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Macroeconomics Lecture notes - Lecture notes, lectures 1 -

12

Macroeconomics 1 (University of New South Wales)

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Macroeconomics
Topic 1: Measuring the economy – output and prices
Definition: macroeconomics deals with the economy as a whole, or with the basic subdivisions or
aggregates that make up the economy
Fallacy of competition: the idea that the whole is different from the sum of its parts
 Economic Goals
o Rising living Standards:
 Tendency for the level of output to increase over time
 Output/population = output per capita
 Distribution of living standards also considered
o Stable Business Cycle:
 Low volatility in fluctuations of actual output around its trend or potential output
o Relatively stable price level: low positive rate of inflation
 Inflation: sustained increase in the overall level of prices in an economy over time
o Sustainable levels of public and national debt:
 Public debt: borrowing by public sector from private sector
 Influenced by government budget deficits/surpluses
 Foreign debt: borrowing by domestic residents from foreign countries
 Influenced by an economy’s current account deficits/surpluses
o Balance between current and future consumption
 How much should an economy invest?
o Full employment
 Provision of adequate employment for all individuals seeking work
 Measuring Output:
o GDP: total market value of all final goods and services produced in the economy during a
specific period of time
 Excludes G/S that are produced in other countries but that might be
consumed in the country (Imports)
 Excludes G/S produced in an earlier time period but re-sold in current
period
 GDP is a measure of aggregate production or output
 Use market prices to value quantities of various G/S
o Goods and services with no observed market price
 Included in GDP:
 National defence (cost of equipment, salaries etc.)
 Roads
 Not included in GDP
 Unpaid housework (household production)
 Volunteer work
o GDP excludes intermediate G/S (goods used in the production process) eg. Flour in bread
 Value added: market value of a firm’s production less the cost of inputs purchased
from other firms
 Equivalent ways to measure GDP
o Expenditure method:
 Accounting identity: expenditure on G/S by final users must equal the value of their
production
 Components of expenditure
 Consumption (C)
 Investment (I)
 Government (G)
 Net Exports (NX) = Exports (X) – Imports (M)
 GDP = Expenditure
 Y = C + I + G+ NX
 Y=C+I+G+X–M

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 Y+M=C+I+G+X
 Supply of G/S + Demand of G/S
o Income Method:
 GDP also equals the aggregate incomes paid to labour (L) and capital (K) in the
production of G/S
 GDP = Labour income + Capital Income
 Nominal GDP vs. Real GDP
o Nominal: values quantities of G/S produced at current year prices
o Real: values quantities of G/S produced at base year prices – measure of the actual
physical volume of production
 Choice of base year:
 Using initial prices as base year: Laspeyres Index
 Using final prices as base year: Paasche Index
o Chain Weighting:
 For any two consecutive year compute the growth rates of real GDP implied by
both indexes
 Take the average of the two growth rates = chain-weighted growth rate
 To compute a change index over a long period, the above approach is applied on a
year-by-year basis
o Is GDP a good measure of economic wellbeing? (omissions from GDP)
 Leisure time
 Household production
 Environmental degradation
 Quality of life
 Economic inequality
 Measures of price level
o Consumer price Index (CPI): measures the cost in that period of a given basket of goods
and services relative to their cost in a fixed year (base year)
Cost of currsnt ysar goods
 CPI=
Cost of bas ysar goods
o Inflation: measured by the percentage change in the CPI over a given period

 Inflation rate: [ CPI −CPI (−1 )

CPI (−1 )
x 100
]
 Rate = 0, prices are constant
 Rate > 0, prices are rising
 Rate < 0, prices are falling (deflation)
o Limitation of CPI
 Quality adjustment and new goods bias
 Quality improvements may show up as higher prices for goods and services
 New goods are often not included until CPI is re-based
 Substitution bias
 No allowance is made for consumer’s substitution towards relatively less
expensive goods
 CPI tends to overstate the rate of inflation
o Costs of Inflation
 Distinguish between relative price change and a change in the general price level
 Inflation reduces the real purchasing power of a given amount of money (Shoe-
leather costs)
 Menu costs: real costs of changing prices
 Introduces noise into the price mechanism
 Distorts tax systems (if not indexed to inflation)
 Unexpected re-distributions of wealth
o Nominal interest rate = % increase in the dollar value of a financial asset

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o Real interest rate = % increase in the real purchasing power of a financial asset
 R = I – π (where r – real interest rate, I – nominal interest rate, π - inflation rate)
o Fisher effect: nominal interest rate = real + expected inflation

Topic 2: Measuring the economy – savings and wealth

 Saving = current income – current consumption
savings
 Savings rate =
incoms
 Savings is a flow, measured in $s per unit of time
 If savings is positive, assets are being accumulated
 If savings is negative, assets are being de-cumulated or liabilities accumulated
 Wealth accumulates as a result of saving from ordinary income and capital gains
o Wealth is a stock (measured in $s at a point in time)
o Wealth = assets – liabilities
o Changes in wealth = saving + capital gains – capital loss
o Wealth can rise if there is no saving
o Net wealth = value of assets – value of liabilities
 Measuring Saving
o Private saving = household/personal saving + business saving
= GDP (Y) – Taxes (T) – Consumption (C)
 Household saving includes:
 Financial assets
 Property
 Employee/personal super contributions
 Business saving includes:
 Undistributed profits
 Spending on capital equipment
 New buildings
 Employer superannuation contributions
o Public Saving = T - G
 Government
 Saving = current income – current spending
 S = Y – C – G (I excluded because it provides for future needs not current ones)
 S=Y–C–G+T–T
 taxes paid by private sector to government less transfer payments from
government to private sector
 less interest payments from government to private sector bond holders
 Transfer payments: payments the government makes to the public for which
it receives no current goods or services in return
 S=Y–C–G+T–T
 S = (Y – T – C) + (T – G)
 S = Private Saving + Public Saving
 Private Saving = Y – T – C
 Public Saving = T – G (Budget Deficit/Surplus)
o National saving measures aggregate saving in an economy
 Why do people save?
o Lifecycle: saving to meet long term objectives
o Precautionary: protection against unexpected events, savings as a form of insurance
o Bequest motive: saving to leave an inheritance
 Saving and the real interest rate
o Ceteris paribus we expect saving to increase with the real interest rate
o Real interest rate (R) is the most relevant to the saving decision
o Real interest rate as the relative price of consuming today versus consuming in the future

