ECO 120- Macroeconomics

1
ECO 120- Macroeconomics

• Weekend School 2
• 3th June 2006
• Lecturer Rod Duncan
• Previous version of notes PK Basu

2
Topics for discussion

• Module 3- fiscal and monetary policy
• The tools the Australian government controls to
  smooth short-run fluctuations in the economy
• Module 4- inflation, unemployment and external
  trade
• The causes and effects of inflation, the link
  between inflation and unemployment, Australian
  trade with the rest of the world
• What will not be discussed
• Answers to Assignment 2 (use the CSU forum for
  this)

3
Fiscal policy

• Source Chapter 9 of the book plus first part of
  Module 3.
• Fiscal policy is the government operation of
  government spending (G) and taxes (T).
• Typically we consider the problem of how the
  government can manipulate G and T so as to
  control economic variables such as output,
  inflation, interest rates, etc.
• Issues how fiscal policy can stabilize the
  economy? what about government borrowing and
  public debt?

4
Definitions

• Budget deficit the budget deficit is the extent
  of overspending by the government
• Budget deficit G T
• Expansionary fiscal policy increasing the
  budget deficit (G? or T?) usually in a recession.
• Contractionary fiscal policy decreasing the
  budget deficit (G? or T ?) usually in an economic
  boom.

5
Budget deficits and surpluses

• If the government spends more than it brings in
  in taxes, what happens? (G gt T)
• The money has to come from somewhere. For
  developed countries, this means borrowing
  (issuing government debt or public debt) from
  domestic residents or foreigners.
• If the government is spending less than it brings
  in in taxes, the government can reduce public
  debt. The Australian government has followed
  this policy in the last 10 years.

6
Types of fiscal policy

• We differentiate two types of fiscal policy
• Discretionary fiscal policy This is fiscal
  policy that comes about from planned changes in G
  and T that the government brings in in response
  to the economic situation.
• Non-discretionary fiscal policy This is fiscal
  policy that comes about from the design of
  spending and taxes. There is no government
  official actively determining these changes.

7
Non-discretionary fiscal policy

• Certain parts of our spending and taxes
  automatically increase demand in a recession
  (when AD lt potential GDP) and decrease demand in
  a boom (when AD gt potential GDP).
• Welfare spending and unemployment benefits are
  part of G and increase in a recession and
  decrease in a boom.
• Income and company taxes are part of T and depend
  on GDP, they increase during a boom and decrease
  during a recession.
• These act as automatic stabilizers on the
  economy, reducing the variability of the economy.

8
Cyclically-adjusted budget deficits

• The automatic stabilizers raise the budget
  deficit in a recession and lower the budget
  deficit in a boom.
• This fact means that we can not just look at the
  budget deficit to determine whether the
  government is overspending, we also have to
  take into account where we are in the business
  cycle.
• Adjusting the budget deficit for the point we are
  in the business cycle is called cyclically
  adjusting. We would expect even a sensible
  government to be in a deficit in a recession.

9
Discretionary fiscal policy

• Discretionary fiscal policy is the manipulation
  of G and T by government officials typically to
  reduce the severity of shocks to the economy.
• It sounds like a good idea, but how does it work
  in reality?
• There are many problems and limitations to the
  use of fiscal policy to reduce recessions and
  booms.

10
Problems with discretion

• Scenario Imagine a train driver that has only
  one control- an accelerator/brake that he or she
  can push or pull on to control the train. This
  is exactly the same situation as the government
  faces with fiscal policy.
• Now what limitations can the train driver face?

11
Problems with discretion

• Limitations
• Correctness of data Is the train driver seeing
  the tracks correctly? Or Does the government get
  the right data about where the economy is?
• Timing of data Is the train driver seeing the
  tracks with enough time to react? Or Does the
  government get the statistics quickly enough to
  do anything?
• Decision lags Can the train driver make a
  decision about the correct action before the
  train reaches the problem spot? Or does the
  government have time to design the correct fiscal
  policy?

