Lecture Slides S1 - 2012

MODULE 1: CONCEPTS
ECONOMIC METHODOLOGY & THE ECONOMISING

PROBLEM
MEASUREMENT - GDP, UNEMPLOYMENT &
INFLATION
RMIT University School of Economics, Finance and Marketing 2
Economic Methodology & the Economising Problem

Economics: Foundations and Models - Chapter 1
Choices and Trade-Offs in the Market - Chapter 2
Learning Objectives:

1. Discuss the following important economic ideas: people are rational;
people respond to incentives; optimal decisions are made at the margin.
2. Understand the issues of scarcity and trade-offs, and how the market
makes decisions on these issues.
3. Understand the role of economics in modern analysis.
4. Distinguish between microeconomics and macroeconomics.
5. Use a production possibility frontier to analyse opportunity costs and
trade-offs.
6. Understand the basics of trade.

Economics
A social science concerned with the allocation of
scarce/limited resources between unlimited and often
competing needs and wants.

Scarcity: The situation in which unlimited wants
exceed the limited resources available to fulfill them.

Trade-off: The idea that because of scarcity,
producing more of one good or service means
producing less of another good or service.
Check Your Understanding
What does the adage There is no such thing as a
free lunch mean?
a. To get something we like, we usually have to give up
another thing we like.
b. Even people on welfare have to pay for food these
days.
c. The cost of living is always increasing.
d. All costs are measured in dollars.
Resource Categories
Resources are divided into 4 main categories.
Land: all natural resources.
Labour: Requires a fundamentally scarce resource -
TIME.
Capital:
Human capital: knowledge & skills that people
develop
Physical Capital: buildings, machinery tools, etc.
Enterprise or entrepreneurial ability
We study economics because of
a. resources.
b. money.
c. scarcity.
d. economists have convinced universities it is a
necessary field of study.
Three ideas are primary throughout the course:

1. People (economic agents) are rational.

2. People (economic agents) respond to economic
incentives.

3. Optimal decisions are made at the margin.

Economics and Individual Decisions
Economists understand that people respond to:
a. the wishes of policymakers.
b. Incentives.
c. threats more than rewards.
d. tax breaks, but not tax hikes.
Economic Models
Economics deals with generalities/statements about
regularities, concerning economic behaviour.
Models are simplified representations of the real world.
Ceteris Paribus
A hypothesis in an economic model: A statement
about an economic variable that may be either correct
or incorrect.
Economic variable: Something measurable that
relates to resources that can have different values.
In testing hypotheses, economists distinguish between
correlation and causality.
Economic models are usually composed of:
a. plastic.
b. beautiful people.
c. assumptions only.
d. diagrams and equations.
Positive versus Normative

Positive: Claims that attempt to describe the world
as it is. Statements of facts. Can be tested
empirically.

Normative: Claims that attempt to prescribe how the
world should be. Opinions. Cannot be tested
empirically.

Which of the following is a positive economic
statement?
a. The government should close income tax loopholes
that enable people to avoid paying tax.
b. We should redistribute income to reduce poverty.
c. Everyone should live at the same standard of living.
d. If the price of petrol rises, a smaller quantity of it will
be bought.
Macroeconomics versus Microeconomics

Microeconomics: The study of how individuals make
decisions. Microeconomics considers how households
and firms make choices, how they interact in markets,
and how the government attempts to influence their
choices.
Macroeconomics: Enables us to better understand
the structure and behavior of the entire economy
(regional, national or global) and to consider issues
associated with measuring performance.
Macroeconomics is the study of the economy as a
whole and includes topics such as inflation,
unemployment, and economic growth.
State whether the following issues are
microeconomic or macroeconomic.
a. The overall unemployment rate
b. A tax that affects workers in the automobile industry.
c. The inflation rate
d. Prices of electronic goods
e. Real GDP
Scarcity and Trade-offs
1. What to produce
2. How to produce it
3. Who will receive the products

WHO DECIDES?
Laissez-
faire/Market
Economy
Command
Economy
Mixed
Economy
A market economy rewards people according to:
a. their need for goods and services.
b. how willing they are to work.
c. their ability to produce things of cultural importance.
d. their ability to produce things that other people are
willing to pay for.
Financial
Markets
Resource
Market
Firm
Government
Product
Market
External
Household
Borrowing & Lending
Private and Public
Production Possibilities Frontier
How to achieve the greatest possible satisfaction of
societys material wants given scarce resources?

Full employment
Full production
Allocative efficiency
Productive efficiency
Which of the following results in production
occurring at the lowest possible cost?
a. Productive efficiency
b. Allocative efficiency
c. Dynamic efficiency
d. All of these options are correct.
Production Possibilities Frontier
butter
guns
A
E
U
Attainable but not desirable
W
Unattainable
10
4

Represents the maximum possible combinations of goods &
services that can be produced with a given quantity of factors of
production and given technology.
An "increase in efficiency" suggests that an
economy:
a. Has moved from a point outside of, to a point on, its
production possibilities curve.
b. Has decided to produce more consumer goods and
fewer capital goods.
c. Is able to get less output from a given amount of
input.
d. Is able to get more output from a given amount of
input.
Opportunity Cost
butter
guns
A
E
3
10
9
1
7
2
4
B
C
D
4
Any movement along the
PPF involves the concept
of opportunity cost.
Can only obtain more of
one good by having less
of the other.
The opportunity cost of any activity is
the highest-valued alternative that must
be given up to engage in the activity
under consideration.
In economics, the cost of something is:
a. the out-of-pocket expense of obtaining it.
b. what you give up to get it.
c. always measured in units of time.
d. always higher than people think.
Increasing & Constant Opportunity Costs
10
butter
guns
A
E
3
9
1
7
2
4
B
C
D
4
Scarce resources are not
equally suitable in all
productive activities.
Economic resources are
not completely adaptable
to alternative uses.
pastries
cakes
A
E
3
10
8
1
6
2
4
B
C
D
4
2
Scarce resources are
equally suitable in all
productive activities.
Economic resources are
completely adaptable to
alternative uses.
Increasing opportunity costs will lead to the
production possibility frontier being
a. bowed inward from the origin.
b. bowed outward from the origin.
c. a negatively sloped straight line.
d. a positively sloped straight line.
Assume a firm can produce a combination of 60
units of X together with 80 units of Y but to produce
70 units of X, the firm can only produce 60 units of Y.
What is the opportunity cost to produce 10 more
units of X?
a. Two units of Y
b. 10 units of X
c. One-half a unit of X
d. 20 units of Y

Trade-offs and disaster relief
More funds for one
disaster relief
means less funds
for other charities.

Economic Growth
Over time PPF can move outwards.

Achieved through economic
growth.

The following will push the PPF out:
Capital accumulation.
Technological progress.
Increased resources
computers
(good for the future)
pizzas (good for the present)
Which of the following would shift the country's
production possibility frontier inward?
a. An increase in the unemployment rate
b. Discovering a cheap way to convert sunshine into
electricity
c. Producing more capital equipment
d. A law requiring workers to retire at age 50
Refer to the above table. As compared to production
alternative D, the choice of alternative C would:
a. Tend to generate a more rapid growth rate.
b. Be unattainable.
c. Entail unemployment.
d. Tend to generate a slower growth rate.
Production possibilities (alternatives) A B C D E F
Capital goods 5 4 3 2 1 0
Consumer goods 0 5 9 12 14 15
Here is a production possibilities table for watches and
bags in Consumer Land.

a. Draw a PPF that corresponds with the data in the
table.
b. Why must Consumer Land sacrifice successively
larger amounts of watches to acquire more bags.
What type of opportunity costs is it facing? ?
Production Alternatives
Type of product A B C D E
Watches (in millions) 10 9 7 4 0
Bags (in millions) 0 5 10 15 20
c. If the economy is currently at production alternative D:
i. What is the opportunity cost of five million more bags?
ii. What is the opportunity cost of three million more
watches?
d. Where would the economy be operating if a recession in
Consumer Land resulted in 2 million people losing their jobs?
e. If the production possibilities frontier for Consumer Land was
a straight line, what would it indicate about the countrys
opportunity costs? What does this indicate regarding
resources?
f. Suppose improvement occurs in the technology of producing
watches but not in the production of bags. Illustrate the
impact on the original production possibilities frontier.
We can use the production possibility frontier and the
concept of opportunity cost to explain the economic
gains from specialisation and trade. (ECON1086:
International Trade covers the important topic of
international trade in more detail).

Trade: the act of buying or selling a good or service in a
market.

Trade
PPF and International Trade
Mercantilism held that countries would grow wealthy by
accumulating gold and silver. They would do so by
exporting as much as possible, and importing as little as
possible.
Adam Smith put forward the idea that the wealth of a
nation depends on the incomes of the people in the
country and what they are able to consume, not on the
gold and silver held by the monarchs and the nobles.
According to Smith, imports rather than exports are the
purpose of trade. Imports of goods and services rather
than the accumulation of gold and silver improve peoples
standard of living.
Absolute and comparative advantage.

Absolute advantage: The ability of an individual, firm
or country to produce more of a good or service than
competitors using the same amount of resources.

Comparative advantage: The ability of an individual,
firm or country to produce a good or service at a lower
opportunity cost than other producers.
Trade
The Benefits of International Trade
David Ricardos theory of comparative advantage
(developed in 1817) showed how a country could
improve the income of its citizens by allowing them to
trade with people in other countries.
International trade allows nations to increase the
productivity of their resources through specialisation and
thereby to realise a higher standard of living than is
possible in the absence of trade.
Trade enables a country and the world to produce and
consume more than would be possible without trade.
The basis for trade is comparative advantage not
absolute advantage.
Individuals, firms or countries are better off if they
specialise in producing goods and services for which
they have a comparative advantage and obtain other
desirable goods and services by trading.
Trade
The basic principle underlying free trade between
nations is
a. Absolute advantage
b. Comparative advantage
c. Mercantilism
d. Productivity growth
Review Your Understanding
Daniel decides to spend an hour swimming rather
than working at $6 per hour. His trade-off is:
a. nothing, because he enjoys swimming more than
working.
b. the increase in skill he obtains from swimming for
that hour.
c. the $6 he could have earned.
d. nothing, because he spent $6 for admission into the
sports complex to swim.
When society requires that firms reduce pollution:
a. there is no trade-off, since everyone benefits from
reduced pollution.
b. there is no trade-off for society as a whole, since the
cost of reducing pollution falls only on the firms
affected by the requirements.
c. there is a trade-off only if some firms are forced to
close.
d. there is a trade-off to the firms owners, workers and
customers.
When the government prevents prices from
adjusting naturally to supply and demand:
a. it stabilises the economy.
b. it adversely affects the allocation of resources.
c. the improvement in equity justifies the reduction in
efficiency.
d. the reduced uncertainty associated with fixed prices
is worth more than the cost in lower efficiency.
What is the basic cause of scarcity?