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o Higher interest rate = current consumption more expensive, incentive to increase savings
(positive correlation between saving and real interest rate)
 Factors acting to reduce saving
o Availability of consumer credit eg. hom equity loans
o Demonstration effects: high consumption levels of neighbours may influence us to consume
more and save less
o Government provision of retirement benefits may lead to less private saving for retirement
 An Economic Model – the supply of and demand for savings model
o National saving: provides funds for investment
o Investment: creation of new capital goods (plant, equipment and buildings) and housing
 Leads to increasing productivity and higher standards of living
o Determinants of Investment
 Firms will invest in new capital if benefits > costs
 Expected costs:
 Prices of new capital goods
 Real interest rate  an increase in the real interest rate raises the
opportunity cost of investing in new capital (even for non borrowers)
 Ceteris paribus:
 a rise in the real interest rate will make investment less attractive
 a rise in the price of capital goods will make investment less attractive
 an increase in aggregate demand will make investment more attractive
o Investment Decisions
 Investment is made based on cost-benefit principle. Keep investing until:
 Marginal cost of investment ≥ marginal benefit of investment
 Expected benefit is the value of marginal product which depends on:
 Productivity of new capital goods
 Capital taxes
 Relative price of output generated
 Investment is negatively related to the real interest rate
o Savings, investment and financial markets
 If there is no international borrowing:
 National saving = investment
 Supply of savings (households, businesses, government) and demand for
savings (for investment) are equalised through the financial markets
o Changes in demand for investment
 Anything that changes the marginal product of investment will shift the demand
for investment funds
 Anything that decreases the marginal product of investment will reduce
demand for funds
 Anything that increases the marginal product of investment will increase
demand for funds
 Introduction of new technology = increase in investment (move to right)
 Decrease in marginal product of capital = decrease in investment
o Changes in supply of savings
 Anything that changes the level of saving will shift the supply of savings
 Saving is made up of public and private saving
 Budget surplus = increase in national saving
 Budget deficit = decrease in national saving
o Crowding Out: increase in government budget deficit = reduces private investment
spending
 A large deficit reduces national saving  drives up interest rate  investment less
attractive 

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Topic 3: Measuring the Economy – Unemployment and the Labour Market

 Demand for labour –the hiring decision
o Firms will hire labour to maximise profits (compare cost to hire an additional [marginal]
worker and benefit that worker generates)
o Marginal cost of miring (MC) = wage of worker
o Marginal benefit (MB) = value of worker’s marginal product (VMP)
 Marginal product of labour
o Firm combines workers with a given amount of capital to produce a product
o As a firm employs more people, output rises
o Diminishing marginal product: nature of the production technology is such that each
additional worker produces less output than the existing workers
o Marginal product of labour = MPL = change in income/ change in labour
o Value of marginal product = price x MPL
 Firm’s demand for labour
o Firm will compare the benefit of an additional worker with the cost of that worker
 firm will employ labour until value of MPL = Money wage
 firm will employ labour until value of MPL = real wage (real wage falls as more
workers are employed  demand for labour is a decreasing function)
 Real wage = nominal wage/price index
 Shifts in the Demand for Labour
o Change in labour productivity due to change in
 Amount of physical capital
 Amount of human capital
 Level of technology
 Management practices
o Change in relative price of the good which labour produces
o Change in demand for final goods
 Supply of Labour
o Suppliers are workers and potential workers
o At a given wage people decide if they are willing to work (supply = total number willing)
o Labour supply is assumed to be an increasing function of the real wage
 Higher wage  greater willingness to sacrifice other pursuits to work
 Positive slope  higher opportunity cost of not working, higher the real wage
 Shifts in the supply of Labour
o Size of working age population
 Demographic factors: birth rate, mortality, immigration
o Participation rate: percentage of working age population seeking employment
 Long term social factors – typical retirement age, years in education, working
parents, participation of women
o Social trends enhancing participation
 Increasing wage inequality:
o Technological change
 Increases worker productivity, basic source of rising living standards
 Skill-based technical change:
 Raises the marginal product of high-skill workers, real wage increases
 Reduces the marginal product of low-skill workers, real wage decreases
o Globalisation
 Importing industry:
 Lower demand for goods, lower relative price, reduced VMP, decreased
demand for labour
 Exporting industry
 Higher demand for goods, higher relative price, increase VMP, increased
demand for labour

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 Measuring the labour market

o Definitions:
 Labour force = total number of people available for work (employed + unemployed)
 Unemployed: person has not worked in past week but is actively seeking work
 Not in labour force: person has not worked in past week and is not actively seeking
work (retirees, full-time student)
 Discouraged workers: people who have given up looking for work
o Participation rate = % working age population who are in the labour force
 = labour force/working age population (15-69) x100
o Unemployment rate = % labour force who are unemployed
 = number unemployed/labour force x100
 Achieving full employment
o Types of unemployment
 Frictional unemployment
 Short term unemployment associated with people searching for the right
job
 Beneficial rather than costly to an economy
 Structural unemployment
 Longer term unemployment arises when the distribution of skills of some
workers does not match the available jobs in the economy
 Some may have lack of skills or subject to discrimination preventing them
from finding stable long-term employment
 Change in economy may result in loss of jobs for specialised workers
 Cyclical unemployment (seasonal)
 Associated with periods of slowdowns in economic activity
o Factors affecting rate of unemployment
 Minimum wage laws
 Aka award wages
 Standard labour demand and supply model predicts setting high minimum
wages produced unemployment
 Government transfer payments paid to the unemployed
 can have disincentive effect on worker’s search effort
 Ageing population
 Reduces labour supply
o Costs of unemployment
 Economic costs: output foregone since workforce is not fully utilised
 Psychological costs: long periods of unemployment can lead to loss of self-esteem,
unhappiness and depression
 Social costs: high unemployment can lead to increased crime, break up of families
and associated social problems
 Loss of human capital
 Health costs
 Budget deficits – lower tax revenue, higher expenditure

Topic 4: The economy in the short run – the business cycle

 Definition: tendency for growth in real GDP to fluctuate in the short term
 Business Cycle Characteristics:
o Peak: high point in economic activity, prior to a downturn in economic activity
o Trough: the low point of economic activity, prior to a recovery in economic activity

