ECONOMICS, MICROECONOMICS and MACROECONOMICS

Fifth Ed.ition with MyEconlab

Douglas McTaggart, Christopher Findlay and Michael Parkin
Definition of Economics
All economic questions arise

because we

want more than we can get.

2 Scarcity is our inability to satisfy a1l our
wants. Faced with scarcity, we must make
choices.
3 Economics studies the choices that we make

to cope with scarcity and the institutions that

influence and reconcile our choices.
4 Economics divides into
a Microeconomics
the study of the
choices that individuals
and businesses
make, the way these choices interact, and
the influence that governments exert on
them.
b Macroeconomics
the study of the
performance of the -national economy and
the global economy.

Economics: A Social Science

Efficient Use of Resources

1 Economists distinguish between

a Positive statements that can be tested

Allocative efficiency is achieved when

1 We are producing on the PPF, and
2 We cannot produce more of any good
without giving up some of another good thal
we value more highly.

b Normative statements based on values

that can't be tested
2 Economic science has three steps:
a Observation and measurement

b Building models

c Testing models

Production Possibilities Frontier

1 The production possibilities frontier (PPF)
is the boundary between attainable and unattainable combinations of goods and services
.9

Er5

Two Big Economic Questions

Two big questions summarise the scope of
economics:
1 How do the choices that people make end
up determining what, how, wien, where, and
for whom goods and services get produced?
2 When do choices made in the pursuit of
self-interest also promote the social interest?

5
Pizzos lmil lons)

v
.!

Factors of Production
Goods and services are produced with factors
of production that earn incomes.
1 Land eams rent.
2 Labour and human capital earn wages.
3 Capital earns interest.
4 Entrepreneurship earns profit.

Economic Choices
1 Choices that you think are best for you are
choices made in your self-interest.
2 Choices that are the best for society as a
whole are choices made in the social interest.

o
!l

45
P zzos (m llions)

At points on the PPl, production is efficient

and uses all the available.resuurces.
3 At points inside the PPF, production is
2

inefficient and some resources are either

unused or misallocated.
4 A movement along the PPF shows a tradeof{.

oppgtlgltly

.5

tqtt

t.5

25

3.5

The outward-bowed PPF iliustrates increasing

(b)

opportunity cost.

5
Plzzos (m lions)

Morginol benefir equols morgincl <ost

Gains from Trade

The Economic Way ofThinkins

1 A person has a comparatizte adztantage rn an

A choice is a tradeoff and every tradeoff has

an opportunity cost
the best alternative we
give up to get something.
2 The choices we make bring changes ln
what, how, when, where, and for whom
goods and services get produced.
3 Opportunity cost is the highest-valued
alternative that we give up to get something.
4 We make choices at the margin by
comparing marginal benefit and marginal
1

activity if he/she can perform the activity at a

lower opportunity cost than anyone else.
2 Differences

in opportunity cost bdng

comparative advantage and gains from

specialisation and trade.
A person has an absolute advantage if he/she
can produce more goods with a given amount
of resources than another person can.
4 The gains from trade arise from comparative
advantage, not from absolute advantage, so
people can gain from trade in the presence of
absolute advantage.
3

cost.
5 Choices are influenced by incentives.

45
Pizzos {mil lon$

Supply

arises in which the quantity demanded again

equals the quantity supplied.

Supply is the relationship between the

quantity supplied of a good and the price of
the good, all other influences on selling plans
remaining the same.
2 Other things remaining the same, the higher
the price of a good, the greater is the quanlity
supplied.
3 A change in the price of a good brings a
movement along its supply curve and a
change in the quantity supplied.
4 Other influences on selling plans are
a Prices of resources used to produce the
1

64A
!

25 30

{:oo
!
1250
3
d200

good

40

Smooth es {per hourl

b Prices of substitutes in production and

complements in production
c Expected future price
d Number of suppliers

Circular Flows

Demond for CD-Rs

(cD bumer $300)

e Technology

:""*,::1.

