Solution Manual For Principles of Macroeconomics, 8th Edition by Robin StonecashJoshua GansStephen K

Instructor Manual

Table of contents Part 1 Introduction Chapter 1 Ten principles of economics Chapter 2 Thinking like an economist Chapter 3 Interdependence and the gains from trade Part 2 Supply and demand: How markets work Chapter 4 The market forces of supply and demand Part 3 The data of macroeconomics Chapter 5 Measuring a nation’s income Chapter 6 Measuring the cost of living Part 4 The real economy in the long run Chapter 7 Production and growth Chapter 8 Saving, investment and the financial system Chapter 9 The natural rate of unemployment Part 5 Money and prices in the long run Chapter 10 The monetary system Chapter 11 Inflation: Its causes and costs Part 6 The macroeconomics of open economies Chapter 12 Open-economy macroeconomics: Basic concepts Chapter 13 A macroeconomic theory of the open economy Part 7 Short-run economic fluctuations Chapter 14 Aggregate demand and aggregate supply Chapter 15 The influence of monetary and fiscal policy on aggregate demand Chapter 16 The short-run trade-off between inflation and unemployment Chapter 17 Contemporary macroeconomics topics Part 8 Final thoughts Chapter 18 Five debates over macroeconomic policy

Principles of Macroeconomics – 8th edition

Chapter 1 Ten principles of economics Learning objectives After reading this chapter, students should be able to:  recognise that people face trade-offs when they make decisions, and discuss how the nature of these trade-offs influences their behaviour  explain why trade among people or nations can be good for everyone, and discuss why markets are a good, but not perfect, way to allocate resources  identify the factors that drive some significant trends in the overall economy.

Key points 

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The fundamental lessons about individual decision making are that people face trade-offs among alternative goals, that the cost of any action is measured in terms of forgone opportunities, that rational people make decisions by comparing marginal costs and marginal benefits, and that people change their behaviour in response to the incentives they face.

The fundamental lessons about interactions among people are that trade can be mutually beneficial, that markets are usually a good way of coordinating trade among people and that the government can potentially improve market outcomes if there is some market failure or if the market outcome is inequitable.

The fundamental lessons about the economy as a whole are that productivity is the ultimate source of living standards, that money growth is the ultimate source of inflation and that society faces a shortterm trade-off between inflation and unemployment.

Chapter outline Introduction Begin by pointing out that economics is a subject that students must confront in their everyday lives. Point out that they already spend a great deal of their time thinking about economic issues: prices, buying decisions, use of their time, etc.

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The word ‘economy’ comes from the Greek word meaning ‘one who manages a household’. This makes some sense, since in the economy we are faced with many decisions (just as a household is).

The fundamental economic problem: resources are scarce.

You will want to start the semester by explaining to students that economics is by and large a subject of logic; however, part of learning economics is understanding a new vocabulary. In order to have a productive discourse, economists generally use very precise (and sometimes different) definitions for words that are commonly used outside of the economics discipline. The use of such precise language is common to other disciplines. Therefore, it will be helpful to students if you follow the definitions provided in the text as much as possible.

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Definition: scarcity – the limited nature of society’s resources.

Definition: economics – the study of how society manages its scarce resources.

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Principles of Macroeconomics – 8th edition

Do not underestimate how challenging these principles will be for the student because most first-year university students have limited experience with viewing the world from a cause-and-effect perspective. This is a good time to emphasise that there are known reasons for why many things work the way they do in the real world. Although we cannot predict the behaviour of any one individual, centuries of observation and analysis have uncovered several general rules explaining the decisions and behaviours of large numbers of individuals.

How people make decisions Principle 1: People face trade-offs 

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‘There is no such thing as a free lunch.’ Making decisions requires trading off one goal for another.

Examples include how a student spends their time, how a family decides to spend its income, how the Australian government spends tax dollars and how regulations may protect the environment at a cost to firm owners.

A special example of a trade-off is the trade-off between efficiency and equity.

– Definition: efficiency – the property of society getting the most it can from its scarce resources.

Example: Wasting no resources when making a pie, so the pie becomes as large as possible.

– Definition: equity – the property of distributing economic prosperity fairly among the members of society.

Example: How should the pie be distributed, i.e. who will get a larger slice of the pie and who will get a smaller slice, or will slices be distributed equally?

– While it is useful to strictly distinguish between efficiency and equity for analytical purposes, these two concepts are also linked. For example, tax dollars paid by wealthy Australians and then distributed to those less fortunate may improve equity but also may lower the incentive to work hard and therefore reduce the level of output produced by our resources.

– This implies that the cost of increased equity is a reduction in the efficient use of resources.

Principle 2: The cost of something is what you give up to get it  

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Making decisions requires individuals to consider the benefits and costs of alternative actions.

Example: What are the costs of going to university?

– We cannot count the complete cost of room and board because the student would have to pay for food and shelter even if they were not in school. These are part of the cost of living and not part of the cost of studying.

– We would want to count the value of the student’s time since she could be working for pay instead of attending classes and studying. Also, on a very nice sunny day some students might value the cost of attending classes much higher than on a rainy day.

Definition: opportunity cost – the best alternative that must be given up to obtain some item.

One of the hardest ideas for students to grasp is that ‘free’ things are not truly free. So you will need to provide students with numerous examples of ‘free’ things with hidden costs, especially considering the value of time. The relevant opportunity cost is the next best alternative, which might differ for each individual.

Principle 3: Rational people think at the margin   

Many decisions in life are incremental in nature: Should I remain in school this semester? Should I take another course this semester?

Definition: marginal change – a small incremental adjustment to a plan of action.

Example: You are trying to decide on how many years to stay in school. Comparing the lifestyle of an individual with a PhD to one of an individual who has dropped out of secondary school would be inappropriate, because the choice is not really to drop out versus a PhD. Instead the decision is whether or not to remain in school for an additional year. Thus, you need to compare the additional benefits of another year in school (the marginal benefit) with the additional cost of staying in school for another year (the marginal cost).

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Principles of Macroeconomics – 8th edition

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Another example: Suppose that flying a 200-seat plane from Brisbane to Perth costs the airline $100,000, which means that the average cost of each seat is $500. Suppose that the plane is minutes from departure, there are several vacant seats and a passenger is willing to pay $300 for a seat.

Should the airline sell the seat for $300? As long as the marginal revenue exceeds the marginal cost, selling the ticket is profitable.

Principle 4: People respond to incentives   

Because people make decisions by comparing costs and benefits, their decisions may change in response to changes in costs and benefits.

Sometimes policymakers fail to understand how policies may alter incentives and behaviour.

Example: Seat belt laws increase the use of seat belts, increasing the probability of surviving a crash.

However, before the law people chose not to use seat belts because it was consistent with their individual optimal risk choice. With the seat belt law these people can achieve their old optimal risk by driving more adventurously. This leads to an increase in the number of car accidents. The net effect for society is ambiguous.

How people interact Principle 5: Trade can make everyone better off   

Consider trade that takes place inside your home. Most families are involved in trade with other families on a daily basis. Most families do not build their own homes, make their own clothes, or grow their own food.

Countries benefit from trading with one another like families do.

This occurs because it allows for countries (or families) to specialise in what they do best.

Principle 6: Markets are usually a good way to organise economic activity  

Definition: market economy – an economy that allocates resources through the decentralised decisions of many firms and households as they interact in markets for goods and services.

Market prices reflect both the value of a product to consumers and the cost of the resources used to produce it. Decisions to buy or to produce goods and services are based on the marginal cost and marginal benefit to each individual. All individuals interact via the market and their choices determine the market price. Therefore, the production costs as well as the benefits from consumption are reflected by the market price.

Explain to students that when households and firms do what is best for themselves, they often end up doing what is best for society, as if guided by market forces – or by an ‘invisible hand’. Spend some time and emphasise the magic of the market. Use numerous examples to show students that the market most often allocates resources to their highest valued use.

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Definition: invisible hand – The idea that buyers and sellers freely interacting in a market economy will create an outcome that allocates goods and services to those people who value them most highly and makes the best use of our scarce resources.

When a government interferes in a market and restricts prices from adjusting freely, decisions are not based on the proper information and may be inefficient.

This helps to explain why centrally planned economies have failed (such as the former USSR).

FYI: Adam Smith and the role of markets.

– Adam Smith’s 1776 work suggested that although individuals are motivated by self-interest, an invisible hand guides this self-interest into promoting society’s economic wellbeing.

– Smith’s astute perceptions will be discussed more fully in the chapters to come.

Principle 7: Governments can sometimes improve market outcomes  

Economic reasons for government interventions are the promotion of efficiency and/or equity.

Government policy can improve efficiency when there is market failure.

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Principles of Macroeconomics – 8th edition

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Definition: market failure – a situation in which a market left on its own fails to allocate resources efficiently.

Examples of market failure: – Definition: externality – the uncompensated impact of one person’s actions on the wellbeing of a bystander. A positive externality makes the bystander better off. A negative externality makes the bystander worse off.

– Definition: market power – the ability of a single economic actor (or small group of actors) to have a substantial influence on market prices.

Note that this lesson states that the government can improve market outcomes. This is not saying that the government will always improve market outcomes.

How the economy as a whole works Principle 8: A country’s standard of living depends on its ability to produce goods and services   

Differences in living standards between one country and another can be quite large. Changes in living standards over time are also great. The explanation is productivity.

Definition: productivity – the quantity of goods and services produced from each hour of a worker’s time.

High productivity implies a high standard of living. Thus, policymakers must understand the impact of any policy on our ability to produce goods and services.

– During the last decade, much debate has centred on federal government budget deficits.

– When the government borrows, it lowers the quantity of funds available for other borrowers, including funds that could have been used to finance a student’s education or to build new factories.

– Therefore, budget deficits are generally believed to lower growth in a country’s standard of living.

Principle 9: Prices rise when the government prints too much money   

Definition: inflation – an increase in the overall level of prices in the economy.

When the government creates an excessive amount of money, the value of money falls. A severe example was Germany in the early 1920s. Less extreme examples include the United States and Australia and New Zealand in the 1970s.

A recent extreme example is Zimbabwe. See NY Times link http://www.nytimes.com/2006/05/02/world/africa/02zimbabwe.html?pagewanted=all&_r=0 This gives some insights into the social costs of inflation.

Principle 10: Society faces a short-term trade-off between inflation and unemployment     

There is a short-term trade-off between inflation and unemployment.

This is a controversial topic among economists.

This trade-off exists if some prices are slow to adjust to market changes.

Example: The government reduces the amount of money in the economy to reduce inflation. People respond by spending less on goods with prices stuck too high, lowering the quantity of goods that firms sell. Firms respond to lower sales by laying off workers, increasing the unemployment rate.

This trade-off is only temporary but is often used as an argument for government policy to control inflation or unemployment.

Conclusion: The big ideas underpinning economics 

Students now have a taste of what economics is all about.

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Principles of Macroeconomics – 8th edition

Adjunct teaching tips and warm-up activities 1

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Make sure that students understand that this is just an introduction to these 10 principles. Students should not feel as if they must understand each of these 10 principles completely at this time.

Instead, point out that the students will be seeing these ideas in action throughout the semester and that they will gain additional understanding as the semester progresses.

Give students a list of activities with time requirements. For example: sleep, 8 hours; sleep, 6 hours; eat breakfast, 30 minutes; ride a bike, 1 hour; go hiking, 2 hours; study, 3 hours; study, 2 hours; go to class, 4 hours; go to class, 6 hours; watch TV, 2 hours; watch TV, 6 hours; take a nap, 1 hour; work, 8 hours; work, 4 hours; etc. Make sure that there are many choices and that there are many pleasurable experiences – too much for a 24-hour period. Ask students which lessons from economics this illustrates. If they do not say 1, 2, 3, and 4, help them see that this exercise has tradeoffs in the choices they make, that each choice has an opportunity cost, that deciding whether or not to sleep four more hours may depend on whether you have already slept for six, and that choices may be influenced by the incentives the student faces. For example, a student who is about to be placed on academic probation has an incentive to study harder.

Divide the students into groups of four. Assign each group the definition of economics or one or two of the lessons from economics. Have each group draw the definition or lesson, no words allowed.

Allow time for classroom discussion of the drawings. For example, you may want the other members of the class to try and guess what the drawing shows. Or, you may just want the group to explain their drawing to the class. Make sure that you fill in any conceptual gaps. Encourage students to keep thinking about the pictures throughout the semester as they cover the remaining chapters and allow them to modify or draw new pictures if they choose.

Check your understanding solutions LO1.1 How people make decisions Q. Describe an important trade-off you recently faced. Give an example of some action that has both a monetary and non-monetary opportunity cost. Describe an incentive your parents offered you in an effort to influence your behaviour.

A: This question is likely to get students thinking about the decision to come to university for a degree.

Trade-offs here might include where they study (at a local or distant tertiary provider), the degree they’re doing (especially if there are different fees), or attending at all (as opposed to seeking employment).

Parents could influence this decision by offering to pay for some of the education costs or by supporting these decisions through free (or low-cost) accommodation. Ideally students should realise not all tradeoffs are ones where they spend money, but also their time, and other ‘options’. Be prepared for other trade-offs however.

LO1.2 How people interact Q. Why is a country better off not isolating itself from all other countries? Why do we have markets and, according to economists, what roles should governments play in them?

A: The three lessons concerning economic interactions are: 1 Trade can make everyone better off.

2 Markets are usually a good way to organise economic activity.

3 Governments can sometimes improve market outcomes.

Trade can make everyone better off because it allows countries to specialise in what they do best and to enjoy a wider variety of goods and services. A country is better off not isolating itself from all other countries because it can take advantage of these gains from specialisation and variety.

Markets are usually a good way to organise economic activity because the invisible hand leads markets to desirable outcomes. Externalities and market power are a source of market failure, i.e. the market outcome will be inefficient. Most economists accept that if the market fails the government can sometimes improve the outcome, i.e. improve efficiency by intervening in the market.

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LO1.3 How the economy as a whole works Q. What factors determine a country’s standard of living? How does printing more money affect a country’s economy in the long term and in the short term?

A: A country’s standard of living depends on its ability to produce goods and services, which, in turn, depends on its productivity, which is a function of the education and skills of workers and the access workers have to the necessary tools and technology. Prices rise when the government prints too much money because too much money is chasing too few goods. The rise in the general price level is called inflation. Society faces a short-run trade-off between inflation and unemployment because some prices are ‘sticky’, so that a change in policy can affect spending, causing unemployment to change in the opposite direction of a change in inflation, until prices have fully adjusted to the change.

Case study solutions Choosing when the stork comes 1. The federal government ended baby bonus payments in 2014. What incentives are created by the ending of the payments?

A: The Australian government’s ‘baby bonus’ was introduced on 1 July 2004 – parents of children born on or after that date would receive a payment of $3000. This created an incentive for parents whose baby was due at the end of June 2004 to delay the birth of their child (by scheduling planned caesareans and inducements a little later) so that they would qualify for the payment.

2. How would you expect people to respond to these incentives?

A: Indeed, the births data show that an estimated 1167 births were shifted from June to July that year. Later in 2006 an increase of $834 prompted about 700 births to be shifted from June to July.

Practice questions solutions Apply and revise 1

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Examples of trade-offs include time trade-offs (such as studying one subject over another, or studying at all compared to engaging in social activities) and spending trade-offs (such as whether to use your last 10 dollars on pizza or on a study guide for that tough economics course).

The opportunity cost of a dinner at a fancy restaurant includes the monetary cost of the meal plus the time cost of going to the restaurant and eating there. The time cost depends on what else you might do with that time. For example, if the next best alternative is picking up a pizza and watching a TV show at home, the time cost may be small, e.g., an old sitcom, or large, e.g., a live broadcast of your favourite sport. If the next best alternative is working an extra three hours at your job, the time cost includes the money you could have earned.

The marginal benefit of a glass of water depends on circumstances. If you have just run a marathon, or you’ve been walking in the Outback desert sun for three hours, the marginal benefit is very high.

But if you have been drinking a lot of water recently, the marginal benefit is probably quite low. The point is that even necessities of life, like water, don’t always have large marginal benefits.

Policymakers need to think about incentives in order to understand how people will respond to the policies they put in place. The text example of seat belts shows that policy actions can have quite unintended consequences. If incentives matter a lot, they may lead to a very different type of policy; for example, some economists have suggested putting knives in steering columns so that people will drive much more carefully! While this suggestion is silly, it highlights the importance of incentives.

Trade among countries isn’t a game with some losers and some winners because trade can make everyone better off. Trades only happen if the buyer and seller agree to the transaction; this indicates that they both must believe that they are better off. By allowing specialisation, trade between people and trade between countries can improve everyone’s welfare.

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Principles of Macroeconomics – 8th edition

The ‘invisible hand’ of the marketplace represents the idea that even though individuals and firms are all acting in their own self-interest, prices and the marketplace guide this self-interest into doing what’s good for society as a whole.

7 Efficiency is the property of society getting the most it can from its scarce resources. Equity is the property of distributing economic prosperity fairly among the members of society. Promoting efficiency and promoting equity are the two broad reasons for government to intervene in the economy. Governments can enhance efficiency, for example, by regulating the price that a monopolist charges. Governments can enhance equity, for example, via policies to achieve a more equitable distribution of economic wellbeing.

8 Productivity is important because a country’s standard of living depends on its ability to produce goods and services. The greater a country’s productivity (the amount of goods and services produced from each hour of a worker’s time), the greater will be its standard of living.

9 Inflation is an increase in the overall level of prices in the economy. Inflation is caused by increases in the quantity of a nation’s money relative to the available goods and services.

10 Inflation and unemployment are negatively related in the short term. Reducing inflation entails costs to society in the form of higher unemployment in the short term because it takes time for all prices to adjust fully.

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Multiple choice 1. a

2. c

3. b

4. b

5. d

6. a

Problems and applications 1

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A family deciding whether to buy a new car faces a trade-off between the benefit of the car and other things they might want to buy. For example, buying the car might mean they must give up going on a holiday for the next two years. So the economic cost of the car is the family’s opportunity cost in terms of what they must give up. b For a politician deciding whether to increase spending on national parks, the trade-off is between parks and other spending items or tax cuts. If more money is spent on national parks, that may mean less spending on national defence or on the police force. Or, instead of spending more money on national parks, taxes could be reduced. c When a company director decides whether to open a new factory, the decision is based on whether the new factory will increase the firm’s profits compared to other alternatives. For example, the company could upgrade existing equipment or expand existing factories. The bottom line is ‘Which method of expanding production will increase profits the most?’ d In deciding how much to prepare for a lecture, a professor faces a trade-off between the value of improving the quality of the lecture compared to other things they could do with her time, such as working on additional research. e A recent graduate deciding whether to undertake graduate studies faces the trade-off between getting a job and earning an income compared to broadening their knowledge and skills through further education.

When the benefits of something are psychological, such as going on a holiday, it isn’t easy to directly compare benefits to costs to determine whether it’s worth doing. But there are two ways to think about the benefits. One is to compare the holiday with what you would do in its place. If you didn’t go on the holiday, would you buy something like a new set of golf clubs? Then you can decide whether you’d rather have the new clubs or the holiday. A second way is to think about how much work you had to do to earn the money to pay for the holiday; then you can decide if the psychological benefits of the holiday were worth the psychological cost of working.

If you are thinking of going swimming instead of working at your part-time job, the economic costs are the monetary expense of swimming and time costs, i.e. the opportunity cost of the wages you’re giving up by not working. If the choice is between swimming and going to the library to study, then the cost of swimming is its monetary and time costs, i.e. the cost to you of getting a lower grade in your course.

