
MD = P x L(Y, i)
• Where L = Some (unspecified) function of real GDP
• ↑ Nominal IR will result in ↓ quantity of money demanded
• Changes in price level or real income will cause a shift in the money demand curve
• Either an ↑ in P or in Y will produce an outward shift and a consequent ↑ quantity money

demanded (i.e. from M0 to M1)
6.3.5 FINANCIAL INNOVATION

• Financial Innovation: Technological/regulatory changes that result in improvements in an
economy’s retail payments system
• Example: “Tap and Go”, direct transfers, online payments (e.g. BPAY)
• ↓ Demand for currency and ↑ Deposits
Page 27 of 51
6.4 SUPPLY OF MONEY
• Private banks perform 2 basic economic functions:
1. Financial intermediation
2. Providing a means of payment through deposits
6.4.1 BANK BALANCE SHEETS

• Even if the bank pays interest on its deposits, it can earn net revenue (profits) by charging a
higher IR on loans (iL) than it pays on its deposits (iD)
Banks as Creators of Money

• Money is created as a consequence of the bank making new loans
Constraints on Banks
• What happens if the borrower withdraws the deposit or uses it to make a payment to an
individual who has an account with a different bank?
• Suppose that deposits ↓ by $500. While the bank has $100 in cash reserves it needs an
additional $400 in cash. What are its options?
- Bank will need to attract additional deposits or borrow the required funds
• Attracting additional deposits
- When the $500 (old) deposits are withdrawn, bank’s existing reserves of $100 are
exhausted and if nothing else happened, bank would be unable to pay out its depositors
- Bank Run: When reserves are insufficient to cover people’s withdrawals when a large
number of people decide to withdraw at the same time
• Borrow in order to obtain the funds needed to repay the deposits
- Bank would seek to offset the decline in its deposits and reserves by borrowing $500 in
the wholesale financial market (i.e. from other banks or financial institutions)
• When banks make a loan, they have the ability to fund the loan by creating a deposit
Banking System in Australia

• Asset side of B/S is loans (Net Loans and Advances) + reserves (Currency & Liquid Assets)
• Banks purchase securities and bonds (issued by govt)+ hold various other assets (e.g. gold,
artwork, intangible assets)
• On the liability side, we have deposits (50% can be withdrawn on demand) + other borrowing
by banks in retail lending markets
• Short-term borrowing corresponds to loans that are re-payable within 1 year
B/S and Leverage

• In evaluating the relative strength/riskiness of a bank’s B/S, consider leverage
ratio and reserve-deposit ratio
• Equity = Reserve + Loans — Deposits

• Leverage Ratio: Loans/equity
- Equity provides a buffer against a bank becoming insolvent in the case of some borrowers
defaulting on re-payment of their loans
• Reserve-Deposit Ratio: Value of its reserves/deposits
- Higher reserve-deposit ratio → Better able to meet a higher level of withdrawals
Page 28 of 51
6.4.2 BANK RUNS & LIQUIDITY
• Mismatch between maturity of many company assets and their liabilities
• Large proportion of total bank liabilities are redeemable at a fixed value by the lender on
demand or at relatively short-notice
• Short-term borrowing can dry-up or disappear during times of financial stress
• Large proportion of bank assets are long-term loans (e.g. mortgages) which aren’t very liquid
• During a bank run depositors will seek to withdraw their deposits b/c they expect that other
deposit-holders to do the same and if they wait may not be able to withdraw their deposits
- In order to meet the unexpected demand, banks will need to borrow from other sources
or try to sell their marketable assets or call-in loans
- Banks can’t meet demand → Forced to suspend depositors from withdrawing their funds
• Potential for bank runs exists for solvent banks too (i.e. bank’s total assets > debt liabilities)
- If a large enough number of people simultaneously demand withdrawal of their deposits

the bank may have insufficient liquid reserves to meet the demand
- Bank would need to stop withdrawals
- Called a liquidity crisis
6.4.3 CENTRAL BANK LENDING & DEPOSIT INSURANCE

• 2 Main responses by policymakers to the possibility of bank runs and liquidity c↑s
• Central Bank Lending

- Banks have insufficient reserves to convert bank liabilities into currency
- Since currency is a flat commodity, it is costless to produce by the central bank
- Always possible for an economy’s central bank to lend a bank/entire banking system the
currency required to meet demand for withdrawal of deposits
- Rule: Central bank should lend to banks that are solvent but short of liquid assets
• Deposit Insurance
- Value of individual bank deposits (up to some max value) – are insured by govt
- Since depositors are assured of being able to receive payment in currency regardless of
the bank’s financial situation, they have less incentive to participate in a bank run
- AU → Fed Govt guarantees deposits of up to $250,000 that are held with banks + ADIs
- Govt will charge banks a fee for the provision of deposit insurance (passed-on to
depositor in terms of lower deposit rate or management fees)
6.4.4. REGULATION OF BANKS

• Prudential/Macro-Prudential Regulation: Govt regulations and controls on banking
• Australian Prudential Regulation Authority (APRA): Chief regulator of all domestic financial
institutions incl. banks operating in Australia
• Internationally many countries (including Australia) adhere to the Basel Accords
• Commonly used examples of macro-prudential tools:
- Capital Ratios: Require banks to maintain a certain ratio of equity capital to a risk

weighted measure of their assets (to account for varying riskiness of assets)
- Liquidity Coverage Ratios: Require a fraction of bank assets be relatively liquid and

easily used to meet potential deposit outflows
- Net Stable Funding Ratios: Sources of bank funding; deposits, borrowing and equity
and their relative stability (i.e. ease with which they can be withdrawn)
- Restrictions on loan-to-value ratios provide limits on the amount that an individual can

borrow to purchase an asset
‣ Example: Loan-to-value ratio of 80% implies the bank can only lend up to 80% of the
market value of the asset
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6.5 MONEY, PRICES & INFLATION
• Quantity Theory: Model linking the price level to the supply of money (rate of inflation to the
growth rate of the money supply)
Definition of the Velocity of Circulation:

V = PY
M
• Where:
- V = Definition of the income velocity of circulation
- PY = nominal GDP (aggregate price level P × real GDP)
- M = Money supply (e.g. currency, M1 or M3)
• Since nominal GDP is a flow variable (measured over some period of time) and M is a stock,
income velocity V indicates avg nominal GDP supported by $1 of money over some period
Quantity Equation:
MV = PY
• To obtain the quantity theory we impose 3 assumptions:
- Both velocity of circulation V and level of real GDP Y are assumed to be constant (or
exogenously fixed)
- M is determined exogenously (of the price level) so that changes in M cause proportional
changes in the aggregate price level P
Quantity Theory of Money:
P = vM
• Predicts aggregate price level is proportional to money supply
• If money stock where to change by a factor of 2, price level would change by a factor of 2
𝜋 = ∆M
• Quantity theory predicts that the rate of inflation is determined by the growth rate of the
money supply
• For rates of money growth and inflation that are relatively low (less than 20% per annum)
there appears to be little evidence of a positive correlation
• For relatively high rates of money growth and inflation there does seem to be evidence of a
positive relationship
Page 30 of 51
7. CENTRAL BANKS & MONETARY POLICY .
Targets and Instruments
• Monetary Policy: Actions taken by RBA to influence SR macroeconomic outcomes
• Targets: Macroeconomic variables that central banks seek to affect (inflation + output gap)
• Monetary Policy Instrument: Variable over which a central bank has direct control
7.1 RESERVE BANK OF AUSTRALIA

