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=
year
year year
PI
PI PI
Price level: a measure of the average prices of
goods and services in the economy.
Inflation rate: The percentage increase in the price
level from one year to the next.
Deflation: A decline in the general price level in the
economy.
RMIT University
RMIT University School of Economics, Finance and Marketing 71
Consumer Price Index (CPI): An average of the
prices of the goods and services purchased by the
typical urban family of 4 in an economy.
The Market Basket: the Department of Statistics
identifies:
A typical or representative household.
The goods and services purchased by the household (this
is the market basket).
Measuring Inflation
RMIT University School of Economics, Finance and Marketing 72
Consumer Price Index
The CPI is the most commonly known price index and is based
on changes in the price of a given basket of consumption g&s.
Fixed basket of 4 apples and 2 burgers
Year Price of apples Price of burgers
2006 $1 $2
2007 $2 $3
2008 $3 $4
Year Cost of basket
2006
2007
2008
Year Consumer price index (2006 is the base year)
2006
2007
2008
RMIT University School of Economics, Finance and Marketing 73
Inflation
Inflation rate calculated used the CPI:
2007:
2008:
RMIT University School of Economics, Finance and Marketing 74
Check Your Understanding
Suppose an economy has only three goods and the
typical family purchases the amounts given in the
following table. If 2000 is the base year, then what is
the CPI for 2008?
Product Quantity Price (2000) Price(2008)
Hair cuts 6 $50 $70
Backpacks 4 $25 $30
Tacos 100 $1.00 $5.00
a. 40.08
b. 208
c. 180
d. 100
RMIT University School of Economics, Finance and Marketing 75
Check Your Understanding
Suppose that the data in the following table reflects
the prices in the economy. What is the inflation rate
in between 2008 and 2009?
Year
CPI
(1990=100)
2008 175
2009 180
a. 4.6%
b. 7.5%
c. 5%
d. 2.9%
School of Economics, Finance and Marketing 76
The CPI is the most widely used measure of
inflation.
Is the CPI accurate?
Four sources of bias in the CPI may lead to its
overstating the inflation rate.
Substitution bias
Increase in quality bias
New product bias
Outlet bias
Issues in the Measurement of Inflation
RMIT University
RMIT University School of Economics, Finance and Marketing 77
Check Your Understanding
If consumers purchase fewer of those products that
increase most in price and more of those products
that decrease in price as compared to the CPI
basket, then
a. changes in the CPI understate the true rate of
inflation.
b. changes in the CPI are unrelated to the true rate of
inflation.
c. changes in the CPI accurately reflect the true rate of
inflation.
d. changes in the CPI overstate the true rate of inflation
RMIT University School of Economics, Finance and Marketing 78
The GDP Deflator: GDP also allows us to calculate
changes in the price level over time. The GDP deflator
is a measure of the price level calculated by dividing
nominal GDP by real GDP and multiplying by 100.
The Producer Price Index (PPI): an average of the
prices received by producers of goods and services at
all stages of the production process.
Other Measures of Inflation
RMIT University School of Economics, Finance and Marketing 79
The purchasing power of the dollar falls over time as
prices rise.
Price indexes, such as the CPI, allow us to adjust for the
effects of inflation so we can compare dollar values over
time.
For example; we can find the 2008 purchasing power
equivalent of a $20,000 salary in 1980. We use the
following formula:
Using Price Indexes to Adjust for the Effects
of Inflation
Value in 2008 dollars = Value in 1980 dollars
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1980 in CPI
2008 in CPI
=$ 20,000
098 , 46 $
82
189
=
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\
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=
T k Y
T
A = A
MPS
MPC
kT =
purchases government in Change
GDP real m equilibriu in Change
Multiplier Purchases Government =
taxes in Change
GDP real m equilibriu in Change
Multiplier Tax =
G k Y
e
A = A
RMIT University
RMIT University School of Economics, Finance and Marketing 249
Check Your Understanding
Suppose the MPC is .75.
If the government increases expenditures by $200 billion
how far does the economy grow?
If the government decreases taxes by $200 billion how
far does the economy grow?