Opportunity cost is best defined as
a. the cost to producers that results from a failed
investment opportunity.
b. the additional cost of producing one more unit of
output.
c. the highest valued alterative that we forego when we
make a choice or decision.
d. the additional cost of purchasing one more unit of a
good.
If an economy had production problems which led to
inefficiency, but then solved these problems and
increased economic efficiency, how would this be
shown on a production possibility frontier?
a. The slope of the production possibility frontier would
become more elastic.
b. There would be a movement from a point inside the
frontier to a point closer to or on the frontier.
c. The slope of the production possibility frontier would
become more inelastic.
d. The production possibility frontier would shift
outwards.
The following Production Possibilities Frontier shows the
maximum possible combinations of food and clothing that can be
produced in a given time period in a particular country.
food
clothing
a. If the country moves upward along the curve and produces
more food, does this involve increasing opportunity costs?
Why/Why not?
b. Under what circumstances would the PPF be a straight line and
what type of opportunity costs would exist?
c. Under what circumstances would the PPF be bowed out from
the origin and what type of opportunity costs would exist?
Production possibilities
(alternatives)
A B C D E F
Given the above production possibilities table for an
economy, what would be the benefit of producing at
production alternative C as compared to production
alternative D?

Production possibilities
(alternatives)
A B C D E F
Refer to the above table. If the economy is producing at
production alternative C, what is the opportunity cost of
the tenth unit of consumer goods?

Refer to the above diagram. If the economy moves from
point C to point B, what is the opportunity cost of each
additional baseball?

Measurement : GDP, Unemployment, Inflation

Measuring Total Production, Income and Economic Growth - Chapter 4
Economic Growth, The Financial System and Business Cycles Chapter 5
(pp. 119-120)
Unemployment - Chapter 9 ( pp. 246-262)
Inflation - Chapter 10 (pp. 272-280)
1. Explain how total production in an economy is measured.
2. Discuss whether GDP is a good measure of economic wellbeing.
3. Discuss the difference between real and nominal variables.
4. Understand how the economic growth rate is measured.
5. Define the unemployment rate and the labour force participation rate, and understand
how they are calculated.
6. Explain the economic costs of unemployment.
7. Identify the different types of unemployment
8. Define the price level and the inflation rate, and understand how they are calculated.
9. Use price indexes to adjust for the effects of inflation.
10. Distinguish between the nominal interest rate and the real interest rate.
11. Discuss the problems caused by inflation.
GDP
Gross Domestic Product (GDP): The total market value of all
final goods and services produced in the economy during a
specific period.
Gross National Product (GNP): The total market value of all
final goods and services produced by residents of a country
(eg. Vietnam residents) during a specific period.

GDP includes only the market value of final goods.
Final good or service: A good or service purchased by a
final user.
Intermediate good or service: A good or service that is an
input into another good or service, such as a tyre on a truck.
GDP includes only current production.
Gross Domestic Product is the total market value of
all
a. intermediate and final goods and services produced
in a time period within a country.
b. goods but not services produced in a time period
within a country.
c. final goods and services produced in a time period
within a country.
d. final goods and services produced in a time period by
citizens of a country, both within the country and by
its citizens working overseas.
Methods to Measure GDP
Three alternative methods to measure GDP:

1. The Production or Value Added Method: The sum of the
value of all goods and services produced by industries in
the economy in a year minus the cost of goods and
services used in production leaving the value added.
2. The Expenditure Method: The sum of the total
expenditure on goods and services by households,
investors, government and net exporters (exports minus
imports).
3. The Income Method: The sum of the income generated by
resources used in the production of goods and services
(includes the sum of wages, salaries and supplements plus
rent, interest, profit and dividends).
Financial
Markets
Resource
Market
Firm
Government
Product
Market
External
Household
Borrowing & Lending
Private and Public
Value of Production = Value of Resources = Value of Income Generated = Expenditure Undertaken
Simple Relationships
RGDP = Y = AE = C + I + G + NX

For a closed economy we simply remove the external sector which makes our
income function:

Y = C+ I + G
We can re-arrange this to derive the investment function:
I = Y C G

S
total
= S
private
+ S
public

S
private
= Y + TR C T and S
public
= T G TR, hence

S
total
= (Y + TR C T) + (T G TR) = Y C G

S = I
One bag of flour is sold for $1.50 to a bakery,
which uses the flour to bake bread that is sold for
$4.00 to consumers. A second bag of flour is sold
to a consumer in a grocery store for $2.00. Taking
these three transactions into account, what is the
effect on GDP?
a. GDP increases by $1.50.
b. GDP increases by $3.50.
c. GDP increases by $6.00.
d. GDP increases by $7.50.
Components of GDP
Consumption: Spending by households on goods and
services, not including spending on new houses.
Investment: Spending by firms on new factories, office
buildings, machinery (planned), and inventories
(unplanned), and spending by households on new
houses.
Government purchases: Spending by federal, state,
and local governments on goods and services.
Net exports: The value of exports minus the value of
imports.
GDP = C + I + G + NX
In the equation GDP = C + I + G + NX, the G
component refers to
a. the purchases of final goods and services by all
levels of government, excluding transfer payments.
b. government expenditures plus all transfer payments.
c. the taxes and expenditure of all levels of government.
d. government expenditures on transfer payments, such
as pensions and unemployment benefits.
GDP does not reflect total current production as
production from the following sources are not
reflected in its calculation:
Household production: Goods and services people
produce for themselves.
The black economy: Buying and selling of goods
and services that is concealed from the government to
avoid taxes or regulations or because the goods and
services are illegal.
Issues in the Measurement of GDP:
Shortcomings of GDP as a measure of total
production
Shortcomings of GDP as a measure of wellbeing:
The composition and distribution of GDP is not captured
in GDP measures.
The value of leisure is not included in GDP.
The level, quality of and access to health care is not
measured in GDP.
GDP does not accurately reflect improvements in the
quality of products.
GDP is not adjusted for pollution or other negative effects
of production.
GDP does not reveal anything about social problems that
also impact on overall societal wellbeing.
Does GDP measure what we want it to
measure?
Nominal (Money/Current) GDP vs Real GDP
Inflation or deflation complicates the comparison of figures
measuring GDP over time, because GDP is a price-times-
quantity figure.
Nominal GDP could increase over time because of increased
output, increased prices or both.
Suppose the economy had a money GDP of $1,000 in 2008,
which results from the production of 1,000 apples that sell at a
price of $1 per apple. Would it be better off in the year 2009
with a money GDP of $2,000?
What would be your conclusion if you found out that the
$2,000 GDP resulted from the production and sale of 1,000
apples at a price of $2 per apple?
Price and Quantities
Year Price of
apples
Qty. of
apples
Price of
burgers
Qty. of
burgers
2006 $1 100 $2 50
2007 $2 150 $3 100
2008 $3 200 $4 150
Year Calculating GDP using current prices
2006
2007
2008
Year Calculating GDP using constant prices (base year 2006)
2006
2007
2008
School of Economics, Finance and Marketing 62
Calculating Real GDP
Real GDP (RGDP): The value of final goods and services
evaluated at base year prices.
Nominal GDP: The value of final goods and services valuated
at current year prices.
Nominal GDP can change over time due to changes in either
price or output. RGDP shows changes in output only.
GDP statisticians select a base year and use this over a
specified period to measure RGDP in order to make
meaningful comparisons of GDP over time.
A simple rule: RGDP equals base year prices times current
year quantities.
Real GDP versus Nominal GDP
100
index price
GDP nominal
RGDP =
RMIT University
Suppose that a very simple economy produces three
goods: movies, burgers, and bikes. Suppose the
quantities produced and their corresponding prices for
2004 and 2009 are shown in the following table:
2004 2009
Product Quantity Price Quantity Price
Movies 20 $6 30 $7
Burgers 100 $2 90 $2.50
Bikes 3 $1000 6 $1100
The base year is 2004. What is nominal GDP in 2009?
a. $7035
b. $3690
c. $6360
d. $3320
Given the following information, what can we say
has happened in the economy from 2008 and 2009?
2008 2009
Nominal GDP $10 000 $12 000
Real GDP $9 500 $10 500
a. The price level has remained constant.
b. The price level has risen.
c. The price level has fallen.
d. Not enough information is available to determine
what has happened to prices.

The Economic Growth Rate: the rate of change in real
GDP from one year to another.

Calculating Economic Growth
100 x
GDP Real
GDP Real - GDP Real
Growth Economic
Previous
Previous Current
=
Slide 65
Measuring Unemployment
Unemployment rate: percentage of the labour force
that is unemployed.

Labour-force Participation rate: percentage of the
adult population in the labour force.

Labour force = No. of employed + No. of
unemployed
100
Force Labour
Unemployed Number
Rate nt Unemployme =
100
Population Adult
Force Labour
Rate ion Participat force - Labour =
Types of Unemployment
Frictional Unemployment
Includes workers who are in the process of voluntarily
switching jobs, workers who are temporarily laid off
because of seasonality, and new entrants into the
labour force. Largely due to imperfect information.
Structural Unemployment
Unemployment due to fundamental changes in the
kinds of jobs that the economy offers. Workers may
have inappropriate skills.
Cyclical unemployment
Due to a deficiency in aggregate demand for goods and
services.
Full Employment and the Natural
Unemployment Rate
When cyclical unemployment is zero, there is full
employment.
Full employment is therefore achieved when real GDP is
equal to its long-run potential GDP.
At full employment, there will inevitably be some structural
and frictional unemployment.
The unemployment rate at full employment is termed the
natural rate of unemployment.
The natural rate of unemployment is not forever fixed and
will vary as rates of frictional and structural unemployment
change.
Issues in the Measurement of Unemployment
Discouraged workers: individuals who have given up
looking for work but would like to work.
Underemployment: All part-time workers are classified
as employed. Yet many part-time employees may
want to work full-time. (Underemployment may also
apply to causal workers who work in excess of 1 hour
per week and are counted as employed even though
they might like to work more hours).
Truthfulness issues
RMIT University
Inflation
100 Rate Inflation
1
1 2
|
|
.
|
\
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=
year
year year
PI
PI PI
Price level: a measure of the average prices of
goods and services in the economy.

Inflation rate: The percentage increase in the price
level from one year to the next.

Deflation: A decline in the general price level in the
economy.

RMIT University
Consumer Price Index (CPI): An average of the
prices of the goods and services purchased by the
typical urban family of 4 in an economy.
The Market Basket: the Department of Statistics
identifies:
A typical or representative household.
The goods and services purchased by the household (this
is the market basket).
Measuring Inflation

Consumer Price Index
The CPI is the most commonly known price index and is based
on changes in the price of a given basket of consumption g&s.
Fixed basket of 4 apples and 2 burgers
Year Price of apples Price of burgers
2006 $1 $2
2007 $2 $3
2008 $3 $4
Year Cost of basket
2006
2007
2008
Year Consumer price index (2006 is the base year)
2006
2007
2008
Inflation
Inflation rate calculated used the CPI:
2007:

2008:

Suppose an economy has only three goods and the
typical family purchases the amounts given in the
following table. If 2000 is the base year, then what is
the CPI for 2008?
Product Quantity Price (2000) Price(2008)
Hair cuts 6 $50 $70
Backpacks 4 $25 $30
Tacos 100 $1.00 $5.00
a. 40.08
b. 208
c. 180
d. 100
Suppose that the data in the following table reflects
the prices in the economy. What is the inflation rate
in between 2008 and 2009?
Year
CPI
(1990=100)
2008 175
2009 180
a. 4.6%
b. 7.5%
c. 5%
d. 2.9%
The CPI is the most widely used measure of
inflation.
Is the CPI accurate?
Four sources of bias in the CPI may lead to its
overstating the inflation rate.
Substitution bias
Increase in quality bias
New product bias
Outlet bias
Issues in the Measurement of Inflation
RMIT University
If consumers purchase fewer of those products that
increase most in price and more of those products
that decrease in price as compared to the CPI
basket, then
a. changes in the CPI understate the true rate of
inflation.
b. changes in the CPI are unrelated to the true rate of
inflation.
c. changes in the CPI accurately reflect the true rate of
inflation.
d. changes in the CPI overstate the true rate of inflation
The GDP Deflator: GDP also allows us to calculate
changes in the price level over time. The GDP deflator
is a measure of the price level calculated by dividing
nominal GDP by real GDP and multiplying by 100.
The Producer Price Index (PPI): an average of the
prices received by producers of goods and services at
all stages of the production process.