5 A change

in any of these influences on

selling plans changes supply
shifts the
suppiy curve.

"

i...,*";iili!JL.".,,,"

t0

t2

14

Olontity {millions of discs per week)

An increase in supply brings a fall in price

and an increase in quantity.
a_When supply increases, the supply curve
shifts rightward.
b At the original price, there is a surplus.
c, The surplus brings a fall in price.
d The fall in price brings an increase in the
quantity demanded.
e The price fails until a new equilibrium
arises in which the quantity demanded again
equals the quantity supplied.
2

.3 3.oo

Demand

-3

1 Demand is the

reiationship between the

quantity. demanded of a good and the price of
the good, all other influences on buying plans
remaining the same.
2 Other things remaining the same, the higher
the price of a good, the smaller is the

quaitity

demanded.
3 A change in the price of a good brings a
movement along its demand curve and a
change in the quantity demanded.
4 Other influences on buying plans are
a Prices of substitutes and Complements
b Expected future price
c Income
d Number of buyers

2.50

Quontity

Market Equilibrium
At the equilibrium price, the quantity
demanded equals the quantity s.tppiied.
3.00
Surplus of
2 million discs
oi $2.00 o disc

2.50

Supply ot CD

Rs

B
auortly

200

t0
(m

t2

lions of d

14

scs per week)

A decrease in demand brings a fall in price

and a decrease in the quantity sr.rpplied.
4 A_ decrease in supply brings a rise in price
and a decrease in the quantity demanded.
3

e Preferences
5 A change in any of these influences on
buying plans changes demand
shifts the
demand curve.

Demond for cD-Rs

5 The table summarises the effects of changes

in demand and supply on price and quantilty.

Demand

No

t0

lncrease

Ouonriry (millions ol discs per week)

Changes in Demand and Supply

1 An increase in demand brings a rise in price

Decrease

^Pl
^Qt

^PJ

AP7
I

ncrease

and an increase in ouantitv.

a l44ren demand'increuies, the demand

curve shifts rightward.

b At the original price, there is a shortage.
c, The shortage brings a rise in price.
d The rise in price brings an inirease in the
quantity supplied.
e The price rises until a new equilibrium

Change

^at
o
a
f

No

APt

^Q?

API

Change

^Qt
Decrease

^Pt
^Q?

^QJ
AP?

AP?

^aJ

^Ql

MrcRoEcoNoMlcs

Taxes

5 Efficient allocation occurs when total

Elasticity
price elasticity of demand is a measure
of the responsiveness of the quantity
demanded of a good to a change in its price.
Price elasticity of demand = (LQ/Q,,")/(LP/P",")
1 The

the sum of consumer surplus and

surplus
is maximised.
producer- surplus
7 A competitive market is allocatively

A tax creates a wedge between the price

paid by the buyer and the price received by
1

the seller.

efficient.

Underproduction or overproduction leads to

inefficency and creates deadweight loss
8

-U

a
Elasticity is

Perfectly elastic

lnfinity
Greater than one

_2a

Unit elastic

One

lnelastic

Less than one

Perfectly inelastic

Zero

Elastic

If

.N zs

Demand is

5oo

5 4.50
e aaA

-g

.9 s.oo
2.50

t5

price cut

a Increases total revenue, demand is elastic.

b Decreases total revenue, demand is

inelastic.
c Leaves totai revenue unchanged, demand
is unit elastic.
3 The cross elasticity of demand measures
the responsiveness of the demand {or a good
to a change in the price of a substitute or
complement.
Goods are

Cross elasticity

Substitutes

PositiYe

Complements

Negative

100 125 150

Quonillv (lhousonds of plzzos per

monlh)

a Perfectly inelastic demand

A price ceiling set belozl the market

the available quantity of housing, a rent

ceiling is inefficient.