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Problems with discretion

• Administration lags If the driver pulls on the
  control, how long will it take for the brakes to
  start to work? Or New spending and taxes have to
  be passed through parliament, which takes time,
  even after a decision is made.
• Operational lags If the brakes start to work,
  how long before the train slows down? Or New
  government spending and taxes take time to affect
  the economy.
• So even the best-designed fiscal policies can go
  wrong if they are in response to the wrong data
  or if they take too long to affect the economy.

13
Political considerations

• There are further concerns we might have about
  the operation of fiscal policy.
• Politicians have to remain popular. No one likes
  taxes, and everyone likes new spending on
  themselves. Will a politician make an unpopular
  decision that may result in them losing the
  election if it is the best decision for the
  economy.
• Electoral cycles Governments have to be
  re-elected every 3-4 years. So a politician
  would love to engineer a boom right before his or
  her election.

14
Crowding out

• Another problem with fiscal policy is that an
  increase in G may increase output but at the
  expense of other components of aggregate
  expenditure.
• Y C I G NX
• Since the economy returns to potential GDP over
  the long-run, an increase in G must come at the
  expense of either C, I or NX or all 3.
• If an increase in G reduces investment spending
  over the long-run, this could lead to lower
  future growth in the economy.

15
Crowding out

• How can this happen?
• An increase in G shifts the AD curve to the
  right.
• This results in higher Y and higher P.
• The increased government borrowing in the market
  for savings raises the interest rate.
• Higher interest rates lead to lower investment
  spending so I drops, shifting AD left.
• Higher interest rates leads to an appreciation of
  the A (as foreign investors put their money in
  Australia), so NX drops, shifting AD left.

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Crowding out- I and NX
AS
ASLS
AD1
P3
P2
P1
AD3
AD2
Qp
Q1
Q2
17
Government debt

• One problem that economic commentators always
  point to is the level of government debt- Our
  debt is too high.
• How do we evaluate the level of government debt?
  How do we know is it is too high.
• Government debt is like any other form of debt.
  You evaluate the debt relative to the
  income/wealth of the person incurring the debt.
• A 500,000 debt might be high to you and me, but
  it might mean nothing to Kerry Packer.

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Government debt

• So we need to evaluate government debt relative
  to government income. But what is the
  appropriate form of government income, as the
  government doesnt earn or produce anything.
• Generally we use the income of the country as the
  comparison, since the government is free to tax
  or claim any part of GDP.

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Government debt

• So our criterion for too much is debt (B, since
  typically government debt is issued in government
  bonds) over GDP (Y)
• B / Y
• Banks would make much the same calculation when
  considering whether to issue someone a home loan.
• In general debt is growing at the rate of
  interest each year, r, while GDP is growing at
  the growth rate of the economy, g.

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21
Monetary policy

• Source Chapter 12 of the book plus second part
  of Module 3.
• Monetary policy is the government operation of
  the money supply and interest rates.
• Typically we consider the problem of how the
  government can manipulate monetary policy so as
  to control economic variables such as output,
  inflation, interest rates, etc.
• Issues how monetary policy can stabilize the
  economy? how will monetary policy affect interest
  rates or exchange rates?

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Who operates monetary policy?

• The Reserve Bank of Australia (RBA) is
  responsible for monetary policy.
• The RBA was given 3 goals when it was created
• Maintain low inflation
• Maintain low unemployment
• Maintain value of the A
• The RBA was only given one policy tool- the money
  supply to achieve 3 goals. In the mid 1990s, the
  RBA was simply told to have one aim
• Maintain low inflation.

23
Definitions

• The RBA implements monetary policy through its
  control of the cash rate.
• Cash rate The cash rate is the rate the RBA
  charges bank for loans within the RBA reserves
  system. The cash rate is the base interest rate
  for the economy, and all other interest rates are
  derived from it.
• Easy monetary policy When the RBA lowers the
  cash rate to stimulate AD.
• Tight monetary policy When the RBA raises the
  cash rate to cut off AD.

24
Interest rates

• As we saw in the Investment section, the
  profitability of investment projects depends on
  the nominal interest rate.
• The lower are interest rates, the more projects
  will be profitable, so the higher will be
  investment spending.
• Since the RBA controls the cash rate, and since
  all interest rates depend on the cash rate, the
  RBA controls I, and so can shift the AD curve.