• Main obligations w.r.t monetary policy:
1. Stability of the currency of Australia
2. Maintenance of full employment in Australia
3. Economic prosperity and welfare of the people of Australia
• Responsible for AU’s payments system + overall efficiency and stability of financial system
7.1.1 INFLATION TARGETING (1996)

• RBA’s annual inflation target is 2% to 3% on average (periodically updated)
• Both RBA and Govt agree that a flexible medium-term inflation target is the appropriate
framework for achieving medium-term price stability
• Allows for the natural SR variation in inflation over the economic cycle and the medium-term
focus provides the flexibility for the RBA to set its policy
7.1.2 HEADLINE AND CORE INFLATION

• Headline Inflation: Includes effects of all price changes & doesn’t exclude effects of volatile
items or one-time price movements due to tax changes
• Core Inflation: Removes some SR variability & provides an improved indicator of the general
long-term trend in inflation aka underlying inflation
• 2 Common approaches to calculating core inflation:
1. Remove historically volatile components of headline inflation e.g. energy prices
- Measure always eliminates the price effects of the same group of items in every period
2. Eliminate a certain proportion of the items – those with the highest and lowest rates of
price change – in any period from headline inflation
- RBA uses this approach in calculating its trimmed mean measure of inflation
7.2 MONETARY POLICY FRAMEWORK

• Changes in policy instruments are transmitted through the economy via the monetary
transmission mechanism and ultimately have an effect on policy targets
• RBA Monetary Policy Instrument → Interbank Overnight CR aka CR
• 3 Key components of the money policy framework:
- Process by which the RBA is able to achieve its CR target
- Process by which a ∆ the CR is able to influence longer-term IR
- How the RBA varies the CR target in response to its target variables
7.2.1 MONETARY POLICY DECISIONS

• Decisions about monetary policy are made monthly by the RBA board
• Based on the Board’s decision, the RBA announces a target value for the CR
• To tighten monetary policy (contractionary), RBA will ↑ target value for CR
• To loosen monetary policy (expansionary), RBA will ↓ target value for the CR
• 100 basis points = 1%, 25 basis points = 0.25%
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7.2.2 PAYMENT SETTLEMENT & THE CASH MARKET
• Private agents pay for their transactions by requesting banks transfer funds from their deposit
accounts into the deposit accounts of their creditors
• Due to the transactions of its customers, throughout the day a bank may owe funds to
another bank and need to clear or settle its debt
• Settlement of payments between banks is done using accounts held by banks at the RBA
aka Exchange Settlement Accounts (ESAs)
• Funds held in ESAs are called Exchange Settlement (ES) funds or Cash
• Banks hold positive quantities of Cash in their ESAs primarily for settling transactions
• Restriction on ESAs: Banks must ensure they have a positive balance of cash in ESA
- Option: Borrow from another bank that has an unexpected surplus of Cash in its ESA
- Usually required to repay the loan within a short period of time (less than 24 hours)
- IR charged on these loans is called the CR
7.2.3 A CHANNEL SYSTEM

• When RBA announces its target value for the CR, RBA provides ESA holders (i.e. banks) with
2 options for borrowing/lending overnight aka standing facilities
1. Allows banks to borrow Cash overnight from RBA at an IR 0.25 above CR target
2. Payment of interest on funds held in ESAs overnight, at IR 0.25 below CR target
• Gives 3 IR (aka channel/corridor system):
- Target CR iT
- Rate (iT — 0.25) → Paid by RBA on ES funds held overnight (Interest On Reserves Rate)
- Rate (iT + 0.25) → Rate at which banks can borrow ES funds overnight from RBA
‣ Secured loan requires bank to provide RBA with specified assets (typically govt bonds)
= to value of borrowed ES funds
• Consider CR < (iT — 0.25) e.g. L
- No bank would lend ES funds at this rate, since they

could earn a higher rate by leaving the Cash in their
ESAs at the RBA
• Consider CR > (iT + 0.25) e.g. H
- No bank would borrow ES funds at this rate, since

they could always borrow them from RBA at lower
rate of (iT + 0.25)
• Consequence of the 2 standing facilities provided by

RBA → actual CR must lie within a 50 basis point
channel, which has the RBA’s target CR as its mid-point
7.2.4 OPEN MARKET OPERATIONS

• RBA’s channel system allows actual CR to deviate from announced target iT
• To ensure actual CR = announced target value iT, RBA uses open market operations

• Open Market Operations (OMO): Central banks buy/sell govt bonds with the private sector
• RBA only conducts OMO with banks holding an ESA
• RBA’s OMO have the following effects:
- If RBA buys bonds from banks, it will pay for the bonds by crediting their ESAs ∴ ↑ Total
supply of ES funds available
- If RBA sells bonds to the banks, it will receive payment by debiting their ESAs ∴ ↓ Total
supply of ES funds available
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7.2.5 DEMAND FOR CASH
• DES → Demand curve for ES funds by banking system
• Cash Rate → OC to holding ES funds at RBA overnight
• ES funds only exists within IR channel ∴ 3 sections
• When actual CR = (iT — 0.25), banks have no incentive

to lend any excess ES funds overnight
- ∴ No OC to holding ES funds ∴ Perfectly elastic
• When actual CR > (iT — 0.25), banks prefer to lend

funds overnight and hold less ES funds in ESAs  
∴ Negative slope
• Once actual CR = (iT + 0.25), banks have no incentive to

borrow in cash market as they can borrow directly from RBA at IR = (iT + 0.25)  
∴ Perfectly elastic
• To ensure actual CR = target, RBA needs to ensure supply of ES funds cut DES curve at iT
7.2.6 SUPPLY OF CASH

• While individual banks can borrow and lend ES funds in cash market, transactions between
banks don’t change total supply of ES funds
• On any given day the supply of ES funds in the system is primarily affected by 2 factors
1. Value of any OMO the RBA undertakes with the banks
2. Transactions btw the private sector (households and businesses) and the Federal govt
‣ Example: If govt social security payments are made to households on a given day, the
RBA will debit the govt account and credit the ESAs of the banks the payment value
‣ Govt transactions with the private sector are the main cause of exogenous changes in
the daily supply of ES funds
• S : Quantity of ES funds that would be available in the absence of any OMO by the RBA
ES
• No reason why this curve should cut DES at the target CR
• Given SES, the RBA can ↑ or ↓ the total supply of ES funds by

undertaking OMO with the banks
• Suppose SES < quantity of ES funds demanded by the banking

system at iT
- RBA needs to use its OMO to ↑ supply of ES funds
- Purchases bonds from banks by crediting banks ESAs
- RBA’s purchase of bonds will cause the SES curve to shift

to the right (i.e. outwards)
• Suppose SES > quantity of ES funds demanded by the banking

system at iT
- RBA needs to use its OMO to ↓ supply of ES funds
- Sells bonds to banks who pay by using ES funds
- RBA’s sale of bonds will shift SES curve left
• RBA’s use of channel system + OMO has resulted in actual

value CR almost always = announced target value
7.2.7 ∆ CR TARGET
• Scenario: RBA announces an ↑ CR target
• Will cause IR channel to shift ↑ by the size of the increase
• RBA will use its OMO to ensure supply of ES funds = banking

system’s demand for ES funds at the higher CR target
• By using the above approach the RBA is able to set its desired value for its CR
Page 33 of 51
7.3 CR & LONG TERM INTEREST RATES
• IR used by central banks to implement monetary policy are very short-term IR
• Changes in CR need to produce systematic changes in longer term IR to be a useful

monetary policy instrument
• Length/term of a loan can vary from less than 24 hours (interbank Cash market) to an infinite
period (i.e. perpetual bond/consol)
• Loans with intermediate maturities (e.g. mortgages, credit cards, govt bonds and bills)
• Long-term rates influence consumption & investment decisions of households & firms
7.3.1 TERM-STRUCTURE/EXPECTATIONS HYPOTHESIS

