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Semester 2

Supplementary Material


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Semester Two



Macroeconomics is the study of the economy as a whole - the study of economic aggregates.
Because all economic activity revolves around the production of output (0), the earning of income
(Y), and expenditure (E) it follows that economists are interested in the size of these aggregates, the
relationships between them, and the reasons why they change.
The circular flow of income model is a good starting point for understanding macroeconomic
relationships. As illustrated on page 3, the circular flow model describes the continuous exchanges
that occur in our modified market economy.

The circular flow model is a simplification of the continuous process of exchange of goods and
money throughout the economy. Households and business firms form the basis of the economic
system. in return for using the resources owned by households in the production process, firms pay
households an income, most of which is spent on consumption (goods and services produced by

In the factor market, firms hire resources from households, in return for which households receive
income. In the goods market, households and business firms exchange income earned during the
production process in return for goods and services.

The goods and factor market part of the model (exchanges between households and firms) reminds
us of the interdependent nature of our economy - one person's spending creates another person's


1. The household sector (or consumers) includes all families, groups and individuals in their
roles as consumers who buy the goods and services provided by other sectors of the
economy. A large proportion of the household sector also provides the resources that go
into the production of those goods and services.

2. The firm sector (or producers) comprises all the units who employ the resources provided
by households to produce the goods and services which are sold to consumers and other
firms. Firms vary in size and complexity, from individual self-employed producers to huge

3. The financial sector comprises the firms which specialise in financial services. Not all of
the income earned in the production process is spent on goods and services (consumption).
Most households choose to save some proportion of their income. The financial sector forms
an important link between savers and investors. The sector includes banks, building societies
and other financial institutions. They act as intermediaries between people or firms with
surplus funds (savings) and those who wish to borrow them.

Economics Semester 2 1 Supplementary Material
4. The government sector (or public sector) consists of all government authorities at national,
state and local level. Some government services are provided free of charge but paid for by
taxation; others are sold to consumers just like the output of non-government firms. Many of
the collective goods and services in the community are provided by the government sector,
which raises most of its revenue from taxation. The government then spends this money to
provide goods and services for the community

5. The overseas sector (or international sector) includes the rest of the world with whom our
economy has economic relations by way of trade and financial flows. Domestic resources
cannot satisfy all of our needs and wants, so the household and producer sectors spend some
of their income overseas. Similarly, people in other countries purchase domestic goods and
services. Domestic goods and services sold overseas are called exports (X); goods and
services which flow into our economy are known as imports (M). The difference between
the two is called net exports.

The five sectors identified above serve as a useful classification of all the participants in the
economy, and enable us to make more sense of the complex flows of money between the various
economic units. The production of goods and services by all sectors of the economy generates
income for the people who contribute their effort and assets to that activity. Thus the income
earned is equal to the value of goods and services produced. And in turn that income is disbursed
by consumers on spending, saving and taxes, and is subsequently used by firms and the government
to pay employees to generate further income. Therefore we talk about the circular flow of income
around the five sectors of the economy.

Economics Semester 2 2 Supplementary Material

1. Simple circular flow model with firms and household sector. For equilibrium Y = E.

2. 3 sector model adds financial sector;
Y = C + S, E = C + I.
For equilibrium Y = E.
i.e. C + S = C + I.
ie. S = I (leakages = injections)

3. 4 sector model adds government sector;
Y = C + S + T, E = C + I + G
For equilibrium Y = E.
i.e. C + S + T = C + I + G,
ie. S + T = I + G (leakages = injections)

4. 5 sector model adds external sector;
Y = C + S + T + M, E = C + I + G + X,
For equilibrium Y = E
i.e. C + S + T + M = C + I + G + X
ie. S + T + M = I + G + X (leakages = injections)

Income earned

Consumption expenditure

The full circular flow model
Economics Semester 2 3 Supplementary Material
Leakages and Injections

Savings, taxation, and imports are known collectively as leakages (or withdrawals). Spending on
these items reduces the spending power of households and firms (both money and real flows).
Investment, government expenditure and exports, on the other hand, are injections that return
money to the circular flow.

Inequality of Leakages and Injections
At any particular point of time, it is highly unlikely that total leakages will exactly equal total
injections. That is Y ≠ E and the economy will not be in equilibrium. This means that usually the
levels of income, output and employment will be changing.

Total Leakages Greater Than Total Injections
If total leakages exceed total injections, more money is being withdrawn from the circular flow than
is being added to it.
The level of income, and hence the level of expenditure in the economy, will fall. A declining
demand for goods and services will, in turn, lead business firms to cut back their production. As
they do so, firms will purchase fewer productive resources from households – and the level of
unemployment will rise.
Falling income, output and employment levels will cause the size of the circular flow to contract,
leading to unemployment; (How can the Government counteract this?)

Total Injections Greater Than Total Leakages
In this case, more money is being added to the circular flow than is being removed from it.
Consequently, income and expenditure will rise. As the demand for goods and services increases,
firms seek to increase their production levels by hiring more resources.
Rising income, output and employment levels will lead to an expansion in the size of the circular
flow, leading to inflation; (How can the Government act so as to try to control inflation?)

Economics Semester 2 4 Supplementary Material

1. The simple circular flow model assumes a two sector economy, composed mainly of:

a) government and business firms
b) government and consumers
c) business firms and households
d) business firms and the finance market

2. In the circular flow model, the flow of resources to firms is matched by :

a) a return flow of income
b) a return flow of saving
c) a return flow of investment
d) a return flow of consumption

3. Which of the following is an injection into the circular flow?

a) saving
b) taxation
c) imports
d) exports

4. When taxation is introduced into the circular flow, the size of the flow will:

a) contract as another leakage is created
b) contract due to the decline in investment
c) expand due to the added injection into the flow
d) expand due to increased consumer spending

5. The five sector circular flow is in equilibrium when :

a) S + I + T = G + X + M
b) S + T + M= I + G + X
c) S + G + M= I + T + X
d) S + I + G = T + X + M

6. Unemployment is most likely to occur when:

a) savings is greater than investment
b) there is a budget deficit
c) there is a favourable balance of payments
d) injections are greater than leakages

7. Exports have the same effect on the circular flow as:

a) taxation
b) savings
c) capital outflow
d) investment

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8. An increase in savings in a closed economy will not result in unemployment if the
increase in savings is matched by a corresponding :

a) increase in taxation
b) increase in investment
c) decrease in investment
d) decrease in consumption

9. The simple two-sector circular flow model shows that:

a) incomes of consumers are the sales receipts of the firm in the next production period
b) cost of resources is equal to the cost of the finished goods they are used to produce
c) consumer spending on goods is equal to incomes derived from production
d) all of the above

10. The full 5 sector circular flow model is in equilibrium when:

a) total injections equal total leakages
b) government spending equals taxation
c) savings equals investment
d) income equals consumption

11. The introduction of the overseas sector into the circular flow will:

a) increase the flow if there are more imports than exports
b) reduce the flow if there are more imports that exports
c) not alter the circular flow unless exports equal imports
d) depend on where the imports are from and where the exports are going

12. Money may be withdrawn from the circular flow by all but one of the following:

a) restriction of bank lending
b) budget deficit
c) reduced investment in Australia
d) budget surplus

13. If the government considers that the level of private spending is too high:

a) it should make government expenditure greater than government revenue
b) it should make government revenue equal to government expenditure
c) it should make government revenue greater than government expenditure
d) it should employ more public servants

14. The government influences the circular flow of income by:

a) borrowing
b) paying wages and social services
c) taxing consumers and firms
d) all of the above
Economics Semester 2 6 Supplementary Material
Unit 1


Economists define inflation as a 'persistent and appreciable rise in the general level of prices'. The
term inflation is applied to price increases that occur across time, and across a range of goods.

The Measurement of Inflation

The main method of reporting the level of inflation in Australia is the Consumer Price Index
(CPI). As an index number, the CPI summarises the overall change in the prices of a large number
of goods and services. The CPI is based on a sample “basket” of prices of consumer goods and
services, and is compiled on a quarterly basis - the Australian Bureau of Statistics (ABS) collects
approximately 100,000 price quotations in compiling the data on which the index is based.
The list of items covered in the CPI basket " …ranges from steak to motor cars, and from dental
fillings to restaurant meals."

International Influences on Inflation

Prices in Australia are not isolated from events in the rest of the world. Movements in international
import prices have a considerable influence on inflation. A good example is the price of fuel;
particularly because it is an important input at all stages of the production process - from gathering
resources to manufacture to distribution. Therefore, it can increase input costs and force up prices of
final goods and services.

Imported goods and services can bring inflationary pressure. As imported goods become more
expensive, those more expensive consumer imports will feed into higher price levels, as they are
included in the CPI basket.

The Consequences of Inflation

Inflation reduces purchasing power if incomes do not rise in line with price rises. That is, real
income falls, and households become worse off because they cannot purchase as many goods and

If inflation rises, this places upward pressure on interest rates because lenders wish to be
compensated for lower real income. Creditors (lenders) lose and debtors (borrowers) gain during
periods of inflation. Lenders lose unless the rate of interest they are charging is enough to cover the
rate of inflation, and allow for a real return on money lent. Long term lenders will be repaid in
inflated dollars which have reduced purchasing power. Savers see the real value of deposits reduced
during inflationary periods. Borrowers tend to benefit from inflation, because they can build up
their assets on borrowed money, knowing that the real value of their repayments will fall over time.

Inflation causes a lack of confidence in money as a store of value, and people often seek
alternatives against price rises that they expect in the future e.g. assets which are likely to
appreciate in value, such as property, antiques or precious metals.

The burden of inflation does not fall evenly on all sectors of the community. Some households
are worse off than others. Those able to anticipate inflation may be able to arrange their financial
affairs to benefit from expected price increases. As explained above, households that are able to
purchase real assets which rise in value with inflation (e.g. property) insulate themselves from falls
in real purchasing power.
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Living standards of low income earners and recipients of transfer income (e.g. pensions) will fall
during periods of inflation unless these payments are indexed to the price index. Sectors of the
economy with market power (perhaps business owners who can pass on price increases to their
customers) seem more capable of maintaining their real incomes.

Inflation promotes uncertainty. Both savings and investment are discouraged, reducing potential
output and employment. Uncertainty about future costs and prices makes it difficult for decision-
makers to be certain about the rate of return which can be earned.

There is evidence to suggest that capital-for-labour substitution occurs when wages (the price of
labour) rise when workers demand a wage increase during inflation. Employers may replace labour
with machines which don't ask for pay rises.

International competitiveness is influenced by relative inflation levels. A country will be at a
disadvantage if its domestic inflation is greater than its competitors. It is likely that an importer will
tend to favour a cheaper competitor’s product.

Inflation affects the CAD because the demand for exports falls as prices rise, and because imports
become more competitive as their prices fall relative to those charged by domestic competitors.



The Labour Force
The proportion of the working age population who are either in work or are actively seeking work is
known as the participation rate. It includes people who were employed and people actively

1,000 000

200 000 800 000

600 000 200 000
Participation rate = 75%

500 000 100 000
unemployment rate = 16.7%
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Questions 1 and 2 are based on the following data collected in a particular region.

Employed Persons Number
• full-time 70,000
• part-time 30,000

Unemployed persons 25,000
Job Vacancies 10,000

1. The size of the labour force in this region is:

a) 70,000 persons
b) 95,000 persons
c) 100,000 persons
d) 125,000 persons

2. The unemployment rate in this particular region is:

a) 8%
b) 10%
c) 20%
d) 25%

3. Official ABS ( Australian Bureau of Statistics) figures tend to underestimate Australia’s
unemployment rate because they do not include:

a) those only seeking part-time work
b) those absent from work due to illness
c) those waiting to start a new job
d) those discouraged from actively seeking work

4. That kind of unemployment caused by a general downturn in the level of economic activity

a) cyclical
b) seasonal
c) frictional
d) structural

5. Which of the following is regarded as a major cause of structural unemployment in

a) rapid rates of inflation
b) rapid rates of technological change
c) rising numbers of discouraged workers
d) increasingly unfavourable attitudes to work

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6. Unemployment which arises because the skills of job-seekers do not match those required
by employers is known as:

a) hidden
b) cyclical
c) hard-core
d) structural

7. The opportunity cost of unemployment is the

a) unemployment benefits paid by the government
b) income tax foregone by the government
c) goods and services purchased with unemployment benefits
d) goods and services which the unemployed could have produced

8. Inflation is most likely to benefit :

a) people on fixed incomes
b) Australian exporters
c) long term savers
d) long term borrowers

9. Cost push inflation is characterised by rising :

a) factor prices
b) exchange rates
c) aggregate demand
d) export prices

10. An example of hidden unemployment would be :

a) Louise leaving teaching and waiting to find a new teaching position
b) Glenys not being able to find work due to poor economic conditions
c) Peter’s teaching skills not being demanded in the market
d) Phil taking early retirement from the workforce as work is difficult to find

Economics Semester 2 10 Supplementary Material
Unit 2
Avoiding Double Counting
To measure total output accurately, all goods and services produced in any given year must be
counted once, but not more than once. Only the value of final goods and services will be counted.
Final goods and services are goods and services that are being purchased for final use and are not to
be subject to further processing, manufacturing or resale. Intermediate goods and services, on the
other hand, are goods and services that are subject to further processing, manufacturing or resale.

Most products go through a series of production stages before reaching a market. Throughout these
production stages, parts or components of most products are bought and sold many times; these
transactions represent part of the cost of the different stages of production. To avoid counting the
parts of final products that are sold more than once, GDP includes only the market value of the final
goods and services and ignores the value of intermediate goods and services. Why? Because the
value of final goods and services includes any intermediate goods required during the production
process. To count intermediate goods separately would involve double-counting and provide an
exaggerated estimate of GDP.

An example will clarify this point. Suppose there are five stages of production in getting a suit
manufactured and into the hands of a consumer who, of course, is the ultimate or final user. As
Table 1 indicates, firm A, a wool grower, provides $40 worth of wool to firm B, a wool processor.
Firm A pays out the $40 it receives in wages, rents, interest and profits. Firm B processes the wool
and sells it to firm C, a suit manufacturer, for $160. What does firm B do with this $160? As
noted, $40 goes to firm A, and the remaining $120 is used by B to pay wages, rents, interest and
profits for the resources needed in processing the wool. The manufacturer sells the suit to firm D, a
clothing wholesaler, who in turn sells it to firm E, a retailer, and then, at last, it is bought for $400
by a consumer, the final user of the product. At each stage, the difference between what a firm has
paid for the product and what it receives for its sale is paid out as wages, rent, interest and profits
for the resources used by that firm in helping to produce and distribute the suit.

The basic question is this: how much should we include in GDP in accounting for the production of
this suit? Just $400, the value of the final product! Why? Because this figure includes all the
intermediate transactions leading up to the product’s final sale. It would be a gross exaggeration to
sum all the intermediate sales figures and the final sales value of the product in column 2 and add
the entire amount, $1090, to GDP. This would be a serious case of double-counting – that is,
counting the final product and the sale and resale of its various parts in the multi-stage production

Economics Semester 2 11 Supplementary Material
To avoid double-counting, national income accountants could calculate only the value added by
each firm. Value added is the market value of a firm’s output (its revenue) less the value of the
inputs it has purchased from others (its intermediate consumption). So, for example, we note in
column 3 of Table 1 that the value added by firm B is $120, the difference between the $160 value
of its output minus the $40 it paid for the inputs provided by firm A.

By adding together the values added by the five firms in Table 1, the total value of the suit can be
accurately determined. Similarly, by calculating and summing the value added by all firms in the
economy, national income accountants could determine GDP.

Table 1
Stage of production
Sales value of
materials or product
Value added
Firm A, wool grower $ 40 $ 40
Firm B, wool processor 160 120
Firm C, suit manufacturer 220 60
Firm D, clothing wholesaler 270 50
Firm E, retail clothier 400 130
Total sales volume $1,090
Value added $400

Economics Semester 2 12 Supplementary Material
GDP and Economic Wellbeing.

GDP is the most common single measure of economic wellbeing of a society. A high GDP does
allow people to enjoy a better standard of living. GDP measures the production, income and
expenditure within the economy. If more goods and services are being produced then there are more
goods and services for the society to use and share.

GDP is not however, a perfect measure of wellbeing. Some things that contribute to a good life
are left out. Economic wellbeing (sometimes called economic welfare) is a broader concept used to
assess the society’s quality of life. To measure the quality of life we should not only look at the
material level of output (GDP) but also at other variables which influence how satisfied people are
with their lives. These other variables include the pattern of distribution, the composition of
production, leisure time, the levels of pollution, the levels of crime, the levels of political freedom
and even the weather.

GDP does not measure the hours that are worked and the quantity of leisure time. People who
work very long hours to produce a large number of goods and services may not have enough time to
enjoy them. The welfare gained by increased output may be due to reduced leisure time.

GDP excludes the quality of the environment. The production of more goods and services may
also result in more pollution. The deterioration of the quality of the air, oceans, forests and rivers
may reduce wellbeing and more than offset increases in output. Pollution may also increase the
incidence of some illnesses further reducing wellbeing.

Also excluded from measures of GDP is the composition of output (the type of goods and services
produced). If a nation concentrates its production on building more military equipment then it must
divert output of goods and services away from consumer products. Likewise, nations who
concentrate on the production of capital and infrastructure (attempting to achieve rapid growth) will
need to reduce the output of consumer goods, at least in the short run..

GDP does not directly measure the quality of the health or education systems.

GDP only counts the production good and services that are bought and sold for money. Many
services are often done by those who are not paid (e.g. child rearing by grandparents) and are not
counted. If the same services were provided by child care centres then they would be counted.

A high level of average income does not mean that all the people have high incomes. A society in
which a large share of the total GDP flows to a small proportion of the economy will mean
extremes of rich and poor. Where the pattern of distribution is very uneven, a high average figure
will be misleading and the general standard of living is likely to be quite low while a few in the
population may have enormous wealth.

We can see by now that GDP gives only part of the picture when observing the general standard of
living. Other indicators may add to our understanding of wellbeing. These indicators include
the infant mortality rate, the literacy rate, the proportion of doctors in the population, the average
number of calories consumed per day and life expectancy.

In conclusion, we should regard GDP as a good but incomplete measure of the standard of living.
There are distortions and omissions. There are abstract aspects of life that cannot be measured in
money terms such as political freedom. It is important to understand what the measure GDP
includes and what it leaves out.

