Macro Economics Revision PDF

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Macro Economics Revision
Macroeconomics 1 (RMIT)
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Macroeconomics 1
Exam Revision

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Table of contents
What is Economics? What is Macroeconomics? ………Page 3 to 11

Measuring the cost of living………Page 10 to16
Unemployment……….Page 17 to 22
Production and Growth………Page 23 to 29
Saving, investment and the financial system…Page 29 to 37
The Monetary system…Page 37 to 44
Inflation: Its causes and costs………Page 44 to 50
Aggregate demand (AD) and aggregate supply (AS)…Page 50 to 67
The influence of monetary and fiscal policy on aggregate demand.
Page 67 to 76
Open-economy macroeconomics: Basic concepts…. Page 76 to 86

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Macro1 Lecture 1
(Chapter 1, 2)
What is Economics? What is Macroeconomics? Is it worth studying?
What Economists do…. (Nothing?)
• We (economists) are extremely influential behind almost all-economic

policy – the carbon tax, mining tax, Interest rate...
• Knowing how the economic policy works will give you extra competitive
edges at a workplace (believe me, you will appreciate this later in your life).
• E.g., People doing well in the stock market know how to read
macroeconomics data
Basic economics principles:

Scarcity
• Scarcity refers to the limited nature of society’s resources.
• For example, Hasan wished he had more time to study but his time was a
scarce resource.
Scarcity
• We encounter scarcity in every decision we make.
• For example, a household must decide who does the chores and how to
allocate its scarce resources.
• Likewise, society must decide what jobs will be done and who will do them.
It must also allocate the goods and services that are produced.
• Management of society’s resources is important because we cannot produce
all the goods and services people wish to have.
Economics
• Economics is the study of how society manages its scarce resources.
• For example, economics helped Jing to understand the production,
consumption and transfer of wealth.
• In most societies, resources are allocated through the combined choices of
millions of households and firms.
• Economists study how people make decisions: how much they work, what
they buy, how much they save and how they invest their savings.
• Economists also study how people interact with one another.
• For instance, economists examine how the buyers and sellers of a good
interact to determine the price at which the good is sold and the quantity
that is sold.
Opportunity cost
• Opportunity cost is the best alternative that must be given up to obtain
some item.
• For example, my opportunity cost of sitting through this lecture is reading a
book and enjoying an espresso at a local café.
The cost of something is what you give up to get it

• Decisions require comparing costs and benefits of alternatives.
– Whether to go to university or to work?
– Whether to go to lectures or sleep in?

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• The opportunity cost of an item is what you give up to obtain that item (it
seems that this way of thinking about cost is only applicable in economics)
 The value of the best alternative foregone when action chosen (Opp.Cost=what
you give up/what you gain)
The role of assumptions in economics

• Many economic models involve unrealistic assumptions.
• We might assume that there are only two goods in the world, or that the
firms and consumers in a market are only concerned with what they buy
and sell today.
• Assumptions help us to simplify complex situations, focusing our attention
on the details that are most relevant to the problem at hand.
• Using assumptions we can construct economic models to learn about the
world. Our models typically consist of diagrams and equations.
The circular flow diagram
Microeconomics
• Microeconomics is the study of how households and firms make decisions
and how they interact in markets.
• For example, microeconomics focuses on individual markets, examining how
incentives and trade-offs influence buyer and seller behaviour.
Macroeconomics
• Macroeconomics is the study of economy-wide phenomena, including
inflation, unemployment and economic growth.
• For example, the setting of monetary policy depends primarily on
macroeconomic factors.

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The economist as policy advisor

• Economists are experts.
• In government, the advice of economists can have a significant impact on
the development of public policy.
• In business, the advice of economists is important for formulating corporate
strategy.
Positive statements
• Positive statements are claims that attempt to describe the world as it is.
• An example of a positive statement is ‘minimum wage laws create
unemployment’.
Normative statements
• Normative statements are claims that attempt to prescribe how the world
should be.
• An example of a normative statement is ‘the minimum wage should be
raised’.
Why economists disagree

• Positive statements are statements about facts.
• Economists do disagree about facts from time to time. These are
disagreements about scientific judgement.
• Normative statements depend on both facts and values.
• A disagreement about public policy can come about when economists hold
different values, such as the appropriate trade-off between equity and
efficiency.
Macro1 (Econ1010) Lecture 2

(Chapter 24)
Measuring a nation’s income
• Microeconomics is the study of how individual households and firms make

decisions and how they interact with one another in markets.
• Macroeconomics is the study of the economy as a whole.
• Its goal is to explain the economic changes that affect many households,
firms and markets at once.
THE ECONOMY’S INCOME AND EXPENDITURE

• When judging whether the economy is doing well or poorly, it is natural to
look at the total income that everyone in the economy is earning.
• Important to know how your economic activities counted in the whole
economy
• For an economy as a whole, income must equal expenditure because:
• Every transaction has a buyer and a seller.
• Every dollar of spending by some buyer is a dollar of income for some seller
THE MEASUREMENT OF GROSS DOMESTIC PRODUCT (GDP)

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• Gross domestic product (GDP) is a measure of the total income and

expenditures of an economy.
• It is the total market value of all final goods and services produced within a
country in a given period of time.
The equality of income and expenditure can be illustrated with the circular-flow
diagram
The circular-flow diagram
Revenue MARKETS Spending

(= GDP) FOR (= GDP)
Goods GOODS AND Goods and
and services SERVICES services
sold bought
FIRMS HOUSEHOLDS
Inputs for Labour, land

production MARKETS FOR and capital
FACTORS OF
Wages, rent, PRODUCTION Income
and profit
(= GDP) = Flow of inputs
and outputs
= Flow of dollars
THE MEASUREMENT OF GDP
• ‘GDP is the market value...’

– Output is valued at market prices.
• ‘... Of all final...’
– It records only the value of final goods, not intermediate goods.
– Is your purchase of a second hand car included? Why?
• ‘... goods and services ...’
– It includes both tangible goods and intangible services.
• ‘... produced ...’
– It includes goods and services currently produced, not transactions
involving goods produced in the past.
• ‘... within a country ...’
– It measures the value of production within the geographic confines
of a country.
• ‘... in a given period of time.’

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– It measures the value of production that takes place within a specific

interval of time, usually a year or a quarter (three months).
The components of GDP
• What is not counted in GDP?
– GDP excludes most items that are produced and consumed at home
and that never enter the marketplace.
– It excludes items produced and sold illicitly, such as illegal drugs (so,
do not buy them…)
• GDP (Y) is the sum of the following:
– Consumption (C)
– Investment (I)
– Government purchases (G)
– Net exports (NX)
Y = C + I + G + NX
Useful to think about how your economic activities are taken into account of the
above equation
• Consumption (C):
– The spending by households on goods and services, with the
exception of purchases of new housing.
• Investment (I):
– The spending on capital equipment, inventories and structures,
including household purchases of new housing.
• Government purchases (G):
– The spending on goods and services by local, state and federal
governments.
– Does not include transfer payments because they are not made in
exchange for currently produced goods or services.
• Net exports (NX):
Exports minus imports.
REAL VERSUS NOMINAL GDP

• Nominal GDP values the production of goods and services at current
prices.
• Real GDP values the production of goods and services at constant prices.

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The GDP deflator
• The GDP deflator is a measure of the price level calculated as the ratio of
nominal GDP to real GDP times 100.
• It tells us the rise in nominal GDP that is attributable to a rise in prices
rather than a rise in the quantities produced.
• The GDP deflator is calculated as follows:
N o m in a l G D P
G D P d e fla to r = 1 0 0
R eal G D P

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Real and nominal GDP
Year Calculating the GDP deflator
2009 ($400/$400) x 100 = 100
2010 ($900/$650) x 100 = 138
2011 ($1600/$900) x 100 = 178
GDP AND ECONOMIC WELLBEING
• GDP is the best single measure of the economic wellbeing of a society.

• GDP per person tells us the income and expenditure of the average person in
the economy.
– Higher GDP per person indicates a higher standard of living.
– However, GDP is not a perfect measure of the happiness or quality of
life.
• Some things that contribute to wellbeing are not included in GDP.
– the value of leisure
– the value of a clean environment
– the value of almost all activity that takes place outside of markets,
such as the value of the time parents spend with their children and
the value of volunteer work.
Other Measures of Wellbeing
• All highly correlated with real GDP
– Genuine Progress indicator
– Physical Quality of Life Index
– Happy Planet Index
– Human Development index
Macro1 (Econ1010)
Lecture 3
(Chapter 25) Measuring the cost of living
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MEASURING THE COST OF LIVING
• Inflation refers to a situation in which the economy’s overall price level is

rising.
• The inflation rate is the percentage change in the price level from the
previous period.
THE CONSUMER PRICE INDEX
• The consumer price index (CPI) is a measure of the overall cost of the
goods and services bought by a typical consumer.
• The Australian Bureau of Statistics reports the CPI each month.
• The CPI is used to monitor changes in the cost of living over time.
• When the CPI rises, the typical family has to spend more dollars to maintain
the same standard of living.
What’s in the CPI’s basket?
How the CPI is calculated
1. Fix the basket. Determine which prices are most important to the typical
consumer.
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– The Australian Bureau of Statistics (ABS) identifies a market basket

of goods and services the typical consumer buys.
– The ABS conducts regular consumer surveys to determine what they
buy and how much they pay.
2. Find the prices. Find the prices of each of the goods and services in the
basket for each point in time.
3. Calculate the basket’s cost. Use the data on prices to calculate the cost of
the basket of goods and services at different times.
4. Choose a base year and compute the index: Designate one year as the
base year, making it the benchmark against which other years are
compared. Compute the index by dividing the price of the basket in one year
by the price in the base year and multiplying by 100.
Calculating the CPI and the inflation rate: An example
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Calculating the CPI: another example

