Slide 1

MODULE 1: CONCEPTS
Chapters 1, 2, 7, 8 & 11:216-222
Slide 2
PART 1:
Economic Methodology & the
Economising Problem
Chapters 1 & 2
Slide 3
Economics
Definition: A social science concerned with the allocation of
scarce/limited resources between unlimited and often competing needs
and wants.
Economics is the study of how society manages its scarce resources.
This definition of economics mentions scarce resources.
A more precise term is relative scarcity in the sense that resources are limited
relative to unlimited wants of society as a whole.
Relative scarcity leads to the allocation problem for available resources. As
resources, which are used to produce goods and services, are scarce, we
cannot satisfy all of societies material wants
This implies that choices must be made..
Slide 4
Resource Categories
Resources are divided into 4 main categories.
Land: all natural resources. represents all natural resources such as rivers, forests, lakes, mineral deposits, flora and
fauna, including biological and environmental diversity.
Labour: Requires a fundamentally scarce resource - TIME. LABOUR includes human effort, both physical and
mental. Labour requires a fundamentally scarce resource: TIME. (In deciding how much time to devote to your studies
at RMIT, solving an economic problem. You have limited time each day and competing alternative demands on your
time. Eg study, sleep, eating, socialising, paid work. Thus you must make a choice between valued alternatives)
Capital: investment goods: CAPITAL are investment goods, used in the production of goods and services. One can
distinguish between two types of capital:
Human capital: knowledge & skills that people develop (through experience, education, and on-the-job
training) that enhance their ability to produce or become more productive.
Physical Capital: buildings, machinery tools, etc. which consists of buildings, machinery, tools, and other
manufactured items that are used to produce other goods and services.
Enterprise or entrepreneurial ability represents the input responsible for:
seeing a business or commercial opportunity,
engaging in risk taking,
and collecting or acquiring, and coordinating the relevant resources.
Slide 5
Lessons
1. Trade-offs: Principle #1: People Face Trade-offs - There is no such thing as a free lunch
Making decisions requires trading one goal for another. EG: how the government spends tax dollars.
2. Opportunity cost: Principle #2: The Cost of Something Is What You Give Up to Get It - The cost of something is what
you give up to get it
Making decisions requires individuals to consider the benefits and costs of some action.
3. Being rational: Principle #3: Rational People Think at the Margin - Rational people think at the margin
Economists generally assume that people are rational. To be rational means to take an action if and only if its benefits exceed
its costs.
Consumers want to purchase the bundle of goods and services that allows them the greatest level of satisfaction given their
incomes and the prices they face.
Firms want to produce the level of output that maximizes the profits they earn.
Many decisions in life involve incremental decisions: Should I study an additional hour for tomorrows exam?
Marginal changes: small incremental adjustments to a plan of action. Example: Why is water so cheap while diamonds
are expensive? Because water is plentiful, the marginal benefit of an additional cup is small. Because diamonds are rare,
the marginal benefit of an extra diamond is high.
4. Incentives: Principle #4: People Respond to Incentives - Something that induces a person to act
Incentive: something that induces a person to act.
Because rational people make decisions by weighing costs and benefits, their decisions may change in response to incentives.
When the price of a good rises, consumers will buy less of it because its cost has risen.
When the price of a good rises, producers will allocate more resources to the production of the good because the benefit from
producing the good has risen.
5. Benefit of trade: Principle #5: Trade Can Make Everyone Better Off - Trade can make everyone better off
Trade is not like a sports competition, where one side gains and the other side loses.
Countries benefit from trading with one another.
Trade allows for specialization in products that countries can do best.
Slide 6
Lessons
6. Benefit of markets: Principle #6: Markets Are Usually a Good Way to Organize Economic Activity - Efficient distribution of resources
Many countries that once had centrally planned economies have abandoned this system and are trying to develop market economies.
Market economy: an economy that allocates resources through the decentralized decisions of many firms and households as they
interact in markets for goods and services. Market prices reflect both the value of a product to consumers and the cost of the resources
used to produce it. When a government interferes in a market and restricts price from adjusting, household and firm decisions are not based on
the proper information. Thus, these decisions may be inefficient.
7. Government involvement: Principle #7: Governments Can Sometimes Improve Market Outcomes - Market failure
The invisible hand will only work if the government enforces property rights. Property rights: the ability of an individual to own and exercise
control over scarce resources. There are two broad reasons for the government to interfere with the economy: the promotion of efficiency
and equity. Government policy can be most useful when there is market failure. Market failure: a situation in which a market left on its own
fails to allocate resources efficiently. Examples of market failure: monopoly Market power: the ability of a single economic actor (or
small group of actors) to have a substantial influence on market prices.
Externality: the impact of one persons actions on the well-being of a bystander.
8. Standards of living: Principle #8: A Countrys Standard of Living Depends on Its Ability to Produce Goods and Services - Depends on ability
to produce goods and services
Differences in living standards from one country to another are quite large. Changes in living standards over time are also great.
The explanation for differences in living standards lies in differences in productivity. Productivity: the quantity of goods and services produced
from each hour of a workers time. High productivity implies a high standard of living. Thus, policymakers must understand the impact of any
policy on our ability to produce goods and services.
9. Money supply: Principle #9: Prices Rise When the Government Prints Too Much Money - Prices increase when the money supply
increases
Inflation: an increase in the overall level of prices in the economy. When the govt creates a large amount of money, the value of money falls.
10. Trade-0ff between inflation and unemployment: Principle #10: Society Faces a Short-Run Trade-off between Inflation and Unemployment -
Decrease in unemployment results in increased inflation
Most economists believe that the short-run effect of a monetary injection is lower unemployment and higher prices.
An increase in the amount of money in the economy stimulates spending and increases the quantity of goods and services sold in the economy. The
increase in the quantity of goods and services sold will cause firms to hire additional workers. An increase in the demand for goods and
services leads to higher prices over time.
Slide 7
Economic Models
ceteris paribus
Economics deals with generalities/statements about regularities, concerning economic behaviour.
Models are simplified representations of the real world.
Economists try to address their subject with a scientists objectivity. Like all scientists, they make appropriate assumptions and build
simplified models in order to understand the world around them.
Economists follow the scientific method.
1. Observations help us to develop theory.
2. Data can be collected and analyzed to evaluate theories.
3. Using data to evaluate theories is more difficult in economics than in physical science because economists are unable to generate
their own data and must make do with whatever data are available.
Assumptions make the world easier to understand. CETERIS PARIBUS = OTHER THINGS BEING EQUAL or IF ALL OTHER
THINGS REMAIN UNALTERED. Economists use the term ceteris paribus to point out that all other relevant variables are assumed
fixed. Used as a reminder that all variables other than the ones being studied are assumed to be constant
In examining economic models, it is useful to concentrate on one factor at a time, and hold all other factors constant.
In this way it is possible to investigate the effects of the variables being considered.
EG: to understand international trade, it may be helpful to start out assuming that there are only two countries in the world producing
only two goods. Once we understand how trade would work between these two countries, we can extend our analysis to a greater
number of countries and goods.
Economists often use assumptions that are somewhat unrealistic but will have small effects on the actual outcome of the answer.
Economists use economic models to explain the world around us.
Most economic models are composed of diagrams and equations. The goal of a model is to simplify reality in order to increase our
understanding. This is where the use of assumptions is helpful.
Road map: Point out how unrealistic it is. For example, it does not show where all of the stop signs, gas stations, or restaurants are
located. It assumes that the earth is flat and two-dimensional. But, despite these simplifications, a map usually helps travelers get
from one place to another. Thus, it is a good model.
Slide 8
Simple Circular Flow Model
Resource
Market
Product
Market
Firm Household
circular-flow diagram: a visual model of the economy that shows how dollars flow through markets among
households and firms.
There are two decision makers in the model: households and firms.
There are two markets: the market for goods and services and the market of factors of production.
Firms are sellers in the market for goods and services and buyers in the market for factors of production.
Households are buyers in the market for goods and services and sellers in the market for factors of production.
The inner loop represents the flows of inputs and outputs between households and firms.
The outer loop represents the flows of dollars between households and firms.
Slide 9
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.
Example of a discussion of minimum-wage laws: Kim says, Minimum-wage laws cause unemployment. Kath says, The
government should raise the minimum wage.
Positive statements can be evaluated by examining data, while normative statements involve personal viewpoints.
Positive views about how the world works affect normative views about which policies are desirable.
Much of economics is positive; it tries to explain how the economy works. But those who use economics often have goals
that are normative. They want to understand how to improve the economy.
Slide 10
Macroeconomics vs Microeconomics
Economics is studied on various levels.
Macroeconomics is concerned either with the economy as a whole or with aggregates such as the
govt, household and business sectors that make up the economy.
Involves discussion of the determination of the aggregate output of goods and services, total
level of employment, total income, aggregate expenditure, general level of prices, and the
influence of government policy.
Microeconomics is concerned with behaviour and decisions of individual economic agents
(households and firms).
Microeconomics: the study of how households and firms make decisions and how they interact in
markets.
Macroeconomics: the study of economy-wide phenomena, including inflation, unemployment, and
economic growth.
Microeconomics and macroeconomics are closely intertwined because changes in the overall economy
arise from the decisions of individual households and firms.
Because microeconomics and macroeconomics address different questions, each field has its own set of
models which are often taught in separate courses.
Slide 11
Production Possibilities Frontier
How to achieve the greatest possible satisfaction of societys material wants given scarce resources?
Full employment
Full production Full production implies the achievement of two kinds of efficiency
Allocative efficiency This involves allocating resources so as to achieve the production of goods and services
most wanted by consumers
Productive efficiency This occurs when the least costly production techniques are used to produce goods
and services. This in turn implies using the minimum quantity of resources to produce a maximum level of
output.
PPF represents the maximum possible combinations of goods & services that can be produced with a given
quantity of factors of production and given technology.
Slide 12
Production Possibilities Frontier
butter
guns
A
E
U
Attainable but not desirable
W
Unattainable
10
4
If all resources are devoted to producing butter, the economy would produce 10 units of butter and zero guns.
If all resources are devoted to producing guns, the economy would produce 4 guns and zero butter.
More likely, the resources will be divided between the two industries. The feasible combinations of output are shown on the
production possibilities frontier.
Because resources are scarce, not every combination of butter and guns is possible. Production at a point outside of the curve
(such as W) is not possible given the economys current level of resources and technology.
Production is efficient at points on the curve (such as A and E). This implies that the economy is getting all it can from the
scarce resources it has available. There is no way to produce more of one good without producing less of another.
Production at a point inside the curve (such as U) is inefficient. This means that the economy is producing less than it can from
the resources it has available. Unemployment or underemployment of economic resources has resulted in a smaller output
than is actually possible. If the source of the inefficiency is eliminated, the economy can increase its production of both goods.
Slide 13
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 production possibilities frontier reveals Principle #1: People face tradeoffs.
Suppose the economy is currently producing 9 units of butter and 1 gun. To increase the production of guns to 2, the production
of butter must fall to 7 units.
Principle #2 is also shown on the production possibilities frontier: The cost of something is what you give up to get it
(opportunity cost).
The opportunity cost of increasing the production of guns from 1 to 2 is 2 units of butter.
Economists generally believe that production possibilities frontiers often have this bowed-out shape because some resources
are better suited to the production of butter than guns (and vice versa).
Note that as the economy moves from A to E, it must give up successively larger amounts of butter to acquire an extra gun.
The opportunity cost of guns is increasing.
Slide 14
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 OC arises from fact that scarce resources are not equally useful or suitable in all productive activities.
Economic resources are not completely adaptable to alternative uses.
As we attempt to increase gun production, resources that are less and less suitable to this use must be used.
As we move from A to E, resources that are highly productive in gun production become increasing scarce.
To obtain more guns, resources that are relatively productive in butter production will be used. It will take more and more of
such resources - and hence a greater sacrifice of butter - to achieve a given increase of 1 unit in gun production.
Slide 15
Growth
Over time PPF can move outwards.
Achieved through economic growth.
The following will push the PPF out:
Capital accumulation.
Technological progress.
computers
(good for the future)
pizzas (good for the present)
The production possibilities frontier can shift if resource availability or technology changes. Economic growth can be illustrated by
an outward shift of the production possibilities frontier.
When the PPF shifts out, this allows the production of more of both types of goods.
When the economys production increases, we say there is economic growth. Economic growth is a persistent expansion of the
economys PPF. What was impossible is now possible.
Assume now we are dealing with an economy that can produce pizzas or computers.
The choice between the two is symbolic of one of the most fundamental choices individuals in any society must face: how much to
invest in order to produce more or better goods versus how much to consume today.
Computers help people produce more or better goods. Pizzas are a form of consumption.
Computers on the vertical axis will be used to represent goods for the future, or capital goods, which promote economic growth.
Goods for the present, consumption goods, on the horizontal.
The production of capital goods like computers come at expense of production of consumption goods. The greater the level of K
accumulation, the less current consumption, but the further the frontier shifts out, allowing greater consumption in the future.
An economys current choice of position on its PPF is a determinant of the future location of that curve.
Slide 16
PPF and International Trade
Mercantilism was a notion popular in the 1700s, and we see variants of it raised today.
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.
A mercantilist policy, therefore, is one that tries to maximise net exports.
Adam Smith in his Wealth of Nations, published in 1776, 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. Indeed, the only reason to export is to pay for imports.
Slide 17
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,
even if the people of the country are less efficient at producing all items.
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.
Each country is defined in part by the endowments of productive factors, ie land, labour and capital,
inside its border.
The fundamental fact upon which international trade rests is that goods and services are much more
mobile internationally than the resources used in their production. Each country will tend to export those
goods and services for which its resource base is most suited.
International trade allows a country to specialise in the goods and services that it can produce at a
relatively low cost, and to export those goods in return for imports whose domestic production is relatively
costly.
As a consequence, international trade enables a country and the world to consume and produce more
than would be possible without trade.
Slide 18
Absolute and Comparative Advantage
A country has an Absolute Advantage in the production of a good if it
uses fewer resources to produce a unit of the good than any other
country.
Comparative advantage: The ability to produce a good at a lower
opportunity cost than others can produce it.
The gains from specialisation and trade depend upon the pattern of
comparative, not absolute advantage.
Trade allows a country to specialise in the goods and services that it
can produce at a relatively low cost and to export those goods in
return for imports whose domestic production is relatively costly.
Slide 19
Application Question 1
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?
Resources are not perfectly substitutable between alternative production techniquesIncreasing opportunity costs
c. If the economy is currently at production alternative D:
i. What is the opportunity cost of five million more bags?
4 million watches
ii. What is the opportunity cost of three million more watches?
5 million bags
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
Slide 20
Application Question 1 cont
e. Where would the economy be operating if a recession in Consumer Land resulted in 2 million people losing their
jobs?
Inside the PPF
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?
Constant opportunity costs. Resources are perfectly substitutable between alternative productive uses
e. 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.
Slide 21
Revision 1
Are the following true or false? Explain.
1. Macroeconomics is primarily concerned with the behaviour of single
households and individual firms.
2. The law of increasing opportunity costs is reflected in the concave (to
the origin) shape of the production possibilities curve.
3. Full production implies that allocative and productive efficiency is
achieved.
4. An economy can be producing at some point outside the production
possibilities frontier due to unemployment and/or underemployment of
resources.
Questions for Review: Problems and Applications:
Chapter 1: 6-10
Chapter 1: 4, 8, 11
Chapter 2: 2-7
Chapter 2: 4, 6, 7
Slide 22
REVIEW
Slide 23
PART 2: Measurement
GDP
Inflation
Unemployment
Chapters 7, 8 & 11:216-222
Slide 24
GDP
Macroeconomists have the task of monitoring the overall economy. For their work of judging whether the economy is doing well or
poorly, they formulate a picture of the macroeconomy over time, and in doing this, they use data which reflect the economic
changes that occur as part of that picture and that macroeconomists try to explain.
Gross Domestic Product (GDP): The total market value of all final goods and services produced in the economy during a
specific period.
GDP represents the amount of money one would need to purchase one years worth of the economys production of all final goods and
services.
GDP is the market value ...Market values are calculated by using market prices.
... of all ... GDP includes all items produced and sold legally in the economy.
... final ... Intermediate goods are not included in GDP. The value of intermediate goods
... goods and services ... GDP includes both tangible goods and intangible services.
... produced ... current production is counted. Used goods sold do not count as part of GDP.
... within a country ... GDP measures the production that takes place within the geographical boundaries of a particular country.