Other Measures of Inflation

The purchasing power of the dollar falls over time as
prices rise.
Price indexes, such as the CPI, allow us to adjust for the
effects of inflation so we can compare dollar values over
time.
For example; we can find the 2008 purchasing power
equivalent of a $20,000 salary in 1980. We use the
following formula:

Using Price Indexes to Adjust for the Effects
of Inflation
Value in 2008 dollars = Value in 1980 dollars
|
|
.
|
\
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1980 in CPI
2008 in CPI
=$ 20,000
098 , 46 $
82
189
=
|
.
|
\
|

Hyperinflation
Extremely rapid increases in the general price level.
In periods of hyperinflation, money loses value so
rapidly, that firms and households try to avoid holding
it.
Hyperinflation is often associated with political
instability and usually accompanied by recession.

Nominal interest rate: The stated interest rate on a
loan.
Real interest rate: The nominal interest rate minus
the inflation rate.
Deflation: A decline in the general price level in the
economy.

Real versus Nominal Interest Rates
In the country of Hyrkania, the CPI in 2000 was 120 and
the CPI in 2001 was 132. Jake, a resident of Hyrkania,
borrowed money in 2000 and repaid the loan in 2001. If
the nominal interest rate on the loan was 12 percent,
what was the real interest rate?
Which of the following is a TRUE statement about
real and nominal GDP?
a. If nominal GDP increases from one year to the next,
we know that production of goods and services has
risen.
b. Increases in average prices do not affect the
calculation of nominal GDP.
c. If real GDP increases from one year to the next, we
know that production of goods and services has
risen.
d. Nominal GDP is a better measure than real GDP in
comparing changes in the production of goods and
service year after year.
Suppose that a very simple economy produces three
goods: movies, burgers, and bikes. Suppose the
quantities produced and their corresponding prices for
2004 and 2009 are shown in the following table:
2004 2009
Product Quantity Price Quantity Price
Movies 20 $6 30 $7
Burgers 100 $2 90 $2.50
Bikes 3 $1000 6 $1100
What is real GDP in 2009, using 2004 as the base year?
a. $3690
b. $7035
c. $6360
d. $3320
In 1995, the Consumer Price Index was 118.5. In 1996,
it was 120.3, and in 1997, it was 120.0.
Calculate the inflation rate in 1996 and 1997.
Using the following table, fill in the missing cells:
Nominal GDP
($ billion)
GDP Deflator RGDP Growth
Rate
Inflation
Rate
1991
361.1 103.1
1992
391.4 106.4
1993
441.7 109.2
1994
632 116.2
Suppose dishwashers are part of the market basket
used to compute the CPI.
Suppose also that the quality of dishwashers improves
while the price of dishwashers stays the same.
If the Department of Statistics is able to precisely adjust
the CPI for the improvement in quality, then, other things
equal, should the CPI increase, decrease or remain
unchanged?
Andrew is offered a job in Adelaide, where the CPI is 80,
and a job in Melbourne, where the CPI is 125. Andrew's
job offer in Adelaide is for $42,000. How much does the
Melbourne job have to pay in order for the two salaries
to represent about the same purchasing power?
MODULE 2: MARKETS
THE PRICING MECHANISM
THE PRODUCT MARKET
THE LABOUR MARKET
EXCHANGE RATE MARKET
FINANCIAL MARKETS
MONEY MARKET

The Pricing Mechanism

Where Prices Come From: The Interaction of Demand and
Supply - Chapter 3


1. Understand the factors that influence the demand for goods and
services.
2. Understand the factors that influence the supply of goods and services.
3. Explain how equilibrium in a market is reached and use a graph to
illustrate equilibrium.
4. Use demand and supply graphs to predict changes in prices and
quantities.
The Market for an Individual Good or Service
The market is one method of producing and rationing
scarce goods and resources.
A market is when a group of buyers and sellers of a
particular good or service interact.
Supply and Demand refer to the behaviour of
individual householders (or consumers) and firms as
they interact with one another in the market.
A competitive market is a market in which there are
many buyers and sellers, so that each has a negligible
impact on price.
Individuals Demand for a Good or Service
A demand schedule shows the various amounts of a product
consumers are willing to purchase at each specific price
point, ceteris paribus (all other things being equal).

The negative or inverse relationship between price and the
quantity demanded is known as the Law of Demand.
Demand shows the
a. quantity of a good that buyers will buy at a given
price.
b. quantity of a good that sellers will sell at a given
price.
c. quantities of a good that sellers will sell at all possible
prices.
d. quantities of a good that buyers will buy at all
possible prices.
Market and Individual Demand

Kates Demand

The market demand curve is the horizontal sum of the
individual demand curves
Quantity of CDs
Quantity of CDs
Price of CD
Price of CD Price of CD
40 40
40
6
4 10
20
20 20
12 8
20
Quantity of CDs
Pauls Demand Market
Demand
When the price is $40,
Kate will demand 6 CDs.
Paul will demand 4 CDs.
The market demand at
$40 will be 10 CDs.
Kate will demand 12 CDs.
Paul will demand 8 CDs.
The market demand at
$20, will be 20 CDs.
A Change in Demand versus a Change in the
Quantity Demanded
A change in demand occurs if any determinant of demand (other
than the price of the good or service itself) changes. This will
shift the demand curve.
An increase in demand shifts the demand curve to the right
and will result in a new equilibrium (P and Q).
A decrease in demand shifts the demand curve to the left and
will result in a new equilibrium (P and Q).
A change in the quantity demanded occurs if the price of the
good or service itself changes. This is reflected by a movement
along an existing demand curve.
An increase in price will lead to a decrease in the quantity
demanded.
A decrease in price will lead to an increase in the quantity
demanded.
A change in demand represents a ________ while a
change in quantity demanded is a ________.
a. shift to a new demand curve; movement along one
demand curve
b. movement along one demand curve; movement
along another demand curve
c. movement along one demand curve; shift to a new
demand curve
d. shift to a new demand curve; shift to a another new
demand curve
Determinants of Demand
(Factors that will Shift the Demand Curve)

1. Tastes or Preferences
A change in tastes in favour of a product causes an increase in
demand.
2. Population and Demographics
An increase in the number of consumers in the market
represents an increase in demand.
3. Income
Normal goods: demand varies directly with income. An
increase in income causes an increase in demand.
Inferior goods: demand varies inversely with income.
Determinants of Demand (cont.)
4. Prices of Related Goods
Substitutes: A good that can be used in place of another
good. A decrease in the price of a substitute good causes the
demand for the other good to decrease.
Complements: Goods that must be used jointly. A decrease in
the price of one good causes the demand curve for the other
good to shift to the right.
5. Expectations
Consumer expectations of higher future prices may result in an
increase in demand.
If tyres and petrol are complements, then
a. an increase in the price of tyres will increase the
consumption of petrol.
b. an increase in the price of petrol will increase the
consumption of tyres.
c. an increase in the price of petrol will reduce the
consumption of tyres.
d. tyres and petrol consumption are unrelated.

Shifts and Movements
What effect will each of the following have on the
demand for NIKE running shoes?
a. NIKE running shoes become more fashionable.
b. The price of REBOCK running shoes, a popular
substitute, goes down.
c. Consumers anticipate that prices on all running
shoes will fall next month.
d. There is a rapid increase in the population due to
increased immigration.

Supply for a Good or Service
A supply schedule shows the various amounts of a product that
producers are willing and able to produce at various prices,
ceteris paribus (all other things being equal).

Positive or direct relationship between price and quantity
supplied is known as the Law of Supply.
Market and Individual Supply
Market supply refers to the sum of all individual
supplies for all sellers of a particular good or service.

Graphically, individual supply curves are summed
horizontally to obtain the market supply curve
A Change in Supply versus a Change in the
Quantity Supplied
A change in supply occurs if any determinant of supply (other
than the price of the good or service itself) changes. This will
shift the supply curve.
An increase in supply shifts the supply curve to the right and
will result in a new equilibrium (P and Q).
A decrease in supply shifts the supply curve to the left and will
result in a new equilibrium (P and Q).
A change in the quantity supplied occurs if the price of the good
or service itself changes. This is reflected by a movement along
an existing supply curve.
An increase in price will lead to an increase in the quantity
supplied.
A decrease in price will lead to a decrease in the quantity
supplied.

Determinants of Supply
(Factors that will Shift the Supply Curve)
1. Resource prices: A decrease in price of inputs
lowers production costs and increases supply.
2. Technology: Technological improvements lowers
production costs and increases supply.
3. Prices of Substitutes in Production
4. Expected Future Prices
5. Number of sellers: The larger the number of
suppliers, the greater is market supply.

Shifts and Movements
Market Equilibrium
The intersection of the supply curve and the demand curve for the
product indicates the equilibrium price and quantity.

At the equilibrium price: quantity demanded = quantity supplied;
The intentions of both buyers and sellers coincide.
There is no incentive to alter the price.
Which of the following describes what occurs at a
market equilibrium?
a. Everyone who wants to buy at the current price can
do so.
b. The market is cleared, there is no surplus and no
shortage.
c. Every seller who is willing to sell at the current price
can do so.
d. All these correctly describe what happens at a
market equilibrium.
Market Disequilibrium: Shortages & Surpluses
A surplus causes a competitive bidding down of price
by suppliers.
A shortage causes a competitive bidding up of price by
buyers.
Market Clearing
D
0
Quantity
Price
S
P
0

Q
0
A

Quantity
Price
D
0
S
P
0

Q
0
A

In the Figure above, if demand was to increase, then
equilibrium
a. price falls and quantity rises.
b. price and quantity fall.
c. price rises and quantity falls.
d. price and quantity rise.
What will happen to the equilibrium price and
quantity of butter in each of the following cases?
State whether demand or supply (or both) have
shifted and in which direction.
a. A rise in the price of margarine;
b. A rise in the price of bread;
c. A tax on butter production and an increased
preference for butter over margarine.
If the price of a product increases from $12 to $15,
assuming all else remains constant, then the
a. demand for the product will decrease.
b. quantity demanded for the product will decrease
c. demand for the product will increase.
d. quantity demanded for the product will increase.
The expectation of higher future prices actually
causes higher prices now because
a. quantity demanded will increase now.
b. supply will increase now as firms try to sell before the
price rises.
c. demand will increase now as people try to buy before
price rises.
d. quantity supply will decrease now.
Pens are normal goods. What will happen to the
equilibrium price of pens if the price of pencils rises,
consumers experience an increase in income,
writing in ink becomes fashionable, people expect
the price of pens to rise in the near future, the
population increases, fewer firms manufacture pens,
and the wages of pen-makers increase?
a. Price will rise.
b. Price will fall.
c. Price will stay exactly the same.
d. The price change will be ambiguous.
Consider the housing market domestically and assume
that due to tax incentives, building and development
companies have dramatically increased the amount of
new housing available in the country, causing a surplus
in the market.
Using market demand and supply illustrate the above
situation.
Using the market for beer, consider the following
events and use the demand-supply model to
illustrate the effects of each event on quantity and
the price.
Briefly state the determinant assumption being
made for each event.
a. Decrease in the price of yeast.
b. The legal age for all alcohol consumption increases
to 21 in the country.
The Product Market

Economic Growth, the Financial System and Business Cycles
- Chapter 5 (pp. 117-124)
Aggregate Expenditure and Output in the Short-Term -
Chapter 7 (pp. 174, 177-187)
Aggregate Demand and Aggregate Supply Analysis - Chapter
8 (pp. 212-225)

1. Understand what happens during business cycles and their relationship
to long-run economic growth.
2. Discuss the determinants of aggregate demand and distinguish
between a movement along the aggregate demand curve and a shift of
the AD curve.
3. Discuss the determinants of the four components of aggregate
expenditure and define the marginal propensity to consume and the
marginal propensity to save.
4. Discuss the determinants of aggregate supply, and distinguish between
a movement along and a shift of the AS curve.
The Business Cycle
The economy grows over time, but there are irregular
fluctuations in its rate of growth from year to year.
The business cycle refers to the periodic but irregular
ups and downs in the level of growth in economic activity
over a period of time.