elasticity of demand measures

the responsiveness of the demand for a good
to a change in income.
Good is

lncome elasticity

Normal
lnferior

Positive

from international trade arise from

comparatlve advantage, and both exPorters
and importers share the gains from trade.
1 The gains

900

zoo

:3s

Negative

5 The price elasticity of supply measures the

500

I
61n

fficiency of Competitiyg_mgflpt _
Allocative efficiency occurs when marginal
social benefit equals marginal social cost.
2 The market demand curve is the marginal
social benefit curve.
3 Consumer surplus is marginal social benefit
minus price, summed over the quantity

Quonuiy (ihousonds of unils per monlh)

consumed.
4 The market supply curve is the marginal
social cost curve.
5 Producer surplus is price minus marginal
cost, summed over the quantity produced.

Labour Markets and the Minimum Wage.

1 A minimum wage is a price floor and when
set aboae the market equilibrium price it

creates a surplus of labour (unemployment).

An unreguiated labour market is efficient

it allocates labour to jobs in which
labour is valued most highly.
3 The minimum wage is inefficient'

because

a6

-3

;5

t5

2a

25
Quonuiy {ihousonds of pizzos per monih}

buyers pay

lnternational Trade

is

responsiveness of the quantity supplied of

good to a change in its price.

the entire tax.

sellers pay the
b Perfectly elastic dernand
entire tax.
sellers pay the
c Perfectly inelastic supply
entire tax.
buyers pay the
d Perfectly elastic supply
entire tax.

Markets with Price Ceilings

4 The income

rc

2 Tax incidence depends on the elasticities of

demand and supply. The extreme cases are

equilibrium price creates a shortage.

2 Because people are willing to pay more for

is

200

Quonuiy lmil lons of pocket per yeor)

2t

22

Auonlily (mil ons of

23
houre per yeor)

?20

2 International trade is restricted bv tariffs and

non-tariff barriers, but these barrieis have
failen since World War TT.
3 Common arguments for protection are
a It raises revenue.

b It sustains the growth of new industries.

c It encourages competition and restrains
monopoly.

It saves jobs.

e We need

tariffs to compete with cheap

foreign labour.
f It penalises lax environmental standards.
g It prevents rich countries from exploiting
poor countries.
4 The arguments for protection are weak, and
the losses from tariffs always exceed the

Term

Symbol Equation

Perfect Competition

Total fixed cost

Total variable cost
Total cost

TFC

1A market in which

TVC

a Many firms sell an identical product to

many buyers.
b There are no restrictions on entry.
c Established firms have no advantage over
new ones.
d Sellers and buyers are weli informed

TC=TFC+TVC

,L

Output

Marginal cost
Average fixed cost
Average variable cost
Average total cost

MC

ATCTLQ

AFC

AFC

AVC

AvC = wctQ

ATC

ATC=AFC+AVC

TFctQ

about prices.

A firm in perfect competition is a price iaker

and maximises profit by producing the
quantity at which price (marginal ievenue)
equals marginal cost.
2

5 Short-run AVC and ATC curves are Ushaped and the MC curve passes through

their minimum points.

.=

<
F 30.00
o
a

gains.
!

Product Curves
short run. a firm operates with a
fixed plant size but in the long run, a firm can
vary the quantities of all the resources it uses.
2 To produce more output in the short run, the
firm increases the quantity of labour
employed. As the quantity of labour increases,
marginal product
1 Tn the

o
T 25.00

to

Tc 20.33
o
o
.9

Initially increases, and

b Eventually diminishes
the principle of
diminishing marginal returns.