• Long-term IR are simple averages of current actual and expected future short-term rates
• Expectations hypothesis of the term structure links short- and long- term IR
• Not just the current value of the CR that is important, but also what people’s expectations
about the future path for the CR
7.3.2 NOMINAL & REAL INTEREST RATES

• Consumer & business decisions are most directly affected by real IR
• Nominal and real IR are related via Fisher effect: i = r + 𝜋e
• Central banks directly control ‘i’ but to affect the real economy and inflation, changes in ‘i’
need to cause similar changes in ‘r’
• Fisher effect suggests that ∆ ‘i’ could affect either ‘r’ or 𝜋e
• SR changes in ‘i’ will tend to have an effect on ‘r’ (same direction)
- In the SR, expected inflation is fixed and not immediately affected by a ∆ ‘i’
• When RBA implements a ∆ in monetary policy by ↑/↓ nominal CR, this will result in ↑/↓
longer-term nominal and real IR
7.4 MONETARY POLICY RULES

• 2 Main macroeconomic variables that are likely to influence the target value of CR:
1. Inflation rate (target of 2-3%)
2. Output gap (or cyclical unemployment rate)
• RBA changes CR (i.e. stance of monetary policy) in response to any persistent deviation of
the inflation rate from its target range or fluctuations in real economic activity
7.4.1 TAYLOR RULE

• Monetary Policy Reaction Function/Policy Rule: Describes the behaviour of a central bank
in setting monetary policy
• Taylor Rule: ~
i = 1.0 + 1.5𝜋 + 0.5Y
• Where: Y = Output gap ((Y — Y*)/Y* x 100)
• Taylor Rule is expressed in terms of the nominal policy rate (i.e. nominal CR)
• Taylor Rule in terms of the real policy rate:
~
r + 𝜋 = 1.0 + 1.5𝜋 + 0.5Y
~
r = 1.0 + 0.5𝜋 + 0.5Y
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7.4.2 SIMPLE POLICY RULE
• Assume RBA’s behaviour can be described by the following policy rule for the real CR:
r = r0 + γ𝜋
• Where 𝜋 = current inflation rate, γ = coefficient indicating how sensitive RBA is to inflation
• Example: If γ is relatively large, this implies that the RBA ↑ real CR by a lot in response to a
1% ↑ inflation
• r0 = Value of the real CR when inflation = 0
- Reflects all factors that might influence RBA’s choice for

the real CR, other than inflation
- Changes in r0 can be viewed as

reflecting exogenous changes in monetary policy
• Policy Reaction Function (PRF) has a positive slope (γ)
• Model allows for deflation 𝜋 < 0
• As inflation ↑ above zero, RBA will ↑ real CR
• Amount by which RBA adjusts the real CR to a ∆ 𝜋 is

determined by the value chosen for γ
• ∆ monetary policy can be thought of as being endogenous/

induced by a ∆ the inflation rate
• Possible to consider an exogenous ∆ monetary policy by an upward/downward shift in PRF
• Suppose that for a given rate of inflation, RBA wants to tighten

monetary policy b/c concerned about rapidly ↑ house prices
- Initial PRF has intercept = r0, inflation rate = 𝜋1
- RBA sets a real policy rate of r1
• Suppose RBA wants to tighten monetary policy, for some

reason unrelated to the current inflation rate
- ↑ r0 to r1 producing an upward shift in the PRF
- Effect of this exogenous tightening is to raise the real CR

from r1 to r2
7.4.3 NON-ZERO INFLATION TARGET

• PRF implicitly assumes that inflation target = 0:
r = r0 + γ(𝜋 — 𝜋T)
• Where 𝜋T = RBA’s target for inflation 
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8. AGGREGATE DEMAND AND SUPPLY .
8.1 DERIVING THE AGGREGATE DEMAND CURVE
• AD Curve: Relationship btw real GDP and inflation rate
• Important component of the monetary transmission mechanism → Changing longer-term real

IR will have a predicable effect on some components of PAE
8.1.1 CONSUMPTION, PLANNED INVESTMENT AND THE REAL IR

• In the income-expenditure model we assumed household consumption is determined by  
(Y — T) = disposable income, C0 = exogenous consumption
• Various factors that could influence consumption expenditure are captured by C0
- One of these factors is the effect of real IR on aggregate consumption
- ↑ Real IR would lead to ↑ household saving
- Let S(r) = Household saving function:
C(r) = (Y — T) — S(r)
• For a given level of disposable income, consumption will be negatively related to real IR
• We can generalise the consumption function to allow for an explicit effect from the real IR:
C= C0 + c(Y — T) — 𝛼r
• Where r = real IR, 𝛼 = positive # indicating how responsive consumption is to ∆ real IR
• User cost (%) is given by:
uc = r + 𝛿
- Where 𝛿 = rate of physical depreciation, r = real IR
• Allow real IR to have a direct influence on the aggregate level of planned investment:
IP = I0 — 𝛽r
• Where 𝛽 > 0 and indicates how responsive IP is to changes in the real IR
• ↑ r will ↑ user cost of capital and ↓ rate of IP
8.1.2 PAE AND THE REAL IR
PAE = C + Ip + G + X — M
Y = (C0 — cT0 + I0 + G0 + X0) — r(𝛼+𝛽) + Y[c(1 —t) — m]
Ye = 1 x [C0 — cT0 + I0 + G0 + X0] — r(𝛼+𝛽)
1 — [c(1—t) — m]
8.1.3 POLICY REACTION FUNCTION (PRF)

• To derive the AD curve, link real GDP and the inflation rate
• Behaviour of RBA by a Policy Reaction Function (PRF):
r = r0 + γ𝜋
• Where γ > 0 indicates endogenous response of the RBA to the inflation rate
• R0 = Factors (other than inflation rate) that might influence the real policy rate
• Changes in R0 reflect discretionary/exogenous changes in monetary policy
Page 36 of 51
8.1.4 AGGREGATE DEMAND CURVE
• Relationship btw real GDP and inflation (negative and represents AD curve)
Y= 1 x {[C0 — cT0 + I0 + G0 + X0 — r0(𝛼+𝛽)] — γ𝜋(𝛼+𝛽)}

1 — [c(1—t) — m]
• Let k = fraction
Y = k [C0 — cT0 + I0 + G0 + X0 — r0(𝛼+𝛽)] — kγ𝜋(𝛼+𝛽)

Y = A0 — kγ𝜋(𝛼+𝛽)
• Movement (up) along AD implies ↑ inflation is associated with ↓ (equilibrium) real GDP
• Assumptions causing AD curve to have a negative slope:
1. Household consumption and Ip are negatively related to real IR
2. RBA systematically responds to ↑ inflation by ↓ real IR (captured by PRF)
• If γ = 0 or 𝛼 = 𝛽 = 0, AD curve would be vertical
• Actions of RBA in responding to changes in inflation play a key role in determining AD slope
8.1.5 OTHER REASONS WHY AD CURVES ARE NEGATIVELY SLOPED