Real GDP
Time
Peak
Trough
Economic Fluctuations
Irregular and unpredictable.
Most macroeconomic quantities fluctuate together.
Changes in the economys output of goods and
services are strongly correlated with changes in the
economys utilisation of its labour force.
Potential real GDP: The level of real GDP attained
when all firms are producing at capacity.
Actual real GDP fluctuates around the long-run
potential in the Business Cycle.

During the expansion phase of the business cycle,
a. employment decreases.
b. income decreases.
c. unemployment increases.
d. production increases.
Slide 122
Aggregate Demand
AD curve shows the amounts of goods and services (RGDP)
that will be purchased at any given price level.
AD is the relationship between the price level and RGDP.
Overall price level of goods and services
An increase in the price level decreases the value of money
because each dollar you have buys less.
When the price level increases how much we can buy with
$1 decreases, in other words, the value of money
decreases in terms of goods and services purchased.

Price
level
RGDP
AD = C+I+G+NX = AE
Aggregate Demand Slopes Downwards
Three key factors help explain the downward slope of the AD
curve and hence the inverse relationship between the overall
price level and the level of RGDP demanded.
1. Wealth Effect
Changes in the price level, with other things remaining the
same, change real wealth, thus changing the level of spending.
2. Interest Rate Effect
Higher prices requires more money for purchases. Higher
interest rates discourages business investment and reduces
consumption expenditure on consumer durables.
3. International Trade Effect
Higher prices causes consumers to spend less on domestically
produced goods and services (g&s) and more on imported g&s.
Because of the slope of the aggregate demand curve
we can say that
a. a decrease in the price level leads to a higher level of
aggregate spending.
b. a decrease in the price level leads to a lower level of
aggregate spending.
c. a decrease in the price level leads to a higher level of
aggregate supply.
d. an increase in the price level leads to a higher level
of aggregate spending.
Components of AE - Shifts of AD
Changes in consumer spending
Expenditures by households on durable goods, non-durable
consumer goods, and on services.
Changes in investment spending
the purchase of capital goods - plant and equipment,
residential structures, and changes in inventory - that can
be used in the production of other goods and services.
Changes in Government spending
Conduct of fiscal policy: changes in government purchases
of goods and services and taxation.
Changes in Net Foreign spending
(Export - Imports) = Net Exports
C = C
O
+ cY
If income is considered a primary determinant of
consumption then:

C: Total consumption expenditure
C
O
: Autonomous/exogenous consumption. Captures the effect of
the non-income factors.
MPC: Marginal propensity to consume. Extra consumption
associated with an extra dollar of disposable income.
MPS: Marginal propensity to save. Extra savings associated with
an extra dollar of disposable income.
Based on the principal that Y
d
= C + S
Y
S
MPS
Y
C
MPC
A
A
=
A
A
=
Consumption Spending
If consumption spending increases from $350
million to $358 million when income increases
from $412 million to $432 million it can be
concluded that the relevant marginal propensity
to consume is:
a. 0.2
b. 0.4
c. 0.6
d. 0.8
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If the MPC is 0.95, then a $10 million increase in
disposable income will
a. increase consumption by $5 million.
b. increase saving by $9.5 million.
c. increase saving by $0.5 million.
d. increase consumption by $950 million.
Consumption Spending
The level of consumption spending is influenced by:
Wealth
Level of consumer debt
Expectations e.g. future incomes or prices
Availability and the cost of credit
Age distribution of the population
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Investment Spending
The level of investment spending is influenced by:
Interest rate
Expectations and business sentiment
Acquisition, operating and maintenance costs
Business taxes
Technological change/innovation
Capital stock

Government Spending
The level of government expenditure is influenced by:
Discretionary Fiscal Policy: deliberate changes in
government spending and tax revenue used to help
stabilise the economy.
Expansionary fiscal policy involves:
Increases in government spending
Lowering of taxes
A combination of the two
Contractionary fiscal policy involves:
Decreases in government spending
Increasing of taxes
A combination of the two
Net Foreign Spending
The three most important variables that determine the
level of net exports are:

The price level in Vietnam relative to the price level in
other countries.
The growth rate of GDP in Vietnam relative to the
growth rates of GDP in other countries.
The exchange rate between the Vietnamese dong and
other countries currencies.

If countries that imported goods and services from
Vietnam went into recession, what would be the
impact on:
a. domestic net exports
b. the aggregate demand curve

The short-run aggregate supply curve (SRAS)
shows the relationship in the short-run between the
price level and the quantity of real GDP supplied by
firms.

Aggregate Supply
Price
level
RGDP
AS
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The Slope of the Short-run Aggregate Supply
Slope (SRAS)
The SRAS is upward sloping, showing that in the short-run
firms will produce more in response to higher prices. The
reason for this is that the price of inputs tends to rise more
slowly than the price of final products due to wage and price
rigidities.
Nominal Wages Rigidities
If the price level falls, real wages rise, production costs
increase; firms hire less labour, thus producing a smaller
output.
Price Rigidities
Not all firms adjust prices immediately in response to
changes in the price level; affecting their competitiveness,
sales and thus production.
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The variables that shift the SRAS curve include:
1. Expected changes in the future price level.
2. Adjustments of workers and firms to errors in past
expectations about the price level.
3. Unexpected changes in the price of an important
natural resource.
4. Plus any factor that shifts the LRAS curve.

Note: Factors 1-3 shift only the SRAS curve not
the LRAS curve
Short-Run Aggregate Supply
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The long-run aggregate supply curve (LRAS) shows
the relationship in the long-run between the price
level and the quantity of real GDP supplied.
Long-Run Aggregate Supply (LRAS)
The long-run
aggregate
supply curve
shows that in
the long-run
increases in the
price level do
not affect the
level of RGDP.
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Shifts in the long-run aggregate supply curve
occur because potential GDP increases over time.
Anything that shifts the LRAS also shifts the
SRAS.
Increases in GDP (or economic growth) which
shift the LRAS are due to:
1. An increase in resources.
2. An increase in the capital stock.
3. New technology
4. Changes in government policy (Incentives to
work and invest)

Factors that Shift the LRAS Curve
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The level of long run aggregate supply is NOT
affected by
a. changes in the price level.
b. changes in the number size of the labour force.
c. changes in the capital stock.
d. changes in technology.
Macroeconomic Equilibrium
Price Level
RGDP
SRAS
AD
Y
f
P
0
LRAS
Price Level
RGDP
SRAS
AD
Y
f
P
0
LRAS
Y
0
Price Level
RGDP
SRAS
AD
Y
f
P
0
LRAS
Y
0
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Suppose the economy is at full employment and
firms become more optimistic about the future
profitability of new investment. Which of the
following will happen in the short run?
a. Prices will decline.
b. Unemployment will decline.
c. Aggregate demand will shift to the left.
d. Output will decline.
What effects might each of the following have on
aggregate demand and/or aggregate supply and
which determinant has changed?
a. A widespread fear of depression among consumers.
b. A tax leading to a 2% increase in petrol prices.
c. A decrease in interest rates.
d. A decrease in government spending on higher
education.
e. The discovery of cheaper energy sources.
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The interest rate effect is described as an increase
in the price level which
a. lowers the interest rate thereby reducing government
spending.
b. lowers the interest rate thereby reducing investment
and consumption spending.
c. raises the interest rate thereby reducing government
spending.
d. raises the interest rate thereby reducing investment
and consumption spending.
The level of real GDP in the long run is called
a. potential GDP.
b. frictional GDP.
c. low capacity GDP.
d. short run GDP.
In the Figure above, which of the points are possible
long run equilibriums?
a. A and B
b. A and C
c. A and D
d. B and D
Macroeconomic equilibrium always occurs when
a. real GDP = potential GDP.
b. aggregate income = national savings
c. aggregate expenditure = C+ I + G + NX.
d. none of the above
If disposable income increases by $100 million, and
consumption increases by $90 million, then the
marginal propensity to consume is
a. 0.6
b. 0.9
c. 0.75
d. 0.8
In the Figure above, given the economy is at point A in
year 1 and point B in year 2, what is the growth rate in
potential GDP between those two years?
In each case, specify which of the four components
of AE will be impacted, and how:
a. Real interest rates increase.
b. Two of Vietnams major trading partners, experience
high GDP growth relative to Vietnam.
c. The business sector becomes pessimistic about
future profits.
d. Most households believe their income prospects are
positive for the foreseeable future.
Imagine that the economy is in long-run equilibrium. Then,
perhaps because of improved international relations and
increased confidence in policy makers, people become more
optimistic about the future and stay this way for some time.
a. What would be the impact on the AD curve?
b. In the short-run, how will this affect the price level and RGDP?
c. As a result of the impact on the price level in (b) what happens
to the expected price level and whats the result for wage
bargaining?
d. How does the change in price expectations in (c) affect the
product market?
e. Illustrate the entire above scenario, highlighting the final long-
run equilibrium
The Labour Market

Unemployment - Chapter 9 (pp.262-264)

1. Explain what factors determine the unemployment rate.
2. Explain labour market equilibrium and disequilibrium
3. Explain the consequence of labour market disequilibrium
4. Describe the changes that have occurred in the determination of wages
and discuss the possible effects on unemployment.
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The Labour Market
Through the workings of the supply of labour and demand
for labour, the levels of employment and the representative
equilibrium wage rate is determined.
The labour market is a resource market meaning that firms
are the demanders and householders are the suppliers in
this market.
The labour market as presented, can be understood in
terms of a representative model (in reality there are many
distinct labour markets)
Supply of labour: Quantity of labour provided by
households at various wage rates.
Demand for labour: Quantity of labour hired by firms at
various wage rates.
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Real Wage Rate
Real wage = nominal wage/overall price level
= w/p

Real wage is the amount of purchasing power that
each worker receives and which the firm pays for
each unit of labour.

The wage rate can be viewed as the opportunity cost
of leisure.
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Labour Market Equilibrium
Real wage
S
L
D
L
Labour
w
p
0
0
N
0
In a perfectly competitive labour market, the wage rate
and level of employment is determined by the
intersection of the demand and supply curves.