'o

5.00

910
oror

1r,,1f,,

o*

a"r1

If the market price is less than minimum

average variable cost, the firm temporarily
shuts down and produces no output.
4 The firm's supply curve is its marginal cost
curve above the shutdown point
the point
of minimum average variable cost.
3

p=

long-run average cost curve shows the

lowest attainable average total cost when both
plant size and labour can be varied.
6 The

.qo
P}
9*
:o

;-

33

+
2

345
Lobour (workeru pe, doy)

quantity of labour increases, average

product also increases at first and eventually
diminishes.
4 When marginal product exceeds average
product, average product increases.
5 When marginal product is less than average
product, average product decreases.
3 As_ the

Sholt-r{n to:!_
opportunity cost of production inclucles
explicit costs and implicit costs.
2 Implicit costs include normal profit.
3 Economic profit equals total revenue minus
opportunity cost.
1 The

4 Costs are either fixed or variable.

a A fixed cost is a cost of production that is

independent of the output level. It is the

cost of a fixed input.
b A variable cost is a cost of production that
varies with the output level. It is the cost of
a variabie input.

Market Structure

The table summarises four types of markets.

Perfect
Monopolistic
competition competition Oligopoly
Many firms
lYany firms
Few firms
ldentical
Differentiated
ldentical or
products
products
differentiated

Monopoly
One firm

No close
substitutes

1A

Quontiiy (Tjhlds per dovl

5 Economic profit encourages entry, economic

loss encourages exit, and in lhe Iong run,

economic profit is zero (normal profit is

earned).

products
Free
Price

entry
eker

Free entry
Price setter

Concentration Concentration

low
Examples:
wheat, corn
ratio very

ratio low
Examples:
food. clorhing

to

Barriers to
entry

entry

Monopoly

Price sefter

Price sefter

Concentration

Concentration
ratio = I 00

ratio

high

Barriers

Example:

Example: local

automobiles

water supply

Monopoly
a market with one firm
- firm
arises when the
a Produces a good with no close

substitutes.

b Is protected by a barrier to entry.

2 A single-price monopoly's marginal revenue
curve is downward sioping.
3 A singie-price monopoly maximises profit
by producing the quantity at which mirginal
revenue equals marginal cost and by seiing
the quantity for the highest price that buyeis
are

willing

to pay.

b An average cost pricing rule (earns zero

economic profit but is inefficient)

a:

EL
6r

4 Hiring the quantity of each factor of

production at which marginal revenue
product equals the factor price is the same as
producing the quantity of output at which
marginal revenue equals marginal cost.
5 A firm's demand for capital depends on the
present value o[ the marginal revenue product

Monopolistic Competition

;6
E-g

In monopolistic competition
a A large number of firms compete.
b Each firm produces a differentiated
product.
c Firms compete on product quality. price,
and marketing.
d Firms are free to enter and exit.
2In the short run, monopolistic compelition is
like monopoly.
3In the long run
a Entry and exit drive economic profit
1

Toro revenue ooin $1r'

2 3

Olonrity (hoircuh per

to zero.

hourJ

bTirms operate with excess capacity.

4 Compared to perfect competition, a single-

price monopoly
a Produces a >maller quanfity and charges
nlgher prrce
b Shrinks consumer surplus
c Expands producer surplus

d Creates a deadr,r eight loss

c Price exceeds marginal cosl.

4 Firms in monopolistic competition compete
with each other through

Innovation and product development

b Marketing
5 Selling costs are high in monopolistic
competition, but they might increase demand
and bring lower prices through economies of
a

of capital.
6 The present value of an amount of money n
years in the future is

Present value = Amount in n years/ (1 + r)'',

In markets for nonrenewable natural
resources, the price is expected to rise at a rate
7

equal to the real interest rate. But in recent

years, the prices of these resources have fallen.
8 The incomes of ali factors of production
divide into opportunity cost and economic
rent.

Public Goods and Free-ridr problem

1 Goods are classified according to

whether

they are rival or nonrival and excludable or

nonexcludable.

sca1e.

gleepery_-

r".a

A small number of firms compete.