• Wealth Effects
- ↑ Inflation will ↓ real value of nominal money balances and

↓ household wealth
- If changes in inflation are unexpected, govt bond holders

will experience capital gains/losses (not offset by IR paid)
- Surprise ↑ inflation will ↓ real value of govt bonds held by

the private sector and ↓ private sector wealth
- ↓ Wealth from higher inflation can result in ↓ household

consumption ∴ ↓ PAE
• Concern about unexpected deflation acts to ↑ real value of

private debt
- Higher debt burden on some households/firms will ↓ consumption and investment
- Although unexpected deflation will only cause a redistribution from borrowers (debtors) to
lenders (creditors); there may be an aggregate effect on PAE if indebted households and
businesses have a relatively large propensity to spend
• Unexpected changes in inflation can ↑ uncertainty in an economy, which may ↑ household

saving (precautionary motive) and lead businesses to ↓/defer investment ∴ ↓ PAE
• Changes in an economy’s inflation rate that aren’t fully offset by ∆ nominal exchange rate, will
affect the real exchange rate and thus net exports
8.1.6 SHIFTS IN THE AD CURVE

• Assume exogenous variables are fixed
• Allowing exogenous variable to change will shift AD curve
• AD curve will shift outwards in response to expansionary

fiscal policy and discretionary monetary policy (i.e. ↓ r0)
• Exogenous changes to AD (aka AD shocks) are a source of

fluctuations in output and inflation
Page 37 of 51
8.2 DERIVING THE AGGREGATE SUPPLY CURVE
• Over time businesses will respond to persistent changes in demand by changing their prices
• Model of AS that allows inflation rate to respond over time to the sign and size of an
economy’s output gap
• Businesses have to choose the rate of change of their prices in any period
• Pricing decisions made by businesses (inflation) will be influenced by 3 factors:
- Expected inflation rate
- Presence of aggregate (i.e. economy-wide) shocks to business production costs
- Size of output gap (i.e. is the economy booming or in a recession)
8.2.1 INFLATION EXPECTATIONS

• Expectations of future inflation rate are an important influence on current pricing decisions
• Example: If a business wants to keep the relative price of its product unchanged, it would
need to ↑ its price at the same rate as expected inflation
• Assume that all businesses expect the inflation rate next period to be 𝜋
• If output gap = 0, and there are no shocks to inflation, then if all businesses set the rate of ∆
of their prices = excepted rate of inflation, then 𝜋 = 𝜋e (actual inflation = expected)
• 2 Models of expectations commonly used in macroeconomics are:

1. Adaptive expectations
‣ Data frequently display a high degree of persistence
‣ Persistence implies that if inflation is high (low) in the current period it will tend to be
high (low) in the subsequent period(s)
‣ Persistence in the inflation rate can a↑ if businesses have adaptive expectations.
2. Rational Expectations Hypothesis states that individuals form their expectations of
future variables by using all relevant information
‣ Under rational expectations:
𝜋 = 𝜋e + 𝜔
‣ Where:
‣ 𝜋 = actual inflation rate
‣ 𝜋e = rational expectation of the inflation rate
‣ 𝜔 = expectation/forecast error → value of 𝜔 is completely unpredictable at the time the
expectation of inflation if formed
8.2.2 ADAPTIVE EXPECTATIONS

• According to the adaptive expectations hypothesis, only past
information is used to form expectations
• Assume expected rate of inflation = actual inflation rate in the

previous period:
𝜋e = (𝜋-1 = 𝜋)
• Current inflation rate = rate in previous period
• In absence of any shocks, inflation will be constant over time
• Exogenous changes in AD curve changes real output, but

have no effect on inflation
Page 38 of 51
8.2.3 INFLATION SHOCKS
• Inflation shock: Any factor (other than inflation expectations or output gap) that causes a ∆
the current inflation rate
• Examples of Inflation Shocks: Changes in indirect tax rates; fluctuations in energy prices (e.g.
oil or electricity prices) and relatively large movements in the exchange rate
𝜋e = 𝜋-1 + 𝜀
• Where 𝜀 = temporary (one-period) shock to inflation
• In the absence of any inflation shock, 𝜀 = 0 and the inflation rate would be constant at 𝜋
• If 𝜀 > 0, AS curve will shift upwards i.e. unfavourable (adverse) inflation shock
• If 𝜀 < 0, AS curve will shift downwards i.e. favourable inflation shock
• Temporary shocks to inflation produce permanent shifts in

the rate of inflation
• In the current period there is a one-period shock 𝜀 =

-0.5% which ↓ current inflation to 1.5%
• What happens to inflation in the following period?
- 𝜀 = 0% since inflation shock only lasts 1 period
- Inflation rate in the next period 𝜋+1 = 𝜋 = 1.5% due to the

adaptive expectations
• In the absence of any new shocks the inflation rate has

permanently ↓ from 2% to 1.5%
• Illustrates how assumption of adaptive expectations

produces persistence in the inflation rate
8.2.4 OUTPUT GAP

• Prior to inflation shock, real output = potential output
• Shock shifts the AS curve upwards by the size of 𝜀 > 0 and
inflation rate ↑ to 𝜋 = 𝜋-1 + 𝜀
• New SR equilibrium is given by the intersection of the new AS
curve and the AD curve
• Real GDP is Ynew and is below potential output in the

economy ∴ contractionary output gap
8.2.5 OUTPUT GAP & INFLATION RATE

• If Ye > Y* ∴ SR expansionary gap in the economy
- In the SR, businesses produce above normal production

levels b/c no pressure to ↑ prices at a rate > current
inflation rate
- Over time, this will ↑ production costs and these need to

be re-couped by ↑ prices at rate > current inflation
- If all businesses behave this way, actual rate of inflation

(i.e. AS curve) will shift ↑
• If Y < Y* ∴ SR contractionary gap in the economy
- Over time, producing at below normal levels is

associated with lower rates of ↑ in production costs and
will eventually feed into price ↑ at a rate < current inflation
- If all businesses behave this way, actual rate of inflation (i.e. AS curve) will shift ↓
• Ye = Y* → LR equilibrium occurs @ intersection of AS curve & AD curve at potential output
- In the LR equilibrium real GDP = potential, and inflation rate is constant over time
Page 39 of 51
8.3 APPLICATIONS OF THE AD & AS MODEL
8.3.1 PERMANENT AD SHOCK
• AD shock reflects some exogenous change that causes a
permanent shift in AD
• Consider a shock that ↑ level of AD
- E.g. ↑ AD if households became more optimistic

about future growth in wages and respond by ↑ C
- Favourable AD shock → shift outwards AD
- In the SR, ↑ AD/PAE leads to ↑ production, w/ no

immediate ∆ the inflation rate
- Real GDP ↑ to Y1 and there is an expansionary gap
• Over time, expansionary gap leads to ↑ inflation and ↑ AS
- New SR equilibrium is ADH = AS2 and features higher

inflation of 𝜋2 and a smaller (still positive) output gap
- Persistent positive gap → continuing pressure for inflation

to ↑ (and for AS curve to keep shifting ↑)
- Positive output gap ↓, but it is not until Ye = Y* that

inflation rate stops rising and is once again constant
- Equilibrium GDP has ↓ back to = potential output
• Permanent AD shock
- Real GDP = potential output, but the rate of inflation in the

economy has ↑ from 𝜋1 to a higher rate of 𝜋H
• Permanent, favourable shock to AD results in a SR ↑ in real
GDP, but over time, rising inflation will shift up the new AD
curve until real GDP = potential output
- New LR equilibrium has permanently higher inflation
8.3.2 TEMPORARY AS SHOCK

• Adverse inflation shock (i.e. a temporary, one-period positive
shock to inflation)
• SR ↑ inflation rate and contractionary output gap
• Contractionary output gap puts downward pressure on

inflation rate and cause AS to shift down along AD curve
• Inflation and AS curve will continue to ↓, until contractionary

gap is eliminated and Y = Y*
• In the new LR equilibrium, both inflation rate and level of

output = their values prior to the inflation shock
8.3.3 IS THE ECONOMY SELF CORRECTING?