... in a given period of time. The usual interval of time used to measure GDP is a quarter (three months). When the government
reports GDP, the data are generally reported on an annual basis.
GDP is a measure of both aggregate production and aggregate income in a nation over a period of one year. Production generates
income, which in turn results in the purchasing power that generates the demand for the products.
GDP measures the total income of everyone in the economy.
GDP measures total expenditure on an economys output of goods and services.
For an economy as a whole, total income must equal total expenditure. If someone pays someone else $100 to mow a lawn, the
expenditure on the lawn service ($100) is exactly equal to the income earned from the production of the lawn service ($100).
Expenditure approach: Sum of all the amount spent on final output of goods and services.
Incomes approach: Money income derived from the production of output.
The production of goods and services generates income. When we add up the entire wage, rental, interest and profit incomes created in
the production of a product, we are using the income approach.
Slide 25
Expenditure Approach: C+I+G+NX=GDP (Y)
In equilibrium GDP expenditures must be equal to income. The Y stands for income because the letter I is used for
investment.
Personal Consumption Expenditure (C)
Durable goods & non-durable consumer goods and services.
These are expenditures by households on durable goods (for example, cars and household appliances), non-durable consumer
goods (for example, food and clothing), and on services (for example, doctors and hairdressers). Consumption includes
expenditure on both imported and domestically produced goods and services. The imported component is later subtracted.
Gross Private Investment (I)
This category includes all final purchases of New capital equipment: machinery, equipment and tools; all building
and construction (residential as well as business); changes in stocks (inventories).
Government Purchases of Goods & Services (G)
This category of spending includes All spending by Federal, state and local government on the finished products
of businesses & direct purchases of resources.
Salaries of government workers are counted as part of the government purchases component of GDP. Transfer payments are not
included as part of the government purchases component of GDP. Transfer payments are actually negative taxes
representing payments from the government to individuals (with no good or service provided in return) rather than payments
from individuals to the government.
Net Exports (X - M) or NX
The difference between the value of our exports and imports (X - M) represents net exports.
We have to add in what foreigners spend on Australian goods and services in determining GDP. Imports, however, do not reflect
productive activity in Australia and therefore they must be subtracted.
Slide 26
Approaches to GDP Calculation
the amount spent on this years total output = the money income derived from the production of this years output.
Value of output = value of income generated in production = value of expenditure
Resource
Market
Product
Market
Firm Household
Why do all three approaches to measuring GDP give us the same answer?
The amount spent on this years total output is equal to the money income derived from the production of this years output, or
put in other words, the value of output equals the value of income generated in its production which equals the value of
expenditure.
Households buy goods and services from firms; firms use this money to pay for resources purchased from households.
In the simple economy described by this circular-flow diagram, calculating GDP could be done by adding up the total purchases
of households or summing total income earned by households.
Because a transaction always has a buyer and a seller, total expenditure in the economy
must be equal to total income.
Slide 27
Money vs Real GDP
As GDP is a price-times-quantity figure, Inflation or deflation complicates the comparison of figures on the GDP over
time, because GDP is a price-times-quantity figure.
GDP is calculated at current prices. In other words, we add up the monetary value of all final goods and services produced
by an economy in a given period.
Money GDP could increase over time because of :
increased output or
increased prices or
both
However, we are interested in GDP to the extent that it measures the quantity of output produced. After all, we are interested
in the productivity of the economy. Has the economy been expanding and growing in real terms, and thus increasing the
likelihood that we will be better off? Or are we worse off? Has GDP increased merely because prices have increased, with
no increase in production or growth?
Therefore, we need to separate these two effects. This is how we come to distinguish between two types of GDP, called
Money [or Nominal] GDP and Real GDP.
Economists measure real GDP by valuing output using a fixed set of prices.
Slide 28
Money vs Real GDP
Suppose the economy had a money GDP of 1,000 in
1997, 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 1998 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?
Slide 29
Price and Quantities
Year Price of meat pies Qty. of meat pies Price of kebabs Qty. of kebabs
2006
1
100
2
50
2007
2
150
3
100
2008
3
200
4
150
Year Calculating nominal GDP
2006
(1 per meat pie x 100 pies) + (2 per kebab x 50 kebabs) = 200
2007
(2 x 150 pies) + (3 x 100 kebabs) = 600
2008
(3 x 200 pies) + (4 x 150 kebabs) = 1200
Year Calculating real GDP (base year of 2006)
2006
(1 per meat pie x 100 pies) + (2 per kebab x 50 kebabs) = 200
2007
(1 x 150 pies) + (2 x 100 kebabs) = 350
2008
(1 x 200 pies) + (2 x 150 kebabs) = 500
Because real GDP is unaffected by changes in prices over time, changes in real GDP reflect changes in the amount of goods
and services produced.
When there is inflation, nominal GDP can increase while real GDP actually declines.
Real GDP will be used as a proxy for aggregate production throughout the course.
Slide 30
Real GDP & GDP Deflator
Real GDP measures output in constant prices.
For example, Real GDP measures the total output in 2007 as if the prices of goods and services remain constant at 1990
prices: that is, we use a base year.
So how do we convert nominal GDP to real GDP?
An adjustment is made by constructing a price index. We use a price index to deflate or inflate the Money (or Nominal)
GDP.
A price index tells us how much the level of prices has increased or decreased relative to what it was in the base year,
where the price index in the base year is set at 100.
Nominal GDP is the production of goods and services valued at current prices.
Real GDP is the production of goods and services valued at constant prices.
Real GDP is a better measure of economic wellbeing because it reflects the economys ability to satisfy peoples needs
and desires. Thus a rise in real GDP means people have produced more goods and services, but a rise in nominal GDP
could occur either because of increased production or because of higher prices.
Real GDP (GDP in constant prices or dollars) controls for price changes and thus captures movements in real
output only.
100
index price
GDP nominal
RGDP v !
Slide 31
GDP Calculation
GDP excludes certain transactions:
Second hand sales Given that the original purchase price would have been included in GDP in the
year it had originally been purchased, including such sales would involve double counting.
Non-productive financial transactions.
Public transfer payments (such as social security payments government makes to
households)
Buying and selling shares
These transactions do not represent any productive activity that adds to the output of final goods and
services.
Certain transactions/activities do not appear in the market and are therefore ignored by GDP:
Legal activities These are such activities as the productive services of the homemakers, eg cooking,
housecleaning, childcare and so. If a householder marries their housekeeper, GDP will fall even
though the same productive activity continues.
Illegal market activities The sale of illegal drugs such as heroin and cocaine, for instance,
represents real production.
Slide 32
GDP as a Measure of Social Welfare
Real GDP is not a precise indicator of social welfare. It is not intended to be a measure of happiness or quality of life.
It may understate or overstate the well-being of society.
Increased leisure over the past several decades has increased welfare, yet is ignored.
The next potential problem in GDP reflecting our social well-being is the fact that increased leisure over the past several decades, ie a reduced
length of the working week, has increased welfare, yet is ignored. A reduction in GDP that results from increased leisure does not
necessarily reflect a reduction in societys well being.
GDP does not accurately reflect improvements in the quality of products.
Another issue is that GDP does not accurately reflect improvements in the quality of products. GDP is a quantitative rather than a qualitative
measure. Consider the improvements made in the quality of personal computers over the last ten years. If personal computers in GDP are
simply valued by their price times their number, then GDP vastly understates the amount of production in terms of memory and speed.
GDP ignores the composition and distribution of output.
Composition: Furthermore, GDP measures total output but ignores the composition and distribution of output that might also affect the economic
well being of society. One economy could have a $100 billion GDP composed entirely of weapons of war, while another could have a $100
billion GDP composed of stylish clothes, sports cars etc. These economies would almost certainly have different standards of living, but this
is not indicated by the GDP data.
Distribution: We also need to raise the issue of the distribution of the output of income. If some people gain and others lose, we cannot say that
there has been an unambiguous increase in welfare. If growing inequality in the distribution of income is seen as undesirable, then total GDP
statistics are an inadequate measure of social welfare.
Changes in population growth alter welfare.
Remember also that if GDP rises, but the population is also growing rapidly, then a societys per capita standard of living may actually be in
decline.
Environmental pollution and other negative by-products associated with production are not deducted from current output.
Another area of concern is environmental pollution and other negative by-products associated with production process. These are not deducted
from current output. The Exxon Valdez oil spill off the coast of Canada required over $2 billion of cleanup expenditure to bring Prince William
Sound back to its pre-spill state. This expenditure is added into GDP, but with no offsetting reduction to GDP to reflect the pollution cost to
society. The GDP may therefore overstate national economic welfare.
Slide 33
Economic Growth
Another important concept to look at is economic growth. Economic growth is measured by
increases in real GDP. The growth rate is the percentage change in GDP from one period to
another.
If GDP was 100 in year 0 and 104 in year 1
g r o w t h r a t e
c h a n g e i n G D P
i n i t i a l G D P



!

v
!

v
!

!
1 0 0
1 0 4 1 0 0
1 0 0
1 0 0
4
1 0 0
4 %
Slide 34
Text Problem
What two things dies gross domestic product measure?
How can it measure two things at once?
Gross domestic product measures two things at once: (1)
the total income of everyone in the economy; and (2) the
total expenditure on the economys output of goods and
services.
It can measure both of these things at once because
income must equal expenditure for the economy as a whole.
Slide 35
Inflation
Inflation: rising level of general prices.
Inflation does not mean that the prices of all goods in the economy are rising. Inflation means
that prices on average are rising. In fact, prices of electronic goods (such as computers) have
fallen in recent years.
Economists measure a countrys annual rate of inflation by computing the percentage change
in the general level of prices from one year to the next. They use the price index discussed
earlier to measure the general price level.
Inflation rate: percentage change in the price level (price index) from one year to the next
100 ate Inflation
1
1 2
v

!
year
year year
PI
PI PI
Slide 36
Consumer Price Index
The most commonly known price index is based on change in the price of a given basket of consumption goods and
services. Consumer price index (CPI): a measure of the overall cost of the goods and services bought by a typical consumer.
Fixed basket of 4 apples and 2 meat pies
Year Price of apples Price of meat pies
2006
1 2
2007
2 3
2008
3 4
Year Cost of basket
2006
(1 x 4 apples) + (2 x 2 meat pies) = 8
2007
(2 x 4 apples) + (3 x 2 meat pies) = 14
2008
(3 x 4 apples) + (4 x 2 meat pies) = 20
Year Consumer price index (2006 is the base year)
2006 (8/ 8) x 100 = 100
2007 (14/ 8) x 100 = 175
2008 (20/ 8) x 100 = 250
The most commonly known price index is based on a change in price of a given basket of consumption goods and services. This is
referred to as the Consumer Price Index (CPI). The basket is chosen to represent the purchasing pattern of a typical consumer.
Fix the basket: The Australian Bureau of Statistics uses surveys to determine a representative bundle of goods and services
purchased by a typical consumer.
Compute the baskets cost. By keeping the basket the same, only prices are being allowed change. This allows us to isolate
the effects of price changes over time.
Slide 37
Inflation
Inflation rate calculated used the CPI:
2007: (175 - 100)/100 x 100 = 75%
2008: (250 - 175)/175 x 100 = 43%
Another measure of prices is the GDP Price Deflator.
It tells us the rise in nominal GDP that is attributable to a rise in prices.
GDP Deflator measures the current level of prices relative to the price
level in the base year.
100
real
nominal
deflator v !
Slide 38
Measuring Inflation
1. Obsolete patterns of expenditure
Introduction of a new good is not reflected in the CPI.
First of all, the CPI may be based on an obsolete pattern of expenditure. The CPI is computed using a fixed basket of goods,
whereas the GDP deflator allows the basket of goods to change over time as the composition of GDP changes. When
a new good is introduced, consumers are better off, because they have more products from which to choose. This
makes every dollar more valuable, which means that there is an increase in the purchasing power of the dollar.
In effect, the introduction of new goods increases the purchasing power of a dollar. Yet this increase in purchasing power is
not reflected in the CPI. Furthermore, since consumers tend to buy less of a good whose price has risen, the CPI will
tend to overstate true inflation.
2. Substitution bias
Does not reflect the ability of consumers to substitute towards goods whose relative prices have fallen.
Because the CPI measures the price of a fixed basket of goods, it does not reflect the ability of consumers to substitute
towards goods whose relative prices have fallen. The fixed basket assumes that consumers continue to buy the now
expensive apples in the same quantity as before. For this reason, the CPI will measure a much larger increase in the
cost of living than consumers actually perceive.
3. Quality changes
Finally, both the GDP deflator and CPI may overstate a true rise in prices by ignoring quality improvements. For example, cars,
computers and CD players improve from year to year. Part of the increase in the price of these items reflects the
improvement in the quality of the product. Yet the CPI and GDP deflator will regard such a price change as inflation
Slide 39
GDP Deflator Consumer Price Index
All goods and services Goods and services bought by consumers
Domestically produced goods and services Domestically and internationally produced goods
and services
Variable quantity of goods and services Fixed quantity of goods and services
Producer goods
Another potential problem with the CPI is that it does not include producer goods. The GDP deflator measures the prices of all
goods and services produced, whereas the CPI measures the prices of only the goods and services bought by consumers.
Thus, an increase in the price of goods bought by firms or the government will show up in the GDP deflator but not in the CPI.
Domestically produced goods
However, the GDP deflator includes only those goods produced domestically. Imported goods are not part of GDP and do not
show up in the GDP deflator. Hence, an increase in the price of a Toyota made in Japan and sold in Australia affects the CPI,
because the Toyota is bought by consumers, but it does not affect the GDP deflator.
The GDP deflator versus the consumer price index
The GDP deflator reflects the prices of all goods produced domestically, while the CPI reflects the prices of all goods bought by
consumers.
The CPI compares the prices of a fixed basket of goods over time, while the GDP deflator compares the prices of the goods
currently produced to the prices of the goods produced in the base year. This means that the group of goods and services used
to compute the GDP deflator changes automatically over time as output changes.
Slide 40
Converting/Adjusting for Inflation
To change dollar values from one year to the next, we can use this formula:
In 1930, Phar Lap won $19,000. Government statistics show a consumer price index of 4.7 for
1930 and 146.3 for 2004. Phar Laps 1930 winnings is equivalent to a 2004 dollars of about?
Winnings in 2004 dollars = $19,000 (146.3/4.7).
Winnings in 2004 dollars = $591,425.
Slide 41
Text Problem
Henry Ford paid his workers $5 a day in 1914. If a price
index was 11 in 1914 and 146 in 2004, how much was
the Ford pay cheque worth in 2004 dollars?
Since Henry Ford paid his workers $5 a day in 1914 and the
consumer price index was 11 in 1914 and 146 in 2004, then
the Ford pay cheque was worth $5 146/11 = $66.36 a day
in 2004 dollars
Slide 42
Real and Nominal Interest Rates
Real Rate of Interest: The cost of borrowing funds for the purchase of real capital.
It is the real rate of interest, rather than the nominal rate, that is crucial in making
investment decisions.
Real Interest Rate = Nominal Interest Rate Inflation Rate
Nominal interest rate: the interest rate as usually reported without a correction for the effects of
inflation.
Real interest rate: the interest rate corrected for the effects of inflation.
Slide 43
Measuring Unemployment
Unemployed: those aged 15 years and over who are actively
looking for work, available to take a job immediately but who
are currently not working.
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
mployed Number Une
ate nt Unemployme v !
100
opulation Adult
Force Labour
ate ion articipat force - Labour v !
Slide 44
Unemployment
Frictional Unemployment
One reason for unemployment is that it takes time to match workers and jobs. 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. Workers have different preferences and abilities, and jobs have different attributes.
The flow of information about job candidates and job vacancies is imperfect. Employers are not fully aware of all
available workers and their job qualifications, and available workers are not fully aware of the jobs being offered by
employers. Nor is the geographical mobility of workers instantaneous. Searching for an appropriate job takes time
and effort. Indeed, because different jobs require different skills and pay different wages, unemployed workers may
not accept the first job offer they receive. Largely due to imperfect information.
Structural Unemployment
Unemployment due to fundamental changes in the kinds of jobs that the economy offers. Technological
change, the development of new industries and the demise of old ones, and the changing economic role of different
regions in a country mean that new kinds of jobs need to be undertaken and that other ones cease to exist.
Unemployment results because the composition of the labour force does not respond quickly to the new structure of
job opportunities. Workers may have inappropriate skills.