RMIT University School of Economics, Finance and Marketing 250
Check Your Understanding
The tax multiplier
a. is negative
b. only works when taxes are cut
c. is larger in absolute value as compared to the
d. is less than one
RMIT University School of Economics, Finance and Marketing 251
Assume the consumption function for a
closed economy is C=50+0.8Y and that
investment is equal to $30bn.
a. Calculate the equilibrium level of income/output
for this economy.
b. Calculate what will happen to equilibrium income
and output if the government undertakes
expansionary policy of $15bn.
Check Your Understanding
RMIT University School of Economics, Finance and Marketing 252
Multiplier Effectiveness
A D
Y Y
P
AD
2
Quantity
of Output
Price
Level
AS
Fixed Price
Variable Price
RMIT University School of Economics, Finance and Marketing 253
Crowding Out Effect
A D
Y
1
RGDP
Price
Level
AS
P
1
A
RMIT University School of Economics, Finance and Marketing 254
If crowding out occurs, an increase in
government spending
a. decreases the interest rate and consumption and
investment spending rise.
b. decreases the interest rate and consumption and
investment spending decline.
c. increases the interest rate and consumption and
investment spending rise.
d. increases the interest rate and consumption and
investment spending decline.
Check Your Understanding
RMIT University School of Economics, Finance and Marketing 255
Goals of Fiscal Policy
Y
f
Y
AD
Quantity
of Output
Price Level
AD
Quantity
of Output
Price Level
SRAS
SRAS
P
1
P
2
LRAS LRAS
Y
f
Y
GDP Gap
GDP Gap
Recessionary Gap Inflationary Gap
Recessionary Gap = GDP Gap
k
e
Inflationary Gap = GDP Gap
k
e
RMIT University School of Economics, Finance and Marketing 256
Putting Everything Together
e
e
e
e
e
k
k
k
G
G k
G k Y
Gap GDP
Gap ry Inflationa
Gap GDP
Gap ry Recessiona
Gap GDP
Gap GDP
=
=
= A
A =
A = A
RMIT University School of Economics, Finance and Marketing 257
Check Your Understanding
If the MPS is 0.25 and the economy has a recessionary
gap of $5 billion, what is the size of the GDP Gap?
RMIT University School of Economics, Finance and Marketing 258
Successful Fiscal Policy
Real GDP
Time
RMIT University School of Economics, Finance and Marketing 259
Case Against Intervention
FiscalLags
Recognition
Administrative/Legislative
Operational/Implementation
Expansionary bias leading to a Political
business cycle
School of Economics, Finance and Marketing 260
Budget deficit: The situation in which the governments
spending is greater than its tax revenue.
Budget surplus: The situation in which the governments
expenditures are less than its tax revenue.
The budget can serve as an automatic stabiliser.
Federal government deficits increase automatically
during recessions because:
1. Tax revenues fall.
2. Unemployment benefits increase.
Federal government deficits decrease or surpluses
increase automatically during expansions because:
1. Tax revenues increase.
2. Unemployment benefit payments decrease.
Deficits, Surpluses and Government Debt
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RMIT University School of Economics, Finance and Marketing 261
Check Your Understanding
Which of the following is an automatic stabiliser?
a. Reductions in nominal wages as inflation rates
rise
b. Unemployment benefit payments to the
unemployed
c. Interest rate changes
d. Increases in government spending on schools
RMIT University School of Economics, Finance and Marketing 262
To counteract the effect of automatic stabilisers
during a recession and keep the budget
balanced, the federal government must ________
government spending, or ________ taxes, and
which will ________ aggregate demand.
a. decrease; increase; reduce
b. increase; decrease; increase
c. increase; increase; reduce
d. decrease; decrease; increase
Check Your Understanding
RMIT University School of Economics, Finance and Marketing 263
Should the federal budget always be balanced?
Is government debt a problem?
These questions are related and the answer is
not always clear-cut.
Economists examine the debt, and the interest
on the debt in proportionate terms to determine
if it is a problem.
Deficits, Surpluses and Government Debt
RMIT University School of Economics, Finance and Marketing 264
Supply side policies:
Fiscal policies that have long-run effects by
expanding the productive capacity of the economy
and increasing the rate of economic growth.
These policy actions primarily affect aggregate
supply, by shifting the long-run aggregate supply
curve to the right.