• In the LR, the economy is self-correcting i.e. adjustments in
AS curve will cause real GDP to move towards Y*
• Example: Following the unfavourable inflation shock, there is a

contractionary gap and ↑ cyclical unemployment
- Puts ↓ pressure on wage & price inflation, but if inflation is

slow to respond, economy will be slow to move back to Y*
- Since negative output gaps and cyclical unemployment are

costly to the economy in terms of forgone output, it is
desirable to return the economy to LR equilibrium faster
Page 40 of 51
8.3.4 POLICY RESPONSES TO AD SHOCKS (PERMANENT)
• Consider an (adverse) AD shock that shifts the AD curve left to ADH
• In the SR inflation is constant and output ↓ below potential to Y1
• Policymakers can respond to ↓ AD curve by undertaking discretionary monetary/fiscal policy
• RBA could implement a discretionary loosening of monetary policy by ↓ r0 in its PRF
• Govt could undertake an expansionary fiscal policy by ↑ govt spending or cutting taxes
• Both policy responses would shift the ADL curve to the right and move equilibrium output
back towards potential
• Appropriate use of macroeconomic policy instruments can speed-up the process of closing
the output gap w/o a permanently lower rate of inflation
• Important element of effective macroeconomic policy is timing
- If policymakers could forecast an AD shock, it may be possible to time their policy

responses to somewhat offset the effects of the shock on real GDP
- Best Case: Expansionary policies fully offset ↓ AD and output would be fully stabilised
8.3.5 POLICY RESPONSES TO AS SHOCKS (1

PERIOD)
• Consider an unfavourable temporary AS shock (ε > 0),
that shifts AS curve up to ASH
• In the SR, inflation ↑ to 𝜋H and output ↓ to Y1
• If policy makers seek to eliminate the output gap and

undertake expansionary policies, AD shifts right
• If expansionary policy is sufficient to move AD to ADA,

the output gap will be eliminated
• New LR equilibrium will have higher inflation (i.e. 𝜋H

compared to 𝜋)
• In this case policymakers are said

to accommodate the inflation shock
• Rather than accommodating the inflation shock, policymakers can choose to take no
discretionary policy actions (8.16)
- In the SR → Higher inflation & contractionary gap
- Over time, contractionary gap will put ↓ pressure on

inflation and will return to its pre-shock equilibrium
• Need to weigh-up the cost of higher inflation

(accommodation) against the costs of having output
below potential for some period (no accommodation)
8.3.6 INFLATION TARGETS

• Inflation target tends to constrain policy choices and
actions of RBA in how it responds to AD and AS shocks
• Central bank with an inflation target could not respond to

an unfavourable AS shock by accommodating it
- Choosing to accommodate a shock by expansionary monetary policy would result in an

inflation rate permanently above target
• If the private sector expects RBA to achieve inflation target, the target is credible
- Under a credible inflation targeting regime, private agents use the value of the inflation
target as their expectation (or forecast) of future inflation
- I.e. inflation target is an anchor for inflation expectations
• Causes inflation rates to return to target relatively quickly following an AS shock
Page 41 of 51
8.3.7 GFC AND AFTER
• Secular Stagnation: Prolonged period of zero/slow
economic growth
• GFC: ↓ US house prices and ↑ uncertainty lead to ↓ desire to
spending i.e. AD curve shifts left
• In 8.18, assume that prior to the GFC the economy is in LR

equilibrium w/ actual and expected inflation rate of 2%
• In the SR, large ↓ AD curve causes output to ↓ below

potential and the economy suffers a deep recession
• In the SR, inflation is constant at 2%, but over time the large
contractionary gap will lead to ↓ inflation rate
• Allowing the economy to self-correct by ↓ AS curve requires

a negative inflation rate (deflation)
• To avoid the possibility of deflation, policymakers responded

to ↓ AD w/ expansionary polices which shifted AD right and
↓ size of the contractionary gap
• In most economies the policy response only partially offset

the initial ↓ in the AD curve
• Initial expansionary fiscal policies resulted in large budget

deficits and ↑ public debt; causing many govts to reverse
these polices before output gaps were closed
• Sometimes referred to as a policy of austerity
• Without completely closing the contractionary gap, over time

there was downward pressure on inflation causing AS curve
to shift downwards
8.3.8 SHOCKS TO POTENTIAL OUTPUT (PERMANENT)

• Robert Gordon argues that the rate of technological
innovation in the US has ↓ and this is responsible for
declining productivity and economic growth i.e. ↓ Y*
• Consider ↓ potential output from Y* to Y*L
- In the SR, ↓ in potential has no effects on the equilibrium

level of GDP or inflation
- In 8.21, although there is a ↓ in potential output, SR

equilibrium remains at the intersection i.e. at Ye = Y*
- SR output > potential i.e. expansionary output gap
- Over time, expansionary gap will put upward pressure on

inflation and AS curve will shift upwards
• Inflation rate will ↑ until AS curve intersects the AD curve at

the new level of potential output of Y*L
• In the LR, ↓ potential output leads to a lower level of real

output and in the absence of any discretionary policy action,
a higher rate of inflation 
Page 42 of 51
9. INTERNATIONAL MACROECONOMICS & EXCHANGE RATES .
9.1 BALANCE OF PAYMENTS
• Balance of Payments: Record of transactions during some period between residents of a
country (e.g. Australia) and non-residents (or foreigners)
• 3 Transactions on CA: Goods and services; Factor income flows; Transfers
9.1.1 BALANCE OF TRADE

• Balance of Trade = X — M (NX)
9.1.2 FACTOR INCOME FLOWS

• Income payments can be made by/to Australian residents for factors of production (labour
and capital) used in the production of GDP
• Primary Income = Primary Income Credits − Primary Income Debits

• Credits = Income payments to Australian-owned factors of production
• Debits = Payments from Australia to foreign factors of production
9.1.3 INTERNATIONAL TRANSFERS

• Secondary Income: Income flows between residents and non-residents
• Captures international transfer payments e.g. international aid, pension, insurance claims
• Transfer Payments: Financial resources provided w/o anything in return
9.1.4 CURRENT ACCOUNT

• Current Account = Balance of Trade + Primary Income + Secondary Income
• Short-term fluctuations in the current account are closely related to those in the BoT
9.1.5 CAPITAL & FINANCIAL ACCOUNT

• Capital and Financial Account: Transactions involving the sale and purchase of assets
• Both accounts measure flows that occur over some period, with the financial account being
the larger and more economically important component
9.1.6 FINANCIAL ACCOUNT