Economics Semester 2 13 Supplementary Material

The Sources of Economic Growth

From an economic viewpoint, output is a function of the resources used to produce that output and
if we are to search for the reasons for growth, we need to examine the factors that influence those
resources and the skills with which they are combined to increase output. Ultimately, a country’s
growth rate is determined by the quantities of labour, capital and natural resources it possesses and
by the quality / skill of combining these, utilising improvements in technology, (i.e. productivity).

Demand factors
A significant source of growth is demand for an increased number and variety of goods and
services. The basis of increased demand in the long term is population growth, and the desire by
people to increase their economic welfare. Population increase results from natural increase (births
minus deaths) and net migration (the increase from immigration minus the loss from emigration).
Also, the development of a trading economy may stimulate growth because trade provides access to
overseas markets and increased potential demand. Migration creates immediate supply of labour,
and immediate demand for goods and services. Migration has also increased the quality of the
labour force by adding to its level of education, training and skills.

The following characteristics of a country’s population would be conducive to economic growth.

• A high proportion of the population in the workforce, i.e. productive
• A well-educated population
• A healthy population
• A population that wants economic growth - it must be motivated by material incentive

So it is not just the size of the population that matters - these other factors are fundamental to
supplying the human resources necessary for growth.

Supply factors
A major determinant of growth concerns the resources available to supply the demand for greater
satisfaction of wants. Economic resources consist of natural and human resources, and physical
capital. Economic growth arises in part from an increase. in the available quantity or quality
(productivity) of these resources. The key to economic growth is how a country develops its
resources: either expanding its resource base, or using its available resource base more effectively.

Increased productivity
More efficient use of available resources is an important general source of economic growth. Other
things being equal, growth will occur if an increased quantity of outputs can be produced from the
same or smaller quantity of inputs - combining resources more productively, so that the same
amount of resources can produce greater quantity or value of goods and services.

1. Human resources and growth
Increasing the quantity and quality of human resources leads to economic growth because labour is
a productive resource (supply side), and people demand goods and services (demand side).

Of great importance, is increases in human capital. Human capital can be defined as the stock of
knowledge and skills that people develop through education and experience. Improvements in
labour productivity generally occur as a result of education, training, the incentive of competition,
better organisation of production within firms and more efficient allocation of resources between
industries. Human capital can be developed through:
Economics Semester 2 14 Supplementary Material

• the provision of the basic building blocks of a productive workforce - social infrastructure
such as schools, hospitals, communication etc.
• the provision of education, which develops the skills, knowledge and understandings that
enable people to take their place in the community, as well as developing knowledge and
skills which can be used in the workplace.
• the provision of on-going training, which develops job-related skills

2. Investment and capital accumulation

In order to grow, an economy needs to divert some of its resources away from current production to
produce goods which will increase our capacity to produce in the future. Such goods are capital
goods (the produced means of production) and add to the capital stock of the nation. The process of
adding to the capital stock of a nation is known as new investment. This is to be distinguished
from depreciation which is the process of replacing the worn-out items of capital equipment. The
sum of net investment and depreciation is gross investment.
The capital stock of the economy includes capital equipment, building structures, and inventories.
Improvements in the capital stock occur as a result of invention, research and innovation. Another
key to economic growth is an increase in the capital to labour ratio to equip workers with a greater
stock of physical capital to enable them to work more productively. Two types of investment in
capital can be distinguished:

• Public or government investment, which creates the framework on which economic
activity is founded. Public investment provides the majority of infrastructure such as roads,
schools, hospitals, water supply and power. These are the parts of the capital stock on which
private sector productivity is founded. Public investment is often referred to as social
overhead capital. In general terms, public investment contributes to economic growth by
laying the foundation on which the private sector can do business e.g. Roads enable the
transport of goods, communications enable the interchange of products and ideas.

• Private or business investment, which includes buildings, machinery and equipment.
Private investment in capital equipment is undertaken in order to produce final goods and

It is necessary to distinguish between capital accumulation caused by capital widening from that
caused by capital deepening. The stock of capital is widened when it grows in proportion to other
productive inputs. Capital widening maintains the stock of capital per head. As population grows,
there will be a necessity to increase the stock of capital - providing more houses, roads, schools,
medical facilities and factories to keep up with the level of demand.

Capital deepening is an increase in the stock of capital relative to the stock of other productive
resources. This causes production to become more capital intensive i.e. deepening the stock of
capital increases the capital/labour ratio; or the capital/land ratio. Capital deepening tends to
increase productivity, making it possible for the workforce to produce a larger total output.

Economics Semester 2 15 Supplementary Material
3. Technological progress

Technology – the ideas or methods used in production. Technological progress can best be defined
as ‘changes in scientific and technical knowledge which involve new discoveries and new
techniques, and the application of these to the production process in order to raise the productivity
of the economy, i.e. output per worker per unit of time.

The application of improved technology to the productive process will increase the productivity of
the resources used. A greater volume of output can then be produced for the same volume of inputs
– better utilisation of resources. The economy can achieve higher levels of output in the future by
adopting more technology. Economic growth is more likely to be founded upon a consistent effort
to develop and apply product and process innovations. Such effort is often referred to as research
and development (R&D).

The potential for growth is increased when effort directed at research is improved. Such efforts
often involve a high degree of risk, however. Technological progress may also have negative effects
in some sectors of the economy. It is a cause of structural unemployment, because job losses may
be due to capital for labour substitution. Technological change favours those who hold highly
skilled jobs at the expense of those who have fewer skills – those who are more likely to be
replaced by technology, rather than be assisted by it. Most of these effects, however, occur in the
short term, and people can take measures to counteract them over time, such as further education
and retraining.

4. Government Policies

Should seek to create a “favourable climate” and optimum conditions for growth, e.g.

a) Policies to promote full employment, low inflation, promotion of business confidence for
continued investment.

b) Encouraging steady expansion of demand (e.g. immigration).

c) Policies to ensure high rates of capital accumulation - e.g. investment allowances on new
equipment, low company taxes, or increased government spending on capital works.

d) Providing protection for local industries against overseas competition, while attempting to
encourage the development of efficient, export orientated industries.

e) Promoting competition to help new ideas, innovation, etc.

f) Expenditure on education (apprenticeships, job training and research (e.g. C.S.I.R.O., grants
to Universities).

g) Provision of social overhead capital - infrastructure e.g. water, power, transport facilities -
the conditions necessary for the growth of industry, mining by private producers.
Economics Semester 2 16 Supplementary Material

The benefits of economic growth are to be found in improved living standards, increased
employment opportunities, improved economic and social mobility, increased levels of social
welfare, increased leisure time, increased participation in international trade, increased levels of
assistance to less-developed countries, and in the self-generating, cumulative nature of the growth
process itself. These are, of course, interrelated.

Improved living standards

The major overall benefit of economic growth is the improved living standards of the population as
a whole. Rising living standards mean higher levels of material well-being. These find their
tangible expression in a greater volume and variety of consumer goods and services, improvements
in the quality of all commodities, better standards of health and nutrition, improved housing
conditions, and so on.

Increased employment opportunities

Economic growth provides improved employment opportunities for an expanding workforce.

The structural changes which accompany growth involve, among other things, the development of
new markets and the expansion of existing ones. Now, because of demand for labour is a derived
one, such structural changes necessarily give rise to new avenues of employment in some sectors of
the economy and growing employment opportunities in others.

Improved economic and social mobility

Economic growth necessarily involves a reallocation of resources. Resources are attracted away
from existing industries and towards new ones. By providing new employment opportunities,
therefore, growth is said to increase the economic mobility of resources – that is, it improves the
ease with which resources of all kinds move between various avenues of employment. Increased
mobility of resources means a more flexible economy; it promotes structural change and is
conducive to rapid economic growth.

Economic growth also means increased social mobility. Rising incomes, improved access to
higher education and a wider range of occupational choice allow individuals to move more easily
between social groups or social classes. These ‘classes’ are closely connected with the status one
enjoys by reason of income, wealth, family name or occupation. Increased social mobility helps to
break down the ‘class barriers’ because it means, in effect, that children do not necessarily ‘follow
in their parents’ footsteps’.

Increased social welfare

Economic growth makes possible a greater provision for the aged, sick and unemployed members
of society. Rising incomes and expenditures which accompany growth provide increased tax
revenue for the government, and so allow increased transfer payments in the form of pensions and
unemployment benefits. Such payments reduce income inequalities and, in so doing, raise the
general living standard as a whole.

Economics Semester 2 17 Supplementary Material
Increased leisure time

The rising productivity levels which accompany growth allow for a reduction in working hours –
and hence an increase in leisure time.

Along with rising real incomes, increased leisure time generates increased expenditures on
recreational activities. These, in turn, promote the development of leisure-oriented industries
(entertainment, sport, travel, etc.), with their accompanying employment opportunities.

Increased participation in international trade

Economic growth allows each country to participate more fully in world trade and thus enjoy the
advantages of international specialisation. For a growing economy, these advantages are to be
found in the greater volume and variety of commodities available for domestic consumption (via
imports), greater access to raw materials supplies, more efficient use of existing resources, and the
transfer of new technologies.


The costs of economic growth include structural unemployment, lower present living standards,
inflation, balance of payments difficulties, the concentration of economic power, as well as the
social costs associated with environmental damage and the deteriorating quality of life.

Structural unemployment

Structural change necessarily involves a reallocation of labour resources. As new industries
develop, the demand by employers for certain kinds of skills will increase, as some of the more
traditional industries decline in importance, the demand for some existing skills will fall. Thus,
while new industries boast increasing employment opportunities, more established industries are
characterised by rising unemployment levels.

Such unemployment is called structural unemployment. It arises, in effect, because the skills of
the unemployed no longer match those required by employers.

Structural unemployment is regarded as a serious problem. Firstly, it involves an
important opportunity cost to society – in terms of goods and services which those unemployed
persons could otherwise have produced. The result is a reduction in the ability of society to satisfy
its material wants.

Secondly, evidence suggests that structural unemployment tends to be long-term in nature. It is not
always so easy for displaced workers to take advantage of employment opportunities in newly
emerging industries. The acquisition of new skills takes time and poses particular problems for
older workers.


High rates of economic growth are likely to be accompanied by inflation. On the one hand, rising
money incomes and increasing demand for goods and services mean greater pressure on scarce
resources in general – and on labour in particular. As the economy approaches full employment,
competition between firms for increasingly scarce labour forces up wages and salaries. Higher
Economics Semester 2 18 Supplementary Material
wages and salaries mean increased production costs and these, in turn, are passed on to consumers
in the form of higher prices. This kind of inflation is called cost-push inflation.

On the other hand, inflation may occur because the rate of growth in output is insufficient to meet
the demand for additional goods and services by the population. This kind of inflation is called
demand-pull inflation.

Inflation poses a number of important problems for a growing economy. Among other things, it
lowers real incomes, increases income inequality and leads to a misallocation of scarce resources.
It also presents an important dilemma for government policy makers. In particular, it means that the
pursuit of rapid growth may have to be at the expense of another desirable economic objective – the
stability of costs and prices.

Balance of payments difficulties

Rapid economic growth may pose balance of payments difficulties in several related ways. Firstly,
a nation’s international competitiveness tends to decline if its domestic rate of inflation exceeds
that of its major trading partners. Declining international competitiveness means rising imports,
falling exports – and larger current account deficits.

Secondly, the increasing demand for imports which accompanies growth tends to put downward
pressure on the exchange rate. Unless the growth in imports is more than matched by increased
exports, the current account deficit will rise and a nation will be forced to borrow more from
overseas. The result is a rising level of foreign debt.

Thirdly, economic growth may pose long-term balance of payments difficulties if new investment is
financed mainly by overseas borrowing. Repayment of the foreign debt in the form of interest and
dividends necessarily places a future strain on the current account.

Harmful externalities and social costs

One of the most serious problems associated with economic growth is the presence of harmful
externalities. Externalities refer to those indirect costs and benefits associated with the production
and consumption of certain goods and services which the price mechanism fails to take into
account. Externalities are also known as spill-over effects.

Negative externalities arise, when cars pump carbon monoxide into the atmosphere, when a
factory discharges waste into a river and kills fish downstream, and even when a picnicker throws
beer cans into the bush. These harmful externalities are called spill-over costs or social costs.

There can be little doubt that economic progress has been accompanied by air and water pollution,
the destruction of the natural environment and the extinction of certain species of wildlife
Also, economic growth has been accompanied by increasing urbanisation. This has a number of
deleterious effects on the quality of life. These include increasing noise and traffic congestion,
overcrowding, the development of ‘slum areas’ as dwelling construction and urban renewal fail to
keep pace with an expanding urban population, the ‘ugliness’ of the big city itself, the growing
problem of garbage disposal, increasing pressure on urban amenities, and the growing incidence of
the physical and emotional problems which accompany the increasing pace and pressure of urban

Economics Semester 2 19 Supplementary Material
Unit 3

Over a long period of years, real GDP will grow as a result of population growth; resource
development; productivity improvements; and the demand for a higher standard of living. An
inherent characteristic of all developed economies is that the rate of growth and the level of
economic activity fluctuates about the trend, or average rate of growth. In some years, countries
experience higher rates of growth - a boom. In other years, economic growth may be lower than
average, perhaps even negative. This cycle of booms and recession is known as the business cycle -
characterised by four phases - boom, downswing, trough, and upswing.

The Phases of the Business Cycle

The business cycle is a regular oscillation of economic activity. Four phases of the cycle are usually
recognised - boom, (peak) downswing (contraction), trough ‘(recession) and upswing (recovery).
As Fig 1 shows, real GDP rises in the recovery phase, reaches a peak, declines through the
recession to a trough and then rises in another recovery. .

boom boom
downswing upswing

1. The boom
The boom is a period when the general level of economic activity is above average. The levels of
aggregate expenditure are at, or beyond, levels required for full employment. Typical characteristics
of the boom include:

• high levels of consumption expenditure
• a general feeling of confidence in the economy.
• firms have increased output
• unemployment is relatively low

Economics Semester 2 20 Supplementary Material
• inflationary pressure is more likely.
• imports (of both consumer and producer goods) are relatively high.

2. The downswing
The level of economic activity cannot keep rising forever. In the upswing to the boom, investment
increases productive capacity and productivity and higher levels of aggregate expenditure mean
resources such as labour are fully employed. But investment becomes more risky after some point
because of limits to capacity. Once investment levels off this translates into lower output and

The rates of increase in potential output fall as shortages of labour or productive capacity occur. It is
not possible to produce more and more output from fully utilised stocks of capital equipment, and
demand pressure may result in price increases rather than increases in output.

At the peak of the cycle, the rates of increase of income, output and expenditure which have
characterised the boom tend to level off. Investment will decline. The effects of falling aggregate
output and income levels start to spread throughout the economy, and it becomes obvious that the
economic climate has deteriorated.

Any of these events may give rise to uncertainty as consumers and firms change their expectations
about the future and change their planned spending habits as a result. The mood of the economy
may also change as the government introduces contractionary fiscal and monetary policy in order to
reduce the level of activity in the booming economy. Interest rates usually rise during the upswing
and boom, and may reach a level where they start to discourage borrowing (because repayments
will be high) and expenditure on durables (because the opportunity cost of spending on
consumption or investment is high).

3. The trough
The trough (otherwise called contraction or recession) is when the level of aggregate expenditure
(income, consumption and investment) is below the economy's potential during the trough, which is
often characterised by:

• higher levels of unemployment
• lower consumer expenditure
• lower inflation (or deflation)
• lower levels of consumer and business confidence
• levels of saving may rise as some people put off consumption

4. The upswing
The decline in economic activity will not continue indefinitely. Productive capital is eventually
worn out and requires replacement. Businesses will develop process and product innovations as
they fight to develop a competitive advantage over their rivals. Higher levels of expenditure,
income, and output affect both firms and consumers. The level of economic activity gradually rises
as the economy resumes its long term growth path. The upswing can also he called the expansion
phase of the cycle.

Economics Semester 2 21 Supplementary Material
Until the late 1930’s, the existence of large scale unemployment in an economy was regarded by
economists as a temporary affair which would right itself. Influenced by this view, governments
adopted a ‘laissez-faire’ attitude towards unemployment. It was believed that only at full
employment was the economy at equilibrium and that at anything less than full employment the
self-adjusting mechanism would begin to work. If labour was unemployed, wages would fall; the
profits of firms would therefore rise and, as a consequence, more labour would be employed.

During the late 1920’s and early 1930’s, however, it became obvious that unemployment was no
temporary matter. For most industrial economies, the unemployed in this period were rarely less
than 10 per cent of the total labour force and, at some stages, reached as high as 25 per cent.
Governments, however, by accepting the theories of orthodox economics, appeared powerless to do
anything to correct it. It was Keynes’ achievement to break with orthodox economics and show
how large scale unemployment may be avoided.

The Great Depression resulted in a considerable re-evaluation of the role of government in the
market economy. Up to this time government was expected to match its revenue with its

The economist John Maynard Keynes argued in book, “The General Theory of Employment,
Interest and Money” (1936), that the traditional approach to fiscal policy – especially maintaining
balanced budgets in periods of recession of depression – was unsound. He had studied economic
trends during the 1920’s and had come to the conclusion that existing economic policies were
unable to solve problems faced by the governments of his day.

Keynes laid heavy emphasis upon the importance of demand in his economic theory and he
stressed the point that it was within the power of governments to influence the level of
unemployment and inflation by policies which changed the total amount of spending within the
economy. He rejected the view which had been put forward by the Classical economist, Jean Say.
Say’s Law stated that “supply creates its own demand”. Say had argued that where production
occurred, the incomes generated during the production process would be sufficient to purchase the
output and indeed would result in the output being purchased.

Keynes, on the other hand, noted that this approach had ignored the role of leakages and injections
in to the circular flow. He saw that an economy is in a state of equilibrium when leakages (savings,
taxation and imports) are equal to injections (investment, government expenditure and exports) in
the circular flow. He saw that an economy need not be in a condition of full employment for it
to be in equilibrium.
Consider the example of an economy at full employment and in equilibrium when the level of
national income is $4000 million. In such an economy, S + T + M = I + G × X. Should the sale of
exports drop, the economy is now in a state of disequilibrium: S + T + M > I + G + X. Leakages
from the circular flow are greater than injections. Incomes fall, demand curves for goods and
services shift to the left and unemployment rises. Full employment can only be restored when
national income is greater than, or equal to, $4000 million. Keynes saw that it was possible for an
economy to be in equilibrium yet not at full employment – in our example all that is necessary is
that leakages from the circular flow equal injections when national income is less than $400 million.