The Effects of Fiscal Policy in the Long-
Run
RMIT University School of Economics, Finance and Marketing 265
The Effects of Fiscal Policy in the Long-
Run
School of Economics, Finance and Marketing 266
The long-run effects of tax policy:
We can look at the effect on aggregate supply of
each of the following taxes:
1. Individual income tax
2. Company income tax
3. Taxes on capital gains
The Effects of Fiscal Policy in the Long-
Run
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RMIT University School of Economics, Finance and Marketing 267
Tax simplification:
There are also potential gains to be derived from
simplifying the tax law.
Resources diverted to tax compliance and tax
minimisation can be put to more productive use.
Tax simplification may improve the efficiency of
firm and household decision making.
The Effects of Fiscal Policy in the Long-
Run
RMIT University School of Economics, Finance and Marketing 268
Long Run Implications of Supply Side
Policies
Supply side policies can increase long run aggregate supply,
thereby reducing the upward pressure on prices following an
increase in aggregate demand
RMIT University School of Economics, Finance and Marketing 269
Review Your Understanding
Expansionary fiscal policy ________ the price level
and ________ equilibrium real GDP.
a. increases; increases
b. increases; decreases
c. decreases; decreases
d. decreases; increases
RMIT University School of Economics, Finance and Marketing 270
Review Your Understanding
To try to combat inflation, the government could
a. conduct expansionary fiscal policy.
b. lower interest rates.
c. decrease taxes.
d. decrease government spending.
RMIT University School of Economics, Finance and Marketing 271
Review Your Understanding
If crowding out occurs, an increase in government
spending
a. decreases the interest rate and consumption and
investment spending rise.
b. decreases the interest rate and consumption and
investment spending decline.
c. increases the interest rate and consumption and
investment spending rise.
d. increases the interest rate and consumption and
investment spending decline.
RMIT University School of Economics, Finance and Marketing 272
Review Your Understanding
Refer to the figure above. If the economy moves from A to B,
which of the following would be the appropriate fiscal policy
to achieve potential GDP?
a. Increase taxes
b. Decrease interest rates
c. Contractionary fiscal policy
d. Increase government spending
RMIT University School of Economics, Finance and Marketing 273
Review Your Understanding
Increases in government spending will lower the
long term growth rate of GDP, if it lowers ________
spending and the government purchases ________
and not ________ goods.
a. net export spending; investment; consumption
b. investment; consumption; investment
c. net export spending; consumption; investment
d. consumption; investment; consumption
RMIT University School of Economics, Finance and Marketing 274
Review Your Understanding
Use the information in the table to answer the questions.
a. At what level of RGDP does the market clear?
b. What is the MPC?
c. Suppose government purchases increase by $500 billion.
What will be the new equilibrium level of real GDP? Use
the multiplier formula to determine your answer.
RMIT University School of Economics, Finance and Marketing 275
Review Your Understanding
Given the above data what actions might the
government take to move the economy to the full-
employment level of output?
RMIT University School of Economics, Finance and Marketing 276
Recession, Inflation and the Long-Run
Aggregate Demand and Aggregate Supply Analysis - Chapter
8 (pp. 226-234)
Unemployment - Chapter 9 (pp. 256-257)
Inflation - Chapter 10 (pp. 280-287)
Learning Objectives:
1. Use the aggregate demand and aggregate supply model to illustrate the
difference between short-run and long-run equilibrium.
2. Use the dynamic aggregate demand and aggregate supply model to
analyse macroeconomic conditions.
3. Understand the difference between demand-pull and cost-push
inflation.
4. Explain the quantity theory of money and use it to explain how high
rates of inflation can occur.
RMIT University School of Economics, Finance and Marketing 277
The short-run and the long-run effects of a decrease in aggregate
demand
Macroeconomic Equilibrium in the Long
Run and the Short Run
School of Economics, Finance and Marketing 278
Costs to the economy as a whole:
Loss of gross domestic product.
Loss of human capital.
Net drain on the budget.
The opportunity cost of funds directed towards welfare
payments.
Costs to the unemployed:
Loss of income.
Loss of skills.
Loss of self esteem.
Unemployment may contribute to family break-ups, health
problems, mental illness, crime and political unrest.
The Costs of Unemployment
RMIT University
School of Economics, Finance and Marketing 279
In general, wages rise with inflation. Inflation can, however, affect
the distribution of income. The extent of redistribution depends partly
on the degree to which inflation was anticipated or unanticipated.
Costs of Inflation
The problem with anticipated inflation:
Menu costs the costs to firms of changing prices.