Real wage
S
L
D
L
Labour
w
p
0
0
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Causes of Unemployment
When wages are set above their market-clearing level:
Minimum wage laws
Unions and collective bargaining: Prevent downward wage
flexibility
Efficiency wages: Firms may make higher profits by paying
above market-clearing wage rates (link between wages and
worker effort, worker quality and company turnover)
Government Policies that influence the incentive to work:
Job network & unemployment benefits and unemployment
insurance
Deficiency in Aggregate Demand
Cyclical unemployment
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Why did Henry Ford
pay his workers twice
as much as other car
manufacturers?
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Mary Sue is the newly appointed CEO of a company
that manufactures CD drives on an assembly line. Her
staff has told her that the output the firm produces,
given the number of workers employed, indicates that
some workers may be shirking. According to
efficiency wage theory, what should she do?
a. Pay all workers more than the equilibrium wage rate
b. Pay all workers below the equilibrium wage rate to
make up for the loss from shirking
c. Make sure that workers are getting paid exactly the
equilibrium wage rate
d. None of the above is correct according to efficiency
wage theory.
When a union bargains successfully with an
employer, in that industry
a. The unemployment and wages increase.
b. Unemployment and wages decrease.
c. Unemployment decreases and wages increase.
d. Unemployment increases and wages decrease.
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Advantages of deregulation:
Numerical and functional labour market flexibility:
Numerical flexibility: ease with which firms can vary the
quantity of labour inputs.
Functional flexibility: ease with which the tasks performed
by workers can be altered.

Disadvantages of deregulation:
Relate primarily to equity, and in particular, the vulnerability of
workers in weak bargaining positions.
Such workers are often low paid and low skilled.
Minimum wages may be used to ensure greater equity.

Labour Market Regulation and Deregulation
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Which of the following have a tendency to raise the
unemployment rate?
a. The establishment of effective trade unions in an
economy
b. Firms deciding to pay efficiency wages in an
economy
c. Implementing a minimum wage in an economy
d. All of these are correct.
Trade unions cause unemployment because the
union contract wage is set
a. above the market wage, causing a shortage of
labour.
b. below the market wage, causing a surplus of labour.
c. below the market wage, causing a shortage of labour.
d. above the market wage, causing a surplus of labour.
What is the rationale behind the efficiency wage model?

The Exchange Rate Market

Macroeconomics in an Open Economy - Chapter 14 (pp. 404-
410)

1. Explain how exchange rates are determined.
2. The difference between the direct and indirect quotations of exchange
rates.
3. How changes in exchange rates affect the prices of imports and exports.
4. The exchange rate market model.
RMIT University
Nominal Exchange Rate
The rate at which one currency is exchanged for
another.
Direct: Vietnamese Dong required to purchase a unit
of foreign currency:

025 , 21
1
VND 025 , 21
1
$
= =
USD Currency Foreign
VND
e
School of Economics, Finance and Marketing 164 RMIT University
Nominal Exchange Rate
Depreciation: the VND is worth less in terms of
another currency. i.e. is less valuable. So, it takes
more VND to purchase a unit of foreign currency.
Exchange rate increases.
Appreciation: means the VND is worth more in terms
of another currency. So, it takes less VND to purchase
a unit of foreign currency. Exchange rate decreases.
When the dong weakens, each dong buys
a. more foreign currency, and so buys more foreign
goods.
b. more foreign currency, and so buys fewer foreign
goods.
c. less foreign currency, and so buys more foreign
goods.
d. less foreign currency, and so buys fewer foreign
goods.
Exchange Rate Market
Market forces in the form of supply and demand determine
the level of the foreign exchange rate.

S
FX
is derived from any transaction which involves a payment from non-
residents to residents. Converting foreign currency to domestic currency.
D
FX
is derived from any transaction which involves a payments from
residents to non-residents. Converting domestic currency to foreign
currency.
D
FX
Quantity
e
S
FX
Exchange Rate Market
Importing:
Demand for FX.
Supply of VND
Exporting
Supply of FX.
Demand for VND.
Changes in Net Exports
D
FX0
Quantity
Exchange rate
S
FX
e
0

Q
0
D
FX
Quantity
Exchange rate
e
0

Q
0
S
FX
Increased Exports Decreased Imports
RMIT University
1. Changes in demand for Vietnam-produced goods
and services and changes in the demand for foreign-
produced goods and services.
2. Changes in the desire to invest in Vietnam and
changes in the desire to invest in foreign countries.
3. Changes in the expectations of currency traders
about the likely future value of the dong and the likely
future value of foreign currencies.
Speculators: Currency traders who buy and sell
foreign exchange in an attempt to profit by
changes in exchange rates
Shifts in demand and supply
If domestically produced goods increased in
price relative to foreign produced goods,
a. exports would increase and imports would decrease
resulting in an appreciation.
b. exports would decrease and imports would increase
resulting in an appreciation.
c. exports would decrease and imports would increase
resulting in a depreciation.
d. exports would increase and imports would decrease
resulting in a depreciation.
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A rise in domestic interest rates relative to
interest rates in other countries may lead to
a. an exchange rate depreciation and an increase in
net exports.
b. an exchange rate appreciation and a fall in net
exports.
c. an exchange rate depreciation and a fall in net
exports.
d. an exchange rate appreciation and an increase in
net exports.
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Vietnams major trading partners experience a severe
recession.
Illustrate the impact on the exchange rate market and
state whether the currency has appreciated or
depreciated as a result.
The Financial Market

Economic Growth, the Financial System and Business Cycle -
Chapter 6 (pp. 125-133)

1. Discuss the role of the financial system in facilitating economic growth.
2. Understand the link between savings and investment and how these
are facilitated by the financial system.
3. To introduce the loanable funds model and understand the sources of
demand and supply in this market.
4. To understand the significance of the real long term rate of interest in
driving investment decisions.

RMIT University
The Financial system: The system of financial
markets and financial intermediaries through which
firms acquire funds from households.

Financial intermediaries include banks and non-bank
financial institutions.
Financial markets include the share and bond
markets.
Shares: financial securities that represent partial
ownership of a firm.
Bonds: financial securities that represent promises
to repay a fixed amount of funds.

Saving, Investment and the Financial System
RMIT University
Financial intermediaries, such as banks, mutual
funds, pension funds, and insurance companies, act
as go-betweens for borrowers and lenders.
Financial markets enable firms to raise funds by
selling financial securities (shares or bonds directly to
savers).
As well as facilitating the channeling of funds from
savers to borrowers the financial system provides
three key additional services for savers and
borrowers:
1. risk sharing,
2. liquidity, and
3. information.
The Role of the Financial System
RMIT University
The demand for loanable funds is determined by the
willingness of firms to borrow funds to engage in new
investment projects.

The supply of loanable funds is determined by the
willingness of households to save, and by the extent
of government saving or dissaving (borrowing /
budget deficit).

Equilibrium in the market for loanable funds
determines the real interest rate and the quantity of
loanable funds exchanged.
Loanable Funds Market Model
RMIT University
Loanable Funds Market
RMIT University
Explaining Movements in Savings, Investment
and Interest Rates
An increase in the demand for loanable funds
RMIT University
Explaining Movements in Savings, Investment
and Interest Rates
The effect of a budget deficit on the market for loanable
funds
RMIT University
Who was better for
economic growth:
Scrooge the saver
or Scrooge the
spender?

Ebenezer Scrooge: Accidental
promoter of Economic growth?
RMIT University
Equilibrium in the loanable funds market determines
a. the current interest rate
b. the real interest rate
c. the expected interest rate
d. the nominal interest rate
Some economists have suggested that interest on
savings should be subject to a lower tax rate than is
currently being paid.
Use the market for loanable funds model to analyse the
impact of a policy change of this nature on savings,
investment, the interest rate and economic growth.
Illustrate the impact on the loanable funds market.
The Money Market

Money, Banks and the State Banks of Vietnam - Chapter 11


1. Define money and discuss its functions.
2. Discuss the definition of the money supply used.
3. Explain how financial institutions create money.
4. Illustrate and discuss the money market.
RMIT University
Money: Assets that people are willing to accept in
exchange for goods and services or for payment of
debts.
Asset: Anything of value owned by a person or firm.
Barter: exchange of goods or services for other
goods or services.
Barter requires a double coincidence of wants.
Commodity money: A good used as money that also
has value independent of its use as money.
Fiat money: Money such as paper currency that is
authorised by the central bank and has no intrinsic
value except in its function as money.
What is Money and Why do we Need it?
RMIT University
Money is
a. the income a person earns over a period of time.
b. a person's assets net of liabilities at any point in time.
c. a liability that people are willing to accept in
exchange for goods and services.
d. an asset that people are generally willing to accept in
exchange for goods and services.
The problem with barter economies is that they
require
a. that there be a double coincidence of wants.
b. a banking system for trade to occur.
c. that there be a single coincidence of wants.
d. less time and trouble to trade as compared with a
money economy.
Money in a World War II
prisoner of war camp.
During World War II
cigarettes were
used as money in
some prisoner of
war camps.
RMIT University
In World War II, cigarettes were used as money in
some prisoner of war camps. Given this, we
would expect to see
a. prices of other goods expressed in terms of
cigarettes.
b. people bartering instead of using cigarettes as
money.
c. only government-issued cigarettes being accepted as
money.
d. no one ever smoking cigarettes in the prisoner of war
camps.
RMIT University
What can serve as money?
What makes a good suitable to use as a medium
of exchange? There are five criterion:

1. The good must be acceptable to most traders
2. It should be a standardised quality
3. It should be durable
4. It should be valuable relative to its weight
5. It should be divisible
What is Money and Why do we Need it?
RMIT University
Functions of Money
1. Medium of exchange
Buying and selling goods and services
Money eliminates need for a coincidence of wants
required for trade to occur in a barter economy.
2. Unit of account
Assist the measurement of the relative worth of various
goods, services and resources.
3. Store of value
A form in which to store wealth due to its liquidity and
convenience
4. Standard of deferred payment
RMIT University
The statement 'a Dell laptop costs VND 42
million' illustrates which function of money?
a. Store of value
b. Medium of exchange
c. Standard of deferred payment
d. Unit of account
RMIT University
How do we Measure Money Today?
M1: The narrowest definition of the money supply
which includes all the paper money and coins that are
in circulation meaning what is not held by the banks
or the state and federal governments plus the value
of all demand deposits with banks.
M3: M1, plus all other deposits with domestic and
foreign owned banks operate domestically.
Broad Money: M3, plus deposits into non-bank
deposit-taking institutions less holdings of currency
and deposits of non-bank depository corporations,
such as finance companies, money market
corporations and cash management trusts.

RMIT University
Reserves: Deposits that a bank keeps as cash in its
vault or on deposit with the Central Bank.
Reserve Ratio: A banks ratio of reserves to deposits.
Excess Reserves: Reserves above the normal ratio
of reserves to deposits.
Financial institutions such as banks are able to create
money through the simple deposit multiplier
process.
Financial Institutions and the Creation of
Money
RMIT University
The portion of ________ that a bank does not loan
out or spend on securities is known as ________.
a. loans; reserves
b. loans; securities
c. deposits; reserves
d. deposits; securities
Banks and Money Creation
Assume the required reserve ratio is 10% and $1,000
is deposited into Bank A.
Bank A
Assets ($1,000) Liabilities ($1,000)
Bank B
Assets ($900) Liabilities ($900)
RMIT University
Banks and Money Creation
Bank C
Assets ($810) Liabilities ($810)
From the original deposit a new loan is created that result in
further deposits into the financial system
Bank A = $1,000
Bank B = $900
Bank C = $810
Bank D = $729
Bank
Total change in demand account deposits = $10,000
RMIT University
If Thrifty Bank receives a $10 000 deposit, and keeps
10% of its deposits in reserve, how much will the
bank loan out?
a. $1000
b. $9000
c. $11 000
d. $10 000
The Simple Deposit Multiplier
The simple deposit/credit/money multiplier: The ratio
of the amount of deposits created by banks to the
amount of new reserves.