Cyclical unemployment
This unemployment category relates directly to stages of the business cycle. Due to a deficiency in aggregate
demand for goods and services. As the economy moves into a recession, the demand for labour decreases
with fewer goods being produced, fewer workers will be required to produce them. Cyclical unemployment is a
major concern of this course.
Slide 45
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 potential GDP.
However, full employment does not mean zero unemployment. 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. This is the unemployment
rate that is sustainable into the future, given the structural and institutional characteristics of the economy.
Frictional and structural unemployment is inevitable in a changing, dynamic economy. This is because, where the types of
goods that firms and households demand varies over time, and where some industries expand and others decline, there
will always be a movement of individuals from one job to another.
The natural rate of unemployment is not forever fixed. It is influenced by the structure of the labour force, by social
customs and by changes in government policy.
For example, young workers experience more unemployment because they change jobs and move in and out of the
labour force more often. The natural rate of unemployment will therefore increase when young workers compose a larger
proportion of the labour force.
Similarly, government policies that encourage workers to reject job offers and continue to search for employment (such as
unemployment benefits), or those that prohibit employers from offering lower wage rates that would induce them to
employ and train low skilled workers (such as legislated minimum wages), will increase the natural rate of unemployment.
Slide 46
Application Question 2
What is the connection between full-
employment, potential RGDP and the
natural rate of unemployment?
All occur when cyclical unemployment = 0
Slide 47
Issues in Measurement
Is unemployment measured correctly?
Measuring the unemployment rate is not as straightforward as it may seem.
There is a tremendous amount of movement into and out of the labour force.
Many of the unemployed are new entrants or re-entrants looking for work.
Many unemployment spells end with a person leaving the labour force as opposed to actually finding a job.
There may be some individuals who are calling themselves unemployed to receive government
assistance, yet they are not trying hard to find work. These individuals are more likely not a part of the true
labour force, but they will be counted as unemployed.
Discouraged workers: individuals who have given up looking for work but would like to work.
Discouraged workers are workers who drop out of the labour force after unsuccessfully seeking
employment, and who are not counted as unemployed. This suggests that the official data will tend to
understate the true unemployment rate. Alternatively, increased confidence by these individuals in finding
a job may increase the measured unemployment rate, as they rejoin the labour force.
Underemployment: All part-time workers are classified as employed. Yet many part-time
employees may want to work full-time. but cannot find suitable full-time work. These workers are in
reality underemployed. By counting these individuals as employed, the official data tends to understate
the unemployment rate.
Slide 48
Costs of Unemployment
GDP gap:Unemployment leads to forgone output and income. This
sacrificed output is measured in terms of the GDP gap. This is the
amount by which the actual level of GDP falls short of the potential
level of GDP (ie if the economys resources were fully employed).
Loss of human capital: When unemployment is prolonged, human
capital deteriorates - ie skills are lost.
The burden of unemployment is unequally distributed:
Unemployment is borne more heavily by certain groups.
Social costs: loss of self-esteem, poor health, increase in crime, loss
of human dignity, increased stress on individuals and families.
Slide 49
Application Question 3
For each of the following indicate whether the person would be classified as
employed, unemployed or not in the labour force:
a. A 65-year old man who has left his job and is now helping his daughter in her
business. Not in the labour force
b. A 22-year old graduate who is looking for a job. Unemployed
c. A 40-year old woman with a PhD in history who has not been able to find a
teaching position and is driving a taxi for 30 hours a week. Employed
d. A 50-year old fisherman who is not working and has given up searching for a job.
Not in the labour force
Slide 50
Revision 2
1. "Gross Domestic Product is defined as the market value of all goods produced
in the economy." Is this statement correct?
2. Does the purchase of stocks and shares by individual entrepreneurs represent
an addition to real productive capital within the economy?
3. Real GDP figures allow economists to make better estimates of changes in
real output than money GDP figures. Explain.
4. "GDP, regardless of the method of calculation, is an accurate indicator of
nation's social well-being, and not simply an economic measure". Comment.
5. Outline three weaknesses of the CPI as a measure of the overall level of
prices in the economy.
6. Is the unemployment rate at full employment (i.e. the natural rate of
unemployment) usually equal to zero?
Questions for Review: Problems and Applications:
Chapter 7: 1, 3-6 Chapter 7: 1-3, 6, 9-11,13
Chapter 8: 1-5 Chapter 8: 1-10
Chapter 11: 1 Chapter 11: 1-3
Slide 51
REVIEW
Slide 52
MODULE 2: MARKETS
Chapters 4, 11:222-238, 12:245-256, 16, & 17:369-371
Slide 53
PART 1: Pricing Mechanism
Chapter 4
Slide 54
Market for an Individual Good or Service
When a good (or resource) is scarce, some criterion must be set up for deciding who will receive the good (or resource)
and who will do without it.
Scarcity makes rationing a necessity. When individuals get less of a good they would like at the terms being offered, the
good is said to be rationed. Different rationing schemes are different ways of deciding who gets societys scarce resources.
There are several possible criteria that could be used in rationing a limited amount of a good among citizens who would like
more of it.
If the criterion were first-come-first-served, goods would be allocated to those who were fastest at getting in line, or those
who were most willing to wait in line. Medical health services provided by public hospitals are rationed by queuing.
The political process might be used and goods would be allocated on the basis of political status and ability to manipulate
the political process to personal advantage.
The market is one method of producing and rationing scarce goods and resources.
A market is a group of buyers and sellers of a particular good or service.
Supply and Demand refer to the behaviour of individuals 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.
Slide 55
Individuals Demand for a Good or Service
Demand is defined as a schedule that shows the various amounts of a product consumers are willing to purchase at
each specific price, all other things being equal.
A tabular version of demand reflects the relationship between the price of a good and the quantity that a consumer would be
willing and able to purchase at various prices.
A fundamental characteristic of demand is that all else constant, as price falls, the corresponding quantity demanded rises.
Alternatively, as price increases, the corresponding quantity demanded falls.
Negative or inverse relationship between price and quantity demanded is known as the Law of Demand.
The inverse relationship between product price and quantity demanded can be presented on a graph.
We measure quantity demanded on the horizontal axis and price on the vertical axis.
Each point represents a specific price and the corresponding quantity the consumer will choose to purchase at that price.
The demand curve illustrates the relationship between the quantity demanded and the price of a good (assuming all other
influences on demand are held constant, ie ceteris paribus).
It slopes downwards to the right because the relationship it portrays between price and quantity demanded is negative or
inverse. The law of demand is reflected in the downward slope of the demand curve.
The availability of substitutes - goods that perform similar functions - helps to explain the logic of the law of demand.
When the price of a good increases, people have a greater incentive to turn to substitute products.
Price per CD ($) Quantity Demanded per Year
50 5
40 10
30 15
20 20
10 25
Quantity
Price
Slide 56
Market and Individual 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
Kates Demand Pauls Demand Market Demand
When the price is $40, Kate
will demand 6 CDs.
When the price is $40, Paul
will demand 4 CDs.
The market demand at $40
will be 10 CDs.
When the price is $20, Kate
will demand 12 CDs.
When the price is $20, Paul
will demand 8 CDs.
The market demand at $20,
will be 20 CDs.
The market demand is the sum of all of the individual demands for a particular good or service. The individual demand curves
are summed horizontally meaning that the quantities demanded are added up for each level of price.
The market demand curve shows how the total quantity demanded of a good varies with the price of the good, holding all
other factors constant.
Slide 57
Determinants of Demand
When we drew the demand curve, we assumed that all determinants of demand, other than the price of the good itself, were
constant. A change in one of the determinants of market demand, other than price, will result in a shift of the demand curve.
(Illustrate using diagrams changes in each of the determinants of demand. )
1. Tastes or Preferences
A change in consumer tastes or preferences in favour of this product means that more is demanded at each price.
A change in tastes in favour of a product causes an increase in demand. and the demand curve shifts to the right.
A change in consumer preferences away from the product (such as the impact of health concerns relating to smoking on the
demand for cigarettes) will result in a reduction in demand, and a shift in the demand curve to the left.
2. Number of Consumers in the Market
An increase in the number of consumers in the market represents an increase in demand. and shifts the demand
curve to the right.
3. Income Effect depends on whether the good is normal or inferior
Normal goods: demand varies directly with income. An increase in income causes an increase in demand.
Inferior goods: demand varies inversely with income. An increase in income will cause a reduction in demand and a
leftward shift in the demand curve for these goods.
Slide 58
Determinants of Demand
4. Prices of Related Goods The effect depends on whether the goods are substitutes or complements.
Substitutes: A good that can be used in place of another good. When two products are substitutes
(eg butter and margarine) the price of one good and the demand for the other are directly or positively
related.
A decrease in the price of a substitute good causes the demand for the other good to decrease.
the demand curve for the other good to shift to the left.
Complements: Goods that must be used jointly. When two gods are complements (eg CDs and CD
players) the price of one good and the demand for the other are inversely related.
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. Expectations
of the future change behaviour today.
Slide 59
Change in Demand & Change in Quantity Demanded
A change in demand results from a change in one or more of the determinants of demand, other than the price of the
good itself.
A change in demand can be represented by a shift in the position of the demand curve.
An increase in demand can be represented by a shift of the demand curve to the right. A decrease in demand can be
represented by a shift of the demand curve to the left.
A change in the quantity demanded is indicated by a movement along a given demand curve.
A movement up the demand curve indicates a decrease in quantity demanded caused by an increase in the own price of the
product.
A movement down the demand curve indicates an increase in quantity demanded caused by a decrease in the price of the
product.
Q
P
D
3
D
1
D
2
Increase in
Demand
Decrease in
Demand
Slide 60
Application Question 4
What effect will each of the following have on the demand for NIKE running shoes?
a. NIKE running shoes become more fashionable.
Increase in demand; Demand curve shifts right.
b. The price of REBOCK running shoes, a popular substitute, goes down.
Decrease in demand; Demand curve shifts left.
c. Consumers anticipate that prices on all running shoes will fall next month.
Decrease in demand; Demand curve shifts left.
d. There is a rapid increase in the population due to increased immigration.
Increase in demand; Demand curve shifts right.
Slide 61
Supply
Supply is a schedule that shows the various amounts of a product that producers are willing and able to produce
at various prices, all other things being equal.
The table shows a positive or direct relationship between price and quantity supplied.
As price rises, the corresponding quantity supplied rises; as price falls, the quantity supplied falls.
Positive or direct relationship between price and quantity supplied is known as the Law of Supply.
From the perspective of the seller, price is revenue per unit.
All other things being equal, the higher the price of the product, the greater incentive to produce and offer it in the market.
We assume that a firm must receive higher prices for additional units of output because those extra units cost more to
produce. Unit costs increase as output increases.
The supply curve is drawn with the assumption that all determinants of supply, other than price, are given and do not
change.
If any other these non-price determinants of supply do change the supply curve shifts.
Price per CD ($) Quantity Demanded per Year
50 25
40 20
30 15
20 10
10 5
Quantity
Price
Slide 62
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.
The market supply curve can be found by summing
individual supply curves. Individual supply curves are
summed horizontally at every price. The market
supply curve shows how the total quantity supplied
varies as the price of the good varies.
Slide 63
Determinants of Supply
1. Resource prices/ factors of production : A decrease in price of inputs lowers production
costs and increases supply. shifts the supply curve to the right.
2. Technology: Technological improvements lowers production costs and increases
supply. - shifts the supply curve to the right.
3. Expectations concerning the future price of a product can also affect a producers current
willingness to supply that product. Expectation of a higher future price may result in a farmer
withholding some of the current wheat harvest from the market (decrease in supply).
4. Number of sellers: The larger the number of suppliers, the greater is market supply.
As more firms enter the industry, the supply curve shifts to the right.
Slide 64
Change in Supply & Change in Quantity Supplied
A change in supply results from a change in one or more of the determinants of supply other than the price of the
good itself. Represented by a shift in the position of the supply curve.
An increase in supply shifts the curve to the right; a decrease in supply shifts it to the left.
A change in the quantity supplied is indicated by a movement along a given supply curve.
A movement up the supply curve indicates an increase in quantity supplied caused by an increase in the price of the product.
A movement down the supply curve indicates a decrease in quantity supplied caused by a decrease in the price of the
product.
Q
P
S
3
S
1
S
2
Increase in
Supply
Decrease in
Supply
Slide 65
Market Equilibrium
Bring the concepts of supply and demand together to see how the price of a product and the quantity bought and sold are
determined.
Consumers and producers make decisions independent of each other, but markets coordinate their choices and influence their
actions.
Indeed, the market price of a commodity will tend to change in the direction that will bring the amount consumers wish to buy into
balance with the amount producers wish to sell.
This means that unless the quantity supplied by producers is already precisely equal to the quantity demanded by consumers,
there will be a tendency for the market price to rise or fall until a balance is reached.
The intersection of the supply curve and the demand curve for the product indicates the equilibrium price and quantity -
markets equilibrium
At the equilibrium price: quantity demanded = quantity supplied; The intentions of both buyers and sellers coincide.
There is no incentive to alter the price.
P
Q
S
D
$30
15
Slide 66
Shortages and Surpluses
Suppose the price is initially above the market clearing price:
At any price above the equilibrium price of $30, quantity supplied
exceeds quantity demanded.
Assume a price of $40. In a competitive market, this cannot be the
prevailing market price, and such a price will not be maintained. There
is a surplus or excess supply of 10 units in the market. At $40,
producers are willing to produce 20 units while buyers are willing to
purchase only 10 units.
The surplus causes a competitive bidding down of price by
suppliers. as they cannot supply all they want to at this price and each
attempts to gain a larger share of the market. This has two effects.
The falling price causes less of the good to be offered. Firms will
produce less because their resources could be more profitably used
elsewhere.
This reduction in the quantity supplied is reflected in a movement back
down supply curve.
The falling price encourages consumers to increase the quantity they
buy. Existing buyers will buy more and new buyers may enter the
market.
This increase in the quantity demanded is reflected in a movement
along the demand curve.
This process of reduction in price and resulting reduction in quantity
supplied and increase in quantity demanded will continue until
equilibrium price and quantity are achieved.
Any price below the equilibrium price of $30, quantity
demanded exceeds quantity supplied. Assume a
price of $20.
There is a shortage or excess demand of 10 units in
the market. At $20, buyers are willing to purchase 20
units, while producers are only willing to supply 10
units.
This price cannot persist in a competitive market.
The shortage causes a competitive bidding up of
price by buyers.
This rising price induces an increase in quantity
supplied by producers (induces firms to allocate
more resources to the production of this commodity)
and a reduction in quantity demanded by buyers
(some consumers are rationed out of the market).
This process will continue until equilibrium price and
quantity is achieved.
The price mechanism rations a good on the basis of
the strength of preferences.
As the price increases, those who least value the
good stop consuming.
Slide 67
Changes to Equilibrium
D
0
Quantity
Price
S
P
0
P
1
Q
0
Q
1
D
1
D
Quantity
Price
S
1
P
0
P
1
Q
0
Q
1
S
0
A
B
C
A B
C
The model of supply and demand is a powerful tool for analysing markets.
Supply and demand together determine the price of the economys goods and services.
These prices serve as signals that guide the allocation of scarce resources in the economy.
Prices determine who produces each good and how much of each good is produced.
An increase in demand results in greater demand for
the product at each and every price level. We move
from point A to point B. At a price of P0 we now have a
shortage. This causes a competitive bidding up of
price. As price increases, quantity demanded
decreases and quantity supplied increases until a new
equilibrium is achieved at point c.
A decrease in supply results in decreased supply of the
product at each and every price level. We move from
point A to point B. At a price of P0 we now have a
shortage. This causes a competitive bidding up of
price. As price increases, quantity demanded
decreases and quantity supplied increases until a new
equilibrium is achieved at point c.
Slide 68
Application Question 5
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;
Price rises, quantity rises (demand shifts to the right: butter and margarine are substitutes)
b. A rise in the price of bread;
Price falls, quantity falls (demand shifts to the left: bread and butter are complementary goods)
c. A tax on butter production.
Price rises, quantity falls (supply shifts to the left).
Slide 69
Application Question 6
Well intentioned fifth-graders in Highline Community School in Denver only
wanted to do the right thing when they launched a program to buy the
freedom of slaves in Sudan, but the plan back-fired.
They freed more than 1,000 slaves, but more than that number may have
become enslaved as a result, humanitarian agencies say.
Use supply and demand analysis to explain why this may have occurred.