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o Contraction: a period in which the economy is moving from a peak to a trough – the level
of GDP falls
o Expansion: a period in which the economy is moving from a trough to a peak – GDP rising
o Recession
 Lasts 18 months on average
 At least two consecutive quarters of negative economic growth (GDP falls)
 Unemployment usually increases
 Inflation usually decreases
 Features of the business cycle
o Not regular and hard to forecast turning points
o Economy wide impact
o Potential for global spill over
o Unemployment increases
o Workers in durable goods are more affected by booms and recessions
o Inflation fluctuates
 Measuring the business cycle
o Potential output: y*
 Amount of output (real gdp) the economy is capable of producing when using
resources at normal rates
 Can grow over time with increase in number of labour and capital resources
available and increases in productivity
 Aging of population can reduce potential output
o Actual output can vary due to:
 Changes in potential output
 Changes in utilisation rate of labour and capital
o Magnitude of recessions and booms
 Output gap = actual GDP less potential GDP
 Output gap = y – y*
o Reasons for short term economic fluctuations
 Changes in level of potential output y*
 Drought  significant fall in potential output growth, leading to
contraction/recession
 Period of particularly rapid innovation  cause unusually large growth in
potential output, leading to expansion or boom
 Gap between actual output and potential output (OUTPUT GAP)
 If gap is negative then under utilisation of resources, Contractionary gap
(y<y*)
o Associated with capital and labour not being fully utilised
 If gap is positive then over utilisation of resources, expansionary gap
o Firms operating above normal capacity and can lead them to raise
prices (inflationary)
o Recessions and unemployment
 Actual rate of unemployment (U)
 Natural rate of unemployment (U*), rate of unemployment that prevails when
cyclical unemployment is 0
 U* = frictional and structural unemployment
 Factors influencing frictional and structural employment  long periods of
high unemployment, structural change, generosity of government benefits
 Cyclical unemployment = u – u* (=0 when u = u*)
 Contractionary gap
 Output gap negative (y – y* < 0)
 Cyclical unemployment positive (u – u* > 0)
 Expansionary gap

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 Output gap positive (y – y* > 0)

 Cyclical unemployment negative (u – u* < 0)

Topic 5: The economy in the short run – the Keynesian aggregate expenditure model
 Keynesian idea:
o Shows how fluctuations in planned aggregate expenditure can cause an output gap
o Model of economy in short run – period of time in which prices do not respond to changes
in demand (prices are fixed)
 Firms do not change prices in response to a change in demand
 Firms fix their price and meet the demand by varying their level of production and
employment
o Firms face some costs to changing prices – menu costs
o In the long run: sustained or persistent changes in demand will eventually lead firms to
change their prices and cause production to return to normal capacity
 Non Keynesian View
o Fluctuations in demand accommodated by flexible prices and wages
o There will never be excess production because firms will cut prices to sell it
o There will never be persistent unemployment because workers will cut their wages to keep
and get jobs
 Keynesian theory: output is determined by the amount people want to spend
o Aggregate expenditure = C + I + G + (X – M)
 Two sector model:
o Assumption
 No government sector
 No foreign sector
o Equilibrium condition
 Firms produce output equal to planned aggregate expenditure
 45 degree line, where PAE intersects = equilibrium
 Y = PAE, PAE = Cd + Ip
 Equilibrium GDP = Ye  1/(1-c) [CIP]
o Cd = C + cY (consumption depends on total, not disposable income)
o Investment expenditure
 Purchase of new buildings and houses, plant and equipment and increases in stocks
(inventories) by the private sector
 What determines current investment expenditure
 Real interest rates
 Expectations of future demand
 I is exogenous (not determined by Y)
 Planned investment is exogenous: Ip = I
o Planned expenditure exceeds aggregate production
 Adjustment to equilibrium
 Firms will experience an unplanned decline in their inventories
 To re-build their inventories firms will increase their level of production
 This causes GDP to increase and move towards equilibrium value (PAE cuts 45)
o Savings function
 S (withdrawls) and Ip (injections)
 S=Y–C
 S = - C + (1-c)Y
 Marginal propensity to save = 1 – c
 If PAE > Y, unplanned rundown of inventories, Y increases
 If PAE < Y, unplanned build up of inventories, Y decreases
 If planned investment > saving, unplanned rundown inventories, Y increases
 Excess demand

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 If planned investment < saving, unplanned build up inventories, Y decreases

 Excess supply
o Paradox of thrift (contradiction of saving)
 An increase in S will increase Y for individual, an increase in S by society as a whole
results in the fall in national income
 Increase in attempted saving ultimately causes no change or fall in actual saving
 An implication of the Keynesian model is that:
 An attempt by the community to increase saving will fail
 The economy will be worse off as a result of the attempt
 Increasing the level of saving at each level of income will shift the
consumption function and PAE down
 Equilibrium occurs at a lower GDP and savings at same level as before due
to a lower Y
 Paradox:
 What is a good thing for individuals may not be good for the economy
 The more we save the less we spend, demand falls, GDP falls, savings will not
change
 Example of the fallacy of competition: any individual can choose to save
more but the community as a whole cant
 Increase in saving by individuals does not lead to greater aggregate saving
 Four Sector Model
o PAE = Cd + Ip + G + X
o Components of expenditure
 Consumption function: Cd = C + c(Y-T), consumption of domestically produced
goods depends on disposable income
 Tax function: T = T + tY
 There is exogenous component to taxes (T) and a part that is proportional
to income tY
∆T
 Define =t as the marginal tax rate (how much tax is paid on an
∆Y
additional dollar of income)
 Expenditure on imports
 Influenced by:
o Domestic GDP (Y)
o International competitiveness
 Relative prices
 Exchange rates
o In aggregate expenditure model, M is positively related to Y
 Import function
o M = m(Y – T)
o Imports are proportional to disposable income
∆M
o We define m as m = as marginal propensity to import
∆(Y −T )
(MPM)
o Cd = C – M = C + c(1 – t)Y
 Government expenditure
 Spending my governments (federal, state, local) on goods and services – on
consumption goods and services and investment (infrastructure)
 What determines government expenditure?
o In the Keynesian aggregate expenditure model, G is exogenous (G =
G), G is determined by fiscal policy
 Expenditure on exports
 Increased expenditure: increased GDP, improved international
competitiveness