• Calculating the consumer price index and the inflation rate: another
example
– Base year is 2002.
– Basket of goods in 2002 costs $1,200.
– The same basket in 2004 costs $1,236.
– CPI = ($1,236/$1,200)  100 = 103.
– Prices increased 3 percent between 2002 and 2004.
Problems in measuring the cost of living

• The CPI is an accurate measure of the selected goods that make up the
typical bundle, but it is not a perfect measure of the cost of living.
Problems
• substitution bias
• Introduction of new goods
• Unmeasured quality changes
• Substitution bias
• The basket does not change to reflect consumer reaction to changes
in relative prices.
• Fixed line vs mobile phones
• Consumers substitute toward goods that have become
relatively less expensive.
• The index overstates the increase in cost of living by not
considering consumer substitution.
• Introduction of new goods
• The basket does not reflect the change in purchasing power brought
on by the introduction of new products.
• New products result in greater variety, which in turn makes
each dollar more valuable.
• Consumers need fewer dollars to maintain any given
standard of living.
• Unmeasured quality changes
• A new DVD player
• If the quality of a good rises (falls) from one year to the next, the
value of a dollar rises (falls), even if the price of the good stays the
same.
• The substitution bias, introduction of new goods, and unmeasured quality
changes cause the CPI to overstate the true cost of living.
• The issue is important because many government programs use the
CPI to adjust for changes in the overall level of prices.
ABS price indexes
• In addition to the consumer price index for the overall economy, the ABS
calculates several other price indexes.
– It reports the index for the capital cities (Sydney, Melbourne, Perth,
Adelaide, Brisbane, Hobart, Darwin) and Canberra as well as for
some narrow categories of goods and services (such as food, clothing
and housing).
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– It also calculates the producer price index, which measures the

cost of a basket of goods and services bought by firms rather than by
consumers.
The GDP deflator versus the CPI
• Economists and policymakers monitor both the GDP deflator and the
consumer price index to gauge how quickly prices are rising.
• There are two important differences between the indexes that can cause
them to diverge.
• First, the GDP deflator reflects the prices of all goods and services produced
domestically, whereas ...
• … the consumer price index reflects the prices of all goods and services
bought by consumers.
• Second, the consumer price index compares the price of a fixed basket of
goods and services to the price of the basket in the base year...
• … whereas the GDP deflator compares the price of currently produced goods
and services to the price of the same goods and services in the base year.
Correcting economic variables for the effects of Inflation
• Price indexes are used to correct for the effects of inflation when comparing
dollar figures from different times.
• When some dollar amount is automatically corrected for inflation by law or
contract, the amount is said to be indexed for inflation.
Correcting economic variables

• Price indexes are used to correct for the effects of inflation when comparing
dollar figures from different times.
• Phar Lap (a famous horse) had winnings of $19,000 in 1930.
• How much is it in for example 2007 dollars? Any guesses?
• Winnings in 2007 dollars = winnings in 1930 dollars × (price level in
2007/price level in 1930)
• From the ABS statistics the CPI in 2007 was 158.4, and in 1930 it was 4.7
• $19,000 × (158.4/4.7) = $640,331
Real and nominal interest rates

• Interest represents a payment in the future for a transfer of money in the
past.
• The nominal interest rate is the interest rate usually reported and not
corrected for inflation. It is the interest rate that a bank pays.
• The real interest rate is the nominal interest rate that is corrected for the
effects of inflation.
For example, you borrow $1000 for one year.
– Nominal interest rate was 15 per cent.
– During the year inflation was 10 per cent.
– Real interest rate = Nominal interest rate – Inflation
– 5 per cent real interest rate = 15 per cent nominal interest rate − 10
per cent inflation rate.
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Macro1 (Econ1010)
Lecture 4
(Chapter 28) Unemployment
How is unemployment measured?
• Unemployment is measured by the Australian Bureau of Statistics (ABS).

– The ABS surveys 0.5% of Australian households chosen randomly.
The survey is known as the Labour Force Survey.
– Estimates of unemployment are derived from this survey

• Based on the answers to the survey questions, the ABS places each adult into
one of three categories:
– employed
– unemployed
– not in the labour force
• The ABS considers a person an adult if he or she is aged 15 or older.
• A person is considered employed if he or she has spent 1 hour of the previous
week working at a paid job or family business.
• The labour force is the total number of workers, i.e. the sum of the employed
and the unemployed.
• A person who is neither employed nor unemployed is not in the labour
force
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The breakdown of the population, 2013
• The unemployment rate is calculated as the percentage of the labour force

that is unemployed.
Number unemployed
Unemployme nt rate = 100
Labour force
Labour-force Participation
• The labour-force participation rate is the percentage of the adult

population that is in the labour force.
Is unemployment measured correctly?
• Discouraged workers, people who would like to work but have given up
looking for jobs after an unsuccessful search, don’t show up in
unemployment statistics
– Where do they show up then?
– What is the effect on the unemployment rate?
• Other people may claim to be unemployed in order to receive financial
assistance, even though they aren’t’t truly looking for work.
– Is this an issue in Australia?
• Underemployed: who are they?
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How long are the unemployed without work?

• Most spells of unemployment are short.
• Most unemployment observed at any given time is long-term.
• Most of the economy’s unemployment problem is attributable to relatively
few workers who are jobless for long periods of time.
• A little numerical demonstration: 14 people, out of which only 2 long-term
unemployed (1 year each) and 12 short-term (1 month each)
• How many people are unemployed on average at any given point in time?
Among them, what is the proportion of long vs short-term unemployed?
Identifying unemployment
• Two main categories:

The natural rate of unemployment (long-run)
The cyclical rate of unemployment (short-run)
• Cyclical Unemployment
– Cyclical unemployment refers to the year-to-year fluctuations in
unemployment around its natural rate.
– It is associated with short-term ups and downs of the business cycle
– What drives these fluctuations?
–
• Natural rate of unemployment
– The natural rate of unemployment is unemployment that does not go
away on its own even in the long run.
– It is the amount of unemployment that the economy normally (on
average) experiences.
Why are there always some people unemployed?
• In an ideal labour market, wages would adjust to balance the supply and
demand for labour, ensuring that all workers (willing to work at the
equilibrium wage) would be fully employed.
• There are two main types of natural unemployment: structural and
frictional
• Frictional unemployment refers to the unemployment that results from
the time that it takes to match workers with jobs.
• Search for the jobs that are best suit their tastes and skills.
Job search
• The process by which workers find appropriate jobs given their tastes and
skills.
• Results from the fact that it takes time for qualified individuals to be
matched with appropriate jobs
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Why some frictional unemployment is inevitable
• Search unemployment is inevitable because the economy is always

changing.
• Changes in the composition of demand among industries or regions are
called sectoral shifts.
• It takes time for workers to search for and find jobs in new sectors.
Public policy and job search
• Can government programs affect the time it takes unemployed workers to
find new jobs? How?
• These programs include the following:
– Government-financed employment agencies
– Public training programs
– Unemployment benefits
• Government-run employment agencies give out information about job

vacancies in order to match workers and jobs more quickly
– Does this work (think about the worker’s incentives)?
• Public training programs aim to ease the transition of workers from
declining to growing industries.
• The unemployment benefit program is a government program that
partially protects workers’ incomes when they become unemployed.
• Do unemployment benefits affect the amount of search unemployment?
– According to 1997 time use data, only 15-20% of unemployed people
report job search activity on any given day, with the average time
spend searching among those people being 80-100 minutes per day.
– The average time spent job searching across all unemployed people
is therefore 16 minutes per day (less than 2 hours per week). Borland
(2009)
Structural Unemployment
• Structural unemployment is due to a mismatch between the skills
required and offered
– Discussions: retraining in turbulent times
– Creative destruction (Schumpeter)
• Why is there structural unemployment?
– Minimum-wage laws.
– Unions.
– Efficiency wages.
Minimum-wage laws
• When the minimum wage is set above the level that balances supply and
demand, it creates unemployment.
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Minimum wages
Unions and collective bargaining
• A union is a worker association that bargains with employers over wages

and working conditions.
• In the 1970s and 1980s, when unions were at their peak, more than half of
the Australian workforce was unionized.
• A union is a type of cartel attempting to exert its market power.
– What is it?
• The process by which unions and firms agree on the terms of employment is
called collective bargaining.
• A strike will be organized if the union and the firm cannot reach an
agreement.
• A strike refers to when the union organizes a withdrawal of labour from the
firm.
• A strike makes some workers better off and other workers worse off.
• Workers in unions (insiders) reap the benefits of collective bargaining,
while workers not in the union (outsiders) bear some of the costs.
• By acting as a cartel with ability to strike or otherwise impose high costs on
employers, unions usually achieve above-equilibrium wages for their
members.
• Union workers may earn up to 10 percent more than nonunion workers.
Are unions good or bad for the economy?
• Critics argue that unions cause the allocation of labour to be inefficient and
inequitable.
– Wages above the competitive level reduce the quantity of labour
demanded and cause unemployment.
– Some workers benefit at the expense of other workers.
• Advocates of unions contend that unions are a necessary antidote to the
market power of firms that hire workers.
• They claim that unions are important for helping firms respond efficiently
to workers’ concerns.
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The theory of efficiency wages
• Efficiency wages are above-equilibrium wages paid by firms in order to

increase worker productivity.
• The theory of efficiency wages states that firms operate more efficiently if
wages are above the equilibrium level.
The theory of efficiency wages