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How monetary policy works

• CauseEffect Chain of Monetary Policy
• Money supply impacts interest rates
• Interest rates affect investment
• Investment is a component of AD
• Equilibrium GDP is changed

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SF1
SF2
Investment demand
10 8 6 0
10 8 6 0
D1
Amount of investment, i
AD1
ASLR
AS
Easy Monetary Policy
Price level
P1
AD3
AD2
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SF2
SF1
Investment demand
10 8 6 0
10 8 6 0
D1
Amount of investment, i
ASLR
AS
Tight Monetary Policy
Price level
P1
AD1
AD2
Real domestic output, GDP
28
Monetary policy and the open economy

• Net Export Effect
• Changes in interest rate affect the value of the
  exchange rate under floating exchange rate.An
  increase in interest rate appreciates the
  currency, resulting in lower net exports
• A decrease in interest rate leads to currency
  depreciation and a rise in net exports
• So an easy monetary policy is enhanced by the net
  export effect.

29
Quantity theory of money

• There is a nice, simple model of money which
  explains many features of money supply and
  demand. This model is called the quantity theory
  of money.
• If we imagine that money is needed for all of the
  purchases made each year, then demand for money
  is the vale of purchases PY.
• The supply of money for purchases is the amount
  of cash in the economy.
• But each piece of money in the economy can be
  used multiple times during a year in
  transactions. We call the number of transactions
  the velocity of money v.

30
Quantity theory of money

• So the total supply of money for transactions in
  a year is v times M vM.
• So demand equals supply requires that
• PY vM
• So if Y goes up, but nothing else does, then
  average level of prices must fall.
• The QTM is good to use for thinking about money
  and inflation.

31
Unemployment

• A person becomes unemployed
• Job loser
• Job leaver
• New entrant or re-entrant into the labour force
• He or she is no longer unemployed
• Hired or recalled
• Withdraws from the labour force

32
Population
Working age population
Labour Force Participation Rate
Labour Force
Employed or Unemployed
Unemployment Rate
33
Labour force participation rate
Proportion of countrys population that takes
part in its economic activities directly (either
actually taking part or willing to)
/
Labour Force
Working Age Population
X
100
LFPR In Australia, in September 2003 ( 10.237
million / 15.955 million ) x 100 64.2
34
Unemployment rate
Proportion of countrys labour force that is
unemployed.
/
(
)
Number Unemployed
Labour Force
X
100
UR in Australia, in September 2003 (0.591
million / 10.237 million) x 100 5.8
35
Types of unemployment

• Three main types of unemployment
• Cyclical unemployment
• Frictional unemployment
• Structural unemployment

36
Cyclical unemployment

• Associated with the ups and downs of the business
  cycle
• Takes place due to insufficient aggregate demand
  or total spending- reflects shifts in AD curve.
• High during recessions and low during booms.
• Fiscal and monetary policies can reduce cyclical
  unemployment - policies are relevant.

37
Frictional unemployment

• Associated with the period of time in which
  people are searching for jobs, being interviewed
  and waiting to commence duties.
• It is inevitable and always exist
• Fiscal and monetary policies can not reduce
  frictional unemployment macroeconomic policies
  are irrelevant.
• Policies that make it easier to find new jobs
  will affect frictional unemployment.

38
Structural unemployment

• Associated with wider structural or technological
  changes in the economy that may make some jobs
  redundant.
• It is inevitable and always exist
• Lasts longer than frictional unemployment
• Fiscal and monetary policies can not reduce
  structural unemployment macroeconomic policies
  are irrelevant.
• Policies that encourage workers to retrain skills
  or to move to a new area with more jobs will
  decrease structural unemployment.

39
Full employment

• Full employment means when all productive
  resources in the economy are in full use -
  implies no cyclical unemployment - still
  frictional and structural unemployment exist -
  they can be low - but can never be zero.
• The full-employment rate of unemployment is
  called the natural rate of unemployment.
• Domestic output consistent with the natural rate
  of unemployment is potential output or full
  employment level of GDP.