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Principles of Macroeconomics – 8th edition

4

If you spend $100 now instead of investing it for a year and earning 5 per cent interest, you are giving up the opportunity to spend $105 a year from now. The idea that money has a time value is the basis for the field of finance, a subfield of economics.

5 The fact that you’ve already sunk $5 million isn’t relevant to your decision anymore, since that money is gone. What matters now is the chance to earn profits at the margin. If you spend another $1 million and can generate sales of $3 million, you’ll earn $2 million in marginal profit, so you should do so. You are right to think that the project has lost a total of $3 million ($6 million in costs and only $3 million in revenue) and you shouldn’t have started it. That’s true, but if you don’t spend the additional $1 million, you won’t have any sales and your losses will be $5 million. So what matters for the current decision is not the total profit, but the profit you can earn at the margin. In fact, you’d pay up to $3 million to complete development; any more than that and you won’t be increasing profit at the margin.

6 a When welfare recipients who are able to work have their benefits cut off after two years, they have greater incentive to find jobs than if their benefits were to last forever. b The loss of benefits means that someone who can’t find a job will get no income at all, so the distribution of income will become less equal. But the economy will be more efficient, since welfare recipients have a greater incentive to find jobs. Thus the change in the law is one that increases efficiency but reduces equity.

7 a Efficiency: The market failure comes from the local telephone monopoly. In Australia there is also an equity argument, i.e. users in rural Australia do not have to pay higher fees than users in highly populated areas. b Equity. c Efficiency: An externality arises because second-hand smoke harms non-smokers. d Efficiency: The market failure occurs because a single generator has market power. e Equity. f Efficiency: There’s an externality because of accidents caused by drunk drivers.

8 a If everyone were guaranteed the best health care possible, much more of our nation’s resources would be devoted to medical care than is now the case. Would that be efficient? If you think that currently doctors form a monopoly and restrict health care to keep their incomes high, you might think efficiency would increase by providing more health care. But more likely, if the government mandated increased spending on health care, the economy would be less efficient because it would give people more health care than they would choose to pay for. From the point of view of equity, if poor people are less likely to have adequate health care, providing more health care would represent an improvement. Each person would have a more even slice of the economic pie, though the pie might be smaller and would consist of more health care and less of other goods. b The minimum wage may ensure more income equality, hence more equity in society. However, a higher minimum wage may also reduce the demand for labour, which means less jobs may be available which could also reduce the efficiency in the economy as not all resources are being utilised to meet needs.

9 Since average income in Australia has roughly doubled every 35 years, we are likely to have a better standard of living than our parents did, and a much better standard of living than our grandparents did. This is mainly the result of increased productivity, so that an hour of work produces more goods and services than it used to. Thus incomes have continuously risen over time, as has the standard of living.

10 If Australians save more and it leads to more spending on factories, there will be an increase in production and productivity, since the same number of workers will have more equipment to work with. The benefits from higher productivity will go to both the workers, who will get paid more since they’re producing more, and the factory owners, who will get a return on their investments.

There’s no such thing as a free lunch, though, because when people save more, they’re giving up current consumption. They get higher future incomes at the cost of consuming fewer goods today.

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Principles of Macroeconomics – 8th edition

11 If more money is printed, people will spend more in the economy. This will lead to an increase in output and higher prices. This ‘inflation tax’ is ultimately going to affect consumers who are spending the money as they are faced with a rise in the prices of goods and services.

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Principles of Macroeconomics – 8th edition

Chapter 2 Thinking like an economist Learning objectives After reading this chapter, students should be able to:  explain how economists apply the methods of science and use models, to shed light on the world  differentiate between positive and normative statements, and discuss the role of economists in making policy  explain why economists sometimes disagree with one another.

Key points  

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Economists try to approach their subject with a scientist’s objectivity. Like all scientists, they make appropriate assumptions and build simplified models in order to understand the world around them.

The field of economics is divided into two subfields – microeconomics and macroeconomics.

Microeconomists study decision making by households and firms and the interaction among households and firms in the marketplace. Macroeconomists study the forces and trends that affect the economy as a whole.

A positive statement is an assertion about how the world is. A normative statement is an assertion about how the world ought to be. When economists make normative statements, they are acting more as policymakers than scientists.

Economists who advise policymakers offer conflicting advice either because of differences in scientific judgements or because of differences in values. At other times, economists are united in the advice they offer, but policymakers may choose to ignore it.

Chapter outline Introduction This chapter is an introduction to economic methodology. The aim is to develop an overview of how economists approach the world and of what it means to think like an economist. Emphasise that learning about the approach and language of economics is a vital step before delving into the substance and details of the subject.

The economist as scientist The scientific method: Observation, theory and more observation  

Observations help us to develop theory. Data can be collected and analysed to test and evaluate economic theories.

Unfortunately, experiments are more difficult in economics than in the physical sciences because repeated and controlled experiments often cannot be performed. Economists frequently have to rely on the natural experiments offered by history.

The role of assumptions 

Assumptions are useful because they simplify the problem without substantially affecting the answer. Most assumptions will be somewhat unrealistic but will have small effects on the actual outcome of the answer.

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Principles of Macroeconomics – 8th edition

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Example: to understand international trade, it may be helpful to start out assuming that there are only two countries in the world producing only two goods. Once we understand trade between these two countries, we can extend the analysis to a greater number of countries and goods.

Economic models 

All models simplify reality in order to improve our understanding of it. The clever use of assumptions assists in this.

To illustrate to the class how simple but unrealistic models can be useful, bring a road map to class. Point out how unrealistic it is. For example, it does not show where all of the stop signs, petrol stations, or restaurants are located. It assumes that the earth is flat and two-dimensional. But, despite these simplifications, a map usually helps travellers get from one place to another. Thus, it is a good model for its purpose.

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Most economic models are composed of diagrams and equations.

Our first model: The circular-flow diagram Figure 2.1

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The circular flow

Definition: circular-flow diagram – a visual model of the economy that shows how dollars and goods and services flow through markets among households and firms.

This diagram is a very simple model of the economy. Note that it ignores the roles of government and international trade. It includes: – Two types of decision makers in the model: households and firms.

– Two types of markets: markets for goods and services, and markets for factors of production.

– Firms are sellers in the goods and services markets and buyers in the factors of production markets.

– Households are buyers in the goods and services market and sellers in the factors of production market.

– The inner loop represents the flow of goods and services between households and firms.

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Principles of Macroeconomics – 8th edition

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The outer loop represents the flow of dollars between households and firms.

Spend more time with these first two models than you might think is necessary. Be aware that the maths skills of some of your students will be limited. It is important the students feel confident with their first graphical and mathematical model. Be deliberate with every point. If you lose them with these models, they may be gone for the rest of the course. Highlight that there are always two opposing arrows, which indicate that a trade (exchange) has occurred.

Our second model: The production possibilities frontier  

Definition: production possibilities frontier – a graph that shows the various combinations of output that the economy can possibly produce given the available factors of production and the available production technology.

Example: a country that produces two goods – cars and computers.

– If all resources are used to produce cars, the economy can produce 1000 cars.

– If all resources are used to produce computers, the economy can produce 3000 computers.

– If resources are divided between the two industries, the feasible combinations of output are shown on the curve.

Figure 2.2

The production possibilities frontier

You may want to emphasise that the production data are measured in terms of annual flows. This will help students to realise that a new production possibilities frontier occurs for each year. Thus, the axes show the level of output per year.

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Production is efficient at all points that lie on the curve. This implies that the economy is getting all it can from the scarce resources it has available. Production at a point inside the curve is inefficient.

Production at a point outside of the curve is not possible given the economy’s current level of resources and technology.

The production possibilities frontier reveals Principle 1: People face trade-offs. Suppose the economy is currently producing 600 cars and 2200 computers. To increase production of cars to 700, the production of computers must fall to 2000.

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 

Principle 2 is also shown on the production possibilities frontier: the cost of something is what you give up to get it (opportunity cost). The opportunity cost of increasing the production of cars from 600 to 700 is 200 computers.

The shape of the production possibilities frontier indicates that the opportunity cost of cars in terms of computers increases as the country produces more cars and fewer computers. This occurs because some resources are better suited to the production of cars than computers and vice versa. For example, when the economy is using most of its resources to make computers, the resources best suited to making computers are already in the computer industry and each car the economy gives up yields only a small increase in the number of computers.

Be aware that students often have trouble understanding why opportunity costs rise as the production of a good increases. You may want to use several specific examples of resources that are more suited to producing one good than another e.g. a computer engineer is more suited to producing computers than cars, an engine designer is more suited to producing cars than computers.



The production possibilities frontier can shift if resource availability or technology changes. Refer to text Figure 2.3. Emphasise that the production possibilities curve depends on the availability of resources and the technology level.

You may also want to teach students about budget constraints at this time (call them ‘consumption possibilities frontiers’). This reinforces the idea of opportunity cost and allows them to see how opportunity cost can be measured by the slope. Also, it will introduce students to straight-line production possibilities frontiers, which are used in chapter 3. However, be careful if you choose to do this, as students find the difference between straight-line and concave production possibilities curves challenging.

ALTERNATIVE CLASSROOM EXAMPLE A small country produces two goods: steel (measured in tons) and trucks. Points on a production possibilities frontier can be shown in a table or a graph: A B C D E Trucks 0 10 20 30 40 Steel 70 60 45 25 0 The production possibilities frontier should be drawn from the numbers above.

Students should be asked to calculate the opportunity cost of increasing the number of trucks produced by 10: o between 0 and 10 o between 10 and 20 o between 20 and 30 o between 30 and 40 Points inside the curve, points on the curve, and points outside of the curve can also be discussed.

ALTERNATIVE CLASSROOM EXAMPLE Ivan receives an allowance from his parents of $20 each week. He spends his entire allowance on two goods: cans of soft drink (which cost $2 each) and tickets to the movies (which cost $10 each).

Students should be asked to calculate the opportunity cost of one movie and the opportunity cost of one can of soft drink.

Ivan’s consumption possibilities frontier (budget constraint) can be drawn. It should be noted that the slope is equal to the opportunity cost and is constant because the opportunity cost is constant.

Ask students what would happen to the consumption possibilities frontier if Ivan’s allowance changes or if the price of a can of soft drink or movies changes.

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Microeconomics and macroeconomics  

Definition: microeconomics – the study of how households and firms make decisions and how they interact in markets.

Definition: macroeconomics – the study of economy-wide phenomena, including inflation, unemployment and economic growth.

The economist as policy adviser 

The study of economics is useful in many career paths.

Positive versus normative analysis    

Example of a discussion of minimum-wage laws: Polly says, ‘Minimum-wage laws cause unemployment’. Norma says, ‘The government should raise the minimum wage’.

Definition: positive statements – claims that attempt to describe the world as it is.

Definition: normative statements – claims that attempt to prescribe how the world should be.

Positive statements can be evaluated using evidence, while normative statements involve personal viewpoints and values.

Use several examples to illustrate the differences between positive and normative statements and stimulate classroom discussion. Possible examples include the minimum wage, budget deficits and petrol taxes.

Economists in government   

In Australia, economists provide advice to government while working in the Commonwealth Treasury, the Department of Finance and the Productivity Commission.

Economists also advise and work for various government bodies such as the Australian Bureau of Statistics, the Australian Competition and Consumer Commission and the Reserve Bank of Australia.

Students also like to know that there are private sector options as well. For example, commercial banks, consultancies, fishing or forestry industry.

Why economists disagree Differences in scientific judgements  



Economists sometimes disagree about the validity of alternative theories or about the size of the effects on the economy of behaviour.

Example: some economists feel that changing the tax system to reduce taxes on income and increase taxes on consumption would increase national savings in Australia. However, other economists believe that changing the tax system this way would have little effect on saving behaviour and therefore they do not support the change.

It is also important to explain that these are not dogmatic differences but are settled (sometimes gradually) by empirical evidence. Positions don’t remain irreconcilably entrenched.

Differences in values 

People have different ideas about what is fair and what are appropriate trade-offs between efficiency and equity. Economists give conflicting advice sometimes because they have different values.

What Australian economists think 

While it may seem as if economists do not agree on much, this is in fact not true.

Emphasise that there is more agreement among economists than most people think.

Many of the things economists agree about would not have the same consensus among the general public.

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Conclusion: Let’s get going 

The first two chapters provide an introduction to the ideas and methods of economics. We are now ready to consider in more detail the principles of economic behaviour and economic policy.

Appendix: Graphing – a brief review Many beginning students will have trouble grasping the most basic graphs. It is important for lecturers to make sure that students are comfortable with these techniques.

Graphs of a single variable See text Figure 2A.1   

Pie chart Bar graph Time-series graph.

Graphs of two variables: The coordinate system See text Figure 2A.2       

Ordered pairs of numbers can be graphed on a two-dimensional grid.

The first number in the ordered pair is the x-coordinate.

The second number in the ordered pair is the y-coordinate.

The point with both an x-coordinate and y-coordinate of zero is called the origin.

Scatterplots are plots of scattered points.

Two variables that increase or decrease together have a positive correlation.

Two variables that move in opposite directions (one increases when the other decreases) have a negative correlation.

Curves in the coordinate system See text Table 2A.1 See text Figure 2A.3 

Often economists want to show how one variable affects another, holding everything else constant.

– An example of this is the demand curve. The demand curve shows how the quantity of a good a consumer wants to purchase varies as its price varies, holding everything else (such as income) constant.

– If income does change, this will alter the amount of a good that the consumer wants to purchase at any given price. Thus, the relationship between price and quantity desired has changed and must be represented as a new demand curve.

See text Figure 2A.4 

A simple way to tell if it is necessary to shift the curve is to look at the axes. When a variable that is not named on either axis changes, the curve shifts.

Slope and elasticity See text Figure 2A.5 



We may want to ask how much a consumer’s purchasing habits respond to changes in the price of a product.

– If the demand curve is very steep, quantity desired does not change much in response to a change in price.

– If the demand curve is very flat, quantity desired changes a great deal when the price changes.

The slope of a line is the ratio of the vertical distance covered to the horizontal distance covered as we move along the line (‘rise over run’).

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slope  

y x

The slope of the demand curve tells us something about how a consumer will react to a change in price. A small slope means that the demand curve is relatively flat and a consumer will adjust the quantity purchased substantially in response to a price change. A large slope means that the demand curve is relatively steep and that the quantity purchased will respond only slightly in response to a price change.

Cause and effect  

Economists often make statements suggesting that a change in variable A causes a change in variable B. Ideally, we would like to see how changes in variable A affect variable B, holding all other variables constant. This is not always possible and could lead to a problem caused by omitted variables. Even if we have identified the correct variables there can still be the problem of reverse causality.

Omitted variables See text Figure 2A.6  

If variables A and B both change at the same time, we may conclude that the change in variable A caused the change in variable B. However, if variable C has also changed, then it is entirely possible that variable C is responsible for the change in variable B.

Reverse causality See text Figure 2A.7   

If variable A and variable B both change at the same time, we may believe that the change in variable A led to the change in variable B. However, it is entirely possible that the change in variable B led to the change in variable A. It is not always as simple as determining which variable changed first because individuals often change their behaviour in response to a change in their expectations about the future. This means that variable A may change before variable B but only because people expect a change in variable B.

Adjunct teaching tips and warm-up activities 1

2

3

Make sure that you give students adequate time to catch up with you as you discuss the production possibilities frontier. Ask frequent questions and give students time to think before answering to make sure that they are following you.

When reviewing graphing with the students, it is best to bring students to the board to be ‘recorders’ of what the other students say as you give a series of instructions like ‘Draw a pie chart’ or ask questions like ‘How tall should the bar be if the value is 120 million?’ Do not make the student at the board responsible for the answer. Instead, he or she should be simply recording what the other students say. Students are often uneasy about graphing at first and need to see that they are not alone.

Have students bring in newspaper articles and, in groups, identify each statement in an editorial paragraph as being a positive or normative statement. Discuss the difference between straight news stories and editorials and the analogy with economists as scientists and as policy advisers.

Check your understanding solutions LO2.1 The economist as scientist Q: In what sense is economics like a science? Draw a production possibilities frontier for a society that produces food and clothing. Show an efficient point, an inefficient point and an infeasible point. Show the effects of a drought. Define microeconomics and macroeconomics.

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A: Economics is like a science because economists devise theories, collect data and analyse the data in an attempt to verify or refute their theories. In other words, economics is based on the scientific method.

Figure 2.3

The production possibilities frontier

The drought has the effect of pivoting the PPF inward about the clothing axis-point. Note that some students might reason that clothing output might also shift inward to some degree, because output of raw inputs of natural fibres (like cotton, or wool) might also decrease during a drought.

Microeconomics is the study of how households and firms make decisions and how they interact in markets. Macroeconomics is the study of economy-wide phenomena, including inflation, unemployment and economic growth.

LO2.2 The economist as scientist Q: Give an example of a positive statement and an example of a normative statement.

Name three parts of government that regularly rely on advice from economists.

A: An example of a positive statement is ‘higher taxes discourage work effort’; many other answers are possible. It is a positive statement as it describes the effect of higher taxes, describing the world as it is.

An example of a normative statement is ‘the government should reduce tax rates’. This is a normative statement as it is a claim about how the world should be.

Parts of the government that regularly rely on advice from economists include Commonwealth Treasury, the Department of Finance, the Australian Bureau of Statistics, the Reserve Bank of Australia and the Australian Competition and Consumer Commission

LO2.3 Why economists disagree Q: Give two reasons why two economic advisers to the federal government might disagree about a question of policy A: Economic advisers to the federal government might disagree about a question of policy due to differing scientific judgements, i.e. in their positive theories, or differences in values, i.e. in their normative views.

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Practice questions solutions Apply and revise 1

Economics is like a science because economists use the scientific method. They devise theories, collect data, and then analyse the data in an attempt to verify or refute their theories about how the world works. Economists use theory and observation like other scientists; however, they are limited in their ability to run repeated or controlled experiments. Instead, they must rely on natural experiments.

Include examples of other sciences that also use natural experiments. Ecology and astronomy can yield good case studies of this.

2

3 4 5 6

Economists make assumptions to simplify problems. If the assumptions are chosen well the resulting simplification does not substantially affect the answer. Assumptions can make the world easier to understand.

Economic models should not describe reality exactly because they would be too complex to understand. A model is a simplification that lets the economist see what is truly important.

You may be an employee and will supply labour (sell) in the market for the factors of production.

When you purchase some earphones, you are spending (buy) in the market for goods and services.

When a firm purchases a coffee machine from the USA, this is not covered by the simplified circular flow model.

Figure 2.4 shows a production possibilities frontier between milk and biscuits (PPF1). If a disease kills half of the economy’s cow population, less milk production is possible, so the PPF shifts inward (PPF2). Note that if the economy produces all biscuits, then it doesn’t need any cows, and production is unaffected. But if the economy produces any milk at all, then there will be less production possible after the disease hits.

Figure 2.4

A shift in the production possibilities frontier

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7 Figure 2.5

The production possibilities frontier of computer and car production

The PPF shows the combinations of output of cars and computers that the economy can produce. An outcome is efficient if the economy is getting all it can from the scarce resources it has available.

The economy can produce any combination on or inside the frontier and these points are said to be efficient levels of production. If the economy is at point A for example, it cannot produce more of one good without producing less of the other. This applies to point C as well. Point B is an inefficient outcome as the economy is producing less than it could from the available resources.

Points outside the frontier are not feasible.

8 The two subfields in economics are microeconomics and macroeconomics. Microeconomics is the study of how households and firms make decisions and how they interact in markets.

Macroeconomics is the study of economy-wide phenomena, including inflation, unemployment and economic growth.