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 Decreased expenditure: decreased GDP, reduced international

competitiveness
o Injection and withdrawals in 4 sector model
 Savings = Y – T – C
 Withdrawals = planned injections
 S+T+M=I+G+X
o How does the Keynesian model explain fluctuations in GDP?
 A change in one of the exogenous variables: Ć , T́ , IP, G, X
 A change in one of the parameters: c, t
o PAE and the output gap
 Output gap = actual output less potential output
 Output gap = Y – Y*
 We can use our model to understand Contractionary (negative) and expansionary
(positive) output gaps
 Decline in planned spending leads to Contractionary gap (Ye – Y*)
 The expenditure multiplier
o Planned investment increases  PAE increases  output increases  consumption
increases  PAE increases …
o The magnitude of increased PAE that results from exogenous expenditure increases is
determined by the expenditure multiplier
o An additional dollar of exogenous PAE generates more that a dollar’s worth of GDP
1
o 2 sector model:
1−c
1
o 4 sector model:
(1− [ ( c−m )( 1−t ) ] )

Topic 6: Fiscal policy

 Review:
o Keynesian model: recessionary gap
 Starting at potential output (Y*), a fall in exogenous C, I, G, X will lead to a
recessionary gap
o Government spending and output gaps
 Government purchase of goods and services are a component of PAE
 Government expenditure is treated as exogenous, so changes in G will shift the PAE
line
 Model implies that changes in G can be used to close output gaps (ensure Y = Y*)
 Policies to stabilise the business cycle
o Fiscal policy: annual budget sets out government’s fiscal policy intentions
o Monetary policy: monthly, reserve bank board
 Set monetary conditions  interest rates, money supply, cash rate
 Stabilisation policies work by influencing PAE
 Components to fiscal policy
o Government expenditure: current goods and services, investment and infrastructure
o Taxes (direct, indirect): income taxes, consumption taxes (GST)
o Transfer payments: unemployment benefits, pensions
o Government decisions about these variables can affect the level of output in the economy
 Taxes, transfers and…
o PAE
 Governments make decisions about the level and types of taxes and transfer
payments made in the economy (not part of G)
 Only have an indirect effect on PAE
o Disposable income
 Affect the level of disposable income (Y – T) received by the private sector

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 Increases in transfer payments and tax will increase disposable income, when
disposable income rises, PAE rises
 Decreases in transfer payments and taxes will decrease disposable income, when
disposable income decreases, PAE decreases
 Equation for PAE in 4 sector model
o PAE = [C – cT + Ip + G + X] + c(1-t)Y
o Government can change
 Exogenous part of taxes and transfers
 The tax rate (a larger tax rate [t] gives rise to a flatter PAE)
 Using Contractionary fiscal policies  increases the tax rate


 Government spending has a greater effect on GDP than an exogenous tax cut
 Government expenditure multiplier is greater than the tax/transfers
multiplier
o Balanced budget multiplier
 Budget surplus (deficit) = T – G
 Initial level of budget surplus is unchanged
 Balance the budget (∆ G=∆ T ) and stimulate the economy
 An increase in government spending that is financed by an increase in taxes will
still have a positive impact on the economy
 Withdrawals  higher income taxes and imports reduce the impact of the
multipliers
 Fiscal policy
o Discretionary fiscal policy: deliberate changes in the level of government spending,
transfer payments or in tax rates
 Fiscal policy equated with structural changes in budget
o Automatic stabilisers: refers to the tendency for a system of taxes and transfers which are
related to the level of income to automatically reduce the size of GDP fluctuations
 Drive cyclical changes
 Fiscal policy changes automatically without specific government action
 As GDP declines, level of taxes paid falls, transfer payments increase  decline in
budget surplus
 Taxes  marginal income taxes
 Transfer payments  unemployment benefits
 Make contractions and expansions in GDP smaller than they would have been
otherwise
o Inflexibility in discretionary fiscal policy:
 Most fiscal policy changes only made on annual basis
 Changing government spending or taxes involves lengthy legislative process
 GFC:
o Falls in GDP preceded by financial/credit crisis (warning for governments)
o Concern about ability of monetary policy to provide sufficient stimulus to economies
o Scope for governments to use fiscal policy
 Fiscal policy and the supply side

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o Fiscal policy can affect potential output Y* as well as planned aggregate expenditure
o Investment spending o infrastructure can play a major role in growth of Y*
o Taxes on labour:
 Income rates and structure of government payments can influence labour supply
decisions
o Taxes on capital:
 Company tax rates can influence firms’ investment decisions and affect the level of
private capital
o Supply side policies aim to increase the amount of labour and human capital, increase
investment and capital stock, increase level of technology
 Fiscal policy and public debt
o Budget surplus/deficit = T – G
o Flow variable
o Deficits need to be financed in some manner
 Borrow from private sector
 Outstanding stock of government borrowing is called public debt
 Public debt equals sum of all past deficits less any surpluses
 Government budget constraint: means of relating government outlays (purchases and transfer
payments) to their method of financing via govt. budget constraint
o Government can fund its outlays in 3 ways:
 Taxes
 Borrowing (ie. selling a government security)
 Printing money
 Central bank as a source of funds: prints money
 Associated with increased inflation but is not a problem if there are
unemployed resources in the economy
o Spending comprises government expenditure in a time period Gt and transfer payments Qr
 When the government runs a budget deficit, stock of public debt is increased
 When government runs a surplus budget, stock of debt will decrease
o Costs of public debt
 Crowding out: high levels of government borrowing may increase interest rates
which crowds out private investment and capital formation
 Intergenerational equity:
 We should not enjoy the benefits of budget deficits now and pass on the
costs of those deficits to future generations
 The extent ot which government expenditure is used for capital will enrich
future generations
o Benefit of public debt:
 Finance provision of public infrastructure
 Public good is under-supplied by the private sector
 Returns to investment in infrastructure are relatively high
 Public debt may have a net benefit for the economy even if there is crowding out
 Forecasting tax revenue depends on:
o Size of labour force
o Level of expenditure in the economy (growth rate of GDP)
o Level of business profits (business income tax)
o Tax rates as well as the number of taxpayers
o As average population age increases, more transfer payments made
 Distribution of income
o Fiscal policy influences distribution of income between households in the economy
 This is done by influencing the total disposable income available to households
through net taxes (tax paid by households minus transfer payments received)
 Progressive taxes