Risk particularly for contracts with a time element
The problem with unanticipated inflation:
There are winners and losers, depending on whether inflation is
higher or lower than anticipated.
For example: those on fixed incomes, such as aged pensions,
will lose if inflation is higher than anticipated.
Borrowers may gain and lenders lose when inflation is higher
than anticipated.
RMIT University
School of Economics, Finance and Marketing 280
Causes of Inflation
Monetary growth greater than growth in RGDP
Demand-pull inflation
Increases in AD
Cost-push inflation
Supply Shocks
Stagflation: a combination of inflation and
recession, usually resulting from a supply shock.
RMIT University
School of Economics, Finance and Marketing 281
Connecting money and prices: The equation of
exchange. The connection between money and
prices is expressed in the following equation.
Velocity of money: The average number of times
each dollar in the money supply is used to
purchase goods and services included in GDP.
The Quantity Theory of Money
x Y P x V M =
M
x Y P
= V
RMIT University
School of Economics, Finance and Marketing 282
According to the assumptions of quantity
theory, if the money supply increases 5% then
at full employment
a. nominal and real GDP would rise by 5%.
b. nominal GDP would rise by 5%; real GDP would be
unchanged.
c. nominal GDP would be unchanged; real GDP
would rise by 5%.
d. neither nominal GDP nor real GDP would change.
Check Your Understanding
RMIT University
School of Economics, Finance and Marketing 283
The quantity equation is transformed to:
Growth rate of money supply + growth rate of velocity =
growth rate of the price level + growth rate of real
output
Which we can rearrange as:
Inflation rate = growth rate of money supply + growth rate
of velocity - growth rate of real output
If Irving Fisher is correct and velocity is constant,
then the growth rate of velocity is zero, so we can
rewrite the equation as:
Inflation rate = growth rate of the money supply
growth rate of real output
The Quantity Theory of Inflation
RMIT University
School of Economics, Finance and Marketing 284
According to the quantity theory of money,
inflation is caused by
a. GDP growing faster than the money supply.
b. GDP growing at the same rate as the money
supply.
c. the money supply growing faster than GDP.
d. the money supply growing slower than GDP.
Check Your Understanding
RMIT University
School of Economics, Finance and Marketing 285
Suppose the money supply is currently growing at 4
% per year, while real GDP is growing at 2%,
calculate the inflation rate assuming Irving Fisher is
correct in his assumption regarding the velocity of
money.
Check Your Understanding
RMIT University
School of Economics, Finance and Marketing 286
The short-run and long-run effects of an increase in aggregate
demand - Demand-pull inflation and a price-wage spiral
Macroeconomic Equilibrium in the Long
Run and the Short Run
RMIT University
School of Economics, Finance and Marketing 287
An increase in aggregate demand causes an
increase in ________ only in the short run, but
causes an increase in ________ in both the
short run and the long run.
a. the price level; real GDP
b. real GDP; real GDP
c. real GDP; the price level
d. the price level; the price level
Check Your Understanding
RMIT University
School of Economics, Finance and Marketing 288
We can create a dynamic aggregate demand and
aggregate supply model by making three changes
to the basic model:
1. Potential real GDP increases continually,
shifting the long-run aggregate supply curve to
the right.
2. During most years the aggregate demand
curve will be shifting to the right.
3. Except during periods when workers and firms
expect high rates of inflation, the short-run
aggregate supply curve will be shifting to the
right.
A Dynamic AD and AS Model
RMIT University
School of Economics, Finance and Marketing 289
A Dynamic AD and AS Model
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RMIT University School of Economics, Finance and Marketing 290
Check Your Understanding
The simple static aggregate demand and aggregate
supply model assumes
a. potential real GDP increases continuously.
b. the economy experiences continuing inflation.
c. the economy's aggregate demand curve shifts to the
right in most periods.
d. the economy does not experience long run growth.
