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Topic 1 – Gross Domestic Product (GDP)


Macroeconomics vs Microeconomic
 Microeconomics = the study of how individuals and firms make choices,
how they interact in markets and how the government attempts to
influence their choices
 Macroeconomic = the study of the economy as a whole (including
topics such as inflation, unemployment and economic growth)

Gross Domestic Product (GDP)


 Gross Domestic Product (GDP) = the market value of all final goods
and services produced in a country during a period of time
o Elements:
 Market value (not quantities as all goods have different
measurements of quantities)
 Final goods and services (not intermediate goods and
services)
 Produced domestically (not imports)
 Produced during the relevant period of time (not goods
produced before the period commenced – e.g. second-hand
goods)
o Exclusions:
 Domestic work
 Illegal activities
 Intermediate goods and services (i.e. goods and services
used in the production of a final good or service – cannot
double count)
 Note: the same good or service can be a final or an
intermediate good depending on context (e.g. a tyre
sold to a car manufacturer is a intermediate good
while a tyre sold directly to a consumer is a final
good)
 Used, second-hand goods (second-hand goods have already
been counted in the GDP of the time period in which they
were produced – cannot double count)
 Financial assets (e.g. stocks, bonds, etc)
 Imports (foreign produced goods and services
 GDP measures the size of the economy and total production
o This is important as knowing the size of the economy has
important policy and business implications (e.g. a business will be
able to forecast sale figures and determine how much to invest)
o GDP also assists in other areas of macroeconomic analysis:
 Trade openness
 Sustainability of a country s debt
 Sustainability of a country s current account deficit

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 GDP is denoted as Y

Measuring GDP
 Production method (or value added method) = the sum of the
incremental value added at each stage of the production process
 Income method = the sum of the income generated from the sale of
domestically produced goods and services
o The income method is almost identical to the production method
 Expenditure method = the sum of expenditures on all domestically
produced goods and services
 Each method will provide the same answer

Example: A cotton farmer sells cotton to a fabric wholesaler for $5. The
wholesaler then processes it and sells it to a clothing retailer for $8. The
clothing retailer sews a shirt with the cotton, which they sell to
customers for $10. What is the GDP (Y) of this shirt?

Production method: Y = value added at each stage of the production


process = $5 + ($8 – $5) + ($10 – $8) = $5 + $3 + $2 = $10

Income method: Y = sum of income generated at each stage of the


production process = $5 + ($8 – $5) + ($10 – $8) = $5 + $3 + $2 = $10

Expenditure method: Y = money spent on the final product = market


value = $10

Components of GDP
 GDP = consumption + investment + government purchases + net exports
 Y = C + I + G + NX
 Consumption = any goods and services purchased by households
o Consumption is divided into services (e.g. medical care, education),
durable goods (e.g. cars) and non-durable goods (e.g. food, clothes)
o Excludes purchases of new houses
 Investment = new fixed capital (e.g. machinery, factories, offices, etc),
new inventory (goods that are produced but not sold) and new
residential houses
o Excludes depreciation of goods or purchases of financial securities
(e.g. shares – this is merely a transfer of assets and no goods and
services are produced from buying and selling shares)
 Government purchases = government spending on consumption and
investment items
o Excludes transfer payment (e.g. Centrelink benefits) as no goods
and services are receive in return for these payments
 Net exports = Exports – imports
o Spending on imports is excluded as GDP is only concerned with
spending on domestically produced goods and services

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o The increase in consumption caused by the purchase of imported


goods is cancelled out by the decrease of net exports

GDP per capita


 GDP per capita =
 GDP per capita is often seen as the average income per person
o This is clearly inaccurate as everyone earns a different income
 GDP per capita is used as an indicator of wellbeing or standard of living
o If a country wants to increase their standard of living, their GDP
must increase faster than the population
o GDP per capita as an indicator of standard of living is inaccurate
because:
 There are many other factors that impact one s
standard of living that is not considered when
determining GDP  e.g. crime rate, distribution of wealth
across the population, leisure, quality of health care and
education, pollution
 Gross National Happiness (GNH) has been suggested
as a new framework for measuring standard of living
 GNH considers sustainable development, cultural
integrity, ecosystem conservation and good
governance
 Some events may increase GDP but reduce wellbeing  car
accidents, money spent on medical service, fires, etc

Cross-country or cross-time comparison of GDP


 When comparing GDP cross-country, figures are based on Purchasing
Power Parity (PPP) valuation to account for price differences across
countries
o E.g. A haircut in the Philippines will cost less than in Australia,
even when expressed in the same currency
 When comparing GDP cross-time, inflation is adjusted for by using real
GDP rather than nominal GDP figures
o Nominal GDP = the market value of final goods and services
evaluated at current year prices
o Real GDP = the market value of final goods and services evaluated
at base year prices
 The base year can be any year – prices are kept constant at
the prices in this year
 Why? This fixes the problem caused by increases in
prices of goods and services increasing GDP even if
production has not increased
 A problem with this method is that over time, prices
of goods and services may change relative to each
other

GDP Deflator

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 GDP deflator =
 GDP deflator is a price index (no units)  it is a measure of the average
prices of goods and services produced in the domestic economy
o The GDP deflator is not an important number in itself; rather, is
important in comparison of different years (e.g. if the GDP deflator
is 100 in 2010 and 103 in 2011, inflation has increased by 3%)
 Inflation = % change in GDP deflator (% change in general price level
in the economy from one year to the next):
o % change in GDP deflator = %change in nominal GDP - % change in
real GDP
o Inflation = %change in nominal GDP – % change in real GDP

Example:

Production and Price Statistics of Futureland


2010 2011
Product Quantity Price per Quantity Price per
unit ($) unit ($)
Wellington/ 95 50 110 60
Gumboots
Raincoat 500 35 550 40
Toilet 500 35 550 15
Paper
Nominal $42, 650 $51, 100
GDP

(a) Using 2010 as the base year, calculate the value of real GDP in
2011:

Real GDP = 2011 quantity x 2010 quantity

Wellingtons: 110 x $50 = $5, 500


Raincoats: 550 x $35 = $19, 250
Toilet Paper: 1, 500 x $12 = $18, 000

Real GDP = $5, 500 + $19, 250 + $18, 000


= $42, 750

The real GDP in 2011 is $42, 750.

(b) Calculate (i) the GDP deflator; and (ii) the price change between
2010 and 2011, using 2010 as the base year.

(i)
GDP deflator =
=
=
= 119.53
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Example con t:

(ii)
Price change between 2010 and 2011= inflation

Inflation = %change in GDP deflator


= GDP deflator in 2011 – GDP deflator in 2010
= 119.53 – 100
= 19.53

The price change between 2010 and 2011 is 19.52.

Example: Between and , Greece s nominal GDP decreased by


% and it s GDP deflator increased by . %. What is the change in
Greece s real GDP?

Inflation = %change in nominal GDP – % change in real GDP


% change in real GDP = %change in nominal GDP – Inflation
% change in real GDP = –6% – 1.7%
= –7.7%

Greece s real GDP contracted by . % in .

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Topic 2 – Economic Growth and Business Cycles


Long-Run and Short-Run Movements
 When analysing changes in GDP (or GDP per capita), it is useful to
distinguished between short-run and long-run movements
o Trend = long-run movements
o Fluctuations = short-run movements (what happens around the
trend)

Potential GDP
 A country s long-run trend GDP value is called potential GDP
 Potential GDP is NOT maximum GDP
o Maximum GDP = the level of GDP attained GDP when firms
operate as long as they can and use as many workers as they
can hire
o Potential GDP = the level of GDP attained when firms operate on
their normal hours using a normal workforce (producing at
capacity)
 Potential GDP will increase over time as labour productivity grows
 Potential GDP can be bigger or smaller than actual GDP
 Output gap (%) =
o If there is an economic boom, actual GDP is greater than potential
GDP (positive output gap)
o If there is an economic slump, actual GDP is less than potential
GDP (negative output gap)

Potential GDP vs Actual GDP

Growth
 Income growth rate =
o Where: = GDP of earlier year
= GDP of later year

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Example: Real GDP per capita was $59, 629 in 2011 and $60, 839 in
2012. What was the income growth rate?

Income growth rate =

=
=
= 2.029%

 To work out how long it would take for an investment to double, apply
the rule of 70
o This is used to estimate the speed at which real GDP per capita is
growing
 A country with a higher growth rate will take less time for
that GDP per capita to double than a country with a slower
growth rate
 Number of years to double =

Example: If you invest $1 on a saving account, that gives 4% interest per


year and you invest the interests back into the same account every year,
how long would it take for the $1 investment to double to $2?

$1 x (1 + 0.04)n = $2
(1 + 0.04)n = 2
N x ln(1 + 0.04) = ln(2)
N x 0.04 = 0.7
N=
N= (proof)
N = 17.5 years

It would take 17.5 years for the investment to double.

