a ETT MACROECONOMICS 3 Determination of output and price level The Business Cycle The Business Cycle Feonomic Activity (real GOP) x5 x6 Years Characteristics of the phases in the business cycle 1. Boom common features include: * high levels of economic growth © stornear the natural zate of unemployment. May even have inflationary sap situation, “shortages of resources possible. Demand/pull inflation predominant * high levels of consumer/business confidence * Possible high demand for imports. Exports may be in less demand (through local inflation). External balance goal may worsen 2. Downturn * Unemployment levels start to rise. Overtime cut é * Stocks begin to accumulate, Production falls, GDP growth slows, Recessionary gap appears. + Demand/pull inflationary pressures lessen * Import demand slows * Confidence levels retreat 3: Trough (maybe a recession if a least 2 consecutive quarters ‘of negative economic growth) * Inflation levels low. Possibility of deflation (falling prices), as in Japan over the last decade. * Gnemployment high but may level out if discouraged job seekers leave the workforce (abour force Participation falls) * Confidence weak. Low levels of spending, low levels of output Recessionary gap widens. * Bankruptcies (personal and business) may increase * Import demand weak. Extemal balance may improve if strong overseas demand for our exports84 KEY AREA3 4. Upturn * Accumulated stocks begin to run down, Retail sales rise. Economic growth grows. Recessionary gap narrows. * Production begins to increase. New workers may be engaged. * Unemployment may initially increase as previously discouraged workers rejoin the labour force. + Confidence begins to rise. Firms may start to invest. * Inflation not necessarily a problem initially if significant levels of unemployed resources available for utilisation Indicators Purpose: to enable economists to measure what has taken place in the economy, to map the current situation, and to predict likely economic activity in the short-term future. Forecasts enable appropriate action to be taken to assist the attainment of desired economic objectives. Indicators help assess the success of past policy actions in meeting the macroeconomic objectives Types of indicators: + Key indicators i Leading: undergo fluctuations in advance of the business cycle. Useful in forecasting the likely course of the economy in the near future, eg. dwelling approvals, consumer/business sentiment fi Coincident: correspond with movements in the business cycle. Assist in plotting the business cycle eg. real GDP, retail sales, motor vehicle registrations {ii Lagging: follow after movement in the business cycle, Confirm the path ofthe eycle eg, consumer price index, unemployment * Composite indicators, These combine a wide range of indicators into the one line on a graph. Eg. ANZ. Bank Index of Economic Activity which combines: * Total new vehicle registrations + Job vacancies *+ ANZ Bank index of factory production + Retail sales These reduce difficulties associated with use of key (individual) indicators, which may give false Signals. For instance a falling unemployment rate may suggest an increase in economic activity. It may, however, have been caused by a fal in the participation rate as discouraged job seekers gave up the search What to look for in interpreting indicators i Time series This is a series of observations of economic variables over a period of time. Indicators are represented graphically with the horizontal axis showing time, ii Trends This is a general movement of a time series. You can see from the following graph that although ‘here is short-term volatility, there has been a downward trend in unemployment in Australia since the year 2002,MACROECONOMICS eee Unemployment 85 60 55 50 45, juno2’ " yunoa” unos” Tautas” unoe” "nor Source: Parliamentary Library. hip lwomeaph goeulibrary iii, Seasonal adjustments ‘Some variations in the level of economic activity can be directly related to seasonal factors connected with climatic, geographic, cultural or social influences, For instance, we would expect retail sales to show a marked increase in December because of the effect of Christmas on consumer spending habits. You can see from the graph below that with the smoothing of significant short term variations we can arrive at a more realistic trend, The expected seasonal effect is averaged out over the period. = Labour Force Participation Rate 65 64 riginal ‘Seasonally adjusted 2 Jung Jun00___Juno1__Juno2 Jun03 Jun04. Source: Labour Force, ABS (6202.0) «ph gov.librarylpubs iv Erratic factors Fluctuations in the business cycle can occur because of irregular, unpredictable events, eg, drought, terrorism attacks. The circular flow model The two-sector model This comprises households and firms, We assume that households sell productive resources to firms (and, labour, capital, enterprise) and in return receive money incomes (eg. wages, salaries, rent, Profit, interest, dividends). The income is spent on goods and services that flow back from firms to households. 