• Financial Account: Transactions involving financial assets (and liabilities)
• Financial Assets: Financial claims by Australian residents on non-residents
- Example: Shares/equities and debt instruments e.g. govt bonds
• Financial Liabilities: Claims on Australian residents by non-residents
- Example: Sale of a Commonwealth Bank share to a non-resident
• 2 Important categories of financial account transactions:
1. Direct Investment: Investor owns at least 10% of equity in the business
2. Portfolio Investment: Transactions in equities and debt where investor has no influence
on the operation of the business
9.1.7 CAPITAL ACCOUNT

• Capital Account: Acquisition and disposals of non-produced, non-financial assets and
capital transfers (including debt forgiveness)
9.1.8 BALANCE OF PAYMENTS

• Current Account + Capital and Financial Account = 0
• Net Errors and Omissions: Measurement errors that cause BOP to not equal zero
Page 43 of 51
9.2 NATIONAL SAVINGS & INVESTMENT IN AN OPEN ECONOMY
• In a closed economy, national savings = investment
• In a closed economy, ↑ investment schedule must be “funded” by an equal ↑ national

savings (and corresponding ↓ consumption)
• To induce ↑ national saving (and ↓ consumption), domestic real IR must ↑
9.2.1 SMALL OPEN ECONOMY

• Residents can borrow/lend in international capital markets at a
constant real IR aka world real IR (rW)
• Constant real IR b/c borrowing/lending is relatively small

compared to the overall size of the world capital market
• When the economy opens-up to the international capital market,

the real IR faced by domestic residents becomes r = rW
• At the lower rW, national saving ↓ to NS1 while investment ↑ to I1
• Gap btw level of national saving and investment = net exports
Y=C+I+G+X—M
NS = Y — C — G
NS — I = X — M
• Since NS < I, NX < 0, economy is running a balance of trade deficit
• Based on the BOP methodology, trade deficit must be balanced by a net KAFA inflow
9.2.2 NO CROWDING-OUT
• In a closed economy, ↑ govt budget deficit shifts NS schedule left
• Shift in NS causes the real IR to ↑ and leads to a ↓ private

investment (crowding out)
• Suppose ↑ budget deficit (i.e. ↓ public saving) so that the national

saving curve shifts to the left from NS to NS1
• In a small open economy, the shift in NS does not affect rW so no

∆ investment; but net exports ↓ (i.e. becomes more negative)
• Size of balance of trade deficit ↑ from (NS — I) to (NS1 — I)
• In a small open economy, there is no crowding-out
• Additional resources needed to fund the existing level of private

investment are obtained through international borrowing
9.2.3 EXOGENOUS INVESTMENT BOOM

• Suppose there is an exogenous ↑ in private investment in a small
open economy i.e. investment boom
• Investment boom is shown as an outward shift in the investment

demand curve from I to IB
• Since businesses can borrow internationally at a constant real

interest, ↑ investment doesn’t induce any ∆ national saving
• Additional investment is funded by ↑ net KAFA inflows and a

corresponding ↑ trade deficit (i.e. from NS — I to NS1 — IB)
Page 44 of 51
9.3 EXCHANGE RATES
9.3.1 NOMINAL EXCHANGE RATE
• Bilateral Nominal Exchange Rate: Measures the value at which the currencies for 2
countries can be exchanged
e = FOREIGN CURRENCY = USD

HOME CURRENCY AUD
• Where e = # units of foreign currency that can be exchanged for one unit of home currency
1 = HOME CURRENCY = AUD

e FOREIGN CURRENCY USD
• Where 1/e = # units of home currency per one unit of foreign currency
• ↑ e means that one unit of home currency exchanges for more units of foreign currency and
this amounts to an appreciation of the home currency against the foreign currency
• ↓ e represents a depreciation of the home currency against the foreign currency
9.3.2 CROSS RATES

• Given 2 bilateral exchange rates it is possible to infer a third bilateral exchange rate aka
cross exchange rate
• Example:
YEN = YEN x USD .

EURO USD EURO
9.3.3 REAL EXCHANGE RATES
• Real Exchange Rate: Measures the price of domestic goods relative to the price of foreign
goods (when prices are expressed in a common currency)
• To compare the prices of a product between AUS relative to US, we need to convert the
prices into a common currency (either USD or AUD)
• To convert the US price into AU price:
PRICE IN AUD = AUD x PRICE IN USD
USD
• Where P = Index of prices for AU (home country), Pf = price index for some foreign country
REAL EXCHANGE RATE = e x P

Pf
• Could also convert the foreign currency price level into Australian prices:
REAL EXCHANGE RATE = P

P x 1/e
f
• ↑ Real exchange rate implies the price of goods in AU are increasing
- ↑ Corresponds to a real appreciation of the Australian dollar
• Since real exchange rate is a measure of the relative prices of goods it can be viewed as an
indicator international competitiveness for an economy
- Appreciation of the real exchange rate implies that a country’s goods are becoming less
internationally competitive and this will tend to reduce net exports
• Trade-Weighted Index (TWI): Measure of Australia’s real exchange rate against our main
trading partners – against real NX as a share of real GDP
Page 45 of 51
9.4 MODELS OF THE NOMINAL EXCHANGE RATE
9.4.1 LAW OF ONE PRICE (LOOP)
• LOOP predicts that after allowing for transportation costs and taxes, a tradable good should
sell for an identical price regardless of its location
• If transportation costs and taxes are relatively small, the price of an internationally traded
good must be the same in all locations
• If this is not the case, there will be profitable opportunities to buy the good in the relatively
cheaper location and sell it the more expensive location
9.4.2 PURCHASING POWER PARITY (PPP)

• Purchasing Power Parity (PPP): Predicts exchange rate between 2 currencies will adjust to
reflect the price levels in the 2 countries (generalises the LOOP to a larger basket of goods)
• If LOOP holds for all goods in 2 countries, then aggregate price levels will be = once they are
converted to a common currency
e = Pf
P
• Eqn is a model of the nominal bilateral exchange rate, where its value is determined by the
relative price level in the foreign and home country
• Exchange rate adjusts so that the price levels in 2 countries are = (when common currency)
• General ↑ prices in the home country (relative to foreign country) will ↓ e which corresponds
to a depreciation in the home country’s exchange rate
• PPP model predicts that countries that experience relatively high inflation will tend to
experience continually depreciating currencies
∆ e = ∆Pf — ∆P = 𝜋f — 𝜋
• Where 𝜋f = inflation in the foreign country , 𝜋 = inflation in the home country
9.4.3 LIMITATIONS OF PPP

• In the SR, there can be deviations btw PPP exchange rates & actual market exchange rates
• Many countries impose trade barriers (e.g. tariffs and quotas) and these raise the cost of
transporting goods between countries
• Non-tradable goods have very high transportation costs and aren’t widely traded e.g.
personal services such as haircuts
9.4.5 SUPPLY CURVE FOR AUSTRALIAN DOLLARS