Economics Semester 2 22 Supplementary Material

Keynes and Unemployment
The Keynesian explanation of unemployment is a theory of effective demand. Unemployment
exists, according to Keynes, not because workers want too high wages, but because the demand for
goods and services is too low and is stabilised at this low level. Fundamentally, then
unemployment occurs because people and firms do not demand the products that the labour force
can produce. The basic proposition is that, if a person’s income rises, only a part of the increment
will be spent on consumption; the rest will be saved.
From the point of view of aggregate incomes in the economy (national income) it is clear therefore
that the community is not prepared to spend all its income on current consumption. That is, the
community does not ask the labour force to produce consumption commodities of a value equal to
its own income.
Keynes makes the assumption that the level of employment in the economy depends upon the level
of national income. In other words, employment depends on the volume of production (since all
incomes arise directly or indirectly from production). More production means more jobs, and vice
versa. In a relatively developed economy with full employment, only a part of the national income
is spent on current consumption. Similarly, only part of the domestic product is composed of
consumption commodities. The rest of the domestic product must be composed of investment
goods. Under conditions of full employment, the amount of labour required to produce these
investment goods, together with that required for consumption commodities, equals the total labour
force. Obviously, the demand for investment goods must come from expenditure of income not
required for consumption. It comes from savings. Now, if the community is not prepared to spend
sufficient of its savings on investment to create full employment, the level of national income will
be less than that required for full employment. Keynes calls this the point of under-employment
equilibrium. Unless more can be spent on producing a greater quantity of commodities (either for
consumption or investment), unemployment will be permanent.

Keynes and Government Policy

Keynes’ theory gives emphasis to two important features. The first is the stress placed on the
national aggregates. If an individual saves a greater part of his income, he may be doing a sound
thing. For a community as whole, however, such an action may be positively harmful unless that
community is prepared to invest sufficiently to compensate for the lower consumption level. The
second feature is the crucial importance of aggregate investment. (Keynes used the term
“investment” in its economic sense of expenditure on investment goods, i.e. on physical
commodities such as machines, factories and houses. He did not mean investment in government
bonds, stocks and shares, etc.) Keynes noted that consumption habits of persons are relatively fixed
for any given level of income. If national income is insufficient for full employment, it would help
if the community spent more on consumption commodities. But this is difficult to achieve. The
key to unemployment, therefore, is investment. In his favour “investment multiplier” analysis,
Keynes demonstrated that investment created jobs not only for those directly producing the
investment goods. Part of the extra incomes earned would create more incomes (and jobs) out of
which some would be spent on consumption … and so on.

Thus, the main conclusion of Keynes’ analysis is that investment is the main factor determining the
level of employment. Because of the importance of this conclusion, much of Keynes’ analysis is
concerned with explaining what actually determines investment. He emphasised the role of
monetary factors and especially interest rates and the supply of credit and money. The flow of
funds from savings into investment will only take place if the expected rate of profit (Keynes called
this the “marginal efficiency of capital”) on such investment is high enough. If interest earnings on,
Economics Semester 2 23 Supplementary Material
say, government bonds or other securities are higher than can be obtained by investing, then savings
will be put into securities rather than investment. Thus low interest rates help investment, and
Keynes was a firm advocate of a “cheap money” policy as a cure for unemployment.

Since the publication of The General Theory, its influence has been profound. In the opinion of
many, Keynes ranks as the greatest of all economists. His emphasis on investment and monetary
factors has been largely responsible for many features of government policy since World War II.
Since there is a tendency for investment by private firms to fall short of the level required for full
employment, Keynes advocated public (i.e. government) investment in public works and a cheap
money policy. To Keynes, the government should undertake public works as a “balancing factor”
to create the extra jobs needed when the private sector did not invest sufficiently for full
employment. Thus, charity and soup lines were not the answer to unemployment; the government
should stimulate the economy through the purchase of commodities in the markets. Such spending
must be new spending and not substitution for private expenditure. In a situation of unemployment,
therefore, public spending should be financed from loans and not from taxes. Tax-finance
represents income removed from the community which would have been spent if left in private
hands. Loan-finance, normally represents a net addition to total spending.

Thus Keynes believed that government intervention in the economy could help restore full
employment. In periods of recession, the government should increase rather than reduce its
expenditure. Since S > I in such times, it made sense for the government borrow in order to
finance its spending. Increased government spending should have the effect of increasing the
demand for goods directly – as the government would be acquiring goods and service in return for
its expenditure – and it would have a multiplier effect on the economy as a whole. Resources
needed to create the goods and services purchased by government would create an increase in
derived demand, so the incomes for factors of production would rise. Potentially, greater incomes
would result in higher levels of consumer spending, greater demand for capital (thus increasing
investment), and lower unemployment.

In periods of high demand and inflation, Keynes believed that a government should run a surplus
budget – that it should spend less than it received. In this way it would be able to reduce the total
demand for goods and services in the economy. By increasing the level of leakages from the
circular flow, the economy could be moved to a state of equilibrium at a lower level of national

From the end of World War II, Demand Management, the regulation of aggregate demand by
fiscal policy in an effort to counter swings in the business cycle, has been used by government in
Western market economies.

Economics Semester 2 24 Supplementary Material

We now consider the factors which are likely to affect household spending decisions. In doing so,
we must keep in mind the special relationship between consumption and saving, since those factors
which alter the level of household spending will also alter the level of household saving.

Factors Affection Consumption

The level of disposable income
The level of disposable income is the key determinant of the level of consumption expenditure. In
general, the higher the level of disposable income within the community, the higher is its level of
household consumption.

As total disposable income rises, of course, total household consumption increases. We can qualify
this statement in two respects.

1. Increases in disposable incomes are accompanied by increases in the Average Propensity to
save (APS). Thus the higher the level of disposable income, the greater is the proportion of
that income which is saved.
2. Increases in disposable income are unlikely to be completely absorbed by increases in
consumption expenditure. Some will be reflected in increased saving. The extent to which
consumption and saving will increase depends, of course, on the sizes of the MPC and the
MPS respectively.

Finally, let us note that it is quite possible (in the short run) for individual households to spend more
than their current disposable incomes simply by borrowing or by drawing on their own past savings.
This reduction in accumulated savings is called dissaving.
The distribution of income
If the distribution of income is uneven, households in upper income groups receive a relatively large
proportion of total disposable income. The APC for these groups is relatively low (while their APS
is relatively high). A more even distribution of income, on the other hand, means that households in
the lower income groups receive a relatively larger share of total disposable income. The APC for
these groups is relatively high.

Thus, the more even is the distribution of income, the higher is the APC – and the higher is the level
of consumption expenditure.
It is often argued that, in the making their spending and saving decisions, households are heavily
influenced by their levels of wealth. The term wealth basically refers to the total value of each
household’s assets (cash, bank deposits, securities, and property such as cars and houses). (Notice
that wealth and income are different concepts.)

Given the same level of current disposable income, those households with accumulated wealth are
more prepared to spend than those with little or no accumulated wealth. There are three reasons for
this. Wealthy households:

1. have a greater capacity to borrow, since they can use their assets as collateral.
2. tend to have a greater volume of past savings on which they can draw.
3. are more likely to spend because their economic futures are relatively secure.
Economics Semester 2 25 Supplementary Material
Consumer expectations
If households expect inflation to continue at relatively high rates, they will be encouraged to ‘buy
now and beat the price rise’. As households bring their expenditure plans forward the level of
consumption will rise. If they expect prices to fall, households are likely to postpone some of their
spending plans, and the level of consumption will fall.

Households are also likely to increase their current spending of they expect their incomes to rise in
the near future. The prospect of improved employment opportunities and rising incomes promotes
consumer optimism and tends to make households somewhat more carefree in their spending
behaviour. If, on the other hand, households face the prospect of unemployment and low future
incomes, they tend to reduce their current spending and increase their level of saving.

Generally, we can say that current economic conditions are likely to have an important influence on
consumer expectations – and a significant impact, therefore, upon household decisions to spend and
to save

The rate of interest
For households, interest rates represent both the cost of borrowing and the reward for saving. Rising
interest rates make borrowing relatively more expensive, and saving relatively more attractive.
Falling interest rates, on the other hand, make borrowing relatively cheaper and saving relatively
less attractive.
Thus, rising interest rates tend to reduce the level of consumption and increase the level of
household saving; falling interest rates tend to increase the level of consumption and reduce the
level of household saving.
Changes in interest rates are particularly important in the case of consumer durables. Cars, electrical
appliances, and the like are relatively expensive, and households tend to finance their purchases of
these items by borrowing. Yet, the relatively long useful life of these goods is such that households
may well be able to postpone planned expenditures on them. Thus, spending on consumer durables
tends to be highly sensitive to interest rate movements.

The availability of credit
For the individual household, credit is a source of additional funds which can be used to finance its
current spending. As credit becomes more readily available, the level of total household expenditure
tends to rise. If credit becomes more difficult to obtain, households are likely to postpone some of
their planned purchases, and the level of consumption tends to fall.

Population size, growth, and age structure
Obviously, the larger the population, the greater the level of total consumption expenditure. Rapid
increases in the population (for example, through immigration programs) are likely to lead to sharp
rises in the level of household spending.
The age structure of the population is also an important factor. A relatively young population tends
to spend more (and save less) than an ageing population. Young couples, for example, typically
borrow to buy a home, and thus spend in excess of their current incomes. Repaying home loans and
raising children tend to keep household savings low for some considerable time. As the children
grow up and leave the family home, and as mortgages are paid off, however, household saving
tends to rise.

Cultural attitudes
If contemporary values are such that social status depends on how much we spend, then the level of
consumption is likely to be relatively high. If, on the other hand, society attaches a high value to
personal thrift, people will tend to save a significant proportion of their current income.
Economics Semester 2 26 Supplementary Material

Investment is expenditure on producer or capital goods that are used to produce final goods and
services in the future, e.g. on new plant, capital equipment, machinery, and so on. The level of
investment is a very important determinant of aggregate demand and the overall health of the
economy. Aggregate private investment is the most volatile element of aggregate expenditure

Factors Influencing Investment Expenditure:

Expected Rate of Net Profit
The level of investment spending is guided by the profit motive; the business sector buys capital
goods only when it expects such purchases to be profitable For example, Suppose the owner of a
small shop is considering investment in a new machine that costs $1000 and has a useful life of
only one year. The new machine will presumably increase the firm’s output and sales revenue.
Specifically, let us suppose that the net expected revenue from the machine is $1100. In other
words, after operating costs have been accounted for, the remaining expected net revenue is
sufficient to cover the $1000 cost of the machine and leave a return of $100. Comparing this $100
return or profit with the $1000 costs of the machine we find that the expected rate of net profit of
the machine is 10 % (=$10 / $1000).

The Real Interest Rate

But there is more important cost associated with investing which our example has ignored. And
that, of course, is the interest rate – the financial cost the firm must pay to borrow the money capital
required for the purchase of the machine. If the expected rate of net profits (10 %) exceeds the
interest rate (say 7 %), it will be profitable to invest. But if the interest rate (say, 12 %) exceeds the
expected rate of net profits (10 %), it will be unprofitable to invest.

The rate of interest is a major influence on investment decisions. Other things being equal, interest
rates and the level of investment expenditure are inversely related. This concept is formalised as the
investment demand curve, on the next page. The investment demand curve shows the relationship
between the (real) interest rate and quantities of planned investment. Interest rates (on the vertical-
axis) represent the price of money. There is an inverse relationship between the rate of interest
and the level of investment.

Lower rates of interest (i) tend to induce higher investment expenditure (I). So if interest rates fall
from i to i1, we would expect a movement along the investment demand curve from Q to Q1. The
line I” shows a shift of the whole investment demand schedule brought about by a change in non-
interest rate factors. An increase in aggregate investment from I to I” would be due to a non-price
factors affecting investment, such as positive expectations about the future business climate.

The difference between nominal and real rates of interest must be noted here. Nominal rates are
the current price of borrowed money (i.e. the face value of the money. The real rate of interest,
however, takes the rate of inflation into account. If nominal rates of interest are at 8 %, and inflation
is 4 %, then the real rate of interest is 4 % (8 minus 4). Real rates of interest are a greater influence
on business decisions than nominal rates.

Economics Semester 2 27 Supplementary Material

Fig. 1 The investment-demand curve
Investment Q Q1

There are two reasons for the inverse relationship between i and I. As noted, interest rates represent
the price of borrowed money, so when interest rates are high, so too are repayments for capital
items purchased with borrowed funds. Secondly, interest rates represent the opportunity cost of
money. Firms have the choice of using money capital for new investment, or for some alternative
purpose. The opportunity cost of investment increases when interest rates are high. For example, if
business interest rates were 12 % p.a., the prospective rate of return on capital equipment must
exceed 12 % before a rational firm would consider investment to be a wise decision, other things
being equal.

Shifts in Investment Demand

Let us briefly consider several of the more important ‘non-interest determinants’ of investment-
demand noting how changes in these determinants might shift the investment-demand curve. Any
factor that increases the net profitability of the investment will shift the investment-demand curve to
the right. Conversely, anything that decreases the expected net profitability of investment will shift
the investment-demand curve to the left.

A major determinant of the level of investment is business expectations -what business thinks
about the current level of economic activity, forecasts for the future, and the impact these will have
on profitability. Business expectations are formed as a result of current economic events such as
levels of sales and enquiries from buyers. If business expectations about future sales arid profit
levels are positive, then it is likely that the investment demand curve will shift to the right. On the
other hand, a downturn in the level of business confidence would see a reduction in planned

Economics Semester 2 28 Supplementary Material

Technological progress
Technological progress – the development of new products, improvements in existing products, the
creation of new machinery and new production processes – is a basic stimulus to investment. The
development of a more efficient machine, for example, will lower production costs or improve
product quality so increasing the expected net rate of profit from investing in the machine. A rapid
rate of technological progress shifts the investment-demand curve to the right, and vice versa.

Acquisition, maintenance and operating costs
As our machine example revealed, the initial costs of capital goods, along with the estimated costs
of operating and maintaining those goods, are obviously important considerations in gauging the
expected rate of net profitability of any particular investment. To the extent that these costs rise, the
expected net rate of profits from prospective investment projects will fall, shifting the investment-
demand curve to the left. Conversely, if these costs decline, expected net profit rates will rise,
shifting the investment demand curve to the right. Wages also may affect the investment-demand
curve because wage rates are a major operating cost.

Business taxes
Businesses look to expected profits after taxes in making their investment decisions. Hence, an
increase in business taxes will lower profitability and tend to shift the investment-demand curve to
the left; a tax reduction will tend to shift to the right.

The stock of capital goods on hand
To the extent that a given industry is well-stocked with productive facilities and inventories of
finished goods, investment will be lessened in that industry since such an industry will be amply
equipped to fulfil present and future market demand. If an industry has enough, or even excessive,
productive capacity, the expected rate of profit from further investment in the industry will be low,
and therefore little or no investment will occur. Excess productive capacity tends to shift the
investment-demand curve to the left; a relative scarcity of capital goods shifts it to the right.

We noted earlier that business investment is based upon expected profits. Capital goods are durable
– they may have a life expectancy of 10 or 20 years and thus the profitability of any capital
investment will depend upon business planners’ expectations of the future sales and future
profitability of the product that the capital helps produce. Business expectations may be based upon
elaborate forecasts of future business conditions that incorporate a number of ‘business indicators’.
Nevertheless, such elusive and difficult-to-predict factors such as changes in the domestic political
climate, of overseas events, population growth, stock market conditions and so on must be taken
into account on a subjective or instinctive basis. For present purposes we note that if businesses are
optimistic about future business conditions, the investment-demand curve will shift to the right, a
pessimistic outlook will shift it to the left.

Economics Semester 2 29 Supplementary Material

The aggregate expenditure (AE) model is based on the ideas first published by John Maynard
Keynes in the 1920s and 1930s. It examines the 'building blocks' of macroeconomic activity - the
components of aggregate expenditure.

Aggregate expenditure can be defined as the total amount that firms and households plan to spend
on goods and services at each level of income. The elements of aggregate expenditure can be
expressed in the equation:

AE = C + I + G + (X-M)

where C = consumption expenditure; I = investment expenditure; G = government expenditure ; X
= exports; and M = imports.

Understanding aggregate expenditure patterns enables us to identify and explain trends in economic
activity. This section will introduce how changes in expenditure affect the level of income in the
economy. This analysis is an important background for later topics.

The Keynesian model is based on the relationship between the level of income received by
households, and the level of consumption and saving which occurs. This is known as the
consumption schedule, or consumption function. Initially, we assume that there is no government
sector and no overseas sector - in which case, there are only two possible things that people can do
with their income: spend it (C for consumption), or save it (S for saving) i.e.


A hypothetical aggregate consumption schedule for the community is shown in the table below,
which shows the planned levels of consumption and savings expenditure at each level of income.
The schedule is also shown graphically.

Y  =  C  +  S 
0    60    ‐60 
100    120    ‐20 
200    180    20 
300    240    60 
400    300    100 
500    360    140 
600    420    180 

Economics Semester 2 30 Supplementary Material
The level of aggregate expenditure is shown on the vertical axis, and income and output levels are
shown on the horizontal axis. It is important to review the concept of macroeconomic equilibrium
here. Equilibrium refers to the level of economic activity at which there is no change in the levels
of output, income or expenditure. That is, E=Y=O.

On the Keynesian model, where AE intersects any point along the 45° line represents a point of
equilibrium. Along the 45° line C + S is equal to the level of Y. Where AE intersects the 45° line, at
point 'a', the total level of expenditure is equal to the level of Y, so there is overall balance and no
tendency to change. Planned spending consumes all output.

Consumption rises by some proportion of income, but it does not start from zero. If the income
level in the economy was zero, the aggregate level of consumption would still be $60 billion,
(where the consumption function intersects the vertical axis). This is referred to as autonomous
consumption, as it occurs independently of the level of income.

Consumption can exceed income if households draw on their savings or rely on transfer payments
(e.g. unemployment benefits), or borrow. At levels of income below $150 billion, aggregate
spending is greater than aggregate income. This is referred to as `dissaving'. After the 'break even'
point, where C = Y and S = 0, (at point a where Y = $ .150 billion) there is a positive level of
saving in the economy.