Financial System
 All advanced economies have a well developed financial system
 Financial system = the system of financial markets and financial
intermediaries through which firms acquire funds from households
o Financial markets = share and bonds market

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o Financial intermediaries = banks, credit unions, insurance


companies
 In financial markets, firms sell financial securities directly to savers
o Financial security = a document that states the terms under which
funds pass from the buyer to the seller
 Shares = financial securities that represent partial
ownership of the firm
 Bonds = financial securities that represent promises to
repay a fixed amount of funds (interest payments each year
+ repayment of loan)
 Financial intermediaries facilitate the flow of fund between
borrowers and lenders/savers
o Banks specialise in assessing the risk of a loan, collecting funds
from various channels, allocating them to credit-worthy borrowers
and setting a price (the interest rate) for the loans to reflect the
cost and risks involved
o The bank will pay the saver an interest in exchange for the use of
the savers funds and will charge the borrower a higher rate of
interest to make a profit

Saving and Investment


 The funds available to firms through the financial system comes from
savings
 When firms are using funds to purchase machinery, offices, etc, they are
engaging in investment
 In a closed economy, there are no exports (NX = 0) (all economies today
are open economies – engage with other economies in trading)
o Y = C + I + G + NX
o Y=C+I+G
o I=Y–C–G
 In a closed economy, the total value of saving in the economy must
equal the total value of investment
 Savings:
o SPrivate = Y + TR – T – C
 The amount of income remaining after a household has
purchased goods and services, paid taxes and received
transfer payments)
o SPublic = T – TR – G
 The amount of tax revenue remaining after the government
has paid for government purchases and made transfer
payments
o S = SPrivate + SPublic
o S = Y = TR – T – C + T – TR – G
o S=Y–C–G (the same as I above)
 Thus, S = I (as the real interest rate (r) will adjust until S = I)
o The relationship between S, I and r an be described by the loanable
fund market model
 In an open economy, domestic investment can be financed by foreign
capital (and domestic savings can be used to finance foreign investment)

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The Market for Loanable Funds

Market for Loanable Funds:

 Market for loanable funds = the interaction of borrowers and


lenders that determines the market interest rate and the quantity of
loanable funds exchanged
 Demand for loanable funds is determined by the willingness of firms
to borrow funds to invest in new projects and of households to borrow
to invest in new houses
o Demand is downward sloping  the lower the interest rate, the
greater quantity of investment projects firms can profitably
undertake
 Supply of loanable funds is determined by the willingness of
households to save and the extent of government saving or dissaving
o Supply is upward sloping  the higher the interest rate, the
greater the reward for saving and the larger the amount of funds
household will save
 Equilibrium in the market for loanable funds will determine the quantity
of loanable funds that will flow from lenders to borrowers as well as the
real interest rate
 Interest rate:
o Nominal interest rate = interest rate stated on the loan
o Real interest rate = nominal interest rate – inflation rate
o The interest rate affects savings:
 A rise in interest rates encourages households to save so
that they have more money in the future
 A rise in interest rates will cause firms to borrow less
money as the interest to be paid back will be higher
 A company should only borrow money to fund projects if the
expected return rate of the project is higher than the interest rate on
the borrowed money

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o If interest rates go up, companies will borrow less money as fewer


projects are profitable

Increase in demand for funds:

Increase in supply for funds:

Subprime Mortgage Crisis


 The global financial crisis (GFC) of 2008 began with the subprime
mortgage crisis in the USA in 2007
 There are two different types of mortgages:
o Prime mortgage = mortgages for borrowers with good credit
records
o Subprime mortgage = mortgages for borrowers with poorer
credit records (higher expected default rates)
 The role of banks is to collect funds from individual savers and channel
them to individual borrowers
o Banks specialise in assessing the risk of a loan and in setting a
price (i.e. interest rate) to reflect the cost of the fund and the risk
involved (i.e. higher risk  higher interest rate)

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 Because mortgage loans have a very long repayment duration (e.g. 20–30
years), they are illiquid assets
o Banks developed mortgage-backed securities (MBS) to convert
this illiquid asset to liquid assets
 MBS = a financial asset which the value is connected to
mortgage loans
 Investors of MBS, what they expect to get is a long-term
stable high investment return
 By selling a MBS to other investors for cash, banks not
only turn illiquid assets to liquid assets but also
transfer the risk associated with mortgage loans to MBS
holders
 If a borrower defaults, the MBS holder bears the loss
 this gives the bank less incentive to scrutinise
the quality of loan applications but more incentive
to make loans
o Borrowers with poor credit records are more
likely to get a loan with little or zero down
payments (liar loans)
 This began the bloom of subprime
mortgages
 The low interest rate in the early 2000 s gave US households an
impression that they would be able to make the interest payments
o When interest rates went back to a more normal level, many
households failed to meet the interest payment obligations
 Failure to make payments  home foreclosures  large
number of houses went on the market  housing prices fell
as supply had increased
 MBS values plummeted
o Because many US toxic MBS s were sold to foreign financial
institutions, the impact was global
 Australian was not as negatively affected as the rest of the
world due to a timely resource boom, RBA lowered official
interest rates, fiscal stimulus package and strong
regulations

Mortgages:

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Business Cycle
 Business cycle = alternative periods od expanding and contracting
economic activity
 During the expansion phase  production, employment and income are
increasing above the trend in growth that the economy experiences over
time
 During the contraction phase  production, employment and income are
falling below the trend in growth
o A contraction phase may be followed by a recession
 Recession = when total production and employment
are decreasing and economic growth is negative
o Contraction or recession ends with a business cycle trough  the
expansion period will begin again

Phases of the Business Cycle:

 Each business cycle is different  however, they share common


characteristics:
o As the economy nears the end of an expansion
 Interest rates are usually rising
 Wages of workers are usually rising faster than prices
 Profits of firms will be falling
 Household and firms will have substantially increased
debts
o As the economy begins contraction
 There will be a decline in spending by firms on capital
goods or by households on new houses and durable goods
 As spending declines  sales decline  firms cut back on
production and lay off workers  rising unemployment 
further declines in spending  possible recession
o As the contraction or recession continues, economic
conditions gradually begin to improve

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 Inflation rate:
o During economic expansions, the inflation rate usually
increases (particularly near the end of the expansion)
o During economic contractions, the inflation rate usually decreases
 Exception: if expansion is due to rising productivity levels
and an expansion of potential GDP or if contractions is
caused by high prices for production inputs
 Unemployment rate:
o During economic expansions, the unemployment rate will
decrease
o During economic contractions and recessions, the unemployment
rate will decrease

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Topic 3 – Long-Run Growth


Growth
 When economists refer to growth, it is mostly in reference to the long-
run movement of real GDP per capita
o Real GDP per capita is still considered the best measure of
economic growth despite its limitations in measuring wellbeing
(higher income will allow individuals to afford better healthcare,
education, more material possessions, etc)
 There is an expectation in advanced countries that living standards will
improve
 Economic growth causes an economy to produce increasing quantities
and types of goods and services
 In the long run, small difference in economic growth rates result in big
differences in living standards
 Different countries have different economics growth rates
o Poor countries have not experiences substantial economic growth

Labour Productivity
 Labour productivity = the amount of output produced per labour
o Labour = one worker per hour
 For the standard of living to improve (consuming more goods and
services), there must be an increase in labour productivity
o Each person must be able to produce more output on average
 Labour productivity will increase if there is:
o More physical capital
o More human capita
o Technological progress
 The relationship between these three elements and labour productivity
and output can be explained by the neoclassical growth model
o Neoclassical growth model = increases in the quantity of
capital per hour worked and increases in technology
determine how rapidly real GDP per hour worked and
country s standard of living will increase

 Physical Capital:
o Physical capital includes manufacturing goods that are used to
produced other goods and services (e.g. computers, machines,
factories, etc)
o Accumulating more physical capital will lead to growth but as
physical capital increases, the amount of output gained will
decrease (law of diminishing returns)
 Human Capital:
o Human capital is accumulated knowledge and skills that
workers acquire from education and training or from their life
experiences
o An increase in human capital will shift the production function
upwards

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 Technological Progress:
o Technological progress (or change) refers to when firms can
produce more output using the same amount of inputs
o Technological change can occur due to:
 Better machinery and equipment
 Better organization and management method
o Technological progress will shift the production function upwards

Per-Worker Production Function


 Per-worker production function = the relationship between real
GDP (or output) per hour worked and capital per hour worked,
holding the level of technology constant
 Anything that affect the accumulation of physical capital, the
accumulation of human capital or technological progress will affect
output per labour and will affect the production function
 Examples:
o A. An increase in subsidies on education  this increase human
capital  the production function will shift upwards (as K/L is the
same but Y/L has increased)
o B. An increase in population due to migration but the capital stock
remains the same  this increases labour  the point at which the
economy is at will move to the left along the production function
as both output per labour and capital per labour have decreased
due to the increase in population
o C. A severe drought that affects the agricultural sector  this
decreases output per labour  the production function will shift
downwards (as K/L is the same but Y/L has decreased)

Movements along and shift of the production function:

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New Growth Theory


 New growth theory = a model of long-run economic growth that
emphasizes that technological change is influenced by economic
incentives and opportunities within the market  thus, is determined by
the working of the market system
 Research and development is required for technological change to
occur (strong focus on human capital)
 An increase in human capital will lead to increasing returns on a whole-
economy scale as knowledge is:
o Non-rival = one firm use of the particular knowledge does not
inhibit others from using it
o Non-excludable = once discovered knowledge become widely
available, anyone can use it
 Without sufficient protection of intellectual property rights, individual or
firms will not be willing to invest in research and development
o Firms would be worried that while they spend funds on
research, other firms will use their research and reap benefits
 To prevent this problem occurring by:
o Protecting intellectual property rights through patents (for
manufactured products) and copyrights (for books, movies, music
and software)
o Subsidising research and development
o Subsidising education (both at the school and firm level)