2 If the firms can illegally collude to restrict
output and raise the price, they can increase
therr profit to thdt of a monopoly.
3 Game theory is used to explain oligopoly
price and ouhput decisions.
4_Firms in a cartel (like people in a prisoners,
drlemma) can either comply or cheat. The
payoff matrix shows the possible outcomes.
1

ts.'* slrsargi,

Cheot

A monopoly can price discriminate if it

a Can identify and separate different buyer
t)?es
b Sells a product that cannot be resold
5 Price discrimination

Comply

a Tncreases economic profit

b Decreases consumei surplus
c Decreases deadweight loss

Trick's

strotegie5

..rrrHR

5 In Nash equilibrium, the firms cheat and the

cartel breaks down.
6. In repeated games with tit-for-tat strategies,
firms can cooperate and achieve u *oltop"oly

profit.

Factor Markets
demand for a factor of production is a
derived demand
it deriveJfrom the
demand for the product.
2 The marginal revenue product of a factor of
production d.etcrmines the demand for the
factor's services.
3 Firms hire the quantities of factors of
production that make the marginal revenue
product equal to the factor priie.
1 The

Natural monopoly can be regulated by

a A marginal cost pricing rule (incurs a loss
but is efficient), or

a,r"l

t-,
I sh rn 6.edn
I

l*'"1
I
I

Cor

""a

-,"*-"r"t","""

let'o,ot

l.

|
I

coo

]
I

"

^,

u,"

'"4'

Nor"or

a*ore

A public good
nonexcludable

nonrival and

- creates

a free,rider problem.

- is necessary to oveicome
3 Public provision

the free-rider problem.

political marketplace might not deliver
the efficient quantity of a public good because
a Bureaucrats seek to maximise budgets
and overprovide.
b Voters are rationally ignorant and don,t
counteract the goals of bureaucrats.
4 The.

Externalities
1 Externalities can be positive (benefits) or
negative (costs) and can arise from production
or consumption.
2 If transaction costs are small, property rights
can be established and externalities can be"
avoided. The outcome is efficient and doesn,t
depend_ on who gets the property rights
the

Coase theorem.
3 Covernment> can attempt to correct for the

extemaIcosts of pollution by using

a Pigovian taxes
b Emission charges
c Marketable permits
4 Governments can attempt to correct for the
external benefits of education and research by
using
a Public provision
b Private subsidies
c Vouchers
d Patents and

copyright:

I lhe dw

i"*"-'""u l^,*n..*-,
2

MACROECONOMICS

c Employed persons

Gross Domestic Product

1 GDP is the market value of all the final
goods and services produced within a counLry
during a given time.
2 GDP can be measured by summing either
all the factor incomes, all the expenditures on
final goods and services, or the value added

d Unemployed persons
2 To be counted as unemployed, a person
a Has actively looked for full-time or parttime work at any time in the four weeks up
to the end of the survey week, or
b Was available to start work in the survey
week, or
c Was

3 The higher the price level, the smaller is the

quantity of real CDP demanded because of
a Wealth effect: Higher price level * less
real wealth D less expenditure
b Substitution effects

i) Higher price level + higher interest

foreign-made goods

waiting to be called back to work

3 The unemplo),'ment rate is the percentage

less expenditure

ii) Higher price level

from which they were temporarily stood

down.

by industries.

rate

of

the labour force that is unemployed, and the

labour force is the sum of the number of
people employed and unemployed.
4 Unemployment may be

r:s

rzs

Frictional
b Structural
a

c Seasonal

:
3

d Cyclical
FuIl employment (and unemployment at the
natural unemployment rate) occurs when
there is no cyclical unemployment.

e substitute
a less expenditure

rrs
t05

3 The sum of

erpenditures is

Consumer Price lndex

Y=C+1+G+NX.

4 Nominal GDP values goods and services

in

current year prices, and real GDP values them

in base-year prices.
5 The GDP deflator is
GDP deflator = (Nominal GDP: Real GDP) x
100.

paid bv consumers in the major cities for a

fixed 'basket' o{ consumer goods and services.
2 The table shows a simplified CPI
calculation.
The Consumer Price

lndex

(Simpliffed Col.ulction)

imperfect measure of economic welfare:

a Overadjustment for inflation
b Household production
c Underground economic activitv
d Health and life erpectanc)
e Leisure time
f Quality of environment
g Political freedom and justice

(o) Cost o, bosket in bose period

1 A business cycle is a

periodic but
irregular up-and-down movement in
production and jobs.
2 A recession is a period during which real
GDP decreases
the growth rate of real
CDP is negative- for at least two

successive quarters.