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o Higher the income earned by household, relatively higher proportion of tax paid on income
o Less unequal distribution of income as a result
o Government transfer payments are targeted toward low income earners and means tested
(narrow gap)
 Relative income inequality
o Lorenz curve: graphical representation of income inequality
o Gini coefficient: summary measure of income inequality
 Area between the line of equality and the Lorenz curve/ total area below the line of
equality
 Higher gini = higher income inequality
 Gini = 0  perfect income equality
 The lower the value, the closer the Lorenz curve to the line of equality, more equal
distribution

Topic 7: Money, Private Banks and the RBA

 Review:
o Fiscal policy (outlined in annual budget)
 Government expenditure
 Taxes (direct, indirect)
 Transfer payments
o Monetary policy (outlined by reserve bank)
 Set monetary conditions  interest rates, money supply
 What happens to saving?
o Currency
o Bank deposits
o Stocks
o Bonds
o Other assets
o Lenders  financial system  borrowers
o Asset prices and yields
 The yield or return on a financial asset is inversely related to the asset’s price
prics ( tomorrow ) +incoms
 rsturn=
prics(today)
 other things equal, an increase in price (today) = decrease in return
o Bonds
 Bond is a legal promise to repay a debt
 Principal = amount that is originally borrowed on the bond
 Coupon payment = regular dollar payment of interest on the bond
coupon paymsnt
 coupon rats=
principal
 term of bond = length of time before bond has to be repaid
 interest rates
 bonds do not have to be held until maturity, can be bought and sold on the
bond market
 bond prices and interest rates are inversely related
 Supply of money: what is money?
o Money: a commodity/token accepted as a means of payment because it fulfils 3 main
functions:
 Medium of exchange
 Good or asset whose primary purpose is to purchase other goods
 Unit of account
 Good that is used to compare the value of all other goods and services
 Gives meaning to terms such as GDP and CPI

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 Store of value
 Good or asset that serves as a means of holding (or transferring) wealth
over time
 Supply of money: measuring money
o How much money is there in the economy? (definitions)
 Currency: notes and coins on issue held by households and businesses (excluding
holdings of currency by banks)
 M1: currency plus current deposits of households and businesses (money held in
cheque and savings accounts) held by banks
 M3: M1 plus all bank deposits of the private non-bank sector (currency + bank
deposits of households and businesses + all other deposits held by households and
businesses eg. term deposits)
 Broad money: M3 plus deposits of households and businesses held by non-banks
(building societies, credit unions)
 Supply of money: what determines the amount of money?
o M3 consists of currency + bank deposits: amount of money also depends on the behaviour
of commercial banks and their depositors
o How banks influence money supply
 Demand deposits (in banks) are redeemable in cash on demand, banks retain a
fraction of deposits as reserve (reserve ration = reserves/deposits), the remainder
they lend
 When banks have excess reserves (actual reserve ration exceeds desired ratio) they
make loans and create money
o Banks as creators of money:
 If central bank prints currency, this is distributed to households and firms
 Households and firms then deposit this into private banks
 Banking system balance sheet reads: Assets = Reserves ($) and Liabilities = Deposits
($)
o 100% reserve banking
 banks take deposits and place currency in their vaults (called bank reserves)
 banks earn income by charging fee for managing the currency
o Bank loans
 Banks decide that is unnecessary to hold all of their deposits in form of reserves
 Some level of reserves is required to meet unexpected withdrawals
 Some households and firms demand currency, banks lend this out of excess reserves
to borrowers in form of bank loans
 Banks are now financial intermediaries
 See lecture slides for examples
 Velocity of money
o How fast does a dollar circulate?
o what is the average value of transactions that a dollar can be used for in a given period of
time?
valus of transactions nominal GDP P× Y
o Velocity = ≈ ≡
monsy stock monsy stock M
 M = Money supply
 V = velocity of circulation
 P = Price level
 Y = real GDP
o Higher velocity  higher speed at which money circulates
o Definition of velocity rearranged gives quantity equation M × V =P ×Y
 States that money stock times velocity equals nominal GDP
o Quantity theory:
 makes two economic assumptions
 velocity is constant

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 output is constant
 M × V́ =P × Ý
 ∆ ( M .V )=∆ ( P. Y )
 if real GDP (Y) is constant in the long run and V is constant then the change in
money supply equals the change in price level
 The reserve bank, money supply and monetary policy
o Functions of the RBA
 Financial system stability
 Conduct of monetary policy
 Other:
 Banker to the government
 Banker to banks
 Custodian of the country’s foreign currency
 Printer of currency
o How the RBA implements monetary policy
 Pre 1980’s: targeting the growth of money supply
 Since 1980’s: setting the cash rate to bring supply and demand for funds into
equilibrium
o how the RBA achieves target for cash rate
 exchange settlement accounts (ESA)/ exchange settlement funds (cash)
 banks borrow and lend cash on short term basis, no market for cash
 RBA intervenes in cash market
 Sets interest rate at which it will borrow and lend to banks
 Conducts open market operations with banks
o Exchange settlement accounts
 Banks hold accounts with RBA in here
 Informally known as cash
 Banks are not allowed to overdraw ESA, must always be in credit
 Provide a means by which banks can clear any payments amongst themselves
o Overnight cash market
 Borrowing and lending for periods up to 24 hours if level of cash holdings low
 Interest rate that clears this interbank market is overnight cash rate and is the rate
that RBA targets
 Actions of banks cant change level of cash in system, actions of RBA can
 RBA can buy and sell bonds (typically government) from/to banks
 If RBA buys bonds it pays for this buy crediting bank’s ESA
 If RBA sells bonds receives payment by debiting bank’s ESA
o Open market operations (OMO)
 Action of buying and selling bonds
 Provide means by which RBA influences overall level of cash
o The cash rate
 If there is excess cash (cash rate below 2.5%), RBA sells bonds reducing supply of
cash
 If there is shortage of cash (above 2.5%) RBA buys bonds increasing supply of cash
 Cash rate is for very short-term borrowing and lending
 Effects of cash rate
 Longer term interest rates follow cash rate closely
 Interest rates decreasing on overnight cash rate attracts longer-term loan
money