The Keynesian consumption function proposes that consumption increases as disposable income
rises, but not by as much as the increase in income.
C exceeds Y until the C function crosses the 45° line (point a). This is also the point at which the
savings = zero but then becomes positive.
The consumption function is generally written as an equation C = a +bY, where a represents the
autonomous component of consumption (here $60 billion), and b represents the marginal
propensity to consume, (MPC), which is the slope of the C line.

The MPC can be defined as the fraction of the last (marginal) dollar of income which is spent on
consumption when income changes. Thus:
MPC = C / Y

The level of spending on consumption rises by a proportion of any increase in income - in the table,
this proportion is 0.6, and is assumed to be constant, so the equation is a straight line). For every $1
increase in income, the consumption function shows that households will spend 60 cents, and save
40 cents. The MPC in this case = 0.6.
Therefore, the equation for the C function in this case is C = 60 + 0.6Y.

The fraction of marginal income that is saved is the marginal propensity to save (MPS).
MPS = S / Y

Our assumption specified that there was no government or overseas sectors in the economy. As a
result, all income is either spent (C) or saved (S). Therefore:
MPC + MPS = 1

The value of the MPC (0.6) in the equation for the consumption function represents the slope of the
C line. If MPC .s 0.6, then MPS must be 0.4, because C S = Y. if consumers spent 70 per cent of
any additional income, and saved 30 per cent, then MPC = 0.7, and MPS = 0.3. The slope of the
line with MPC = 0.7 would be greater (steeper) than the consumption function shown in the
diagram above. A consumption function with a slope of 0.9 would be steeper again. A steeper
Economics Semester 2 31 Supplementary Material
consumption function means that households spend a greater proportion of any increase in income
(Y) they receive. Economists generally believe that the MPC and MPS are relatively stable as Y
rises as the MPC and MPS do not vary with proportion of total income which is spent

The overall proportion of income that is spent or saved at any level of income is the APC {average
propensity to consume) and APS (average propensity to save). The APC is defined as the proportion
of total income which is spent. APS is defined as the proportion of total income which is saved.
APC and APS vary as the level of income changes.

The consumption function is regarded as the cornerstone of Keynesian aggregate expenditure
theory. We can now begin to add to the model by relaxing our assumption that consumers can only
spend and save their income.

Adding the Financial Sector

Aggregate saving creates a pool of funds in financial intermediaries which re-enters the circular
flow through a stream of investment.
To introduce the concept, we assume that business investment decisions are independent of the
aggregate level of income in the economy - that is, they are autonomous. Autonomous investment
means that the investment is independent of income.

Assuming that there is no government or overseas sector, then the level of aggregate expenditure in
the whole economy must now be equal to the sum of consumption expenditure plus investment
AE = C + I

Y  C  S  I  C+I 
0  60  ‐60  60  120 
100  120  ‐20  60  180 
200  180  20  60  240 
300  240  60  60  300 
400  300  100  60  360 
500  360  140  60  420 
600  420  180  60  480 
b C+I
I 60

Economics Semester 2 32 Supplementary Material

Equilibrium in this economy occurs where the levels of leakages and injections are equal. This
model extends the consumption function by adding an investment function. C+I is the aggregate
expenditure (AE). Equilibrium occurs where Y =$300 billion. (i.e. where S = I; and where the C + I
line crosses the 45° line (point b on the diagram). At the equilibrium level of income, there is no
tendency for the level of income to change.

There is always an automatic tendency towards equilibrium in the economy. If Y = $400 billion, for
example, the savings leakage is greater than the investment injection. Aggregate expenditure (C + I
) is insufficient to support the level of output which firms have already produced, so firms cut
production and aggregate output and income fall, until equilibrium is restored at point b (Ye level
of income).

On the other hand, at the level of income Y = $200 billion, the total amount of expenditure (C + I)
in the economy is greater than the planned output (i.e. 45° line). Investment exceeds savings,
leading to a reduction in stock, an increase in production, and higher levels of income.

Only at Y = $300 billion can the economy be in equilibrium, with the levels of aggregate
expenditure matching planned output (where the C + 1 line cuts the 45° line).

Economics Semester 2 33 Supplementary Material
Unit 3


1. Induced investment will decrease as a result of a decrease in:

a) business expectations
b) saving
c) the level of technology
d) income

2. An increase in autonomous investment will:

a) reduce the level of saving
b) reduce the level of consumption
c) shift the total expenditure line upwards
d) shift the total expenditure line downwards

3. Which of the following will cause a decrease in autonomous investment?

a) a fall in interest rates
b) a reduction in business taxes
c) a fall in business expectations/confidence
d) a fall in the level of income in the economy

4. The marginal propensity to consume is:

a) consumption expenditure divided by saving
b) the increase in income divided by the increase in consumption
c) the increase in income divided by consumption
d) the increase in consumption expenditure divided by the increase in income

5. If national income rises, owing to a rise in investment, we would expect:

a) consumption and savings to rise
b) consumption and savings to fall
c) consumption to rise, savings to fall
d) consumption to fall, savings to rise

6. If C = 200 + .75 Y and I = 100, the equilibrium level of income is:

a) 600
b) 750
c) 1050
d) 1200

Economics Semester 2 34 Supplementary Material
7. If C = 200 + .75 Y and I = 100 and the level of national income (Y) is 1,100 then:

a) there will be a build up of stocks
b) consumption is less than savings
c) total expenditure exceeds total output
d) savings exceeds investment

8. I = 50 and S = -100+0.25Y, then the equilibrium level of national income is equal to:

a) 150
b) 300
c) 600
d) 900

9. A rise in income of $2,000 causes consumption spending to rise by $1,600. The M.P.C. is
equal to:

a) 0.2
b) 0.8
c) 1.6
d) 2

10. In the diagram below CC is a consumption function. The marginal propensity to consume is
equal to:

a) the distance BX
b) the ratio BX/AB
c) the ratio BX/YA
d) the ratio BX/OY




Economics Semester 2 35 Supplementary Material
Unit 4

Changes in the Level of Spending

Changes may occur in any of the components of aggregate expenditure. Because one man's
spending is another man's income, any addition to (or reduction of) the level of spending in the
economy will have far-reaching effects on the level of income. A change in any of the withdrawals
from the circular flow, or injections to it, will lead to on-going effects throughout the economy.
Economists use a model called the multiplier to explain this process.

Consider than what happens when there is an increase in investment - perhaps a firm decides to
spend $10m building a new factory in a country town. The initial (new) investment creates income
for people who supply goods, services and labour to build the factory. Those people then spend that
income on goods and services on sale elsewhere in the town - food, clothing, school fees, furniture
and so on. This increases the level of business activity in the town, and perhaps employment as

To analyse the impact of new investment, assume that prior to the building of the new factory:
• the level of income is $300m
• the economy is in equilibrium, with S = I at $60m
• the MPC is 0.6, so for every extra dollar earned, 60c will be spent, and 40c saved.

The investment in the factory ($10m) creates new income for people working on the project.
Assuming the MPC is 0.6, they spend $6m, which becomes someone else's income in the round
two. 60 per cent of this is spent ($3.6m) and 40 per cent saved ($2.4m). In round three, new income
is $3.6m, of which $2.6m is spent and $1.4m saved. The cycle of 'one man's spending creating
another man's income' continues over time. After four periods of the income / spending cycle,
$21.7m of extra income has been created from the autonomous increase in investment of $10m in
period 1. After an infinite number of spending rounds, an initial $10m investment has created $25m
extra income for the economy - $15m in new consumption, and $10m in new saving. At this point,
note that the additional saving generated by new income ($10m) equals the initial new investment.
That is, S = I once again and the economy has returned to equilibrium.

An easier way to examine the impact of the change in investment uses the multiplier formula:
k = 1 / MPS

k = 1 /1 – MPC

where 'k' is the multiplier coefficient, and MPC and MPS refer to the marginal propensity to
consume and save. If MPS = 0.4, k =1 / 0.4 = 2.5. This means that, for an economy with an MPC =
0.6, the final effect of autonomous investment on the level of expenditure will be two and a half
times the initial change in investment. If MPS = 0.2, k =1 10.2 = 5. This means that, for an
economy with an MPC = 0.8, the final effect of autonomous investment on the level of expenditure
will be five times the initial change in investment.

The size of the multiplier

The community's propensity to spend and save determines the impact of any increase in investment.
There is a direct relationship between the size of the MPC and the size of the multiplier. This
relationship is illustrated using the multiplier formula k = 1 / MPS (or k = 1 / 1 - MPC).
Economics Semester 2 36 Supplementary Material
If the MPC was 0.9, the multiplier would be 10, whereas if the MPC was lower (say 0.5), the
multiplier would be 2. The more willing that people are to spend any extra income they receive, the
higher the value of the multiplier, and the greater the impact of any change in expenditure on the
level of economic activity.

The multiplier shows how one person’s spending creates another person’s income. An initial
investment creates new income, which is either spent or saved by those who have earned it. The
proportion which is spent creates income for others in the second time period. This is also spent or
saved. The final new income which has flowed from the initial investment can be determined using
the formula:
ΔY = k x ΔI

(i.e. 2.5 x 10 = 25), where k is the multiplier. Had the MPC been higher (say 0.8), the multiplier
would be larger and more income would have been created.

The Operation of the Multiplier

325 300
Then there is an autonomous increase in investment the level of spending and income in the
economy expands in successive rounds of new spending which creates new income. The multiplier
process means an initial new investment of $10m creates $25m in new income at the new

The Impact of the Multiplier

Initial equilibrium occurs at Y = 300m. Then firms decided to increase I by $10m (shown on the
diagram as I + ΔI). This created extra income in the economy, which gave consumers extra
spending power. Because one man's spending is another man's income, there was a series of
increases in spending and income until the economy reaches a new equilibrium at a higher level of
income. A small change in investment has resulted in a multiplied change in aggregate income.

The increase in I is shown as the shift upwards of the investment schedule, from I to I+ΔI.
Aggregate expenditure increases by the same amount, from C + I, to C + I +ΔI. This represents a
planned real income level of $300m. After the new $10m investment, the equilibrium level of
income rises to $325m.

Economics Semester 2 37 Supplementary Material
The multiplier process could also work in reverse - if investment falls, the level of income in the
economy falls by a greater amount than the initial reduction in investment. The multiplier principle
also applies to other changes in autonomous expenditure such as changes in government
expenditure or net exports. In fact, any increase in an injection will be multiplied to result in a
higher level of aggregate expenditure.

The Full Aggregate Expenditure Model

The Keynesian model can be extended to include the government and overseas sectors. As before,
consumption (C) increases as Y increases. Investment (I) is autonomous $60 billion, no matter what
the level of income. Likewise, government expenditure (G) tends to be very stable from year to
year is and so is considered independent of the level of Y (G = $80 billion).

Exports are also independent of the level of domestic national income. Exports are influenced by
economic conditions in the rest of the world –overseas demand for exports fluctuates according to
overseas economic growth and other conditions.

Imports, however, rise with Y, as they are influenced by changes in the level of domestic economic
activity. In periods of high economic activity, consumers and businesses buy more imports. They
are subtracted in the AE equation, because imports are a leakage.

The Keynesian Aggregate Expenditure Model

The figure below shows Y on the horizontal axis and AE on the vertical axis. To show AE on the
graph, we add each expenditure components at various level of GDP.

AE = C + I + G + (X-M).

The equilibrium level of income in this economy occurs when aggregate expenditure equals Y,
when Y = $400 billion. This point corresponds to where the 45° line intersects the AE line. There is
no tendency for change.

AE =
exp Y  C  I  G  X  M  AE 
0  60  60  80  40  40  200 
100  120  60  80  40  50  250 
200  180  60  80  40  60  300 
300  240  60  80  40  70  350 
400  300  60  80  40  80  400 
500  360  60  80  40  90  450 
600  420  60  80  40  100  500 

Economics Semester 2 38 Supplementary Material
The Paradox of thrift

Let us explore one of the many questions raised by Keynesian analysis: what happens if we, as a
society, attempt to save more? Most of us would quickly reply that we will be better off. After all,
we tend to believe that saving is a good thing. If you want something, surely the best way to get it
is to save for it.

Keynesian theory suggests that what is a good thing for the individual household may not, however,
be a good thing for the economy as a whole. While saving may well benefit the individual, too
much saving can lead to a fall in the level of income, output and employment. And, because saving
depends on income, falling income levels mean that households will actually fail in their attempt to
save more.

This apparent contradiction is called the paradox of thrift. Stated simply, the paradox of thrift is
that society’s attempts to save more will reduce the equilibrium level of income and actually fail to
raise aggregate saving.

Explaining the paradox of thrift

The paradox of thrift is based on the simple idea that each household can save more only if it is
willing to spend less. If all households reduce their expenditure on goods and services, business
firms will soon find their sales falling short of their current output and will cut back their production
levels accordingly. As they do so, the level of income, output and employment will fall and society
as a whole will actually be worse off.

A more concise explanation requires a simple diagram. In Figure 1 the initial saving function is S
Investment (I) is autonomous, and the initial equilibrium level of income is Oye
. At this level of
income, society’s total volume of saving is Oa.

Figure 1. Illustrating the paradox of thrift

Economics Semester 2 39 Supplementary Material

Now suppose that people suddenly become more thrifty, and all households decide to same more
out of every level of income. The saving function shifts upwards from S
to, say, S
.. As a result,
the equilibrium level of income, output and employment falls from OYe
to OYe
. What is more,
the multiplier effect ensures that the decline in the equilibrium level of income is much larger than
the attempted increase in saving. In these circumstances, society could hardly be regarded as being
better off.

A paradox in three ways

Our analysis of the effects of this sudden increase in saving leads to several paradoxical
conclusions. Firstly, despite its intentions to the contrary, society has actually failed to save any
more than it did previously. The level of aggregate saving at Oye
is exactly the same as at Oye
namely, Oa. Society has actually been prevented from saving any more by the multiple decrease in
income which, paradoxically, was caused by its efforts to be more thrifty!

Secondly, our discussion clearly points out that what is beneficial from the viewpoint of the
individual household may be detrimental from the viewpoint of society as a whole. For the
individual household, saving adds wealth and permits higher levels of future spending. From
society’s viewpoint, the increase in saving leads to falling income, output and employment. (The
paradox of thrift is a good illustration of the logical error known as the fallacy of composition.
What is true for the individual household is not necessarily true for all households taken together.)

Finally, efforts by households to be more thrifty are likely to come at a time which is most
damaging to society. Let us assume that the economy appears headed for a recession. As
unemployment levels begin to rise, more and more workers are likely to fear retrenchment. How do
these individuals react? Certainly not by going on a spending spree! Rather, they tend to cut back
their spending in order to save for the hard times ahead. Their attempts to save more may actually
bring about the recession everyone fears. From society’s viewpoint, the solution for individuals -
to spend less and to save more ends up becoming part of the problem.

Economics Semester 2 40 Supplementary Material

The simplest description of demand pull inflation is 'too much money chasing too few goods' -
high levels of demand caused by high levels of aggregate expenditure

Demand pull inflation can be illustrated using a Keynesian aggregate expenditure model, such as
the figure below. The full employment level of output is YF. Any level of aggregate expenditure
(a) above full employment output (b) indicates that there is an excessive level of spending in the
economy. The vertical distance between the two lines (ab) at full employment is known as the
inflationary gap. Planned expenditure (a) exceeds the level of output (b) at which all available
resources will be fully employed. The economy does not have the capacity to produce a higher level
of output, resulting in upward pressure on prices.

Diagram of the Inflationary Gap

To close the inflationary gap, the level of AE must be lowered to push the economy to equilibrium
level at full employment.


1. Fiscal Policy:
The government should implement a Budget Surplus -↓ G and ↑ T

2. Monetary Policy:
Interest rates should be increased ↑S, ↓C, ↓I

Economics Semester 2 41 Supplementary Material

Many economists refer to cyclical unemployment as demand-deficient unemployment, referring to
the rise in unemployment when the level of aggregate expenditure is less than that required for full
employment of the country's resources.

The Keynesian explanation for cyclical unemployment is known as the deflationary gap. It occurs
when the level of aggregate expenditure is insufficient to sustain full employment levels of income
and output in the economy. As illustrated below, the economy's resources are fully employed at YF
and output is (a). However, this economy is experiencing aggregate expenditure AE and the
economy is at equilibrium income YE. This level of aggregate expenditure is insufficient for full
employment. Thus lower aggregate expenditure causes cyclical unemployment - firms reduce
demand for inputs and lay off workers. The deflationary gap is the distance ab.

Diagram of the Deflationary Gap

To close the deflationary gap, the level of AE must be raised to push the economy to full
employment level.


1. Fiscal Policy:
The government should implement a Budget deficit - ↑G and ↓T

3. Monetary Policy:
Interest rates should be decreased ↓S, ↑C, ↑I

Economics Semester 2 42 Supplementary Material
Unit 4


1. The “Paradox of Thrift” can be described as a situation where:

a) more income is associated with less actual savings
b) additional attempted savings by society may lead to less actual saving
c) additional attempted savings by society may lead to more actual saving
d) additional consumption by society may be associated with less savings

2. Y = C+I
C = 40 + 0.9Y
I = 40
If autonomous investment increases by 20 then equilibrium income will rise by:

a) 20
b) 180
c) 200
d) 220

Questions 3 to 6 refer to the table below:-

National Income Consumption Investment
0 100 60
200 260 60
400 420 60
600 580 60
800 740 60
1,000 900 60

3. The equilibrium level of income is equal to:

a) 100
b) 200
c) 600
d) 800

4. The consumption function consistent with this data is:

a) C = 100+0.8Y
b) C = 50+0.6Y
c) C = 100+0.25Y
d) C = 0.8Y - 100

Economics Semester 2 43 Supplementary Material
5. The multiplier in this model of the economy is equal to:

a) 2
b) 4
c) 5
d) 10

6. If the level of investment were to rise by 50, then the new equilibrium level of national
income would be:

a) 1,000
b) 1,050
c) 1,250
d) 1,500

Question 7 and 8 refer to the diagram below:


7. If OA is the full employment level of national income, the inflationary
gap is indicated by:

a) OX
b) GH
c) AB
d) BC

8. If OF is the full employment level of national income, the
appropriate government economic policy would be:

a) increase government spending and budget for a deficit
b) decrease government spending
c) increase interest rates and reduce the budget deficit
d) increase interest rates and increase the budget surplus

Economics Semester 2 44 Supplementary Material
Questions 9 to 11 refer to the table below:





0 50 15 15
100 130 15 15
200 210 15 15
300 290 15 15
400 370 15 15
500 450 15 15

9. The equilibrium level of income is:

a) 200
b) 300
c) 400
d) 500

10. If the level of government expenditure were increased from 15 to 25,
the new equilibrium level of income would be:

a) 210
b) 310
c) 410
d) 450

11. The marginal propensity to consume in this example:

a) decreases as income decreases
b) increases as income increases
c) remains constant as income increases
d) is low then rises

12. If Y = C + I and C = 100 + 0.6Y, then the value of the multiplier is:

a) 20
b) 4
c) 1.66
d) 2.5

13. Which of the following would be an appropriate policy response on the part of a

a) decrease government spending to close the deflationary gap
b) decrease taxes to close the inflationary gap
c) increase government spending to close the deflationary gap
d) increase government spending to close the inflationary gap

Economics Semester 2 45 Supplementary Material

Unit 5


An alternative to Income and Expenditure Analysis can be used to explain the fluctuations in
economic activity that take place during the business cycle. The alternative model is known as the
Aggregate demand/aggregate supply model ( or AD/AS model for short). This model has the
advantage in that it can show changes in the price level (i.e. inflation). Economic activity can also
be viewed in terms of the total (aggregate) level of demand and supply. As with demand and supply
analysis in micro economics, shifts in aggregate demand and aggregate supply in the economy will
change the level of output (GDP growth) and the level of prices (inflation).