8586 KEY AREA 3 This can be shown diagrammatically. a Salaies, Rant PrOM sree DWGaR | (Producive Resources (lana, Labour Capi ERapASS) ‘Goode and Senioas — Real Flows = Money Flows ‘The ‘money flows’ in the model consist of income which flows from firms to households. This returns to firms as expenditure on consumption goods and services, “Real flows’ are the flow of productive resources from households to firms and the flow of goods and services from firms to households, The full mode! Our tworsector model is not realistic as it assuaes that all income is spent. Money, however, leaks out es savings and moves through the financial sector to return to the circular flow as investment spending by firms. OF course the economy goes beyond households, firms and the financial sector, There is also the Sovernment and the overseas sector to consider: Total leakages from the circular Now comprise savings (S), taxation payments (T) and spending on imports (M). Injections back into the circular flow occur via investment spending (1), government budgetary spending (G) and earnings from exports (X). Thus the full circular flow model appears: Faas House [Soads ane Saniass} {Expensescsi epoca en eer oo ay | j | MACROECONOMICS Factors affecting the components of aggregate demand Consumption Factors affecting consumption include: * Level of income * Expectations of future job prospects ‘+ Expectations of future price movements * Age and sex distribution of the population Distribution of income * Costs and availability of credit * Attitudes to saving and spending Hint: The factors affecting savings are exactly the same as the factors affecting consumption. Investment This comprises additions to stocks and the creation of capital goods such as machinery. Factors influencing investment include: + Likelihood of profits + Business confidence * Technological developments Government Factors influencing government spending include: * Labour costs © Costs and availability of credit * Goverment taxation and spending decisions ‘+ Major government objectives (eg. if price stability overrides full employment, or vice versa) * Policies regarding equity which will affect taxation and transfer payments * Desire to provide collective wants * Desire to stabilise the economy Overseas Sector Factors influencing spending in the overseas sector Demand for our exports depends on such factors as: ‘Our demand for imports depends on such factors as: * Income and economic activity overseas + Our infation rate + Industrial and politcal stability + World commodity prices + The exchange rate * Our level of economic activity and income + Existence of protection, eg. tariffs * Inflation rate in Aust. compared with our trading partners + The exchange rate + Ability to fulfil our own wants88 KEY AREA3 The role of financial institutions ‘They act as intermediaries between borrowers and lenders. Their role as an intermediary can be seen in terms of our circular flow model, with savings leaking from the household sector and being injected back into the system as investment via the financial sector. HOUSEHOLDS FIRMS, { t Savings Financial Investment (Leakage) Sector (Injection) + Financial intermediaries match lenders with (those with ‘surplus units’) with borrowers (those with deficit units). + They also spread the risk, Due to the fact that they lend to a large number of borrowers, they minimise the risks associated with a certain borrower failing to repay their loan. + They mobilise savings, thus enabling investment to take place. This in turn leads to an increase in aggregate demand and an increase in economic activity. ‘+ Most financial institutions exist to make a profit for their shareholders. Some other financial institutions though, are not so profit-driven. Credit Unions, for example, exist mainly to service their members’ requirements and return profits to members in the form of lower costs ‘+ Many financial institutions specialise in particular areas (eg. superannuation funds), thus becoming more efficient and theoretically being able to offer lower costs to their clients. The effect of leakages and injections on the circular flow model The economy is in equilibrium when total leakages = total injections. ‘The economy will expand when injections exceed leakages. It will contract when leakages exceed injections. The concept of the expenditure multiplier i Anautonomous (independent of income) change in any of the components of aggregate demand CLG, or (X-M), will result in a larger change in national income. This occurs because of induced changes in total spending Example: Let us assume that, in anticipation of greater profits, the Kramer Crematorium spends $1 million buying the adjacent property. The expenditure process in this case is triggered by an autonomous increase in investment. This initial spending is autonomous (independent) of income. The sellers of the property, Seinfield & Sons, receive the $1 million. Any spending they do is induced spending, that is, it is brought about by the extra income they have received because of the property sale. Perhaps they intend to save 20%, thus $200,000 will leak out of the circular flow, the remaining $800,000 being spent on consumption goods/services in Elaine’s Emporium and providing her with extra income. She might save part of this extra income too (let's keep it at 20%), and therefore spends $640,000 ($800,000 $160,000), at George's Jalopies. You can see what is happening: George saves 20% (for example), spends 80% of his extra income ($512,000) and so the process continues until the total of leakages (in this case all that is saved) equals the amount of the initial autonomous change in spending.es Te | i MACROECONOMICS ‘The end result s an increase in total income that is greater than the initial investment. The initial spending is autonomous, but the secondary changes in spending are all induced by a change in income. We could