School of Economics, Finance and Marketing 291
The short-run and long-run effects of a supply shock - Cost-push
inflation
Macroeconomic Equilibrium in the Long
Run and the Short Run
RMIT University
School of Economics, Finance and Marketing 292
Which of the following is considered a supply
shock?
a. The increasing investment in the economy causing
the capital stock to rise
b. A decline in wages
c. An improvement in technology
d. An unexpected large increase in the price of
natural gas
Check Your Understanding
RMIT University
School of Economics, Finance and Marketing 293
Supply Shocks and Policy Choices
Policy Options:
1. Do nothing
2. Do something
a.AD INF
but further
UNE
b.AD UNE
but further
INF
AD
RGDP
Price Level
P
0
Y
0
SRAS
0
A
RMIT University
School of Economics, Finance and Marketing 294
Fighting Inflation Reducing AD
RGDP
Price Level
SRAS
0
P
0
LRAS
Y
f
AD
0
A
RMIT University
School of Economics, Finance and Marketing 295
Why might the short run aggregate supply curve shift
to the right in the long run, following a decrease in
aggregate demand?
a. Workers and firms adjust their expectations of wages and
prices downward and they push for higher wages and
prices.
b. Workers and firms adjust their expectations of wages and
prices upward and they accept lower wages and prices.
c. Workers and firms adjust their expectations of wages and
prices upward and they push for higher wages and prices.
d. Workers and firms adjust their expectations of wages and
prices downward and they accept lower wages and prices.
Check Your Understanding
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RMIT University School of Economics, Finance and Marketing 296
The level of real GDP in the long run is called
a. potential GDP.
b. frictional GDP.
c. low capacity GDP.
d. short run GDP.
Review Your Understanding
RMIT University School of Economics, Finance and Marketing 297
Review Your Understanding
Because of a supply shock, in the short run
a. the aggregate supply curve shifts to the left.
b. equilibrium real GDP rises.
c. unemployment falls.
d. the price level falls.
RMIT University School of Economics, Finance and Marketing 298
Review Your Understanding
Which of the following is NOT an assumption made
by the dynamic model of aggregate demand and
aggregate supply?
a. Aggregate demand shifts to the right during most
periods.
b. Aggregate supply shifts to the right except during
periods when workers and firms expect higher
wages.
c. Aggregate demand and potential real GDP decrease
continuously.
d. Potential real GDP increases continuously.
RMIT University School of Economics, Finance and Marketing 299
Review Your Understanding
Which of the following can cause cost-push inflation
if the economy is currently in equilibrium at full-
employment GDP?
a. A decrease in personal income tax rates, which
increases after tax income
b. A flood which destroyed much of the country's crops
c. An increase in the size of the labour force
d. An increase in the capital stock in the country
RMIT University School of Economics, Finance and Marketing 300
Review Your Understanding
If a supply shock occurs in the economy, what is the
likely impact for inflation and unemployment?
RMIT University School of Economics, Finance and Marketing 301
What are the policy options available to the government
to combat a supply shock and what are the costs of
each policy option?
Review Your Understanding
RMIT University School of Economics, Finance and Marketing 302
Illustrate and explain the implications for the
inflation/unemployment trade-off if we persist in
undertaking expansionary policy in an attempt to reduce
the unemployment rate below the natural rate of
unemployment.
School of Economics, Finance and Marketing 303
Economic Development and Growth
Economic Growth, the Financial System and Business
Cycles - Chapter 5 (pp. 110-117)
Long-Run Economic Growth: Sources and Policies -
Chapter 6
Learning Objectives:
1. Explain the basic idea of how a market system works.
2. Understand why property rights are necessary for a well-functioning
economy.
3. Discuss the importance of economic growth and its impact on living
standards.
4. Describe the trends in economic growth in the world.
5. Use the economic growth model to explain why economic growth rates
differ between countries.
6. Discuss why many poor countries have not experienced rapid economic
growth.
RMIT University
School of Economics, Finance and Marketing 304
Long-Run Economic Growth is the Key
to Rising Living Standards
Long-run economic growth: The process by
which rising productivity increases the average
standard of living.
Real GDP per capita is used to measure
changing living standards over time.
Real GDP per capita =
Real GDP
population
RMIT University
School of Economics, Finance and Marketing 305
Recall: economic growth is calculated using the following
equation:
Calculating Economic Growth Rates
100 x
GDP Real
GDP Real - GDP Real
Growth Economic
Previous
Previous Current
=
For longer periods we look at average annual growth
rates. Note: the long-term could be 50 or 100 years or
more.
An approximation of average annual growth for shorter
periods is a simple average.
3.1% + 2.4% + 3.2%
3
= 2.9%
RMIT University
Use the table below to answer the following questions:
Calculate the growth rate of real GDP for each year
from 2004 2007.