They have increased the demand in the
market for slaves. Demand shifts to the right
and there is an increase in both the quantity
and price of slaves.
Slide 70
Revision 3
Questions for Review: Problems and Applications:
Chapter 4: 1-11 Chapter 4: 1-7, 9-11, 13
1. Given that demand curves for products and/or services do not remain static over time,
identify and explain each of the major determinants of market demand (other than the
price).
2. An increase in demand caused by an increase in income is the same as an increase in
the quantity demanded caused by a decrease in price. True or false?
3. Assume a surplus of a particular product exists in a competitive market. What will be
the two major effects of the associated fall in price?
Slide 71
REVIEW
Slide 72
PART 2:
Labour Market
Chapter 11:222-238
Slide 73
The Labour Market
Through the workings of the supply of labour and
demand for labour, the levels of employment and
the wage is determined.
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.
Slide 74
Real Wage Rate
A household decides to allocate time between
(a) market activity (supplying labour to earn an income, in order to facilitate consumption) and
(b) non-market activity such as household work, leisure and non-market productive activity such as
education and training.
The wage rate determines the value of working, and hence how much labour will be supplied.
Wage rate can be viewed as the opportunity cost of leisure.
If the wage rate increases, the opportunity cost of leisure increases.
A higher wage implies more hours of labour supplied.
Real wage = nominal wage/overall price level = w/p
The nominal wage or money wage is simply the amount of the wage meansured in dollars and cents.
People are interested not only in their actual w but also in the purchasing power of their wage.
Real wage is the amount of purchasing power that each worker receives and firm pays for each
unit of labour.
Slide 75
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.
Slide 76
Causes of Unemployment
Why is there unemployment?
In an ideal labour market, wages would adjust so that the quantity of labour supplied and the quantity of labour demanded would
be equal.
However, there is always unemployment even when the economy is doing well. The unemployment rate is never zero; it fluctuates
around the natural rate.
Minimum wage laws
Minimum wage set above market-clearing wage rate
Unemployment can occur because of minimum-wage laws. The minimum wage is a price floor.
If the minimum wage is set above the equilibrium wage in the labour market, a surplus of labour will occur. Any time a wage is kept
above the equilibrium level for any reason, the result is unemployment.
Most workers in the economy earn a wage above the minimum wage.
Minimum-wage laws therefore have the largest effect on workers with low skill and little experience (such as teenagers).
Unions and collective bargaining
Prevent downward wage flexibility
Union: a worker association that bargains with employers over wages and working conditions.
Collective bargaining: the process by which unions and firms agree on the terms of employment.
Unions play a smaller role in the Australian economy today than they did in the past. 25% percent of Australian workers now belong to
unions. Twenty years ago a little more than 50% of Australians belonged to unions. In Sweden and Denmark, more than three-
quarters of workers belong to unions.
Unions try to negotiate for better wages, better benefits and better working conditions than the firm would offer if there was no union.
Strike: the organised withdrawal of labour from a firm by a union.
Economists have found that union workers typically earn up to 10% more than similar workers who do not belong to unions.
Are unions good or bad for the economy?
Critics of unions argue that unions are a cartel, which causes inefficiency because fewer workers end up being hired at the higher union
wage.
Advocates of unions argue that unions are an answer to the problems that occur when a firm has too much power in the labour market
(for example, if it was the only major employer in town). Larger firms may hold significant monopsony power in the labour market
and by acting in a like manner in the opposite direction, unions act to redress the lower wages that result from the application of
monopsony power.
Slide 77
Causes of Unemployment
Efficiency wages
Firms may make higher profits by paying above market-clearing wage rates - above-equilibrium wages paid by firms in order to increase worker productivity.
Link between wages and worker effort
In many jobs, workers have some discretion over how hard to work. As a result, firms monitor the efforts of their workers, and workers caught shirking their responsibilities are
fired. But not all shirkers are caught immediately because monitoring workers is costly and imperfect. A firm can respond to this problem by paying wages above the
equilibrium level. High wages make workers more eager to keep their jobs and, thereby, give workers an incentive to put forward their best effort.
Link between wages and worker quality
When a firm hires new workers, it cannot perfectly gauge the quality of the applicants. By paying a high wage, the firm attracts a better pool of workers to apply for its jobs. If
a firm lowers wages, its best workers will most likely find a new job at the old (higher) wage and therefore will most likely leave.
Link between wages and company turnover
Workers quit for many reasons - to take jobs in other firms, to move to other parts of the country, to leave the labour force. The frequency with which they quit depends on the
entire set of incentives they face, including the benefits of leaving and the benefits of staying. The more of firm pays its workers, the les often its workers will choose to leave.
Thus, a firm can reduce turnover among its workers by paying them a high wage.
Firms care about turnover because it is costly to hire and train new workers. Newly hired workers are also not as productive as experienced workers. Firms with higher turnover,
therefore, will tend to have higher production costs.
Link between wages and worker health
Better-paid workers can afford to eat better and can afford good medical care. This is not applicable in rich countries such as Australia, but can raise the productivity of workers
in less-developed countries
Job search
Matching workers to jobs
Incentives
Job search: the process by which workers find appropriate jobs given their tastes and skills. Because workers differ from one another in terms of their skills and tastes and jobs
differ in their attributes, it is often difficult for workers to match with the appropriate job.
Search unemployment often occurs because of a change in the demand for labour among different firms. When workers decide to stop buying a good produced by Firm A and
instead start buying a good produced by Firm B, some workers at Firm A will likely lose their jobs. New jobs will be created at Firm B, but it will take some time to move the
displaced workers from Firm A to these openings. The result of this transition is temporary unemployment. The same type of situation can occur across industries as well.
This implies that, because the economy is always changing, search unemployment is inevitable. Workers in declining industries will find themselves looking for new jobs and
firms in growing industries will be seeking new workers.
Public policy and job search: Government programs can help to reduce the amount of search unemployment. These programs include: Government-run employment agencies
& Public training programs.
Critics of these programs argue that the private labour market will do a better job of matching workers with employers and therefore the government should not be involved in the
process of job search.
Unemployment benefits: a government program that partially protects workers incomes when they become unemployed. Because unemployment benefits reduce the hardship
of unemployment, they potentially increase the amount of unemployment that exists.
Slide 78
Text Problem
How does a union in the car industry affect wages and
employment at Holden and Ford? How does it affect wages and
employment in other industries?
A union in the car industry raises the wages of workers at Holden and
Ford by threatening to strike. To prevent the costs of a strike, the firms
generally pay higher wages than they would if there were no union.
However, the higher wages reduce employment at Holden and Ford.
Wages and employment in other industries are affected, since
unemployed autoworkers seek jobs elsewhere, reducing wages and
increasing employment.
Slide 79
PART 3:
Exchange Rate Market
Chapter 14:304-306
Slide 80
Nominal Exchange Rate Nominal Exchange Rate
The rate at which one currency is exchanged for
another.
Direct: Dongs required to purchase a unit of foreign
currency:
5 . 079 , 16
1
N 6,079.50 1
1
$
! !
USD
V
Currency Foreign
VND
e
Slide 81
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 a currency appreciates, it is said to strengthen; when a
currency depreciates, it is said to weaken.
Slide 82
Real Exchange Rate
Rate at which a person can trade the goods and services of one country for the goods and services of another.
Using the direct method of quotation, a decrease in the RER means that Vietnamese
goods have become more expensive relative to foreign goods and vice versa.
The real exchange rate depends on the nominal exchange rate and on the prices of goods in the two countries
measured in the local currencies.
The real exchange rate measures the price of a basket of goods and services available domestically relative to
the price of a basket of goods and services available abroad.
A depreciation in the Vietnamese real exchange rate means that Vietnamese goods have become cheaper
relative to foreign goods. Vietnamese exports will rise, imports will fall and net exports will increase.
Likewise, an appreciation in the Vietnamese real exchange rate means that Vietnamese goods have become
more expensive relative to foreign goods. Vietnamese exports will fall, imports will rise and net exports will
decline.
*
) (
P
P e
RER
v
!
Slide 83
Exchange Rate Market
THUS:
Depreciation e EX and IM Quantity FX supplied increases & Quantity of FX demanded falls.
Negative relationship between e and quantity demanded
Positive relationship between e and quantity supplied
When the domestic currency weakens, depreciates, domestic goods become cheaper relative to foreign goods. Exports
increase and imports decrease thus as the exchange rate increases quantity of FX demanded decreases. Negative
relationship between the exchange rate and the quantity of FX demanded downward sloping curve. Positive relationship
between the exchange rate and the quantity of FX supplied upward sloping curve.
Appreciation e EX and IM Quantity FX supplied decreases & Quantity of FX demanded increases.
When the domestic currency strengthens, appreciates, domestic goods become more expensive relative to foreign goods.
Exports decrease and imports increase thus as the exchange rate decreases, quantity of FX demanded increases and
quantity of FX supplied decreases.
Importing:
Demand for foreign currency.
Supply of VND.
When domestic residents buy foreign goods, imports
increase.
To pay for the imports we convert domestic currency to
foreign currency. Demand for foreign currency increases
and the supply of VND increases.
Exporting
Supply of foreign currency.
Demand for VND.
When foreigners buy domestically produced goods,
exports increase.
To pay for the exports, foreigners convert foreign currency
to domestic currency. Supply of foreign currency increases
and demand for VND increases.
Slide 84
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
Slide 85
Changes in Net Exports
D
FX1
Quantity
Exchange rate
S
FX
e
1
e
0
Q
1
Q
0
D
FX0
D
FX
Quantity
Exchange rate
S
FX0
e
1
e
0
Q
1
Q
0
S
FX1
Increased Exports Decreased Imports
Increased sale of natural resources.
The domestic currency appreciates
Increased tariffs on imports to protect domestic industry.
Thus demand for imports fall as domestic goods are
cheaper relative to foreign goods.
As we decrease imports, quantity of FX demanded falls we
are not converting domestic currency to foreign currency.
Domestic currency appreciates.
Foreign goods become cheaper relative to domestic goods
and imports increase while exports falls the domestic
economy contracts.
Slide 86
Commanding Heights
The Battle of Ideas:
Prologue
The Old Order Falls
Communism on the Heights
A Capitalist Collapse
Global Depression
Worldwide War
Planning the Peace
Germanys Bold Move
Slide 87
Revision 4
Questions for Review: Problems and Applications:
Chapter 11: 4, 6-7 Chapter 11: 4, 6-9
Chapter 14: 3, 5 Chapter 14: 5c, 6-7
Chapter 15: 3 Chapter 15: 6
1. What will happen to the equilibrium real wage and level of employment if there is a
reduction in capital investment?
2. Why might unemployment exist?
Slide 88
REVIEW
Slide 89
PART 4: Product Market
Chapter 16
Slide 90
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.
Business cycles are irregular but recurrent patterns of fluctuations in economic activity. They are apparent in aggregate measures
of sales, output, income, employment, and a number of other measures over a period of years, quite apart from any long-run
trends in these series.
A business cycle is identified as a sequence of four phases:
Peak: Economic activity has reached a temporary maximum. The economy is at full employment and the level of domestic
output is also growing at close to capacity. The price level is likely to be rising.
Recession: A period where the level of output declines (ie economic growth is negative) in two or more successive quarters
Trough: The trough of the business cycle is where employment and output growth bottom out at their lowest level.
Recovery: In the recovery phase, the economys level of output and employment expand towards full employment.
Real GDP
Time
Peak
Trough
Slide 91
Economic Fluctuations
Irregular and unpredictable.
Most macroeconomic quantities such as income, spending or production fluctuate together.
Changes in the economys output of goods and services are strongly correlated with changes in the economys
utilisation of its labour force.
In other words, when real GDP declines, the rate of unemployment rises.
Important in economic growth theory to distinguish between the longer-term economic trend from the shorter-term fluctuations
in the economy. The upward trend line in real GDP will be referred to as potential GDP. Potential GDP represents the long-
run tendency of the economy to grow. Real GDP fluctuates around potential GDP. Note that potential GDP as defined here
is not the maximum amount of real GDP. As illustrated above, sometimes actual GDP goes above potential GDP.
Potential real GDP may rise for four reasons:
growing population
growing stock of capital equipment
growing stock of human capital
advancing technology
Okuns law
According to Okuns law, when real GDP grows at its average rate of 3%, the unemployment rate remains unchanged.
When the economy expands more rapidly than 3%, the unemployment rate falls by about half as much. There is a strong
correlation between GDP and unemployment.
Slide 92
Aggregate Demand
As we have seen in our discussion of the business cycle, economic activity fluctuates from year
to year.
What causes these short term fluctuations in economic activity?
AD curve shows the amounts of goods and services (RGDP) that will be purchased at any
given price level.
Aggregate demand is the relationship between the overall price level and real GDP.
Recall that GDP (Y) is made up of 4 components: consumption (C), investment (I), government
purchases (G) and net exports (NX).
Each of the four components is a part of aggregate demand.
The AD curve does not slope downwards for the same reasons as the market demand curve
slopes downwards. In the latter case, when the price of ice cream increases, the quantity
demanded will decrease because consumers can use their incomes to buy products other than
ice cream. This microeconomic substitution from one market to another due to a change in
relative prices is impossible when we are analysing the economy as a whole.
Price level
Real GDP
AD
Slide 93
Aggregate Demand Slopes Downwards
1. Wealth Effect
Changes in the price level, with other things remaining the same, change real wealth, thus changing the level of
spending.
First, when prices fall, the value of dollars in peoples wallets and bank accounts rises, so they are wealthier. As a result, they spend
more, thereby increasing the quantity of goods and services demanded. Wealth effect or real money balance effect that operates on
consumption. Because of this, a negative relationship between the price level and the quantity of goods and services purchased
emerges. Thus change in price results in a movement along the AD curve.
1. Interest Rate Effect
Higher prices requires more money for purchases. Higher interest rates discourages business investment and
reduces consumption expenditure on consumer durables.
Second, when prices increase, people need more money to make their purchases, so there is an increased demand for money,
which increases the interest rate. The higher interest rate discourages business investment and interest-sensitive consumption,
decrasing the quantity of goods and services demanded.
1. Foreign Purchases Effect
Higher prices causes consumers to spend less on domestically produced goods and services and more on imported
goods and services.
A decrease in the price level in Australia relative to trading partners make Australian goods less expensive relative to imports,
therefore exports go up, imports go down, and the net export component (X-M) of aggregate demand increases.
Further, since lower prices lead to a lower interest rate, some domestic investors will invest abroad, supplying dollars to the foreign
exchange market, thus causing the dollar to depreciate. The decline in the real exchange rate causes net exports to increase, which
increases the quantity of goods and services demanded.
All three of these effects imply that, all else being equal, there is an inverse relationship between the price level and the quantity of
goods and services demanded.
Slide 94
Shifts of AD
Changes in consumer spending
Expenditures by households on durable goods, non-durable consumer goods, and on services.
Australians become more concerned with saving for retirement and reduce current consumption. This will decrease
aggregate demand.
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.
The computer industry introduces a faster line of computers and many firms decide to invest in new computer
systems. This will lead to an increase in aggregate demand.
If firms become pessimistic about future business conditions, they may cut back on investment spending, shifting
aggregate demand to the left.
An increase in the supply of money lowers the interest rate in the short run. This leads to more investment spending,
which causes an increase in aggregate demand.
Changes in Government spending
Conduct of fiscal policy: changes in government purchases of goods and services and taxation.
The federal government decides to reduce purchases of new weapon systems. This will decrease aggregate
demand.
If governments decide to build more state highways, aggregate demand will shift to the right.
Changes in Net Foreign spending
(Export - Imports) = Net Exports
When Europe experiences a recession, it buys fewer Australian goods, which lowers net exports. Aggregate
demand will shift to the left.
If the exchange rate of the Australian dollar increases, Australian goods become more expensive to foreigners. Net
exports fall and aggregate demand shifts to the left.
Slide 95
C = C
O
+ cY
If income is considered a primary determinant of consumption then:
The consumption function relates the total planned consumption expenditure of all households to the factors that determine it.
C
O
: Autonomous/exogenous consumption. Captures the effect of the non-income factors. Autonomous Consumption
is consumption that is independent of income. In other words, when disposable income changes, autonomous consumption
does not change.
MPC: Marginal propensity to consume. Extra consumption associated with an extra dollar of disposable income. The
Marginal Propensity to Consume tells us how much of an additional dollar of disposable income will be spent.
For example, if the MPC=0.8, then 80 cents of the next dollar earned will be spent.