Reol GDP (bt lions of

1 The CPI measures the average of the prices

6 Seven factors make real GDP an

Business Cycles

85

4 Aggregate

2003/04 do lo6)

demand changes when there are

changes in
a Expectations
b Fiscal policy and monetary policy
c The world economy

Aggregate Supply
1 The quantity of real GDP suppiied depends
E^pendiiure

5 kg of oonges
6 hoirctr
200 bus rides

0.80/ks

I1.00 och
0-70 eoth

66
r40

,lo
52r0.00

x 100 = 100
s2 I 0-00

cPt

(b) Cosi of bosket in current period

iems

i. ihe bos+perlod

boskei

E,pendirure
$

5 kg d oonges
6 hoirc*
20o bus ndes

1.20/ks
I2.50 eoch
0,75 eoch

Tml e4endirure

6
150

231
323r.00

cPt

S2lojoxl00=ll0

3 The formula for the CPI is

CPJ = (Cost of basket at current prices/
Cost of basket at base-period prices) x 100.

4 The inflation rate is the percentage change

in the price level from one year to the next.

5 The CPI is an imperfect measure of the price

1eve1 and the inflation rate because of
a New goods bias

b Quality change bias

c Commodity substitution bias
d Outlet substitution bias

on
a The quantity of labour
b The quantity of capital
c The state of tcchnology
2 The quantity of real GDP supplied at full
employment (at the natural rate of
unemployment) is potential GDP and is
independent of the price leve1.
3 The quantity of real GDP supplied in the
short run deviates from potential GDP as
employment deviates from full employment.
4 The higher the price level, other things
remaining the same, the greater is the
quantity of real GDP supplied in the short

IUn.
5 In the short run, the money wage rate and
the prices of other resources are fixed. In the
long run, all prices are flexible.
d

9 r:s
3

rzs

!
.5

t)

:o

105

Aggregate Demand
Employment and Unemployment
population is divided into ser.eral
labour market categories:
a Working-age population (the total
number of civilians aged 15 to 69 years)
b Labour force (the total number of
people either employed or r.nemployed)
1 The

quantity of real GDP demanded is the

sum of real consumption expenditure, C,
investment, I, government expenditures, G,
and exports, X, minus imports, M.
2 Aggregate demand is the relationship
between the quantity of real GDP demanded
and the price level. other things remaining
1 The

the same.

i95
f

R*t cDP
poreilrol

b"t*

GpP

Reol GDP obove

]

poleniro

GDP

860 880 900 92A 940

Reo GDP (bil lons ol

960

2003/04 dollo6l

6 A change in the price level with an

equal
percentage change in the muney wage rale
prrngs a movement along
lhe / ,4S curve.
7 A,change in the price lJvel wilh no
change
m the money wage rate brings a movement
along the SAS curve.

!r

:
g

res

t2s

I t5

I P,ice revel

o
o
3
.g

risq

o"a l

money woge rote

by the rme

rises

remrS"

'

105

600

e5

800

600

t,ooo

70a 76a 8AO

Reol cDP (billions

Disposob e ncome
{b Iion! or 2003/04 dolto6)

of te99loo

dollore)

(o) Aggregore expenditure

aggregate planned expenditure equals real

dou

900
Reol

E;
:5

cDp (biilions of 2003,r04 doltore)

=;g
i8

Short-run

-r.ro""o.ro-i.
occurs \^ hen the quantily of "qrrilrb.rrr-real CDp

demanded equals the

supplied.