40
Classical employment theory

• Economy always operates under full employment -
  it is automatic and self sustaining - if there is
  any unemployment that is only temporary.
• Price-wage flexibility
• the assumption that all prices, including wages
  and interest rates, are flexible and will,
  rapidly adjust to remove disequilibria
• Classical theory and laissez faire
• the price system ensured that price-wage
  flexibility and fluctuations in the interest rate
  was capable of maintaining full employment

41
Classical theory
P1
Price Level
P2
AD1
AD2
Q1
Real Domestic Output
42
Keynesian employment theory

• Full employment is not automatic - unemployment
  exists for longer periods - the Great Depression
  of the 1930s - sticky wages and prices.
• Horizontal aggregate supply curve during
  recession - recessionary or Keynesian range.
• Change in AD impacts on unemployment - not on
  price level.
• Once the full employment level is reached -
  vertical AS curve - change in AD affects price
  level only.
• Unstable aggregate demand - especially
  investment, so that demand management and
  stabilisation policies by the government are
  essential.

43
Keynesian theory
AS
P1
Price Level
AD1
AD2
Q2
Q1
Real Domestic Output
44
Measuring inflation

• We measure the general price level through a
  price index such as the Consumer Price Index
  (CPI)
• Inflation is a continuous rise in the general
  price level. We measure inflation

45
Inflation in Australia, 1970-2004
46
Two types of inflation

• We can differentiate two different sources of
  inflation in an economy
• Demand-Pull Inflation
• Occurs when an increase in AD pulls up the price
  level.
• Cost-Push Inflation
• Occurs when an increase in the cost of production
  at each price level shifts the AS curve leftward
  resulting in increased prices.

47
Demand-pull inflation

• Short-run There is an increase in demand, such
  as an increase in consumer spending, so AD shifts
  rightward. AS does not change in the short run,
  and we have a movement along the AS curve. Price
  level and GDP increases..
• Long run Workers will realise their real wages
  have fallen and will demand and receive increased
  nominal wages. As costs rise, supply decreases
  and the AS to shift to the left. Price level
  increases, and GDP declines.
• May be caused by expansionary fiscal and monetary
  policies - can be countered by contractionary
  policies by the government.

48
Demand-pull inflation- SR and LR
ASLR
Price Level
AS1
A decrease in aggregate supply.... Increases the
price level and output returns to original level
P3
c
P2
b
P1
a
AD2
AD1
Real GDP
o
Q1
Q2
49
Cost-push inflation

• Short-run Increased prices and decreased real
  output (and more unemployment). Causes can be
• Wage push increase in wage rate - power of
  trade unions
• Supply shocks - increase in prices of major raw
  materials - oil etc.
• Profit push increase in profit requirement of
  large monopoly businesses.
• The AS curve shifts to the left/up as prices and
  costs rise, and firms cut back on output.

50
Cost-push inflation

• Long-run There are two scenarios.
• Government intervention ( shift in AD) If
  government intervenes to increase AD, prices and
  output will rise, moving us back to the natural
  rate of output.
• No Government intervention (no shift in AD) If
  government does not intervene to increase AD, a
  severe recession will result. However nominal
  wages will eventually decline and will restore AS
  to its original position, moving us back to the
  natural rate of output.

51
Cost-push inflation- SR and LR
ASLR
AS2
AS1
An attempt to increase AD will only
further increase the price level
P3
c
b
Price Level
P2
P1
a
AD1
Real GDP
o
Q2
Q1
52
Phillips curve

• Suggests an inverse relationship (or a trade-off)
  between inflation and the unemployment rate
• Named after A W Phillips who originally
  discovered the relationship between unemployment
  and nominal wages, using British data in 1950s.
• In general, inflation is associated with economic
  expansion, and unemployment with economic
  recession.
• During expansion the greater the rate of growth
  of AD - inflation is high, and unemployment is
  low.
• During recession the slower the rate of growth
  of AD - inflation is low, and unemployment is
  high.

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Phillips curve
7 6 5 4 3 2 1 0
Annual rate of inflation (percent)
1 2 3 4 5 6 7
Unemployment rate (percent)
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Policy implications of Phillips curve

• Trade-off suggests a rise in inflation should
  lead to a decline in unemployment, and vice
  versa.
• In general, both can not be brought down to the
  minimum level.
• The society must make a choice between low
  inflation and low unemployment.