The MPC for an economy always lies between zero and one.
Any increase in income will be partially spent on additional consumption (therefore MPC > 0).
Whilst the remaining part will be saved (therefore MPC < 1).
Not all disposable income is spent.
MPS: Marginal propensity to save. Extra savings associated with an extra dollar of disposable income.
Because there are only two things an individual can do with his or her income in this simple model, once we know the
dependence of consumption on disposable income, we automatically know the dependence of saving on disposable income.
Based on the principal that Y
d
= C + S
Consumers have 2 choices of what to do with an additional amount of income: they can either spend or save.
Since all disposable income is either consumed or saved, then the portion of additional disposable income not consumed must
be saved.
The sum of MPC and MPS will always equal 1.
Y
S
MPS
Y
C
MPC
(
(
!
(
(
!
Consumption Spending
Slide 96
Consumption Spending
Wealth
Changes in consumption will be affected by changes in wealth.
What is the difference between income and wealth? Both income and consumption are flow variables. They are measured as
dollars per year. Wealth is a stock variable. It is measured simply by the total value of ones assets. Thus, when stock or
real estate prices rise in value and people expect this change to last for a long time, individuals who own these assets will
increase their level of consumption. They will do so because their overall wealth has grown, even if they do not
immediately receive any income from the increase in value.
Price level
If the price level falls, purchasing power increases and consumers respond by buying more goods and services.
Level of consumer debt
If they owe large amounts of money, people tend to refrain from consumption spending and devote more income to reducing
their debts.
Expected future incomes or prices
Expected future unemployment will cause households to save more. If the economy is beginning to enter a recession and
people are fearful of losing their jobs, they may reduce expenditures to save for a rainy day of possible unemployment.
The reverse is also true.
Availability and the cost of credit
When interest rates rise, the interest income from saving increases. in other words, higher interest rates induce people to put
their income in the bank or in a bond to earn the higher return. When saving goes up, consumption must go down.
therefore, a rise in the interest rates reduces consumption. Furthermore, higher interest rates discourages interest-
sensitive spending.
Age distribution of the population
Middle aged individuals are more likely to save - that is, they tend to save a greater proportion of their income - than are the
young and old.
Slide 97
Investment Spending
Anything that changes the expected net rate of profit changes investment spending.
Interest rate
Interest rates are a cost to borrowing and since most investment projects are funded through borrowing rather than using
retained earnings, an increase in interest rates results in a decrease in investment and vice versa.
Expectations
If businesses are optimistic about future profits, the investment increases.
One of the most important determinants of expectations of returns to investment is future sales. When sales are high today,
firms may expect future sales to be high and perhaps even increasing. With high and increasing sales, firms will want to have
more capital. That is, they will want to invest more. The fact that increases in output may lead to further increases in output as
a result of increased investment is referred to as the investment accelerator.
Acquisition, operating and maintenance costs
An increase in these costs will cause the expected net rate of profit to decrease, and investment is reduced.
Business Taxes
Businesses look to expected profits after tax when making investment decisions. A reduction in business taxes will cause the
expected net rate of profits to increase, and investment will increase.
Technological change/innovation
Stimulates investment. More effective machinery reduces production costs or increases quality, thus increasing the expected
net rate of profit, increasing investment.
Capital stock.
When the economy moves into a recession, there is sufficient established capital equipment to meet current demand. Excess
or sufficient productive capacity will tend to reduce investment.
Slide 98
Government Spending
Governments influence aggregate expenditure through the conduct of fiscal policy. Fiscal policy consists of changes in two
government functions. They are: the purchases of goods and services (G) and taxation (T).
Discretionary Fiscal Policy: deliberate changes in government spending and tax revenue used to help stabilise the
economy. It involves deliberate attempts to stimulate or constrain the level of economic activity, or to fine tune the
economy.
For Keynesians, the fundamental purpose of fiscal policy is to eliminate a recessionary or an inflationary gap.
Since the automatic forces that classical economists discussed were, in Keynesian eyes, unreliable or unendurably slow in
restoring full employment equilibrium, Keynesians saw discretionary government interventions as necessary.
Two types of basic fiscal policy need to be identified. They are: expansionary fiscal policy & contractionary fiscal policy.
When a recessionary gap exists, Keynesian economists advocate an expansionary fiscal policy. Expansionary fiscal
policy involves:
Increases in government spending
Lowering of taxes
A combination of the two
This fiscal policy therefore increases the government budget deficit or decreases the surplus.
Expansionary policies are policies that increase aggregate demand and GDP.
If demand-pull inflation exists due to an inflationary gap, Keynesian economists advocate a contractionary fiscal policy.
Contractionary fiscal policy involves:
Decreases in government spending
Increasing of taxes
A combination of the two
This type of fiscal policy thereby reduces the government budget deficit or increases the surplus.
Contractionary policies are those that decrease AD and GDP.
Slide 99
Net Foreign Spending
The term (X M) represents net exports, or the net demand for domestic goods & services that arises from foreign trade.
Net exports may be positive or negative.
Exports (X) are domestically produced goods and services that are sold overseas. Determinants of exports:
- Relative Price levels: higher domestic prices make it more difficult for domestic producers to compete with foreign
producers. Thus, higher domestic prices discourage exports to the rest of the world
- The Exchange Rate: the value of the dollar in terms of foreign currencies determines how expensive Australian goods
appear to foreign buyers. If the dollar has a high value, Australian goods will appear expensive & exports will be
discouraged. If the dollar has a low value, Australian goods will be cheaper to foreigners and exports will be
encouraged. If foreigners pay less in terms of their currency, there will be an increase in the demand for exports
- Foreign Income: the higher are foreign incomes, the higher are domestic exports
Imports (M) are foreign produced goods and services that are sold domestically. Determinants of imports:
- Relative Price levels: imports will be encouraged the lower foreign prices are compared to domestic prices
- The Exchange Rate: imports will be encouraged by a higher exchange value of the domestic currency as foreign goods
appear cheaper to Australian residents
- Tastes: if tastes move in favour of Australian produced goods, the demand for imports will decrease
Slide 100
Commanding Heights
The Battle of Ideas:
Indias Way
Chicago Against the Tide
The Spectre of Stagflation
A Mixed Economy Flounders
Slide 101
Revision 5
1. Define the concept of a business cycle, identifying the main phases. Illustrate your
answer with a diagram.
2. Explain in detail why the aggregate demand curve slopes downwards. Your
explanation should make clear why it is different from a demand curve applying to a
single product or service.
Problems and Applications:
Chapter 16: 1
Slide 102
REVIEW
Slide 103
Short-run Aggregate Supply
AS curve shows the amounts of goods and services
(RGDP) that will be produced at any given price level.
Aggregate supply is the relationship between the
overall price level and real GDP.
Price level
Real GDP
AS
Slide 104
Short-run Aggregate Supply Slope
There are three reasons the short-run aggregate-supply curve slopes upward.
Market Imperfections
Misperceptions theory: changes in the overall price level may mislead producers; resulting in changing
behaviour in their own markets.
The misperceptions theory suggests that changes in the overall price level can temporarily mislead suppliers. When the
price level falls below the level that was expected, suppliers think that the relative prices of their products have declined,
so they produce less. Suppliers may believe that the reward of supplying their product has fallen and thus they decrease
the quantity that they supply. Thus, a lower price level reduces the quantity of goods and services supplied.
Nominal Wages Rigidities
If the price level falls, real wages rise, production costs increase; firms hire less labour, thus producing a
smaller output.
Nominal wages are often slow to adjust in the economy due to long-run contracts between workers and firms. The sticky
wage theory suggests that because nominal wages are slow to adjust, a decline in the price level means real wages are
higher, raising the costs of production, so firms hire fewer workers and produce less, causing the quantity of goods and
services supplied to decline. Therefore, because wages do not adjust to the price level, a lower price level makes
employment and production less profitable, leading firms to lower the quantity of goods and services supplied.
Price Rigidities
Not all firms adjust prices immediately in response to changes in the price level; affecting their
competitiveness, sales and thus production.
The sticky-price theory suggests that the prices of some goods and services are slow to change. This is often blamed on
menu costs. If some economic event causes the overall price level to decline, the relative prices of goods whose prices
are sticky will rise and the quantity of those goods sold will decline, leading firms to cut back on production. If the price
level falls unexpectedly and a firm does not change the price of its product quickly, its relative price will rise and this will
lead to a loss in sales. Thus, when sales decline, firms will produce a lower quantity of goods and services. Because not
all prices adjust instantly to changing conditions, an unexpected fall in the price level leaves some firms with higher-than-
desired prices, which depress sales and cause firms to lower the quantity of goods and services supplied. Thus, a lower
price level reduces the quantity of goods and services supplied.
Note that each of these theories suggest that output deviates from its natural rate when the price level deviates from the
price level that people expected. Note also that the effects of the change in the price level will be temporary. Eventually
people will adjust their price level expectations and output will return to its natural level; thus, the aggregate-supply curve
will be vertical in the long run.
Slide 105
SRAS Shifts
Changes in the economys capital stock quantity/quality (productivity): Size of economys
labour force and capital stock. If this increases, maximum amount of output economy can produce has
increased. SRAS curve shifts to the right. Improvements in technology increases labour productivity;
that is each worker can produce more. The economys firms can obtain more output per unit of input.
This will reduce production costs per unit of output increasing supply.
Changes in government policy (minimum wage laws): Lower tax rates may give greater incentives
to work, save and invest. The economys capacity to produce and supply goods and services increases
as people respond to these incentives.
Expectations of the price level wage contract negotiations: When people expect the price level
to be high, they will tend to set nominal wages high. High wages tend to raise firms costs and, for any
given actual price level, reduce the quantity of goods and services that firms supply.
Changes in input prices: An increase in input prices will increase the per-unit costs of production.
Profits will fall, firms will only be willing to produce the same amount of output if receive higher product
price, or produce a smaller real GDP for a given price level. This will shift the SRAS curve
upwards/leftwards.
Slide 106
LR Aggregate Supply
In the long-run, an economys supply of goods and services depends on its supplies of
capital and labour and on available production technology.
The price level does not affect the long-run determinants and the AS is vertical in the long-
run.
Because the price level does not affect the determinants of output in the long run, the long-run
aggregate-supply curve is vertical at the natural rate of output.
Price level
LRAS
RGDP Y
f
Slide 107
LRAS Shifts
The position of the aggregate supply curve occurs at an output level sometimes referred to as potential output or full-
employment output. This is the level of output that the economy produces when unemployment is at its natural rate.
Anything that changes the natural rate of unemployment/potential level of output shifts the LRAS curve
Labour
Increases in immigration increase the number of workers available. The long-run aggregate-supply curve would
shift to the right.
Any change in the natural rate of unemployment will alter long-run aggregate supply as well.
Capital
An increase in the economys capital stock raises productivity and thus shifts long-run aggregate supply to the
right.
This would also be true if the increase occurred in human capital rather than physical capital.
Technology
The invention of the computer has allowed us to produce more goods and services from any given level of
resources. As a result, it has shifted the long-run aggregate supply curve to the right.
Opening up international trade has similar effects to inventing new production processes. Therefore, it also shifts
the long-run aggregate-supply curve to the right.
Resources
A discovery of a new mineral deposit increases long-run aggregate supply.
A change in weather patterns that makes farming more difficult shifts long-run aggregate supply to the left.
A change in the availability of imported resources can also affect long-run aggregate supply.
Government Policy (Incentives to work)
Tax rates
Welfare benefits
Slide 108
Macroeconomic Equilibrium
Price Level
RGDP
SRAS
AD
Y
f
P
0
Price Level
RGDP
SRAS
AD
Y
f
P
0
LRAS
LRAS
Y
0
Long-run equilibrium is found where the aggregate-demand curve intersects with the long run aggregate-supply curve.
Output is at its natural rate.
Also at this point, perceptions, wages and prices have all adjusted so that the short-run aggregate-supply curve intersects at
this point as well.
Slide 109
Application Question 7
What effects might each of the following have on aggregate demand and/or aggregate supply and why?
a) A widespread fear of depression among consumers.
AD shifts left; decrease in AD; Decrease in C & I as the population fear difficult financial situations to come.
b) A tax leading to a 2% increase in petrol prices.
AS shift left; decrease in AS; Increased costs to production; decreased AS
c) A decrease in interest rates.
AD shifts right; increase in AD; Higher consumption of interest-sensitive goods; higher business investment.
d) A decrease in government spending on higher education.
AD shifts left; decrease in AD; Decrease in component of AD.
e) The discovery of cheaper energy sources.
AS shifts right; increase in AS; Decrease in production costs.
Slide 110
Origins
The classical view of the economy: The AS curve is vertical at the full employment total output level Yf, reflecting the classical
view that prices, wages and the interest rate will always adjust quickly to any shift in aggregate demand to keep the economy
operating at Yf. Prices adjust to bring markets for goods and labour into equilibrium at full employment.
If AD declines, then the economys price level falls to p2. Why? When output exceeds AD, not all of the output produced by
the economy is bought. Classical economists assumed that profit maximising firms would decrease prices to induce people to
increase AD by enough to buy all of the output being produced. As the price level has falls the real wage increases. Excess
supply of labour (= unemployment). Workers will quickly accept lower nominal wages in order to keep their jobs at the
previous real wage. The economy continues to produce the full employment output that it did before the downwards
adjustment of all prices and wages. AD determines only the price level. It has no effect on real GDP. Self correcting state
of affairs.
Keynesian model: Anything that decreases (at a given price level) consumption, investment, government expenditures or net
exports can give rise to a leftward shift in the AD curve, bringing the economy to a level of output below the full employment
level. Nominal wages and prices are inflexible and dont fall in response to fall in AD. Therefore real wage is fixed. Lower
levels of output and employment. Because w/p fixed, both firms and workers have moved off their curves. Unemployment is a
goods or product market phenomenon (ie deficient effective demand), not a labour market phenomenon. No self correcting
mechanisms which will ensure a return to full employment.
Slide 111
Classical Theory Keynesian Theory
Market clears at the full-
employment level of output
Market clears at any level of
output
Supply determines output,
demand sets price
Supply-side model
Demand determines output
Demand-side model
Prices and wages are completely
flexible ensuring a return to full-
employment equilibrium
Prices and wages are rigid and
the economy will not
automatically return to full-
employment equilibrium
Government intervention not
required as the economy is self-
correcting
Government intervention is
required because of various
market failures
Unemployment exists due to the
maintenance of wage rates
above market clearing levels
Unemployment exists due to a
deficiency of aggregate demand
Slide 112
Application Question 8
Several European economies have had high rates of unemployment in the
past several years. For example, by the end of 1999, France had an
unemployment rate of 10.8%, Germany 10.2%, Italy 11.1%, Spain 15.4%.
While some economists have argued that these high unemployment rates
are largely reflect high natural rates of unemployment, others suggest that
insufficient aggregate demand may be responsible.
Illustrate how this debate over high unemployment in Europe reflects
disagreement on where European aggregate demand curve lies relative
to full-employment levels of output.
Argument One: High natural rates of unemployment.
Argument Two: deficient demand.
Slide 113
Commanding Heights
The Battle of Ideas:
Deregulation Takes Off
Thatcher at the Helm
Reagan Rides In
War in the South Atlantic
The Heights Go Up for Sale
The Battle Decided
Slide 114
Revision 6
Questions for Review: Problems and Applications:
Chapter 16: 3-6, Chapter 16: 2-4, 6-11
1. What does the long run aggregate supply curve represent?
2. Does the self-adjusting mechanism of classical economics guarantee zero
unemployment? If not, what type of unemployment is avoided in the Classical model,
but not in the Keynesian model?
Slide 115
REVIEW
Slide 116
PART 5:
Money Market
Chapters 12:245-250, 253-256 & 17:369-371
Slide 117
What is Money?
Money: the set of assets in an economy that people regularly use to buy goods and services from other people. Money
serves three functions in our economy.
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.
Firstly, money is used as a medium of exchange, ie money is used to buy and sell goods and services. It enables trade
between buyers and sellers who are in every other respect unmatched. The vast majority of consumers produce virtually
none of the goods and services they consume, and consume little or nothing of what they produce. Specialisation occurs
where workers or machines perform a narrow range of tasks and are therefore able to produce large amounts of particular
good or service. Specialisation enhances productivity by taking advantages of differences in abilities, encouraging learning
by doing (developing skills) and saving time in not having to shift continually from one task to another. Specialisation gives
rise to the need for trade, and trade creates markets. For specialisation to work, we need a means of exchanging
goods. Exchange can occur on the basis of bartering, ie I give you the surplus of what I produce in exchange for the surplus
of what you produce. But the problem with bartering is that it requires what we will call a coincidence of wants. Money
makes specialisation and trade much easier: I sell the good that I produce for money, and use the money to buy the goods I
want. Money eliminates the 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.