Economic Openness (Globalisation)


 Economic openness is when a domestic economy is open to foreign
trade and investment
 Economic openness will affect growth
o E.g. When North Korea and South Korea, the two countries were
equally poor. However, South Korea opened up to international
trade and investment, while North Korea did not. The GDP per
capita of South Korea is now 17 times that of North Korea
 Types of economic openness:
o Trade – domestic firms can import better equipment and
materials
o Foreign Direct Investments (FDI) – firms build factories in a
foreign country or will buy ownership of a foreign company
(brings in both funds and new technology)
 Or foreign firms buy more than 10% shares in a domestic
firm (according to IMF)
o Foreign Portfolio Investment (FPI) – firms buy shares or bonds
(less than 10%) in foreign companies (brings in only funds)
 Trade and FDI s increase competition in domestic firms to become more
efficient in order to survive
 Advantages of economic openness:
o Allows developing countries to break the cycle of low saving and
investment; thus, enabling higher growth and ultimately catch-up
o Technological developments are readily diffused beyond national
borders

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 Disadvantages of economic openness:


o Rich nations exploit the developing world for low wages and poor
health and safety and environmental regulations
o Undermines distinctive cultures
o Market failures have a global impact (e.g. GFC)

Catch-Up
 The economic growth model predicts that poor countries will grow
faster than rich countries
o If this is correct, poor countries should be catching up with rich
countries  this is not the case
 The hypothesis is that poor countries will experience a higher level of real
GDP per capita growth than rich countries as developing countries are
not as greatly affected by diminishing marginal returns than
developed countries this will result in convergence in real GDP per
capita and standards of living throughout the world
 Reasons for slow economic growth in poor countries:
o Failure to enforce the rule of law (e.g. property rights, contracts)
o Wars and revolutions
o Poor public education and health
o Slow technological developments
o Low rates of saving and investment
 Poor countries can break out of a low-growth cycle through foreign
investment (easier for the country to get funds and technology)

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Topic 4 – Aggregate Expenditure and Output in the Short


Run
Inventory and Investment
 Inventories = goods that have been produced but not yet sold
 Inventoried will be accounted for in the investment section of GDP
 Actual Investment (I) = Planned Investment (IP) + Unplanned
Investment (IU)
 Planned investment includes:
o Spending on equipment, machinery, factories and buildings
o Planned changes in inventories
o New houses
 Unplanned investment includes:
o Unplanned changes in inventories
 If less goods are sold than expected – Iu > 0
 Firms will reduce production and employment will
fall
 Real GDP will fall in the next period
 If more goods are sold than expected – Iu < 0
 Firms will increases production and employment
will rise
 Real GDP will rise in the next period
 Actual investment spending > planned investment spending when
there is an unplanned increase in inventories
 Actual investment spending = planned investment spending when there is
no unplanned change in inventories
 Actual investment spending < planned investment spending when
there is an unplanned decrease in inventories

Example:

Toyota expects to sell 700 new cars to domestic consumers, 50 to


governments and 170 to overseas consumers every quarter. It also keep
80 of its new cars in its showrooms.

1. How many new cars does Toyota produce per quarter? What
is its planned investment?

Y = C + G + NX + IP + IU
= 700 + 80 + 170 + 80 + 0
= 1000

Toyota produced 1000 new car per quarter. Its planned


investment is 80 (planned change in inventory).

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Example con t

2. If overseas market sales unexpectedly decline to 100, what is


Toyota s unplanned investment and actual investment?

Unplanned investment would be 70 (unplanned change in


inventory).
Actual investment = IP + IU
= 80 + 70
= 150
3. If domestic market sale unexpectedly rises to 800, what is
Toyota s unplanned investment and actual investment?

Unplanned investment would be –100 (unplanned change in


inventory).
Actual investment = IP + IU
= 80 – 100
= –20

Toyota would have to use old stock to fulfill demand.

Aggregate Expenditure Model


 The AE model demonstrates that in any particular period, the level of
GDP is determined mainly by the level of aggregate expenditure
 Assumption that prices (of goods and services and of capital and labour)
are constant
o This assumption is reasonable in the short-run but not in the long-
run
 Planned Aggregate Expenditure = the total amount of spending in
the economy
o The sum of consumption, planned investment, government
purchases and net exports
 AEP = C + IP + G + NX
 Thus, Y = AEP + IU

Determining the Level of Aggregate Expenditure in the Economy


 Consumption
o Five important variables that determine the level of consumption
 Current disposable income (Yd) = income remaining
after paying income tax and receiving transfer payment
 As current disposable income increases (decreases),
consumption increases (decreases)
 Household wealth = value of a household s assets inus
the value of it s liabilities
 As household wealth increases (decreases),
consumption increases (decreases), even if current
disposable income is unchanged

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Expected future income = income expected to be
earned by a household in the future
 Current disposable income will explain consumption
well providing that current income is not unusually
high or low compared with expected future income
 Price level = the average prices of goods and services in
the economy
 An increase (decrease) in the price level would
decrease increase a household s wealth; thus,
enabling them to purchase less (more) with the
same income
 Real interest rate = the nominal interest rate corrected
for the impact of inflation
 When the interest rate increases (decreases), the
reward for saving increases (decreases); thus,
households are likely to save more (less) and spend
less (more). The cost of money to spend on durable
goods also increases (decreases)
o Consumption has two components:
 Autonomous consumption  consumption independent
of income
 Induced consumption  consumption dependent on
income

o Consumption function:
 The consumption function explains the relationship
between consumption and disposable income
 A change in consumption depends on a change in
disposable income
 C = a + bYd
 a = autonomous consumption
 bYd = induced consumption
o b = marginal propensity to consume (MPC)
o Yd = disposable income
 Marginal Propensity to Consume:
 MPC = =
o The resulting decimal is the percentage of
income which a household will spend
 Marginal Propensity to Save:
 MPS = =
o The resulting decimal is the percentage of
income which a household will spend
 MPC + MPS = 1
 E.g. If MPC = 0.7 and MPS = 0.3, when Yd increases by
$100, consumption will increase by $70 ($100 x
70%) and saving will increase by $30 ($100 x 30%)

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 Investment
o Four important variables that determine the level of investment
 Expectation of future profitability
 A firm is likely (unlikely) to invest in new factories,
offices and equipment if they expect (do not expect)
that demand for their product to stay strong
 Interest rate
 An increase (decrease) in the interest rate will result
in less (more) investment spending as it would be
more (less) expensive for firms to borrow money
 Taxes
 An increase (decrease) in company income tax
would decrease (increase) the after-tax profitability
of investment spending
 Cash flow = the difference between the cash revenues
received by the firm and the cash spending by the firm
 The more (less) profitable a firm, the greater (lesser)
its cash flow and the greater (lesser) its ability to
finance investment

 Government Purchases
o Main source of government revenue is taxation
 The more (less) taxes the government receives, the more
(less) funds the government has to spend on government
purchases

 Net Exports
o Three important variable that determine the level of net exports
 The price level in Australia relative to the price level in
other countries
 When the inflation rate is lower (higher) in Australia
that in other countries, the prices of Australian
products increase slower (faster) than the prices of
foreign products. This increases (decreases) the
demand for Australian products  exports will
increase (decrease) and imports will decrease
(increase)
 The economic growth rate in Australia relative to the
economic growth rate in other countries
 If income rises faster (slower) in Australia than in
other countries, Australian purchases of foreign
goods and services increases faster (slower) that
foreign purchases of Australian goods and services
 exports will decrease (increase) and imports will
increase (decrease)
 The exchange rate between the Australian dollar and
other currencies
 An increase (decrease) in the value of the AUD will
decrease (increase) exports as Australian goods are

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more (less) expensive in foreign currencies and


increase (decrease) imports as foreign goods are
less (more) expensive in AUD.

Components of AEP:

The Multiplier Effect


 The multiplier effect is the process by which an increase in autonomous
expenditure leads to a larger increase in real GDP
o Why? If one area of spending increases, individuals affected by that
spending will receive more income. This extra income will be
spent on other goods and service. Those people who receive
income from those goods and services will receive more income.
This extra income will be spent on other goods and services (and
so on)

 Multiplier =

=
 The larger MPC, the more sensitive an economy is to changes in
autonomous expenditure

Example: A government increases its spending on schools by $10


million. If the MPC of the economy is 0.6, what is the multiplier? What is
the change in GDP due to this increase in spending?