Topic 8: The Reserve Bank and the Economy

 RBA targets the interest rate (on bonds)
o Given demand for money function, RBA will supply whatever quantity of money required to
achieve its target interest rate value

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 Ie. Money supply is constant whilst money demand is downwards sloping

o Shifts in money demand accommodated by the RBA at the interest rate target
 Using open market operations (OMO) to targt the cash rate
o Banks hold accounts with RBA: exchange settlement accounts
o The balance in ESA is called the exchange settlement funds or cash
o Cash rate: interest rate which brings together the supply and demand for exchange
settlement funds into balance
o RBA uses OMO to influence the cash rate
 Open market operations involve
o RBA buying and selling short-term government bonds
 Selling government bonds means bank reserves fall, as buyers pay for them and
draw on their bank deposits  cash rate rises
 Buying government securities means bank reserves rise, RBA pays for them and the
sellers deposit the proceeds into banks  cash rate falls
o Money supply is whatever is required to maintain the cash rate
 Bonds
o The coupon rate depends on:
 The term of the bond (length of time until the bond’s maturation date)
 Credit risk (risk that the borrower will go bankrupt and not repay loan)
 Tax treatment of coupon payments
o Bond owners are not required to hold their bonds until their maturation dates, always free
to sell their bonds in the bond market
o Bond prices and interest rates
 Price of bond can be greater than, less than, or equal to the principal amount of the
bond, depending on how the current or prevailing interest rate in financial markets
compares with the interest rate at the time the bond was issued
 Market for 90 day bills:
o Supply of bills (short-term bond)
 Firms supply (issue) bills to borrow funds for 90 days
 Borrow more when interest rate on bills is low
 Low interest rate implies a high price for bills
 Therefore supply curve for bills is increasing
o Demand of bills
 Lend more when interest rate on bills is high
 High interest rate implies low price for bills
 Demand curve for bills is decreasing in their price
o Effect of increase in the cash rate on 90 day bill market
 Factors that shift the supply and demand curve for bills will change their price and
interest rate
 A raise in target level of cash rate means that banks are able to participate in both
the overnight cash market and the commercial bill market
 When cash rate increases:
 Demand for commercial bills (willingness to lend to firms) will tend to call:
demand curve shifts left
o This occurs because some banks leave bill market in favour of higher
returns in overnight cash market
 Supply of commercial bills (demand for 90 day loans) will tend to rise:
supply curve shifts outwards
o Some borrowers in overnight cash market seek funds in 90 day bill
market due to higher cash rate
 Decrease in the price of 90 day bills leads to an increase in the interest rate
of 90 day bills
o Arbitrage

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 Whilst RBA targets a very short interest rate, changes in cash rate eventually lead
to changes in longer term interest rates
 Market rates = cash rate + premium (reflects risk or liquidity factors)
o Can the RBA target the real interest rate?
 Targets nominal interest rate (i) – the cash rate – through OMO
 Decisions to save and invest depend on the real interest rate ®
 Recall, r = i – inflation
 Since inflation rate adjusts slowly, RBA can change the real interest rate ®
in the short run by changing nominal interest rate (i)
 How changing monetary conditions affects the economy – the transmission mechanism
o Current monetary policy works by changing the cash rate
 RBA sells/buys government securities to achieve targeted cash rate
 Bank sells/buys government securities to accommodate the RBA and reserves
change
 As bank reserves fall/rise, banks reduce/increase loans
 The increase/decrease in the cash rate feeds through to other short term interest
rates
 Impacts general level of spending and the broader economy
 PAE and the real interest rate
o Two main channels
 Higher real interest rates will lead households to reduce current consumption eg.
due to higher mortgage payments
 Higher real interest rates will raise the cost of borrowing and reduce investment by
firms
 RBA fights a recession
o Decrease rates  decrease saving and increased consumption  increased investment 
depreciation of Australian dollar  lower real exchange rate  increase in international
competitiveness  increased demand for exports, decreased demand for imports
 Model for PAE
o PAE = [C – cT + I + G _ X – (a + b)r] + cY
o Exogenous expenditure now depends on the real interest rate
o For any given level of output, PAE will fall with a rise in the real interest rate
 Why lowering interest rates does not always work
o A lower interest rate will be associated with increased planned aggregate expenditure by
households
o However, lower real interest rates need not always stimulate expenditure
 Consumption
 Households may raise saving for precautionary reasons
 They will to reduce net debt and to rebuild wealth persists
 Investment
 Especially in recessions, investment may be interest inelastic
 Modelling the behaviour of the RBA – the policy reaction function
o The RBA attempts to stabilise the economy by manipulating the real interest rate in
response to the output gap and the inflation rate
o Policy reaction function tries to explain/predict by how much the RBA changes the cash
rate when there are changes in the state of the economy (eg. output gap, inflation rate)
 Policy reaction function
o Application to behaviour of RBA
 Not directly applicable due to different weights on the output gap and inflation
 Until recently likely higher weight on inflation (due to specific inflation target of 2-
3%) although global financial crisis has required consideration of recessionary
output gap

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Topic 9: A model of Output and Inflation: AD/AS Model