Calculate the average annual growth rate over the
same period.
Year Real GDP, $ (billions in 2004 prices)
2004 790
2005 810
2006 825
2007 850
Check Your Understanding
School of Economics, Finance and Marketing 306 RMIT University
School of Economics, Finance and Marketing 307
One way to judge how rapidly real GDP per
person is growing is to calculate the number of
years it would take to double.
Calculating Economic Growth Rates and
the Rule of 70
Number of years to double =
70
Growth rate
This rule shows small differences in growth
compound over time.
This leads to large differences in the number of
years it takes for real GDP to double.
RMIT University
School of Economics, Finance and Marketing 308
The rule of 70 states that
a. the number of years it takes an economy to
double is the growth rate times 70.
b. the number of years it takes an economy to
double is 70 divided by the growth rate.
c. it takes an economy 70 years to double in size.
d. the number of years it takes an economy to
double is the growth rate divided by 70.
Check Your Understanding
RMIT University
School of Economics, Finance and Marketing 309
Use the table below to answer the following
questions:
a. How long will it take China to double its real GDP?
b. How long will it take the UK to double its real GDP?
GDP growth (annual %) China UK
2004 10.1 2.7
2005 10.7 2.5
2006 10.4 2.8
Check Your Understanding
RMIT University
School of Economics, Finance and Marketing 310
Average annual growth rates for the world economy
Economic Growth Over Time Around the
World
Source: J. Bradford DeLong (1998), Estimating World GDP, One Million B.C. Present, working paper,
University of California, Berkley.
RMIT University
School of Economics, Finance and Marketing 311
Why do growth rates matter?
An economy that grows too slowly fails to raise
living standards.
In the 1980s and 1990s, a small group of Asian
countries, such as Taiwan and Singapore, achieved
high rates of growth. These are sometimes referred
to as the newly industrialising countries.
Economic Growth Over Time Around the
World
RMIT University
School of Economics, Finance and Marketing 312
GDP per capita, 2007
Economic Growth Over Time Around the
World
RMIT University
School of Economics, Finance and Marketing 313
Labour productivity: The quantity of goods and
services that can be produced by one worker or by
one hour of work. Two key factors determine
labour productivity.
1. Increases in Capital per Hour Worked
Capital: Manufactured goods that are used to
produce other goods and services; examples are
computers, factory buildings, and machine tools.
Human capital: The accumulated knowledge
and skills that workers acquire from education
and training, or from their life experiences.
What Determines How Fast Economies
Grow?
RMIT University
School of Economics, Finance and Marketing 314
2. Technological Change: Change in the ability of a
firm to produce a given level of output with a given
quantity of inputs.
Accumulating more inputs such as labour, capital,
and raw materials will not ensure that an economy
experiences economic growth unless technological
change also occurs.
Three main sources of technological change:
Better machinery and equipment.
Increases in human capital.
Better means of organising and managing production.
What Determines How Fast Economies
Grow?
RMIT University
School of Economics, Finance and Marketing 315
Which is more important for economic growth:
More capital or technological change?
Technological change is the key to sustaining
economic growth.
Endogenous growth theory: a model of long-run
economic growth that emphasises that
technological change is influenced by economic
incentives, and so is determined by the working of
the market system.
What Determines How Fast Economies
Grow?
RMIT University
RMIT University School of Economics, Finance and Marketing 316
Check Your Understanding
Endogenous growth theory
a. states that the rate of technological change is caused
by economic incentives.
b. does not adequately explain the factors that
determine productivity.
c. states that the rate of technological change is
unaffected by economic incentives.
d. states that the rate of technological change is
determined outside the working of the market
system.
School of Economics, Finance and Marketing 317
Which of the following will result in an
increase in labour productivity?
a. A decline in the capital stock per hour worked
b. A decline in the amount of human capital per
worker
c. An increase in technology
d. A decrease in the number of people attending
institutions of higher education
Check Your Understanding
RMIT University
School of Economics, Finance and Marketing 318
Free Market: A market with few government restrictions on
how a good or service can be produced or sold, or on how
a factor of production can be employed.
Adam Smith argued the benefits of a free market system in
his famous book The Nature and Causes of the Wealth
of Nations (published in 1776).