Secondly, money is used as a unit of account. Prices quoted in monetary units give a common standard for comparing the
relative market values of goods and resources. It is easier to conduct economic transactions when there is a standard unit in
which to do so. Society uses the monetary unit as a yardstick for measuring the relative worth of goods and resources. With
a money system, we dont have to state the price of each product for which it can be exchanged; we dont need to specify
the price of cows in terms of corn, crayons, cigars, and cherries.
2. Store of value
A form in which to store wealth due to its liquidity and convenience
Finally, money is used as a store of value. Money is the most liquid of all assets, ie it is readily available as a means of
exchange. It therefore provides a convenient form in which to store wealth. Unlike a harvest of fruit or corn etc., the money
you place in a safe or bank account will still be available to you months or years later when you wish to use it.
Slide 118
Demand for Money
Transactions Demand Asset Demand
Demand for money as a medium of exchange. Depends on
money (nominal) GDP.
Demand for money as a financial asset and store of wealth.
Transactions demand for money: People want money as a medium of exchange in order to purchase goods and services
conveniently. Households, for instance, must have enough money on hand to buy groceries and pay mortgage and utility bills
until the next pay check. Businesses need money to pay for labour, materials, power, and so on. Money demanded for all such
purposes comes under the heading of the transactions demand for money.
The basic determinant of the amount of money demanded for transaction purposes is the level of nominal GDP.
The larger the total money value of all goods and services exchanged in the economy, the larger will be the amount of money
needed to negotiate these transactions.
The larger the number of transactions, the larger the total money value of all goods and services exchanged in the economy,
the higher the transactions demand for money.
The transactions demand for money varies directly with nominal GDP.
Because the transactions demand for money depends on the level of nominal GDP and is independent of the interest rate, we
draw the transactions demand as a vertical line.
We assume that the amount of money demanded for transactions is unrelated to changes in the interest rate, ie, higher
interest rates will not reduce the amount of money demanded for transactions.
Asset demand for money: The second reason for holding money is based on moneys function as a store of value. This is the
demand for money as a financial asset and store of wealth.
Slide 119
Slope of the Demand for Money
Consider an individual who is faced with a choice between holding their wealth in the form of money or in the
form of other financial assets.
Advantage of holding money: liquidity
Advantage of holding financial assets (bonds): interest return
What determines the asset demand for money?
In comparison with holding bonds, the advantages of holding money are:
its liquidity: it is immediately useable in making purchases
the lack of risk: money is an attractive asset to be holding when the prices of goods/services and other financial
assets are expected to fall. When the price of a bond decreases, the bondholder will suffer a loss if the bond must
be sold before maturity. There is no such risk with holding money.
The disadvantage of holding money as an asset is that compared to holding bonds, it does not earn interest income.
Knowing this, the holder of the money has the problem of deciding how much of their financial assets to hold as bonds
and how much as money. The solution depends primarily on the rate of interest.
A household/business incurs an opportunity cost when holding money, i.e. interest income is forgone or sacrificed.
If a bond pays 10% interest then it costs $10 p.a. of forgone income to hold $100 as cash.
The effect of the interest rate
When the interest rate or opportunity cost of holding money as an asset is low, the public will choose to hold a large
amount of their wealth in the form of money. When the interest rate is high, it is costly to be liquid and the amount
of assets held in the form of money will be small.
When it is expensive to hold money as an asset, people will hold less of it; when money can be held cheaply,
people will hold more of it.
Thus the asset demand for money varies inversely with the rate of interest.
Slide 120
Slope of the Demand for Money
Another reason for the slope involves the inverse relationship between the price of bonds and the
interest rate. Lower bond prices are associated with higher interest rates.
Suppose a bond with no expiration date pays a fixed $50 annual interest payment and is selling
for its face value of $1000.
The interest yield on this bond is 5%.
Suppose the price of this bond falls to $667 because of an increase in the supply of bonds. The
$50 fixed annual interest payment will now yield 7% to whomever buys the bond:
5%
$1000
$50
!
7.5%
$667
$50
!
Slide 121
Asset Demand for Money
If the interest rate is currently above what people consider to be its
normal level, then it is expected that the interest rate is likely to fall.
Due to the inverse relationship between the price of the bond and the
interest rate, this carries with it the expectation that bond prices will
rise.
Why? Everyone will want to buy your bond because the return on
your bond would be higher than the return available elsewhere.
Potential buyers will bid up the price of your bond.
People will therefore prefer to hold more bonds and less money
because of the capital gains they will realise.
Slide 122
Money Supply
The quantity of money circulating in Australia is sometimes called the money supply.
Included in the measure of the money supply are currency, current deposits and other monetary assets.
Currency: the paper bills and coins in the hands of the public.
Current deposits: balances in bank accounts that depositors can access on demand by using a debit card or writing a cheque.
Credit cards are not a form of money; when a person uses a credit card, he or she is simply deferring payment for the item.
Because using a debit card is like writing a cheque, the account balances that lie behind debit cards are included in the measures
of money.
For the most part, the supply of money is determined by the RBA.
This implies that the quantity of money supplied is fixed (until the RBA decides to change it).
Thus, the supply of money will be vertical (perfectly inelastic).
Currency: Notes and Coins
M3: Currency; and Bank deposits
Broad Money: M3 and Non-Bank Financial Institution deposits
Ms determined exogenously
Slide 123
Money Market and Equilibrium
The intersection of money demand and money supply determines equilibrium price. The price in this case is the equilibrium
interest rate.
Although in the economy there is not one sole interest rate, for the purpose of modelling we will assume that this is so. We can
make this abstraction as we are concerned with the general movement of interest rate and not the actual value. Furthermore,
since all the various interest rates in the economy generally move in the same direction we can easily make our simplification
without affecting the robustness of our model.
What happens if the economy is not in equilibrium in the money market? Or how does the money market maintain equilibrium?
If the interest rate is below the equilibrium, then an excess demand for money, or a shortage of money, exists. That is, the
demand for money is greater than the supply of money.
In their attempts to obtain more money, people try to convert other assets, such as bonds, into money by selling them. As
everyone tries to sell their bonds, they flood the market with bonds. This pushes bond prices down, which raises the interest
rate. When the interest rate rises, the opportunity cost of holding money increases, and therefore the quantity of money
demanded declines, represented by movement up along demand curve. The process stops when bond prices have fallen far
enough to raise the interest rate to r0, eliminating the excess demand for money.
If the interest rate is above the equilibrium level, we are faced with an excess supply of money or a surplus of money.
At such a time, people want to hold less money and thus try to convert money holdings into other assets, such as bonds. This
causes an increase in the demand for bonds which results in bond prices increasing and the interest rate falling. As the interest
rate falls, the quantity of money demanded increases (represented by a movement down the demand curve). The process
continues until the excess supply of money is eliminated and the equilibrium interest rate is achieved.
Slide 124
Application Question 9
If there is an increase in nominal GDP illustrate and
explain how the money market re-establishes
equilibrium.
Increase in nominal GDP results in an increase in the
transactions demand for money, so Md shifts right. At the
existing interest rate there is an excess demand for money.
Participants convert bond holdings to money holdings.
Bond prices fall and interest rates start to rise until the
excess demand is eliminated.
Slide 125
Fractional Reserve Banking System
Banks Concerned With...
Providing safekeeping facilities.
Making a profit.
Modern banking systems work on a fractional reserve system. A problem occurs because, to be safe, the
bank would want to keep all deposits on reserve. By reserve, we mean in the form of cash, held in the
bank vaults. But to make a profit, the bank would want to lend out deposits at a higher rate of interest.
The solution was to recognise that only a small proportion of depositors are likely to want to convert
deposits to money on any given day, so the bank only needs to keep enough deposits on reserve to meet
reasonable day to day requirements. It can then lend the rest to make a profit.
A Fractional Reserve Banking System describes the practice of holding a fraction of money
deposited as reserves and lending out the rest.
Reserve Ratio: fraction of total deposits that the bank holds as reserves (R)
Slide 126
Banks and Money Creation
Assume the required reserve ratio is 10% and $1,000 is deposited into Bank A.
Bank A
Assets Liabilities
Reserves $100 Deposits $1,000
Loans $900
Bank B
Assets Liabilities
Reserves $90 Deposits $900
Loans $810
The amount by which the banks actual reserves exceed its required reserves is the banks excess reserves, ie the total
reserves less required reserves.
If the R for all banks is 10%, then the maximum amount Bank A can lend out is $900. This is therefore the banks excess
reserves. Bank A must put aside $100 to meet the required reserve requirement. A single bank cannot lend out more than the
amount of its excess reserves.
When the bank makes these loans, the money supply changes.
Before the bank made any loans, the money supply was equal to the $1000 worth of deposits.
Now, after the loans, deposits are still equal to $1000, but borrowers now also hold $900 worth of currency from the loans.
Therefore, when banks hold only a fraction of deposits in reserve, banks create money.
Note that, while new money has been created, so has debt.
The creation of the money does not stop at this point.
Borrowers usually borrow money to purchase something and then the money likely becomes redeposited elsewhere.
Suppose a person borrowed the $900 to purchase something and the funds then get redeposited in Bank B. Here is this banks
T-account (assuming that it also sets its reserve ratio to 10%):
If the $810 in loans becomes redeposited in another bank, this process will go on and on.
Each time the money is deposited and a bank loan is created, more money is created.
Slide 127
Banks and Money Creation
Bank C
Assets Liabilities
Reserves $81 Deposits $810
Loans $729
Bank D
Assets Liabilities
Reserves $72.90 Deposits $729
Loans $656.10
Slide 128
Money Multiplier
Original deposit = $1,000
Bank A = $900
Bank B = $810
Bank C = $729
Total money supply = $10,000
To Calculate: Initial Deposit x Money Multiplier = $10,000
Money Multiplier (m): the amount of money the banking system generates with each dollar of reserves.
R
1
m !
So at each round, banks are generating deposits through their lending activities.
As we know, deposits are a significant part of the money supply. Therefore, banks are creating money by generating deposits.
The amount of money created by this process is some multiple of the total amount of excess reserves.
There are two approaches to calculating the effect on the money supply, both yielding the same answer.
They are as follows:
Initial deposit($1,000) + the sum of all the induced deposits($9,000) = $10,000
Initial deposit x money multiplier = $10,000
The deposit/money multiplier we have been using (which is the reciprocal of the required reserve ratio) assumes that banks are
fully loaned up, ie there are no excess reserves anywhere in the financial system. However, deposit creation does not happen
automatically.
Slide 129
Complications
Deposit creation depends on the decisions of potential lenders and borrowers. Therefore we need to take
into account a number of issues that may prevent the money supply increasing by the maximum amount
previously determined.
The deposit multiplier calculated as the reciprocal of the RRR assumes that banks are fully loaned
up. However ...
Leakage into excess reserves: extra reserves may be kept by banks for liquidity purposes - If
banks wish to keep a certain amount of excess reserves for liquidity purposes, then a smaller
amount of reserves are passed on from one bank to the next, and therefore the full amount of deposit
expansion will be less. The deposit multiplier will be smaller.
Leakage due to cash withdrawal: not all loaned funds may be deposited into banks - A cheque
recipient may deposit only part of the amount of the cheque into the banking system and hold the rest
in cash. Thus a smaller amount of reserves end up being transferred from one bank to another, and
the full amount of the deposit expansion is reduced.
Variation in the willingness to lend and borrow: consumers may not wish to borrow and banks
may not wish to lend - At one extreme, if there is no lending and no borrowing, there will be no
deposit expansion at all. The extent of borrowing and lending is often influenced by the phase of the
business cycle.
Slide 130
Application Question 10
Imagine that the banking system receives additional deposits of $100 million and that
all the individual banks wish to retain their current liquidity ratio of 20 per cent.
a) How much will banks choose to lend out initially?
$80 million (retaining $20 million as reserves).
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?
Increase by a further $80 million.
c) How much of these latest deposits will be lent out by the banks?
$64 million (80% of $80 million).
d) By how much will the money supply eventually have risen, assuming that none of the
additional liquidity is held outside the banking sector?
$500 million (given a bank multiplier of 5 = 1/0.2)
e) What is the size of the bank multiplier?
5
Slide 131
Commanding Heights
The Agony of Reform:
Prologue
The Ghosts of Norilsk
Behind the Iron Faade
Indias Permit Raj
Slide 132
Revision 7
Problems and Applications:
Chapter 12: 3, 6-7, 9, 11
1. Describe the major functions of money within an economic system.
2. In what circumstances might an economy no longer view currency,
especially notes, as an acceptable medium of exchange?
Are the following true or false? Explain.
3. The price of bonds, and the interest rate received from holding bonds,
are positively related.
4. The total demand for money is a negative function of the rate of interest,
but at any interest rate of total demand for money is determined by the
level of income in the economy.
5. The smaller the required reserve ratio, the larger the deposit multiplier.
Slide 133
REVIEW
Slide 134
MODULE 3: INFLATION,
UNEMPLOYMENT AND
GOVERNMENT POLICY
Chapters 12:250-259, 13, 17:373-383, 18
Slide 135
PART 1:
Fiscal Policy
Chapter 17:375-383
Slide 136
Fiscal Policy
Governments influence AD through the conduct of fiscal
policy. Fiscal policy consists of changes in government
purchases of goods and services (G) and taxation (T).
Discretionary Fiscal Policy: deliberate changes in
government spending and tax revenue used to help
stabilise the economy.
Expansionary fiscal policy
involves:
Contractionary fiscal policy
involves:
Increases in government
spending
Decreases in government
spending
Lowering of taxes Increasing of taxes
A combination of the two A combination of the two
Slide 137
Multiplier Effect
economic activity > government spending
Changes in government expenditure give rise to even larger changes in total income and output.
One persons spending becomes another persons income.
Why does the change in government spending lead to even larger changes in total income and output.
Initial increase in expenditure generates an equal amount of income, ie wage, rent, interest and profit.
Income recipients will spend a portion of their additional income on consumption, leading to a further increase in real GDP and total
income, which in turn induces further increases in consumption. The initial spending triggers a chain reaction that causes the total
change in income and output to be a multiple of the initial spending.
Changes in aggregate expenditure give rise to even larger changes in total income and output.
Economists refer to this process as the multiplier effect.
The term multiplier is used to indicate the number by which the initial spending would be multiplied to obtain the total sum of the
increases in income and output.
If multiplier = 3, this means that for every $1 rise in expenditure, income and output will increase by $3
The multiplier principle builds on the point that one individuals expenditure becomes another individuals income.
What determines the size of the multiplier?
The smaller the fraction of any change in income that is saved, the greater the proportion of the additional income that will be used for
consumption, and hence the greater the multiplier.
The smaller the MPS, bigger the MPC, therefore, the bigger is the multiplier.
The concept of the multiplier is very important for policymaking. The most significant effect of the multiplier is that very small changes
in spending may be greatly magnified in resulting income and employment changes. In the Keynesian model, changes in expenditure,
give rise to the business cycle, and can create economic instability.
On the other hand, the multiplier suggests that a relatively small increase in government spending could stimulate output, enabling the
government to push the economy out of recession more easily.
Impact on the Economy:
Expenditure Multiplier:
G k Y
e
( v ! (
MPS MPC
k
e
1
or
1
1

!
Slide 138
Application Question 12
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.
Y=50+0.8Y+30
Y=80+0.8Y
0.2Y = 80
Y=$400bn
b) Calculate what will happen to equilibrium income and output if the
government undertakes expansionary policy of $15bn.
Y= G x 1/MPS
= 15 x 1/0.2
= 15 x 5
= $75bn
Slide 139
Multiplier Effectiveness
AD
Y Y
P
AD
2
Quantity
of Output
Price
Level
AD
Y Y
AD
2
Quantity
of Output
Price
Level
AS
AS
P
1
P
2
Fixed Price
Variable Price
Slide 140
Crowding Out Effect
A D
Y
2
Y
1
AD
2
Quantity
of Output
Price
Level
AS
P
1
P
2
Md
2
Quantity
of Output
Interest
Rate
Ms
r
1
r
2
Md
1
AD
3
P
3
A
A
B
C
D
G Y M
T
M
D
r C & I Y
An expansionary fiscal policy tends to increase interest rates and reduce investment spending,
thus weakening the expansionary impact of fiscal policy.