 RBA policy reaction function – captures tendency to raise cash rate when economy is overheating
(expansionary gap) and reduces cash rate when economy is sluggish (recessionary gap)
 Aggregate demand curve: combination of PAE curve dependant on real interest rate and policy
reaction function for RBA  shows relationship between output and inflation
o PAE = (C – cT + I + G + X – (a + b)r) + c(1 – t)Y
 Policy reaction function of RBA
o r = r + g(inflation)
o r and g are positive constants
o g indicates how many percentage points the RBA raises the real interest rate in response
to given rise in inflation
o r indicates the value of the real interest rate when inflation is 0
o model implies a negative relationship between equilibrium output and the rate of inflation
 Y = constant ( a+b ) g
¿¿
o All things equal, an increase in inflation is associated with a fall in equilibrium output
 Why does higher inflation lead to lower PAE and output (negative slope)
o Inflation and interest rates: when inflation exceeds the RBA target, the RBA will react by
raising interest rates to reduce AD
o Increase in r reduces consumption and investment (ie. PAE) and this produces a fall in
output
 Other reasons include wealth, distributional and uncertainty effects
 Why does equilibrium of output change at a given level of inflation (cause of shifts in AD)?
o Exogenous changes in components of PAE
 Expectations, fiscal policy, world output and other economic conditions
o Shifts in the RBA policy reaction function
 Reflected terms of a higher or lower nominal and real interest rate at any given
rate of inflation
 Inflation and Aggregate supply
o The AD curve contains two endogenous variables
 Output
 Inflation
o To solve for these two variables we need to develop a model for aggregate supply
 Inflation inertia
o In short-run we assume that inflation is sticky
o In the absence of any large shocks the rate of inflation tends to change relatively slowly
o Reasons for inflation inertia:
 Inflation expectations:
 Feed into current wage and price setting decisions
 Slow to adjust
 Long term nominal wage and price contracts
 Build in expected inflation for a number of years
o πt = πt−1+εt shock
 Inflation and the output gap
o Expansionary (y>y*)  rising inflation
o Contractionary (y<y*)  falling inflation
o Zero (y=y*)  constant
 AS Curve: πt = πt−1+γ ¿
o Y > 0, AS has a curve has a positive slope
 Factors that shift AS curve
o Changes in resources (labour, capital, natural resources) and/or changes in technology
o Changes in inflation expectations
o Inflation shocks

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 Oil price shocks

 Increases in money wages (faster than rises in labour productivity)
 Taxes on business
 Exchange rate shocks and prices of imported units
 Is economy self-correcting?
o AD-AS model implies that economy may experience output gaps in the short run, it may
return to equilibrium in the long run
o Negative AS shock  recessionary gap
 Excess supply of goods and services, decrease relative prices (rise by less than costs)
 Inflation falls (SRAS shifts down) and moves along AD (output increases as
RBA follows policy reaction function)
 Output increases until equilibrium and cyclical unemployment falls until
unemployment reaches natural rate
o Positive AD shock  expansionary gap
 Excess demand for goods and services, increase relative prices (by more than costs)
 Inflation rises (SRAS shifts up) and move along AD (output falls as RBA
follows policy reaction function)
 Output falls until equilibrium and unemployment rises until it reaches
natural rate
 Role for stabilisation policy
o Speed at which economy returns to long-run equilibrium may be unacceptably slow
o Macroeconomic policy may be able to reduce and length of fluctuations in output gap and
inflation
 Disinflation:
o Process whereby tight monetary policy is applied to reduce the rate of inflation in an
economy
o In the short run, disinflation can be costly in terms of lost output and high unemployment
o Once a country has attained a low inflation rate, it my introduce institutional
arrangements to ensure it is sustained
 GFC
o Financial/banking crisis
o Large falls in US house prices (wealth effects)
o Increased uncertainty (weak consumption and investment)
o All point to shift in the AD curve
 Shocks to Potential output
o Labour force: population ageing, famine, net migration
o Capital obsolescence
o Drought
o War

Topic 10: Macroeconomic Policy

 Role for stabilisation policy
o AD-AS model implies that economy may be self-correcting (y eventually returns to y*)
o If actual economy is slow to self-correct, there is scope for use of fiscal and monetary policy
to respond to shocks
o Stabilisation policy acts to reinforce any self-correction process
 AS shocks and Stabilisation policy
o Policy makers face a trade off:
 Higher inflation vs. smaller output gap
 Lower inflation vs. larger output gap
 Summary:
o With AD shocks
 Stabilisation policy acts to return economy to original pre shock equilibrium

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o With AS shocks
 Stabilisation policy will face a trade off between inflation and output gap
 Aggregate supply effects of fiscal policy
o Fiscal policy can affect potential output as well as output
o Government can increase public capital or infrastructure
o Taxes and transfers can affect incentives to work and produce
o Changes in marginal income tax rates can affect labour supply decisions

Topic 11: The open economy – trade and capital flows

 The Balance of Payments
o Systematic records of one country’s economic transactions with the rest of the world
o Records international receipts and payments
o Measures money flows - $ value
o Transactions between residents of a country and non-residents
 Current account
 Transactions leading to a change of ownership of commodities or a direct
flow of income
 Non-reversible transactions
 Made up of: Goods, services, income and current transfers
 Capital Account
 Transactions involving the purchase or sale of assets
 Made up of: capital and financial account
o Types of transactions
 Credits – payments from overseas eg. exports
 Debits – payments to overseas eg. imports
o Balance of payments = current account + capital and financial account
 Any imbalance on the current account has an offsetting balance on the capital and
financial account
o Current Account
 When the balance is negative  CAD, when positive  CAS
 Balance on merchandise trade (exports less imports of goods)
 + Net services
 + Net income (includes labour and property income; interest, dividend and royalty
payments)
 Australia’s net income from international transactions in services is
negative  we are a debtor nation (borrow about twice as much as we
lend)
 + Current transfers (migrant funds, unconditional foreign aid)
 one way transactions – no current exchange of goods or services
 includes pensions received by Aussies abroad, gifts to foreign relatives etc.
 = balance on current account

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o structural reasons for Australia’s CAD (long term issues)

 heavy concentration on primary product exports eg. minerals, wheat, wool
 reliance on low value added exports eg. education, tourism
 dependence on high value imports eg. cars, computers, manufactured goods
 comparatively low productivity in manufacturing eg. no value added
 culture of high consumption
 cuts in protection of local industries (decreased tariffs)
 decline in some manufacturing or firms move offshore – more imports
 growing info technology deficit
 high costs for shipping, transport, insurance (services)
 huge net income deficit (largest component of CAD)
o past foreign investment and borrowing to cover large trade deficits
o mainly interest repayments plus payment of profits, rent overseas
o debits on incomes section of current account
o worse when Australian dollar is low or interest rates are high (attract
foreign investment)
o cyclical reasons for Australia’s CAD (short term)
 very high domestic growth
 weaker growth internationally
 past low terms of trade
 drought
 rising profits from Australian firms has increased income debits to overseas
shareholders
 Relationship between capital and the current accounts
o Records all international transactions that involve the acquisition of either an asset or
liability
o Current account:
 New liabilities  inflow of foreign currency: recorded as credits as they bring in
foreign exchange
 Acquisition of assets  outflow of foreign currency: recorded as debits as they
required foreign currency to be given up by domestic residents
o Capital account
 Net capital transfers – include the cancellation of debts of poor countries and funds
taken in and out by migrants