55
Phillips curve in Australia
1977
1983
1993
1970
2003
56
Stagflation

• Simultaneous experience of high and increasing
  unemployment and inflation - cost-push inflation.
• Caused by
• Aggregate supply shocks such as severe increases
  in fuel costs, and devaluations
• Productivity declines or
• Inflationary expectations and wages -
  expectations about the likely future path and
  rate of increase of the general price level.

57
Stagflation in Australia

• 1973-74 Cost push - caused by international oil
  price rise.
• 1979 cost-push - caused by international oil
  price rise.
• 1981-82 cost push - caused by rapidly rising
  wages.

58
Closed and open economies

• A closed economy is one that does not interact
  with other economies in the world.
• There are no exports, no imports, and no capital
  flows.
• An open economy is one that interacts freely with
  other economies around the world.

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An open economy

• An open economy interacts with other countries in
  two ways.
• It buys and sells goods and services in world
  product markets.
• It buys and sells capital assets in world
  financial markets.
• The Australian economy is a medium-sized open
  economyit imports and exports relatively large
  quantities of goods and services.

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Exports and imports

• Exports are domestically produced goods and
  services that are sold abroad.
• Imports are foreign produced goods and services
  that are sold domestically.
• Net exports (NX) or the trade balance is the
  value of a nations exports minus the value of
  its imports.
• NX X - M

61
Net exports

• A trade surplus is a situation where net exports
  (NX) are positive.
• Exports gt Imports
• A trade deficit is a situation where net exports
  (NX) are negative.
• Imports gt Exports

62
Net Exports (1949-1996)
of GDP
In A
63
Net exports and domestic GDP

• Aggregate Expenditure C I G X - M
• Level of X depends on foreign countries income,
  not domestic income
• Level of M is dependent on domestic income or GDP.

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What affects net exports?

• The tastes of consumers for domestic and foreign
  goods.
• The prices of goods at home and abroad.
• The exchange rates at which people can use
  domestic currency to buy foreign currencies.
• The costs of transporting goods from country to
  country.
• The policies of the government toward
  international trade.

65
Exchange rate

• The exchange rate is the rate at which a person
  can trade the currency of one country for the
  currency of another.
• The nominal exchange rate is expressed in two
  ways.
• In units of foreign currency per one Australian
  dollar
• In units of Australian dollars per one unit of
  the foreign currency

66
Exchange rate

• At an exchange rate between the US dollar and the
  Australian dollar is 0.70 US cents to one
  Australian dollar.
• One Australian dollar trades for 0.70 of US.
  This is the form we will use.
• One US trades for 1.43 (1/0.7) of an Australian
  dollar.

67
Determination of exchange rates

• The market price of something is determined in
  the market.
• Under the Floating Rate system, price of a
  currency (its exchange rate) in the international
  market for currency is determined by its demand
  and supply.
• A is a floating currency - floated in December
  1983.

68
Value of A (1949-1996)
Yen/A
US/A
69
Determination of exchange rates

• Demand for A (people who want to buy A)
• By overseas buyers of Australian goods and
  services (including their tourist visits to
  Australia)
• By overseas investors who want to buy Australian
  physical and financial assets.
• Supply of A (people who want to sell A)
• By Australian importers (including overseas trips
  by Australians)
• By Australian investors who want to buy physical
  and financial assets overseas.

70
Appreciation/Depreciation
If a dollar buys more foreign currency, there is
an appreciation of the dollar -- say, one A
buys one US instead of 70 US cents at
present. If it buys less there is a depreciation
of the dollar -- say, one A buys 50 US cents
instead of 70 US cents at present.
71
Demand for A

• As exchange rate (US per A) increases (say,
  from US 0.70 to US 1), exports become more
  expensive. Overseas buyers will buy less of
  Australian goods and services. Demand for A
  falls.
• (Just opposite when the value of A decreases)
• So, Demand curve for A (or any other currency)
  is downward sloping - as exchange rate increases,
  demand for the currency falls, and vice versa.