Crowding-out effect: the offset in aggregate demand that results when expansionary fiscal policy
raises the interest rate and thereby reduces investment spending.
Thus, even though the increase in government purchases shifts the aggregate demand curve
to the right, this fall in consumption and investment will pull aggregate demand back toward the
left. Thus, aggregate demand increases by less than the increase in government purchases.
Therefore, when the government increases its purchases by $X, the aggregate spending for goods
and services could rise by more or less than $X, depending on whether the multiplier effect or the
crowding-out effect is larger.
G Y Number of transactions undertaken Demand for money
Interest rate C & I Y
Slide 141
Taxation
Changes in taxes will stimulate or constrain the economy.
The taxation impact is smaller than the spending impact because taxes affect
aggregate expenditure indirectly.
Taxes work through consumption; affecting income, consumption and savings.
A decrease in taxes increases income. Not all income is spent some is saved
MPC & MPS.
As the MPC is less than 1, there will be an increase in consumption less than the full increase
in income (the decrease in tax).
Y = C + I + G + NX
Direct Impact
Slide 142
Taxation
Changes in taxes affect spending by the size of
the tax X MPC.
Tax Multiplier:
Impact on the economy:
T k Y
T
( v ! (
MPS
MPC
k
e
!
Slide 143
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
The amount by which aggregate expenditures fall short of level necessary to achieve the full-employment level of GDP is
called the recessionary gap.
Inflationary gap: Occurs when aggregate expenditures exceed the full employment level of output.
Some economists advocate active monetary and fiscal intervention is necessary to tame an inherently unstable private sector.
The Keynesian view holds that the private sector is inherently unstable and contains no mechanism to assure an automatic
return to full employment.
Fluctuations in aggregate expenditures lead to wide fluctuations in output and periodic episodes of inflation.
According to this view, the central government can and should play a direct and active role in trying to stabilise the economy.
Keynesians believe that it is necessary for the central government to use its tax and spending policies aggressively to
stimulate the economy during recession and slow the economy clown during inflationary times.
Slide 144
Successful Fiscal Policy
Real
Time
Slide 145
Case Against Intervention
Some economists believe that fiscal policy tools should only be used to help the economy achieve long-run goals, such as
low inflation and economic growth.
The primary argument against active policy is that these policy tools may affect the economy with a large time lag. By the time
these policies take effect, the condition of the economy may have changed
Lags: There are two kinds of time lags that can affect fiscal policy. They are inside lags and outside lags.
Inside lags: are lags in implementing policies. These can be due to such phenomena as:
Recognition: it takes time to identify and recognise a problem. In fact, it often takes several months before it is clear that
there is a serious problem with the economy. We often need to monitor at least three quarters before a pattern can
become visible
Administrative: furthermore, there can be a substantial administrative lag. Once a problem has been identified, eg a
downturn of the economy has been observed and the government wishes to prevent a serious recession from taking
place, then any changes in taxes or spending must be approved by both houses of parliament. In other words, money bills
are often difficult to pass especially if the government does not have a majority in the Upper House
Outside lags: are due to the time it takes for policies to work.
Operational: If taxes are cut, individuals and businesses must change their spending plans before any effects will be felt
in the economy. Remember, it takes time for the multipliers to work.
The major problem with all of these lags is that, by the time the macroeconomic effects of government action are fully
realised, the action may no longer be appropriate. So if, for instance, an expansionary fiscal policy was undertaken to prevent
a recession, its effects may not be felt for six to nine months, by which time the economy may have turned around and be
experiencing growth. If the expansionary impact then hits the economy, instability will result and inflation is likely to occur.
Expansionary bias: Other arguments used against fiscal policy include the view that an expansionary bias exists. Deficits
are seen to be politically attractive, and surpluses politically painful. Tax reductions and increases in government spending
are politically popular, and therefore expansionary fiscal policy is undertaken more often than contractionary policies.
Political business cycle: Finally, a political business cycle has been observed in our economy. Politicians might manipulate
fiscal policy to maximise voter support, even though their fiscal decision destabilises the economy. That is, an expansionary
fiscal policy is usually observed prior to an election, with contractionary policies being implemented once the government has
been elected.
Slide 146
Non-Discretionary Fiscal Policy
Weve mentioned that discretionary fiscal policy faces lag problems. However, there are a few fiscal programs that avoid
the lags involved in implementing policies. They are automatic in that they do not need new legislative action in order to
work. In reality, the government determines the tax rates, but not the level of tax revenues.
Tax revenues vary directly with the level of GDP
Personal income taxes have progressive rates and result in more than proportionate increases in tax
revenue as GDP and income increases.
Payroll tax payments increase as employment increases.
Unemployment benefits and other forms of social security payments by government decrease as income
and GDP increase.
Conversely, when an economy begins to dip into a recession, government payments for unemployment benefits will
increase as the number of unemployed workers increase. So without any change in policy, the unemployment
compensation program has the desired counter-cyclical effect on AD.
If a recessionary gap exists, fiscal policy will automatically become expansionary. Without actively doing anything, tax
receipts will fall (fewer people employed and paying taxes) and social security payments increase (more people
unemployed and therefore receiving payments from the government). Effectively, fiscal policy is expansionary in its
impact on the economy. The reverse occurs if we have an inflationary gap.
Slide 147
Automatic Stabilisers
Therefore these Automatic stabilisers (changes in fiscal policy that change aggregate demand when the economy goes
into a recession/inflation without policymakers having to take any deliberate action)
increase the government deficit (reduce surplus) during a recession
increase the government surplus (reduce the deficit) during recovery help to counter both inflation and
unemployment, without requiring government discretion.
Automatic stabilisers act automatically to reduce the severity of the business cycle.
While the automatic stabilisers in the Australian economy are not sufficiently strong to prevent recessions completely, they
do reduce the volatility of output and employment. Such automatic stabilisers increase AD during a recession and reduce
AD during an economic boom.
But what if the economy is producing a level of output well below the full employment level? A tax system in which tax
revenues varies directly with GDP may gives rise to a fiscal drag. The expansionary impact of an increase in autonomous
expenditure is blunted by the presence of built in stabilisers.
If government expenditure increases, the increases in income at each stage of the multiplier process are not all available
for spending. Some, for instance, is required to pay income taxes on the extra income earned. There is an additional
leakage from expenditure due to taxation. Because taxes limit the rise in consumption spending, AD does not increase by
as much at each stage of the multiplier process, so the multiplier process does not stimulate income by as much.
It may therefore be difficult to reduce unemployment, or achieve and sustain full employment.
Slide 148
Balanced Budgets
Most of us are aware of the concerns that are regularly voiced when the government has a
deficit or surplus on its books. So the next question we need to look at is whether the
government should pursue annually balanced budgets.
The answer is generally a resounding no. An annually balanced budget intensifies the
business cycle.
Suppose the economy encounters unemployment and falling income.
tax receipts will automatically decline and transfer payments increase
to balance its budget, governments will need to increase taxes, decrease spending
or do both. These policies are contractionary, each further dampens, rather than
stimulates AD.
Slide 149
Commanding Heights
The Agony of Reform:
Latin American Dependencia
Counterrevolution in Chile
Chicago Boys and Pinochet
Heresy in Russia
Bolivia at the Brink
Shock Therapy Applied
Slide 150
Revision 8
Questions for Review: Problems and Applications:
Chapter 17: 3-5 Chapter 17: 7-10, 12, 13
Are the following true or false? Explain.
1. The taxation multiplier must be smaller than the autonomous
expenditure multiplier.
2. Balanced budgets are neutral in their impact on the level of economic
activity.
3. If the government pursues an annually balanced budget, then according
to the Keynesian model this will reduce the severity of the business
cycle.
4. Time lags, and increases in the general price level may reduce the
effectiveness of discretionary fiscal policy.
Slide 151
REVIEW
Slide 152
PART 2:
Monetary Policy
Chapters 12:250-252, 256-259 & 17:373-374
Slide 153
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 154
Monetary Policy
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 Goal: Maintain the exchange rate within a particular
band.
Internal Balance Goal: Maintain the inflation rate within a particular
band.
Slide 155
External Balance
When there is an increase in the demand for the Dong; the market
exchange rate strengthens and the exchange rate moves to the lower
end of the established band, the Authority sells VND to banks.
The money base (supply) will increase, pushing down Vietnamese
dollar interest rates. Lower domestic interest rates relative to foreign
interest rates restrain capital inflows into the nation (encouraging
outflows).
Supply of foreign decreases, weakening the currency to restore
stability.
Slide 156
External Balance
r
M
s0
M
1
M
s1
M
D
M
0
r
0
r
1
M
p
Y
1
AD
0
Y
0
p
0
p
1
RGDP
AS
AD
1
Capital Outflows Increase D
FX Increase IM (D
FX
) & Decrease EX
(S
FX
)
D
FX0
Quantity
Exchange rate
S
FX1
e
0
S
FX0
D
FX1
The increase in the money supply affects both the product market and the foreign exchange market.
Foreign exchange market: The decrease in domestic interest rates relative to foreign interest rates results in capital outflows
as financial market investors move funds overseas to take advantage of higher interest returns elsewhere; thus increased
demand for foreign exchange.
Product market: Falling interest rates encourages spending in the product market. Increase both investment spending and
interest-sensitive consumer spending, shifting AD right. This puts pressure on the domestic price level. As domestic prices rise
relative to foreign prices, domestic goods and services become less competitive and therefore imports increase and exports
decrease, thus increased demand for FX and decreased supply of FX.
Both impacts lead to an increase in the exchange rate, thus a currency depreciation ensuring the exchange rate remains
within the desired band.
Slide 157
External Balance
When there is a decrease in the demand for the Dong and the currency
weakens; the exchange rate moves to the upper end of the established
band, the Authority purchases VND from banks.
The money base (supply) will decrease, pushing up Vietnamese dollar
interest rates. Higher domestic interest rates relative to foreign interest
rates induce capital inflows into the nation.
Supply of foreign currency increases, strengthening the currency and
restoring stability.
Slide 158
External Balance
r
M
s1
M
0
M
s0
M
D
M
1
r
1
r
0
M
p
Y
0
AD
1
Y
1
p
1
p
0
RGDP
AS
AD
0
Capital Inflows Increase S
FX Decrease IM (D
FX
) & Increase EX (S
FX
)
D
FX1
Quantity
Exchange rate
S
FX0
e
0
S
FX1
D
FX0
The decrease in the money supply affects both the product market and the foreign exchange market.
Foreign exchange market: The increase in domestic interest rates relative to foreign interest rates results in capital inflows
as financial market investors move funds to Singapore to take advantage of the higher interest returns available; thus
increased supply of foreign exchange.
Product market: Increasing interest rates discourages spending in the product market. Decrease both investment spending
and interest-sensitive consumer spending, shifting AD left. This results in a falling domestic price level. As domestic prices fall
relative to foreign prices, domestic goods and services become more competitive and therefore imports decrease and exports
increase, thus decreased demand for FX and increased supply of FX.
Both impacts lead to a decrease in the exchange rate, thus a currency appreciation ensuring the exchange rate remains within
the desired band.
Slide 159
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.
Slide 160
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.
Slide 161
Internal Balance Contractionary Policy
r
M
s1
M
0
M
s0
M
D
M
1
r
1
r
0
M
p
Y
0
AD
1
Y
1
p
1
p
0
RGDP
AS
AD
0
Inflows S
FX
IM (D
FX
) & EX (S
FX
)
D
FX1
Quantity
Exchange rate
S
AUD0
e
0
S
AUD1
D
FX0
Slide 162
Internal Balance Expansionary Policy
r
M
s0
M
1
M
s1
M
D
M
0
r
0
r
1
M
p
Y
1
AD
0
Y
0
p
0
p
1
RGDP
AS
AD
1
Outflows D
FX
IM (D
FX
) & EX (S
FX
)
D
FX0
Quantity
Exchange rate
S
AUD1
e
0
S
AUD0
D
FX1
Slide 163
Monetary Policy Effectiveness
Many economists argue that when the economy is in a deep recession, monetary policy is relatively ineffective. They believe
that the demand curve for money is relatively flat. As a result, monetary authorities have a hard time driving the interest rate
down further.
Increasing the money supply has only a small effect on interest rates. Exacerbating the problem facing monetary authorities
is that in deep recessions, prices actually fall.
What investors actually care about are real interest rates, ie the difference between the nominal interest rates and the rate of
inflation. If the nominal interest rate falls, but the rate of inflation falls more, then real interest rates rise.
Moreover, given investors pessimism about economic prospects, it takes a large fall in interest rates to induce firms to invest
much more.
Since by definition, in a recession, there is considerable excess capacity, the marginal return from extra investment is close to
zero. New machines simply add to excess capacity, not to profits.
Hence as the economy goes into recession, the investment spending becomes relatively unresponsive to changes in interest
rates.
There is a similar problem for consumption spending. Households are far more cautious regarding how they spend their
money and lower interest rates may not be enough to encourage them to increase spending.
Therefore, monetary policy is largely ineffective in deep recessions.
Responsiveness of capital flows, consumption and investment changes to changes in interest rates.
Phase of the business cycle
Private decisions of lenders and borrowers.
Size of the multiplier
Another determinant of the effectiveness of monetary policy includes the size of the autonomous expenditure multiplier.
The greater the autonomous expenditure multiplier, the more effective is monetary policy. This is related to the greater the
change in RGDP from a given change in investment demand due to a change in interest rates.
Slide 164
Application Question 11
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?
Tight money. Sell CGS to the banks to contract the MS and increase
interest rates, thereby discouraging I and interest-sensitive
consumption to decrease economic activity.
Slide 165
Commanding Heights
The Agony of Reform:
The Miracle Year
Poland in Transition
Gorbachev Tries China
Soviet Free Fall
India Escapes Collapse
Russia Tries to Privatise
Property Becomes Theft
Closing the Deal
A Decade of Radical Change
Slide 166
Revision 9
Questions for Review: Problems and Applications:
Chapter 12: 4-5, 7 Chapter 12: 8, 10
Chapter 17: 1, 4-5
Are the following true or false? Explain.
1. If the RBA increases the money supply, subsequent portfolio adjustment
will reduce interest rates, which in turn will increase investment
expenditure.
2. The buying and selling of government securities in the open market by
the Central Bank is a major cause of changes in the money supply.
3. The monetary authorities can influence the money supply or the rate of
interest but they cannot set the two independently.
Slide 167
REVIEW
Slide 168
PART 3:
Inflation and Unemployment
Chapters 13 & 18
Slide 169
Price Level
Price of goods and services.
Measures the value of money in terms of goods and services.
When the price level rises, people have to pay more for the goods and services that they
purchase.
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 the value
of money decreases in terms of goods and services purchased.
There are many determinants of the demand for money.
One variable that is very important in determining the demand for money is the price level.
The higher prices are, the more money that is needed to perform transactions.
Thus, a higher price level leads to a higher quantity of money demanded.
Slide 170
Quantity Theory of Money
Quantity theory of money illustrates the relationship between money and nominal GDP. Money exchanged in
purchase of goods and services, by definition, must equal the dollar value of goods and services purchased.
MV = PY, where
M is the supply of money
V is the velocity of circulation. It indicates how fast a given stock of money circulates to finance
transactions. the rate at which money changes hands
P is the price level.
Y is real GDP
Hence PY = nominal or money GDP
We make an assumption that the velocity of circulation is constant over time. Velocity does, in reality, change, eg the
introduction of ATMs increases the rate at which money circulates in the economy, which implies greater velocity.
However, the assumption of constant velocity provides a good approximation in many situations.
Transmission mechanism: The relationship between the money market and the market for goods and services is known
as the transmission mechanism. There are a number of ways in which monetary changes are transmitted to aggregate
demand, and hence GDP and/or prices.
The quantity equation shows that an increase in the quantity of money must be reflected in one of the other three
variables.
Specifically, the price level must rise, output must rise, or velocity must fall.
Slide 171
Quantity Theory of Money
Quantity theory of money asserts that the quantity of money available determines the price level and that the growth
rate and thus the quantity of money available determines the inflation rate.
Ms P INF
The immediate effect of an increase in the money supply is to create an excess supply of money. People try to get rid of
this excess supply in a variety of ways. Ms ESM at prevailing interest rates.