Aggregate Demand

The curve slopes down from left to right i.e. as prices fall there is a rise in the aggregate quantity of
goods and services demanded.

There are three reasons explaining the shape of the aggregate demand curve :
1. As prices fall the level of real income rises and therefore people can afford to buy an
increased quantity of goods and services out of their money income.

2. As the level of prices falls the country’s products become more competitive and easier to
sell to other countries. Therefore the level of exports demand will increase.

3. Falling prices (or a minimal level of price rises) indicate a lower level of inflation. Lower
levels of inflation allow interest rates to fall and therefore investment rises (increasing aggregate

Aggregate Supply

The aggregate supply curve slopes upward from left to right i.e. as the level of supply increases the
level of prices will rise. If wages are assumed to be held constant then a rise in prices reduces the
real wage, making production cheaper in real terms. Firms will be attracted to increase output as the
general price level rises. Also, as the economy approaches capacity aggregate supply becomes less
elastic : the curve becomes steeper becoming vertical at the full employment level of output.

There are two reasons explaining the shape of the aggregate supply curve :

1. As the economy approaches its capacity (the full employment level) most available
resources are already employed and therefore available resources become scarce. As a result the
level of resource prices will rise bringing inflation pressure to the economy. This explains why the
curve becomes steeper as the economy moves towards full employment.

2. When the economy’s level of output falls, the aggregate supply curve becomes flat. The
reason for this is that after a certain point prices will not fall significantly even if aggregate demand
is shifting to the left. Prices may not fall because trade unions will resist reductions in wages or
perhaps because minimum wage legislation exists. In times of falling economic activity, the
demand for resources may be falling but resource prices may be “sticky” i.e. not falling.
The fall in aggregate demand for resources (e.g.labour) may be reflected in lower employment
rather than lower wages.
Economics Semester 2 46 Supplementary Material

Demand pull inflation can be modelled using the AD/AS model. Rising demand puts pressure on
prices, particularly in the classical range of the AS curve (i.e. as the economy approaches full
capacity). Firms cannot increase real output to meet the high level of spending, because all
resources are fully employed. Excess demand bids up the prices of the output constrained by limited

The AD/AS model can also be used to show cyclical unemployment. A fall in aggregate demand
causes the AD curve to shift to the left. The new equilibrium is at a lower level of real GDP. Lower
real GDP translates to less demand for labour.

Two views of the Keynesian Aggregate Supply Curve

The diagram below shown on the left illustrates the radical Keynesian view. Demand can be
increased up to the point of capacity (full employment) before any significant rise in inflation

The diagram on the right shows the moderate Keynesian view. As the economy approaches capacity
(full employment) increases in demand lead to increasing pressure on prices for both finished goods
and services and resources.

The shape of the aggregate supply curve and the implications for government policy.

Yf Yf

If the government injects demand into the economy when the level of economic activity is low (and
aggregate supply is more elastic) the injection may produce significant increases in output and
employment with only limited inflation pressure.

Injections during a period of high economic activity (when supply is less elastic) are likely to
produce only limited increases in output and employment but significant inflation pressure.

Therefore, the most appropriate time for government injections is when the level of economic
activity is below the full employment level.

Economics Semester 2 47 Supplementary Material
Unit 5

1. Which of the following would tend to reduce the growth of aggregate demand?

a) an increase in the household savings ratio
b) an increase in exports
c) a decrease in imports
d) a decrease in indirect taxation

2. A shift of the AD curve to the right is most likely to be caused by a rise in :

a) interest
b) taxation
c) imports
d) consumption

3. Why does an aggregate demand curve slope downward?

a) because all demand curves slope downward
b) because as the price level rises the real wage falls, causing total spending to rise
c) because as the price level rises the purchasing power of the money supply falls
d) because as the price level rises workers expect higher future inflation

4. A sharp rise in the price of oil caused by war in the Middle East is most likely to :

a) shift AD to the right causing prices to rise
b) increase employment and national income but reduce inflation
c) shift AS to the left causing both inflation and unemployment to rise
d) lead to an inflationary gap

5. The AS curve would shift to the left for all the following reasons EXCEPT :

a) a decrease in productivity.
b) a decrease in business taxes
c) an increase in interest rates.
d) an increase in the price of commodities used for production.

6. As the size of the labour force increases over time, which of the following will take place?

a) AS will shift to the right
b) AS will shift to the left
c) AD will shift to the right
d) AD will shift to the left

Economics Semester 2 48 Supplementary Material
7. The shape of the aggregate supply curve above could be explained by :

a) the multiplier
b) the paradox of thrift
c) the economy’s limited resources
d) an inflationary gap

8. If the price level increases, which of the following will take place?

a) AS will shift to the right
b) AS will shift to the left
c) AD will shift to the right
d) none of the above

Economics Semester 2 49 Supplementary Material
Unit 6

The prices a country receives for its exports of goods and services is an important determinant of
export income. Likewise, the prices that must be paid for imported goods and services will have an
important bearing on total import payments. The terms of trade is an index which measures the
relative movements in the prices of exports and imports.

Movements in the terms of trade can have a significant influence on the balance of payments and
the standard of living of a nation's inhabitants, An increase in the general level of import prices, for
example, will mean that consumers and producers will generally be worse off - in order to consume
the same quantity of imports, they will have to increase their spending. If export prices fall, on the
other hand, then exporters could find their income failing. This could result in the level of national
income decreasing and the balance of goods and services in the balance of payments decreasing.

The importance of the terms of trade index is that it provides a measure of the quantity of imports a
country can obtain in exchange for a given volume of exports. If the terms of trade decline, (that is,
if export prices fall relative to import prices) then to purchase a given quantity of imports will
require a greater quantity of exports. In other words, a fall in the terms of trade would be
synonymous with a reduction in a country's standard of living since less could be imported for a
given amount of exports.

The Terms of Trade Index

The terms of trade is a ratio of export prices to import prices:

Terms of Trade = Export Price Index x 100
Import Price Index

The absolute value of the terms of trade index is relatively unimportant - it is the movement in the
index which is relevant. If the terms of trade falls, then this is referred to as an unfavourable
movement. It may be because import prices rise at a faster rate than exports. The terms of trade can
rise where export prices increase more quickly than import prices, or import prices fell by a greater
proportion than did export prices. In other words, they became more favourable.

Terms of Trade ‐ Movement 
Export Price Index       x  100     ↓ 
                Import Price Index 
Export Price Index       x  100     ↑ 
                 Import Price Index 
Less imports can be purchased with a given volume 
of exports 
More imports can be purchased with a given volume 
of exports 
or  or 
More exports are required to purchase a given 
volume of imports 
Less exports are required to purchase a given 
volume of imports 
Purchasing power of national income decreases  Purchasing power of national income increases 

Economics Semester 2 50 Supplementary Material


Tariffs are the most widely used protective measure in the manufacturing sector. A tariff is simply a
tax placed on an import. It is designed to increase the price of the foreign good or service so that the
competing domestic good receives a price benefit. Domestic producers gain by increasing output
and the government gains from the tax revenue.
However, consumers get less of the product and have to pay a higher price. Tariffs protect the
domestic industry by switching consumption away from imports to domestic goods. Other
producers in the economy will also be affected by the tariff. They will have to pay higher prices for
the imported good. This will mean that their costs will increase. The adverse effects of a tariff will
ripple through the economy lowering production and consumption in other sectors of the economy.
Tariffs, while decreasing imports in the protected industry, may actually result in lower exports for
other producers and may result in a net decrease in employment. Inefficient industries expand at the
expense of efficient industries.

Q1 Q2 Q3 Q4

The above figure shows the demand and supply curves for a domestic good. When the economy is
opened to the rest of the world, the world price is PW. The effect on the domestic industry of trade
is that local production of cars contracts to Q1 while demand expands to Q2. The shortfall between
production and consumption - Q1Q2 - is made up by imports. If the government imposes a tariff on
imports, then it is the same as placing a tax on the imported good. The new price of the good on the
domestic market is PT. The higher price benefits local producers because they can now compete
more favourably against the imports. The tariff is only placed on imported goods, but this raises the
effective price for both imports and locally produced goods. Domestic production expands to Q3,
demand contracts to Q4 and imports are reduced to Q3Q4. The tariff thus results in domestic
producers gaining a bigger slice of the market. They now sell more at a higher price. This will mean
less imports will be sold on the domestic market, and they will be sold at a higher price.
The government receives revenue from the tariff equal to the rectangle ABCD. The revenue is equal
to the size of the tax multiplied by the number of imports Q3Q4.
Economics Semester 2 51 Supplementary Material

Subsidies are grants or payments made by the government to domestic producers. They are paid for
out of general taxation revenue and directly lower a producer's costs of production. The domestic
producer can sell his product at a lower price to compete against the imported good. While
subsidies do not raise prices as with tariffs, resources are attracted into industries receiving
subsidies at the expense of efficient industries.

Q1 Q2 Q3

The above figure shows the effects of a subsidy granted to domestic producers. The world price for
the good is PW. Total demand for the good is Q3 of which Q1 is locally supplied and Q1-Q3 is
imported. If the government pays a subsidy to local firms, then their supply curve effectively
increases from S to S1. Domestic firms can now supply more at the same price. They expand
production to Q2 gaining a larger share of the market while imports are reduced to Q2-Q3.

Tariffs versus Subsidies
If we compare the economic effects of the subsidy with a tariff it is easy to see why many
economists favour subsidies as a means of protection over tariffs. With a subsidy there are no direct
adverse effects on the consumer. Consumers pay the same price and purchase the same quantity of
the good. Consumers do bear an indirect burden in that the cost of the subsidy has to be paid for
from government taxation revenue. There is still a redistribution of income away from consumers to
domestic producers. Resource allocation in the economy is also affected. Subsidies have the
advantage in that they tend to be more short term compared with tariffs. Since tariffs earn revenue
for the government they become more difficult to remove. Subsidies, on the other hand, are an
expenditure item and are therefore more liable to review than tariffs.

Economics Semester 2 52 Supplementary Material


Quotas are a direct quantity restriction on the amount of some product that importers can bring into
a country. Many domestic firms favour quotas over tariffs because it provides then with a degree of
certainty as to the exact quantity of imports they will be competing against. The quantity of imports
under a tariff system depends on the strength of demand. In this way, quotas are more restrictive
than tariffs because they control the absolute amount of the product imported.

Tariffs versus Quotas
Quotas have very similar effects to tariffs. They result in higher prices for both domestic and
imported goods. Consumers suffer because of the increased price and reduced quantity, while
domestic suppliers gain from the larger market share. Unlike tariffs, quotas do not raise revenue for
the government. When comparing tariffs and quotas, economists tend to favour tariffs since they are
deemed less restrictive.

Economics Semester 2 53 Supplementary Material
1. Infant industries: when an industry is first starting off, it cannot be expected to be
able to compete with established industries overseas. Therefore, until it gets on its
feet it should be protected.
2. Diversification: rather than placing too great a reliance on one type of production, a
country should widen its productive base and in order to do so it may have to protect
some of the industries.
3. Balance of payments: if a country is running persistent balance of payment deficits,
it should attempt to reduce its imports and/or increase its exports. Protection can do
both of these, by making imports more expensive or cutting the number of items that
can be imported and by reducing the cost structure of firms wishing to export by the
payment of subsidies.
4. Anti-dumping: when a country sells large quantities of a good in another country
for less than it costs to produce it, simply because it had a surplus of production and
wanted to get something for it, this is known as ‘dumping’. Protection can increase
the price of dumped goods to the prevailing market price. This is one of the more
justifiable reasons for protection, since no domestic producer could possibly be
expected to compete against this type of practice.
5. Employment: if we were to remove protection entirely, this would reduce jobs and
lead to massive unemployment.
1. Protection involves charging higher prices for some goods than is necessary, so
reducing the living standard of the community.
2. Protection involves a misallocation of resources from countries that can produce a
good cheaply and efficiently to a country that will produce inefficiently.
3. Fewer goods will be produced on a global basis if some countries have to protect
their industry, so the world’s real income will fall.
4. A high protection policy may lead to retaliation from other countries, further
worsening the initial position.
5. Protecting one industry will pass on higher costs to other industries which may have
to import components.
6. Protection encourages inefficient firms to keep on producing. They are not receiving
true market messages about the prevailing demand for their goods at that price.
7. There is a redistribution of wealth, away from consumers and efficient firms, to
inefficient firms and the Government.
8. Tariffs and quotas place us in a poorer export position because they reduce the
necessity to produce more efficiently at a lower cost.

Economics Semester 2 54 Supplementary Material
Unit 7

Foreign Investment
Foreign investment refers to the stock of financial assets in a country owned by foreign residents
and financial transactions in the Balance of Payments which increase or decrease this stock.

Foreign investment may take the form of borrowing or it may be in the form of equity - the selling
of assets (shares of companies, resources) to overseas residents.

Foreign investment transactions are included in the financial account of the balance of payments
and are divided into direct, portfolio, financial derivatives, other investment, and reserve assets. The
two most important categories are direct investment and portfolio investment. Reserve assets are
those external financial assets controlled by the Reserve Bank or the Australian Treasury for use in
financing payment imbalances or intervention in foreign exchange markets.

Direct investment represents funds invested in an Australian enterprise by a foreign resident which
gives the investor a "significant influence" over that enterprise i.e. ownership of 10 % or more.
Direct investment is thus associated with either the ownership and/or control of Australian
enterprises and resources. Direct investment would occur if an overseas firm established a new
subsidiary firm in Australia or took over an existing Australian owned firm.

Portfolio investment refers to all other foreign investment that is not direct investment. It does not
result in the increasing ownership or control of Australian enterprises. Portfolio investment occurs if
an overseas firm purchases less than 10 % of the shares of an Australian company. It comprises
both equity securities and debt securities (borrowing) such as the issue of bonds and notes and other
money market instruments. Debt securities form over two thirds of total portfolio investment. This
is opposite to direct investment where the dominant type is equity capital.

Saving – investment gap
An economy must either have an adequate domestic savings base to meet the demands of investors,
or be able to access sources of financial capital in other countries. An adequate domestic savings
ratio will lead to a pool of funds being available for lending. If domestic savings are small,
investment in capital equipment may have to be based on foreign capital inflows.

Australia has, for most of its history, been a financial capital importer. This means that it has relied
on foreign capital inflow to boost domestic savings. In other words, Australia is a net importer of
financial capital (foreign investment). Australia is a small nation in terms of population and it
cannot raise enough savings to facilitate the development of its resources. The amount of
investment an economy can undertake is determined by the level of savings. If domestic savings are
low, then for investment to expand, foreign savings must be used. Foreign investment is making use
of overseas savings and it has been of great benefit to the Australian economy. Without it, our
standard of living would be lower, and our rate of economic development far slower. However,
there are also costs associated with a high degree of dependence on capital inflow.

Economics Semester 2 55 Supplementary Material

Costs and Benefits of Foreign Investment

There are many benefits associated with foreign investment. It supplements domestic saving to
enable a higher rate of capital accumulation and economic growth. It provides access to new

Foreign investment is a flow of funds, some of which may be used to finance investment and some
of which may be used for speculative purposes. Investment expenditure affects both aggregate
demand and aggregate supply. Being a component of aggregate demand, investment increases the
level of economic activity, employment and national income, Investment also expands the
productive capacity of the economy by increasing the stock of physical capital - in other words it
moves the economy's production possibility frontier outwards.

Australia has had to rely on foreign investment to supplement national savings. Foreign
investment has enabled Australia to fund a much higher rate of investment and therefore to develop
our industries and resources to enable the economy to grow at a higher rate and to enjoy a higher
standard of living.

Australia's current account in the balance of payments is normally in deficit, with imports of goods,
services and income payments far exceeding the export of goods, services and income receipts.
The balance on the financial account represents net financial transactions with the rest of the world,
that is, the inflow of foreign investment into Australia, minus the outflow of Australian investment
abroad. A large surplus on the capital and financial account (foreign investment) is required to
finance the deficit on the current account. A current account deficit is balanced by a surplus on
the capital and financial account.

Direct foreign investment has the advantage that it can bring with it new technology and managerial
expertise. These can help improve the efficiency of Australian industry and aid the long term
growth of the economy. Overseas firms establishing new subsidiaries will directly add to
employment and contribute to increased taxation revenue for the government.

The costs associated with foreign investment include the payments which must be made to
compensate foreign investors. These payments include interest, profits and dividends which add to
the income deficit in the current account.

There are also the twin 'evils' of foreign ownership and foreign debt. If most of the capital inflow is
in the form of equity (ownership), a concern is the 'selling' of Australian assets. Foreign control,
might conflict with government economic policy, and profits would be sent back to the parent

Foreign debt became the major issue associated with the large amount of capital inflow through
borrowing. Interest payments on this borrowing have now become the most significant debit item in
the income category of the current account. As long as the foreign investment boosts Australia's
future productive capacity, then the servicing of the debt does not impose a problem. It is only when
the borrowing is used for consumption or for non-productive investment that a crisis could develop.

Foreign investment in the form of portfolio investment can be short term and speculative, and
therefore may be destabilising. While direct investment has the advantage of being fairly long term,
portfolio investment could be withdrawn at any time. Portfolio investment is a function of short
term profitability and is highly sensitive to relative interest rates.