• Australian residents are willing to supply AUD in exchange for USD to purchase US goods
• At an exchange rate of e0, 1 AUD will buy 0.8 US
• As AUD appreciates against the USD, the price of US goods in AUD becomes less expensive
• To make the additional purchases, AU residents must supply

more AUD to obtain additional USD
• ∆ e causes a movement along the supply curve for AUD
• Factors causing an outward shift in SA:
- ↑ Preference by Australian residents for US goods,

services or assets
- ↑ Real GDP in AU (due to a strong economy)
- ↑ Real returns on US assets relative to Australian assets
Page 46 of 51
9.4.6 DEMAND CURVE FOR AUSTRALIAN DOLLARS
• US Residents will demand AUD to purchase Australian goods
• Suppose AUD depreciates against the USD to e1 = 0.8
• ↓ e results in ↑ QAUD that US residents demand
• As the AUD depreciates against the USD, the price in US

dollars of AU goods becomes less expensive
• To make additional purchases they will demand more AUD
• ∆ e causes a movement along the demand curve
• Factors causing an outward shift in DA:
- ↑ Preference by US residents for AU goods
- ↑ Real US GDP (due to a strong economy)
- ↑ Real returns on AU assets relative to US assets
9.4.8 FLEXIBLE EXCHANGE RATE

• Floating/flexible exchange rate is determined by shifts in
demand and supply curves for a currency
• ↑ Demand curve from DA to DAH will cause an appreciation of

the AUD against the USD
• Flexible exchange rate regimes have a relatively high degree of

SR volatility in the exchange rate
• Volatility may tend to ↑ cost of international trade and hence

reduce trade flows
9.4.9 FIXED EXCHANGE RATE

• Country’s nominal exchange rate is fixed at some value
• Suppose NZ has fixed it’s exchange rate (treat as home country) to be higher against the
AUD at ē ∴ Excess supply
• Usually, excess supply would cause the NZD to depreciation but it doesn’t bc Reserve Bank
of NZ would purchase (using AUD) the excess supply of NZ dollars
• Provided the RBNZ intervenes in the foreign exchange market and purchases any excess
supply of NZD, it will be possible to maintain the value of e = ē
• NZ is said to have an overvalued exchange rate relative to the fundamental value (aka

equilibrium value) of the exchange rate
• Stock of AUD/AUD denominated assets would form part of the

RBNZ’s foreign exchange or international reserves
• Changes in the central bank’s holdings of reserves are
separated from private sector foreign exchange transactions  
∴ Possible to experience a BOP deficit/surplus
• Excess supply of NZD = NZ running a BOP deficit
• BOP deficit would = NZD value of decline in foreign reserves
• Successful maintenance of a fixed exchange rate requires that

a country’s central bank has an appropriate level of liquid
foreign assets or can borrow foreign currency
Page 47 of 51
9.4.10 SPECULATIVE ATTACKS
• If there is a perception that a country may run out of
international reserves, holders of that country’s currency may
sell those assets to avoid loss in value b/c future
depreciation
• Speculative Attack: When many market participants sell a

country’s currency in a short space of time
• Suppose market participants anticipate that the current fixed

value of the NZD against the AUD is unsustainable
• At some point in the future the NZD will have to be devalued

due to an exhaustion of the RBNZ’s reserves of AUD
• Prior to this actual event, many market participants may sell

their NZD denominated assets in exchange for AUD
• Relatively large right shift of supply curve from SNZ to SNZA
• RBNZ will need to purchase an even greater quantity of NZD and so ↑ rate at which it is
running-down its AUD stock
• If the speculative attach is “successful” the RBNZ may decide to abandon its fixed exchange
rate and move to a flexible regime; or discretely devaluate e below ē
9.4.11 EXCHANGE RATES & MONETARY POLICY

• In open economies, exchange rate provides another channel though which monetary policy
can affect AD and real GDP
• Return on domestic assets (relative to return on foreign assets)

can shift demand and supply of currency
• Main mechanism central banks currently use to implement

monetary policy is changes in real IR
- Suggests monetary policy actions are likely to have

implications for a country’s exchange rate
• Consider the AUD-NZD exchange rate (flexible exchange rate)
- Suppose RBNZ implements contractionary monetary policy
- Policy will ↑ real IR in NZ relative to Australia
- Tend to ↑ AU demand for NZ financial assets and ↓

demand by NZ residents for AU assets
- Supply shifts left as NZ desires to purchase less AU assets

and demand shifts right as AU desires more NZ assets
- NZD will appreciate against the AUD
• Contractionary monetary policy will appreciate a country’s exchange rate and vice versa
• Assume (SR) a nominal appreciation (depreciation) results in a real appreciation (depreciation)
• Provided home and foreign price levels are sticky

in the SR, ↑ e will result in an appreciation of the
real exchange rate
• Higher value for the real exchange rate will ↓ NX

and this will ↓ AD and real GDP 
Page 48 of 51
10. ECONOMIC GROWTH & THE AGGREGATE PRODUCTION
FUNCTION .
10.1 ECONOMIC GROWTH
• Economic growth using real GDP per-capita (y) where:
y = Y
POP
• Y = GDP and POP = total population
• Since we are concerned with longer-term trends in production, we assume output gap = 0,
i.e. Y = Y*
• Conventional to use real GDP per capita to measure a country’s living standards
10.1.1 DECOMPOSITION FOR PER-CAPITA REAL GDP

Y = Y xL
POP POP L
Y = L xY
POP POP L
• Where Y = Real GDP (assume Y = Y*), POP = Total Population, L = Total Labour Employment
• Where L/POP = Total population employed, Y/L = Labour productivity
• ↑ Real GDP per-capita must be associated with ↑ proportion of the population that is
employed and/or an ↑ in aggregate labour productivity
• Short term trends in employment to total population ratio is bounded by 0 and 1 ∴ limit on its
ability to grow over time
• Labour productivity can display persistent growth over time and is the primary source of
long-term ↑ in real GDP per-capita
10.2 AGGREGATE PRODUCTION FUNCTION

• Production Function: Links inputs used by a business in their production process to the
amount of output that is produced
• Assume real GDP can be represented by an aggregate production function
• Suppose that the production of real GDP depends on 3 inputs:
1. Aggregate quantity of labour used (L)
2. Aggregate stock of physical capital in the economy (K)
3. Current state of technology available in the economy (A)
Y = F(K, L, A)
10.2.1 COBB-DOUGLAS PRODUCTION FUNCTION

• Cobb-Douglas Production Function:
Y = F(K, L, A) = AK𝛼L1-𝛼
• Growth in real GDP can be attributed to growth in technology, labour input and capital stock
• Function exhibits constant returns to scale in labour and capital and both labour and capital
individually exhibit diminishing marginal productivity
Page 49 of 51
10.2.2 CONSTANT RETURNS TO SCALE
• Returns to scale is concerned w/ how output changes when we change all inputs by some
common amount
• Cobb-Douglas production features constant returns to scale (CRS) in L and K
• If sum of exponents > 1, there are increasing returns to scale (IRS)
• If sum of exponents < 1, there are decreasing returns to scale (DRS)
10.2.3 MARGINAL PRODUCTS

• Returns to Scale: Effect on output of a common ∆ more than one input
• Marginal Product: Effect on output of a ∆ a single input (ceteris paribus)
• Aggregate MPL: ∆ Aggregate output for a (small) ∆ labour input when K and A are held fixed
• Aggregate MPK: ∆ Aggregate output for a (small) ∆ capital input when L and A are held fixed
MPL = (1 — 𝛼) Y MPK = 𝛼 Y
L K
• MPL = Exponent on L x avg product of labour (Y/L)
• MPK = Exponent on K x avg product of capital (Y/K)
• Since both A and K are fixed, as L ↑, MPL must ↓ (same if you swap K and L)
• Cobb-Douglas exhibits decreasing marginal productivity for both L and K inputs
10.3 SOURCES OF ECONOMIC GROWTH