Change in deposits = initial deposit x multiplier
($1,000 x 10 = $10, 000)
Change in the money supply = change in demand
account deposits initial deposit ($10,000 - $1,000
= $9,000)
Simple deposit multiplier =
1
RR
RMIT University
If the reserve ratio is 0.05 then the simple deposit
multiplier is
a. 20
b. 10
c. 2
d. 5
Other things the same if reserve requirements are
decreased, the reserve ratio?
a. decreases, the money multiplier increases, and the
money supply decreases
b. increases, the money multiplier increases, and the
money supply increases
c. decreases, the money multiplier increases, and the
money supply increases
d. increases, the money multiplier increases, and the
money supply decreases
RMIT University

Suppose Colin deposits VND 60 million into ABC Bank.
Assume ABC Bank has no excess reserves at the time of
this deposit, and the banks reserve ratio is 0.20
a. Show the initial impact of Colins deposit on the banks
balance sheet, and the maximum amount ABC Bank can now
lend as a result of this deposit.
b. What is the maximum increase in deposits that can result
from Colins initial deposit? What is the increase in the money
supply?

RMIT University
Imagine that the banking system receives additional deposits
of VND 100 billion and that all
the individual banks wish to retain their current liquidity ratio
of 20 per cent.
a. How much will banks choose to lend out initially?
b. What will happen to banks' liabilities when the money that is
lent out is spent and the recipients of it deposit it in their bank
accounts?
c. How much of these latest deposits will be lent out by the
banks?
d. By how much will the money supply eventually have risen,
assuming that none of the additional liquidity is held outside
the banking sector?
e. What is the size of the bank multiplier?
Money Supply
r
M
s
Quantity of Money

Notes and Coins; Bank deposits and Non-Bank
Financial Institution deposits
Ms determined exogenously
RMIT University
The Money Market
The Demand for Money
RMIT University
The money demand curve is downward sloping
because
a. lower interest rates cause households and firms to
switch from money to financial assets.
b. lower interest rates cause households and firms to
switch from financial assets to money.
c. lower interest rates cause households and firms to
switch from money to bonds.
d. lower interest rates cause households and firms to
switch from money to shares.
RMIT University
The Money Market
Shifts in the Money Demand Curve
RMIT University
Money Market and Equilibrium
Quantity of Money
r
M
D
r
0
M
S
RMIT University
A decrease in real GDP can
a. increase money demand and increase the interest
rate.
b. decrease money demand and increase the interest
rate.
c. decrease money demand and decrease the interest
rate.
d. increase money demand and decrease the interest
rate.
RMIT University
The money market model is concerned with
________ and the loanable funds market model is
concerned with ________.
a. short-term real interest rates; long term real interest
rates
b. short-term nominal interest rates; long term nominal
interest rates
c. short-term real interest rates; long term nominal
interest rates
d. short-term nominal interest rates; long term real
interest rates
When a grocery store accepts your VND 10,000 note
in exchange for bread and milk, this illustrates that
the VND 10,000 note is serving as a
a. store of value.
b. standard of deferred payment.
c. unit of account.
d. medium of exchange.
Suppose you deposit VND 200,000 into a bank that
has a reserve ratio of 0.01. How does this affect the
bank's balance sheet?
a. Reserves rise by VND 20,000.
b. Excess reserves rise by VND180,000.
c. Required reserves rise by VND 200,000.
d. Deposits rise by VND 100000.
RMIT University
Mia puts money into a piggy bank so she can spend it
later. What function of money does this illustrate?
What will be the impact on the bank multiplier of a
decision by the banks to hold a higher liquidity ratio?
An increase in real GDP
a. decreases the buying and selling of goods and
decreases the demand for money as a medium of
exchange.
b. increases the buying and selling of goods and
decreases the demand for money as a medium of
exchange.
c. increases the buying and selling of goods and
increases the demand for money as a medium of
exchange.
d. decreases the buying and selling of goods and
increases the demand for money as a medium of
exchange.
MODULE 3: INFLATION,
UNEMPLOYMENT, GOVERNMENT
POLICY, DEVELOPMENT AND
GROWTH
MONETARY POLICY
FISCAL POLICY
RECESSION, INFLATION & THE LONG-RUN
DEVELOPMENT & GROWTH

Monetary Policy

Monetary Policy - Chapter 12

1. Define monetary policy and describe the main goal of monetary policy.
2. Describe how the Central Bank affects interest rates.
3. Use aggregate demand and aggregate supply graphs to show the effects of
monetary policy on real GDP and the price level.
4. Discuss the Central Banks use of monetary policy.
5. Discuss the role of the State Bank of Vietnam.

RMIT University
What Is Monetary Policy?
Monetary policy: The actions taken by the Central
Bank of a nation to affect interest rates and/or
exchange rates.

Generally the main goals of Monetary policy are
Price Stability
Sustainable Economic Growth.
State Bank of Vietnam
The State Bank of Vietnam defines its principal roles as:
Promoting monetary stability and formulating monetary policy.
Promoting institutions stability and supervising financial
institutions.
Providing banking facilities and recommending economics
policies to the government.
Providing banking facilities for the financial institutions.
Managing the countrys international reserves.
Printing and issuing banknotes.
Supervising all commercial banks activities in Vietnam. Lending
state money to the commercial banks.
Issuing government bonds, organising bond auctions.
Being in charge of other roles in monetary management and
foreign exchange rates.
Slide 219
State Bank of Vietnam
Central banks in most developed economies
usually describe their aims in terms of the pursuit of
non-inflationary growth.
Today, theres a consensus that price stability
should be the overriding objective of monetary
policy.
External Balance
When there is a decrease in the demand for
Vietnamese Dong and the currency weakens; the
exchange rate moves to the upper end of the
established band, the Authority purchases VND from
banks and/or sells government securities to banks.
The money base (supply) will decrease, pushing up
Vietnamese dong interest rates. Higher domestic
interest rates relative to foreign interest rates induce
capital inflows into the nation and reduce outflows.
Supply of foreign currency (FX) increases and demand
for foreign currency decreases, strengthening the
currency and restoring stability.
External Balance
p
Y
0
p
0
RGDP

AS

AD
0
Quantity
Exchange rate
S
FX0
e
0

D
FX0
Buy VND
Decrease in the money supply
Increase domestic interest rates
Internal Balance
Goal: Maintain the inflation rate within a particular
band.
Sale and purchase of government securities changes
bank reserves and thus their ability to extend credit,
thus changing the money supply and the interest rate.
The Monetary Authority targets interest rates by
affecting system liquidity.
Monetary policy influences the size of bank reserves.
This influences:
The size of the money supply.
The interest rate and the availability of credit.
Investment spending, interest-sensitive consumption
spending thus output, employment and the price level.
Open Market Operations
Monetary Authority actions designed to change
interest rates by changing system liquidity to change
the cost of credit and thus economic activity and the
price level.
Easy Money: Authority announces its decision to
reduce interest rates it buys government securities
to maintain the lower interest rates; expanding the
money supply and reducing the cost of credit.
Tight Money: Authority announces its decision to
increase interest rates it sells government
securities to maintain the higher interest rates;
reducing the money supply and increasing the cost of
credit.
Internal Balance Contractionary Policy
D
FX0

Quantity
Exchange rate
S
FX0

e
0

Q
0

p
Y
0

p
0

RGDP
AS
AD
0

Decrease in the money supply
Increase domestic interest rates
Internal Balance Expansionary Policy
Quantity
Exchange rate
e
0

Q
0

D
FX0

p
AD
0

Y
0

p
0

RGDP
AS
S
FX0

Increase in the money supply
Lower domestic interest rates
If the interest rate is below the Central Bank's
target, the Central Bank would:
a. buy bonds to increase the money supply.
b. buy bonds to decrease the money supply.
c. sell bonds to increase the money supply.
d. sell bonds to decrease the money supply.
If the Central Bank pursues expansionary monetary
policy then interest rates will
a. fall and GDP will fall.
b. rise and GDP will rise.
c. fall and GDP will rise.
d. rise and GDP will fall.
Equilibrium in the Money Market
With interest rate targeting, the money supply curve
is a horizontal line at the Central Banks target
interest rate.
Monetary Policy Effectiveness
Responsiveness of capital flows,
consumption and investment to changes
to changes in interest rates.
Phase of the business cycle
Private decisions of lenders and
borrowers.
Size of the expenditure multiplier
Suppose you are the monetary policy adviser for the
government. The economy is experiencing a large
and prolonged inflationary trend. What change in
open market operations would you recommend?
If the central bank buys bonds and securities in
the open market, this is likely to lead to
a. a rise in interest rates and a depreciation of the
Vietnamese dong.
b. a fall in interest rates and a depreciation of the
Vietnamese dong.
c. a fall in interest rates and an appreciation of the
Vietnamese dong.
d. a rise in interest rates and an appreciation of the
Vietnamese dong.
Why Does The Share Market
Care about Monetary Policy?
The share
market reacts
when the
Central Bank
implements
policy to either
raise or lower
interest rates.
Explain the process by which an easy money policy
affects equilibrium output and employment.

How may the business cycle impact on the effectiveness
of monetary policy?

If the stock market crashes and aggregate demand
decreases, what can the Central Bank do to offset this
decrease in aggregate demand?

a. If the Central Bank sells financial instruments in the
open market, what may happen to net exports
analyse the impact via the product market.
b. If the Central Bank sells financial instruments in the
open market, what may happen to net exports
analyse the impact via the exchange rate market.

Fiscal Policy

Aggregate Expenditure and Output in the Short Run - Chapter
7 (pp. 195-200)
Fiscal Policy - Chapter 13
1. Define the multiplier effect and use it to calculate changes in equilibrium
GDP.
2. Define fiscal policy.
3. Explain how fiscal policy affects AD and how the government can use
fiscal policy to stabilise the economy.
4. Explain how the multiplier process works with respect to fiscal policy.
5. Discuss the difficulties that can arise in implementing fiscal policy.
6. Explain how the federal budget can serve as an automatic stabiliser.
7. Discuss the long-run supply side effects of fiscal policy.

Fiscal Policy: Changes in federal taxes and
purchases that are intended to achieve
macroeconomic policy objectives, such as full
employment, price stability, and healthy sustainable
rates of economic growth.
Fiscal Policy

There are two key approaches to fiscal policy; following rules
implied by automatic stabilisers or else implementing a
discretionary fiscal policy.