• Why may a firm prefer to pay higher than equilibrium wages ?
– Worker health: Better paid workers eat a better diet and thus are
more productive.
– Worker turnover: A higher paid worker is less likely to look for
another job.
• A firm may prefer higher than equilibrium wages for the following reasons:
– Worker effort: Higher wages motivate workers to put forward their
best effort.
– Worker quality: Higher wages attract a better pool of workers to
apply for jobs.
• Why does the firm simply not pick the higher quality/hardworking workers
without paying them a higher wage?
Asymmetric Information
• In many transactions, one individual has better information than the other.
• Adverse selection occurs when one person knows more about the
attributes of a good than another and, as a result, the uninformed person
runs the risk of being sold a good of low quality.
– Unknown type
– Examples
– Good/bad quality worker
– Screening and signalling (education)
• Moral hazard occurs when one person (the agent) is performing some task
for another person (the principal). Because the principal cannot perfectly
monitor the agent’s behaviour, the agent tends to undertake less effort than
the principle considers desirable.
– Unknown action
– Examples
– Will work hard vs shirk
– Can you think of an incentive contract?
– Unemployment benefits?
Macro1 Lecture 5
(Chapter 26) Production and Growth
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Production and Growth

• A country’s standard of living depends on its ability to produce goods and
services.
• Within a country there are large changes in production/standard of living
over time.
• The same is true across countries
• When talking about economic growth we mean growth of real GDP... (Why
not nominal GDP?)
•
Economic Growth and Compounding
• Annual growth rates that seem small become large when compounded for
many years.
• Compounding refers to the accumulation of a growth rate over a period of
time.
– What is your intuitive understanding?
• In Australia between 1950 and 2011, average income, as measured by real
GDP per person, has grown by about 1.9 percent per year
• This have lead to a 3.2 times increase in the real GDP per capita (living
standards)
• Isn’t this magic?
– Einstein called compounding ‘the greatest mathematical discovery of
all time’
Another Example
• Delta and Bec both graduate from university at the age of 22 and take jobs
earning $30,000 per year.
• Delta lives in an economy where incomes grow at 1% per year whereas Bec
lives in an economy where incomes grow at 3% per year.
• How much will they be earning 40 years later? Any guesses?
• How do you work it out?
What has been happening to poverty in the aggregate?
• With aggregate economic growth in the developing world as a whole since
1980 we have seen aggregate poverty fall.
– “$/day” poverty rate has fallen from around 40% in 1981 to 21% in
2001
– Number of poor has declined by 350 million
• However, much less sign of progress if one excludes China
“$1/day”
• The World Bank has taken the position to measure absolute consumption
poverty on a consistent basis across countries
• But, whose poverty line should it be?
• In 1990, the Bank chose to measure global poverty by the standard of means
in the poorest countries, which gave the “$1/day” line
• In more updated measure, it is $1.25/day.
What has been happening with the poverty as the whole world incomes
grew?
% Living below $1/day (developing world)
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• The determines:
– The LEVEL of production per capita (worker) which affects the living
standards
– And its GROWTH rate (which affects the changes in living standards)
The production function

• Economists often use a production function to describe the relationship
between the quantity of inputs used in production and the quantity of
output from production.
• The inputs used to produce goods and services are called the factors of
production
Y = F(L, K, H, N, A)
– Y = quantity of output
– F( ) is a function that shows how the inputs are combined - available
production technology
– L = quantity of labour
– K = quantity of physical capital
– H = quantity of (intangible) human capital
– N = quantity of natural resources
– A = (intangible) technological knowledge
How do you interpret these variables?
• For more details see the textbook
• What is the translation of this equation?
• From the data it follows that technology has a different relationship so we
often write this as Y = A*F(L, K, H, N)
• We are more interested in the values ‘per worker’ (per capita).
– We want to divide everything by L.
• L can have different effects on the production function – we distinguish
between constant, increasing, and decreasing returns to scale
• A production function has constant returns to scale if, for any positive
number x,
xY = F(xL, xK, xN, H, A)
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• That is, a doubling of all inputs causes the amount of output to double as
well
– An example: L and K
• We will use this since production functions with constant returns to scale
have an interesting implication.
– Setting x = 1/L,
Y/L = F(1, K/ L, N/ L, H, A)
- Where all variables are per worker (/L) as we wanted
Economic Growth and living Standards

• Do you think the following can increase living standards of
individuals (i.e. the level of Y/L)?
– Increase in L?
– Increase in N?
– Increase in K?
– Increase in H and A?
• Do you think the following can sustain increases in living standards
of individuals (i.e. the growth of Y/L)?
– Increase in L?
– Increase in N?
– Increase in K?
– Increase in H and A?
Productivity
• The factors of production directly determine productivity.
– Natural resources, N
– Physical capital, K
– Human capital, H
– Technological knowledge, A
• Which of these have a permanent (long-run) effect and which only
have a temporary (short run) effect?
• The data shows that sustained economic growth per capita is all about
productivity (efficiency), A and H
• While N and K are important, their effect on growth disappears over time.
• Illustrations: having X kg of steel and producing a car, or snail mail vs the
Internet.
•
The Effect of K
• One way to raise productivity is to invest more current resources in the
production of capital
• What is needed for investment to be able to take place? (i.e. where
does the money come from?)
• Allude to the fact of the income identity relationship whereby I=S
Diminishing Returns
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• However, as the stock of capital rises, the extra output produced from an
additional unit of capital falls; this property is called diminishing returns
(to capital)
– Let’s draw this
– An example: L and K
– What is the difference from decreasing returns to scale?
• Because of diminishing returns, an increase in the saving rate leads to
higher growth only for a while
Output per worker (Y/L) and capital per worker (K/L)
Diminishing returns and the catch-up effect

• In the long run, the higher saving rate leads to a higher level of productivity
and income, but not to higher growth in these variables
• The catch-up effect refers to the property whereby countries that start off
poor tend to grow more rapidly than countries that start off rich
• It is often called ‘convergence’ across countries (as opposed to ‘divergence’
which refers to a widening gap between countries)
Investment from abroad
• Is it desirable? Why?
• Investment from abroad takes several forms:
– Foreign direct investment
• Capital investment owned and operated by a foreign entity.
– Foreign portfolio investment
• Investments financed with foreign money but operated by
domestic residents.
The Effect of H
• In Australia, each year of schooling raises a person’s wage, on average, by
about 8 percent.
• Gapminder: Plot primary completion rates (under education)
against income pp. What do you see?
– Does correlation imply causality?
• Thus, one way the government can enhance the standard of living is to
provide schools and encourage the population to take advantage of them.
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• Should University education be free? Why and Why not?

• The ‘public good’ property of H and A – the externality (these inputs do not
face diminishing returns as compared to the tangible inputs like K and L)
The Effect of H on A
• How exactly does higher H translate into higher Y/L?
– A quote from the movie Gothika: ‘All that education, but you can't
remember an umbrella?”
• Does somebody’s education have any effect on other people (an
externality)?
The effect of A
• What is ‘research and development (R&D)’?
• The advance of technological knowledge has led to higher standards of
living.
– Most technological advance comes from private research by firms
and individual inventors.
– Government can encourage the development of new technologies
through research grants, tax breaks, and the patent system
• Are patents desirable? – the benefits to the inventors
VS. the knowledge externality
•
Other Important Factors (pre-conditions) of High Output/Income
• Can you think of any?
– Property rights (legislation) and political stability? Gapminder
Botswana
– Free trade?
– Culture?
– Risk taking?
– Work ethic?
– Morality?
– Religion?
• Which of these can sustain economic growth? Why?
• Let’s look more closely to what government can do to help…
Economic growth and public policy

• What are the government policies that can raise productivity and
living standards (Y/L)?
– Encourage saving?
– Encourage investment into physical capital?
– Encourage investment from abroad?
– Encourage education and training?
– Promote research and development?
– Establish secure property rights and maintain political stability?
– Promote free trade?
– Immigration?
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An issue with population growth
• What do you think of the relationship between population growth

and economic growth (development)?
• Correlation rather than causation
A Maltus trap for China?
Present Population = 1.3 billion (20% of the world’s population)

Problem – only 11% of China’s land is arable and this has already been in
cultivation for many years.
Therefore, the land can not support many more people than what exists now.
Change in Policy Slogan in China

• ‘One is the best and Two in the Most’ in 1978
• ‘Reward Having one child and punish having three’ in 1978
• ‘One child per couple’ in 1979
Macro1 (Econ1010)
Lecture 6
(Chapter 27) Saving, investment and the financial system
Types of financial institutions