Economics Semester 2 56 Supplementary Material

Interpreting the Current Account Balance

There are several different ways of viewing a current account balance. Firstly, the current account
balance reflects the trade balance of goods, services and income between Australia and the rest of
the world. Basically a current account deficit will occur if a nation's imports and income paid to
overseas residents exceeds the value of its exports plus income received from overseas. Secondly, a
current account deficit represents the difference between total national income and gross national
expenditure. If expenditure exceeds income, then the nation is spending more than it earns.

This situation is often compared to that of an individual. If John Citizen spends more than he earns,
then he must sell some of his assets or borrow money to pay for his consumption. Selling assets is a
short term measure since they will eventually be depleted. Borrowing is viable as long as the
repayments can be met. However, if borrowing continues to increase, then it is possible for the
interest payments to absorb all available income. In this situation, John Citizen would be declared
bankrupt. The solution to his problem is either to increase his income so that he can continue to
enjoy a high standard of living or to decrease his spending to match his income level. The above
scenario needs to be qualified in one important way. Borrowing to fund consumption is bad, but
borrowing for investment purposes is different. If John Citizen was working part-time and studying
part-time, then his future income is likely to be higher on completion of his studies and he will be
able to service his debt more easily. However, if he borrows just to fund current consumption and
his future income is not likely to change, then he is heading for financial problems.

A third way to view the current account deficit is that it represents the difference between a nation's
investment and its savings. If national investment exceeds national savings, then the gap represents
the current account deficit. This is now the accepted way of viewing a current account imbalance.
This view also makes the current account deficit appear much less threatening. What this means is
that by running a current account deficit, a country can fund a higher rate of investment than if it
had to rely on its domestic sayings alone. Australia, being a small country, is not able to generate
enough savings to finance the investment needed to develop the economy. Drawing on foreign
savings enables a country like Australia to achieve a higher rate of investment and economic

The problem that the growth of total foreign liabilities (doubling since the early 1980s) creates is
the increase in the size of the net income deficit in the current account. Some commentators became
alarmed that this could lead to a 'debt trap'. Whether the current account deficit is financed by either
equity or debt will result in outflows of income to overseas residents in the form of dividends and
profits or interest payments. The real 'banana republics' of the world reach the situation where their
interest payments become greater than their export earnings so that they have to borrow to meet the
interest bill.
Australia is not in this position. In fact, because the current account deficit reflects the gap between
national investment and national savings, then the nation's capital stock will increase. This will
expand the economy's productive capacity and provide for future income growth that will help
service the current account deficit. Running a current account deficit can actually lead to a country
increasing its national wealth and standard of living over time.

It is important to remember that there is nothing inherently 'bad' about a current account deficit.
Australia has always incurred a current account deficit and will, at least for the next 50 years. It may
be that Australia's current levels of foreign debt and current account deficit are optimal given the
structure of the economy. The current account deficit and the associated foreign debt should only be
targeted if they are considered 'excessive' or are viewed as being unsustainable. For the current
account deficit to be reduced, gross national expenditure must be reduced relative to gross domestic
Economics Semester 2 57 Supplementary Material
product. This simply means that the country's spending needs to be matched with the country's
income. Alternatively, we know from our earlier analysis of the current account, that the imbalance
reflects the gap between national investment and national saving. If savings could be increased
relative to investment, then the current account deficit would narrow. National saving consists of
both government (public) and private savings. But should government policy be forcing people to
save more? What is wrong with supplementing domestic savings with foreign saving? Trade in
savings leads to gains similar to trade in goods and services.

From: G.Parry, S.Kemp, Exploring Macroeconomics, 8
edition, Ch 2, Tactic Publications

Economics Semester 2 58 Supplementary Material
Unit 7

Questions 1 and 2 are based on the following diagram which shows
the production possibility frontiers of two countries A and B:

CD Players
(’000) ←COUNTRY A


5 20
TV’S ( ’000)

1. Which of the following statements is correct?

a) country A has an absolute advantage in producing TV’s
b) country B has an absolute advantage in producing CD players
c) country A has a comparative advantage in producing CD players
d) country B has a comparative advantage in producing CD players

2. If country A specialised in CD players, country B in TV’s and trade took place then:

a) only country A would gain from trade
b) both countries would gain from trade
c) neither country would gain from trade
d) TV production would decline

3. A reduction in the level of tariffs on imported cars would have the effect of:

a) raising domestic protection levels
b) increasing domestic market competition
c) promoting cyclical unemployment
d) increasing the price of exports

4. For the balance on Goods (merchandise trade) to be in surplus:

a) the capital account must be in deficit
b) the current account must be in surplus
c) export receipts must exceed import payments
d) net income must also be in surplus

Economics Semester 2 59 Supplementary Material
Question 5 relates to the following balance of payments data for an imaginary

$ Billion
Balance on Merchandise Trade 5.0
Service Credits 5.0
Service Debits 10.0
Net income and Transfers -20.0

5. The Balance of Payments on Current Account shows a:

a) zero balance
b) deficit of $10 billion
c) deficit of $20 billion
d) surplus of $30 billion

6. Which of the following is not a method of domestic protection?

a) a subsidy
b) a tariff
c) a quota
d) dumping

Question 7 is based on the following table which shows quantities
of coal and computers produced by countries A and B using the same quantity of resources.

A 100 400
B 100 50

7. Country A has an absolute advantage in:

a) coal
b) computers
c) coal and computers
d) neither coal nor computers

8. If world trade were free:

a) there would be no artificial barriers imposed by governments
to the movement of commodities between nations
b) countries would specialise according to comparative advantage
c) each country would have unrestricted access to the markets of
all other countries
d) all of the above

Economics Semester 2 60 Supplementary Material
9. A tariff effectively:

a) subsidises Australian importers
b) reallocates resources towards domestic producers
c) redistributes income away from domestic producers
d) reallocates resources away from domestic producers

10. If a Korean company bought 5% of shares in Australian company BHP, then this would be
an example of:

a) corporate borrowing
b) direct investment
c) foreign debt
d) portfolio investment

Economics Semester 2 61 Supplementary Material
Unit 8


A floating or free exchange rate is one whose value is determined by the market forces of supply
and demand. Its value can change daily and even by the minute as it reflects changes in the demand
and the supply of its currency.
A floating exchange rate simply means that the equilibrium price will change whenever the demand
or the supply curves shift. If the demand for Australian dollars increases because there is an
increase in the demand for Australian exports, then the value of the Australian dollar will rise, that
is, the Australian dollar will appreciate. If there was an increase in the supply of Australian dollars,
due to an increase in imports, then the value of the Australian dollar would decrease, it would
depreciate. As long as the value of the Australian dollar is allowed to move in accordance with
shifts in demand and supply, then it is a free or floating exchange rate.
A floating exchange rate means that the total balance of payments will always balance. The sum of
all the credit transactions (the demand for $A) will equal the sum of all the debit transactions (the
supply of $A). This means that if there is a deficit on current account, then under a free exchange
rate, a matching surplus on the capital and financial account will occur.


The main factors (other than price) that influence the demand and supply curves in the foreign
exchange market are as follows :

1. Changes in Tastes and Preferences
Any change in the preference of overseas consumers for our exports affects the exchange rate. If
overseas consumers’ preferences change in favour of Australian made goods then demand for our
currency to pay for these goods increases. This in turn causes an appreciation of the $A. Growth in
the popularity of Australia for overseas tourists will also put upward pressure on the value of the
$A. On the other hand, if overseas consumers’ preferences change against our goods the subsequent
fall in demand for our currency will lead to a depreciation of the $A.

2. The State of the International Economy
Recession or growth in the world economy directly affects the demand for our exports, possibly
raising both their quantities and prices. An expansion in world income increases our exports
whereas a contraction reduces them. Thus strong growth overseas should lead to an appreciation of
the $A due to an increase in demand for $A.

3. The State of the Australian Economy
Whether the Australian economy is expanding or stagnating affects our imports. Increasing levels
of national income push up our import bill for consumer and investment goods while declining
levels depress it. Thus strong growth in Australia could cause a depreciation of the $A due to an
increase in supply of $A as Australians purchase more imports.

Economics Semester 2 62 Supplementary Material
4. The Ratio of Domestic to Overseas Price Levels (Relative Inflation Rates)
This is one of the determinants of our international competitiveness. If the price level in Australia
is higher than that of our trading partners as a result of higher inflation rates in Australia, then both
our exports and imports are affected. Australian products are now more expensive than their
foreign equivalents. Consequently our exports will fall as other countries switch to other suppliers,
and our imports will rise as Australians substitute cheaper foreign goods for the dearer locally
produced items. The decrease in demand and at the same time an increase in supply of the $A will
lead to a depreciation

5. Differences between Domestic and Overseas Interest Rates
Interest rate differentials affect both capital inflow and outflow. Higher domestic interest rates for
example, encourage capital inflow (foreign investment) to Australia and discourage capital outflow
from Australia. This will cause an increase in the demand for $A and at the same time cause a
decrease in supply of $A which will result in an appreciation of the $A.

6. Speculation and Expectations
Speculation is the practice of buying and selling financial or real assets in order to make a capital
gain on the anticipated change in its value. If United States speculators anticipated that the
Australian dollar would rise in the next six months by 20% they would sell United States dollars
and buy Australian dollars. These speculators would then convert them back to United States
collars after the Australian exchange rate had increased. After paying the transaction costs there
would still be a substantial profit. If the Australian dollar was expected to fall, the speculators
holding Australian dollars would sell their Australian dollars and purchase them back at the
anticipated lower price. Foreign exchange speculators are effectively betting on the future course of
the exchange rate. Like people who bet on horses, some speculators study the fundamentals, while
others base their decisions on rumour in the market.
Speculation on a large scale is self-fulfilling. If there is a general feeling that the value of the
Australian dollar will fall, this will eventuate. The supply of Australian dollars on the foreign
exchange market will increase as speculators sell Australian dollars and the price of the Australian
dollar will fall.
While “herd sentiment” about the future course of the exchange rate is affected by rumours, market
expectations are largely based on what is known as the fundamentals. The fundamentals are those
underlying factors that determine the supply and demand for the currency on the foreign exchange
market. The daily movements in short term, and long term interest rates are constantly monitored
so the direction and extent of foreign investment flows can be forecast. The major participants in
the foreign exchange market closely follow the balance of payments to study trends in the value of
imports, exports, and the current account position. Other economic statistics that are important in
the formation of expectations are the inflation rate, national accounts and the level of net foreign
debt. The government forecasts provided in the Federal Budget Statements can alter expectations

Economics Semester 2 63 Supplementary Material

When the currency is allowed to float free from the interference of the central bank (in Australia,
the Reserve Bank) then it is referred to as a 'clean' float.

Whenever the government or central bank intervenes in the foreign exchange market to influence
the movement of the currency, or to set its value in a particular 'range' then this is referred to as a
'dirty' float or managed exchange rate.

Direct intervention means that the Reserve Bank can act as either a buyer or a seller of the
currency, indirectly influencing its rate through the market system. If, for example, the Reserve
Bank wanted to prevent the exchange rate from falling to too low a level, it would enter the market
as a buyer of Australian dollars and use its reserves of foreign exchange to bid up the price.
Conversely if the Bank wished to stop the currency from appreciating, it would sell Australian
dollars, increasing the supply and hence reducing any upward pressure on the exchange rate.

Indirect intervention means the Reserve Bank could affect the value of the exchange rate through
monetary policy. Monetary policy is used to change interest rates. If interest rates are increased,
then foreign investment will be attracted to the Australian economy increasing the demand for
Australian dollars and appreciating the currency.

Fixed Exchange Rate
Some economies prefer to use a fixed exchange rate system rather than a floating exchange rate.
With a fixed exchange rate, the monetary authority ties or fixes the value of the currency to another
currency or group of currencies termed a 'basket'. This 'fixed' value of the exchange rate is
maintained despite changes in the demand and supply conditions. The currency is not allowed to
'float' up or down in response to trade and capital flows or any other factors.

If the currency is over-valued, there is an excess supply of currency. The monetary authority must
be prepared to enter the market and buy the surplus of dollars. The money supply would contract
There will be an overall deficit in the balance of payments. Conversely, if there existed an excess
demand for currency at the fixed rate of exchange (a balance of payments surplus) then the Central
Bank would sell and would expand the money supply.

Fixed Versus Floating Exchange Rates
Fixed exchange rates provide for a stable exchange rate and therefore eliminated the uncertainty
associated with a floating rate. The major disadvantages of a fixed exchange rate is that balance of
payments problems may arise which impact on the domestic economy, and they increase the degree
of uncertainty for those involved in the external sector and uncertainty effectively increases the cost
of international transactions.

A floating exchange rate regime has the advantage of providing automatic adjustment in the balance
of payments. The exchange rate varies to change the prices of traded goods, services and capital. In
this way, the balance of payments will always balance. If for example, there is an excess supply of
currency, then a depreciation will raise the prices of imported goods and services in domestic
currency and lower the prices of exported goods and services in foreign currencies. This will
automatically help remove the excess supply. Under a floating exchange rate, the balance of
payments does not affect the domestic money supply and this is seen as being highly desirable.

Economics Semester 2 64 Supplementary Material
Unit 8

1. If export prices fell by 5% and import prices fell by 10%, then for that period:

a) the balance of trade has improved
b) the terms of trade have deteriorated
c) the current account will be in surplus
d) the terms of trade have improved

2. Debt servicing repayments are recorded as a:

a) credit on the current account
b) debit on the current account
c) debit on the capital account
d) capital outflow

3. If the Reserve Bank intervenes in the forex market and buys Australian dollars market using
Japanese Yen, it will have the effect of:

a) increasing the value of the $Aust
b) decreasing the value of the $Aust
c) increasing the value of the $Aust and the Yen
d) increasing Australia’s foreign reserves

4. A current account deficit of $15 billion implies for a particular year:

a) that imports exceeded exports by $15 billion
b) that foreign debt decreased by $15 billion
c) a capital account surplus of $15 billion
d) a rise in the value of the $Aust

5. The difference between what Australia owes the rest of the world and what they owe us is
equal to:

a) public debt
b) the current account deficit
c) net foreign debt
d) capital account deficit

6. A fall in the value of the Australian dollar against the US dollar should:

a) reduce the willingness of Australian producers to sell to the US
b) assist Australia to lower its inflation rate
c) increase the price of US goods in Australia
d) lower the level of Australian foreign debt

Economics Semester 2 65 Supplementary Material
Question 7 relates to the exchange rate diagram below:

Price of $A S1
in $US ←
0.60 -----------
0.50 --------------


0 15 20 Quantity of $A (bill.)

7. This diagram shows that against the $US:

a) the Australian dollar appreciated by $5bn
b) the Australian dollar depreciated by $5bn
c) the Australian dollar appreciated by 20%
d) the Australian dollar depreciated by 20%

8. Which of the following would put upward pressure on the value of a floating Australian

a) Qantas purchases of U.S. built aircraft
b) a fall in Australia’s real interest rates relative to real interest rates overseas
c) Australian tourists travel to the Beijing Olympics
d) the purchase of an Australian tourist resort by Japanese businessmen

9. If a country’s terms of trade deteriorates, then:

a) prices for exports have risen greater than prices for imports
b) the value of that country’s currency in terms of another
country’s currency will automatically increase
c) any existing current account deficit will decrease
d) a greater volume of exports will be required to pay for any given volume of imports

10. Australia’s current account deficit could be improved in the short run by:

a) an increase in Australian demand for Japanese cars
b) repaying outstanding overseas loans
c) a successful promotion campaign overseas to “ study in Australia ”
d) the purchase of American planes for the Australian Air Force

Economics Semester 2 66 Supplementary Material
Unit 9


Banks use savings to create loans. Lending of savings by banks leads to an increase in spending and
a subsequent increase in deposits which increase the money supply

The Credit Creation Multiplier
Good and services are purchased with borrowed funds, and then Output and Income (Y) is created.
Y flows back to banks as additional deposits, and this process repeats indefinitely. Money is used
again and again (multiplied).

Key Assumptions
All loaned money will be spent domestically and money returns to the banks and there are no
leakages from banking system. As money is deposited in the banking system, banks only need to
keep a small part of their deposits as reserves (say, 20%). The rest can be lent out (Advances)..

What are Reserves ?
The proportion of deposits that the bank does not advance (loan) to borrowers. Reserves are kept in
liquid form such as cash, government securities, gold.

If deposits are $100 required reserve are 20% ($20) banks can lend an extra $80 which will then be
redeposited in the bank. Deposits are then $100 +$80. Since reserves required are 20% of $180 =
$36, banks can lend an extra $144 which is then redeposited in the bank.


100 80 20
80 64 16
64 51.20 12.80
51.20 40.96 10.24
40.96 32.77 8.19
32.77 26.21 6.55
26.21 20.97 5.24
20.97 16.78 4.19
16.78 13.42 3.36
13.42 10.74 2.68
total reserves:

total deposits: total advances:
total reserves + last amount
457.05 357.05 100

This process of excess reserves used to make loans, which are then deposited, which then cause
excess reserves, will continue until reserves equal 20% of bank deposits.
Economics Semester 2 67 Supplementary Material
Although no new money was physically created in addition to the initial $100 deposit, new bank
deposits are created through loans. The total reserves plus the last deposit (or last loan, whichever is
last) will always equal the original amount, which in this case is $100. As this process continues,
more deposits and loans are created.
The most common mechanism used to measure this increase in deposits and loans (advances or
credit created) is typically called the money multiplier. It calculates the amount of money that an
initial deposit can be expanded to with a given reserve ratio.
Reserve Ratio (R), = reserves as a percentage of deposits. Eg. 20%
The money multiplier is the reciprocal, = 1 / reserve ratio, and is the maximum amount of
money banks can create for a given quantity of reserves.
To find the total change in deposits:
New deposit x multiplier = total change in deposits

To find the total advances:
Total change in deposits - New deposit = Advances

Importance of the Reserve Ratio
A higher reserve Ratio means a lower multiplier, so the higher the reserves the lower the level of

Economics Semester 2 68 Supplementary Material


The Reserve Banks of Australia (RBA) is Australia’s central bank. A central bank generally has
the role of controlling a country’s money and banking system. As such, it is different from other
banks – it is not set up as a financial business with the desire to make profit. Rather, its primary
purpose is the overall management of the financial sector in accordance with the economic
objectives of the Commonwealth Government. The RBA was created in 1959 under the Reserve
Bank Act 1959. .