Multiplier =
=
=
= 2.5

Δ GDP = Multiplier x Δ Government spending


= 2.5 x $10 million = $25 million

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Equilibrium
 Short-run equilibrium occurs when AEP = Y
 In short-run equilibrium, Y is not necessarily equal to potential GDP

Short-run equilibrium:

 If AEP > Y
o The economy demands more than the economy produces
(total spending > total production)
 There will be an unplanned decrease in inventory (IU < 0)
 Firms will increase production in the next period until
AEP = Y
 Employment will rise to cater for the increase in
production
o Knock-on effect: Increase in demand from consumers 
warehouse sells more goods  warehouse orders more goods
from the producer  producer increases production 
employment rises  increased spending in other areas of the
economy as individuals have more money
 If AEP < Y
o The economy demands less than the economy produces (total
spending < total production)
 There will be an unplanned increase in inventory (IU > 0)
 Firms will decrease production in the next period until
AEP = Y
 Employment will fall to cater for the decrease in
production
o Knock-on effect: Decrease in demand from consumers 
warehouse sells less goods  warehouse orders less goods from
the producer  producer decreases production  employment
falls  decreased spending in other areas of the economy as
individuals have less money  may lead to a recession
 Increases and decreases in AEP cause the year to year fluctuations in GDP

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Topic 5 – Aggregate Demand and Aggregate Supply


Aggregate Demand and Supply Model
 The aggregate demand and supply model explains fluctuations in real
GDP and in the price level
 In the short run, the price level is determined by the intersection of the
aggregate demand curve and the short-run aggregate supply curve

Aggregate Demand (AD) Curve


 AD curve = the relationship between price level and quantity demanded
of real output
 A fall in the price level will increase the quantity of real output demanded
 The aggregate demand curve is downward sloping. Why?
o The Wealth Effect  as the price level increases (decreases), real
wealth of households decreases (increases) (as they can buy less
(more) with their current wealth); thus, consumption decreases
(increases)
o Interest Rate effect  as the price level increases (decreases), the
households and firms would have to borrow more (less) money
from banks to conduct investment. This drives the nominal
interest rate up (down); thus, reducing (increasing) investment
o International Trade effect  as the price level in Australia
increases (decreases), the profitability of purchasing Australian
products decreases (increases). Thus, exports will decrease
(increase), imports will increases (decrease) and net exports will
decrease (increase)
o Note: it is assumed that government purchases are independent of
the price level as government purchases are determined by policy
makers
 Movements along the AD curve occurs due to changes in the price level
 Shifts of the AD curve occur due to:
o Changes in government and central bank policies (e.g. if the
government purchases more goods regardless of the price level)
o Changes in the expectation of households and firms (if
optimistic (pessimistic) about the future, there will be an increase
(decrease) in consumption)
o Changes in foreign variables (e.g. exchange rate, economic
growth)

Aggregate Supply (AS) Curve


 Aggregate supply is considered in terms of both in the short-run and in
the long run
 Long-run aggregate supply (LRAS):
o LRAS curve = the relationship between the price level and quantity
of real output supplied in the long-run
 Long-run = when no variable are fixed
o LRAS curve is a vertical line  in the long run, changes in the
price level do not affect the level of real GDP

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o LRAS curve is at potential GDP


o Shifts of the LRAS curve occur due to:
 Changes in capital stock (especially public infrastructure)
 Technological advance
 Changes in the number of workers
 Short-run aggregate supply (SRAS):
o SRAS curve = the relationship between the price level and quantity
of real output supplied in the short-run
 Short-run = when some variable are fixed
o SRAS is upward sloping. Why?
 As the price level rises, firms are willing to supply more
goods and services as the price of inputs rises slower than
the rise in profits
o SRAS is different to LRAS due to sticky prices
 Prices are sticky (slow to respond to changes in AD) in the
short run because:
 Menu costs – there are generally cots involved in
changing the price of a good or service
 Firms are uncertain about whether the increase in
demand will be sustained or not
 Wages (and other input costs) are locked into a
contract (often for a period of years)
o Movements along the SRAS curve occurs due to changes in the
price level
o Shifts in the SRAS occur due to:
 The same factors that shift the LRAS curve
 Expected changes in the future price level
 Adjustments by workers and firms to correct errors in
past expectations about the price level
 Unexpected changed in the price of an important
natural resource

Macroeconomic Equilibrium
 Equilibrium occurs at the intersection of the AD curve and the SRAS curve
 In the long run, the AD curve and the SRAS curve will intersect on the
LRAS curve (the economy will be at potential GDP)
 Expansion
o 1. The economy begins at point A
o 2. There is an increase in aggregate demand  AD curve shifts to
the right
o 3. The economy will move along the SRAS curve to point B  this
point is beyond potential GDP; thus, indicating that resources are
being over-utilised and there is upward pressure on wages
o 4. An increase in wages will increase the cost of production for
firms  this will shift the SRAS curve to the left
o 5. The economy will move along the AD curve to point C  the
economy is back at potential GDP but the price level has risen

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Expansion:

 Recession
o 1. The economy begins at point A
o 2. There is a decrease in aggregate demand  AD curve shifts to
the left
o 3. The economy will move along the SRAS curve to point B  this
point is below potential GDP; thus, indicating that resources are
being under-utilised and there is downward pressure on wages
(workers are willing to accept lower wages)
o 4. A decrease in wages will decrease the cost of production for
firms  this will shift the SRAS curve to the right
o 5. The economy will move along the AD curve to point C  the
economy is back at potential GDP but the price level has fallen

Expansion:

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 Supply Shock
o 1. The economy begins at point A
o 2. A sudden change in the availability of a natural resource (e.g. oil)
will decrease supply  SRAS curve will shift to the left
o 3. The economy will move along the AD curve to point B  this
point is below potential GDP; thus, indicating that resources are
being under-utilised and there is downward pressure on wages
(workers are willing to accept lower wages)
o 4. After an extended period of time (years), the resulting fall in
wages will decrease the cost of production for firms  this will
shift the SRAS curve to the right (back to the original positi on)
o 5. The economy will move along the AD curve to point A  the
economy is back at potential GDP and at the same price level

Supply Shock:

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Topic 6 – Unemployment
Unemployment Rate
 Each month, the ABD conducts a labour force survey to calculate the
unemployment rate
 To be classified by the ABS as unemployed, the person must have:
o Worked for less than one hour in paid employment in the
week before the survey;
o Actively looked for work in the previous four weeks; and
o Is currently available to start work
 Unemployment rate = percentage of the labour force that is unemployed
 Labour force = no. employed + no. unemployed (according to ABS)

 The unemployment rate does not give an accurate depiction of the


unemployment situation in Australia due to the strict definition of
unemployed
o Discouraged workers (those available for work but have
stopped searching for work as they believe there are no jobs
for them) are not included in the no. of unemployed
o Institutionalised people (i.e. people in jail) are not include
o Those who are underemployed are considered as employed
(understates joblessness)
 Features of unemployment:
o UER of young people is much higher than that of older people
 This is because the labour force in older age groups is
smaller as many are retired
o In the past:
 The UER of women was higher than men
 The UER of men was more volatile than that of women
 The UER of different age groups was not that different

Labour Force Participation Rate


 Labour force participation rate = percentage of the working age
population that is in the labour force
 Working age population = anyone 15 years or older

Types of Unemployment
 Cyclical Unemployment
o Unemployment caused by the business cycle
 Economic expansion  job creation  lower
unemployment
 Economic contraction  job destruction  higher
unemployment
o Cyclical unemployment will equal 0 when the economy id
producing at its potential output level (Y=Y*)

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o After a contraction, the unemployment rate will not immediate rise


because discouraged workers re-enter the labour force (until they
find work, they are unemployed) and business are reluctant to re-
hire workers as they want to be confident that the expansion of the
business cycle is not just temporary before hiring more workers
(this lag may take 1–2 years)
 Frictional Unemployment
o Short term unemployment due to the fact that it takes time for
employees to find the right job and employers to find the right
employees (mismatch of workers)
o Frictional unemployment includes seasonal unemployment –
unemployment due to seasonal factors, such as weather and other
calendar-related events (e.g. ski instructors, employees at a beach
resort, companies which sell Christmas products)
o Some frictional unemployment is good as it means that workers
and firms are taking their time to match the right workers with the
right jobs
 Structural Unemployment
o Unemployment arising from the persistent mismatch between
the skills and characteristics of workers and the requirements
of jobs arising from the changing structure of the economy
o Structural unemployment is for a longer term than frictional
unemployment as it takes time for workers to learn new skills
o Factors that cause structural unemployment include technological
change, minimum wage, trade union power and efficiency wage

 Full employment/natural rate of unemployment = when there is 0


cyclical unemployment
o There will always be some frictional and structural unemployment
o Natural rate of unemployment is also known as the non-
accelerating inflation rate of unemployment (NAIRU)
 Long-term unemployment = a person is classified as long-term
unemployed if they have been unemployed for one year or more

Costs of Unemployment
 Unemployment has negative personal and social impacts
 The size of the impact depends on the duration of the unemployment (the
longer people are unemployed, the more they lose their skills and
workplaces contract and thus it is harder for them to get a job)
 Costs of unemployment to the economy as a whole:
o Loss of GDP (people have less money to buy things)
o Loss of human capital (skills deteriorate when people are
not using them)
o Retraining costs
o Costs to government (due to unemployment benefits)
o Opportunity cost of funds being directed towards unemployment
benefits
 Costs of Unemployment to the unemployed:
o Loss of income

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o Loss of skill
o Loss of self-esteem
o Social costs on society (e.g. problems)
o Health problems
o Crime
o Political unrest

Unemployment Benefits
 Unemployment benefits are an important automatic stabiliser of an
economy
 Unemployment benefits have the effect of:
o Lessening financial pressure on the unemployed – allows more
time for job searching so they can find a job for which they are best
suited to (allows for increased labour market efficiency)
o Reducing the opportunity cost of unemployment (i.e. reducing the
incentive to work) as the unemployed are still receiving an income
(this leads to longer periods of unemployment)
o Reducing income inequality
 With unemployment benefits, the shift of real GDP after a demand shock
will be less severe

Without unemployment benefits: With unemployment benefits:

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Topic 7 – Inflation
General
 Inflation = the sustained increase in the price level
 Price level = a measure of the average price of goods and services in
the economy
o The price level is unitless
 Inflation rate (%) = the percentage increase in the price level from
one year to the next
o Note: Since 1990, the inflation rate in Australia has usually been
below 4% (with the exception of one-off spikes)
 There are a number of ways to measure the price level:
o Consumer price index (CPI)
o GDP deflator
o Producer price index (PPI)
o Wholesaler price index (WPI)
o Retail price index (RPI)
 Types of inflation:
o Inflation refers to an increase in price levels from year to year
o Deflation = negative inflation (decrease in the price level – e.g.
2%)
 Deflation expectation (occurs in countries with a long
trend of deflation – e.g. Japan) = consumers expect there to
be deflation, meaning that the price of goods and services
will decrease. Thus, consumers hold off their spending.
Aggregate demand continues to contract and
unemployment increases.
o Disinflation = a reduction in the inflation rate (i.e. the price
level is increasing but at a slower rate than the year before – e.g. a
change in the inflation rate from 3% to 2%)
o Hyperinflation = very high inflation (no specific threshold as to
what constitutes very high – usually where inflation > 100%)
 Hyperinflation tends to occur in periods of war or political
unrest when the government spends more than it has. The
government will order more money to be supplied in the
economy

Consumer Price Index (CPI)


 The CPI is the most commonly used price index for measuring inflation
 CPI= a measure of how much a typical family of four in a capital city
needs to spend on a representative basket of goods and services in a
particular year relative to the base year
o Based upon the ABS market basket i.e. what the ABS has
determined is what a typical household would purchase)
 CPI is also referred to as the cost-of-living index
 The inflation rate is the % increase in CPI from year to year
 The CPI overstates the true inflation rate due to:

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o Substitution bias – the CPI does not take into account consumer
substitution between products as the price of products change
o Increase in quality bias – the CPI does not take into account the
percentage of the increase in price that is due to an increase in
quality of the good or service
o New product bias – the ABS only updates its market basket every
6 years; thus, new products will not be immediate included
o Outlet bias – the ABS does not take into account the prevalence of
discount stores and online shopping. Basing prices on full-price
stores will overstate the cost of the market basket.

Measuring Inflation (using CPI)


 Method:
o Step 1: Calculate the cost of the basket of goods and services
($)
 Costs = (price of good 1 x quantity of good 1) + (price of
good x quantity of good + … + price of good n x
quantity of good n)
 Costs = P1Q1 + P2Q2 + …+ PnQn
o Step 2: Calculate the CPI

o Step 3: Calculate the inflation rate (%)

 Note:
o Any year can be used as the base year  changing the base year
will change the CPI values but will not change the inflation rate
between two years
o CPI of the base year = 100

Example: Use the information in the following the table to calculate the
annual rate of inflation for 2009 as measure by the CPI (where 2006 is the
base year)

Product Quantity Price Price Price


(2006) (2008) (2009)
Haircuts 1 $20 $22 $25
Hamburgers 9 $4 $4.20 $4.50
DVDs 2 $15 $15 $14

Costs (2006) = (1x$20) + (9x$4) + (2x$15) = $86


Costs (2008) = (1x$22) + (9x$4.20) + (2x$15) = $89.80
Costs (2009) = (1x$25) + (9x$4.50) + (2x$14) = $93.50

CPI (2008) =
=
=

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CPI (2009) =
=
=

= 4.12%

The inflation rate in 2009 was 4.12%.

Nominal vs. Real variables


 Nominal variable are not adjusted for inflation
 Real variable are adjusted for inflation
 The purchasing power of the dollar falls over time as the price level rises
(i.e. you could buy more stuff for $1 in 1960 than you can in 2013)
 Comparing dollar value over time:
o Real value =
o =
o Nominal value (year 2) = Nominal value (year 1) x

Nominal vs. Real Interest Rates


 Exact equation:
 Approximated equation:
o Where:
 r = real interest rate
 i = nominal interest rate
 π = inflation rate
o Note: in the exact equation: r, i and π are expressed in decimal
form not as a % (e.g. 0.03 not 3%). In the approximated equation,
they can be expressed as a %
 The real interest rate represents the true cost to borrowers and the
trust (before tax) return to lender
o Banks and other financial institutions forecast the inflation rate in
order to obtain the best return. If the actual inflation rate differs
from the expected inflation rate, the trust cost and return will be
different from the expected cost and return
 If actual inflation < expected inflation
 Lenders gain and borrowers lose
 If actual inflation > expected inflation
 Borrowers gain and lenders lose

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o Governments with large public debts will have an incentive to


raise inflation above the expected level in order to reduce their
real cost of borrowing

Causes of Inflation
 Inflation is cause by too much money chasing too little goods and
services
 There are two types of inflation:
o Demand–pull inflation  caused by an increase in the aggregate
demand for goods and services (positive demand shock) and
production levels are unable to meet this demand immediately
 Excess demand pulls the price level up  leads to higher
employment and higher output
 Can be caused by expansionary monetary policy,
expansionary fiscal policy, increase in consumer
confidence, increase in export demand from overseas, etc
o Cost–push inflation  caused by a decrease in the aggregate
supply of goods and services (negative supply shock) and
production levels are unable to meet this demand immediately
 Excess demand pulls the price level up  leads to lower
employment and lower output
 Can be caused by natural disasters, increase in import
prices, increase in wages that exceed productivity growth,
increase in electricity prices, etc

Demand-pull inflation: Cost–push inflation:

 Price wage spiral = demand-pull inflation will raise the price level;
thus, triggering cost-push inflation
o Process = demand-pull inflation cause an increase in the price level
 real wages decrease  workers bargain for higher wages to
compensate for inflation  nominal wages will increase 

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negative supply shock (SRAS curve moves to the left) as the cost of
production has increased  cost-push inflation causes another
increase in the price level  real wages decrease  etc

Price wage spiral:

Costs of Inflation on the Economy


 National income generally increases with inflation; thus, it is a fallacy to
believe that as the price rises, consumers can no longer afford to buy as
many goods and services
 Inflation affects the distribution of income  some people will find
that their income rises faster than the rate of inflation; however, people
on fixed incomes are likely to be hurt by inflation
 Paper money will decrease in value (costs of holding paper money)
 Menu costs = costs to firms of changing prices
 Increases in nominal income will push people into higher tax brackets

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Topic 8 – Money & Banking


Money
 Money = assets that people are generally willing to accept in
exchange for goods and services or for the payment of debts
 Functions of money:
o Medium of exchange – a single good is recognised as the thing
used to buy other goods and services
o Unit of account – goods and services are measured in terms of
one unit type (e.g. $)
o Store of value – money is stored easily and does not lose value
(excluding the effect of inflation)
o Standard of deferred payment – money can be used for
borrowing and lending
 Measures of money:
o Currency = notes and coins held by the non-bank private
sector (i.e. individuals and firms)
o M1 = currency + the value of all demand deposits with banks
in Australia
 Demand deposits = deposits in financial institutions that
are transferrable by cheque, debit cards at EFTPOS
terminals and through electronic transfer between
accounts
o M3 = M1 + all other deposits (e.g. term deposits) with banks in
Australia
o Broad money = M3 + deposits into non-bank deposit-taking
institutions (e.g. credit unions, building societies, etc), excluding
holdings of currency and deposits of non-banking depository
corporations (e.g. finance companies, money market corporations
and cash management trusts)
 Note: liquidity (accessibility) of money decreases as you
move from currency to broad money

Bank Balance Sheet


 A bank balance sheet lists the assets, liabilities and shareholder s
equity of a bank
o Assets include:
 Reserves = deposits that a bank keeps as cash in the bank s
vaults or on deposit with the RBA
 Banks must hold reserves to meet their
obligations when savers withdraw money
o If a bank does not have enough cash to meets
its obligations, it will be forced to sell its non-
liquid assets (e.g. shares and bonds) quickly
or borrow from the RBA or other banks at a
cost
 Loans = promises from households and business to repay
money borrowed
 Securities = shares and bonds

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o Liabilities include:
 Deposits = money that households deposit with banks
 This is a liability as the bank is liable to pay savers
back when savers wish to receive their money)
o Shareholder s equity = the value of the bank
 Shareholder s equity = Total assets – total liabilities
 A bank will be solvent when assets > liabilities
(equity will be positive)
 A bank will be insolvent when assets < liabilities
(equity will be negative)
o When a bank becomes insolvent, it has three
options:
 Declare bankruptcy
 Bail-out – external investors inject
new capital into the bank
 Bail-in – bank creditors convert loans
into shares
 Total assets must equal total liabilities & shareholder s equity
 A bank balance sheet allows one to understand where a bank receives its
funding and how it uses those funds

Example bank balance sheet:


Assets Liabilities + Shareholder s equity
Reserves 10 Deposits 100
Securities 50 Shareholder s equity 50
Loans 90
Total Assets 150 Total Liabilities 150

 T-Account = a simplified version of a bank balance sheet which


reflects changes in values of assets or liabilities (ignores values that
do not change)

Example T-account:
Assets Liabilities + Shareholder s equity
Reserves +20 Deposits +20