• Financial markets
– Institutions through which savers can directly provide funds to
borrowers
– Bond market
– Stock market (ASX)
• Financial intermediaries: indirectly
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– Banks
– Managed funds
• Is there any ‘other’?
– Credit unions
– Pension (superannuation) funds
– Insurance companies
Financial markets: the bond market
• What is a bond?
• A bond is a certificate of indebtedness (IOU) that specifies obligations of the
borrower to the holder of the bond
• Who can issue bonds?
•
Characteristics of a bond
• Term: The length of time until maturity.
• Credit risk: The probability that the borrower will fail to pay some of the
interest or principal.
– What is considered to be the safest bond?
– Is there any relationship between riskiness and
return/interest?
• Tax treatment: The way in which the tax laws treat the interest on the
bond.
– In Australia interest earned on bonds is taxed as any other form of
income. In the U.S. municipal bonds are federal tax exempt.
Financial markets: the stock market

• A share is a claim to partial ownership in a firm.
• The sale of stock to raise money is called equity financing.
– Compared to bonds, do shares offer higher/lower
risk/returns?
– Share (a part owner) vs. Bond (a creditor)
– Make a difference when the corporations doing well/losing
money
– Plot it on a diagram
The stock market

• What is the most important stock exchange in Australia?
– the Australian Stock Exchange (ASX).
• What are the most important stock exchanges overseas?
– the New York Stock Exchange, the American Stock Exchange,
NASDAQ, the Tokyo Stock Exchange, and the London Stock
Exchange.
• What information do most newspaper stock tables provide?
• Price (of a share)
• Volume (number of shares sold)
• Dividend (profits paid to stockholders)
• Price-earnings ratio
– What can this suggest?
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The stock market

• You may be interested to know that Warren Buffett, one of the worlds’
richest people, based his investment strategy on finding undervalued
companies. According to Investopedia.com a $10000 investment in Buffett’s
Berkshire Hathaway in 1965 would have been worth nearly $30 million by
2005, 60 times more than an investment in the S&P 500 stock market index.
• Theodore Roosevelt said in 1908: ‘There is no moral difference between
gambling at cards or in lotteries or on the race track and gambling in the
share market?’
Financial intermediaries: indirect borrowing
• Banks
– Take deposits from people who want to save and use the deposits to
make loans to people who want to borrow.
– Pay depositors interest on their deposits and charge borrowers
slightly higher interest on their loans
• What is the difference between retail and investment banking?
Financial intermediaries
• Banks help create a medium of exchange by allowing people to write
cheques against their deposits or use credit cards
• A medium of exchanges is an item that people can easily use
to engage in transactions.
• This facilitates the purchases of goods and services.
• Can banks create money out of thin air (just by putting an entry in
their accounting system?). Is that a problem?
Financial intermediaries:
managed funds
• What is a managed fund?
• Does it sell or buy shares?
– They allow people with small amounts of money to easily diversify
their portfolio
– What does portfolio and diversification mean?
Saving and investment in the national income accounts

• Recall that GDP is both total income in an economy and total expenditure
on the economy’s output of goods and services:
Y = C + I + G + NX
• Assume a closed economy – one that does not engage in international trade
(imports and exports are zero):
Y=C+I+G
Some important identities
• Now, subtract C and G from both sides of the equation:

Y–C–G=I
• The left side of the equation is the total income in the economy after paying
for consumption and government purchases.
• What is it then?
– National saving, or just saving (S).
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• Substituting S for Y - C - G, the equation can be written as:

S=I
• This equation states that savings equals investment. Is it always true?
• Important macroeconomic distinction between them that differs from our
common usage of the term investment
– Is buying shares/bonds an investment?
Some important identities
• National saving, or saving, is equal to:

S=I
S=Y–C–G
S = (Y – T – C) + (T – G)
• What ‘trick’ did we perform there?
• What components do the two brackets represent?
National Saving Consists of Private and Public Components

• Private saving is the amount of income that households have left after
paying their taxes and paying for their consumption.
Private saving = (Y – T – C)
• Public saving
– Public saving is the amount of tax revenue that the government has
left after paying for it’s spending.
Public saving = (T – G)
Budget Surplus and Deficit
• If T > G, the government runs a budget surplus because it receives more
money than it spends.
• The surplus of T − G represents public saving.
• If G > T, the government runs a budget deficit because it spends more money
than it receives in tax revenue
• What about current Australian budget?
• And the past?
• When is a surplus or a deficit likely to occur? What do they lead to?
The market for loanable funds

• Financial markets ‘coordinate’ the economy’s saving and investment in the
market for loanable funds.
• The market for loanable funds is the market in which those who want to
save supply funds and those who want to borrow to invest demand funds
• Loanable funds refers to all income that people have chosen to save and
lend out, rather than use for their own consumption.
Supply and demand for loanable funds

• The supply of loanable funds comes from people who have extra income
they want to save and lend out.
• The demand for loanable funds comes from households and firms that wish
to borrow to make investments.
• The interest rate is the price of the loan.
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• It represents the amount that borrowers pay for loans and the amount that
lenders receive on their saving.
Real and nominal interest rates

• Interest represents a payment in the future for a transfer of money in the
past.
• The nominal interest rate (i) is the interest rate usually reported and not
corrected for inflation.
– It is the interest rate that a bank pays or asks for
• The real interest rate (r) is the nominal interest rate that is corrected for
the effects of inflation:
r = i – inflation
– Do we know in advance what inflation will be?
– expected vs realized (ex ante vs ex post)
• Can i or r be negative?
• You deposit $100 in the bank for one year

• In your economy only shampoos are purchased and the price increases from
$10 to $11
• The nominal interest rate is 10%.
• What is the inflation rate?
• What is the real interest rate?
• How much money will you have at the end?
• How many shampoos can you buy at the end?
• See the difference between nominal and real variables?
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Supply and demand for loanable funds

• Are their decisions affected by nominal or real interest rate?
• Financial markets work much like other markets in the economy.
– The equilibrium of the supply and demand for loanable funds
determines the real interest rate.
• What government policies can affect saving and investment?

– taxes on saving
– taxes on investment
– government budgets
Policy 3: government budget deficits and surpluses
• Recall: What is T>G and G>T?

• Is it better to run deficits or surpluses?
• Deficits: Pros:
– Stimulates the economy when in recession
• Cons:
– Accumulation of government debt
• What is wrong with that?
– Crowding out effect
• What is it?
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• A budget deficit decreases the supply of loanable funds.
– Shifts the supply curve to the left.
– Increases the equilibrium interest rate.
– Reduces the equilibrium quantity of loanable funds.
Adjustment to a New Equilibrium

• The move from point A to C is in fact a combination of three movements,
occurring at the same time
• Important distinction: move of a curve vs move ALONG a curve
– The latter is only due to the change of the variable on the y axis
– The former is due to some other variables, not the y axis variable
Adjustment to a New Equilibrium Cont’d
• Movement 1: there is a move of the whole S curve to the left (by $700), i.e.
from A to B
• As a consequence, there is shortage of saving and this bids up the interest
rate up
• BECAUSE of that increase in r, there are two additional movements, ALONG
the S and D curves.
• Movement 2: up along the D curve, from A to C.
• Why is this?
• Movement 3: up ALONG the S curve, from B to C.
• Why is this?
• All these combined; does the equilibrium quantity change more or
less than the initial change in public savings? Why?
• One implication of this model is that government borrowing to finance its

budget deficit reduces the supply of loanable funds available to finance
investment by households and firms.
• This fall in investment is referred to as crowding out.
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– The deficit borrowing crowds out private borrowers who are trying
to finance investments
– Does it matter what the deficit is used for?
– Is public investment ‘better’ than private?
– Will Y fall or rise after an increase in G?
Policy 1: taxes and saving incentives

• What does a decrease in the tax rate on savings do to households’
incentive to save (at any given interest rate)?
– The supply of loanable funds curve shifts to the right.
– The equilibrium interest rate decreases.
– The quantity demanded for loanable funds increases.
– Does the equilibrium saving increase as much as private
saving? Why?
Policy 2: taxes and investment incentives
• What does an increase in the investment tax credit (i.e. a decrease in

the effective corporate tax rate) do to firms’ incentive to borrow (at
any given interest rate)?
– Increases the demand for loanable funds.
– Shifts the demand curve to the right.
– Results in a higher interest rate and a greater quantity saved.
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Macro1 (Econ1010)
Lecture 7
(Chapter 29) The Monetary system
The Meaning of Money

• We all know how to spend it, but what is it really that we are spending?
What is money?
• Money is the set of assets in an economy that people regularly use to buy
goods and services from other people.
– Does a house qualify as money?
– And cigarettes?
– And those 10 ringgit left in your wallet since last year’s trip to
KL?
– And Telstra bonds/shares?
• Is money just currency (cash)?
– Common misperception
– What about deposits on your account? And credit cards?
The functions of money
• What are the main functions of money?

– Medium of exchange (means of payment)
– Unit of account
– Store of value
• Which one is the most important?
Medium of exchange
• An item that buyers give to sellers when they want to purchase goods and
services.
• A medium of exchange is anything that is readily acceptable as payment.
• What if there was no money?
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• Double coincidence of wants: ‘The shivering baker needs to find a hungry

tailor’
• Search cost.
The functions of money

• Unit of account
– A unit of account is the yardstick people use to post prices and record
debts.
• Store of value
– A store of value is an item that people can use to transfer purchasing
power from the present to the future.
The Types of money
• Commodity money takes the form of a commodity with intrinsic value.
– Examples: gold, silver, cigarettes.
• Fiat money is used as money because of government decree.
– It does not have intrinsic value.
– Examples: coins, currency, cheques, deposits
– Zero-coupon bond of infinite maturity.
Money in the Australian economy

• Currency is the plastic notes and metal coins in the hands of the public.
• Current deposits are balances in bank accounts that depositors can access
on demand by using a debit card or writing a cheque.
• Monetary aggregates: narrow vs. broad money
• What is liquidity?
• Monetary base (MB)
• Money stock
M1 – currency
plus deposits in
banks
M3- M1 plus all
deposits of the
private non-
bank sector
Broad money
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Demand for Money
• How much money does an individual ‘demand’?