Automatic stabilisers: Government spending and taxes that
automatically increase or decrease along with the business
cycle.
Discretionary fiscal policy: when the government is taking
actions to change spending or taxes to achieve its objectives.
Rules (Automatic Approach) versus
Discretionary Action
Discretionary fiscal policy is when
a. existing taxation policy automatically smoothes out
business cycle fluctuations in the economy.
b. politicians are discrete about policy changes, and do
not advise consumers or producers of new policies.
c. policy is left to the discretion of the State Bank of
Vietnam.
d. the government changes the levels of expenditure or
taxation.
Expansionary fiscal policy
Increasing government expenditure, or decreasing taxes, or
both. The goal is to shift aggregate demand to the right.
Appropriate when the economy is in a below full-employment
equilibrium.
Contractionary fiscal policy
Decreasing government expenditure, or increasing taxes, or
both. The goal is to shift aggregate demand to the left.
Appropriate when the economy is at an above full-
employment equilibrium.
Using Fiscal Policy to Influence Aggregate
Demand
Fiscal policy refers to the
a. government's ability to regulate the functioning of
financial markets.
b. spending and taxing policies used by the government to
influence the level of economy activity.
c. techniques used by firms to reduce its tax liability.
d. the policy by the Central Bank to affect the cash rate.
RMIT University
The multiplier effect: The series of induced
increases in consumption spending that results from
an initial increase in autonomous expenditures. The
process by which an increase in autonomous
expenditure leads to a larger increase in real GDP.
Autonomous expenditure: Expenditure that does
not depend on GDP.
Multiplier: The increase in equilibrium real GDP
divided by the increase in autonomous expenditure.
The Government Purchases (Expenditure)
and Tax Multipliers
RMIT University
An initial increase in autonomous
government spending, such as
building new railway lines, will
increase aggregate demand by an
amount that is more than the initial
amount of new spending.

The Government Purchases or Expenditure
Multiplier in Action
Figure 14.6 The multiplier effect and
aggregate demand
RMIT University
The government decides to fund the building of a new
bridge. The owner of the company that builds the bridge
pays her workers. The workers increase their spending.
Firms that the workers buy goods from increase their
output. This type of effect on spending illustrates
a. the multiplier effect.
b. the crowding-out effect.
c. None of the above is correct.
d. the Fisher effect.

The Multiplier Effect
e expenditur autonomous in Change
GDP real m equilibriu in Change
Multiplier e Expenditur =
MPC - 1
1
Multiplier e Expenditur =
The multiplier effect occurs both when autonomous
expenditure increases and when it decreases.
The multiplier effect makes the economy more sensitive
to changes in autonomous expenditure than it would
otherwise be.
The larger the MPC, the larger the value of the multiplier.
Our formula for the multiplier is very simplified, but
nevertheless serves to illustrate the process.
RMIT University

The Government Purchases (Expenditure)
and Tax Multipliers
MPS MPC
k
e
1
or
1
1
=
T k Y
T
A = A
MPS
MPC
kT =
purchases government in Change
Multiplier Purchases Government =
taxes in Change
Multiplier Tax =
G k Y
e
A = A
RMIT University
Suppose the MPC is .75.
If the government increases expenditures by $200 billion
how far does the economy grow?
If the government decreases taxes by $200 billion how
far does the economy grow?
The tax multiplier
a. is negative
b. only works when taxes are cut
c. is larger in absolute value as compared to the
d. is less than one
Assume the consumption function for a
closed economy is C=50+0.8Y and that
investment is equal to $30bn.
a. Calculate the equilibrium level of income/output
for this economy.
b. Calculate what will happen to equilibrium income
and output if the government undertakes
expansionary policy of $15bn.

Multiplier Effectiveness
A D
Y Y
P
AD
2

Quantity
of Output
Price
Level
AS
Fixed Price
Variable Price
Crowding Out Effect
A D
Y
1

RGDP
Price
Level
AS
P
1

A
If crowding out occurs, an increase in
government spending
a. decreases the interest rate and consumption and
investment spending rise.
b. decreases the interest rate and consumption and
investment spending decline.
c. increases the interest rate and consumption and
d. increases the interest rate and consumption and
Goals of Fiscal Policy
Y
f
Y
AD
Quantity
of Output
Price Level
AD
Quantity
of Output
Price Level
SRAS
SRAS
P
1

P
2

LRAS LRAS
Y
f
Y
GDP Gap
GDP Gap
Recessionary Gap Inflationary Gap
Recessionary Gap = GDP Gap
k
e

Inflationary Gap = GDP Gap
k
e

Putting Everything Together
e
e
e
e
e
k
k
k
G
G k
G k Y
Gap GDP
Gap ry Inflationa
Gap GDP
Gap ry Recessiona
Gap GDP
Gap GDP
=
=
= A
A =
A = A
If the MPS is 0.25 and the economy has a recessionary
gap of $5 billion, what is the size of the GDP Gap?
Successful Fiscal Policy
Real GDP
Time
Case Against Intervention
FiscalLags
Recognition
Administrative/Legislative
Operational/Implementation
Expansionary bias leading to a Political
business cycle
Budget deficit: The situation in which the governments
spending is greater than its tax revenue.
Budget surplus: The situation in which the governments
expenditures are less than its tax revenue.
The budget can serve as an automatic stabiliser.
Federal government deficits increase automatically
during recessions because:
1. Tax revenues fall.
2. Unemployment benefits increase.
Federal government deficits decrease or surpluses
increase automatically during expansions because:
1. Tax revenues increase.
2. Unemployment benefit payments decrease.
Deficits, Surpluses and Government Debt
RMIT University
Which of the following is an automatic stabiliser?
a. Reductions in nominal wages as inflation rates
rise
b. Unemployment benefit payments to the
unemployed
c. Interest rate changes
d. Increases in government spending on schools
To counteract the effect of automatic stabilisers
during a recession and keep the budget
balanced, the federal government must ________
government spending, or ________ taxes, and
which will ________ aggregate demand.
a. decrease; increase; reduce
b. increase; decrease; increase
c. increase; increase; reduce
d. decrease; decrease; increase

Should the federal budget always be balanced?
Is government debt a problem?
These questions are related and the answer is
not always clear-cut.
Economists examine the debt, and the interest
on the debt in proportionate terms to determine
if it is a problem.

Deficits, Surpluses and Government Debt
Supply side policies:
Fiscal policies that have long-run effects by
expanding the productive capacity of the economy
and increasing the rate of economic growth.
These policy actions primarily affect aggregate
supply, by shifting the long-run aggregate supply
curve to the right.

The Effects of Fiscal Policy in the Long-
Run

Run

The long-run effects of tax policy:
We can look at the effect on aggregate supply of
each of the following taxes:
1. Individual income tax
2. Company income tax
3. Taxes on capital gains
Run
RMIT University

Tax simplification:
There are also potential gains to be derived from
simplifying the tax law.
Resources diverted to tax compliance and tax
minimisation can be put to more productive use.
Tax simplification may improve the efficiency of
firm and household decision making.
Run
Long Run Implications of Supply Side
Policies
Supply side policies can increase long run aggregate supply,
thereby reducing the upward pressure on prices following an
increase in aggregate demand
Expansionary fiscal policy ________ the price level
and ________ equilibrium real GDP.
a. increases; increases
b. increases; decreases
c. decreases; decreases
d. decreases; increases
To try to combat inflation, the government could
a. conduct expansionary fiscal policy.
b. lower interest rates.
c. decrease taxes.
d. decrease government spending.
If crowding out occurs, an increase in government
spending
a. decreases the interest rate and consumption and
b. decreases the interest rate and consumption and
c. increases the interest rate and consumption and
d. increases the interest rate and consumption and
Refer to the figure above. If the economy moves from A to B,
which of the following would be the appropriate fiscal policy
to achieve potential GDP?
a. Increase taxes
b. Decrease interest rates
c. Contractionary fiscal policy
d. Increase government spending
Increases in government spending will lower the
long term growth rate of GDP, if it lowers ________
spending and the government purchases ________
and not ________ goods.
a. net export spending; investment; consumption
b. investment; consumption; investment
c. net export spending; consumption; investment
d. consumption; investment; consumption
Use the information in the table to answer the questions.
a. At what level of RGDP does the market clear?
b. What is the MPC?
c. Suppose government purchases increase by $500 billion.
What will be the new equilibrium level of real GDP? Use
the multiplier formula to determine your answer.
Given the above data what actions might the
government take to move the economy to the full-
employment level of output?
Recession, Inflation and the Long-Run

Aggregate Demand and Aggregate Supply Analysis - Chapter
8 (pp. 226-234)
Unemployment - Chapter 9 (pp. 256-257)
Inflation - Chapter 10 (pp. 280-287)
1. Use the aggregate demand and aggregate supply model to illustrate the
difference between short-run and long-run equilibrium.
2. Use the dynamic aggregate demand and aggregate supply model to
analyse macroeconomic conditions.
3. Understand the difference between demand-pull and cost-push
inflation.
4. Explain the quantity theory of money and use it to explain how high
rates of inflation can occur.

The short-run and the long-run effects of a decrease in aggregate
demand
Macroeconomic Equilibrium in the Long
Run and the Short Run
Costs to the economy as a whole:
Loss of gross domestic product.
Loss of human capital.
Net drain on the budget.
The opportunity cost of funds directed towards welfare
payments.
Costs to the unemployed:
Loss of income.
Loss of skills.
Loss of self esteem.
Unemployment may contribute to family break-ups, health
problems, mental illness, crime and political unrest.
The Costs of Unemployment
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In general, wages rise with inflation. Inflation can, however, affect
the distribution of income. The extent of redistribution depends partly
on the degree to which inflation was anticipated or unanticipated.

Costs of Inflation
The problem with anticipated inflation:
Menu costs the costs to firms of changing prices.
Risk particularly for contracts with a time element
The problem with unanticipated inflation:
There are winners and losers, depending on whether inflation is
higher or lower than anticipated.
For example: those on fixed incomes, such as aged pensions,
will lose if inflation is higher than anticipated.
Borrowers may gain and lenders lose when inflation is higher
than anticipated.

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Causes of Inflation
Monetary growth greater than growth in RGDP
Demand-pull inflation
Increases in AD
Cost-push inflation
Supply Shocks
Stagflation: a combination of inflation and
recession, usually resulting from a supply shock.

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Connecting money and prices: The equation of
exchange. The connection between money and
prices is expressed in the following equation.

Velocity of money: The average number of times
each dollar in the money supply is used to
purchase goods and services included in GDP.

The Quantity Theory of Money
x Y P x V M =
M
x Y P
= V
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According to the assumptions of quantity
theory, if the money supply increases 5% then
at full employment
a. nominal and real GDP would rise by 5%.
b. nominal GDP would rise by 5%; real GDP would be
unchanged.
c. nominal GDP would be unchanged; real GDP
would rise by 5%.
d. neither nominal GDP nor real GDP would change.
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The quantity equation is transformed to:

Growth rate of money supply + growth rate of velocity =
growth rate of the price level + growth rate of real
output

Which we can rearrange as:

Inflation rate = growth rate of money supply + growth rate
of velocity - growth rate of real output

If Irving Fisher is correct and velocity is constant,
then the growth rate of velocity is zero, so we can
rewrite the equation as:

Inflation rate = growth rate of the money supply
growth rate of real output

The Quantity Theory of Inflation
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According to the quantity theory of money,
inflation is caused by
a. GDP growing faster than the money supply.
b. GDP growing at the same rate as the money
supply.
c. the money supply growing faster than GDP.
d. the money supply growing slower than GDP.
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Suppose the money supply is currently growing at 4
% per year, while real GDP is growing at 2%,
calculate the inflation rate assuming Irving Fisher is
correct in his assumption regarding the velocity of
money.
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The short-run and long-run effects of an increase in aggregate
demand - Demand-pull inflation and a price-wage spiral

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An increase in aggregate demand causes an
increase in ________ only in the short run, but
causes an increase in ________ in both the
short run and the long run.
a. the price level; real GDP
b. real GDP; real GDP
c. real GDP; the price level
d. the price level; the price level
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We can create a dynamic aggregate demand and
aggregate supply model by making three changes
to the basic model:
1. Potential real GDP increases continually,
shifting the long-run aggregate supply curve to
the right.
2. During most years the aggregate demand
curve will be shifting to the right.
3. Except during periods when workers and firms
expect high rates of inflation, the short-run
aggregate supply curve will be shifting to the
right.
A Dynamic AD and AS Model
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A Dynamic AD and AS Model
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The simple static aggregate demand and aggregate
supply model assumes
a. potential real GDP increases continuously.
b. the economy experiences continuing inflation.
c. the economy's aggregate demand curve shifts to the
right in most periods.
d. the economy does not experience long run growth.