Creation of Money
 Banks create money by issuing credit (loans) through the multiplier
effect
o E.g. If a bank receives $500 in deposits and the reserve ratio is
10%, it will keep $50 as reserves and lend $450. This $450 will be
deposited within another bank; thus, increasing its reserves. The
money supply has been increased from $500 to $950 (and so on)
 Reserve ratio = the ratio of deposits that a bank keeps as reserves
o Reserve ratio =
o A bank s reserve ratio is often %

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 Simple deposits multiplier =


o The smaller the reserve ratio, the greater the growth in the money
supply

Central Bank and the Money Supply


 The RBA will engage in monetary policy to affect the money supply
 The RBA is involved in the financial system to alter daily liquidity in
the system to keep interest rates unchanged
o Process: Everyday there is a large volume of withdrawals and
injections of money into the financial system  this leas to banks
experiencing either a shortage or surplus of funds at the end of the
day
 If there s a shortage  banks have to purchase funds on the
short-term (overnight) money market  this increase
demand for overnight funds (cash)  this pushes up the
price of overnight funds (i.e. the overnight money market
interest rate, known as the cash rate)
 If there s a surplus  banks will sell funds on the overnight
money market  this increase supply of overnight funds 
this pushes the cash rate downwards
 Note: the cash rate is the interest rate upon which all
other interest rates are based upon
o If the RBA did not intervene, the daily changes in liquidity would
cause interest rates to fluctuate wildly
 Open market operations = the RBA purchasing or selling financial
instruments such as Cth government securities (CGS) and private
bonds and securities, either by outright purchase or sale or by the
use of a repurchase agreement
o Repurchase agreement = RBA offers to buy or sell CGS s and other
financial instruments from/to banks provided the bank is
prepared to repurchase (or resell) them at a future date (usually in
a few days at an agreed price
o The RBA can control the money supply by:
 Purchasing bank securities will increase bank s
reserves and lead to an increase in the money supply
 Selling securities will decrease bank s reserves and
lead to a decrease in the money supply
 Reserve requirements = some central banks will change reserve ratios to
control the money supply
o Increasing the reserve ratio will decrease the money supply (as
less money can be loaned)
o Decreasing the reserve ratio will increase the money supply (as
more money can be loaned)
 Quantitative easing = expanding the money supply to boost growth when
interests are near 0%

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Quantity Theory of Money


 A theory that explains the price level and inflation in the long run
 Money Supply x Velocity of Money = Price Level x GDP
o MV = PY
o This is so as the amount of money spent (MV) must equal the
amount sold (PY)
o Velocity of money = the average number of times each dollar is
used to purchase goods and services
 ΔM + ΔV = ΔP + ΔY
o Rearranged to be: Inflation ΔP = ΔM + ΔV – ΔY
 V is assumed to be constant in the long run; thus:
 Inflation = ΔM– ΔY
o If the growth in the money supply is
greater than the growth in GDP, there will
be inflation (and vice versa)

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Topic 9 – Monetary Policy


Monetary Policy
 The main goals of the RBA is to:
o Maintain the financial integrity and stability of the Australian
financial system
o Implement monetary policy
 Monetary policy = actions taken the by the RBA to manage interest
rates in order to achieve macroeconomic objectives
 Goals of monetary policy:
o Full employment of the labour force
o Stability of the Australian currency
o Economic prosperity and welfare for the people of Australia
 Monetary policy is mainly achieved through setting the cash rate
 Since 1993, the RBA has focussed monetary policy mainly on achieving
price stability
o Inflation targeting = a monetary policy strategy where the central
bank commits to a specific level or range of inflation
 In Australia, the RBA s inflation target is between % and
3% per annum on average over the business cycle
 A business cycle will typically last a few years. It is
possible for the RBA to tolerate the inflation rate
being below 2% or above 3% in a given year
 The RBA is concerned with core inflation, which is the CPI
inflation after removing temporary price fluctuations
of individual items
 Why? Such temporary price fluctuations will
disappear quickly. Any monetary policy put in place
to respond to these changes will have a lag of 6-12
months; thus, would be unnecessary when actually
taking effect

Interbank Money Market


 Exchange settlement account (ESA) = the bank account that commercial
banks, other financial institutions and the Commonwealth government
holds with the RBA
o ESA s are used when transferring money between banks and
the RBA (not when dealing with customers)
o Funds in the account are called exchange settlement funds (ESF)
 ESF s are part of a bank s reserves
 ESF s earn interest at a rate % less than the target cash
rate; thus, there is an incentive to minimise ESF s
 If bank s have insufficient funds in their ESA s to settle necessary
transactions, they must borrow from other banks ESA s in the Interbank
Money Market (IMM) (also known as the Overnight or Wholesale Money
Market

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o The interest charged on funds borrowed in the IMM is known as


the cash rate (determined by the supply and demand for cash in
the IMM)
 The demand for money will shift to the right if real GDP
increases (as the number of sales has increased, meaning
that consumers need to hold more money) or if the price
level increase (as the amount of money needed for a given
transaction has increases)
 The RBA controls the supply of cash through open market
operations

Open Market Operations OMO s


 OMO s involves the RBA purchasing or selling financial instrument
such as Commonwealth Government Securities and private bonds
either through outright sale or by the use of a repurchase agreement
 The RBA can determine the supply of cash in the IMM through OMO s
o RBA selling securities  this reduces liquidity in the IMM as the
banks purchases these securities with ESF s; thus, decreasing the
supply of cash. There will be excess demand for cash in the
IMM, causing the cash rate to rise.
o RBA buying securities  this injects liquidity in the IMM as the
money received by banks from these sales goes into their ESA s;
thus, increasing the supply of cash. There will be excess supply
for cash in the IMM, causing the cash rate to fall.

RBA selling securities: RBA buying securities:

Retail Money Market


 The RBA only has the power to set the cash rate; however, the cash rate
strongly influences other interest rates in the economy, such as
mortgage rates and business loan rates.
o Thus, the cash rate can have an impact on real GDP
 If the cash rate decreases, banks would prefer to lend excessive
reserves to borrowers outside of the IMM. This means that the supply

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of funds in other money markets would increase, causing interest rates to


fall.

Effect on Aggregate Demand


 Changes in interest rates will affect consumption, investment and net
exports and thus, aggregate demand
 Consumption:
o Substitution Effect – if the interest rate increases, households are
encouraged to save more and delay current consumption. This will
lower current consumption
o Income Effect – higher interest rates will have different effects on
net savers and net borrowers. Higher interest rates means higher
lifetime income for net savers but lower lifetime income for net
borrowers. This will prompt net savers to consumer more now
and net borrowers to consume less.
 Overall, consumption will decrease
 Investment:
o Higher interest rates mean higher costs of borrowing, which will
lower investment
o Higher interest rates could lower share pries, reducing the amount
of capital firms can raise by issuing shares
 Net Exports:
o Higher interest rates in Australia makes investing in Australian
financial assets more attractive that those in other countries. This
drives the $AUD up. Exports decreases and imports decrease, net
exports decrease.
 Overall:
o If the interest rates increases – consumption, investment and
net exports decreases. Thus, aggregate demand decreases.
o If the interest rate decreases – consumption, investment and net
exports increases. Thus, aggregate demand increases.

Expansionary vs Contractionary Policy


 Expansionary monetary policy = the use of monetary policy to lower
interest rates in order to increase real GDP. This is used when there is
a negative output gap (economic slump, negative demand shock)
o Process:
 . The RBA undertakes OMO s and buys bonds and
securities  this injects liquidity into the IMM and
increases the supply of cash in the IMM
 2. The excess supply of cash decreases the cash rate
 3. This decreases interest rates
 4. This increases aggregate demand
 5. Real GDP and the price level will increase

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Expansionary monetary policy:

 Contractionary monetary policy = the use of monetary policy to raise


interest rates in order to refuse inflation. This is used when there is a
positive output gap (economic boom, high inflation)
o Process:
 1. The RBA undertakes OMO s and sells bonds and
securities  this withdraws liquidity into the IMM and
decreases the supply of cash in the IMM
 2. The reduction in supply of cash increases the cash rate
 3. This increases interest rates
 4. This decreases aggregate demand
 5. Real GDP and the price level will decrease

Contractionary monetary policy:

Effectiveness of Monetary Policy


 Monetary policy can only affect aggregate demand and is largely
ineffective at dealing with stagflation caused by a negative supply
shock

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o Expansionary monetary policy would raise the inflation rate


further
o Contractionary monetary policy would raise the unemployment
rate further
 Monetary policy is subject to time lags  by the time that the
monetary policy has its full impact on the economy, the economic
circumstances may have changed and the policy may no longer be
appropriate
 Monetary policy affects some sectors and groups of people more
than others (e.g. the effect on net exports affects those in the agriculture,
manufacturing and services sector more as they face much international
competition)
 For monetary policy to be effective:
o Changes in the cash rate must be passed on to interest rates and
other financial assets
o Firms, consumers and investors must respond to changes in real
interest rates (consumption and investment must change)
o Net exports must also respond to changed in the interest rate
 For expansionary monetary policy to be effective, banks must be willing
to expand credit/lending

Inflation Targeting
 Arguments in favour inflation targeting:
o The RBA can have an impact on inflation but not on real GDP (in
the long run, real GDP returns to its potential level and potential
GDP is not affected by monetary policy)
o An inflation target makes it easier for households and firms to
form accurate expectation of future inflation; thus, improving their
planning
o Helps institutionalise good Australian monetary policy
o Promotes accountability
 Arguments against inflation targeting:
o Reduces the flexibility of monetary policy to address other goals
o Assumption that the RBA can accurately forecast future inflation
rates is not always correct
o Holding the RBA accountable only for an inflation goal may make it
less likely that the RBA will achieve other important goals