-I

940

Macroeconomic Equilibrium
1

Equilibrium expenditure occurs when

r,500

,20A

a'6 1,040

jantity of real CDp

900

6
135

600

7AA

Reol GDP (billions

125

I
I

t5

300 5OO

9OO

t.300 I 5oo
2003/04 dolloru)

DP (biilions of

105

2 When aggreB-ate planned expenditure

exceeds real CDp, irventories are run
down,
production increases, and real GDp increases.
3 When real GDp exceeds aggregate
planned
ex pend i tu re, in ven to ries pi li"u
plp roi uction
decreases, and real CDp decreases.

95

880 900 eza o4o

Reol

growth outstrips potential CDp growlir.

4 I he business cycle occurs becaise aggregate

and strort_run aggregdte supili

::i1i9
uuctuate but the money wage and oihei
ad

factor
just quickly enough lo keep

real GDP at potential CDL

The Consumption Function

inqease i. airporuUt" ir,.ornJri,lg, *
l-{l
rncrease rn consumption expendifure,
ot-her
thhgs remaining the same.
2 The marginal
fropensity ro consume. MpC,
th" fri:ti9l
the change in disposable
l:mcome thal is of
consumed, and the marsinal
propensity to save, MpS, is the fractiotiof
the
Jnglge in disposable income that is saved.

3 MPC+MPS=t.

The Multiplier

960

cDp {btllions of 2003/04 doilorel

2 Economic growth results from persistent

rncreases in potential GDp
3 lnfla{ion occurs when aggregate demand

pnces.don't

doilors)

(b) Aggregore demond

zlO-aoo
ot I 99el00

1 Money is any object that serves as

the
means of payment
a method of settlins
o
debt
- and serves three other functions,
a Medium of exchanse
b Unit of account
c Store of value
2 Money in Austrajia today consists
of
currency and deposits at binks and other

depository institutions.
Three oificial meus.rres of money are M1,
M3, and broad money.
3

1,A change in autonomous expenditure

changes equilibrium expenditure by

mo.e
than the change in autonomous expenditure.
2 The multiplier (ignoring income iaxes
and

rmports) is

Multiplier = Ly / Ln = 1/ (1

_ MPC).

3 Income tares and imports make the

multtplier smaller.
multiplier applies to the change in real
L;Dl'at a given price level and lells "us the
magnitude of the shift of the AD curve. The

Brood

-"""r Il#;
$9r.3

finonciol instituiions

illi3

956,8).2

Olher deposirs

$203.4

4 The

change in e-quilibrium real CDp a"p*"as

on
ihe_slope of the S,4S curve as well as
the shift

of the AD cuffe. (See figure

in.e*t.oi.r-.r.j

Cefrificoies of

deposir

Fiscal Policy
Government expenditures, transfer
Payments/ and taxes have multiplier effects on

$t 15.3

$167.3

aggregate demand.

2 Induced taxes and transfer payments

act as
automatic stabilisers.
3.Tares have supply-side effects because
thev
change the incenLives to work, save, and

invest.

MI
Cureni deposiis wiih

C!trency

bonks

S r

82.3

$1

47.9

$34.3

Monetary Policy Effects

4 The monetary base is the sum of bank

reserves and currency held outside the banks.

5 Banks create money by making loans.
6 The money multiplier equals the change in
the quantity of money divided by the change
in the money base.
7 The money multiplier (AMIAMB) equals
(L + a)l( a + b) where a is the ratio of currency
to deposits and b is the required reserve ratio.

The Demand for Money

1 The demand for money is the relationship
between the quantity of real money
demanded and the interest rate, other things
remaining the same.