People can:
1. They may buy goods and services with the funds. They may use these excess funds to make loans to others.
These loans are then likely used to buy goods and services. In either case, the increase in the money supply leads
to an increase in the demand for goods and services. Because the supply of goods and services has not changed,
the result of an increase in the demand for goods and services will be higher prices. Consume more; increased
demand for goods and services P.
2. Increased demand for bonds, price of bonds increase and bond yields and interest rates fall. Falling
interest rates increase demand for goods and services P.
If Y is fixed at the full employment level, and V is constant, ie not affected by a change in Ms, then an increase in Ms will
increase P, ie an increase in the Ms will increase the price level. If prices are perfectly flexible, an increase in Ms will lead
to an equi-proportionate increase in the price level. Higher rates of money growth would thus lead to higher inflation.
Y P V M !
Slide 172
Quantity Theory of Money
The quantity of money available in the economy determines the value of money and growth in the quantity of money
is the primary cause of inflation.
Money Neutrality: changes in the money supply affect nominal, not real variables.
If the money supply doubles; the price level doubles; nominal wages double.
Real variables remain unchanged production; employment; real wages; real interest rates.
If the money supply increases, the economys ability to produce goods and services doesnt change.
The inflation tax
Some countries use money creation to pay for spending instead of using tax revenue.
Inflation tax: the revenue the government raises by creating money.
Hyperinflation is generally defined as inflation that exceeds 50% per month.
The inflation tax is a tax on everyone who holds money.
Point out that an inflation tax is a more subtle form of taxation than the standard forms
of taxation (income tax, sales tax etc.).
Almost all hyperinflations follow the same pattern.
The government has a high level of spending and inadequate tax revenue to pay for its spending.
The governments ability to borrow funds is limited.
As a result, it turns to printing money to pay for its spending.
The large increases in the money supply lead to large amounts of inflation.
The hyperinflation ends when the government cuts its spending eliminating the need to create new money.
Slide 173
What about the Short-Run?
If output is at less than full employment in the short run, then
The quantity of money determines the dollar value of the economys output.
Implication is that a change in money supply transmits directly to level of economic activity, or, at full
employment, to level of prices.
If output is at less than full employment in the short run, and we are in the upward sloping, intermediate range of the
SRAS curve, then Y is no longer fixed.
An increase in the money supply must lead to an increase in nominal GDP. A change in the quantity of money must
cause a proportional change in nominal GDP. That is, the quantity of money determines the dollar value of the economys
output.
What is the rationale behind this?
When there is an increase in the money supply, people end up holding more of their wealth in the form of money than they
really want to. It is assumed that people react by spending these excess cash balances in an effort to get rid of them.
This increases aggregate demand for goods and services, and sets in motion the traditional Keynesian multiplier process.
However, this increase in nominal GDP is distributed among the price level and output. The problem is that, although we
know that nominal GDP will increase, we dont know the distribution between the price level and output. What proportion
of the increase in the money supply will result in an increase in output and what proportion will go towards the increase in
the price level?
Y and P s
PY
o o o
!
Slide 174
Costs of Inflation
Menu costs: the costs of changing prices. Menu costs occur when people spend resources changing their posted prices. During period of inflation,
firms must change their prices more often.
Misallocation of resources: Relative-price variability occurs because as general prices rise, a fixed dollar price translates into a declining relative
price, so the relative prices of goods are constantly changing, causing a misallocation of resources. When inflation reaches a very high level,
economies tend to allocate considerable resources to avoiding the costs of inflation and to take advantage of the discrepancies in prices charged
by different sellers. Because price increases are never perfectly co-ordinated across firms, increases in the rate of inflation lead to a greater
variability of relative prices, and this tends to distort how society allocates it resources. During periods of inflation, people are more interested in
investing their savings in assets designed to protect them against inflation, such as real estate, rather than in productive investments that result in
the growth and efficiency of the economy.
Tax distortions: Law-makers rarely take into account inflation when they write tax laws. The nominal values of interest income and capital gains
are taxed (not the real values). The combination of inflation and taxation causes distortions in incentives because people are taxed on their
nominal capital gains and interest income instead of their real income from these sources. Inflation tends to raise the tax burden on income
earned from savings. This, in turn, might discourage savings. Economists call the interest rate that the bank pays the nominal interest rate. It is
the nominal rate that makes headlines in newspapers and influences voters; the increase in your purchasing power due to the interest paid is
known as the real interest rate. The real rate of interest is the difference between the nominal interest rate and the rate of inflation. Income tax
treats the nominal interest earned on savings as income, even though part of the nominal interest rate merely compensates for inflation. Because
the after tax real interest rate provides the incentive to save, saving is much less attractive in an economy with inflation than in an economy with
stable prices.
Confusion, inconvenience and risk: Inflation causes confusion and inconvenience because it reduces moneys ability to function as a unit of
account. If one is not sure whether prices are going to increase or remain the same, any contract that has a time dimension becomes hazardous
because of uncertainty.
Falling purchasing power if nominal wages do not keep pace with changes in the price level. Annual wage increases are not a reward for
effort but an attempt to keep pace with inflation. Most individuals believe that the major problem caused by inflation is that inflation lowers the
purchasing power of a persons income. However, as prices rise, so do incomes. Thus, inflation does not in itself reduce the purchasing power of
incomes.
Unexpected inflation an arbitrary redistribution of wealth: Unexpected inflation redistributes wealth between borrowers and lenders. Sam
Student takes out $20,000 in loans at 7% interest (nominal). In 10 years, the loan will come due. After his debt has compounded for 10 years at
7%, Sam will owe the bank $40,000. The real value of this debt will depend on inflation. If the economy has a hyperinflation, wages and prices will
rise so much that Sam would be able to pay the $40,000 out of pocket change. If the economy has deflation, Sam will find the $40,000 a greater
burden than he imagined. Because inflation is often hard to predict, it imposes risk on both Sam and the bank that the real value of the debt will
differ from that expected when the loan is made.
Slide 175
Application Question 13
The Former Governor of the Reserve Bank of India
warned of the potential for inflation, as money
supply growth exceeded the expected growth in the
real economy.
Using the quantity theory of money, explain the
economic thinking behind this concern.
MV = PY
Money supply is increasing faster than Y (output) thus
prices are taking up the slack and we are facing rising
inflation.
Slide 176
Commanding Heights
The New Rules of the Game:
Prologue
NAFTA: The First Test
Crossing Borders
Emerging Market Hunters
Averting a Meltdown
The Global Village
Global Contagion Begins
Contagion Engulfs Asia
Russia Defaults
Slide 177
Revision 10
Questions for Review: Problems and Applications:
Chapter 13: 1, 3, 6-7 Chapter 13: 1, 3, 5-9
Is the following true or false? Explain.
Regardless of whether real output is fixed at the full employment level or
not, the quantity theory of money states than an increase in the money
supply will lead to an equi-proportionate increase in the price level.
Slide 178
REVIEW
Slide 179
Short-Run Phillips Curve
AD P & Y thus INF & UNE
What impact will a shift towards a more expansionary macroeconomic policy have on output and employment? Can expansionary
policies reduce the unemployment rate? If so, how long can the lower unemployment rate be maintained, and at what cost? To look at
the impact of expansionary macroeconomic policy, we look at the result of an increase in AD curve.
As AD increases, real GDP increases (unemployment decreases), the price level increases, and the economy moves closer to full
employment. If AD persistently increases in this way, we have demand-pull inflation.
This suggests that high rates of inflation should be accompanied by low rates of unemployment.
Empirical work during the 1950s and 1960s appeared to verify the existence of this inverse relationship, suggesting a trade-off between
inflation and unemployment. The Phillips curve (PC) illustrates this alleged inverse relationship between the unemployment rate and the
rate of inflation. It is named after the New Zealand economist A. W. Phillips who, in 1958, put forward empirical evidence of such a
trade-off for the British economy over the period 1862-1957. American economists Paul Samuelson and Robert Solow showed a similar
relationship between inflation and unemployment for the United States two years later. The PC relationship shows that when we:
decrease the inflation rate we increase unemployment rate
decrease the unemployment rate we increase inflation rate.
The belief was that low unemployment is related to high aggregate demand and high aggregate demand puts upward pressure on
prices. Likewise, high unemployment is related to low aggregate demand and low aggregate demand pulls price levels down.
Phillips curve offered policymakers a menu of possible economic outcomes. Policymakers could use monetary and fiscal policy to
choose any point on the curve.
Given that monetary and fiscal policy can both shift the aggregate-demand curve, these types of policies can move the economy along
the Phillips curve.
AD
0
RGDP
Price Level
SRAS
P
0
P
1
Y
0
Y
1
AD
1
UNE
INF
SRPC
INF
0
INF
1
UNE
1
UNE
0
Slide 180
Long-Run Phillips Curve
AD
0
RGDP
Price Level
P
0
P
1
LRAS
Y
f
AD
1
A
B
UNE
INF
INF
0
INF
1
LRPC
N
f
A
B
AD P thus INF
Output remains at the potential/full-employment level with unemployment at the natural rate of unemployment.
In 1968, economist Milton Friedman argued that monetary policy is only able to choose a combination of unemployment and
inflation for a short period of time. At the same time, economist Edmund Phelps wrote a paper suggesting the same thing.
This is true because, in the long run, monetary growth has no real effects. This means that it cannot affect the factors that
determine the economys unemployment rate.
Thus, in the long run, we would not expect there to be a relationship between unemployment and inflation. This must mean
that, in the long run, the Phillips curve is vertical.
The vertical Phillips curve occurs because, in the long run, the aggregate supply curve is vertical as well. Thus, increases in
aggregate demand lead only to changes in the price level and have no effect on the economys level of output. Thus, in the long
run, unemployment will not change when aggregate demand changes, but inflation will.
The long-run aggregate-supply curve occurs at the economys natural rate of output; thus, the long-run Phillips curve occurs at
the natural rate of unemployment.
Slide 181
Expectations and the Phillips Curves
Now well take a look at a theory that suggests that there is no long run trade-off between inflation and unemployment. This is known as the natural rate hypothesis (adaptive exp).
Assume that the initial equilibrium is at P1, Yf, and AD increases via expansionary monetary or fiscal policy. The price level cannot remain fixed if firms are to be induced to
produce more, because firms will insist on an increase in the price level to cover the increasing marginal cost of production. As a result of the increase in AD, the price level has
increased but with no immediate change in nominal wages. Output and employment grow.
For a time, the economy will be experiencing both rising prices and output beyond full employment. This high level of output will not last long, however. Workers will realise that
their real wages have fallen. To achieve a return of their real wage to the original level, workers will demand an increase in their nominal wage. Firms, anxious to maintain their
output levels, meet those demands: if firms do not raise wages, they either lose workers, or have to hire less productive ones. Nominal wages will rise relative to product prices.
This shifts the SRAS to the left until it intersects AD2 on the vertical LRAS curve.
As the previous relationship between resource prices and product prices is restored, output will fall back to the Yf.
The economy is back producing its potential Yf output, and hence we are at the natural rate of unemployment, but at a higher price level because of two rounds of price increases,
the first caused by increased AD and the second caused by decreased AS as nominal wages increase.
Conclusion: In sum, expansionary monetary or fiscal policy aimed at reducing the unemployment rate below the natural rate will result in an ever-increasing, or accelerating, rates
of inflation. The long-run Phillips curve is vertical at the natural rate of unemployment, and hence there is no long-run trade-off between inflation and unemployment.
Expectations and the short-run Phillips curve
The expected level of inflation is an important factor in understanding the difference between the long-run and the short-run Phillips curves. Expected inflation measures how much
people expect the overall price level to change. The expected rate of inflation is one variable which determines the position of the short-run aggregate-supply curve. This is true
because the expected price level affects the perceptions of relative prices that people form and the wages and prices that they set.
In the short-run, peoples expectations are somewhat fixed. Thus, when the RBA increases the money supply, aggregate demand increases along the upward sloping short-run
aggregate-supply curve. Output grows (unemployment falls) and the price level rises (inflation increases).
Eventually, however, people will respond by changing their expectations of the price level.
Specifically, they will begin expecting a higher rate of inflation.
Suppose the economy is at point A and policymakers wish to lower the unemployment rate. Expansionary monetary policy or fiscal policy is used to shift aggregate demand to the
right. The economy moves to point B, with a lower unemployment rate and a higher rate of inflation.
Over time, people get used to this new level of inflation and raise their expectations of inflation. This leads to an upward shift of the short-run Phillips curve. The economy ends up
at point C, with a higher inflation rate than at point A, but the same level of unemployment.
AD
0
RGDP
Price Level
SRAS
1
P
1
P
2
LRAS
Y
f
Y
AD
1
SRAS
0
A
B
C
P
0
UNE
INF
INF
0
INF
2
LRPC
N
f
A
C
B INF
1
UNE
PC
0
PC
1
Rational expectations: no short-run or long-run trade-off.
Any change in the price level immediately translates to
changes in nominal wages. Simultaneous shifts in AD and
AS thus the economy moves directly from point A to Point
C with no intermediate trade-off
Slide 182
Supply Shocks and Policy Choices
Let us see what happens when we have an AS shock and what the choices facing the
government are.
Supply shock: an event that directly alters firms costs and prices, shifting the economys
aggregate-supply curve and thus the Phillips curve.
The decrease in equilibrium output and the increase in the price level left the economy
with stagflation.
This less favourable trade-off between unemployment and inflation can be shown by a shift
of the short-run Phillips curve. The shift may be permanent or temporary, depending on how
people adjust their expectations of inflation.
Following an AS shock, the new equilibrium is Pt B. The actual output is less than the LR
potential output. This means that output will be below the natural rate. The price level has
also increased, and we have a simultaneous increase in the price level and unemployment.
Policy-makers controlling AD face a difficult choice between two options:
The first option is to hold AD constant. Over time, labour and other resource costs will
decrease, shifting the SRAS curve back. Eventually, lower resource prices will restore the
Yf output rate at the lower price level. This self correction process will take time and the cost
of this process will be a painful recession
The second option involves the government increasing AD to prevent a reduction in output in
response to an adverse supply shock. In this option, the economy moves from point B to C.
The cost of this policy is a permanently higher level of prices.
AD
RGDP
Price Level
SRAS
1
P
0
P
1
Y
0
Y
1
SRAS
0
A
B
UNE
INF
SRPC
0
INF
0
INF
1
UNE
1
UNE
0
SRPC
1
Slide 183
Fighting Inflation Reducing AD
The sacrifice ratio
To reduce the inflation rate, the RBA must follow contractionary monetary policy.
When the RBA slows the rate of growth of the money supply, aggregate demand falls.
This reduces the level of output in the economy, increasing unemployment.
The economy moves from point A along the short-run Phillips curve to point B, which
has a lower inflation rate but a higher unemployment rate.
Over time, people begin to adjust their inflation expectations downward and the shortrun
Phillips curve shifts. The economy moves from point B to point C, where inflation is lower
and the unemployment rate is back to its natural rate.
Therefore, to reduce inflation, the economy must suffer through a period of high
unemployment and low output.
Sacrifice ratio: the number of percentage points of annual output lost in the process of
reducing inflation by 1 percentage point.
A typical estimate of the sacrifice ratio is 5. This implies that for each percentage point
inflation is decreased, output falls by 5%.
Rational expectations: the theory according to which people optimally use all the
information they have, including information about government policies, when forecasting
the future.
Proponents of rational expectations believe that when government policies change,
people alter their expectations about inflation.
Therefore, if the government makes a credible commitment to a policy of low inflation,
people would be rational enough to lower their expectations of inflation immediately. This
implies that the short-run Phillips curve would shift quickly without any extended period of
high unemployment.
AD
1
RGDP
Price Level
SRAS
0
P
1
P
0
LRAS
Y
f
Y
AD
0
SRAS
1
C
B
A
P
2
UNE
INF
INF
2
INF
0
LRPC
N
f
C
A
B INF
1
UNE
PC
0
PC
1
Slide 184
Commanding Heights
The New Rules of the Game:
The Battle Joined
The Global Divide
Capitalism Redefined
The Bottom End of Globalism
The Battle Resumed
9/11
Slide 185
Revision 11
Questions for Review: Problems and Applications:
Chapter 18: 1-5 Chapter 18: 1-10
Are the following true or false? Explain.
1. The simple Phillips curve analysis demonstrates conclusively that
governments do not have a menu of inflation and unemployment
outcomes from which to choose.
2. The long run Phillips curve shows clearly that demand management
policies can buy a reduction in the rate of unemployment by paying the
price of a higher rate of inflation.