The short-run and long-run effects of a supply shock - Cost-push
inflation
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Which of the following is considered a supply
shock?
a. The increasing investment in the economy causing
the capital stock to rise
b. A decline in wages
c. An improvement in technology
d. An unexpected large increase in the price of
natural gas
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Supply Shocks and Policy Choices
Policy Options:
1. Do nothing
2. Do something
a.AD INF
but further
UNE
b.AD UNE
but further
INF
AD

RGDP
Price Level
P
0

Y
0
SRAS
0
A

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Fighting Inflation Reducing AD
RGDP
Price Level
SRAS
0
P
0

LRAS
Y
f
AD
0
A

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Why might the short run aggregate supply curve shift
to the right in the long run, following a decrease in
aggregate demand?
a. Workers and firms adjust their expectations of wages and
prices downward and they push for higher wages and
prices.
b. Workers and firms adjust their expectations of wages and
prices upward and they accept lower wages and prices.
c. Workers and firms adjust their expectations of wages and
prices upward and they push for higher wages and prices.
d. Workers and firms adjust their expectations of wages and
prices downward and they accept lower wages and prices.
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The level of real GDP in the long run is called
a. potential GDP.
b. frictional GDP.
c. low capacity GDP.
d. short run GDP.
Because of a supply shock, in the short run
a. the aggregate supply curve shifts to the left.
b. equilibrium real GDP rises.
c. unemployment falls.
d. the price level falls.
Which of the following is NOT an assumption made
by the dynamic model of aggregate demand and
aggregate supply?
a. Aggregate demand shifts to the right during most
periods.
b. Aggregate supply shifts to the right except during
periods when workers and firms expect higher
wages.
c. Aggregate demand and potential real GDP decrease
continuously.
d. Potential real GDP increases continuously.
Which of the following can cause cost-push inflation
if the economy is currently in equilibrium at full-
employment GDP?
a. A decrease in personal income tax rates, which
increases after tax income
b. A flood which destroyed much of the country's crops
c. An increase in the size of the labour force
d. An increase in the capital stock in the country
If a supply shock occurs in the economy, what is the
likely impact for inflation and unemployment?

What are the policy options available to the government
to combat a supply shock and what are the costs of
each policy option?

Illustrate and explain the implications for the
inflation/unemployment trade-off if we persist in
undertaking expansionary policy in an attempt to reduce
the unemployment rate below the natural rate of
unemployment.
Economic Development and Growth

Economic Growth, the Financial System and Business
Cycles - Chapter 5 (pp. 110-117)
Long-Run Economic Growth: Sources and Policies -
Chapter 6
1. Explain the basic idea of how a market system works.
2. Understand why property rights are necessary for a well-functioning
economy.
3. Discuss the importance of economic growth and its impact on living
standards.
4. Describe the trends in economic growth in the world.
5. Use the economic growth model to explain why economic growth rates
differ between countries.
6. Discuss why many poor countries have not experienced rapid economic
growth.
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Long-Run Economic Growth is the Key
to Rising Living Standards
Long-run economic growth: The process by
which rising productivity increases the average
standard of living.

Real GDP per capita is used to measure
changing living standards over time.
Real GDP per capita =
Real GDP
population

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Recall: economic growth is calculated using the following
equation:

Calculating Economic Growth Rates
100 x
GDP Real
GDP Real - GDP Real
Growth Economic
Previous
Previous Current
=
For longer periods we look at average annual growth
rates. Note: the long-term could be 50 or 100 years or
more.
An approximation of average annual growth for shorter
periods is a simple average.

3.1% + 2.4% + 3.2%
3
= 2.9%
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Use the table below to answer the following questions:
Calculate the growth rate of real GDP for each year
from 2004 2007.
Calculate the average annual growth rate over the
same period.
Year Real GDP, $ (billions in 2004 prices)
2004 790
2005 810
2006 825
2007 850
One way to judge how rapidly real GDP per
person is growing is to calculate the number of
years it would take to double.

Calculating Economic Growth Rates and
the Rule of 70
Number of years to double =
70
Growth rate
This rule shows small differences in growth
compound over time.
This leads to large differences in the number of
years it takes for real GDP to double.
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The rule of 70 states that

a. the number of years it takes an economy to
double is the growth rate times 70.
b. the number of years it takes an economy to
double is 70 divided by the growth rate.
c. it takes an economy 70 years to double in size.
d. the number of years it takes an economy to
double is the growth rate divided by 70.
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Use the table below to answer the following
questions:
a. How long will it take China to double its real GDP?
b. How long will it take the UK to double its real GDP?
GDP growth (annual %) China UK
2004 10.1 2.7
2005 10.7 2.5
2006 10.4 2.8
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Average annual growth rates for the world economy
Economic Growth Over Time Around the
World
Source: J. Bradford DeLong (1998), Estimating World GDP, One Million B.C. Present, working paper,
University of California, Berkley.
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Why do growth rates matter?

An economy that grows too slowly fails to raise
living standards.
In the 1980s and 1990s, a small group of Asian
countries, such as Taiwan and Singapore, achieved
high rates of growth. These are sometimes referred
to as the newly industrialising countries.
World
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GDP per capita, 2007
World
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Labour productivity: The quantity of goods and
services that can be produced by one worker or by
one hour of work. Two key factors determine
labour productivity.
1. Increases in Capital per Hour Worked
Capital: Manufactured goods that are used to
produce other goods and services; examples are
computers, factory buildings, and machine tools.
Human capital: The accumulated knowledge
and skills that workers acquire from education
and training, or from their life experiences.

What Determines How Fast Economies
Grow?
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2. Technological Change: Change in the ability of a
firm to produce a given level of output with a given
quantity of inputs.
Accumulating more inputs such as labour, capital,
and raw materials will not ensure that an economy
experiences economic growth unless technological
change also occurs.
Three main sources of technological change:
Better machinery and equipment.
Increases in human capital.
Better means of organising and managing production.

Grow?
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Which is more important for economic growth:
More capital or technological change?
Technological change is the key to sustaining
economic growth.
Endogenous growth theory: a model of long-run
economic growth that emphasises that
technological change is influenced by economic
incentives, and so is determined by the working of
the market system.

Grow?
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Endogenous growth theory
a. states that the rate of technological change is caused
by economic incentives.
b. does not adequately explain the factors that
determine productivity.
c. states that the rate of technological change is
unaffected by economic incentives.
d. states that the rate of technological change is
determined outside the working of the market
system.
Which of the following will result in an
increase in labour productivity?
a. A decline in the capital stock per hour worked
b. A decline in the amount of human capital per
worker
c. An increase in technology
d. A decrease in the number of people attending
institutions of higher education
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Free Market: A market with few government restrictions on
how a good or service can be produced or sold, or on how
a factor of production can be employed.
Adam Smith argued the benefits of a free market system in
his famous book The Nature and Causes of the Wealth
of Nations (published in 1776).
Smith assumed individuals act in a rational, self-interested
way.
If not restricted by government, then firms would be led by
the invisible hand of the market to provide consumers with
what they wanted.
The price mechanism in the free market leads producers to
change supply in accordance with consumer demand.

The Market System and Economic Growth
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Private property rights provide the legal basis of a
free market system.

Property rights: The rights individuals or firms
have to the exclusive use of their property,
including the right to buy or sell it.

Property Rights
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A well established and legally enforced system
of property rights

a. encourages investment growth but reduces
entrepreneurial activity.
b. reduces economic efficiency which reduces the
rate of economic growth.
c. encourages economic growth by increasing the
incentive to be innovative.
d. discourages economic growth by discouraging
innovation.
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Government policy can increase the accumulation of
knowledge and capital in three ways:

1. Protecting intellectual property rights with patents and
copyrights.
Patent: the exclusive right to a product for a period of time
from the date the product was invented.
2. Subsidising research and development.
3. Subsidising education.

Grow?
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What is the ultimate purpose of patents and
copyrights?

a. To provide owners with large profit forever.
b. To encourage the expenditure of funds on
research and development to create new products.
c. To protect firms from being taken advantage of by
producing firms.
d. To do all of these things.
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Joseph Schumpeter and Creative Destruction.

To Schumpeter, the entrepreneur is central to
economic growth:
The function of entrepreneurs is to reform or
revolutionise the pattern of production by exploiting an
invention or, more generally, an untried technological
possibility for producing new commodities or producing
an old one in a new way.
Grow?
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Catch Up: the prediction that the level of
GDP per capita in poor countries will grow faster
than in rich countries.

Some poorer countries have experienced rapid
growth rates, but many have not.

Why Isnt the Whole World Rich?
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Figure 7.8 The rule of law and growth
Source: Based on David Dollar and Aart Kraay (2000), Property Rights, Political Rights, and the Development
of Poor Countries in the Post-Colonial Period, World Bank Development Research Group Working Paper, October
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There is no one answer to the question as to why all
countries do not experience economic growth.

Most economists identify 5 key factors:
1. Failure to enforce the rule of law:
Rule of Law: the ability of a government to enforce
the laws of a country, particularly with respect to
protecting private property and enforcing contracts.
2. Wars and revolutions:
Many countries that were poor in 1960 have
experienced extended periods of violent changes of
government during the years since. Eg. Afghanistan,
Angola and Ethiopia.
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3. Poor public education and health:
Many low-income countries have weak public school
systems, so many workers are unable to read and write.
People who are sick work less, and are less
productive when they do work.
4. Slow technological development:
The economic growth model shows the importance of
technological change.
5. Low rates of saving and investment:
The low savings rates in developing countries contribute
to a vicious cycle of poverty.
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Which of the following is a reason why low
income countries might experience economic
growth?
a. The country has endured extended periods of war.
b. The country fails to enforce a rule of law.
c. The country has a high rate of savings and
investment.
d. The country suffers from poor health
infrastructures.
Globalisation is defined as the process of
countries becoming ________ open to foreign
trade and ________ open to foreign
investment.
a. less; less
b. more; less
c. more; more
d. less; more
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The benefits of globalisation:
Foreign Direct Investment: The purchase or
building by a corporation of a facility in a foreign
country.
Foreign Portfolio Investment: The purchase by
an individual or firm of stock or bonds issued in
another country.
Globalisation: The process of countries becoming
more open to foreign trade and investment.
Globalisation
Criticisms of Globalisation
Globalisation undermines distinctive cultures.
Multi-national firms exploit low wages and poor
health, safety and environmental regulations in
the developing world.
Economic growth contributes to global
warming, deforestation and other
environmental problems.
Globalisation
REVISION OF MODULES 1, 2 & 3

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MODULE 1: CONCEPTS

ECONOMIC METHODOLOGY & THE ECONOMISING

RMIT University School of Economics, Finance and Marketing 80

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