A change in the cash rate changes other

interest rates and the exchange rate.
2 A change in interest rates and the exchange
rate changes the quantity of money, credit,
and loans.
3 A change in interest rates, the exchange rate,
and the quantity of money, credit, and loans
changes expenditure p1ans.
4 A change in expenditure plans changes
aggregate demand with a multiplier effect and
changes equilibrium real GDP and the price
level (and inflation rate).
5 The effects of monetary policy are spread
over about tvvo years after a cash rate change.
1

Foreign Exchange Rate

1 The foreign exchange rate is the price at
which one currency exchanges for another.
2 The exchange rate is determined by demand
and supply in the market for foreign

exchange.

in expectations about the future

exchange rate influence both the demand and
ihe supply and bring fluctuations in the
exchange rate.
4 Purchasing power parity means equal value
of money.
5 h-rterest rate parity means equal interest
rates when exchange rate changes are taken
into account.
3 Changes

MD,

id-i;

2 The demand for money changes when there

are changes in real GDP and financial

innovation.

1 The Reserve Bank of Australia, the central

bank, regulates the banking system and

conducts monetary policy.
2 The Reserve Bank's monetary policy
instrument is the cash rate
the interest rate
- for reserves.
in the interbank loans market
3 The Reserve Bank's monetary policy tool is
the open market operation.
4 An open market operation is the purchase or
sale of securities by the Reserve Bank.
5 An open market operation changes the
reserves of the banking system, which
changes the cash rate.
5 An open market purchase increases the
quantity of reserves and lowers the cash rate.
An open market sale decreases the quantity of
reserves and raises the cash rate.
/.oo

6.50

600

inflation is started by an

in aggregate supply and is sustained by

increases in the quantity of money.
3 Unanticipated inflation causes
a A redistribution of income
b Deparfures from full employment
4 Anticipated inflation increases
a Transaction costs

b After-tax real interest rates

c Uncertainty

The QuantityTheory of Money

1 The quantity theory of money states that in
the long run, an increase in the quantity of
money, M, brings an equal percentage
increase in the price level, P.
2 The quantity theory is based on the equation
of exchange:
MV = PY,
3 In the long run, Y is potential GDP and V is
constant, so P is proportional to M.

The Phillips Curve

short-run Phillips curve shows the

relationship between inflation and
unemployment at a constant
1 The

a Expected
5.50

5.00

Ouoniiiy of funds
supplied ofter open
morkei operoiion to
hit cosh roie iorget

204

400

600

800

1.000

Reseryes on deposil ot Reserue Bonk {m;llions of dollorel

inflation rate

b Natural unemployment rate

2 The long-run Phillips curve is verticai at the
natural rate of unemployment.
3 The short-run Phillips curve and the longrun Phillips curve intersect at the expected
inflation rate and the natural rate of
unemployment.

15

to

Unemployment rote (percentose of lqbour force)

An increase in the expected inflation rate

shifts the short-run Phillips curve upward so
that it intersects the long-run Phillips curve at
the higher expected inflation rate.
5 A decrease in the natural rate of
unemployment shifts both the long-run Phillips
curve and the short-run Phillips curve leftward
so that they intersect at the lower natural rate
of unemployment and the expected inflation
rate.
4

Economic Growth
1 The loundations of economic growth are
a Markets
b Property rights
c Monetary exchange
2 The activities that create economic growth

are
a Saving and investment in physical capital

increase in aggregate demand and is sustained

by increases in the quantity o{ money.
2 Cost-push inJlation is started by a decrease

The Reserve Bank of Australia

lnflation
1 Demand-pul1

b Investment in human capital

c Discovery of new technologies

Economic Growth Theories

1 Classical

growth theory predicts that

economic growth stimulates population

growth and keeps the standard of living at the
subsistence level.
2 Neoclassical growth theory predicts that in
the absence of technological change, economic
growth will come to an end because of
diminishing retums of capital.
3

New growth theory predicts that growth will

persist because discoveries are a public capital

good and knowledge is capital that is not
subject to diminishing returns.

lnternational Finance
current account records payments for
imports, receipts from exports, and net interest
and transfers paid abroad.
2 The capital account records international
borrowing and lending.
3 Net exports (approximately equal to the
current account balance) are determined by
the excess of private saving over private
investment and the govemment budget
1 The

balance:

6-M)=(S-D+ArI-G)
VV
^.

ffi