Independence of the RBA


 The RBA is independent of the government; however, as the RBA is
created under legislation, the RBA would not conduct monetary policy
that strongly opposed the government
 Reasons for independence:
o Avoid inflation
o Avoid the government using the central bank for political purposes
 Reasons against independence:
o No accountability as members are not elected
 The Governor of the RBA is second only to the Treasurer of Australia
in their ability to affect the Australian economy

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Topic 10 – Fiscal Policy


Fiscal Policy
 Fiscal policy = changes in federal taxes, transfer payment and
government purchase that are intended to achieve macroeconomic
policy objectives, such as full employment, price stability and
sustainable economic growth
o Fiscal policy typically refers to actions of the federal government
(not those of the state and local government)
o Not all decisions about taxing and spending by the federal
government are fiscal policy decisions  only those intended to
achieve macroeconomic policy goals (e.g. a decision to cut taxes of
those with private health insurance is a health policy action, not a
fiscal policy action)
 Fiscal policy can offset the effects of the business cycle on the economy
o Change in government purchases, transfer payments and taxes will
affect aggregate demand, which will affect real GDP, employment
and the price level
 Automatic stabilisers = government transfer payments and taxes
that automatically increase or decrease along with the business
cycle (e.g. no government action required)
o In an expansion  taxes increase and transfer payments decrease
o In a recession  taxes decrease and transfer payments increase
o Automatic stabilisers does not amount to fiscal policy as it
does not involve government action
 Discretionary fiscal policy = when the government is taking actions
to change transfers or taxes to achieve its economic objectives
o Expansionary fiscal policy:
 Used in an economic slump
 An increase in government purchases or transfer payments
or a decrease in taxes  increases AD
o Contractionary fiscal policy
 Used in an economic boom (when the inflation rate is high)
 A decrease in government purchases or transfer payments
or a increase in taxes  decreases AD

Multiplier Effect
 A change in government purchases or taxes will lead to a series of
induced changes in consumption and investment

o Change in AD = government purchase amount x multiplier


o The taxation multiplier has a negative effect because an increase in
taxes will decrease real GDP

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o The taxation multiplier is smaller that the government purchases


multiplier in absolute values because a change in taxes will lead to
a change in disposable income. Some of this change will be saved
and some will be spent (according to MPC and MPS values).
Whereas, the initial impact on aggregate demand of government
purchases is total.
 The multiplier figures are based on the assumption that the price level is
constant.
o However, the price level is not constant. Therefore, real GDP will
not increase by the full multiplier, as an increase in aggregate
demand will cause a rise in the price level.

Crowding Out
 Crowding out = a decline in private expenditure as a result of an
increase in government purchases which has diverted financial and
real resources away from the private sector
 Financial crowding out = if the government finances it spending by
borrowing, it will increase the demand for funds and thus, push the
interest rates up. Higher interest rates will reduce private consumption
and investment and may cause the AUD to appreciate, causing net export
to decline.
 Resource crowding out = the government competes with the private
sector for labour, land, intermediate goods and other real resources,
putting upward pressure on wages and prices. Higher wages and prices
reduce private consumption, investment and net exports.
 There will be partial crowding out in the short run and possibly complete
crowding out in the long run (no increase in Y)

Crowding out effect:

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Time Lag
 Fiscal policy is subject to time lags
o Recognition lag = the time it takes for policy-makers to recognise
there is a problem to be addressed
o Legislative lag = the time it takes for policy to be approved by
both Houses of Parliament
o Implementation lag = the time it takes to implement the policy
and for it to take effect

Budget Balance
 There will be a:
o Budget surplus – when the government s tax revenue is
greater than the expenditures (T – G – TR > 0)
 Occurs in an economic boom
o Budget deficit – when the government s tax revision is smaller
than its expenditure (T – G – TR < 0)
 Occurs in an economic slump
 The federal budget acts an automatic stabiliser as taxes and transfer
payments can change automatically due to business cycle
o In an expansion: real GDP increases so income and company taxes
increase. Unemployment decreases so transfer payments
decreases. Government debt is likely to decrease.
o In a recession: real GDP decreases so income and company taxes
decrease. Unemployment increases so transfer payments
increases. Government debt is likely to increase as the government
will have to finance their expenditure through borrowing.
 Structural (aka cyclically adjusted) budget surplus or deficit = deficit
or surplus when real GDP is at potential GDP (Y=Y*)
o This provides a more accurate indicator of whether government s
policy is expansionary or contractionary
o When Y=Y*, the cyclical component of a budget surplus or
deficit = 0. Therefore, at Y*, all of the budget surplus/deficit is
structural
o Structural budget surplus  the government is engaging in
contractionary fiscal policy (taxes increase, government or
transfer payments decrease)
o Structural budget deficit  the government is engaging in
expansionary fiscal policy (Taxes decrease, government or transfer
payments increase)
 Maintaining a balanced budget every year is not a good idea as this
could lead to destabilising policies:
o In a recession, it is likely there will be a budget deficit. To balance
the budget, the government must increase taxes and decreases
government purchases and transfer payments through
discretionary contractionary fiscal policy. This would lead to a
further decrease in real GDP.

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o In an expansion, it is likely there will be a budget surplus. To


balance the budget, the government must decrease taxes and
increase government purchases and transfer payment through
discretionary expansionary fiscal policy. This would lead to a
further increase in real GDP and inflation.

Long-Run Effect of Fiscal Policy


 Fiscal policy can either be to meet short run or long run goals
o Short run effect – stabilising the economy
o Long run effect – expanding the productive capacity of the
economy and increasing the rate of economic growth
 The long-run effect of tax policy:
o Tax wedge = the difference between the pre-tax and post-tax
return to an economic activity
o Economists believe that the smaller the tax wedge for any
economic activity, then more of that economic activity will occur

Supply Side Policies


 Supply side policies = fiscal policies that have long run effects by
expanding the productive capacity of the economy and increasing
the rate of economic growth.
o These policies primarily affect LRAS
 Examples:
o Lowering personal income tax may increase the incentive to work;
thus, the labour supply
o Lowering company income tax and capital gain tax might
encourage investment
 Reagonomics = the supply-side economic policies promoted by the US
President Ronald Reagan during the s.
o His main policies included reducing income tax, capital gain tax,
government spending, government regulation and inflation
 Supply side policies seem good in theory; however, in practice, no one is
sure if there is an actual effect on the LRAS curve as the effect is in the
long-run and a lot of stuff happens in the long-run

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Topic 11 – Macroeconomics in an Open Economy


Balance of Payments
 Balance of payments = the record of a country s international trade,
borrowing, lending, capital and investment flows with other
countries
 Balance of Payments = Current Account Balance + Capital Account
Balance + Financial Account Balance + net errors and omissions = 0
 Current Account Balance (CAB):
o Records current, or short term, flows of funds into and out of a
country
o Current account includes:
 Net exports (NX) (also called the balance of trade in goods
and services):
 The value of the goods and services in a country
exports minus the value of the goods and services a
country imports
 If NX is positive, there is a trade surplus but if NX is
negative, there is a trade deficit
 Net primary income (NPI):
 Income received by Australian residents from
investments in other countries (e.g. profits,
dividends and interest repayments on loans) and
income sent home by Australians working overseas
minus income paid overseas on investments in
Australia by residents of other countries and income
sent home by expatriates working in Australia
 Net secondary income (NSI):
 Transfers received by Australian residents from
other countries minus transfers made to residents of
other countries (including overseas aid, remittances
and pensions)
o Remittances = cash gifts sent by emigrants to
their families back in their original countries
 Capital Account Balance (KAB):
o Records minor transactions such as migrants asset transfers,
debt forgiveness and sales and purchases of non-produced,
non-financial assets (land titles, copyright, patents, trademarks
and franchises)
 Financial Account Balance (FAB):
o Financial account balance is equal to foreign purchases of
physical and financial assets in Australia (capital inflow)
minus Australian purchases of physical and financial assets in
foreign countries (capital outflows)
o Financial account includes:
 Foreign direct investment (FDI) – e.g. firms buy or build
physical assets (e.g. factories) abroad

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 Foreign portfolio investment (FPI) – e.g. investors buy


financial assets (e.g. bonds or shares) abroad
 Reserve asset – e.g. purchase of foreign assets (e.g. foreign
currencies or gold) by the central bank
 Principle of determining whether a value is positive or negative:
o If the item involves capital coming into the country, the value is
positive
o If the item involves capital going out of the country, the value is
negative
 In theory, the balance of payments = 0
o Why? If the current account balance is in surplus, there are excess
foreign currency earnings. These earnings will be used to purchase
foreign assets (financial account outflow) or give it away as non-
investment related transfers such as migrants assets transfers
(capital account outflow). Therefore, the current account surplus
will be exactly offset by a deficit in the capital account and
financial account.
o To make the balance of payments = 0, a net errors and
omissions term is added
 Twin deficit hypothesis = where a government budget deficit also
leads to a current account deficit
o In order for the government to fund a budget deficit, the Australian
Treasury must raise an amount equal to the deficit by selling
government bonds. To make this an attractive investment, the
Treasury may increase the interest rate on bonds. These increased
interest rates will attract foreign investors and cause an
appreciation of the dollar, causing imports to rise and exports to
fall, a net decrease in net exports. If a budget deficit leads to a
decline in net exports, the result can be referred to as the twin
deficits hypothesis.
o Equations:
 Snational + net inbound FI = I
 Snational (capital provided by Australia) + net inbound
FI (capital provided by foreign countries) = I
(domestic investment)
 Snational – I = –net inbound FI
= –FAB (as KAB is very small)
= CAB
 If Snational – I is negative, CAB will be negative. This
means that national savings are not sufficient to pay
for domestic investment. There is a saving gap. The
saving gap can be reduced by either borrowing from
overseas or by saving more.
o There are problems with borrowing:
 There will be an increase in interest
payments, which will lead to future
CAB deficits. The debt size could
increase if the debt is in foreign

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currencies and the domestic currency


depreciates.
 A high debt to GDP may lead to a lower
credit rating, causing a higher risk
premium on future borrowing.