9 Positive statements are descriptive and make a claim about how the world is, while normative statements are prescriptive and make a claim about how the world should be. Here’s an example of each. Positive: A rapid growth rate of money is the cause of inflation. Normative: The government should keep the growth rate of money low.

10 Economists sometimes offer conflicting advice to policymakers for two reasons. Economists may disagree about the validity of alternative positive theories about how the world works. Economists may have different values and, therefore, different normative views about what policy should try to accomplish.

Multiple choice 1. c

2. a

3. b

4. c

5. d

6. a

Problems and applications 1

In Figure 2.6, the four transactions are shown.

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Principles of Macroeconomics – 8th edition

Figure 2.6

2

a

Figure 2.7 depicts a ‘production possibilities frontier’ between guns and butter. It is bowed out because when most of the economy’s resources are being used to produce butter, the frontier is steep and when most of the economy’s resources are being used to produce guns, the frontier is very flat. When the economy is producing a lot of guns, workers and machines best suited to making butter are being used to make guns, so each unit of guns given up yields a large increase in the production of butter; thus the production possibilities frontier is flat. When the economy is producing a lot of butter, workers and machines best suited to making guns are being used to make butter, so each unit of guns given up yields a small increase in the production of butter; thus the production possibilities frontier is steep.

Figure 2.7

b c d

Point A is impossible for the economy to achieve; it is outside the production possibilities frontier. Point B is feasible but inefficient because it’s inside the production possibilities frontier.

The Hawks might choose a point like H, with many guns and not much butter. The Doves might choose a point like D, with a lot of butter and few guns.

If both Hawks and Doves reduced their desired quantity of guns by the same amount, the Hawks would get a bigger peace dividend because the production possibilities frontier is much steeper at point H than at point D. As a result, the reduction of a given number of guns, starting at point H, leads to a much larger increase in the quantity of butter produced than when starting at point D.

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3

Figure 2.8 shows a production possibilities frontier between cleanliness of the environment and income. The shape and position of the frontier depend on the cost to maintain a clean environment – the productivity of the environmental industry. Gains in environmental productivity, such as the development of a no-emission auto engine, and greener production technologies, lead to shifts of the production-possibilities frontier, like the shift from PPF1 to PPF2 shown. Note that ‘production’ of a clean environment is actually lower pollution.

Figure 2.8

4

a

b

i

No cars are washed and the workers mow 40 lawns (Larry mows 10 lawns, Moe mows 10 lawns, and Curly mows 20 lawns). (A) ii No lawns are mown and the workers wash 40 cars (Larry washes 10 cars, Moe washes 20 cars, and Curly washes 10 cars). (B) iii The workers mow 20 lawns (Larry mows 5 lawns, Moe mows 5 lawns, and Curly mows 10 lawns) and wash 20 cars (Larry washes 5 cars, Moe washes 10 cars, and Curly washes 5 cars). (C) iv The workers mow 25 lawns (Larry mows 5 lawns and Curly mows 20 lawns) and wash 25 cars (Larry washes 5 cars and Moe washes 20 cars). (D) The production possibilities frontier for this economy is represented by Figure 2.9, with all four points shown.

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Figure 2.9

c

5

6

d a b c d e a

b

c d

e

7

a

The frontier is bowed out because not all of the workers are equally good at mowing lawns and washing cars. Curly is better at mowing lawns, and Moe is better at washing cars. When the economy is mowing a lot of lawns, Moe is needed to mow some lawns, so each lawn that is mown yields a large decrease in the number of cars washed; thus the production possibilities frontier is relatively steep. Similarly, when the economy is washing a lot of cars, Curly is needed to wash some cars, so each car that is washed yields a large decrease in the number of lawns mown; thus the production possibilities frontier is relatively flat.

The allocation (C) is inefficient. It lies inside the production possibilities frontier.

A family’s decision about how much income to save is microeconomics.

The effect of government regulations on car emissions is microeconomics.

The impact of higher saving on economic growth is macroeconomics.

A firm’s decision about how many workers to hire is microeconomics.

The relationship between the inflation rate and changes in the quantity of money is macroeconomics.

The statement that society faces a short-term trade-off between inflation and unemployment is a positive statement. It deals with how the economy is, not how it should be. Since economists have examined data and found that there’s a short-term negative relationship between inflation and unemployment, the statement is a fact, therefore it is a positive statement.

The statement that a reduction in the rate of growth of money will reduce the rate of inflation is a positive statement. Economists have found that money growth and inflation are very closely related. The statement tells how the world is, and so it is a positive statement.

The statement that the Reserve Bank should reduce the rate of growth of money is a normative statement. It states an opinion about something that should be done, not how the world is.

The statement that society ought to require social security recipients to look for jobs is a normative statement. It doesn’t state a fact about how the world is. Instead, it is a statement of how the world should be and is thus a normative statement.

The statement that lower tax rates encourage more work and more saving is a positive statement.

Economists have studied the relationship between tax rates and work, as well as the relationship between tax rates and saving. They have found a negative relationship in both cases. So the statement tells how the world is, and is thus a positive statement.

Economists may disagree about the validity of alternative positive theories of how the world works and this is due to differences in scientific judgements. Although economics sheds light on much about the world, there is still much to be learned. Economists disagree as they have

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b

c

differing views on the validity of alternative theories and we can expect this to reduce as time goes on and we learn more through findings and models of what the world is like.

Economists may disagree about normative views due to different values. We may not expect this to reduce as time goes on based on the face that people will always have differences in values even if more information is learnt and discovered. This will not necessarily change value systems and beliefs.

As time goes on, you might expect economists to disagree less about public policy because they will have opportunities to observe different policies that are put into place. As new policies are tried, their results will become known, and they can be evaluated better. It is likely that the disagreement about them will be reduced after they have been tried in practice. For example, many economists thought that wage indexation would be a good idea for determining wage increases, while others thought it was a bad idea. When wage indexation was tried in the 1980s, the resulting system was not flexible enough to deal with the external shocks of the time. As a result, most economists came to believe that wage increases are better determined with reference to productivity increases and structural change.

Still, it is unlikely that the differences between economists will ever be completely eliminated.

Economists differ on too many aspects of how the world works. Plus, even as some policies get tried out and are either accepted or rejected, creative economists keep coming up with new ideas.

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Chapter 3 Interdependence and the gains from trade Learning objectives After reading this chapter, students should be able to:  explain how everyone can benefit when people trade with one another  use comparative advantage to explain the gains from trade  apply the theory of comparative advantage to everyday life and national policy.

Key points 1

2

3 4

Each person consumes goods and services produced by many other people both in our country and around the world. Interdependence and trade are desirable because they allow everyone to enjoy a greater quantity and variety of goods.

There are two ways to compare the ability of two people in producing a good. The person who can produce the good with a smaller quantity of inputs is said to have an absolute advantage in producing the good. The person who has the smaller opportunity cost of producing the good is said to have a comparative advantage in producing the good. The gains from trade are based on comparative advantage, not absolute advantage.

Trade makes everyone better off because it allows people to specialise in those activities in which they have a comparative advantage.

The principle of comparative advantage applies to countries as well as to people. Economists use the principle of comparative advantage to advocate free trade among countries.

Chapter outline Introduction Begin by explaining that there are two basic ways that people can satisfy their wants. The first is to be economically self-sufficient. The second is to specialise in the production of one thing and then trade with others. With rare exceptions, individuals and nations tend to rely on specialisation and trade. This chapter considers the reasons for economic interdependence. What exactly do people gain when they trade with one another? Why do people choose to become interdependent?

A parable for the modern economy 

An example: Two tasks – cooking and laundry – and two people, Leonard and Sheldon, who both like to eat and to wear clean and ironed clothes.

– The gains from trade are obvious if Leonard only cooks and Sheldon only does laundry.

– The gains from trade are also fairly obvious if Sheldon and Leonard are capable of doing the other task, but only at great effort. Then specialisation and trade can benefit both.

– Gains from trade are less obvious if one person is better than the other at doing both tasks.

Production possibilities 

Leonard and Sheldon each have 12 spare hours a week to work on cooking, laundry or a combination of the two. Text Table 3.1 shows the number of hours each needs to make one meal or do one basket of laundry.

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Make sure that you write out all of the algebra involved in this example. If you leave out steps, students will not know where the numbers came from.



The production possibilities can also be graphed. These production possibilities frontiers are drawn linearly instead of being bowed out. This assumes that Sheldon’s and Leonard’s ‘technology’ for cooking and doing laundry allows them to switch between producing one good and the other at a constant rate.

– As we saw in chapter 2, these production possibilities frontiers represent the principles of tradeoffs and opportunity costs.

It is worthwhile to take the time to explain where the x- and y-intercepts come from.

Point out that Sheldon could cook six meals if all of his time is spent on cooking or he could do three baskets of laundry if all of his time is spent on laundry.



We initially assume that the two divide their time as shown in text Figure 3.1. Sheldon produces and consumes four meals and washes one basket, Leonard produces and consumes 12 meals and washes two baskets.

See text Figure 3.1 You should emphasise that these production possibilities frontiers also represent Leonard’s and Sheldon’s consumption possibilities if there is no trade.

Specialisation and trade 

Suppose Leonard suggests that Sheldon specialises in doing the laundry and then trades with Leonard who will specialise more in cooking.

– Sheldon will spend 12 hours a week doing laundry, getting three baskets done a week.

– Leonard will spend nine hours a week cooking to make 18 meals and spend 3 hours a week doing one basket of laundry.

– Leonard will trade five meals a week for a basket-and-a-half of laundry.

Students will ask where this ‘price’ or rate of exchange comes from. Explain that voluntary trade requires that both parties agree, which they do if they can improve their position. Therefore, the price must be preferable to their own opportunity costs (see Table 3.3). Refer to later lectures for the exact price determination.



The gains from trade:

See text Table 3.2 – – –

Leonard cooks 18 meals and trades five meals leaving him with 13 meals. He also does one basket of laundry and gets 1½ baskets in the trade for a total of 2½ baskets of laundry.

Sheldon does three baskets of laundry and trades 1½, leaving him with 1½ baskets. He also receives five meals in the trade with Leonard.

In both cases, they are able to consume more after the trade than they could before the trade.

Comparative advantage: The driving force of specialisation Absolute advantage  

Definition: absolute advantage – the comparison among producers of a good according to their productivity.

Leonard has an absolute advantage both in laundry and cooking.

Opportunity cost and comparative advantage See text Table 3.3 – –

For Leonard the opportunity cost of doing a basket of laundry is six meals because in the 3 hours it takes to do a basket he could cook six meals.

For Sheldon the opportunity cost of doing a basket of laundry is only two meals because in the 4 hours it takes him to do a basket he could cook two meals.

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–

The opportunity cost of cooking a meal is the inverse of the opportunity cost of doing a basket of laundry.

Your students may have a hard time comprehending this. It is a good idea to go through these calculations several times and write out every step on the board.

Students benefit from seeing the calculations. Emphasising that the comparative advantage states which producer is relatively better at something might ease students’ understanding.



Definition: comparative advantage – the ability to produce a good at a lower opportunity cost than another producer.

– Sheldon has a lower opportunity cost of doing laundry so he has a comparative advantage in doing laundry.

– Leonard has a lower opportunity cost of cooking meals so he has a comparative advantage in cooking meals.

– Because the opportunity cost of producing one good is the inverse of the opportunity cost of producing the other, it is impossible for a person to have a comparative advantage in the production of both goods (unless they both have exactly the same opportunity costs).

Comparative advantage and trade 

When specialisation in a good occurs, assuming there is a comparative advantage, total output will increase.  As long as the opportunity cost of producing the goods differs across the two individuals, both can gain from specialisation and trade. They can always negotiate to find a solution that makes them both better off.

– Sheldon gets five meals in exchange for doing 1½ baskets of laundry, buying each meal for 0.3 of a basket of laundry. This is lower than his opportunity cost of 0.5 baskets of laundry and therefore is beneficial to him.

– Leonard buys a basket of laundry for a price of just over three meals. This price of laundry is lower than his opportunity cost of laundry which is six meals. So he also benefits.

FYI: The legacy of Adam Smith and David Ricardo.

– In Adam Smith’s 1776 book An Inquiry into the Nature and Causes of the Wealth of Nations, he writes of the ability of producers to benefit through specialisation and trade.

– In David Ricardo’s 1817 book Principles of Political Economy and Taxation, Ricardo develops the theory of comparative advantage and argues against restrictions on free trade.

– The benefits of free trade are one issue that is generally agreed upon by economists and the theories and arguments developed by these two men 200 years ago are still used today.

The price of trade 

For both parties to gain from trade, the price at which they trade must lie between their opportunity costs -

Leonard and Sheldon agreed to trade at a rate of 3/10 of a basket of laundry for each meal. This lies between Leonard’s opportunity cost (1/6 of a basket) and Sheldon’s opportunity cost (1/2 of a basket of laundry)

-

The price does not need to be exactly 3/10 but it must be somewhere between 1/6 and ½ for both parties to gain.

Applications of comparative advantage Should Serena Williams mow her own lawn?  

Given Williams’ athleticism, it is entirely possible that she could mow her lawn faster than most people. This implies that she has an absolute advantage.

However, if the opportunity cost of her time is $1 000 000 (her pay to film a sports shoe television commercial), it is likely that someone else will have a comparative advantage in mowing his lawn.

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

Both she and Todd will be better off as long as she pays Todd more than the individual’s opportunity cost ($40) and less than $1 000 000.

Should a country trade with other countries?     

Just as individuals can benefit from specialisation and trade with one another, so can populations of people in different countries.

Definition: imports – goods and services produced abroad and sold domestically.

Definition: exports – goods and services produced domestically and sold abroad.

The principle of comparative advantage suggests that each good or service should be produced by the country with a comparative advantage in producing that good or service, i.e. the country with the smaller opportunity cost.

Through specialisation and trade, countries can have more of all goods to consume.

Discuss how differences in resource endowments can be significant factors in determining opportunity cost and comparative advantage. Such differences include climate, soil composition, education and training of the labour force, capital stock and infrastructure.



In the news: You’re dividing the chores wrong - This is an article which discuses that although one person may be better at doing every chore, this does not mean that person has to do everything - Chores should be divided so efficiency and marginal costs are taken into account.

- You want to assign each person the tasks on which he or she has a comparative advantage.

Conclusion: Trade can make everyone better off 

The principle of comparative advantage shows that trade can make everyone better off.

Adjunct teaching tips and warm-up activities 1

2

When teaching this material for the first time, it is best to walk the students through point by point using the text, unless you are completely confident about the material. Better to use the book than to stumble through the presentation.

Arrange students in groups of three or four to write a comparative advantage problem of their own.

Tell them to make creative yet plausible examples. For instance, one example might be Bert and Ernie from Sesame Street producing one meal and one clean house. Give the students 10 minutes to work on creating their examples at the end of class. Instruct them to bring a neatly written copy for the next class. Let the students vote on which group has the best example and award a small prize to each of the group’s members (such as a candy bar). After the class, make all the examples available to the students as practice problems for the exam.

Check your understanding solutions LO3.1 A parable for the modern economy Q: Draw an example of a production possibilities frontier for Robinson Crusoe, a shipwrecked sailor who spends his time gathering coconuts and catching fish. Does this frontier limit Crusoe’s consumption of coconuts and fish if he lives by himself?

Does he face the same limits if he can trade with native residents on the island?

A: Figure 3.1 below shows a production possibilities frontier for Robinson Crusoe between gathering coconuts and catching fish. If Crusoe lives by himself, this frontier limits his consumption of coconuts and fish, but if he can trade with natives on the island he will be able to improve his situation. It is highly unlikely that the other individuals have exactly the same skill set and thus opportunity costs as Crusoe.

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can improve by specialising and trading. In the graph this improvement would be depicted by a consumption point outside Crusoe’s production possibilities frontier.

Figure 3.1

LO3.2 Comparative advantage: The driving force of specialisation Q: Robinson Crusoe can gather 10 coconuts or catch one fish per hour. His friend Friday can gather 30 coconuts or catch two fish per hour. What is Crusoe’s opportunity cost of catching one fish? What is Friday’s? Who has an absolute advantage in catching fish? Who has a comparative advantage in catching fish?

A: Crusoe’s opportunity cost of catching one fish is 10 coconuts, since he can gather 10 coconuts in the same amount of time it takes to catch one fish. Friday’s opportunity cost of catching one fish is 15 coconuts, since he can gather 30 coconuts in the same amount of time it takes to catch two fish. Friday has an absolute advantage in catching fish, since he can catch two per hour, while Crusoe can only catch one per hour. But Crusoe has a comparative advantage in catching fish, since his opportunity cost of catching a fish is less than Friday’s.

LO3.3 Applications of comparative advantage Q: Suppose that the world’s fastest typist happens to be trained in brain surgery.

Should that person type for himself or hire a secretary? Explain.

A: If the world’s fastest typist happens to be trained in brain surgery, they should hire a secretary. They have an absolute advantage in typing, but a comparative advantage in brain surgery, since their opportunity cost in brain surgery is low compared to the opportunity cost for other people.

Practice questions solutions Apply and revise 1

2

A PPF is bowed out when the rate at which society could trade one good for the other depended on the amounts that were produced. A linear PPF represents a constate rate of trade off, and is therefore a straight line.

Absolute advantage reflects a comparison of the productivity of one person, firm, or nation to that of another, while comparative advantage is based on the relative opportunity costs of the persons, firms, or nations. Absolute advantage means the party can produce the good (or service) at the lowest input cost. Comparative advantage means the party can produce it at the lowest opportunity

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3

4

5 6

cost. While a person, firm, or nation may have an absolute advantage in producing every good, they generally can’t have a comparative advantage in every good.

Many examples are possible. Suppose, for example, that Roger can prepare a fine meal of pasta in just 20 minutes, while it takes Anna 1 hour. And Roger can vacuum the floor in 2 hours, while it takes Anna 3 hours. Roger has an absolute advantage in both cooking and vacuuming, but Anna has a comparative advantage in vacuuming the floor. Vacuuming takes Anna the same amount of time as three meals, while it takes Roger six meals’ worth of time.

Comparative advantage is more important for trade than absolute advantage. In the example in question 2, Anna and Roger will complete their chores more quickly if Anna does at least some of the vacuuming and Roger cooks the pasta for both of them. This is because Anna has a comparative advantage in doing the vacuuming, while Roger has a comparative advantage in cooking.

For both parties to gain from trade, the price at which they trade must lie between their opportunity costs.

Economists tend to oppose policies that restrict trade among nations because trade allows all countries to achieve greater prosperity by allowing them to receive the gains from comparative advantage. Restrictions on trade hurt all countries.

Multiple choice 1. d

2. b

3. a

4. d

5. b

6. d

Problems and applications 1

a

See Figure 3.1 below. If Maria spends all 5 hours studying economics, she can read 100 pages, so that is the vertical intercept of the production possibilities frontier. If she spends all 5 hours studying sociology, she can read 250 pages, so that is the horizontal intercept. The time costs are constant, so the production possibilities frontier is a straight line.

Figure 3.1

b

2

It takes Maria two hours to read 100 pages of sociology. In that time, she could read 40 pages of economics. So the opportunity cost of 100 pages of sociology is 40 pages of economics. a Workers needed to make:

b

One car

One tonne of grain

Australia

1/4

1/10

Japan

1/4

1/5

See Figure 3.2 below. With 100 million workers and four cars per worker, if either economy were devoted completely to cars, it could make 400 million cars. Since an Australian worker can

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produce 10 tonnes of grain, if Australia produced only grain it would produce 1000 million tonnes. Since a Japanese worker can produce 5 tonnes of grain, if Japan produced only grain it would produce 500 million tons. These are the intercepts of the production possibilities frontiers shown in the figure. Note that since the trade-off between cars and grain is constant, the production possibilities frontier is a straight line.