According to the Reserve Bank’s Charter, in its conduct as Australia’s central bank, the Reserve
Bank is to be guided by three broad objectives:

• The stability of Australia’s currency
• The maintenance of full employment
• The economic prosperity and welfare of the people of Australia

In reality, its highest priority in recent years has been to sustain low inflation or non-inflationary
economic growth,


Control of note issue
The Reserve Bank is the sole issuing authority for Australian currency. All Australian currency is
manufactured by Note Printing Australia, which is a division of the Reserve Bank. The volume of
notes and coins on issue at any particular time will vary according to the community’s demand for
funds. At certain times of the year (e.g. Christmas) the demand for cash will be greater than at other
times and RBA will seek to accommodate this demand for money.

Regulation of the payments system
The Reserve Bank is responsible for the payments system, ensuring efficiency and stability of
payment methods such as electronic cash, travellers’ cheques and stored value cards. This function
is carried out by the Payments Systems Board within the Reserve Bank.

Banker to the banks
Banks hold exchange settlement accounts with the Reserve Bank. These accounts are used to allow
banks to settle a debt between them, as well as with the Reserve Bank at the end of each day’s
trading. They can also be used by banks to buy and sell government securities from the RBA.

Responsibility for holding Australia’s reserves of gold and foreign currency dealings
The RBA’s reserves provide the funds that can be used to make international payments, or for
Reserve Bank operations in the foreign exchange market. The RBA also oversees dealers in the
foreign exchange market.

Economics Semester 2 69 Supplementary Material
Banker and source of financial and economic advice to governments
The Reserve Bank provides banking and financial agent services to the Commonwealth
Government, as well as some state governments. The government can lodge excess funds with the
Reserve Bank, as well as obtain funds through the issue of treasury bills, which essentially amounts
to the Reserve Banks printing the new money that the government needs.
The Reserve Bank also acts as a financial agent to the government, raising short term (treasury
notes) and long term (government bonds) loans, making interest payments on these loans, as well as
buying them back on maturity.
Finally, the Reserve Bank acts as a source of financial and economic advice to the government.
The Reserve Bank publishes regular assessments of the state of the economy and financial markets,
which represent important input for the process of making economic policy.

Conducting monetary policy on behalf of the government
The conduct of monetary policy is the most important ongoing responsibility of the Reserve Bank.
Monetary policy can be defined as Reserve Bank action designed to influence the cost and
availability of money in the Australian economy (through influencing the general level of interest
rates). The Reserve Bank conducts monetary policy with the aim of achieving a sustained low
inflation rate while encouraging economic growth.

Systemic stability
The RBA’s traditional role of prudential supervision of banks recently shifted to the Australian
Prudential Regulation Authority (APRA). However, the RBA retains its traditional responsibility
for the overall stability of the financial system. It provides guidelines to foster the stability of
individual financial institutions, and these guidelines will be enforced by the APRA. Prudential
supervision is concerned with maintaining the longer term stability of the financial system by
avoiding (or at least reducing the risk of) financial crises. This protects the deposits of members of
the public, without actually providing a formal guarantee for depositors’ funds. Banks are allowed
to make their own decisions about how much of their assets should be kept in ‘liquid’ form.


In the past The RBA traditionally had the statutory responsibility to ensure that our banks were
financially stable and were managed in such a way to minimise the risks to depositors’ funds.
Following on from the Financial System Inquiry in 1997 ( the Wallis Report) the Government
announced several changes to the financial system:

• The distinction between banks and non banks was abolished so most financial institutions
are able to offer a full range of banking services. Banks, building societies and credit unions
are now called ‘authorised deposit taking institutions’. (ADIs)

• The Reserve Bank has lost its prudential supervision role . The supervision of individual
banks together with other financial institutions has now been handed over to a new body
called the Australian Prudential Regulation Authority (APRA).

• The RBA now is to focus on monetary policy, financial stability and regulation of the
payments system.

• ADI’s will be responsible for managing their own day to day liquidity and each must have
plans to withstand a bank specific or ‘name’ crisis such as a run on the bank. They must
also maintain adequate capital reserves to absorb losses which might emerge. The Chief
executives of the ADIs will also be required to provide reports to APRA for approval on
their systems for managing risks.
Economics Semester 2 70 Supplementary Material

1. The main role of money is to act as a:

a) unit of account
b) store of value
c) medium of exchange
d) standard for deferred payments

2. Which of these is not a function of the Reserve Bank of Australia?

a) act as banker to the banks
b) act as financial agent to the Federal Government
c) supervision of banks’ cash reserves
d) control over Australia’s reserves of foreign currency

3. An increase in the money supply in the economy may occur with:

a) a federal government budget surplus
b) sales of Commonwealth Government Securities
by the Reserve Bank
c) a federal government budget deficit
d) a current account deficit

Questions 4 - 6 refer to the Gibbs Bank Balance Sheet below:

showing minimum reserves
Liabilities $bn Assets $bn
Deposits 200 Reserves 40
Advances 160
200 200

4. The money multiplier is:

a) 1/5
b) 4/5
c) 2
d) 5

5. A new deposit of $20bn will increase total deposits to:

a) $300bn
b) $260bn
c) $220bn
d) $100bn

Economics Semester 2 71 Supplementary Material
6. Advances (loans) will increase by :

a) $240bn
b) $80bn
c) $40bn
d) $20bn

7. The value of money is determined by:

a) the amount of interest it can earn
b) the goods and services it can buy
c) the Reserve Bank
d) the interest rate

8. The opportunity cost of keeping wealth in the form of real assets is:

a) made worse if inflation increases
b) the rates or taxes that must be paid on the assets
c) of the loss of liquidity
d) equal to the interest rate

9. Which of the following are examples of Financial Intermediaries?

a) Stockbrokers and financial advisors
b) The Reserve Bank
c) mortgages, personal loans
d) banks and credit unions

10. Liquidity refers to the:

a) speed of access to financial assets
b) ease with which an asset can be converted to cash
c) desire of individuals or firms to hold cash
d) ease with which cash can be converted to an asset

11. A Budget surplus will:

a) increase bank deposits and increase the money supply
b) increase bank deposits and decrease the money supply
c) decrease bank deposits and increase the money supply
d) decrease bank deposits and decrease the money supply

12. Ceteris Paribus, an increase in the money supply will:

a) cause inflation
b) decrease the level of income, output, and employment
c) increase the level of income, output and employment
d) not change economic activity

Economics Semester 2 72 Supplementary Material
13. Banks can create more money by:

a) increasing their liquidity levels
b) increasing their cash reserve ratios
c) charging a higher rate of interest on loans
d) increasing their loans to the private sector

14. A bank always holds a cash reserve of 20%. The minimum new deposit necessary
to increase the banks total advances by $10000 is :

a) $2000
b) $2500
c) $7500
d) $10000

15. A rise in Australia’s inflation rate will most lead to an increase in :

a) the exchange rate
b) the current account surplus
c) nominal interest rates
d) real interest rates
Economics Semester 2 73 Supplementary Material
Unit 10

Monetary policy involves action by the Reserve Bank (RBA) on behalf of the government, designed
to influence the level of interest rates and the money supply. By influencing these variables, the
RBA is also able to influence the overall level of economic activity in the short term and achieve
medium to long term price stability.

In the short term, tightening of monetary policy through increased interest rates will slow down
economic activity. Higher interest rates will cause a reduction in consumer spending as consumers
face higher costs for mortgages and consumer loans. Businesses also need to borrow to purchase
new capital equipment. Higher interest rates will make borrowing more expensive so business
investment will decline as well. The overall effect will be one of falling aggregate demand and
slowing of economic activity.

To boost aggregate demand and the level of economic activity the RBA would need to loosen
monetary policy by reducing interest rates, which increases both consumer and business spending in
the economy.

The main instrument of monetary policy is the use of Market Operations (MO) designed to
influence the interest rate structure in the economy. A detailed explanation of how MO works is
covered later in this topic. The Government does not regulate the level of interest rates directly, but
its actions influence market interest rates, helping it to achieve its objectives relating to the level of
economic activity, inflation and unemployment.

The RBA now conducts its MO of purchasing or selling government securities directly with the
banks (and the few major NBFIs) through their exchange settlement accounts. Through selling or
buying government securities the RBA creates a shortage or a glut of funds in the short-term money
market respectively, thus seeking to affect the cash rate of interest (the previous distinction between
the official and unofficial money market now becoming redundant).

A change in the general level of interest rates will cause a change in the demand for credit. Higher
interest rates will deter borrowing, whereas lower interest rates will encourage it.

The transmission mechanism through which monetary policy impacts upon the economy can be
summarised as follows :
• Upward pressure on interest rates through MO leads to falling consumption and investment
demand in the economy thus reducing the level of spending and slowing economic activity
• The fall in spending will lead to a fall in the demand for money, and since in equilibrium money
supply equals money demand, the money supply in the economy will fall as well.
Thus monetary policy can be either tightened or loosened depending on whether the government
wishes to dampen down or boost the level of economic activity.

A tightening of monetary policy would involve MO putting upward pressure on interest rates,
which would have the effect of dampening consumer and investment spending, resulting in a lower
level of economic activity, with lower inflation, and the possibility of higher unemployment.

On the other hand, a loosening of monetary policy would put downward pressure on interest rates,
boosting consumer and investment spending, resulting in a higher level of economic activity, with
falling unemployment, and an increase in inflationary pressures.
Economics Semester 2 74 Supplementary Material

While a change in monetary policy can be made almost immediately (i.e. it doesn’t require
legislation, or parliamentary approval) it can take considerably longer for that change to bring about
the desired changes to economic variables such as the rate of economic growth, inflation, and
unemployment. There can be a lag of somewhere between 6 and 18 months. Thus, the timing of
monetary policy can pose problems for the government. Economic circumstances could change
during the relatively long lag period and render current monetary policy inappropriate. For
example, it might still be stimulating the economy when dampening is required.

Market Operations
Market operations are conducted directly between the RBA and counter parties in the cash market,
which is a market for the deposit and lending of funds overnight. Banks, financial institutions and
large companies will deposit any surplus cash n the market in order to earn interest. Conversely,
institutions with a deficit in cash can borrow from the cash market. The interest rate on these funds
is called the cash rate which is determined by the demand and supply for funds. The RBA set a
cash rate target each day and attempts to ensure sufficient liquidity or cash to meet market demand
so that the cash rate does not change. This is known as liquidity management. The only exception
to this is when the Reserve Bank wishes to alter the stance of monetary policy. The cash market is
necessary for financial institutions to have access to deposit and lending facilities to settle debts
between themselves through their Exchange Settlement Accounts (ESAs).

The demand for cash is determined by the reserves of cash (exchange settlement funds) held by
banks in their ESAs with the Reserve Bank. These funds are used on a daily basis by the banks in
settling debts between themselves. The Reserve Bank stipulates that these accounts must not be
overdrawn, so banks typically keep reserve balances in their ESAs to meet unexpected requirements
for cash. They also receive a nominal rate of interest on these accounts.

The supply of cash in the short term money market is determined by the Reserve Bank. Settlement
of debts between commercial banks does not change the supply of cash, only the balances in each
bank’s Exchange Settlement Account. The supply of cash will only change when the Reserve Bank
makes a payment to a commercial bank’s ESA. .

The Reserve Bank controls the volume of cash through its market operations on a daily basis.
Purchases of Commonwealth Government Securities (CGS) by the Reserve Bank will lead to a rise
in the supply of cash when payment is made into a bank’s ESA. When the Reserve Bank sells CGS
commercial banks will withdraw funds from their ESAs and make a payment to the Reserve Bank,
reducing the supply of cash in the market.
Economics Semester 2 75 Supplementary Material
Figure 1.1:

Illustrates how the RBA would ease the stance of monetary policy by changing the cash rate using
market operations. The Reserve Bank would announce its intention to lower the cash rate at the
beginning of the trading day in the cash market and issue a press release to the media. It would buy
existing Commonwealth Government Securities (CGS) from banks and other institutions in the cash
market. This increases the supply of cash because payment for the CGS are deposited in banks’
Exchange Settlement Accounts, creating an excess supply of cash or liquidity. This puts downward
pressure on the cash rate as banks would lend their excess liquidity rather than keep it in their ESAs
as they can earn higher market rates of interest through commercial lending to their customers. A
lower cash rate would in turn lower the cost of borrowing and put downward pressure on other short
term interest rates, which in turn would lower other medium and long term interest rates.

Figure 1.1: An Easing of Monetary Policy Through Market Operations
Reserve Bank
Purchase of
CGS or 'Repos'
Cash Market
1. Increase in cash or liquidity
in the cash market
2. Lower cash rate and other
interest rates
Economics Semester 2 76 Supplementary Material
Figure 1.2:

Illustrates how the RBA would tighten the stance of monetary policy by changing the cash rate
using market operations. The Reserve Bank would announce its intention to raise the cash rate at
the beginning of the trading day in the cash market and issue a press release to the media. It would
sell Commonwealth Government Securities (CGS) to banks and other institutions in the cash
market. This would decrease the Exchange Settlement Accounts, creating a deficit of cash or
liquidity. This would put upward pressure on the cash rate as banks would have to borrow liquidity
to keep their ESAs in surplus as required by the RBA. A higher cash rate would in turn raise the
cost of borrowing and put upward pressure on short term interest rates which in turn would raise
other medium and long term interest rates.

Cash rates respond to changes in the demand and supply for cash in the cash market. The Reserve
Bank sets an objective for monetary policy in terms of the cash rate and uses its control over the
supply of cash to achieve this desired cash rate. If there is a neutral stance of monetary policy, then
there is no need to alter the cash rate. An excess demand for cash will be met by Reserve Bank
market operations to increase the supply of cash and an excess supply of cash will most likely be
met with Reserve Bank actions to reduce the supply of cash. Such actions by the Reserve Bank are
designed to create a stable cash rate and are part of its liquidity management operations.

Figure 1.2: A Tightening of Monetary Policy Through Market Operations
Reserve Bank
Sale of
CGS or 'Repos'
Cash Market
1. Decrease in cash or liquidity
in the cash market
2. Higher cash rate and other
interest rates

Economics Semester 2 77 Supplementary Material

The Rate of Interest

For households, interest rates represent both the cost of borrowing and the reward for saving.
Rising interest rates make borrowing relatively more expensive, and saving relatively more
attractive. Falling interest rates, on the other hand, make borrowing relatively cheaper and saving
relatively less attractive.

Thus, rising interest rates tend to reduce the level of consumption and increase the level of
household saving; falling interest rates tend to increase the level of consumption and reduce the
level of household saving.

Changes in interest rates are particularly important in the case of consumer durables. Cars,
electrical appliances, and the like are relatively expensive, and households tend to finance their
purchases of these items by borrowing. Yet, the relatively long useful life of these goods is such
that households may well be able to postpone planned expenditures on them. Thus, spending on
consumer durables tends to be highly sensitive to interest rate movements.

It should be emphasised that it is the real rate of interest, rather than the nominal rate, that is
crucial in making investment decisions. The nominal interest rate is expressed in terms of dollars of
current value, while the real interest rate is stated in terms of dollars of constant or inflation-
adjusted value. In other words, the real interest rate is the nominal rate less the rate of inflation.


The impact of changes in interest rates on the economy is known as the transmission mechanism of
monetary policy. The transmission channels are shown in Figure 1.3. Changes in the cash rate will
firstly impact on short tern interest rates, then medium to long term interest rates, altering the cost
of borrowing and the returns for lending funds. The six channels according to the Reserve Bank
through which these changes operate are:

• The effects on investment, savings and consumption decision. Higher interest rates
will discourage borrowing and spending on consumption and investment, but
encourage saving. Lower interest rates will encourage borrowing and spending on
consumption and investment but discourage saving.

• Alterations in the cash flows between borrowers and lenders. Higher interest rates
will reduce cash flows for households, businesses and governments as more cash has
to be paid to services existing debt. Lower interest rates will increase cash flows as
less money has to be paid in servicing existing debt.

• Alterations in the cost of credit and effects on money flows. Higher interest rates
will raise the cost of credit borrowings and purchases whereas lower interest rates
will lower the cost of credit borrowings and purchases.

• The effects on asset prices such as houses, cars and shares which may alter the
distribution of wealth. Higher interest rates which discourage borrowing and
spending on the acquisition of financial assets will lead to a fall in asset prices.
Lower interest rates will encourage borrowing to purchase financial assets and lead
to higher asset prices.

Economics Semester 2 78 Supplementary Material
• The effects on the exchange rate and the relative prices of domestic and foreign
goods and services. Higher interest rates relative to overseas will encourage capital
inflow, increasing the demand for Australian dollars and lead to exchange rate
appreciation, reducing the cost of imports but raising the cost of exports. Higher
interest rates therefore have a contractionary effect on trade and the economy.
Lower interest rates will lead to capital outflow and exchange rate depreciation,
reducing the cost of exports but raising the cost of imports. Lower interest rates have
an expansionary effect on trade and the economy.

• The effects on inflationary expectations and economic behaviour. Higher interest
rates will reduce inflationary expectations by reducing wage and price demands.
Lower interest rates will raise inflationary expectations by increasing wage and price

The monetary policy transmission mechanism is illustrated in Figure 1.3, with changes in interest
rates affecting domestic expenditure. For example, higher interest rates will reduce consumption,
investment and government expenditure. Lower domestic spending in turn will reduce output or
economic growth. If output growth slows, so will employment growth and inflationary
expectations. The exchange rate will appreciate, causing a loss of export competitiveness. So
overall, higher interest rates have a contractionary effect on the economy. Lower interest rates will
increase consumption, investment and government expenditure. Higher domestic spending will
increase output or economic growth. If output growth rises, so will employment growth and
inflationary expectations. The exchange rate will depreciate, causing a rise in export
competitiveness. So overall, lower interest rates have an expansionary effect on the economy.

Figure 1.3: The Transmission Mechanism of Monetary Policy
Changes in the
Cash Rate
Cash Market
Changes in
Changes in Output
Employment, Prices,
the Exchange Rate
and Expectations

Economics Semester 2 79 Supplementary Material

B. Investment Demand A. The Money Market
Sm1 Sm
Quantity of money

C. Equilibrium Level of
Investment Q Q1




Economics Semester 2 80 Supplementary Material
Strengths of Monetary Policy

Monetary policy is recognised as being the most important economic policy tool of the government
to influence economic activity because of its flexibility and the speed at which monetary policy
decisions can be made and implemented. Changes in interest rates can have a powerful effect on the
level of spending in the economy.