• What are the main determinants?
– Transactions/income?
– Wealth?
– Speculation?
– Inflation?
– What is the velocity of money?
• So what has driven the trend?
The Money supply
• The money supply is the quantity of money available in the economy

• Why is it important?
• How is money supply determined?
• Creation of supply money by the central bank AND the banking system
1. The RBA (monopolistically)
- Open market operations
1. Money stock (M1-M3) through interactions between the CB,
commercial banks and the public and the ‘multiplication’ process
Banks and the money supply
• Can banks also affect money supply?

• Influencing the quantity of demand deposits
• Reserves are deposits that banks have received but have not loaned out.
• Why do banks hold reserves?
– Required vs voluntary reserves
• In a fractional-reserve banking system, banks hold a fraction of the money
deposited as reserves and lend out the rest
• Reserve ratio (R) is the fraction of deposits that banks hold as reserves
• Reserve ratio – 10 percent
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Money creation with fractional-reserve banking

• The money multiplier is the amount of money the banking system
generates with each dollar of reserves
• What is then the value of the money multiplier (m)?
• The money multiplier is the reciprocal of the reserve ratio:M = 1/R
• With R = 20%, what is M?
• What about the real world values?
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Is the Multiplier Model Correct? No.

Is it Useful? Yes.
• Above it is assumed that the initial step in the process of changing money
supply is on the banks liabilities side
– i.e. there is some change in deposits which will affect money supply.
• But can this be the other way round?
• Can this be that a bank decides to give a loan, creates electronic money out
of nothing, and THEN creates a deposit to the loan’s recipient?
The Reserve Bank of Australia

• The Reserve Bank of Australia (RBA) serves as the nation’s central bank
since 1959
• Is the RBA ‘independent’ from the government? Why?
• It has two main functions:
– The formulation and administration of monetary policy. What is
it?
– What are the goals of monetary policy?
– To maintain financial stability
Organisation of the RBA

• What is the Reserve Bank Board?
– Responsible for the Bank's monetary and banking policy.
– How many members does it have and who are they?
– How often and when does the board meet?
– How are changes in the stance of monetary policy
communicated?
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Monetary policy in Australia
• What is the monetary regime in Australia called?

• When did monetary policy in Australia start pursuing an inflation
target?
• What is the horizon of the inflation target?
• What does the explicit inflation target do?
– Accountability
– The inflation target also anchors private sector inflation
expectations.
– Credibility
The inflation forecast targeting regime
• Is policy forward-looking? Why?

• If inflation is forecast to be:
– Above the target, monetary policy has to be tightened to move
inflation down
• Contractionary policy
– Below the target, monetary policy should be eased
• Expansionary policy
The inflation-targeting regime
• What is the cash rate?

– The cash rate is the interest rate that financial institutions can earn
on overnight loans of their currency or reserves (the short-term
money market which financial institutions operate in).
The inflation-targeting regime
• The RBA now targets the cash rate (as its instrument) as a means of
influencing the inflation rate.
• When the cash rate rises, interest rates in the retail market rise. Likewise
when the cash rate falls, interest rates fall.
– The next slide (new) has a demonstration
– Topical issue: banks not passing on the cash rate reduction
• As changes in the cash rate flow through to interest rates, generally
economic activity is affected
How does the Reserve Bank affect the cash rate?

• Open market operations
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– Purchasing or selling Australian government securities

• To increase the amount of cash in the economy, the RBA buys government
securities from financial institutions.
– Injecting cash into money markets
– What then happens to the money supply?
• To decrease the money supply, the RBA sells government securities to
financial institutions.
– Withdrawing cash from the system
Problems in affecting the economy
• The RBA has been able to control movements in the cash rate and thereby
influence the cash market but its ability to control the money supply is not
precise.
• The RBA must wrestle with two problems that arise due to fractional-
reserve banking
• The RBA does not control the amount of money that households choose to
hold as deposits in banks.
• The RBA does not control the amount of money that bankers choose to lend.
Macro1 (Econ1010)
Lecture 8
(Chapter 30) Inflation: Its causes and costs
History of inflation
• Did we ever observe deflation? Why?
• And disinflation?
• And hyperinflation?
Inflation
• Inflation is an increase in the overall level of prices.
• Deflation is a decrease in the overall price level.
• Hyperinflation is an extraordinarily high rate of inflation.
The Causes of Inflation

• If P is the price of goods and services, measured in terms of money, then 1/P
is the value of money measured in terms of goods and services.
• When the overall price level rises, the value of money falls.
• The demand and supply of money determines the value of money.
• What is the ‘easiest’ way to create high inflation?
• Milton Friedman ‘Inflation is always and everywhere a monetary
phenomenon.’
• What does he mean?
• The quantity theory of money is used to explain the long-run
determinants of the price level and the inflation rate.
Money supply
• The money supply is a policy variable that is controlled by the central
bank.
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• Through instruments such as open-market operations, the central bank

directly controls the quantity of money supplied by the banking system.
• Note that the RBA no longer targets the money supply. The RBA now targets
interest rates and inflation.
Money demand
• Money demand has several determinants, including interest rates and the
average level of prices in the economy.
• People hold money because it is the medium of exchange.
• The amount of money people choose to hold depends on the prices of goods
and services.
The classical dichotomy and monetary neutrality

• Nominal variables are variables measured in monetary units.
• Real variables are variables measured in constant units.
• This separation is the classical dichotomy.
• According to the classical dichotomy, different forces influence real and
nominal variables.
• Real economic variables do not change with changes in the money supply.
• Changes in the money supply affect nominal variables but not real variables.
• The irrelevance of monetary changes for real variables is called monetary
neutrality.
Quantity theory of money
The velocity of money refers to the speed at which the typical dollar bill
•
travels around the economy from wallet to wallet.
• Velocity (V) = nominal GDP (P × Y) / money supply (M)
• The quantity equation:
MV=PY
– What is the right hand side?
Velocity and the quantity equation

• The quantity equation shows that an increase in the quantity of money in an
economy must be reflected in one of the three other variables:
– the price level must rise
– the quantity of output must rise, or
– the velocity of money must fall.
– Explaining the equilibrium price level, inflation rate and the quantity
theory of money:
– Assume the velocity of money is relatively stable over time.
– When the central bank changes the quantity of money, it causes
proportionate changes in the nominal value of output (P  Y).
– Because money is neutral, money does not affect output.
– When the central bank alters the money supply, these changes are
reflected in prices.
– Therefore, when the central bank increases the money supply
rapidly, the result is a high rate of inflation.
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Money Neutrality
• The figure shows that velocity of money is relatively stable over time
– What can affect it?
• What does real output depend on?
• Therefore, using M  V = P  Y, what effect will an increase in the
quantity of money ultimately have?
• The irrelevance of monetary changes for real variables is called money
neutrality.
• One crucial qualification (which we will discuss in future lectures) – the
distinction between the short and long run
• Let’s look at this in a diagram
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The inflation tax
• Why does the government print too much money?

• Inflation tax
– An inflation tax is like a tax on everyone who holds money.
• How can you end a hyperinflation?
The Fisher effect
• The Fisher effect: How does the nominal and real interest rate
respond to the inflation rate?
• Nominal interest rate = real interest rate + inflation rate
• According to the Fisher effect, when the rate of inflation rises, the nominal
interest rate rises by the same amount.
• The real interest rate stays the same.
• The Fisher effect refers to a one-to-one adjustment of the nominal interest
rate to the inflation rate.
The costs of inflation

• Has anyone here experienced high inflation? How did it affect your
life?
– Ask your parents about the 1970s/80s.
• One homeowner talking to his neighbour: "You know, inflation’s not so bad.
At least it allows us to live in a higher-priced neighbourhood without having
to move.“
– What’s wrong with the logic?
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• Inflation does not in itself reduce people’s real purchasing power.