Cars (millions)

Figure 3.2

Grain (millions of tonnes)

c

d

e

f

g

Since an Australian worker produces either four cars or 10 tonnes of grain, the opportunity cost of one car is 2½ tonnes of grain, which is 10 divided by 4. Since a Japanese worker produces either four cars or 5 tonnes of grain, the opportunity cost of one car is 1.25 tonnes of grain, which is 5 divided by 4. Similarly, the Australian opportunity cost of 1 tonne of grain is 0.4 cars (4 divided by 10) and the Japanese opportunity cost of 1 tonne of grain is 0.8 cars (4 divided by 5). This gives the following table: Opportunity cost of: 1 car (in terms of tonnes of grain given up)

1 tonne of grain (in terms of cars given up)

Australia

2.5

0.4

Japan

1.25

0.8

Neither country has an absolute advantage in producing cars, since they are equally productive, having the same output per worker. Australia has an absolute advantage in producing grain, since it is more productive, having greater grain output per worker.

Japan has a comparative advantage in producing cars, since it has a lower opportunity cost in terms of grain given up. Australia has a comparative advantage in producing grain, since it has a lower opportunity cost in terms of cars given up.

With half the workers in each country producing each of the goods, Australia would produce 200 million cars and 500 million tonnes of grain (50 million workers times 10 tonnes each).

Japan would produce 200 million cars (50 million workers times four cars each) and 250 million tonnes of grain (50 million workers times 5 tonnes each).

From any situation with no trade, in which each country is producing some cars and some grain, suppose Australia changed one worker from producing cars to producing grain. That worker would produce four fewer cars and 10 additional tonnes of grain. Then suppose Australia offers to trade 7 tonnes of grain to Japan for four cars. Australia is willing to do this because it values four cars at 10 tonnes of grain, so it will be better off if the trade goes through. Suppose Japan changes one worker from producing grain to producing cars. That worker would produce four more cars and 5 fewer tonnes of grain. Japan will take the trade because it values four cars at 5 tonnes of grain, so it will be better off. With the trade and the change of one worker in both Australia and Japan, each country gets the same amount of cars as before and both get additional tonnes of grain – 3 tonnes for Australia and 2 tonnes for Japan. Thus by trading and changing their production, both countries are better off.

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3

a

b c

4

a

b

Monica’s opportunity cost of making a pizza is making six pots of coffee. Rachel’s opportunity cost of making a pizza is making four pots of coffee. Monica has an absolute advantage in making pizza since she can make one in half an hour, while it takes Rachel one hour. Since Rachel’s opportunity cost of making pizza is less than Monica’s opportunity cost, Rachel has a comparative advantage in making pizza.

Since Rachel has a comparative advantage in making pizza, she will make pizza and exchange it for coffee that Monica makes.

The highest price of pizza in terms of pots of coffee that will make both flatmates better off is six pots of coffee. If the price were higher than that, then Monica would prefer making her own pizza at an opportunity cost of six pots of coffee rather than trading for pizza that Rachel makes.

The lowest price of pizza in terms of pots of coffee that will make both flatmates better off is four pots of coffee. If the price were lower than that, then Rachel would prefer making her own coffee (she can make four pots of coffee instead of making a pizza) rather than trading for coffee that Monica makes.

Since a South Korean worker can make either two cars a year or 30 bags of wheat, the opportunity cost of a car is 15 bags of wheat. Similarly, the opportunity cost of a bag of wheat is 1/15 of a car. The opportunity costs are the reciprocals of each other.

See Figure 3.3 below. If all 10 million workers produce two cars each, they produce a total of 20 million cars, which is the vertical intercept of the production possibilities frontier. If all 10 million workers produce 30 bags of wheat each, they produce a total of 300 million bags, which is the horizontal intercept of the production possibilities frontier. Since the trade-off between cars and wheat is in this case constant, the production possibilities frontier is a straight line.

If South Korea chooses to consume 10 million cars, it will need 5 million workers devoted to car production. That leaves 5 million workers to produce wheat and they will produce a total of 150 million bags (5 million workers times 30 bags per worker). This is shown as point A on Figure 3.3.

Figure 3.3

5

c

If Thailand buys 10 million cars from South Korea and South Korea continues to consume 10 million cars, then South Korea will need to produce a total of 20 million cars. So South Korea will be producing at the vertical intercept of the production possibilities frontier. But if South Korea gets 20 bags of wheat per car, it will be able to consume 200 million bags of wheat, along with the 10 million cars. This is shown as point B in the Figure 3.4. South Korea should accept the deal because it gets the same number of cars and 50 million more bags of wheat.

a

English workers have an absolute advantage over Scottish workers in producing scones, since English workers produce more scones per hour (50 vs 40). Scottish workers have an absolute advantage over English workers in producing jumpers, since Scottish workers produce more jumpers per hour (2 vs 1).

Comparative advantage runs in this case the same way. English workers have an opportunity cost of 1/50 jumpers per scone, one jumper per hour divided by 50 scones per hour. Scottish workers have an opportunity cost of 1/20 jumper per scone, two jumpers per hour divided by 40 scones per hour. So England has a lower opportunity cost per scone and hence has a comparative 0308 Copyright 2021 Cengage Learning Australia Pty Limited

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b

c

6

a b

c

d

advantage in the production of scones. Scottish workers have an opportunity cost of 20 scones per jumper, 40 scones per hour divided by two jumpers per hour. English workers have an opportunity cost of 50 scones per jumper, 50 scones per hour divided by one jumper per hour.

So Scotland has a lower opportunity cost per jumper and hence has a comparative advantage in the production of jumpers.

If England and Scotland decide to trade, Scotland will produce jumpers and trade them for scones produced in England. A trade with a price between 20 and 50 scones per jumper will benefit both countries, as they’ll be getting the traded good at a lower price than their opportunity cost of producing the good in their own country.

Even if a Scottish worker produced just one jumper per hour, the countries would still gain from trade, because Scotland would still have a comparative advantage in producing jumpers. Its opportunity cost for jumpers would be 40 scones per jumper, instead of 20 scones per jumper before. But there are still gains from trade since England has a higher opportunity cost of 50 scones per jumper.

With no trade, one blue shirt trades for one maroon shirt in Brisbane, since productivity is the same for the two types of shirt. The price in Sydney is two maroon shirts per blue shirt.

Brisbane has an absolute advantage in the production of both types of jumpers, since a worker in Brisbane produces more (three shirts per hour) than a worker in Sydney (two maroon shirts or one blue shirt per hour). Sydney has a comparative advantage in producing maroon shirts, since the opportunity cost of producing a maroon shirt in Sydney is ½ a blue shirt, while the opportunity cost of producing a maroon shirt in Brisbane is one blue shirt. Brisbane has a comparative advantage in producing blue shirts, since the opportunity cost of producing a blue shirt in Brisbane is one maroon shirt, while the opportunity cost of producing a blue shirt in Sydney is two maroon shirts.

If they trade shirts, Brisbane will produce blue shirts for export since it has the comparative advantage in blue shirts, while Sydney will produce maroon shirts for export, which is Sydney’s comparative advantage.

Trade can occur at any price between one and two maroon shirts per blue shirt. At a price lower than one maroon shirt per blue shirt, Brisbane will choose to produce its own maroon shirts at a cost of one maroon shirt per blue shirt instead of buying them from Sydney. At a price higher than two maroon shirts per blue shirt, Sydney will choose to produce its own blue shirts at a cost of two maroon shirts per blue shirt instead of buying them from Brisbane.7 Creating a table to compare the opportunity costs is a useful aid for this question:

7 Country

a b

Inputs

Cars Wine Germany 400 2 France 600 X This implies the opportunity cost of one car in Germany is 200 wine, and in France, it is 600/X wine. The opportunity cost of one case of wine in Germany is 0.005, and in France it is X/600.

Gains from trade are possible for all values of X not equal to 3. If X is equal to 3, then no country has a comparative advantage in producing either good.

For all values of X less than (but not equal) to 3, Germany will have the comparative advantage in cars and hence, export cars. France will have the comparative advantage in wine, so Germany will import wine. For example, if X was equal to 2, then the opportunity cost of one car in France would be 300 wine compared to Germany at 200 wine.

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8

a

b

c

d

9

a

b

c

d

China would export shirts because it has the lower opportunity cost of shirts. For China, the opportunity cost of 1 shirt is 1/10 computer. For the US, the opportunity cost of a shirt is 1/5 computer. Therefore, China has a comparative advantage in the production of shirts and the United States has a comparative advantage in the production of computers. The price of a shirt will fall between 1/5 and 1/10 of a computer. An example would be a price of 1/7 of a computer.

Suppose China produced only shirts (100 shirts) and exported 50 shirts in exchange for 7.14 computers (50/7 = 7.14). This trade makes China better off than it was before trade (50 shirts and 5 computers). The United States would also benefit from this trade. If the United States produced only computers (20 computers), and traded 7.14 of them to China for 50 shirts, the United States would have 12.86 (20-7.14) computers and 50 shirts and would be better off than before trade (10 computers and 50 shirts) The price of a computer would fall between 5 and 10 shirts. If the price were below 5, the United States would not be willing to export computers because the opportunity cost of a shirt for the United States is 1/5 computer. If the price were greater than 10 shirts, China would not be willing to import computers because (for China) the opportunity cost of a computer is 10 shirts.

Once the productivity is the same in the two countries, the benefits of trade will disappear. Trade is beneficial because it allows countries to exploit their comparative advantage. If China and the United States have exactly the same opportunity cost of producing shirts and computers, there will be no more gains from trade.

True. Two countries can achieve gains from trade even if one of the countries has an absolute advantage in the production of all goods. All that is necessary is that each country has a comparative advantage in some good.

False. It is not true that some people have a comparative advantage in everything they do. In fact, no one can have a comparative advantage in everything. Comparative advantage reflects the opportunity cost of one good or activity in terms of another. If you have a comparative advantage in one thing, you automatically have a comparative disadvantage in some other thing.

False. It is not true that if a trade is good for one person, it can’t be good for the other one.

Trades can and do benefit both sides – especially trades based on comparative advantage. If both sides didn’t benefit, voluntary trades would never occur.

True. Trade means that both parties are able to consume more than they would without trade.

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Chapter 4 The market forces of supply and demand Learning objectives After reading this chapter, students should be able to:  identify a competitive market  explain what determines the demand for a good in a competitive market  explain what determines the supply of a good in a competitive market  describe how supply and demand together determine the price of a good, and how prices allocate scarce resources in market economies.

Key points       





Economists use the model of supply and demand to analyse competitive markets. In a competitive market, there are many buyers and sellers, each of whom has little or no influence on the market price.

The demand curve shows how the quantity of a good demanded depends on the price. According to the law of demand, as the price of a good falls, the quantity demanded rises. Therefore, the demand curve slopes downwards.

In addition to price, other determinants of the quantity demanded include income, tastes, expectations, and the prices of substitutes and complements. If one of these other determinants changes, the demand curve shifts.

The supply curve shows how the quantity of a good supplied depends on the price. According to the law of supply, as the price of a good rises, the quantity supplied rises. Therefore, the supply curve slopes upwards.

In addition to price, other determinants of the quantity supplied include input prices, technology and expectations. If one of these other determinants changes, the supply curve shifts.

The intersection of the supply and demand curves determines the market equilibrium. At the equilibrium price, the quantity demanded equals the quantity supplied.

The behaviour of buyers and sellers naturally drives markets towards their equilibrium. When the market price is above the equilibrium price, there is excess supply, which causes the market price to fall. When the market price is below the equilibrium price, there is excess demand, which causes the market price to rise.

To analyse how any event influences a market, we use the supply-and-demand diagram to examine how the event affects the equilibrium price and quantity. To do this we follow three steps. First, we decide whether the event shifts the supply curve or the demand curve. Second, we decide which direction the curve shifts. Third, we compare the new equilibrium with the old equilibrium.

In market economies, prices are the signals that guide economic decisions and thereby allocate scarce resources. For every good in the economy, the price ensures that supply and demand are in balance. The equilibrium price then determines how much of the good buyers choose to purchase and how much sellers choose to produce.

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Chapter outline Introduction This chapter introduces the theory of supply and demand. It shows how supply and demand determine prices in a market economy and how prices, in turn, allocate the economy’s scarce resources. It illustrates how elasticity measures the responsiveness of buyers and sellers to changes in market conditions. It also examines the impact on resource allocation of government policies that directly control prices.

Markets and competition What is a market? 

Definition: market – a group of buyers and sellers of a particular good or service.

You may want to provide examples of markets other than the traditional retail store or the stock market. For example, the classified advertising section of a newspaper, the university careers service, or the market for marijuana at a nightclub. Be sure to list the good or service being sold, the buyers and the sellers in each example.

What is competition?     



Definition: competitive market – a market in which there are many buyers and many sellers so that each has a negligible impact on the market price.

Students may find the name for this type of market misleading. You will have to point out that firms in a competitive market do not face head-to-head rivalry as in sports competitions.

Characteristics of a perfectly competitive market: – The goods being offered for sale are all the same.

– The buyers and sellers are so numerous that none can influence the market price.

Because buyers and sellers must accept the market price as given, they are often called ‘price takers’. Agricultural markets provide good examples of perfect competition.

Other market types: – A market with only one seller is called a monopoly market.

– A market with only a few sellers is called an oligopoly.

– A market with a large number of sellers, each selling a product that is slightly different from its competitors’ products, is a monopolistically competitive market.

We will start by assuming perfect competition.

Demand The demand curve: The relationship between price and quantity demanded    

Definition: quantity demanded – the amount of a good that buyers are willing and able to purchase.

What determines the quantity demanded? The central determinant is price.

– Quantity demanded is usually negatively related to price. This implies that the demand curve is downward-sloping.

Definition: law of demand – the claim that, other things being equal, the quantity demanded of a good falls when the price of the good rises.

Definition: demand schedule – a table that shows the relationship between the price of a good and the quantity demanded.

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Table 4.1

Catherine’s demand schedule Price of an ice-cream $0.00 0.50 1.00 1.50 2.00 2.50 3.00



Quantity of ice-cream demanded 12 10 8 6 4 2 0

Definition: demand curve – a graph of the relationship between the price of a good and the quantity demanded.

When you draw the demand curve for the first time, take the time to plot each of the points from the demand schedule. This way, students who have difficulty with graphs can see the relationship between the demand schedule and the demand curve. This is a good time to see if students understand the (x, y) coordinate system.

Text Figure 4.1

Catherine’s demand curve

Make sure that you explain that when we discuss the relationship between quantity demanded and price we hold all other variables constant. You will need to emphasise this more than once to ensure that students understand why a change in price leads to a movement along the demand curve.

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ALTERNATIVE CLASSROOM EXAMPLE Here is a demand schedule for black pens: Price Quantity 0.40 1000 0.80 800 1.20 600 1.60 400 2.00 200

Market demand versus individual demand 

The market demand is the sum of all of the individual demands for a particular good or service.

The individual demand curves are summed horizontally — meaning that the quantities demanded are added up for each level of price.

See Table 4.2 See Figure 4.2  



The market demand curve shows how the total quantity demanded of a good varies with the price of the good, holding all other factors constant.

FYI: Ceteris paribus.

– When a demand curve is drawn, everything but price and quantity demanded is held constant.

Economists use the term ceteris paribus to point out that all other relevant variables, such as tastes and expectations, are assumed fixed.

Definition: ceteris paribus – a Latin phrase, translated as ‘other things being equal’, used as a reminder that all variables other than the ones being studied are assumed to be constant.

Shifts in the demand curve 

When any determinant of demand changes (other than price), the demand curve will shift. An increase in demand can be represented by a shift of the demand curve to the right. A decrease in demand can be represented by a shift of the demand curve to the left.

See Figure 4.3 Students have a hard time understanding the difference between a change in price (which causes a movement along the demand curve) and a change in another determinant (which shifts the demand curve). You will have to emphasise the difference between ‘change in quantity demanded’ and ‘change in demand’ several times using different examples. The Case study on smoking will help to explain this difference as well. Repeat the rule of thumb: If the variable is not on either axis it will cause a shift. Relate the horizontal shift of the demand curve to the fact the x-axis has quantities. Hence this is the dimension demand curve must shift.



Table 4.3, lists the variables that influence quantity demanded and how a change in each variable affects the demand curve.

It would be a good idea to work through an example changing each of these variables individually. Students will benefit from the discussion as well as the practice of drawing the graphs.

  

Income – The relationship between income and quantity demanded depends on what type of good the product is.

Definition: normal good – a good for which, other things being equal, an increase in income leads to an increase in quantity demanded.

Definition: inferior good – a good for which, other things being equal, an increase in income leads to a decrease in quantity demanded.

Be careful! Students often confuse inferior goods with what economists call ‘bads’.

One way to differentiate them is to ask students whether they would ever be willing to pay for such things as pollution or garbage.

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   

 

Prices of related goods: Definition: substitutes – two goods for which a decrease in the price of one good leads to a decrease in the demand for the other good.

Definition: complements – two goods for which a decrease in the price of one good leads to an increase in the demand for the other good.

Tastes: – If you like something you buy more of it. Economists do not normally try to explain people’s tastes; however, they do examine what happens when tastes change.

Expectations: – This could include expectations of future income or expectations of future price changes.

Number of buyers: – Because market demand is derived from individual demands it also depends on the number of buyers. An extra buyer would shift the quantity demanded in the market at every price and the demand curve would shift to the right.

Supply If you have taken enough time teaching demand, students will catch on to supply more quickly. However, remember that as consumers, students can understand demand decisions more easily than supply decisions. You may want to point out to them that they are suppliers of their time and effort in the labour market.

The supply curve: The relationship between price and quantity supplied  

 

Definition: quantity supplied – the amount of a good that sellers are willing and able to sell.

Quantity supplied is positively related to price. You can relate to the bow-shaped PPF: The more of one good that is produced, the higher is the cost of production because suitable inputs become more and more scarce. Thus larger quantities are only produced if they can be sold at a higher price.

What determines the quantity supplied? Again, the central determinant is price.

Definition: law of supply – the claim that, other things being equal, the quantity supplied of a good rises when the price of the good rises.

Again you will want to point out that everything else is held constant when we discuss the relationship between price and quantity supplied. Students should understand that a change in price causes a movement along the supply curve.



Definition: supply schedule – a table that shows the relationship between the price of a good and the quantity supplied.

Table 4.4 Tony’s supply schedule Price of an ice-cream $0.00 0.50 1.00 1.50 2.00 2.50 3.00



Quantity of ice-cream supplied 0 0 1 2 3 4 5

Definition: supply curve – a graph of the relationship between price of a good and quantity supplied.

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Principles of Macroeconomics – 8th edition

Text Figure 4.5 Tony’s supply curve

Market supply versus individual supply 

The market supply curve can be found by summing individual supply curves. Individual supply curves are summed horizontally at every price. The market supply curve shows how the total quantity supplied varies as the price of the good varies.

See Table 4.5 See Figure 4.6 ALTERNATIVE CLASSROOM EXAMPLE Here is a supply schedule for black pens: Price Quantity 0.40 400 0.80 500 1.20 600 1.60 700 2.00 800

Shifts in the supply curve 

When any determinant of supply changes (other than price), the supply curve will shift. An increase in supply can be represented by a shift of the supply curve to the right. A decrease in supply can be represented by a shift of the supply curve to the left.

See Figure 4.7 You will want to take time to emphasise the difference between a ‘change in supply’ and a ‘change in quantity supplied’.



Table 4.6 lists the variables that influence quantity supplied and how a change in each variable affects the supply curve:

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Principles of Macroeconomics – 8th edition

– –

Input prices: The quantity supplied is negatively related to the price of inputs used to make the good.