Monetary policy is very flexible
This is arguably the greatest strength of monetary policy. Decisions about appropriate domestic
market operations are made every day by the RBA - thus monetary policy can be far more flexible
than other types of policy. It does not require specific authorisation by Parliament, which also adds
to its flexibility. Monetary policy decisions can be made and implemented very quickly. The
decision and action time lags for monetary policy are relatively short compared with fiscal policy.

Monetary policy has greater political neutrality
The transmission route for monetary policy is more subtle than that of other policies. Interest rates
affect every sector of the economy, and people tend not to see the policy as particularly aimed at
"them". Monetary policy is independent of the political process. Decisions made by the Reserve
Bank are based on economic rather than political reasons.

Monetary policy is very effective during boom periods
It is recognised that monetary policy is more effective in the control of high levels of aggregate
demand and inflation, than during the recession phase of the business cycle. Tighter money policy
has greater force than easy money policy because higher interest rates have more direct effect on
economic decisions than do lower rates. When interest rates are high, they assume a very important
role in the decisions of consumers who have to borrow, or investors comparing likely rates of

• Monetary policy is most effective under floating exchange rates
There is an important link between interest rates and the exchange rate. Changes in interest rates
affect the interest rate differential with other countries which influences capital movements. A cut
in interest rates for example will lead to a fall in capital inflow. This will reduce the demand for the
currency and lead to a depreciation. Net exports will be stimulated as export prices fall and import
prices rise. Thus an expansionary monetary policy (reducing interest rates) will not only increase
consumption and investment, but also increase net exports.

Economics Semester 2 81 Supplementary Material

Weaknesses of Monetary Policy

• Time lags.
As with all other types of policy, monetary policy suffers from time lags.

The lags refer to the time it takes for the policy to actually affect the level of economic activity —
the lag for monetary policy is longer than for fiscal policy. This is because monetary policy works
indirectly through interest rates to affect the level aggregate demand in the economy – it can take a
very long time before the private sector begins to borrow and invest after a cut in interest rates as
confidence in the economy may be lacking.

• Monetary policy is less effective during a recession.
Monetary policy is thought to be more effective in a period where economic activity is high, than
when the economy is in recession. Low interest rates may not be enough to stimulate private
spending when economic conditions are pessimistic. The old adage 'you can lead a horse to water,
but you can't make him drink' is an appropriate -description of this weakness of monetary policy.

• Monetary policy is a “blunt” instrument.
When interest rates are raised or lowered, it applies across the whole economy. It is not selective in
that it cannot apply to just particular items or areas. It cannot be used to target a particular group or

Economics Semester 2 82 Supplementary Material

1. In Keynesian analysis if growth in the money supply exceeds increases in
real production:

a) supply will exceed total expenditure and prices will fall
b) total expenditure will exceed supply and prices will fall
c) supply will exceed total expenditure and prices will rise
d) total expenditure will exceed supply and prices will rise

2. You receive $200 interest after saving $4000 for a year. The nominal rate of interest is:

a) 5%
b) -7%
c) 7%
d) 17%

3. You receive $200 interest after saving $4000 for a year. The CPI
increased by 12 %. The real rate of interest is:

a) 5%
b) -7%
c) 7%
d) 17%

4. The main instrument used by the Reserve Bank to implement Monetary
Policy is:

a) Market Operations
b) interest rate controls
c) Capital Adequacy Requirement
d) controlling the supply of notes and coins

5. Market Operations involves:

a) the RBA buying and selling government securities directly
to financial institutions
b) the RBA selling government securities to finance a budget deficit
c) the RBA dealing directly with all financial markets
d) the RBA dealing only with the Non Bank Financial Intermediaries

6. The sale of government securities by the Reserve Bank in the open
market will tend to:

a) increase liquidity
b) decrease liquidity
c) decrease the level of interest rates
d) increase economic activity

Economics Semester 2 83 Supplementary Material
7. Monetary Policy may be defined as:

a) market operations
b) government attempts to set the rate of interest
c) Reserve Bank action to influence economic activity by varying the cost and
availability of money
d) government action to guarantee the safety of all financial institutions

8. According to Keynesian theory changes in the money supply:

a) lead to changes in interest rates, investment and national income
b) have little or no effect on interest rates
c) are not related to changes in interest rates
d) cause inflation

9. The broad aim of monetary policy is:

a) to maintain full employment
b) to eliminate the current account deficit
c) non-inflationary growth of the economy
d) to reduce government spending

10. If the demand curve for money shifted to the left, ceteris paribus,
the effect would be:

a) a fall in interest rates
b) a rise in interest rates
c) an increase in the quantity supplied of loanable funds
d) no change to interest rates

11. To ease monetary policy the Reserve Bank could:

a) dirty the floating exchange rate by buying Australian dollars
b) sell securities to the banks
c) increase the supply of cash to the banks Exchange Settlement Accounts
d) buy securities in the primary bond market

12. A suitable monetary policy response to excessive aggregate demand
would be to:

a) tighten monetary policy by buying government securities
b) tighten monetary policy by selling government securities
c) expand government spending
d) increase the level of taxation

Economics Semester 2 84 Supplementary Material
13. A rise in domestic interest rates will:

a) encourage people to increase consumption
b) put downward pressure on the Australian dollar
c) have a contractionary effect on the economy
d) increase inflation

14. Which of the following is most likely to bring about a rise
in interest rates?

a) reduction in the level of ESA balances
b) reduction in government budget deficit
c) fall in unemployment
d) rise in the value of the $A

15. What is the likely effect on GDP and interest rates of the RBA
engaging in the sale of securities through its market operations?

a) rise in GDP; rise in interest rates
b) fall in GDP; rise in interest rates
c) rise in GDP; fall in interest rates
d) fall in GDP; fall in interest rates

Economics Semester 2 85 Supplementary Material
Unit 11

Taxation: Main Functions:
• to raise revenue for the government
• to redistribute income and wealth
• to influence resource allocation: - to encourage or discourage the use of certain resources.
• to stabilise economic activity - to change the level aggregate spending in the economy and
reduce the economic fluctuations associated with the business cycle.

Types of Taxation

Impact means `where the tax is levied or collected'.
Incidence means 'where the burden of the tax falls. - in other words, who pays the tax.

One way to classify types of taxation is to study from whom they are collected. Direct taxation is
collected from the taxpayer's income, so the impact and the incidence of direct tax fall on the same
person. Indirect taxation such as the Goods and Services Tax (GST) are collected from taxpayers'
expenditure. In this case, the impact and incidence fall upon different people. With the GST, for
example, the seller or producer of the good pays the tax, but then passes it on to the consumer
through higher prices. The seller collects the tax, but it is actually paid by the consumer.
% of

Progressive Proportional Regressive
The rate of tax
increases as income
The rate of tax
remains the same as
income rises
The rate of tax falls
as income rises

The Burden of Taxation

We can further classify tax types according to how they are levied. Progressive taxes claim an
increasing proportion of income as income increases. The burden of a progressive tax theoretically
falls mainly on those who earn higher levels of income. Australia, like many other countries, has a
system of income tax 'brackets' which create a 'step function' relationship between income and tax
Regressive taxes, however, place a greater burden on lower income earners, because they take a
decreasing proportion of income as income increases. Consider a sales tax levied at a flat rate on an
item such as a bottle of wine. The low income earner will pay the same dollar value of tax on the
wine as does the high income earner. To the low income earner, however, the tax is a higher
proportion of his or her income.
Proportional taxation takes a constant proportion of income, no matter what level has been earned.
An example of a proportional tax is Australian company tax, where all companies, irrespective of
size or earnings, currently pay tax at the rate of 30 per cent of their profits.
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(Debt Financing)

A deficit has to be financed ( paid for) and there are three options available:

1. borrow from the Reserve Bank ( monetary financing or printing money )
2. borrow from overseas
3. borrow from the public ( non monetary financing )

OPTION 1 : involves injecting new money into the system and thereby the money supply
increases. Borrowing from the Reserve Bank ( printing money ) will affect the money supply,
interest rates and possibly inflation.

OPTION 2 : Since the floating of the $A, this no longer increases the money supply. As the
overseas funds enter Australia, a foreign exchange dealer will give up existing $A in return for the
foreign exchange and so the net effect of the spending and financing transactions on the domestic
money supply is neutral. However as foreign exchange is swapped for $A, this represents demand
for the Australian currency and so will put upward pressure on the exchange rate. Repayments of
loans and interest are a drain on the Balance of Payments in the future.

OPTION 3 : Selling bonds to the public also has a neutral effect on the money supply.
Householders, firms, banks, etc, swap existing money for government securities. As the government
spends these funds ( e.g. on defence, welfare payments etc) aggregate demand rises and this can be
inflationary, as well as increasing demand for imports. (This applies to the other options as well )

Financing the deficit by local bond sales may put pressure on interest rates to rise since the bonds
have to be sufficiently attractive to induce the public to purchase them. These higher rates make it
more expensive and more difficult for the corporate sector to raise finance and may cause
“crowding out”, i.e. the government sector spending increases cause decreases in corporate sector

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The “Public” sector refers to all 3 levels of government, as well as Government Business
Enterprises, or Semi-Government Authorities ( Pacific Power, Telstra, Sydney Water etc ).

* where public sector revenue ( T ) is exceeded by expenditure ( G ) ( i.e. budget deficits ),
government must finance this by raising loans, i.e. selling Treasury Notes and Bonds and other
securities to the private sector.

* The PSBR is the total amount of this loan raising by all governments each year. i.e. the annual
borrowing requirement of the public sector, which adds to the Public Debt.

* the PSBR is usually much greater than just the Federal Government Budget deficit. Therefore, a
large Federal Government surplus is usually needed to bring PSBR to zero. The PSBR tends to push
interest rates up and is said to “crowd out” private sector activity, including corporate investment in
plant and equipment. Higher interest rates tend to attract overseas funds, raising the value of $A.
This makes exports more expensive and imports cheaper, worsening our Trade balance. That
portion of the PSBR financed by borrowing overseas also adds to the foreign debt.

* the PSBR may also be inflationary and have a negative influence on business confidence.

The Crowding Out Effect :

Government economic activity is said to crowd out, or take the place of private sector activity, e.g.
government taxation reduces private consumption
government spending demands goods, services and resources which are then
unavailable for use by private sector
government borrowing ( PSBR ) absorbs available savings funds and pushes
interest rates up, which reduces private sector investment.

Some economists believe that any level of government expenditure crowds out a significant amount
of private sector activity and hence, government activity should be reduced.

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Strengths of Fiscal Policy

• It can be more selective: resources can be reallocated by alteration of sales taxes on
particular items; government expenditure can be directed deliberately to high priority areas;
the tax structure can be altered to encourage or discourage particular forms of spending.

• While slower to implement than monetary policy, its results are more immediate - changes
in tax can affect disposable income immediately, while changes in interest rates involve lags
between when the decision is taken and when impact is felt.

• Fiscal policy is effective in all stages of economic activity, whereas other policies,
especially monetary policy, is more effective in restraining inflation than it is in promoting

• There are elements of fiscal policy which act as AUTOMATIC (or BUILT - IN )
STABILISERS - which act in a counter cyclical fashion.

Weaknesses of Fiscal Policy

• Fiscal policy is relatively inflexible - budgets are brought down only once a year, generally.

• Which policy should be used, for example, to stimulate economic activity? Reduce taxes?
Increase spending?

• If the government stimulates activity by increasing spending, where should the government
spend the extra? Will such government spending compete with private investment rather
than adding to it? Should tax rates thus be cut? How big should the government then let its
deficit become? How will it pay for the deficit?

• An important effect of the budgetary process is its unintended impact on decisions taken in
the private sector. The crowding-out hypothesis suggests that when a government runs a
budget deficit, it can actually make it harder for the private sector to participate in recovery
because the supply of loanable funds is tighter. Crowding-out occurs because governments
must borrow to finance a deficit. The government enters the financial markets to seek out
loanable funds. In doing so, they increase the demand for these funds. Demand/supply
analysis will predict that the price of borrowed money (the interest rate) will rise. This could
have a negative effect on firms in the private sector because the availability of loanable
money falls, and its price is higher. Hence business borrowing becomes a more risky
proposition, and private firms may decide not to go ahead with plans to borrow. At the
extreme, crowding-out could become a zero-sum game - increased government expenditure
would be cancelled out by reduced private sector activity. In such a case, expansionary fiscal
policy would have no effect on the economy.

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1. Fiscal Policy is usually defined as:

a) the total value of government debt
b) the public sector borrowing requirement
c) the variations in outlays and revenue of the Commonwealth Government
d) the difference between the outlays and revenue of all levels of government in a given

2. A contractionary fiscal policy would be consistent with:

a) taxation cuts
b) increasing a budget deficit
c) cutting government expenditure
d) all of the above

3. A cyclical budget deficit could result from:

a) increasing unemployment
b) higher than expected taxation revenues
c) planned higher levels of government expenditure
d) greater economic growth than predicted

4. In financing a budget deficit the government would create the
greatest inflationary impact by:

a) cutting income tax rates
b) borrowing from the Reserve Bank
c) borrowing from overseas
d) borrowing from the domestic private sector

5. A surplus budget is where:

a) the cyclical component of the budget is greater than
the structural component
b) government outlays exceed revenue
c) government outlays are less than revenues
d) the PSBR is zero

6. Automatic fiscal stabilisers:

a) operate only as the economy goes into a recession
b) smooth cyclical changes in economic activity
c) require discretionary policy decisions before they operate
d) are no longer used by the Commonwealth government

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7. The Australian personal income taxation system:

a) is a regressive direct tax
b) has its impact and incidence at the same point
c) has its impact and incidence at different points
d) is a progressive indirect tax

8. Progressive taxation:

a) takes a larger proportion of income as income falls
b) features lower average rates of taxes as income rises
c) shifts the burden of taxation onto lower income earners
d) features higher marginal rates as incomes rise

9. The tax illustrated in the table below is:

Income Amount of Tax Taken
1000 100
2000 200
3000 300
4000 400

a) regressive
b) progressive
c) indirect
d) proportional

10. The crowding out effect:

a) is only caused by Commonwealth government borrowing
b) is reduced by lowering the PSBR
c) only effects the supply of loanable funds and not interest rates
d) is reduced by raising the PSBR

11. A Federal Government budget surplus tends to:

a) reduce government revenue
b) increase the government’s contribution to national saving
c) provide a fiscal stimulus to the economy
d) increase ‘crowding out’ of the private sector

12. Which of the following is a limit on the usefulness of fiscal policy?

a) It is unable to target specific sectors of the economy
b) It is very flexible
c) budget decisions can often be influenced by political decisions
d) there may be a long time lag before its impact is felt in the economy

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Unit 12


INTERNAL STABILITY means the ability of a country to manage the domestic economy, in
terms of the following 3 areas:

Price stability is a situation in which there is very little sustained increase in the general price level
- that is, low rates of inflation. Achieving price stability is important because inflation adversely
affects decision-making for both households and firms; erodes international competitiveness;
distorts the distribution of income; and influences the allocation of resources throughout the

Full employment is the situation in which everyone in the workforce who is willing to work can
find employment. It is impossible to achieve a zero rate of unemployment due to the existence of
job search (frictional unemployment) and structural change. For Australia the 'natural rate' of
unemployment - the lowest rate of unemployment which can be achieved without inflationary
pressure developing — seems to be about 4-5 per cent of the workforce. This reflects structural
problems in the labour market. Cyclical or demand-deficient unemployment will add to this 'base
rate' during troughs in the business cycle.

Economic growth is defined as the increasing capacity of the economy to satisfy the wants of its
members. Growth is usually measured by the change in real Gross Domestic Product.
While economic growth is vital to ensure rising living standards, excessive growth {rates exceeding
5 per cent) may create problems such as inflation and a current account deficit if excess spending
spills over into imports and borrowing from overseas. A very high rate of economic growth may
also create excess demand leading to higher prices. There is also a valid concern that very high rates
of economic growth create pressure on the environment - the pressure for development may
outweigh the careful attention to the side-effects of this development.

EXTERNAL STABILITY means the ability of a country to meet the financial obligations which
result from international transactions. For Australia, the emphasis is on avoiding an unsustainable
current account deficit in the balance of payments. When Australians purchase more goods and
services than they sell to foreigners, then either foreign debt or the level of foreign ownership will
increase. As explained in chapter two, the level of current account deficit and foreign debt place the
spotlight on the low level of national saving.

Economic Objectives Conflict and Compatibility

The economic problem applies as much to national economic objectives as it does to personal goals
- at any point in time the nation has limited resources with which to address the satisfaction of
unlimited wants. Hence, choices have to be made between alternative courses of action, and
national economic objectives have to be prioritised.
Some objectives are compatible, in the sense that the policies applied to achieve one objective also
help to achieve other objectives at the same time. Other objectives cannot be pursued
simultaneously, because they involve conflicts in policy making.

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Compatible Policy Objectives

Some of the objectives above can be achieved simultaneously, because the policies used to achieve
them are complementary.

Examples of these compatible policy objectives include:

• higher economic growth and lower unemployment . Economic growth creates demand for
more goods and services. Hence, the resources used to produce these goods and services are
also in greater demand. Secondly, since economic growth improves the material welfare of
the people, levels of demand will rise, providing further stimulus to the expansion output
and employment. Policies to achieve lower unemployment aim to have more people in
work, and earn income to spend on other goods and services. High employment means the
economy can achieve production and income levels nearer its potential.

• the external balance objective is compatible with low inflation. If domestic prices rise faster
than prices in trading partners, exports become harder to sell on overseas markets and
imports from overseas become more competitive on the local market, tending to produce a
worsening current account deficit.

Conflicting Objectives

Some macroeconomic objectives are difficult to achieve at the same time. The policies that would
be used to pursue them are in conflict.,

Examples of these incompatible policy objectives include:

• it is difficult to reduce the levels of inflation and unemployment at the same time. There is a
trade-off between high employment and stable price levels - increasing levels of economic
activity are usually associated with greater employment of resources, but excess demand for
resources will cause their prices to rise.

• economic growth places pressure on resources if the economy has little excess capacity –
this may be inflationary in the short run because competition for resources pushes up their

• high rates of economic growth tend to increase the current account deficit. This is because
growth often spills over into higher demand for imports of both consumer and capital items.
If higher import demand continues, both the current account deficit and the foreign debt rise.

• economic growth may also increase structural unemployment in the short run.

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