• What are you going to do if you expect higher inflation?
– Wages
– Interest rates…
Costs of High Inflation and Deflation

• Anticipated inflation:
– Frequency of firms’ changing prices?
• Menu costs
– Tax distortions
• Indexation?
• Unanticipated inflation:
– Investment: creditor vs. debtor
– Fairness
• Deflation:
– Postponing consumption and investment
– Possible ‘liquidity trap’
Inflation-induced tax distortion

• Inflation exaggerates the size of capital gains and increases the tax burden
on this type of income.
• With progressive taxation, capital gains are taxed more heavily
• The income tax system treats the nominal interest earned on savings as
income
– Why is this wrong?
• The after-tax real interest rate falls, making saving less attractive.
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Confusion and inconvenience

• Inflation causes dollars at different times to have different real values.
• Therefore, with rising prices, it is more difficult to compare real revenues,
costs, and profits over time
• Are errors (in investment and spending) more or less likely?
• How is productivity affected?
Arbitrary redistributions of wealth

• Unexpected inflation redistributes wealth among the population in a way
that has nothing to do with either merit or need.
• These redistributions occur because many loans in the economy are
specified in terms of the unit of account – money.
– If inflation turns out higher than expected: who loses and who
gains?
Implications for Monetary Policy

• Having identified the costs of inflation, an important question arises:
• Why do central banks commonly have inflation targets of around 2%
rather than 0% (which would be perfect price stability)?
• There are two main reasons:
– Keeping well away from deflation
– Being able to reduce interest rates by more in a downturn
Macro1 (Econ1010) Lecture 9

(Chapter 33) Aggregate demand (AD) and aggregate supply (AS)
The Big Picture of the Topic
• This topic looks at the economy in the short run

• How long is the long/short run?
Short run is for 1-2 years window, while we have looked at long-run (like
10-20 years)
• What is the main difference?
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The Business Cycle
Three key facts about economic fluctuations

1. Economic fluctuations are irregular and unpredictable.
2. Most macroeconomic variables (that measure some type of income or
production) fluctuate together
• Do they do so by the same amounts?
3. As output falls, unemployment rises
• Why?
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Unemployment never approaches to zero, it fluctuates around the natural rate
Explaining short-run economic fluctuations

• Most economists believe that classical theory describes the world in the long
run but not in the short run
– What about the changes in the money supply?
– What about monetary neutrality?
Recap: long-run theory
• Chapter 26: GDP depends on

– Number of workers
– Physical capital per worker
– Human capital per worker
– Natural resources per worker
– Technological knowledge
– Laws, government policies, and their enforcement
• Chapter 27: saving, investment, and the real interest rate depend on the
supply and demand for loanable funds
• Chapter 28: unemployment depends on
– How well the labor market matches unemployed workers to job
vacancies, and
– How close the wage is to the equilibrium wage
• Chapter 30: the price level depends on the quantity of money, and the rate
of inflation depends on the growth rate of the quantity of money
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• The factors that affect the real interest rate and the inflation rate together
determine the nominal interest rate.
The basic model of economic fluctuations

• Two main macroeconomic variables, output and prices, are used to develop
a model to analyze the short-run fluctuations.
– The economy’s output of goods and services measured by...?
– The overall price level measured by...?
• The model looks at the aggregated behavior of households and firms, how it
is affected by Y and P and how these in turn affect the behavior
Aggregate Demand
• The aggregate-demand curve (AD) shows the quantity of goods and services
that households, firms, and the government want to buy at each price level
– An important note: it is also possible to present the model in terms of
inflation rather than the price level, with the intuition slightly
changed (inflation rate used in a textbook)
– In the slides we will use P (price level) rather than Inflation
Rate since it is easier to understand.
• What are the components of AD?
(Hint: recall Y = C + I + G + NX)
AGGREGATE DEMAND
• The aggregate demand for goods and services has four components:
Aggregate Demand = C + I + G + NX
• Aggregate Supply = Y
• In equilibrium, supply = demand
• Therefore, in equilibrium
Y = C + I + G + NX
• In ‘Price and Market’, a demand curve concerns about a substitution
and relative price change for particular goods.
• Also, mention that in a textbook, Inflation rate used in a vertical axis

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• In ‘Price and Market’, a demand curve concerns about a substitution and

relative price change for particular goods.
why the demand curve for ice cream can’t explain the AD curve
• The demand curve for an individual commodity is downward sloping

because of two effects:
– Substitution effect: when ice cream becomes cheaper people buy
more ice cream because they are switching from frozen yogurt (a
substitute)
– Income effect: when price of ice cream falls and income is
unchanged, people feel richer and, therefore, buy more ice cream
• But the AD curve can consider only changes in the overall price level. If all
prices decrease, there can be no substitution effect
• It is inconsistent to talk about changes in aggregate demand while
assuming unchanged income, because aggregate income must be equal to
aggregate demand. Therefore, the income effect can’t be applied to the
aggregate economy.
Why the aggregate-demand curve is downward sloping
1) The price level and consumption − the wealth effect:

– Everything else constant, how will a decrease in the price level make
consumers feel?
– What will they do?
– How wills this affect AD?
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Why the Aggregate-Demand Curve Is Downward Sloping: the Wealth Effect

(the Pigou effect)
• P↓ causes the purchasing power of consumers’ monetary wealth ↑

• This causes consumption ↑
– Besides, if a price decline is perceived to be temporary it makes sense
to buy what you need now, while prices are still low
• C ↑ causes aggregate demand (C+I+G+NX) ↑
2) The price level and investment − the interest rate effect (also known as
theory of liquidity preference):
– Everything else constant, how will a decrease in the price level affect
the interest rate? (Use the Fischer equation)
– How will this affect investment and AD?
3) The price level and net exports − the exchange-rate effect:
– How will the above decrease in the interest rate affect the real
exchange rate?
– How will this affect NX and AD?
– Use the open economy model…
Why the Aggregate-Demand Curve Is Downward Sloping: the Interest Rate

Effect
• P↓ causes nominal interest rate ↓
– Fisher effect (reminder:
Nominal interest rate=Real interest rate + Inflation (P)
• Nominal interest rate ↓ encourages greater investment spending by
businesses (I ↑)
• I ↑ means aggregate demand (C+I+G+NX) ↑
Why the Aggregate-Demand Curve Is Downward Sloping: the Exchange-

Rate Effect
• P↓ causes nominal interest rate ↓
– The same Fisher effect
• Foreigners sell the dollars they had been holding in AUS banks
• The value of the dollar ↓
• As a result, home goods become cheaper relative to foreign goods.
• This makes home net exports increase (NX ↑)
• NX↑ means aggregate demand (C+I+G+NX) ↑
Shifts of AD and along AD
• Which of these 3 effects is the most important for the Australia

economy?
• If P changes, does this shift the AD?
– Move along the curve
• Many other factors, however, affect the quantity of goods and services
demanded at any given price level.
– Move of the whole curve
– Possibly sources of shifts?
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Shifts in aggregate demand

• In the short run, shifts in aggregate demand cause fluctuations in the
economy’s output of goods and services.
• In the long run, shifts in aggregate demand affect the overall inflation rate
but do not affect output.
Why the Aggregate-Demand Curve Might Shift

• P↓ causes C+I+G+NX ↑
– This explains the downward slope of the aggregate demand curve
• Many other factors can affect C+I+G+NX even when the price level stays
unchanged.
• When these factors change, the aggregate demand curve shifts.
A
D C+I+G+
NX
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Why the Aggregate-Demand Curve Might Shift
• Shifts arising from

– Consumption: consumer optimism, tax rates, prices of assets (stocks,
bonds, real estate)
– Investment: technological progress, business confidence, tax rates,
money supply
– Government Purchases
– Net Exports: foreign GDP, expectations about exchange rates
The aggregate-supply curve
• The aggregate-supply curve (AS) shows the quantity of goods and

services that firms choose to produce and sell at each price level.
• In the long run (LR), is Y affected by P?
• What is then the slope of LRAS?
• The price level (P) does not affect LR determinants in the long run
The long-run aggregate-supply curve
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Potential output level, determined by capital, labour and technology

The price level does not affect these variables in the long run.
This level of production is also referred to as potential output or full-employment
output.
Why the Long-Run Aggregate-Supply Curve Might Shift

• Any change in the economy that alters the natural rate of output will shift
the long-run aggregate-supply curve.
– Labor: population growth, immigration, natural rate of
unemployment
– Capital, physical or human
– Natural Resources: price of imported oil
– Technology
– Laws, government policies
Short-run fluctuations in output and price level should be viewed as deviations

from the continuing long-run trends.
The short-run aggregate-supply curve
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• What is the main difference between the LR and the short run (SR)?
• We empirically observe that in the SR, unlike the LR, an increase in the
overall level of prices in the economy tends to raise the quantity of
goods and services supplied.
• A decrease does the opposite
• Put differently, P has temporary but not permanent positive effect on Y
• What does the SRAS look like then?
• WHY does a nominal variable like M or P have effect on a real

variable like Y???
• There are 3 main theories
• All have something to do with some imperfections in the adjustment process
• All lead to an upward sloping SRAS
• (1) the misperceptions theory
• (2) the sticky-wage theory
• (3) the sticky-price theory

(1) The misperceptions theory
– Firms: changes in the overall price vs relative prices
• What does a firm do if the prices of its products fall?
– Consumers: nominal wage vs real wage
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• What does an employee do if the nominal wage

increases?
Shape of the AS Curve: The Misperceptions Theory example

• Suppose an overall decline in demand reduces all prices
• A wheat farmer, however, sees only that wheat prices have fallen and
continues to believe that the prices of the things that she buys (milk, shoes,
clothes, etc.) are unchanged at the level she had expected
• This makes work less attractive and the farmer reduces her production of
wheat.
– I am assuming that the wheat farmer knows only how to produce
wheat…
• When this is repeated across the economy, both the overall price level and
total output fall
• (2) The sticky-wage theory (wage rigidity)

– Are nominal wages slow or fast to adjust? Why?
– If there is an unexpected fall in the price level what then happens to
the real wage?
– And the quantity of goods and services supplied?
The Sticky-Wage Theory

• Suppose wages for 2016 were set in 2015
• These wage agreements were based on the output prices that were expected
to prevail in 2015
• Suppose actual prices in 2016 fall short of what was expected
• Wages do not adjust immediately to the unexpectedly low price level.
• An unexpectedly low price level and an unchanged wage level make
employment and production less profitable.
• This induces firms to reduce the quantity of goods and services supplied.
• (3) The sticky-price theory (price rigidity)