Technology: Changes in technology change the costs of production and change quantity supplied.

You will want to be careful here as this is production technology and not technology as embodied in the goods themselves. Also, you may need to carefully explain that an improvement in production technology makes each worker more productive and so lowers the costs of production.

– –

Expectations, especially about the future price of the good: If suppliers expect the price to rise they will be more likely to store some of the good and supply less to the market today.

Number of sellers: Because market supply is derived from individual supply it also depends on the number of sellers. An extra seller would shift the quantity supplied in the market at every price and the supply curve would shift to the right.

Supply and demand together Equilibrium  

The point where the supply and demand curves intersect is called the market’s equilibrium.

Definition: equilibrium – a situation in which supply and demand have been brought into balance.

Students will benefit from seeing equilibrium using both a graph and a supply-anddemand schedule. The schedule will make it easier for students to understand concepts such as shortages and surpluses.

See Figure 4.8  

Definition: equilibrium price – the price that balances supply and demand. The equilibrium price is often called the ‘market-clearing’ price because there will be neither goods, nor unsatisfied demand, left over after trading.

Definition: equilibrium quantity – the quantity supplied and the quantity demanded when the price has adjusted to balance supply and demand.

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Text Figure 4.9

  

If the actual market price is higher than the equilibrium price, there will be a surplus of the good.

Definition: surplus – a situation in which quantity supplied is greater than quantity demanded.

– To sell off the surplus, producers will lower the price until the market reaches equilibrium.

If the actual price is lower than the equilibrium price, there will be a shortage of the good.

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Principles of Macroeconomics – 8th edition

 

Definition: shortage – a situation in which quantity demanded is greater than quantity supplied.

– Sellers will respond to the shortage by raising the price of the good (without losing sales) until the market reaches equilibrium.

Definition: law of supply and demand – the claim that the price of any good adjusts to bring the supply and demand for that good into balance.

Three steps for analysing changes in equilibrium 

See Table 4.7 -

1) Decide whether the event shifts the supply or demand curve (or perhaps both).

-

2) Decide in which direction the curve shifts.

-

3) Use the supply and demand diagram to see how the shift changes the equilibrium.



A shift in the supply curve is called a ‘change in supply’ and a shift in the demand curve is called ‘change in demand’.



A movement along a fixed supply curve is called ‘change in the quantity supplied’ and a movement in the demand curve is called ‘change in the quantity demanded’.

Conclusion: How prices allocate resources 

Prices are signals that guide economic decisions and allocate scarce resources.

Check your understanding solutions L.O4.1 Identify a competitive market Q: What is a market? What are the characteristics of a perfectly competitive market?

A: A market is a group of buyers (who determine demand) and a group of sellers (who determine supply) of a particular good or service. A perfectly competitive market is one in which the goods being offered for sale are all the same and in which there are many buyers and many sellers so that each has a negligible impact on the market price.

L.04.2 Demand Q: List the determinants of the demand for pizza. Give an example of a demand schedule for pizza, and graph the implied demand curve. Give an example of something that would shift this demand curve. Would a change in the price of pizza shift this demand curve?

A: The determinants of the quantity of pizza demanded should include price, income, prices of related goods, tastes, expectations and the number of buyers.

Here is an example of a demand schedule for pizza:

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Price of pizza slice

Number of pizza slices demanded

$0.00

10

0.25

9

0.50

8

0.75

7

1.00

6

1.25

5

1.50

4

1.75

3

2.00

2

2.25

1

2.50

0

The demand curve is graphed in Figure 4.1.

Figure 4.1

Examples of things that would shift the demand curve include changes in income, prices of related goods like soft drink or hot dogs, tastes and expectations about future income or prices.

A change in the price of pizza would not shift this demand curve; it would only move from one point to another along the demand curve.

LO 4.3 Supply Q: List the determinants of the supply of pizza. Give an example of a supply schedule for pizza, and graph the implied supply curve. Give an example of something that would shift this supply curve. Would a change in the price of pizza shift this supply curve?

The determinants of the quantity of pizza supplied include the price of pizza, the prices of inputs into pizza production, the technology for producing pizza, expectations about things like the future price of pizza and the number of suppliers of pizza.

Here is an example of a supply schedule for pizza:

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Price of pizza slice

Number of pizza slices supplied

$0.00

0

0.25

100

0.50

200

0.75

300

1.00

400

1.25

500

1.50

600

1.75

700

2.00

800

2.25

900

2.50

1000

The supply curve is graphed in Figure 4.2.

Figure 4.2

Examples of things that would shift the supply curve include changes in prices of inputs like tomato sauce and cheese, changes in technology like more efficient pizza ovens or automatic dough makers, and changes in expectations about the future price of pizza.

A change in the price of pizza would not shift this supply curve; it would only move from one point to another along the supply curve.

LO 4.4 Supply and demand together Q: Analyse what happens to the market for pizza if the price of tomatoes rises.

Analyse what happens to the market for pizzas if the price of hamburgers falls.

A: As tomatoes are an input in the production of pizzas, an increase in the price of tomatoes will cause supply of pizzas to decrease (shift in supply). Hamburgers are substitutes to pizzas so if the price of hamburgers falls, this will cause a decrease in the demand for pizza (shift in demand).

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Case study solutions Are smartphones and tablets substitutes or complements?

1. Provide another example of two goods that are complements for some people, and substitutes for others. How might people consume the two goods together?

A: Gas stove and barbeques. Someone might need to use the stove to boil the corn cobs before placing it on the BBQ. (Used as complements 2. How might one good act as a substitute for the other?

A: Another person will use either the gas stove or barbeque by itself to cook the corn. (Used as substitutes)

Two ways to reduce the quantity of smoking demanded 1. Suppose that the government legalised marijuana, allowing it to be sold by licensed retailers. How would you expect legalisation of marijuana to affect demand for cigarettes?

A: Studies have found that higher cigarette prices are associated with reduced use of marijuana, which means these goods are complements (rather than substitutes). Therefore the legalisation of marijuana is likely to increase the demand for cigarettes.

2. Now suppose that the government also placed a tax on marijuana, raising its price. How would the tax on marijuana affect demand for cigarettes?

A: Raising the price of marijuana through a tax will reduce consumption of marijuana and lowers the quantity demanded. This is shown as a movement along the curve. As less marijuana is being used, this means that there will also be a reduction in the demand for cigarettes, and therefore a shift in the demand for cigarettes.

Practice questions solutions Apply and revise 1 2

3

4

5

A competitive market is a market in which there are many buyers and many sellers so that each has a negligible impact on the market price.

The demand schedule is a table that shows the relationship between the price of a good and the quantity demanded. The demand curve is the downward-sloping line relating price and quantity demanded. The demand schedule and demand curve are related because the demand curve is simply a graph showing the points in the demand schedule. The demand curve slopes downward because, other things being equal, when the price of a good rises, the quantity demanded of the good falls. People buy less of a good when its price rises, both because they can’t afford to buy as much and because they switch to purchasing other goods. This is the so-called law of demand.

A change in taste causes a shift of the demand curve. At any given price, the consumer is now able to buy more (or less) than previously. A change in the price causes a movement along the demand curve. For any given price, the consumer’s demand is unchanged. This leaves the demand curve in its current position. The change in price simply moves up (or down) the curve.

Carrot juice for Harry is an inferior good. The decrease in income causes him to purchase more carrot juice. After Harry’s income decline, his demand curve for carrot juice would shift to the right (his demand increases).

A supply schedule is a table showing the relationship between the price of a good and the quantity a producer is willing and able to supply. The supply curve is the upward-sloping line relating price and quantity supplied. The supply schedule and the supply curve are related because the supply curve is simply a graph showing the points in the supply schedule.

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6

7

8 9

The supply curve slopes upward because when the price is high even more expensive production becomes profitable. Therefore suppliers supply more output to the market. The result is the law of supply – other things being equal, when the price of a good rises, the quantity supplied of the good also rises.

A change in producers’ technology leads to a shift in the supply curve, because ‘technology’ is on neither axis. For any given price, the seller is willing to sell more (or less) than previously. This is a movement of the curve. A change in price leads to a movement along the supply curve. For any given price, the quantity supplied is exactly the same as it was before as it was after.

The equilibrium of a market is the point at which the demand and supply curves intersect. At the equilibrium price, the quantity of the good that buyers are willing and able to buy exactly balances the quantity that sellers are willing and able to sell. If the price is above the equilibrium price, sellers want to sell more than buyers want to buy, so there is a surplus. Sellers try to increase their sales by cutting prices; that continues until they reach the equilibrium price. If the price is below the equilibrium price, buyers want to buy more than sellers want to sell, so there is a shortage.

Sellers can raise their price without losing customers; that continues until they reach the equilibrium price.

The demand for pies will decrease (shift) and the quantity supplied will decrease (movement) as a result of a lower equilibrium price for pies.

Prices are the signals that guide economic decisions and allocate scarce resources. The intersection of the supply and demand curves represents the market equilibrium. At the equilibrium price, the quantity demanded equals the quantity supplied. When the market price is above equilibrium price, there is excess supply which causes the market price to fall. When the market price is below the equilibrium price, there is excess demand, which causes the market price to rise.

Multiple choice 1. b (hamburger buns are a complement, not an input)

2. b

3. d

4. b

5. b

6. c

Problems and applications 1

a

The cyclone destroys the banana crops, reducing the supply of bananas. This results in a shift to the left of the supply curve for bananas. Equilibrium price is higher.

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b

When cinemas discount tickets on Tuesdays, this increases demand and leads to a shift to the right of the demand curve, resulting in a higher equilibrium price. c

The increase in the price of petrol will reduce the demand for used cars, so the equilibrium price of a used SUV will decrease as shown below:

2

The statement that ‘an increase in the demand for notebooks raises the quantity of notebooks demanded, but not the quantity supplied’ is false, in general. As Figure 4.3 shows, the increase in demand for notebooks results in an increased quantity supplied. The only way the statement would be true is if the supply curve were perfectly inelastic, as shown in Figure 4.4.

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Figure 4.3 Notebook market

Figure 4.4 Notebook market with perfectly inelastic supply

3

a b c d e

Tastes/Number of buyers towards SUV increases. Demand for SUVs increase.

Input prices increase. Supply for SUVs decrease.

New technology. Supply increases.

Price of substitute increases so people shift towards SUVs. Demand for SUVs increase.

Incomes reduce. Demand for SUVs decrease.

4

a

i ii

Film-streaming services and TVs are complements, as TVs are a most popular way to view movies online.

Film-streaming services and cinema tickets are substitutes, as they are different ways movies can be viewed by consumers. Film-streaming services have to be done so in combination with a complement, like a TV.

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iii TVs and cinema tickets are also substitutes, as they are different ways movies can be viewed by consumers. TV viewing has to be done so in combination with a complement, like a Blu-ray player or film-streaming service. b The reduction in the cost of manufacturing TVs causes the supply curve to shift from S’ to S”, resulting in a decline in the equilibrium price of TVs and an increase in the equilibrium quantity sold.

Figure 4.5 Cost of manufacturing TVs declines

c

The graph below now represents the market for film-streaming services. This shows the demand increases from D’ to D” (because TVs are cheaper and this is a complementary good). This results in an increase in the equilibrium price of film-streaming services and an increase in the equilibrium quantity sold.

Figure 4.6 Demand for film streaming services increases

The graph below now represents the market for cinema tickets. This shows that demand decreases from D’ to D” (because TVs are cheaper and a substitute for watching movies at the 0416 Copyright 2021 Cengage Learning Australia Pty Limited

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cinema). This results in a decrease in the equilibrium price of cinema-tickets and a decrease in the equilibrium sold.

Figure 4.7 Demand for cinema tickets

5

Technological advances that reduce the cost of producing computer chips represent a decline in an input price for producing a computer. The result is a shift to the right in the supply of computers, as shown in Figure 4.8. The equilibrium price falls and the equilibrium quantity rises, as the figure shows.

Figure 4.8

Since computer software is a complement to computers, the increased equilibrium quantity of computers increases the demand for software. The result is a rise in both the equilibrium price and quantity of software.

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Since typewriters are substitutes for computers, the increased equilibrium quantity of computers reduces the demand for typewriters. The result is a decline in both the equilibrium price and quantity of typewriters.

6

a

When an outbreak of ‘foot and mouth’ disease hits sheep farms in New Zealand, it raises input prices for producing woollen jumpers. As a result, the supply of woollen jumpers shifts to the left, as shown in Figure 4.9. The new equilibrium has a higher price and lower quantity of woollen jumpers.

Price of woollen jumpers

Figure 4.9

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b

A decline in the price of leather jackets leads more people to buy leather jackets, reducing the demand for woollen jumpers. The result, shown in Figure 4.10, is a decline in both the equilibrium price and quantity of woollen jumpers.

Price of woollen jumpers

Figure 4.10

Quantity of woollen jumpers c

Taylor Swift wearing a woollen jumper raises the demand for woollen jumpers, as shown in Figure 4.11. The result is an increase in both the equilibrium price and quantity of woollen jumpers.

Price of Woollen Jumpers

Figure 4.11

Quantity of Woollen Jumpers d

The invention of new knitting machines is an improvement in production technology, which increases the supply of woollen jumpers. As Figure 4.12 shows, the result is a reduction in the equilibrium price and an increase in the equilibrium quantity of woollen jumpers.

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Price of Woollen Jumpers

Figure 4.12

Quantity of Woollen Jumpers 7

Since tomato sauce is a complement for hot dogs, when the price of hot dogs rises, the quantity demanded of hot dogs falls, thus reducing the demand for tomato sauce, causing both price and quantity of tomato sauce to fall, as shown in Figure 4.13.

Price of tomato sauce

Figure 4.13

Quantity of tomato sauce Since the quantity of tomato sauce falls, the demand for tomatoes by tomato sauce producers falls, so both price and quantity of tomatoes fall, as shown in Figure 4.14.

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Price of tomatoes

Figure 4.14

Quantity of tomatoes When the price of tomatoes falls, producers of tomato juice face lower input prices, so the supply curve for tomato juice shifts down, causing the price of tomato juice to fall and the quantity of tomato juice to rise, as shown in Figure 4.15.

Price of tomato juice

Figure 4.15

Quantity of tomato juice The fall in the price of tomato juice causes people to substitute tomato juice for orange juice, so the demand for orange juice declines, causing the price and quantity of orange juice to fall, as shown in Figure 4.16. Now you can see clearly why a rise in the price of hot dogs leads to a fall in the price of orange juice!

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Price of orange juice

Figure 4.16

Quantity of orange juice 8

a b c

Quantity supplied equals quantity demanded at a price of $6 and quantity of 81 pizzas (Figure 4.17).

If price were greater than $6, quantity supplied would exceed quantity demanded, so suppliers would reduce their price to gain sales.

If price were less than $6, quantity demanded would exceed quantity supplied, so suppliers could raise their price without losing sales. In both cases, the price would continue to adjust until it reached $6, the only price at which there is neither surplus nor shortage.

Figure 4.17

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9

The news of the increased health benefits from consuming oranges will increase the demand for oranges, increasing both the equilibrium price and quantity.

If farmers use a new fertiliser that makes orange trees more productive, the supply of oranges will increase, leading to a fall in the equilibrium price but a rise in the equilibrium quantity.

If both occur at the same time, the equilibrium quantity will definitely rise, but the effect on equilibrium price will be ambiguous (more information is needed to analyse which effect is greater).

10 a

Milk is an input in the production of cheese and flour is an input in the production of macaroni. A fall in price of milk will cause an increase in supply of cheese, which will lead to a lower equilibrium price. A fall in the price of flour will increase the supply of macaroni, which leads to an increase in the equilibrium quantity of macaroni as the supply curve shifts downwards. As macaroni and cheese are complements, an increase in the equilibrium quantity of macaroni will also increase demand for cheese and therefore increase the equilibrium price for cheese.

b

A rise in the price of milk (an input to cheese) will decrease the supply of cheese. This means that the supply curve will shift to the left and equilibrium price will be higher. As macaroni and cheese are complements, a higher price of cheese will mean demand for macaroni will decrease. This means that demand will shift to the left and equilibrium quantity for macaroni will fall.

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11 a

As Figure 4.18 shows, the supply curve is vertical. The constant supply makes sense because the picture theatre has a fixed number of seats no matter what the price.

Price of picture theatre tickets

Figure 4.18

800

Quantity of picture theatre tickets b c

Quantity supplied equals quantity demanded at a price of $8. The equilibrium quantity is 800 tickets.

If we include the new film goers to the existing ones, then the new demand schedule is as below: Price

Quantity demanded

Quantity supplied

$4

1400

800

8

1100

800

12

800

800

16

500

800

20

200

800

The new equilibrium price will be $12, which equates quantity demanded to quantity supplied. The equilibrium quantity is 800 tickets.

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Chapter 5 Measuring a nation’s income Learning objectives After reading this chapter, students should be able to: • consider why an economy’s total income equals its total expenditure • learn how gross domestic product (GDP) is defined and calculated • see the breakdown of GDP into its four major components • learn the distinction between real GDP and nominal GDP • consider whether GDP is a good measure of economic wellbeing.

Key points • •

•

•

•

Because every transaction has a buyer and a seller, the total expenditure in the economy must equal the total income in the economy.

Gross domestic product (GDP) measures an economy’s total expenditure on newly produced goods and services and the total income earned from the production of these goods and services. More precisely, GDP is the market value of all final goods and services produced within a country in a given period of time.

GDP is divided among four components of expenditure: consumption, investment, government purchases and net exports. Consumption includes spending on goods and services by households, with the exception of purchases of new housing. Investment includes spending on new equipment and structures, including households’ purchases of new housing. Government purchases include spending on goods and services by local, state and federal governments, but exclude transfer payments made to individuals since such payments do not involve the production of goods or services. Net exports equal the value of goods and services produced domestically and sold abroad (exports) minus the value of goods and services produced abroad and sold domestically (imports).

Nominal GDP uses current prices to value the economy’s production of goods and services. Real GDP uses constant base-year prices to value the economy’s production of goods and services. The GDP deflator – calculated from the ratio of nominal to real GDP – measures the level of prices in the economy.

GDP measures an economy’s total income and spending and is one measure of economic wellbeing in that people generally prefer higher incomes to lower incomes. But since it is based on the market value of goods and services it is not a perfect measure of wellbeing. For example, GDP excludes the value of leisure, the value of a clean environment and other activities that take place outside of markets.

Chapter outline Introduction Regardless of whether microeconomics is taught before macroeconomics or viceversa, students need to be reminded of the differences between the two areas of study. Begin by defining the two terms and contrasting and comparing their focus.

• • •

Microeconomics: the study of how households and firms make decisions and how they interact in markets.

Macroeconomics: the study of economy-wide phenomena including inflation, unemployment and economic growth.

In this chapter we discuss some of the data that economists and policymakers use to monitor the overall economy, specifically the gross domestic product (GDP).

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The economy’s income and expenditure •

To judge whether an economy is doing well, it is useful to look at gross domestic product (GDP).

Students have heard of GDP and they are genuinely interested in learning more about what it is. The basic point that you must get across is that GDP is a measure of both aggregate production and aggregate income in a nation over a period of one year. The main point you can get across using the circular-flow diagram is that production generates income, which in turn results in the purchasing power that generates the demand for and hence expenditure on the products.

•

– GDP measures the total income of everyone in the economy.

– GDP measures total expenditure on an economy’s output of goods and services.

For an economy as a whole, total income must equal total expenditure.

– If someone pays someone else $100 to mow a lawn, the expenditure on the lawn service ($100) is exactly equal to the income earned from the production of the lawn service ($100).