expand this model to include the government and overseas sector. ‘As you can see if you refer back to the circular flow model, leakages involve savings (from households), taxation payments (to the government) and import spending (through the overseas sector) The principle is still the same whether referring to a two sector or full circular flow model: an initial change in spending leads to a greater change in national income. Let us assume that an initial autonomous change in investment of $200 occurs. ar the intial increase in autonomous investment as the leakage to savings, let us say 20% aT leakage to taxes, let us say 10% AM leakage through import expenditure, let us say 10% ac the induced change in income expenditure, 60% (100% of the income received minus the 40% in leakages) AS - S40 AT - $20 Leakages aM- $20 oe AS = $24 al 7 aT - $12 00 ——» aM- $12 ac -$120 ay $120 ~ ac - $72 > ay ew sn Initial autonomous initial change in induced change in induced change change in investment income consumption in consumption creates AY creates AY ji You cin see from this example that ater 3 rounds income has increased by $200 (round 1), another $120 (round 2), and $72 (round 3). fii The process comes to an end when the total leakages equal the initial change in spending (in this case, $200) 8990 KEY AREA3 iv. The greater the leakages, the smaller will be the multiplier effect as the fraction of extra income actually consumed will be smaller. ¥ The multiplier process works in reverse also. An autonomous fall in spending will result in a greater fall in income, Use of the aggregate demand and aggregate supply model to determine output and price level Note: In class you might be showing SAS sas SAS. oras: oras: Price Levels Price Levels Price Levels. Real GDP. Real GDP. Real GOP. Don't be worried by these variations. The explanation is relatively simple. Consider this: 4 sas Price Levels t + + aay Ta aay 7 ape ST fe Hoge Real GDP. In the recessionary range an economy would be operating at low levels of economic activity, far from its full potential, Unemployment would be high; resources would be wasted. There would be low levels of aggregate demand. An economy could be in the trough phase of the business cycle. There would be a significant recessionary gap (see page 95). The SAS curve at this stage is highly elastic because of the excess capacity operating in the economy. LAs sas Price Levels ‘AD Real GDP.MACROECONOMICS __ 91 ‘An increase in AD could cause the economy to move into the intermediate range. Stocks may start to rin down and inflationary pressures could appear, as can be seen in the graph below: Las, ‘SAS. Price Levels “AD? | AD?| Yor Ye! vr Real GDP, Real GDP would increase. The economy moves closer to the full employment position. This situation ‘would be seen in the upturn phase of the business cycle. The inflationary range occurs as the economy approaches full employment, and could appear thus: Price Levels z zy ‘There are high levels of aggregate demand and economic activity. There may be high demand for imports, impacting negatively on external balance. ‘Theeconomy could evenbe operating with aninflationary gap (p.95). Short- run aggregate supply is highly inelastic, thus unresponsive to increases in AD because the economy is temporarily above full employment. This ‘would coincide with the boom phase of the business cycle. Yer er varver Ww ‘The inelastic component of SAS co-incides with a position on the production possibility curve as resource ‘use is being maximised. This can be seen below, in a simplified manner: Production Possibilty Cure A Price Level92 KEY AREA 3 If you are showing SAS as; Price Levels Real GDP. Xess merely a more distinet version of the curved recesionary intermediate and inflationary ranges referred to on page 90 Price Levels Real GDP ‘Those using astraight line shown above) for SAS are actually omiting the recessionary and inflationary ranges and showing only the intermediate range, which after all, is where most economies function fog ‘much of the time. At university you are likely to encounter this version of the SAS curve, bt in the Yorn 22 exam you will encounter the curve (shown below) in multiple choice questions. Either ofthe thes versions is acceptable in your essay answers. SAS. Price Levels. Real GDP The macroeconomic model shows the relationship between price Ievels (on the vertical axis) and real GDP on the other. ii Changes in aggregate demand Aggregate demand comprises the total planned spending decisions ofall sectors of the economy, ie, households who consume (C); fms who invest (D; government spending (G); and the overseas sector of exports minus imports (X - M).MACROECONOMICS 93 What can cause a change in aggregate demand? ‘There are many factors, including consumer/business confidence, ‘budgetary action and overseas demand for our exports. For more the components of aggregate demand, p.87’ interest rate movements, government details look back to ‘Factors affecting If the economy is functioning at ess than the full employment level of income, interest rate cuts may trigger an increase in aggregate demand, causing: Increase In demand Explanation Impact on macroeconomic goals Effect on macromodel Last Price level Worsens price stability (inflation T ) |S*S" | income/Production Economic growth improves Boe Employment 7 Full employment improves Shep i oS ‘ap? | Imports may 7 (particularly | External balance may worsen (but | feppreaching YO. wth t | tere are other