– Do firms change prices frequently or infrequently? Why?
– If there is an unexpected fall in the price level what then happens?
– What does this do to sales?
Upward slope of the AS Curve: The Sticky-Price Theory

• Prices of some goods and services adjust sluggishly in response to changing
economic conditions
– An unexpected fall in the price level leaves some firms with higher-
than-desired prices.
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– This depresses their sales, which induces these firms to reduce the
quantity of goods and services they produce.
The Shifts in the SRAS

• If P changes, does this shift the SRAS?
– move along the curve
• Many other factors, however, affect the quantity of goods and services
supplied at any given price level.
– Move of the whole curve
– Possible sources of shifts?
• Does the SRAS shifts with the LRAS?
• What roles do expectations of firms and household play?
– If there is an increase in the expected price level, how does it affect
the quantity of goods and services supplied and the SRAS? Why?
• SRAS curve shifts RIGHT if the natural rate of output increases. This
happens if an increase in labour, physical K, human K, natural resources and
technology
• SRAS curve shifts RIGHT if the expected price level decreases, because
lower P level (along with lower wage rates) encourage firms to expand
production due to lower costs of production
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Two causes of
recession
• In some LR equilibrium (called the steady state) all the main variables are
either constant or change by a certain (unchanging) percentage
• For example: inflation is 2% each year, output growth is 3% each year etc.
– Can you show this in the AS/AD diagram?
• New economic developments (shocks) however may shift the three curves
further and this leads to SR fluctuations
– Give examples of shocks
• The economy then has a tendency to go back to some LR equilibrium (either
the original one or a new one).
• This works through the supply side and is called the self-correcting
mechanism
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Case (1): ECONOMIC FLUCTUATIONS: AD

• In summary
• Contraction (leftward shift) in Aggregate Demand (AD)
– In the short run,
• output decreases,
• the overall price level decreases, and
• the unemployment rate increases
– In the long run,
• the overall price level decreases,
• but output and the unemployment rate remain unchanged at
their long-run levels
Case (2): ECONOMIC FLUCTUATIONS: AS

• A leftward shift in Short-Run Aggregate Supply
– Output falls below the
natural rate of
employment
– Unemployment rises
Stagflation!
– The price level rises
• If the government does nothing, the SRAS will shift back to where it was.
– The price level, total production and unemployment will be
unaffected in the long run.
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Stagflation
• Adverse shifts in aggregate supply cause stagflation — a period of recession

and inflation
– Output falls and prices rise.
– Can policymakers do something about it?
– Will discuss this in detail next week
• When did Australia last experience it?
Does the economy always self-corrects?

• A heated debate now among economists
• Neo-classical economists answer yes, Keynesians no
• All the time, this is debated in the time of crisis like the one we had recently
(GFC)
The effects of a shift in aggregate supply

• Policy responses to recession
– Do nothing and wait for prices and wages to adjust (the economy to
self correct)
– Take action
– Which curve can policymakers affect?
– Through what policies?
• We will discuss this next week, here is just a little preview
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Macro1 Lecture 10
(Chapter 34) The influence of monetary and fiscal policy on aggregate
demand
The effect of policies
• Which side of the economy can policymakers affect?

• Do policies affect Y and P directly or indirectly?
• What is the transmission mechanism?
– High degree of uncertainty
– Long and variable lags
• How long do you think it takes a change in the cash rate to affect output
and inflation?
• We first look monetary policy and then fiscal policy
• Fiscal policy is very inflexible and is normally not used in SR stabilization
(unless the ‘shock’ is big such as the global financial crisis)
Monetary Policy (MP): Review

• What is MP?
• Which institution carries out MP?
• What are MP goals?
• What is the MP framework/regime in Australia?
– What do the lags imply?
– Policy must be forward looking: Inflation-forecast targeting
– What are the alternatives?
• What is the MP instrument?
– What are the alternatives?
What Do Real World CBs Do?
• The Board (or the MP committee) or the Governor

• ‘Interest rate target’
• The desired cash rate is achieved through open market operations in the
money market
– Short-term money (‘Overnight money’, ‘one month money’ etc.)
• Didn’t’t we say the interest rate was determined in the market for loanable
funds by spending and investment decisions?
– Are interest rates for same/different for different maturities?
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The Transmission Process:

• How do commercial banks respond to this decrease in the cash rate?
• What is the effect on C, I?
• What is the effect on the real exchange rate and hence NX? (a topic for open
macroeconomics)
• What is the effect on AD?
• What is the effect on output and inflation?
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Putting all this together:

The effect of monetary policy in the AS/AD diagram
• Let’s consider the effect of various ‘shocks’.
• What are the two main types?
– AD and AS
• Each type can be ‘positive’ (i.e. increase the curve – shift out) or ‘negative’
(i.e. decrease the curve – shift in)
– Do positive/negative mean that they are good/bad for the economy?
• We first examine a positive AD shock and then a negative SRAS shock
– At home try other shocks
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Ensure to discuss movement along SRAS curve from A to B, using imperfection

theory
Also, adjustment in LR - a shift of SRAS curve to LEFT
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This is the case that MP care more about the stability of Y, which is less likely in its
policy response
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• What is a bigger problem, AS or AD shocks?

• AS entail a tradeoff
– What is stagflation?
• AD are easier to stabilize
– But if there are lags may still not be stabilized perfectly
• Pre-emptive (forward looking) behavior of the CB
Fiscal Policy
• Discretionary vs Automatic stabilizers
• Both refer to changes in the overall level of government purchases (G) or
taxes (T).
• Discretionary is a deliberate change in T or G whereas due to automatic
stabilizers the changes occur automatically, due to some legislation settings
• Both types of fiscal policy influence saving, investment, and therefore
economic growth in the long run.
• Do they work through the supply or demand side of the economy?
Discretionary changes in government purchases
• When a T change is the effect on aggregate demand direct or is indirect?

– Through the spending decisions of firms or households.
• When G changes is the effect on aggregate demand direct or is indirect?
• There are two macroeconomic effects from the change in G:
– The multiplier effect
– The crowding-out effect
The multiplier effect
• Government purchases are said to have a multiplier effect on aggregate

demand
– Each dollar spent by the government can in theory raise the
aggregate demand for goods and services by MORE than a dollar.
• Why? Is it similar to the process of money multiplication?
– When you consume (using G) you are passing on the money and
allowing others to also consume more
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Expenditure Multiplier
• Recall the money multiplier:

m = 1/r
r was the reserve ratio, i.e. a leakage from the multiplication process.
• What is a similar leakage from the consumption process?
• The formula for the multiplier is therefore:
Multiplier = 1/MPS
where MPS is the marginal propensity to save, i.e. the % of your EXTRA income you
will save
• Since you either save or consume, we have
MPS = 1 − MPC
where MPC is the marginal propensity to consume
– the fraction of extra income that a household consumes rather than
saves.
The crowding-out effect
• Fiscal policy may not affect the economy as strongly as predicted by the
multiplier. Why?
• What does an increase in G do to the interest rate?
• What does this do to investment spending?
- The crowding-out effect.
• This tends to dampen the effects of fiscal policy on aggregate demand.
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Changes in taxes
• When the government cuts personal income taxes, it increases households’
take-home pay (disposable income).
– What do households do with it?
– What will be the effect on AD?
• The size of the shift in aggregate demand resulting from a tax change is
affected by the multiplier and crowding-out effects
– Will the tax multiplier be the same as the expenditure
multiplier? What is its value?
– Is it also determined by the households’ perceptions about the
permanency of the tax change?
The case against active stabilization policy

• Some economists argue that monetary and (primarily) fiscal policy
destabilise the economy.
• Because of the substantial lags they suggest the economy should be left to
deal with the short-run fluctuations on its own
• In addition to the self-correcting mechanism there is one policy channel that
is not discretionary as above but works automatically
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Automatic Stabilisers
• Automatic stabilisers are changes in fiscal policy that stimulate aggregate

demand when the economy goes into a recession without policymakers
having to take any deliberate action.
• Automatic stabilisers include
– The progressive tax system
– Some forms of G (unemployment benefits)
• How does this work? Assume a recession...
– What happens to unemployment?
– What happens to tax burden and welfare payments?
– What is the effect on AD?
• Counter-cyclical effect
The effect of fiscal policy in the AS/AD diagram

• Same as the MP (on paper)
• What does an increase in taxes or decrease in G do?
• What does a decrease in taxes or increase in G do?
• In the real world FP cannot be used successfully
- Long lags (parliament etc)
- Impossible to do small changes
- Agents’ response hard to predict...(e.g. increases in T have a very strong
discouraging effect on work effort)
The economy in the Long Run and Short Run
• The economy in the long run (classical economic theory):

– Output is determined by capital and labour and the available
production technology.
– The interest rate adjusts to balance supply of and demand for
loanable funds.
– The inflation rate adjusts to balance the supply of demand for money
in the long run. Changes in the supply of money lead to
proportionate changes in the inflation rate.
The economy in the Long Run and Short Run
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Macro1 (econ1010) Lecture 11

(Chapter 31) Open-economy macroeconomics: Basic concepts
Open-economy macroeconomics
• What is an open economy?

– It is all about trade and financial flows
• What is a closed economy?
• Are some economies more open than others? Why?
• What has been the trend over the past four decades?
• What about the Australian economy?
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Blue line for export and the red curve is the stuff we buy over seas
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The Accounts in the Balance of Payments
1) What is the current account?