– We can also use the circular-flow diagram from chapter 2 to show why total income and total expenditure must be equal.  Households buy goods and services from firms; firms use this money to pay for resources, such as labour, purchased from households.  In the simple economy shown in this diagram, calculating GDP can be done by adding up the total purchases of households or summing the total income of households.

Text Figure 5.1 Revenue (= GDP)

Goods & services sold

Spending (= GDP) MARKETS FOR GOODS & SERVICES  Firms sell  Households buy

HOUSEHOLDS

FIRMS

 Buy and consume goods and services  Own and sell factors of production

 Produce and sell goods and services  Hire and use factors of production

Inputs for production

MARKETS FOR FACTORS OF PRODUCTION  Households sell  Firms buy

Wages, rent & profit (= GDP) 

Goods & services bought

Land, labour & capital

Income (= GDP)

Note that this simple diagram is somewhat unrealistic as it omits saving, taxes, government purchases and investment purchases by firms. For example, extending the economy could include the government sector, the taxes paid by households and firms to government (government income), which are used by the government to purchase goods and services (government expenditure). Extending the model further to include the overseas sector increases the source of income and also the range of expenditure that can be undertaken (import and export of goods and services). But essentially, because a transaction always has a buyer and a seller, total expenditure in the two, three, or four sector economy must be equal to total income.

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The measurement of gross domestic product •

Gross domestic product (GDP): the market value of all final goods and services produced within a country in a given period of time.

To put GDP in terms the students may understand better, explain to them that GDP represents the amount of money one would need to purchase one year’s worth of the economy’s production of all final goods and services.

‘GDP is the market value ...’

• To add together different items, market values are used.

• Market values are calculated by using market prices. ‘... of all ...’

• GDP includes all items produced and sold legally in the economy.

• The value of housing services is somewhat difficult to measure.

– If housing is rented, the value of the rent is used to measure the value of the housing services.

– For housing that is owned (or mortgaged), the government estimates the rental value and uses this figure to value the housing services.

• GDP does not include illegal goods or services or items that are not sold in markets.

– When you hire someone to mow your lawn, that production is included in GDP. – If you mow your own lawn, that production is not included in GDP. ‘... final ...’

• Intermediate goods are not included in GDP. Make sure that students realise that investment goods (such as structures and vehicles used in production) are not intermediate goods. Investment goods represent products purchased for final use by business firms.

•

– The value of intermediate goods is already included as part of the value of the final good.

Goods that are placed into inventory are considered to be ‘final’ and included in GDP as a firm’s inventory investment.

– Goods that are sold out of inventory are counted as a decrease in inventory investment.

– The goal is to count the production when the good is finished, which is not necessarily the same time that the product is sold.

‘... goods and services ...’

• GDP includes both tangible goods and intangible services. ‘... produced ...’

• As mentioned above, current production is counted.

• Used goods sold do not count as part of GDP. ‘... within a country ...’

• GDP measures the production that takes place within the geographical boundaries of a particular country.

• If a New Zealand citizen works temporarily in Australia, the value of his or her output is included in GDP for Australia. If an Australian owns a factory in Malaysia, the value of the production of that factory is included in Malaysia’s GDP and not included in Australian GDP. However, it would be included in Australia’s GNP since this is a measure of the value of goods and services produced by a country’s residents.

Students sometimes have trouble understanding that the production of a foreign firm operating in Australia is part of Australian GDP. Help them make the connection by using the circular-flow diagram. Show them that, even if it is a foreign firm, the firm’s workers are living in Australia and buying clothes, groceries and other goods in Australia. Thus, the workers in the foreign firm operating in Australia are fuelling the domestic economy.

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‘... in a given period of time.’

• The usual interval of time used to measure GDP is a quarter (three months).

• When the government reports GDP, the data are generally reported on an annual basis.

• In addition, data are generally adjusted for regular seasonal changes (such as Christmas).

The components of GDP •

GDP (Y) can be divided into four components: consumption (C), investment (I), government purchases (G) and net exports (NX).

Students will ask why GDP is called ‘Y.’ Remind them that in equilibrium GDP expenditures must be equal to income. The ‘Y’ stands for income because the letter ‘I’ is used for investment.

• • •

Consumption: spending by households on goods and services, with the exception of purchases of new housing.

Investment: spending on capital equipment (i.e. equipment used to produce goods and services), inventories and structures, including household purchases of new housing.

Government purchases: spending on goods and services by local, state and federal governments.

– Salaries of government workers are counted as part of government purchases since the payments represent the cost of providing the services which are a component of GDP. – Transfer payments are not part of government purchases (as discussed under Key points).

Spend some time in class distinguishing between government purchases and transfer payments. Point out that transfer payments represent payments from the government to individuals, with no good or service provided in return. Define net taxes as the difference between taxes paid to the government and transfer payments received from the government.

•

Net exports: spending on domestically produced goods by foreigners (exports) minus spending on foreign goods by domestic residents (imports).

See text Table 5.1 • Table 5.1 shows these four components of GDP for 2018.

Make sure that you point out Table 5.1. Call attention to the importance of consumption, being more than double investment or government expenditure, and that net exports are negative. Get students to think about what a negative figure represents.





FYI: Three measures of income.

– There are three approaches to calculating the value of national output (GDP). These methods are conceptually the same but due to the quantity and range of data are typically not equal to each other. A statistical discrepancy is used to equate GDP (E) = GDP (I).

– The first measure, GDP (E) the expenditure approach, calculates all the expenditures – consumption, investment, government and net exports (C + I + G + NX) – in the economy over a given period of time. This is the method described in the text.

– The second measure, GDP (I) the income approach, sums all the factor incomes, including wages, salaries and supplements paid to labour and profits received by both public and private businesses.

– The third measure, GDP (P) the production approach, involves taking the market value of goods and services produced by each firm in an industry and deducting the cost of goods and services used by each of the firms in the production process. That is, it calculates the value added by each firm in each industry. By using only the value added at each production point, double counting is avoided.

– The Australian Bureau of Statistics (ABS) presents the above information in a different format.

They show consumption (made up of both household and government), investment (both business and government) and net exports (exports less imports). However, regardless of which approach is used, when the data is added, it should be the same!

The relationship between the different ways income can be measured is shown graphically in Figure 5.2. Get the students to look at the ABS website, http://www.abs.gov.au and see how the

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different types of expenditure are grouped. Get them to give examples for each type of expenditure.

Real versus nominal GDP • • •

There are two possible reasons for total spending to increase from one year to the next.

– The economy may be producing a larger output of goods and services.

– Goods and services could be selling at higher prices.

When studying GDP over time, economists would like to know how much of the increase in GDP is due to output increasing and how much is due to prices increasing.

Thus, economists measure real GDP by valuing output using a fixed set of prices.

A numerical example Make sure that you do this example or a similar numerical example in class. If you feel comfortable improvising, let the students pick two goods and then make up an example with them.

See text Table 5.3 • Two goods are being produced: kebabs and instant noodles Year Price of Quantity of Price of instant noodles kebabs kebabs 2017 2018 2019

•

• •

$10 $11 $12

50 75 100

Quantity of instant noodles

$4 $45 $6

75 100 150

Nominal GDP: the production of goods and services valued at current prices.

– Nominal GDP for 2017 = ($10 × 50) + ($4 × 75) = $800.

– Nominal GDP for 2018 = ($11 × 75) + ($5 × 100) = $1325.

– Nominal GDP for 2019 = ($12 × 100) + ($6 × 150) = $2100.

Real GDP: the production of goods and services valued at constant prices.

Let’s assume that the base year is 2017.

– Real GDP for 2017 = ($10 × 50) + ($4 × 75) = $800.

– Real GDP for 2018 = ($10 × 75) + ($4 × 100) = $1150.

– Real GDP for 2019 = ($10 × 100) + ($4 × 150) = $1600.

Make sure that it is clear to students where these numbers come from so that they can calculate nominal GDP and real GDP on their own.

•

Because real GDP is unaffected by changes in prices over time, changes in real GDP reflect changes in the amount of goods and services produced.

Emphasise that when there is inflation, nominal GDP can increase while real GDP actually declines. Make sure that students know that real GDP will be used as a proxy for aggregate production throughout the course.

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Alternative Classroom Example The country of (insert name) produces two goods: footballs and basketballs. Below is a table showing prices and quantities of output for 3 years: Year

Price of footballs

Quantity of footballs

Price of basketballs

Quantity of basketballs

Year 1 Year 2 Year 3

$10 12 14

120 200 180

$12 15 18

200 300 275

Nominal GDP in Year 1 = ($10 × 120) + ($12 × 200) = $3600 Nominal GDP in Year 2 = ($12 × 200) + ($15 × 300) = $6900 Nominal GDP in Year 3 = ($14 × 180) + ($18 × 275) = $7470 Using Year 1 as the Base Year: Real GDP in Year 1 = ($10 × 120) + ($12 × 200) = $3600 Real GDP in Year 2 = ($10 × 200) + ($12 × 300) = $5600 Real GDP in Year 3 = ($10 × 180) + ($12 × 275) = $5100 (Note that nominal GDP rises from Year 2 to Year 3, but real GDP falls.)

GDP deflator for Year 1 = ($3600 / $3600) × 100 = 1 × 100 = 100 GDP deflator for Year 2 = ($6900 / $5600) × 100 = 1.2321 × 100 = 123.21 GDP deflator for Year 3 = ($7470 / $5100) × 100 = 1.4647 × 100 = 146.47

The GDP deflator • GDP deflator: a measure of the price level calculated as the ratio of nominal GDP to real GDP •

times 100.

Example calculations, using the nominal and real GDP data from above: GDP deflator for 2017 = ($800 / $800) × 100 = 100.

GDP deflator for 2018 = ($1325/ $1150) × 100 = 120.

GDP deflator for 2019 = ($2100 / $1600) × 100 = 131.

Make sure that you point out that nominal GDP and real GDP will be equal in the base year. This implies that the GDP deflator for the base year will always be equal to 100.

GDP and economic wellbeing Get students involved in a discussion of the merits and problems involved with using GDP as a measure of wellbeing. Students are often as interested in what is not included in GDP as they are in what is included. Have the students break into small groups and list the things that might be missing if we use GDP as a measure of wellbeing. Then, have each group report their results and summarise them on the board.

• • •

GDP measures both an economy’s total income and its total expenditure.

GDP per person can tell us the income and expenditure level of the average person in the economy.

GDP measures the market value of goods and services and since not all goods and services are sold on the market, GDP will not reflect all goods and services provided in the economy. In this way, GDP may not be a very good measure of the economic wellbeing of an individual.

– GDP omits important factors in the quality of life including leisure, the health of the population, volunteer work, the quality of the environment and the value of goods produced but not sold in formal markets (e.g. the back yard vegetable garden).

– GDP also says nothing about the distribution of income.

– However, GDP does help us achieve a good life. Nations with larger GDP generally have better education and better health care.

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Principles of Macroeconomics – 8th edition

Conclusion • •

This chapter discussed how the total income of a nation is measured.

It is necessary to acknowledge the importance of just measuring GDP.

Adjunct teaching tips and warm-up activities 1

2

Take a poll of your students to see how many have heard of GDP or have read or heard news stories about GDP growth. Have a contest and see which student can come closest in guessing the level of GDP for Australia in 2018. Do the same for GDP growth.

Refer to Table 5.3 describing a hypothetical economy that produces burgers and salads. Have a contest to determine which of your students can invent the cleverest hypothetical economy. You may do this in groups or as individuals, in class, or as a take-home assignment. The nation should be named and three goods or services identified as the products of the economy, with their respective prices. Use the winning example to demonstrate the calculation of nominal GDP, real GDP and the GDP deflator.

Check your understanding solutions LO5.1 The economy’s income and expenditure: Q. What two things does gross domestic product measure? How can it measure two things at once?

A: Gross domestic product measures two things at once: (1) the total income of everyone in the economy; and (2) the total expenditure on the economy’s output of goods and services. It can measure both of these things at once because income must equal expenditure for the economy as a whole.

LO5.2 The measurement of gross domestic product: Q. Which contributes more to GDP – the production of a tonne of wool or the production of a tonne of iron ore? Why?

A: The production of a tonne of iron ore contributes more to GDP than the production of a tonne of wool because the contribution to GDP is measured by market value and the price of a tonne of iron ore is much higher than the price of a tonne of wool.

LO5.3 The components of GDP Q: What are the four components of expenditure? Give an example of each.

A: The four components of expenditure are: (1) consumption; (2) investment; (3) government purchases; and (4) net exports. Examples of these include: 1) A family lunch bought from Burger Hut 2) Bega company buying a new factory 3) RAAF’s purchase of new jet fighters 4) Qantas buying aeroplane from Airbus.

LO5.4 Real versus nominal GDP Q: Define real and nominal GDP. Which is a better measure of economic wellbeing?

Why? Given the GDP deflator, if nominal GDP doubles and real GDP remain constant, what has happened to the price level?

A: Nominal GDP is the production of goods and services valued at current prices. Real GDP is the production of goods and services valued at constant prices. Real GDP is a better measure of economic wellbeing because it reflects the economy’s ability to satisfy people’s needs and desires. Thus a rise in real GDP means people have produced more goods and services, but a rise in nominal GDP could occur either because of increased production or because of higher prices.

Therefore, if nominal GDP doubles and real GDP remains constant, this means that the price level has doubled.

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LO5.5 GDP and economic wellbeing Q: Why should policymakers care about GDP? Why should they also consider other measures of wellbeing?

A: Although GDP is not a perfect measure of wellbeing, policymakers should care about it because a larger GDP means that a nation has the ability to provide better health care, better educational systems and more of the material necessities of life. Other measures of wellbeing should also be considered as the GDP does not take into account leisure (which also contributes to quality of life), quality of the environment and the value of all activities that take place outside of markets.

Case study solutions Real GDP over recent history: 1. Based on your understanding of real GDP, briefly list three reasons why Australia’s real GDP has almost quadrupled since 1970?

A:    

Figure 5.3 shows quarterly data on real GDP for Australia since 1970.

We can see that real GDP has increased over time. Real GDP in 2015 was almost four times its 1970 level.

We can also see that GDP does not grow at a steady rate. There are times when real GDP declines. These periods are called recessions.

Figure 5.3 also shows that there has been no decline in GDP growth since 1992, a much longer period of growth than in the past.

GNI, life expectancy and literacy 1. Why is it useful to compare the real GNI per person across different countries?

A: Rich and poor countries have different levels of GDP per person. We can expect countries with a large GDP to have a higher standard of living, and these will be strongly correlated with measures of the quality of life.

2. Compare and contrast real GNI per person to the other measures in Table 5.4. Do you think real GNI per person a good measure of economic wellbeing based on your findings?

A: From Table 5.4, we can observe that countries with higher real GNI per person will have a higher life expectancy as well as a higher value for the mean years of schooling. This indicates that GNI per person is a relatively good measure of economic wellbeing.

Practice questions solutions Questions for review 1 2

3 4 5

An economy’s income must equal its expenditure since every transaction has a buyer and a seller.

Expenditure by buyers equals income by sellers.

Whether the production of a tonne of wheat or the production of a tonne of coal contributes more to GDP depends on which product has a higher market value. The product with a higher market value per tonne contributes more to GDP. The contribution to GDP is $6, the market value of the cheese, which is the final good that is sold.

The sale of a vintage car doesn’t affect GDP at all because it involves no current production.

The four components of GDP are consumption (such as the purchase of a music CD), investment (such as the purchase of a computer by a business), government purchases (such as the purchase of military aircraft) and net exports (such as the sale of Australian wine to Britain less the import of French champagne to Australia).

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6

Nominal GDP in 2020 is ($9.50×200) = $1900; in 2021 nominal GDP is ($12.75×250) = $3187.50.

Real GDP in 2020 is ($9.50×200) = $1900; real GDP in 2021 is ($9.50×250) = $2375. The GDP deflator in 2020 is ($1900/$1900)×100 = 100. The GDP deflator in 2021 is (3187.50/2375.00)×100 = 134. Nominal GDP increased by 67.8%, real GDP increased by 25% and the GDP deflator by 34%.

It is desirable for a country to have a large GDP because people could enjoy higher expenditures.

But GDP isn’t the only important measure of wellbeing. For example, laws that restrict pollution cause GDP to be lower. If laws against pollution were eliminated, GDP would be higher but the pollution might make us worse off. Or, for example, an earthquake would raise GDP, as expenditures on clean-up, repair and rebuilding increase. But an earthquake is an undesirable event that lowers our welfare.

Multiple choice 1. c 2. a 3. c 4. b 5. a

Problems and applications 1 a

2 3

4

5

6

Household expenditure increases, i.e. consumption increases. By convention, such durable goods are still classed as consumption. b The purchase of a new iPad would increase the consumption component of GDP. It is a purchase of a final good in the year it is produced. c Assuming the Rio was produced last year, selling it this year would cause the firm’s inventory investment to decrease and household expenditures to increase (cancelling out). This avoids counting the car twice for GDP over two years. d The purchase of a bus ticket would increase the consumption component of GDP. It is a purchase of a final service. e A new light rail system is part of government expenditure (public good), hence government purchases increase. f Wine is a consumption good, hence consumption increases. g Shutting down a factory reduces the level of (inventory) investment in the economy.

Household consumption increases.

With transfer payments, nothing is produced, so there is no contribution to GDP. Money is being transferred from the government to households with no exchange of goods or services.

Purchases of new housing are included in the investment portion of GDP because housing lasts for a long time. For the same reason, purchases of new refrigerators could be thought of as investment, but by convention, they are not. The logic could apply to any durable good, such as household appliances. However, the lifetime of housing is much greater than other household goods and for this reason it is counted as investment.

Given that GDP ideally measures the value of all final goods and services produced in an economy over a year, GDP should include the value of volunteer work. This should also make GDP a better measure of economic wellbeing as these services are now included.

2017/18 is the current base year. It is updated to reflect changes in the composition of goods, sizes and quality of said products over time.

Year Nominal GDP (in millions) GDP deflator (base year 2011) 2018 $1 687 453 99.5 2019 $1 715 321 99 a The growth rate of nominal income is ($1 715 321 – $1 687 453 / $1 687 453 x 100 per cent = 1.65 per cent. b The growth rate of the deflator is (99 – 99.5) / 99.5 x 100 per cent = -0.5 per cent. c Real income in 2018 measured in 2011 prices is $1 687 453 / (99.5/100) = $ 1 696 932. d Real income in 2019 measured in 2011 prices is $1 732 647 e The growth rate of real income is 2.10% 0509 Copyright 2021 Cengage Learning Australia Pty Limited

Principles of Macroeconomics – 8th edition

f

The growth rate of nominal income is lower than the growth rate of real income because of deflation.

7 Since the impact of rising prices is removed when reporting real GDP, economists prefer to look at real GDP instead of nominal GDP as a measure of economic wellbeing. Higher prices means nominal GDP and people’s incomes will increase. However, it does not mean that the quantity of goods and services has increased or that people are able to purchase more goods and services.

8 Many possible answers. ABS website, http://www.abs.gov.au reports the latest quarterly GDP data.

Up to the March Quarter 2020 the Australian GDP decreased modestly, held back by declines in net exports, consumption and investments in total dwellings.

9 To tell if the mining company is better off, you’d need to know if the prices of the goods it buys have increased by more or by less than the prices of the goods it sells.

10 GDP per capita is a better measure of economic wellbeing, as it implies that households in Norway can afford to consume more goods and services than households in Japan. Nonetheless, it is not a perfect measure of wellbeing. Other indicators such as health and the environment also contribute to wellbeing as GDP does not capture them well.