72
Supply of A

• As exchange rate increases (say, from US 0.70 to
  US 1), imports become cheaper. Australians will
  buy more of foreign (imported) goods and
  services. Supply of A increases.
• (Just opposite when the value of A decreases)
• So, Supply curve of A (or any other currency) is
  upward sloping - as exchange rate increases,
  supply of the currency increases,
• and vice versa.

73
Determination of exchange rates
Exchange rate (cost of 1 A in terms of US)
Supply of A
Demand for A
Amount of A
74
Balance of payments

• Reflected in international balance of payments
  accounts.
• Records all transactions between the entities in
  Australia and those in foreign nations
• Two basic accounts
• Current Account
• Capital Account

75
Balance of payments

• Current account of a countrys international
  transaction refers to the record of receipts from
  the sale of goods and services to foreigners
  (exports), the payments for goods and services
  bought from foreigners (imports), and also
  property income (such as interest and profits)
  and current transfers (such as gifts) received
  from and paid to foreigner.
• Capital account is a summary of countrys asset
  transactions with the rest of the world.

76
Balance of payments
Current Account Balance (,-) Capital
Account Balance (,-) Demand for A equals
Supply of A. If we have a current account
deficit (we are importing more than we are
exporting), then we must also have a capital
account deficit (investors overseas are
accumulating Australian assets).
77
CAD (Current Account Deficit) and exchange rate

• CAD impacts on
• Inflow of foreign investment - higher the CAD,
  higher the surplus in capital account - higher
  investment in Australia by the foreigners -
  higher the demand for A.
• Outflow of foreign currency - income (interest
  profit) on foreign investment goes out of the
  country- higher the CAD, higher the demand for
  foreign currency - higher the supply of A.
• Exact impact depends on relative strengths of the
  two opposing forces.

78
Current Account Deficits (1949-1996)
of GDP
In A
79
Is the Current Account Deficit a Problem?

• Represents a debt we will have to repay in the
  future.
• Just as for a household, the extent of the
  problem depends on our ability to service the
  debt- but notice that CAD as a percentage of GDP
  (ability to service debt) is still low.

80
Terms of Trade

• The ratio of average price of goods and services
  exported by a country to the average price of its
  imports.
• If prices of imported goods are rising at a
  faster rate than the prices of exported goods,
  then the terms of trade for that economy is
  considered as deteriorating. The economy is
  loosing in the process of foreign trade.

81
Terms of Trade (1949-1995)
82
Purchasing Power Parity (PPP)
The purchasing-power parity theory is the
simplest and most widely accepted theory
explaining the variation of currency exchange
rates. According to the purchasing-power parity
theory, a unit of any given currency should be
able to buy the same quantity of goods in all
countries.
83
Intuition for PPP

• In an open economy, I have the choice of buying
  an orange in Australia or an orange from
  Indonesia and importing the orange back to
  Australia.
• If transport costs are low, the price of traded
  goods should be the SAME, once we translate into
  a common currency.
• This is called the law of one price.

84
Purchasing-Power Parity

• Law of one price
• When converted to a common currency value through
  the exchange rate, the price of identical goods
  should be the same across countries
• Pd E x Po/s,
• Where Pd is the domestic price, Po/s is the
  foreign price and E is the exchange rate.

85
Tips for preparing for the exam

• Practice. Do the problems in the back of the
  book chapters. Do the problems on the books
  website. Do the problems in the study guide.
• Read the question. Read carefully.
• Answer the question. Dont answer the question
  you think was asked. Answer the question that
  actually was asked. Most exam errors happen
  here. Remember to read the question.

86
Tips for preparing for the exam

• Be sure to answer all of the question.
• Dont put down too much. Dont provide a whole
  background of a model unless the question asks
  for it. If the question asks you to analyse a
  scenario, go straight into the scenario.
• Dont put down too little. In an essay question,
  provide your reasoning and analysis. Draw a
  relevant graph and talk about the graph. Dont
  just say Yes.

87
Final exam tip

• Dont panic! Relax and breath. You do not need
  to write for 3 hours to do well in an economics
  exam. Often a well-ordered sentence is worth
  more than 2 pages of semi-coherent babbling.
  Stop and think about your answer.