10.3.1 PER-WORKER PRODUCTION FUNCTION
Y=A K𝛼
L L
• Let y = Y/L and k = K/L
y = Ak𝛼
• Labour productivity is affected by tech, physical capital to labour ratio and the size of 𝛼
• For a constant level of tech, ↑ level of capital per worker (k) will ↑ labour productivity
• Since exponent on capital per worker 𝛼 < 1, there are diminishing marginal returns to  
↑ capital per worker
• As capital to labour ratio ↑, so does the output to labour ratio (aka labour productivity)
• However, as k ↑ the effect on labour productivity of a given ↑ in k becomes smaller
• Since ↑ capital per worker runs into diminishing returns, higher levels of investment and
capital can’t be the primary source of growth in labour productivity or real per capita GDP
10.3.2 TECHNOLOGY
• ↑ Level of technology will (ceteris paribus) lead to an equal ↑ in labour productivity
• ↑ A would produce an upward rotation of the production function
• Continual growth in technology is sufficient to ↑ labour productivity and ↑ living standards
• Value of A represents a variety of variables and factors:
- Stock of ideas and knowledge available to businesses
- Quality of entrepreneurial and management skills
- General legal and political environment. Are property rights secure and is there an
independent legal system for enforcing contracts? Likely incentives for businesses to
produce and innovate
- Level of social capital e.g. level of trust or degree of corruption
Page 50 of 51
10.3.3 HUMAN CAPITAL
• Human Capital: Accumulation of investment in education and training embedded in a worker
• ↑ Investment in human capital accumulation is a driver of growth in labour productivity
• Human capital accumulation may be subject to diminishing marginal returns
• Investment in education by an individual is commonly thought to have a public/social benefit

in addition to the private return
10.3.4 INFRASTRUCTURE & PUBLIC CAPITAL

• Public Capital: Physical capital provided primarily by the govt sector
• Example: Highways and roads, public transport systems; urban water and sewerage
• Used by many economic agents and in absence of congestion, may have some elements of
a public good
• Sometimes funded by taxes and are provided free/subsidised to businesses and households
10.3.5 NATURAL CAPITAL

• Incl. land, natural resources and environmental capital
• Productive land, energy and mineral resources all have the potential to ↑ output per worker
10.4 GROWTH ACCOUNTING

10.4.1 GROWTH OF OUTPUT
Y = AK𝛼L1-𝛼
∆Y = ∆A + 𝛼(∆K) + ∆L(1 — 𝛼)
• Where ∆Y = (Y-Y-1/Y-1) x 100
• In any period, we can decompose the growth rate of output into:
1. Contribution from growth in technology (∆A)
2. Contribution from growth in capital (𝛼 x ∆K)
3. Contribution from the growth of labour ((1 —𝛼) x ∆L)
10.4.2 GROWTH OF TECHNOLOGY

∆A = ∆Y — 𝛼(∆K) — ∆L(1 — 𝛼)
• Growth rate of A aka total factor productivity or multi-factor productivity
10.4.3 LABOUR & CAPITAL INCOME SHARES

• One issue w/ calculating ∆A is that we need an estimate for 𝛼
• Under certain assumptions, 𝛼 is easily calculated from national accounting data
• Suppose labour and capital markets are competitive:
MPL = w MPK = r
• Where w = aggregate real wage, r = aggregate return to capital (aka real IR)
(1 — 𝛼) Y = w 𝛼Y=r
L K
(1 — 𝛼) = w x L 𝛼=rxL
Y Y
• Since Y = real GDP = real national income, RHS = labour’s share of income
• ∴ Exponent on labour (1 — 𝛼) is the share of income that goes to labour
Page 51 of 51

ECON1102 Final Exam Notes

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UNSW Semester 2 ECON1102: Macroeconomics 1

• Non-market production activities (e.g. household cooking), second-hand or used goods is

1.1.1 MONETARY VALUE

• Note: Market prices are used in the calculation of GDP

1.1.2 GOODS & SERVICES W/O MARKET PRICES

1. Estimate a market value for the good or service

1.1.3 INTERMEDIATE GOODS & VALUE ADDED

• 2 Ways to calculate the contribution of the production of a hamburger to GDP:

• Quarter: Includes the month in its name + 2 previous months

1.1.4 EXPENDITURE APPROACH TO GDP

• Private Investment Spending (I): Expenditure by businesses

• Exports (X) and Imports (M)

• Note: Private investment includes ∆ level of inventories that are held by businesses

- ∆ Inventory = Inventory (end of period) — Inventory (beginning of period)

- Inventories: Currently unsold stocks of goods held by businesses

• Government Expenditure: Current/consumption spending and capital/investment spending

1.1.6 SECOND-HAND GOODS

Y = LABOUR INCOME + CAPITAL INCOME + (INDIRECT TAXES — SUBSIDIES)

• Compensation: Measure of total wages and salaries

• Gross Operating Surplus: Measure of payments to capital

1.1.8 GROSS NATIONAL INCOME (GNI)

1.1.9 NOMINAL & REAL GDP

• Chain Weighting (Chain Weighted GDP)

1.1.10 NOMINAL, REAL GDP AND THE GDP

• Real GDP Per-Capita: Real GDP/Population

• ↑ Reflects growth in the quantity production, improvements in quality and ↑variety

1.1.12 GDP & ECONOMIC WELFARE

• Solutions to persistent criticisms of GDP:

1.1.14 BUSINESS CYCLES

• Expansion: Period when ↑ GDP

• Recession: Period when ↓ GDP

• Peak: Highest level of GDP

• Trough: Lowest level of GDP

• Australia hasn’t had a Classical recession since

1.1.15 TECHNICAL RECESSION

1.2 CONSUMER PRICE INDEX (CPI)

• Inflation: Situation in which the general price level in an economy is rising

• Deflation: Situation in where the general price level is ↓ing

CPI = COST IN CURRENT YEAR

• Rate of Inflation (%)

𝜋= CPI — CPI-1. x 100

- E.g. Selling a renovated house

- In response households are likely to substitute apples for oranges

1.2.2 TRENDS IN INFLATION & DEFLATION

• Unexpected inflation causes a transfer from lenders to borrowers

• 2 Costs associated with (positive) inflation: Menu Costs and Shoe-Leather Costs

- More frequent switches will be associated with higher transactions costs

- Transactions costs are shoe-leather costs (tend to ↑ with inflation)

‣ Inflation ↓ the real purchasing power of a given amount of money

- Unexpected redistribution of wealth due to fixed nominal incomes

- Distorts tax systems (if not indexed to inflation)

- Introduces noise into the price mechanism

1.2.4 OPTIMAL RATE OF INFLATION

• Why not target an inflation rate for zero?

- Inflation allows for some flexibility in reducing real wages

• Persistent deflationary episodes have been associated with stagnant/negative growth

• Bad deflations are associated with low economic output

• Policy makers wish to:

- Avoid high and variable inflation

• Employed: Minimum 1 paid/compensated hour of work per week (or on leave)

• Full-Time: At least 35 hours in all jobs during the previous week

• Not in Labour Force: Doesn’t meet requirements e.g. volunteers, homeworkers

• Underemployment: Working less than willing and able to

- Want to work and can begin work within 4 weeks

• Possible for some nominal IR to be negative (e.g. Japan) 