11 a In countries like India, people produce and consume illegal drugs that are not included in GDP. So GDP per person in India and in Australia will differ by more than their comparative economic wellbeing. Any comparison needs to keep in mind the shortcomings of real GDP as a measure of wellbeing. b Given the black market involves transactions that include final goods and services, then ideally they should be included. GDP does not distinguish between expenditures on goods and services that are harmful (e.g. cigarettes, sugar-laden soft-drinks) from those that are beneficial (food).

Illegal trade could still have negative effects however – houses used to cook meth, for example, may become too contaminated to live in and this should be measured as a reduction in investment. c The fact that developing countries have much larger underground economies than developed suggests that their economic wellbeing is underestimated. Many more goods and services are being produced in these countries that are not being counted.

12 a GDP measures the market value of goods and services and since not all goods and services are sold on the market, GDP will not reflect all goods and services provided in the economy. b In this way, information such as greenhouse gas emissions can be used to examine the impact of climate change on GDP. Since climate change affects resource availability negatively by way of increased exposure to forest fires, drought, floods and environment stress, including greenhouse gas emissions, it would lower GDP. 13 a The increased labour-force participation of women has increased GDP in Australia, since it means more people are producing goods and services. b If our measure of wellbeing included time spent working in the home and taking leisure, it wouldn’t rise as much as GDP, since the rise in women’s labour-force participation has reduced time spent working in the home and taking leisure. c Other aspects of wellbeing that are associated with the rise in women’s increased labour-force participation include increased self-esteem and prestige for women in the workforce, especially at managerial levels, but decreased time spent with children, although quality time could increase. Such aspects would be quite difficult to measure. d An increase in the number of fathers staying at home would decrease labour-force participation and hence decrease GDP. This change could offset some of the increase arising from the increase in female participation.

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Principles of Macroeconomics – 8th edition

Chapter 6 Measuring the cost of living Learning objectives After reading this chapter, students should be able to: • learn how the consumer price index (CPI) is constructed • consider why the CPI is an imperfect measure of the cost of living • compare the CPI and the GDP deflator as measures of the overall price level • see how to use a price index to compare dollar figures from different times • learn the distinction between real and nominal interest rates.

Key points •

•

•

• • •

The consumer price index shows the cost of a basket of goods and services relative to the cost of the same basket in the base year. The index is used to measure the overall level of prices in the economy. The percentage change in the price level from one period to the next measures the inflation rate.

The consumer price index is an imperfect measure of the cost of living for three reasons. First, it does not take into account consumers’ ability to substitute towards goods that become relatively cheaper over time. Second, it does not take into account increases in the purchasing power of a dollar due to the introduction of new goods. Third, it is distorted by unmeasured changes in the quality of goods and services. Because of these measurement problems, the CPI overstates annual inflation by about 1 percentage point.

Although the GDP deflator also measures the overall level of prices in the economy, it differs from the consumer price index because it includes goods and services produced rather than goods and services consumed. As a result, imported goods affect the consumer price index but not the GDP deflator. In addition, while the consumer price index uses a fixed basket of goods, the GDP deflator automatically changes the group of goods and services over time as the composition of GDP changes.

Dollar figures from different points in time do not represent a valid comparison of purchasing power. To compare a dollar figure from the past to a dollar figure today, the older figure should be inflated using a price index.

Various laws and private contracts use price indexes to correct for the effects of inflation. The tax laws, however, are only partially indexed for inflation.

A correction for inflation is especially important when looking at data on interest rates. The nominal interest rate is the interest rate usually reported; it is the rate at which the number of dollars in a savings account increases over time. By contrast, the real interest rate takes into account changes in the value of the dollar over time. The real interest rate equals the nominal interest rate minus the rate of inflation.

Chapter outline Introduction •

This chapter examines how economists measure the overall cost of living, including how the consumer price index is constructed and how we use such a price index to compare dollar figures from different points in time.

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Principles of Macroeconomics – 8th edition

The consumer price index • 

Consumer price index (CPI): a measure of the overall cost of the goods and services bought by a typical consumer.

FYI: The change to decimal currency. Discusses the change to decimal currency in 1966, the potential names for the new currency and the challenge of converting old currency (based on pounds) to dollars. Despite fears that the changeover would be costly (the money supply has to be replaced with new notes and coins) and possibly inflationary, the switch was made with little fuss.

How the consumer price index is calculated See text Table 6.1 • Fix the basket.

– The Australian Bureau of Statistics uses survey of metropolitan households to determine a representative bundle of goods and services purchased by a typical consumer.

– Example: six coffees and eight muffins.

• Find the prices.

– Prices for each of the goods and services in the basket must be determined for each time period.

– Example: Year Price of coffees Price of muffins 2020 $5.00 $5.00 2021 $6.25 $6.50 2022 $7.50 $7.75 • Compute the basket’s cost.

– By keeping the basket the same, only prices are being allowed change. This allows us to isolate the effects of price changes over time.

– Example:  Cost in 2020 = ($5.00 × 6) + ($5.00 × 8) = $70.00.  Cost in 2021 = ($6.25× 6) + ($6.50 × 8) = $89.50  Cost in 2022= ($7.50 × 6) + ($7.75 × 2) = $107.00 Again, it is very important that students understand where all of these numbers come from. Students often have a difficult time recreating the steps taken in class without the instructor’s help.

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ALTERNATIVE CLASSROOM EXAMPLE 1 Fix the basket: three footballs and four basketballs.

2 Find the prices: Year Price of footballs Price of basketballs Year 1 $10 $12 Year 2 12 15 Year 3 14 18 3 Compute the cost of the basket: Cost in Year 1 = (3 × $10) + (4 × $12) = $78 Cost in Year 2 = (3 × $12) + (4 × $15) = $96 Cost in Year 3 = (3 × $14) + (4 × $18) = $114 4 Using Year 1 as the base year, compute the index: CPI in Year 1 = ($78 / $78) × 100 = 1 × 100 = 100 CPI in Year 2 = ($96 / $78) × 100 = 1.2308 × 100 = 123.08 CPI in Year 3 = ($114 / $78) × 100 = 1.4615 × 100 = 146.15 5 Compute the inflation rate: Inflation rate for Year 2 = [(123.08 – 100) / 100] × 100 per cent = 23.08 per cent Inflation rate for Year 3 = [(146.15 – 123.08) / 123.08] × 100 per cent = 18.74 per cent

•

Choose a base year and compute the index.

– The base year is the benchmark against which other years are compared.

– The formula for calculating the price index is:

 cost of basket in current year  CPI =    100  cost of basket in base year  –

Example (using 2020 as the base year):  CPI for 2020 = ($70.00) / ($70.00) × 100 = 100.  CPI for 2021 = ($89.50) / ($70.00) × 100 = 128.  CPI for 2022 = ($107) / ($70.00) × 100 = 153.

Point out that the CPI must be equal to 100 in the base year.

•

Compute the inflation rate.

– Inflation rate: the percentage change in the price index from the preceding period.

Make sure that you explain that inflation does not mean that the prices of all goods in the economy are rising. Inflation means that prices on average are rising. In fact, prices of electronic goods (such as computers) have fallen in recent years.

–

The formula used to calculate the inflation rate is:

 CPI Year 2 - CPI Year 1    100% inflation rate =  CPI Year 1   –

Example:  Inflation rate for2021 = (128 – 100) / 100 × 100 per cent = 28 per cent.  Inflation rate for 2022 = (153 – 128) / 128 × 100 per cent = 20 per cent.

Be sure to point out to students that it is possible for the CPI to fall if deflation is present. Point out to students that even though they have not experienced deflation in their lifetimes, it has occurred during several periods of Australian history and recently in Japan.

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Principles of Macroeconomics – 8th edition

•

Another important price index: the producer price index – Producer price index: a measure of the cost of a basket of goods and services bought by firms.

– Because firms pass on higher costs to consumers in the form of higher prices on products, the producer price index is believed to be helpful in predicting changes in the CPI.

• FYI: What is in the CPI’s basket?

See text Figure 6.1 • Figure 6.1 shows the make-up of the market basket used to compute the CPI. • The largest category is housing, which makes up 23 per cent of a typical consumer’s budget, followed by food and non-alcoholic beverages at 16 per cent and recreation and culture at 13 per cent.

One way to highlight this is to draw the pie chart on the board without the category names and let the students decide what goes where.

Problems in measuring the cost of living 

In the news: What happens when prices don’t go up very much?

-

See Figure 6.2 Australia inflation running below target range

-

See Figure 6.3 Core inflation: US, Japan, Eurozone & China

•

•

•

• • •

See Figure 6.4 RBA inflation forecasts risk losing credibility Substitution bias – When the price of a good changes, consumers often respond by substituting another good in its place.

– The CPI does not allow for this substitution; it is calculated using a fixed basket of goods and services.

– This implies that the CPI overstates the increase in the cost of living over time.

Introduction of new goods – When a new good is introduced, consumers have a wider variety of goods and services to choose from.

– This makes every dollar more valuable, which means that there is an increase in the purchasing power of the dollar.

– Because the market basket is not revised often enough, these new goods are left out of the bundle of goods and services included in the basket.

Unmeasured quality change: – If the quality of a good falls from one year to the next, the value of a dollar falls; if quality rises, the value of the dollar rises.

– Attempts are made to correct prices for changes in quality, but it is often difficult to do so because quality is hard to measure.

The size of these problems is also difficult to measure.

The issue is important because many government transfer programs (such as Social Security) are tied to increases in the CPI. Most studies indicate that the CPI overstates the rate of inflation by between 0.5 to 2.0 percentage points per year.

The GDP deflator versus the consumer price index • •

The GDP deflator reflects the prices of all goods produced domestically, while the CPI reflects the prices of all goods bought by consumers.

The CPI compares the prices of a fixed basket of goods over time, while the GDP deflator compares the prices of the goods currently produced to the prices of the goods produced in the base year. This means that the group of goods and services used to compute the GDP deflator changes automatically over time as output changes.

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Principles of Macroeconomics – 8th edition

See text Figure 6.5 • Figure 6.5 shows the inflation rates calculated using the CPI and the GDP deflator, demonstrating they tend to move together.

Correcting economic variables for the effects of inflation Dollar figures from different times To change dollar values from one year to the next, we can use this formula:

 Price level in Year 2  Value in Year 2 dollars = Value in Year 1 dollars     Price level in Year 1  •

Example: Phar Lap’s 1930 winnings in 2016 dollars: Winnings in 2016 dollars = winnings in 1930 dollars × price level in 2016 price level in 1930 Winnings in 2013 dollars = $19 000 × (109.4 / 42.7). = $769 500.

Indexation • • •

Indexation: the automatic correction of a dollar amount for the effects of inflation by law or contract.

As mentioned above, many government transfer payment programs use indexation for the benefits.

There are uses of indexation in the private sector as well. Some wage contracts include Cost-ofLiving-Allowances (COLAs).

Real and nominal interest rates Use an example to make the importance of real interest rates clear. Suppose a student has $100 in his savings account earning 3 per cent interest. Ask students what will happen to the purchasing power of that money if prices rise 3 per cent during the year.

Then, change the inflation rate to 5 per cent and then 1 per cent and go through the example again.

• •

Nominal interest rate: the interest rate as usually reported without a correction for the effects of inflation.

Real interest rate: the interest rate corrected for the effects of inflation.

real interest rate = nominal interest rate - inflation rate See text Figure 6.6 • Figure 6.6 shows real and nominal interest rates from 1970. The difference between the two interest rates indicates the extent of inflation. For example, in the 1970s and 1980s inflation was much higher than in the 1990s. Note that nominal and real interest rates do not always move together.

• In the news: Mr Index goes to Hollywood.

– Reports of box office success are often made in terms of the dollar values of ticket sales.

– These ticket sales are then compared with ticket sales of movies in the past.

– However, no corrections for changes in the value of a dollar are made.

– A table of the top 20 films with the estimated box office gross in 2010 dollars reveals the winner to be Gone with the Wind.

ALTERNATIVE CLASSROOM EXAMPLE Your father graduated from school and took his first job in 1972, which paid a salary of $7000.

What is this salary worth in 1999 dollars?

CPI in 1972 = 41.8 CPI in 1999 = 166 Value in 1999 dollars = 1972 salary × (CPI in 1999 / CPI in 1972) Value in 1999 dollars = $7000 × (166 / 41.8) = $7000 × 3.97 = $27,790 0605 Copyright 2021 Cengage Learning Australia Pty Limited

Principles of Macroeconomics – 8th edition

Conclusion 

This chapter discussed how economists measure the overall level of prices in the economy and how they use price indexes to correct economic variables for the effects of inflation

Adjunct teaching tips and warm-up activities 1

2

Have students ask their parents (or grandparents) how much they paid for their first car and in what year they bought it. (If there are older students in the class, ask them to remember how much they paid for their first car.) Students can then determine how much they would have to pay in current dollars using the consumer price index.

Ask for a volunteer to search the Internet to find out average medical care prices for the past 20 to 50 years. Make a graph and compare the rising medical prices with rising prices in general using the CPI for the same period.

Check your understanding solutions LO6.3 The GDP deflator versus the consumer price index Q: Explain briefly what the consumer price index is trying to measure. How does the consumer price index differ from the GDP deflator?

A: The consumer price index tries to measure the overall cost of the goods and services bought by a typical consumer. The difference between the CPI and the GDP deflator is that the GDP deflator reflects the prices of all goods and services produced domestically, whereas the CPI reflects the prices of all goods and services bought by consumers. The CPI compares the price of a fixed basket of goods and services with the price of the basket in the base year. The ABS changes the basket of goods every four to five years. The GDP deflator compares the price of currently produced goods and services with the price of the same goods and services in the base year. Therefore the group of goods and services automatically change over time.

LO6.5 Real and nominal interest rates Q: If the real interest rate is 3.5 per cent and the nominal interest rate is 5 per cent, what is the inflation rate?

A: 3.5=5 minus inflation rate. Therefore, the inflation rate is 1.5 per cent.

Practice questions solutions Questions for review 1

2

3

4

An 8 per cent increase in the price of electricity has a greater effect on the consumer price index than an 8 per cent increase in the price of an iPhone because electricity is a bigger part of the average consumer’s basket.

The three problems in the consumer price index as a measure of the cost of living are: (1) substitution bias, which arises because people substitute toward goods that have become relatively less expensive; (2) the introduction of new goods, which are not reflected quickly in the CPI; and (3) unmeasured quality change.

If the price of a Royal Australian Navy submarine jet rises, there is no effect on the consumer price index, since submarines aren’t consumer goods. But the GDP deflator is affected, since Royal Australian Navy submarines are included in GDP. The GDP deflator reflects the price of all goods and services produced domestically.

A government official deciding on how much to increase pensions would use the CPI as a measure of inflation. A businesswoman trying to decide on a 10-year investment in manufacturing in Australia would use the PPI instead of the CPI, because the PPI measures the cost of a basket of 0606 Copyright 2021 Cengage Learning Australia Pty Limited

Principles of Macroeconomics – 8th edition

5

goods and services purchased by firms, whereas the CPI measures the cost of a basket of goods and services purchased by a typical consumer that includes the pensioner.

The nominal interest rate is the rate of interest paid on a loan in dollar terms. The real interest rate is the rate of interest corrected for inflation. The real interest rate is the nominal interest rate minus the rate of inflation.

Multiple choice 1. c

2. c

3. d

4. a

5. a

Problems and applications The price of computers increases 20 per cent [= ($24 – $20) / $20 x 100 per cent]; the price of sushi increases 37 per cent [= ($240 – $175) / $175 x 100 per cent]; the price of Boost Juice increases 11.11 per cent [= ($5 – $4.50) / $4.50 x 100 per cent].

To find the percentage change in the overall price level, follow these steps: i Determine the fixed basket of goods: 100 computers, 10 sushi, 200 Boost Juice. ii Find the price of each good in each year:

1

a

2

Year Computers Sushi Boost Juice 2020 $20 $175 $4.50 2021 $24 $240 $5 iii Compute the cost of the basket of goods in each year: 2020 = $4650 2021 = $5800 iv Choose one year as a base year (2020) and compute the CPI in each year: 2020: $4650/ $4650 x 100 = 100 2021: $5800 / $4650 x 100 = 124.7 v Use the CPI to compute the inflation rate from the previous year: 24.7per cent b Sushi is more expensive relative to Boost Juice, since their price rose 37 per cent while the price of Boost Juice rose 11.11 per cent. The wellbeing of some people changes relative to the wellbeing of others. Those who purchase a lot of sushi become worse off relative to those who purchase a lot of Boost Juice and computers.

To find the percentage change in the overall price level, follow these steps: i

3

Find the price of each good in each year:

Year Cauliflower Broccoli Carrots 2020 $1.33 $2.40 $0.15 2021 $3.33 $2.50 $0.25 ii Compute the cost of the basket of goods in each year: 2020: (75 x $1.33) + (50 x $2.4) + (600 x $.15) = $310 2021: (60 x $3.33) + (60 x $2.5) + (600 x $0.25) = $500 iv Choose one year as a base year (2020) and compute the CPI in each year: 2020: $310 / $310 x 100 = 100 2021: $500 / $310 x 100 = 161.29 v Use the CPI to compute the inflation rate from the previous year: (161.29 –100) / 100 x 100 per cent = 61.29 per cent Since the CPI rose 2600 per cent, that means [CPI (2016) – CPI (1950)] / CPI (1950) x 100 per cent = 2600 per cent, so CPI (2016) / CPI (1950) –1 = 26, so CPI (2016) / CPI (1950) = 27. So if an item costs under 27 times as much in 2016 than it did in 1950, then it’s relatively less expensive. The easiest way to see this is to take the 1950 price, multiply it by 27 and compare it to the 2016 price.

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A day at the cricket: =$6.75 < $76, so the 2016 cost is higher.

Woman’s Day magazine: = $1.35 < $4.40, so the 2016 cost is higher.

Orange marmalade: = $3.24 < $6.95, so the 2016 cost is higher.

A Holden sedan: = $18,900 < $42,000, so the 2016 cost is higher.

Sending a package by air from Sydney to the UK: = $34.56 > $11.20, so the 2016 cost is lower.

4 The decrease in the price of using taxis and the increased use of Uber means that taxis should have a lower weight in the consumer basket of goods used to calculate the CPI. Uber should be included.

An adjustment for decreased quality in the product, if Uber provides a poorer or less safe service, might also have to be made.

5 a introduction of new goods b unmeasured quality change c substitution bias d unmeasured quality change e substitution bias 6 a ($2.50 – $0.05) / $0.05 x 100 = 4900 per cent. b ($45.00 – $3.35) / $3.35 x 100 = 1243.28 per cent. c In 1970: $0.05 / ($3.35/60) = 0.9 minutes. In 2016: $2.50 / ($45/60) = 3.33 minutes. d Workers’ purchasing power fell in terms of newspapers.Note the wage estimates set out in the text are incorrect and reflect the wage rates that applied in the US. 7 a Lack of indexing decreases the value of fixed incomes such as pensions. If there is no indexing, real income decreases as prices increase. Need to consider if residing in Australia is worthwhile.

Lack of indexing requires retirement funds to be invested to receive a return greater than the rate of inflation. b Australia’s rate of inflation is 2 per cent less than the rate in the United Kingdom. If the pension received from the United Kingdom is indexed, a British citizen residing in Australia is better off. c Since the elderly consume more health care than younger people and since health care costs have risen faster in Australia than in the UK, it’s possible that the elderly in Australia are worse off. To investigate this, you’d need to put together a market basket for the elderly, which would have a higher weight on health care. You’d then compare the rise in the cost of the ‘elderly’ basket with that of the general basket for CPI. Adjustments would need to be made for the proportion of health care costs covered by Medicare benefits as compared with private health insurance benefits and out-of-pocket expenses.