Smith assumed individuals act in a rational, self-interested
way.
If not restricted by government, then firms would be led by
the invisible hand of the market to provide consumers with
what they wanted.
The price mechanism in the free market leads producers to
change supply in accordance with consumer demand.
The Market System and Economic Growth
RMIT University
School of Economics, Finance and Marketing 319
Private property rights provide the legal basis of a
free market system.
Property rights: The rights individuals or firms
have to the exclusive use of their property,
including the right to buy or sell it.
Property Rights
RMIT University
School of Economics, Finance and Marketing 320
A well established and legally enforced system
of property rights
a. encourages investment growth but reduces
entrepreneurial activity.
b. reduces economic efficiency which reduces the
rate of economic growth.
c. encourages economic growth by increasing the
incentive to be innovative.
d. discourages economic growth by discouraging
innovation.
Check Your Understanding
RMIT University
School of Economics, Finance and Marketing 321
Government policy can increase the accumulation of
knowledge and capital in three ways:
1. Protecting intellectual property rights with patents and
copyrights.
Patent: the exclusive right to a product for a period of time
from the date the product was invented.
2. Subsidising research and development.
3. Subsidising education.
What Determines How Fast Economies
Grow?
RMIT University
School of Economics, Finance and Marketing 322
What is the ultimate purpose of patents and
copyrights?
a. To provide owners with large profit forever.
b. To encourage the expenditure of funds on
research and development to create new products.
c. To protect firms from being taken advantage of by
producing firms.
d. To do all of these things.
Check Your Understanding
RMIT University
School of Economics, Finance and Marketing 323
Joseph Schumpeter and Creative Destruction.
To Schumpeter, the entrepreneur is central to
economic growth:
The function of entrepreneurs is to reform or
revolutionise the pattern of production by exploiting an
invention or, more generally, an untried technological
possibility for producing new commodities or producing
an old one in a new way.
What Determines How Fast Economies
Grow?
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Catch Up: the prediction that the level of
GDP per capita in poor countries will grow faster
than in rich countries.
Some poorer countries have experienced rapid
growth rates, but many have not.
Why Isnt the Whole World Rich?
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Figure 7.8 The rule of law and growth
Why Isnt the Whole World Rich?
Source: Based on David Dollar and Aart Kraay (2000), Property Rights, Political Rights, and the Development
of Poor Countries in the Post-Colonial Period, World Bank Development Research Group Working Paper, October
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There is no one answer to the question as to why all
countries do not experience economic growth.
Most economists identify 5 key factors:
1. Failure to enforce the rule of law:
Rule of Law: the ability of a government to enforce
the laws of a country, particularly with respect to
protecting private property and enforcing contracts.
2. Wars and revolutions:
Many countries that were poor in 1960 have
experienced extended periods of violent changes of
government during the years since. Eg. Afghanistan,
Angola and Ethiopia.
Why Isnt the Whole World Rich?
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Why Isnt the Whole World Rich?
3. Poor public education and health:
Many low-income countries have weak public school
systems, so many workers are unable to read and write.
People who are sick work less, and are less
productive when they do work.
4. Slow technological development:
The economic growth model shows the importance of
technological change.
5. Low rates of saving and investment:
The low savings rates in developing countries contribute
to a vicious cycle of poverty.
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Which of the following is a reason why low
income countries might experience economic
growth?
a. The country has endured extended periods of war.
b. The country fails to enforce a rule of law.
c. The country has a high rate of savings and
investment.
d. The country suffers from poor health
infrastructures.
Check Your Understanding
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Globalisation is defined as the process of
countries becoming ________ open to foreign
trade and ________ open to foreign
investment.
a. less; less
b. more; less
c. more; more
d. less; more
Check Your Understanding
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The benefits of globalisation:
Foreign Direct Investment: The purchase or
building by a corporation of a facility in a foreign
country.
Foreign Portfolio Investment: The purchase by
an individual or firm of stock or bonds issued in
another country.
Globalisation: The process of countries becoming
more open to foreign trade and investment.
Globalisation
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Criticisms of Globalisation
Globalisation undermines distinctive cultures.
Multi-national firms exploit low wages and poor
health, safety and environmental regulations in
the developing world.
Economic growth contributes to global
warming, deforestation and other
environmental problems.
Globalisation
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REVISION OF MODULES 1, 2 & 3