infuences on ex Satz |local infation, imports may be | bal. beside local inftation) Real GDP YF cheaper You can see the conflicting goals See if you can work through what happens with a decrease in demand in the questions at the end of this section, A summary of policies the government could imp demand can be found in the section following, on E iii Changes in short run aggregate supply (SAS) Changes in short run supply occur as a result of changes lement to either increase or decrease aggregate ‘conomic Policies in costs. Changes in any of the factors of Production (land, labour, capital, enterprise) influence short run supply. Changes in wages, the cost of raw materials and government taxes are common costs firms incur. A short term shift does not affect the LAS curve. It does not alter the natural rate of unemployment Position (Y4). Neither do costs change physical capacity. An increase in short run supply, eg. caused by sustained significant falls in world oil prices will appear: Explanation Impact on macroeconomic goals Shortrun inerease Ih supply Impact on macro-mode! LAS sas i JSAS? 5 Pet Soe & a | So Tevevi Real GOP Income/Production Employment 7 Imports 1 (lower local inflation may increase competitiveness of local goods. Exports may 1) Price level J (infiation slows) Price stability improves Economic growth improves Full employment improves, with movement towards YF Extemal balance may improve All goals improve (You can work out what happens with a decrease in short-run supply in the questions at the end of this section),94 KEY AREA3 You can see that this would be a highly desirable situation for the PPC government. the short term, None of the macroeconomic goals conflict. Nevertheless, economic growth and the full employment objectives can only improve until the economy reaches YF (see previous graph). ‘Wouldn't it be better still for the economy's entire potential to increase? You can see that the full capacity position does not alter if costs fall (i.e. the inelastic component of the SAS curve remains the same). ‘To move the entire Aggregate Supply curve in the long run involves a shift in the production potential of the entire economy, as the adjacent diagram suggests. ast) | sas? iv Changes in long run aggregate supply (LAS) Why is the LAS curve vertical? Itis the country’s labour supply (resources) and capital and technology which determine the quantity of goods and services provided and which create its natural rate of unemployment (Yf). Therefore the LAS curve operates independently of what is happening to price levels, hence the ine is vertical. Itis changes in potential which shift the LAS curve and create a new higher or lower natural rate of unemployment. The current microeconomics reform at work in Australia is geared towards increasing our productive capacity. Technology is often involved, Such measures as deregulation ofthe financial sector, labour market reform (including enterprise bargaining), the lessening of protection and waterfront reforms are geared to improving productivity and ultimately, our international competitiveness, If the LAS curve moves, so will the SAS curve. If we use the example of microeconomics reform, this is because increased efficiency means lower costs per unit, and you know that costs shift the SAS curve, So as well as potential changing because of microeconomics reform (moving the LAS curve), so too will the SAS curve move to the right, creating a new full capacity level of real GDP, ‘Microeconomics reform, leading to a Jong run increase in supply will appear as shown below: Long run increase in supply Explanation Impact on macroecon Impact on macro model goals Price level J (inflation slows) | Price stability improves: IncomerProduction + Economic growth improves Employment Full employment improves (towards Possibly imports | and exports‘ Y*) (with faling domestic ination) | Exteral balance may improve ae * Anew lower natural rate of ule Real GOPMACROECONOMICS _95. v Equilibrium and the AD/SAS/LAS model Remember that macroeconomic equilibrium occurs where AD and SAS intersect. The economy is always moving towards equilibrium. This may not coincide with an improvement in the macro- economic objectives, hence the need for government intervention (discussed in the next section, Economic Policy). Hint: Always use arrows on your graph to show the movements in price levels and real GDP resulting from changes in AD or AS. The arrows show the movement from the original equilibrium position (Ye!) to the new one (Ye?) vi The recessionary gap There is usually some degree of recessionary gap operating in the economy. This does not mean that the economy is necessarily in recession. Some prefer the term “deflationary gap’ ‘The recessionary gap shows the amount by which equilibrium real GDP falls short of the full ‘employment level of real GDP. As one of the government's goals is full employment, it gives guidance to policy makers (who would need also to factor in the value of the expenditure multiplier when considering the effect of possible policy actions on real GDP and full employment). ‘The recessionary gap appears: Price Levels: vii The inflationary gap ‘The economy may be temporarily above its long-run level. Policy actions possible to eliminate this ‘gap are discussed in the next section. It shows the amount by which real GDP must be reduced so that income equilibrium and the natural rate of unemployment (¥f) will coincide. The nation gp app ee § | Shean ; aa 1 Real GDP.