• The flow of goods and services
• Income (from investment or work)
• Current transfers (aid-consumption oriented, pensions)
• Interest repayments
2) What is the capital account? A small category
• Capital transfers (aid-investment oriented)
3) What is the financial account?
• Foreign investment (direct, portfolio, loans)
The flow of goods and services
• What qualifies as exports and imports?

• Net exports (NX) are the value of a nation’s exports minus the
value of its imports.
– What factors affect net exports?
– Net exports are also called the trade balance.
• What is then a trade deficit and surplus?
• Using the previous slide is current account deficit the same thing
as trade deficit?
The flow of financial resources

• Commonly group the capital and financial accounts together and
call them net foreign investment (NFI) or also net capital outflow
(NCO)
– The purchase of foreign assets by domestic residents minus
the purchase of domestic assets by foreigners
• What happens to NFI when an Australian resident buys shares in
British Telecom?
• Give an example that has the opposite effect
• When an Australian resident buys shares in British Telecom, the
purchase raises Australian net foreign investment.
• When a Japanese resident buys a bond issued by the Australian
government, the purchase reduces Australian net foreign
investment.
The flow of financial resources

• What factors affect NFI?
– Do the nominal or real interest rates matter?
– The perceived economic and political risks of a country?
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– Which country would you not invest in at the

moment?
 Variables that influence net foreign investment (NFI):
 the real interest rates being paid on foreign assets
 the real interest rates being paid on domestic assets
 the perceived economic and political risks of holding assets
abroad
 the government policies that affect foreign ownership of
domestic assets.
What is the Relationship Between the Accounts?

• For an economy as a whole, we have:
NFI = CAB (current account balance)
– An identity
– a country can only consume more than it produces if
foreigners are willing to supply it with its capital
• A example to demonstrate: Australian firm sells wheat overseas
– With the foreign currency acquiring foreign assets or
foreign goods and services
– What happens to CAB and NFI in each case?
The current account measures an imbalance between a country’s net
exports (NX) as well as the net flow of income (NY) and net flow of
transfers (NT): CAB = NX + NY + NT
Saving, investment and International Flows

• Gross National Disposable Income (GNDY):
GNDY = GDP + NY + NT
GNDY = (C + I + G + NX) + NY + NT
NY (net income) – earning from investment overseas
NT (Net transfers) – gifts and grants from overseas
• Gross national saving (S):
S = GNDY – C – G
S = C + I + G + NX + NY + NT – C – G
S = I + NX + NY + NT
S = I + CAB
S = I + NFI
Saving=Domestic Invest. + Net foreign invest.
NX – net exports
CAB (current account balance) = NX+NY+NT
NFI (Net Foreign Investment)
Saving, investment and NFI
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• How does NFI affect the market for loanable funds?

• Now national saving have to be split between domestic and net
foreign investment, i.e.
• S = I + NFI
The exchange rate (ER)

• International transactions are influenced by international prices.
• The two most important international prices are the nominal
exchange rate and the real exchange rate
• What is the nominal exchange rate?
• What are the two ways in which it can be expressed?
– in units of foreign currency per one Australian dollar:
indirect quote (we will use throughout)
– in units of Australian dollars per one unit of the foreign
currency: direct quote
Nominal exchange rates: quotes and changes

• Assume the exchange rate between the Japanese yen and
Australian dollar is 80 yen to one dollar.
– One Australian dollar trades for 80 yen.
– One yen trades for 1/80 (= 0.0125) of a dollar.
• What is appreciation and depreciation?
– Strengthening vs weakening
– Say one dollar buys 100 yen now. What if…?
• Appreciation- when the value of our currency is going up.
Real exchange rates

• What is the real exchange rate?
– Nominal ER adjusted for price level differences
– the rate at which a person can trade the goods and
services of one country for the goods and services of
another
– Example: If a case of German beer is twice as expensive as
Australian beer, the real exchange rate is 1/2 case of
German beer per case of Australian beer
• What does the real ER depend on?
Real exchange rates (RER)
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• Depends on the nominal exchange rate and the prices of

goods in the two countries measured in local currencies
Domestic price level

Real RE= nominal ER *
Foreign price level
• What do you think is more important for exports and imports,
real or nominal ER?
• What does a depreciation (fall) in the Australian real ER
lead to?
• What does an appreciation do?
• If net exporting is increasing the aggregate demand with
shift to the right
Real Exchange Rates (question may see on the exam)

• Suppose:
– Price of Australian rice is P = $4.00 per ton
– Price of French rice is P* = €2.00 per ton
– Price of a dollar is e = €3.00 per dollar
• Note that:
– Price of a ton of Aus rice is $4.00 or, equivalently, €12.00
(because each dollar is worth 3 euros)
– Therefore, a ton of Aus rice costs the same as 6 tons of
French rice
– Therefore, the real exchange rate = 6.
Real Exchange Rates

• Recap: How did we get 6 as the real exchange rate?
– We multiplied 3 and 4 and divided the result by 2. That is,
– We calculated e × P / P*
– where e is the nominal exchange rate, P* is the foreign
price level and P is the domestic price level.
Real Exchange Rates: Effect of Depreciation

• A depreciation (fall) in the Aus real exchange rate means that
Aus goods have become cheaper relative to foreign goods.
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• This encourages consumers both at home and abroad to buy

more Aus goods and fewer goods from other countries.
• As a result, Aus exports rise, and Aus imports fall. Therefore,
• Aus net exports increase.
Real exchange rates

• A depreciation (fall) in the Australian real exchange rate
means that Australian goods have become cheaper relative
to foreign goods.
– This encourages consumers both at home and abroad to
buy more Australian goods and fewer goods from other
countries.
– As a result, Australian exports rise and Australian imports
fall, and both of these changes raise Australian net exports.
How is the ER determined? (Long run perspective)

• The purchasing-power parity theory (PPP) is the simplest and
most widely accepted theory explaining the variation of currency
exchange rates.
• a unit of any given currency should be able to buy the same
quantity of goods in all countries
– the law of one price.
• Does it hold empirically?
The Basic Logic of Purchasing-Power Parity

• If the law of one price were not true, unexploited profit
opportunities would exist.
• The process of taking advantage of differences in prices in
different markets is called arbitrage.

• If arbitrage occurs, eventually prices that differed in two
markets would necessarily converge.
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• According to the theory of purchasing-power parity, a

currency must have the same purchasing power in all
countries and exchange rates move to ensure that.
Price level in AUS Value of a dollar in yen  Price level in Japan
Price level in Japan
Nominal value of a dollar in yen 
Price level in AUS
Price level in AUS Value of a dollar in yen  Price level in Japan

• The purchasing-power parity equation above can be
rewritten in two ways:
value of dollar in yen  price in AUS
1
price in Japan
Price level in the AUS
• This equation simply means that
– The real exchange rate = 1.

Price level in AUS
• We also saw that purchasing-power parity implies the equation
above. This equation means that:
• The nominal exchange rate between the currencies of two
countries must reflect the different price levels in those countries.
• When prices rise in AUS, the dollar is worth less in yen.
• When the central bank prints large quantities of money, the
money loses value in two ways:
• It buys fewer goods and services, as discussed previously, and
• It buys smaller amounts of other currencies
Implications of purchasing-power parity (PPP)
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• If the purchasing power of the dollar is always the same at home

and abroad, will the ER change?
• The nominal ER therefore reflects...?
• e = P*/P
• When the central bank prints large quantities of money, the
money loses value both in terms of the goods and services it can
buy and in terms of the amount of other currencies it can buy.
Limitations of purchasing-power parity

• Do you go and buy your Big Mac in the Philippines?
Because cheaper?
– Many goods are not easily traded or shipped from one
country to another.
• Tradable goods are not always perfect substitutes when they are
produced in different countries
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What is Economics? What is Macroeconomics? ………Page 3 to 11

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What Economists do…. (Nothing?)

• We (economists) are extremely influential behind almost all-economic

Basic economics principles:

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The role of assumptions in economics

The circular flow diagram

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The economist as policy advisor

Why economists disagree

Macro1 (Econ1010) Lecture 2

Measuring a nation’s income

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THE ECONOMY’S INCOME AND EXPENDITURE

THE MEASUREMENT OF GROSS DOMESTIC PRODUCT (GDP)

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• Gross domestic product (GDP) is a measure of the total income and

The circular-flow diagram

Revenue MARKETS Spending

Inputs for Labour, land

THE MEASUREMENT OF GDP

• ‘GDP is the market value...’

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– It measures the value of production that takes place within a specific

REAL VERSUS NOMINAL GDP

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The GDP deflator

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Real and nominal GDP

Year Calculating the GDP deflator

2009 ($400/$400) x 100 = 100

2010 ($900/$650) x 100 = 138

2011 ($1600/$900) x 100 = 178

GDP AND ECONOMIC WELLBEING

• GDP is the best single measure of the economic wellbeing of a society.

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MEASURING THE COST OF LIVING

• Inflation refers to a situation in which the economy’s overall price level is

THE CONSUMER PRICE INDEX

What’s in the CPI’s basket?

How the CPI is calculated

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– The Australian Bureau of Statistics (ABS) identifies a market basket

Calculating the CPI and the inflation rate: An example

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Calculating the CPI: another example

Problems in measuring the cost of living

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– It also calculates the producer price index, which measures the

Correcting economic variables

Real and nominal interest rates

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How is unemployment measured?

• Unemployment is measured by the Australian Bureau of Statistics (ABS).

How is unemployment measured?