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 Net acquisition/disposal of non-produced, non financial assets

o Financial account:
 Official sector – records the transactions of the government sector and the reserve
bank (change in RBA’s holdings of foreign exchange and gold)
 Non official sector – records the transactions of private sector firms, financial
institutions and households  direct and portfolio investment balances of net
foreign investment in Aus and Aus investment abroad
 Determinants of international capital flows
o Purchases and sales of real and financial assets across international borders (ie. portfolio
investment and direct investment in the capital and financial account)  international
capital flows
 Capital inflows  purchases of domestic assets by foreigners
 Capital outflows  purchases of foreign assets by domestic households and firms
 Difference between the two flows are net capital inflows
o Determinants of capital flows
 Relative domestic and foreign interest rates
 Higher real domestic interest rate promotes net capital inflows
o Foreigners buy more domestic assets
o Domestic residents buy less foreign assets
 Increase in belief that exchange rate will depreciate
 Relative riskiness – due to:
 Risk of loss of capital (political risk, default, bankruptcy by foreign business)
 Exchange rate risk
 An increase in riskiness of domestic assets reduces net capital inflows
(domestic assets become less attractive to purchasers)
 Expected long term returns
 Speculation
 Speculative demand is the dominant consideration
o Value of exchange rate largely determined by speculative capital
flows
o Exchange rate expectations are largely self-fulfilling
 Relationship between current account and capital/financial account
o If current account surplus:
 Capital and financial account deficit  lending to and purchases of assets from the
rest of the world
o If current account deficit:
 Capital and financial account surplus  borrowing from and sale of assets to the
rest of the world
 Cumulative impact of capital and financial account surpluses = increase in net
foreign liabilities
 Saving, investment and capital inflows
o Closed economy, saving = investment
o Open economy, savings from other countries can finance domestic investment
o NS + KI = I
 NS = national saving (private saving plus government saving)
 KI = net capital inflow [below equilibrium of savings and investment]
 If negative, there is net capital outflow [above equilibrium of savings and
investment] (domestic savings are larger than required to finance domestic
investment, excess lent to other countries)
 I = investment
o Small open economies – Australia
 Large capital flows tend to eliminate any sustained differences in the interest rates
between domestic and foreign interest rates

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o The saving rate and trade deficit

 Australia has often run a trade deficit = imports > exports
 Link between national saving and trade deficit
 If NS < I, NX is negative  trade deficit
 Effect of investment boom on trade deficit
 Higher net capital inflow and increase in net exports

Topic 12: The Economic Growth

 What is economic growth?
o Measuring economic growth
 Long term growth refers to a rise in living standards not the rise in total GDP
 Conventional to use real GDP per capita as a measure of country’s living standards
and stage of development
 Real GDP per capita = GDP/ Population
 Although not a perfect measure of economic wellbeing, real GDP per person is
positively related to life expectancy, infant health and literacy
o Convergence and catch up
 Idea that relatively poor countries will have higher growth rates than rich
countries and eventually catch up in terms of the level of per capita GDP
 For some groups of countries there is evidence of convergence
 What determines economic growth?
o GDP/POP = GDP/number of employed workers X N/POP
o Accordingly, real GDP can only grow if:
 Average labour productivity grows
 The share of the working population grows
o Factors affecting labour productivity:
 Physical capital per worker
 Increases in quantity and quality of physical capital
 Includes stock of machines, tools, plant and equipment, buildings
 Human capital per worker
 Refers to education and training, skills and talents of labour
 Raises quality of unskilled labour input
 Land and natural resources per worker
 Productive land, energy and mineral resources have potential to improve
labour productivity
 Level of technology
 Stock of ideas and knowledge
 Viewed as primary source of economic growth
 Combination of primary research and development
 Entrepreneurship and quality of management
 Development of new firms and the way firms are organised
 Political and legal environment
 External to the firm
 Includes the system of property rights, degree of political stability
o Factors affecting worker/population ratio
 Age distribution of the population
 Birth rate, death rate, immigration
 Social norms eg. childcare, family size
 Incentives provided by the taxation and welfare systems eg. retirement pension age
 Long term trends affecting participation
 Working parents, retirement ages, years in education
 How to promote economic growth
o Human capital: policies to improve education, training and research
o Physical capital: policies to increase investment, especially in the newest technology

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o Level of technology: policies to increase research and development

o Other: sensible regulation, enforcement of property rights, transparent and stable
government and justice system
 Costs/limits to growth
o Costs of economic growth
 Can economic growth continue indefinitely without depleting natural resources
and causing massive change to the global environment?
o Limits to growth?
 Environmental concerns – consider technological improvements
 Higher levels of GDP per person are associated with lower levels of pollution
 Population growth concerns – richer countries have smaller families
 Developing a model of economic growth
o Production function represents the relationship between
 Primary factors of production
 Labour
o Supply of labour
 Economists use labour, l, as the total number of hours or
work supplied
 Individuals compare the benefits of working – the real wage
received against the cost of working
o Demand for labour
 Benefits to the firm of employing an additional unit of labour
are measured by the marginal revenue product of labour
MRP = P x MP
 MP and MRP decline due to the fact that
 Successive workers are assigned the most productive
tasks
 Pragmatic problems of adding more staff to fixed
capital
 Capital
o Key determinant of economic growth
o Real interest rate is an opportunity cost of employing capital
 Rate of interest the firms need to pay if borrowing funds or
rate it could receive if funds are saved
o Diminishing marginal productivity of capital
 Marginal benefit (marginal product of capital) = marginal
cost (real interest rate)
 The production function
 Assumptions
o Adding more capital to fixed labour increases total product but
decreases marginal productivity
o Adding more labour to fixed capital increases total product but
decreases marginal productivity
o All secondary factors of production remain constant
 Cobb – Douglas production function
α (1 – α)
yt = A kt lt
t
o Y = amount of real output
o K = capital stock
o L = amount of labour
o A = secondary factors of production

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o
 Secondary factors of production
 Known collectively as total factor productivity because they impact on the
ability to transform primary factors into input
o Technology
o Management expertise
o Skills
o Other factors eg. infrastructure, political stability etc.

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