Foreign Exchange Market


 Nominal exchange rate = the value of one country s currency in
terms of another country s currency
o The real exchange rate corrects the nominal exchange rate for
changes in prices of goods and services between countries (even
when the prices are put in the same currency)
 Money is exchange on the foreign exchange (FX) market
 Nominal exchange rate =
 The market exchange rate is determined by demand and supply of two
currencies
 Demand for $AUD comes from:
o Foreign firms and consumers that want to buy goods and services
produced in Australia
o Foreign firms and consumers that want to invest in Australia
o Currency traders who believe that the value of the $AUD will be
greater in the future
 Supply of $AUD comes from:
o Australian firms and consumers who want to buy foreign products
o Australian firms and consumers who want to invest overseas
o Currency traders who believe that the value of the $AUD will be
less in the future

Foreign exchange matter:

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 Shifts in demand:
o During an economic expansion in another country, the
demand for $AUD will increase. E.g. If there is an economic
expansion in Japan, the income of Japanese households will rise
and the demand by Japanese consumers and firms for Australian
goods and services will rise. Also, the demand for Japanese goods
and services will rise, causing extra demand for Australian
minerals and energy. The demand for $AUD will increase.
o If interest rates in Australian are relatively higher than
interest rates in other countries, the demand for $AUD will
increase as the desirability of investing in Australian financial
assets will increase
o If currency traders think that the $AUD will appreciate, the
demand for $AUD will increase
 Shifts in Supply:
o During an economic expansion in Australia, the supply of
$AUD will increase as Australian consumers and firms will spend
more in other countries. $AUD must be supplied in order to
exchange for other currency.
o If interest rates in another country are relatively higher than
interest rates in Australia, the supply id $AUD will increase as
the desirability of investing in foreign financial assets will increase.
o If currency traders think that a foreign currency will
appreciate, the supply of $AUD will increase as currency
traders will be purchasing other currencies

Currency Appreciation and Depreciation


 If the exchange rate is not at equilibrium level, there will either be
appreciation or depreciation of the $AUD
 Currency Appreciation:
o When the market value of a currency rises relative to another
currency
o If the exchange rate is below equilibrium level, there is a shortage
of $AUD; thus, there will be upward pressure on the exchange rate
 Currency Depreciation:
o When the market value of a currency falls relative to another
currency
o If the exchange rate is above equilibrium level, there is a surplus of
$AUD; thus, there will be downward pressure on the exchange rate
 Effect of appreciation and depreciation:
o If the home currency appreciates  exports become more
expensive to foreign buyers and imports become cheaper to
Australian buyers; thus, net exports will fall and reduce
aggregate demand and real GDP
o If the home currency depreciates  exports become cheaper to
foreign buyers and imports become more expensive to Australian
buyers; thus, net exports will rise and increase aggregate
demand and real GDP

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Policy in an Open Economy


 Monetary policy has a greater impact on aggregate demand in an
open economy (with a flexible exchange rate regime) than in a closed
economy
o Expansionary monetary policy will lead to lower interest rates,
which will lead to an exchange rate depreciation, which increase
net exports. In a closed economy there is no net exports that would
be affected.
 Fiscal policy has a smaller impact on aggregate demand in an open
economy than in a closed economy
o Expansionary fiscal policy such as selling government bonds will
push up the interest rate which will lead to an exchange rate
appreciation, which decreases net exports

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Topic 12 – International Financial Systems


Trade Competitiveness
 Trade competitive can be measured in a number of ways:
o Bilateral nominal exchange rate (e.g. $USD/$AUD)
 A bilateral nominal exchange rate does not fully reflect a
country s trade competitiveness because it omits:
 The nominal exchange rates against other trading
partners
 The differences in price levels
o Trade weighted index (TWI) = a measure of the value of a
currency against a basket of the currencies of the country s
main trading partners
 The basket of currencies will change over time as country s
change their trading partners and the weight of each
currency will change depending on how much a country
trades with another currency
 A country s bilateral nominal exchange rate and TWI are
not the same but will move closely with each other
 A country s TWI graph does not tell us everything  e.g.
Australia may not trade with Brazil but Australia is still a
trade competitor of Brazil. Thus, if the Brazilian currency
depreciates it will undercut Australian sales. However, as
Brazil is not a main trading partner, the effect is not
captured on the TWI graph
o Real exchange rate (RER) = the price of domestic goods and
services in terms of foreign goods and services
 RER = nominal exchange rate x

Exchange Rate Systems


 There are four main types of exchange rate systems:
o Floating exchange rate system = the exchange rate is
determined by the demand and supply of the currency in the
FX market
 The central bank only intervenes when the currency is
excessively volatile on under/overvalued
 There is no pure floating exchange rate regime  the IMF
used the term independently floating regime
 E.g. Australia, Mexico, USA
o Managed floating exchange rate system = the exchange rate is
determined mostly by market demand and supply, but with
frequent central bank intervention
 E.g. Argentina, Singapore, Papua New Guinea
o Fixed exchange rate system = countries agree to keep the
exchange rate fixed
 E.g. Historically, the gold standard and Bretton woods

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o Pegged exchange rate system = a country unilaterally agree to


peg their currency (home currency) against another currency
(anchor currency)
 E.g. The Bahamas and China peg their currency against the
$USD
 The Bahamans and China are the home currency and
the USA is the anchor currency
 Regardless of the exchange rate system, the exchange rate will be
determined by the FX market  the central bank will intervene in the
market to maintain the target exchange rate

Appreciation/Depreciation vs Revaluation/Devaluation
 Appreciation = the value of a floating currency rises relative to another
currency
 Depreciation = the value of a floating currency falls relative to another
currency
 Revaluation = the value of a fixed/pegged currency is raised relative to
the anchor currency
 Devaluation = the value of a fixed/pegged currency is lowered relative to
the anchor currency

Fixed/Pegged Exchange Rate System


 Benefits of a fixed/pegged exchange rate system:
o Facilitate international investment and trade, especially with the
anchor currency
o Fix foreign debt levels and repayments
o Reduce fluctuations in import prices
o Prohibit the central bank from printing money excessively
 Costs of a fixed/pegged exchange rate system:
o Countries lose monetary policy independency (e.g. if the US
increases interest rates, Malaysia will have to increase interest
rates (even if the conditions in the country do not warrant it)
o Countries are open to speculative currency attack when the
currency overvalues

Currency Attack
 Traders can make money from speculating
o E.g. – Thailand/USA – before the peg is broken, the trader will
borrow 25 baht and sell the 25 baht in the FX market for $1. After
the peg is broken, the trader will sell the $1 in the FX market and
get 33 baht. The borrower will repay 25 baht and make an 8 baht
profit. This not the complete story – selling the 25 baht increases
the money supply in the FX market. This leads to an excess supply
of baht. The central bank needs more foreign reserves to increase
the demand for baht. This raises interest rates, which causes the
baht to depreciate more. This means that the profits of the trader
will be even larger. This creates an incentive to attack currency.

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Currency Attack:

The US-China Exchange Rate Dispute


 China started to peg the yuan to the $USD in 1994
 The US argues that the artificially low value of the yuan give China
producers unfair advantages over the US producers, causing a large
trade deficit of the US against China

US-China Exchange Rate;

The Big Mac Index


 The Big Mac index shows the $USD price of a Big Mac in different
countries and the implied over, or under, valuation of their currencies
against the $USD

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 Law of one price (LoP) = with the absence of transportation costs


and trade barriers, a product should be sold at the same price
everywhere when expressed in the same currency
o Otherwise, traders will profit from shipping the product from
countries of a lower price to those of a higher price until the prices
are equalised

Long Run Exchange Rate


 Purchasing Power Parity (PPP) = in the long run, the exchange rate
moves to equalise the purchasing power of different currencies
o Long run nominal exchange rate =
o Long run real exchange rate = LRNER x =1
o If this was to hold, in the long run, a basket of goods and services
that costs $520 USD in the USA and that $520 USD were then
converted into Yuan, thus amount would buy the same goods and
services in China
 Factors that affect the relative price levels affect the long run nominal
exchange rate:
o Relative money supply growth
o Relative productivity
 PPP does not hold in reality because:
o Some goods and services are not traded internationally by nature
(e.g. house) or due to high transportation costs (e.g.. car repairing
services)
o Product and consumer preferences are different across countries,
so the basket of goods and services are identical
o Countries impose barriers to trade (e.g. tariffs and quotas)

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