8 a When inflation is lower than expected, the real interest rate is higher than expected. For example, suppose the market equilibrium has an expected real interest rate of 3 per cent and people expect inflation to be 4 per cent, so the nominal interest rate is 7 per cent. If inflation turns out to be 2 per cent, the real interest rate is 7 per cent minus 2 per cent equals 5 per cent. b Since the real interest rate is higher than was expected, the lender gains and the borrower loses. c During the Global Financial Crisis, homeowners who had fixed-rate mortgages in the mid-2000s lost from paying higher real interest rates while the banks who made the mortgages benefitted from the lower than expected inflation rate. d If high inflation is expected, it would be best to fix the mortgage rate provided the difference between the fixed rate and the variable rate is less than the expected rate of inflation.

9 Lower inflation means that the real interest rate should be relatively lower. This means that fixed-rate mortgages will not change in response to the interest rate and it will therefore be a disadvantage compared to having a variable rate mortgage. (This is assuming the variable rate is lower than the fixed rate). The banks who lent them this fixed rate will be the winners in this scenario.

10 a With a nominal interest rate of 1.5 per cent and inflation of 1 per cent, the real interest rate is: 1.5 per cent – 1 per cent = 0.5 per cent. With a tax rate of 37 per cent, the after-tax real interest rate is [1.5 per cent – (1.5 per cent x 0.37)] – 1 per cent = -0.055 per cent. The effective tax rate

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on real interest income is (1.5 per cent – -0.55 per cent) / 1.5 per cent x 100 per cent = 103.67 per cent. b With a nominal interest rate of 3 per cent and inflation of 3 per cent, the real interest rate is 0 percent. With a tax rate of 37 per cent, the after-tax real interest rate is -1.11 per cent. The effective tax rate on real interest income is 137%. c Inflation discourages saving by interacting with the tax system to increase the tax rate on interest income.

11 Bracket creep occurs when inflation increases people’s nominal incomes, pushing them into higher tax brackets, so they have to pay a higher proportion of their incomes in taxes, even though they aren’t getting higher real incomes. As a result, real tax revenue rises.

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Chapter 7 Production and growth Learning objectives After reading this chapter, students should be able to: • understand economic growth around the world • understand the role of productivity and its determinants • examine economic growth and public policy.

Key points •

• •

•

Economic prosperity, as measured by GDP per person, varies substantially around the world. The average income in the world’s richest countries is more than 10 times that in the world’s poorest countries. Because growth rates of real GDP also vary substantially, the relative positions of countries can change dramatically over time.

The standard of living in an economy depends on the economy’s ability to produce goods and services. Productivity, in turn, depends on the amounts of physical capital, human capital, natural resources and technological knowledge available to workers.

Government policies can influence the economy’s growth rate in many ways – encouraging saving and investment, encouraging investment from abroad, fostering education, health and nutrition, maintaining property rights and political stability, allowing free trade, controlling population growth and promoting the research and development of new technologies.

The accumulation of capital is subject to diminishing returns – the more capital an economy has, the less additional output the economy gets from an extra unit of capital. Because of diminishing returns, higher saving leads to higher growth for a period of time, but growth eventually slows down as the economy approaches a higher level of capital, productivity and income. Also because of diminishing returns, the return on capital is especially high in poor countries. Other things being equal, these countries can grow faster because of the catch-up effect.

Chapter outline Introduction •

In this chapter, we look at the forces that determine quantities and prices, focussing on the long-run determinates of both the level and the growth rate of GDP. Firstly, the international data on real GDP per person is examined. Then, the role of productivity is explored and thirdly, the link between productivity and the economic policies that a nation pursues is addressed.

Economic growth around the world See text Figure 7.1 • The figure shows economic prosperity varies greatly. Western Europe, Japan, North America and Australasia have the highest levels. Per capita GDP is much lower in Sub-Saharan Africa.  Table 7.1,shows data on real GDP per person for 17 countries during different periods of time.  The data reveal the fact that living standards vary a great deal between these countries.  Growth rates are also reported in the table. Botswana has had the largest growth rate over the period 1950–2017, 6.5 per cent per year (on average).

Use Table 7.1 to make the point that a one percentage point change in a country’s growth rate can make a significant difference over several generations. The powerful effects of compounding should be used to underscore the process of economic growth.

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

•

Because of different growth rates, the ranking of countries by income per person changes over time.

In 1950, Japan’s income per person was close to that of Bangladesh’s. Today Japan’s income per person is close to that of Australia’s, while Bangladesh by contrast, has not experienced any growth.

FYI: The magic of compounding and the rule of 70.

– Compounding refers to the accumulation of a growth rate over a period of time.

– 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 cent per year. Bec lives in an economy where incomes grow at 3 per cent per year. Forty years later (when both are 62) Delta will be earning $45 000 and Bec will be earning $98 000.

– The rule of 70 can help us understand the effects of compounding: if a variable grows by x per cent per year, then that variable doubles in approximately 70 / x years.

– In Bec’s economy, incomes grow by 3 per cent per year, so it takes about 70 / 3, or 23 years for incomes to double.

Productivity: Its role and determinants Why is productivity so important?

•

• •

Example: Robinson Crusoe – Because he is stranded alone, he must catch his own fish, grow his own vegetables and make his own clothes.

– His standard of living depends on his ability to produce goods and services.

Productivity: the amount of goods and services produced for each hour of a worker’s time.

Review of Principle #8: A country’s standard of living depends on its ability to produce goods and services.

How is labour productivity determined?

• • •

•

Physical capital: the stock of equipment and structures that are used to produce goods and services.

– Example: Crusoe will catch more fish if he has more fishing poles.

Human capital: the knowledge and skills that workers acquire through education, training and experience.

– Example: Crusoe will catch more fish if he has been taught the best fishing techniques.

Natural resources: the inputs into the production of goods and services that are provided by nature, such as land, rivers and mineral deposits.

– Example: Crusoe will have better luck catching fish if there is a plentiful supply around his island.

Technological knowledge: society’s understanding of the best ways to produce goods and services.

– Example: Crusoe will catch more fish if he has figured out the best places on the island to fish.

The production function • •

A production function describes the relationship between the quantity of inputs used in production and the quantity of output from production.

The production function generally is written like this:

Y = A F(L, K, H, N)

•

where Y = output, L = labour, K = physical capital, H = human capital, N = natural resources, A reflects the available production technology and F ( ) is a function that shows how inputs are combined to produce output.

Many production functions have a property called constant returns to scale.

– This property implies that as all inputs are doubled, output will exactly double.

– This implies that the following must be true: 𝑥𝑌 = 𝐹(𝑥𝐿, 𝑥𝐾, 𝑥𝑁, 𝐻, 𝐴) where x = 2 if inputs are doubled.

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–

This also means that if we want to examine output per worker we could set x = 1/L and we would get the following: 𝑌 𝐾 𝑁 = 𝐹(1, , , 𝐻, 𝐴) 𝐿 𝐿 𝐿 This shows that output per worker depends on the amount of physical capital per worker (K / L), human capital (H), society’s technology (A) and the amount of natural resources per worker (N / L).

Economic growth and public policy Ask students what factors they believe will lead to economic growth in the future.

The importance of saving and investment •

Because capital is a produced factor of production, a country can change the amount of capital that it has.

• However, there is an opportunity cost of doing so; if resources are used to produce capital goods, fewer goods and services are produced for current consumption.

See text Figure 7.2 • Figure 7.4 shows economic growth rates and investment levels of 18 countries for 1950 to 2017.

– Countries that devote a large share of GDP to investment tend to have high growth rates.

– Of course, from the data given it is difficult to determine cause and effect.

Diminishing returns to physical capital and the catch-up effect •

•

Diminishing returns: the property whereby the benefit from an extra unit of an input declines as the quantity of the input increases.

– As the capital stock rises, the extra output from an additional unit of capital will fall.

– Thus, if workers already have a large amount of capital to work with, giving them an additional unit of capital will not increase their productivity by much.

An important implication of diminishing returns is the catch-up effect.

– Catch-up effect: the property whereby countries that start off poor tend to grow more rapidly than countries that start off rich.

– When workers have very little capital to begin with, an additional unit of capital will increase their productivity by a great deal.

– This helps explain why (referring to Figure 7.4) Japan had a growth rate more than two times larger than Australia even though both countries devoted a similar share of GDP to investment.

– However, in the long-run a higher saving (and investment) rate leads to a higher level of productivity and income, but not higher growth in these variables

Investment from abroad • •

• •

Saving by domestic residents is not the only way for a country to invest in new capital.

Investment in the country by foreigners can also occur.

– Foreign direct investment occurs when a capital investment is owned and operated by a foreign entity.

– Foreign portfolio investment occurs when a capital investment is financed with foreign money.

Some of the benefits of foreign investment flow back to foreign owners. But the economy still experiences an increase in the capital stock, which leads to higher productivity and higher wages.

The World Bank is an organisation that tries to encourage the flow of investment to poor countries.

Education •

•

Investment in human capital also has an opportunity cost.

– When students are in class, they cannot be producing goods and services for consumption.

– In less-developed countries this opportunity cost is considered to be high; as a result, children often drop out of school at a young age.

Because there are positive externalities in education, the effect of lower education on the economic growth rate of a country can be large.

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•

Many poor countries also face a ‘brain drain’ – the best educated often leave to go to other countries where they can enjoy a higher standard of living.

Health and nutrition • • • •

Investing in the health of the population provides a way for a nation to increase productivity and raise living standards.

Other things equal, healthier workers are more productive.

Although malnutrition is rare in developed nations, for people in developing nations, poor health and inadequate nutrition can be obstacles to higher productivity.

Where malnutrition is a bigger risk in the poorer countries, studies have found that height is an indicator of productivity. Because a worker’s productivity reflects the wage he earns, researchers have found that taller workers tend to earn more.

Property rights markets, trust and political stability • • • 

Protection of property rights and promotion of political stability are two other important ways that policymakers can improve economic growth.

There is little incentive to produce products if there is no guarantee that they cannot be stolen.

Contracts must also be enforced.

Countries with questionable enforcement of property rights or an unstable political climate will also have difficulty in attracting foreign (or even domestic) investment.

Social trust is also positively associated with economic growth. Countries such as Australia and NZ tend to have high levels of social trust. Countries such as Russia and Brazil have lower levels.

Free trade • • • • • •

Some countries have tried to achieve faster economic growth by avoiding transacting with the rest of the world, so-called inward oriented policies.

However, we know that trade allows a country to specialise in what it does best and thus consume beyond its production possibilities.

When a country trades wheat for steel, it is as well off as it would be if it had developed a new technology for turning wheat into steel.

– So most economists believe countries are better off pursuing outward oriented policies.

The amount a nation trades is determined not only by government policy but also by geography.

In the news: The United Nation’s development goals. See Figure 7.3 – World leaders in September 2000 committed their nations to specific targets on eight key issues that perpetuate poverty, with a deadline of 2015, and these goals were known as the Millennium Development Goals.

– One of the goals is to halve world poverty by 2015.

– Recent estimates in 2010 suggest that this target has been met.

– A number of the other targets and progress are also reported on.

Discouraging excessive population growth •

• • • •

How does the number of people affect the amount of GDP per person? With returns to scale tangible inputs, physical capital and natural resources increase in proportion with the number of people, so the ratios K/L and N/L are unchanged. If the increases are not matched by proportional increases in capital and natural resources these factors are spread more thinly and the ratios K/L and N/L fall so Y/L falls.

Countries with high population growth rates also have a large number of school-age children, putting strains on the educational system.

Some countries have already instituted measures to reduce population growth rates.

Policies that foster equal treatment for women should raise economic opportunities for women leading to lower rates of population.

Population growth has decreased in virtually all developing countries, with improvements in income. World fertility has halved over the past six decades.

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•

However, excessively low fertility is a problem if it falls below the replacement rate of 2.1, as the population begins to shrink. This impacts on the sustainability of public finances, for as the population ages the proportion of retirees increases relative to taxpayers.

Research and development • • • • •

The primary reason why living standards have improved over time has been due to large increases in technological knowledge.

The Australian government promotes the creation of new technological information by providing research grants and providing tax incentives for firms engaged in research.

The patent system also encourages research by granting an inventor the exclusive right to produce the product for a specified number of years.

The patent system might also discourage innovation by wasting resources on expensive legal battles, or deter research areas where simultaneous discoveries are common.

In the news: Using experiments to evaluate aid and ignite prosperity – This study was undertaken on a large scale in Bangladesh. A control group of families got no aid for a year. Another group received aid of various kinds over one year.

– Unsurprisingly, the families that received aid for one year had lower poverty rates (and better nutrition and mental health).

– Surprisingly, this persisted after the aid was ceased. Aid could lead to durable and sustainable changes in poverty.

Start a class discussion of the trade-offs that are necessary to sustain economic growth. Point out that current consumption must be forgone for higher consumption in the future. Ask students to examine the trade-offs involved with each of the public policies discussed.

Conclusion: the importance of long-run growth 

Long-term growth is linked to increases in productivity.

– –

This can be encouraged by accumulation of physical and human capital.

Increasing technological knowledge is also a means to increase productivity.

Adjunct teaching tips and warm-up activities Before beginning this chapter, let groups of students select a developing country or newly industrialised country to research. Ask them to find out information about GDP, growth, productivity, imports and exports, etc. As the class progresses through this chapter, draw heavily from their countries for examples.

Check your understanding solutions LO7.1 Economic growth around the world Q: What has been the approximate annual growth rate of real GDP per person in Australia over the past half century? Before reading the rest of the chapter, can you suggest any possible explanations for the differences in growth rates between Australia and China over this period?

A: The approximate growth rate of real GDP per person in Australia is 2.0 per cent (from table 7.1).

Some possible explanations for the difference in China’s growth rate of 3.9 per cent compared to Australia’s 2.0 per cent include the productivity rate, which refers to the amount of goods and services produced for each hour of a worker’s time. Economic policies could also play a role.

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LO7.2 Productivity: Its role and determinants Q: What are the key determinants of labour productivity? Which one do you think is most important? Explain your reasoning A: The key determinants of labour productivity are: (1) physical capital, which is the stock of equipment and structures that are used to produce goods and services; (2) human capital, which is the knowledge and skills that workers acquire through education, training and experience; (3) natural resources, which are inputs into production that are provided by nature, such as land, rivers and mineral deposits; and (4) technological knowledge, which is the understanding of the best ways to produce goods and services.

Human capital and technological knowledge are most important as these improve the quality of the production inputs rather than just adding more inputs. These non-tangible inputs generate a positive externality.

LO7.3 Economic growth and public policy Q: If university education was fully paid for by the Australian government, what could this do to the level of human capital in Australia? Discuss the pros and cons A: This could increase the level of human capital, as this will encourage more people to acquire knowledge and skills through education training and experience. The pros of government-funded education are a better educated society; the cons include the cost of providing a free education.

Q: How can a country deal with brain drain? In order for governments of low-income countries to reduce this problem, they require the recipients of their scholarships in foreign countries to commit to returning home and working for the government for a certain number of years. What is your view of this arrangement?

A: This arrangement seems fair for both parties and provides a benefit to the low-income country of providing scholarships in foreign countries.

Q: What are some of the key factors that link health and nutrition to human capital?

A: Investing in the health of the population provides a way for a nation to increase productivity and raise living standards. Other things equal, healthier workers are more productive. Although malnutrition is rare in developed nations, for people in developing nations, poor health and inadequate nutrition can be obstacles to higher productivity.

Q: Describe the global trends in poverty over the past several decades. Find out more about the Sustainable Development Goals for the 2016-2030 period and discuss which of them you believe are likely to be achieved. Think about some specific ideas for how environmental sustainability can be enhanced globally A: Extreme poverty, the proportion living on less than $1.25 per day, was 836 million in 2015, a decline from 1.9 billion in 1990. This is a typically a result of rising incomes and the main way the poverty can be reduced further is to increase economic growth in the developing regions of the globe. Some ideas for environmental sustainability are to promote and incorporate policy in which corporations need to abide by and to educate society further on these issues.

Q: What is your view of immigration? How does immigration affect the economy? If you were the prime minister in your home country, how would you design the immigration system?

A: Many answers possible. Benefits of immigration may include increasing productivity and growth, while the costs may include increased competition for employment opportunities as well as being a burden on welfare benefits. The immigration system could be designed in a way to ensure that immigrants will contribute to an expanding workforce and increase productivity of the economy. For example, accept skilled workers or workers in a particular industry which is growing or has shortages in labour.

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Q: Why is research and development (R&D) important for long-run economic growth?

A: R&D is important as it advances technical knowledge and encourages innovation. These will affect labour productivity through increased human capital and technology and will in turn, promote economic growth in the long run.

Q: Refer to the previous article ‘What it takes to lift families out of poverty’. Do you think global aid works?

A: This study was undertaken on a large scale in Bangladesh. A control group of families got no aid for a year. Another group received aid of various kinds over one year. The families that received aid for one year had lower poverty rates (and better nutrition and mental health). Surprisingly, this persisted after the aid was ceased. Aid could therefore lead to durable and sustainable changes in poverty.

Case study solutions Are natural resources or global warming limits to growth?

1. Can technological progress reduce the effects of climate change?

A: As the population has grown over time, we have discovered ways to lower our use of natural resources. Technological progress has provided ways to enable growth to continue. Market prices do not indicate any problem with the supply of natural resources. Global warming also imposes constraints on the ability of economies to grow in the not so distant future unless the growth of energy consumption is limited. For example, it is estimated that if global energy consumption increases at a 2.3 per cent growth rate the laws of thermodynamics imply that we reach boiling temperature in 400 years.

The link between population growth and technological progress 1. What do you think are the pros and cons to the economy having a larger population?

A: The pros of a larger population are the possibility of a larger labour force and therefore a greater GDP. The cons include insufficient education and lack of human capital for very large populations. Rapid population growth may also depress economic prosperity by reducing the amount of capital each worker has.

2. Do you believe Michael Kremer’s prerequisite for having a larger population is valid?

A: The economist, Michael Kremer, argues that population growth has been an engine of technological progress. Technological progress is linked to larger populations as there are more people to discover things. This needs to also work in hand with human capital (education and training)

Practice questions solutions Questions for review 1

2

GDP per person measure’s a country’s standard of living through by looking at the economy’s total production, total income and its total expenditures on goods and services. The growth rate of GDP per person reflects economic growth and the economic prosperity and quality of life in a country. A higher GDP per person reflects higher standard of living in that country.

Productivity will determine a country’s standard of living. The four determinants of productivity are: (1) physical capital, which is the stock of equipment and structures that are used to produce goods and services; (2) human capital, which consists of the knowledge and skills that workers acquire through education, training and experience; (3) natural resources, which are inputs into production that are provided by nature; and (4) technological knowledge, which is the understanding of the best ways to produce goods and services. Human capital and technological

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knowledge are most important as these improve the quality of the production inputs rather than just adding more inputs. These non-tangible inputs generate a positive externality.

The opportunity cost of investing in physical capital is forgoing current consumption. It can be possible to overinvest. Diminishing returns to capital imply that eventually, the increase in GDP produced from the additional capital will be lower than its investment expenditure. The opportunity cost of investing in human capital is also reductions in current consumption (e.g. university students tend not to have a lot of current consumption). It is for the same reason as physical capital (diminishing returns) possible to over-invest in human capital.

Both returns to scale and returns to an input, describe the case where the quantity of an input (like physical capital) increases. The important difference is that for returns to scale, all the other inputs are changed by the same percentage. In the returns to an input, only the level of that input is changed. It is less likely to see decreasing returns to scale because first, the constraints on output caused by fixed levels of other inputs don’t operate.

Increasing the rate of immigration, assuming the migrants are in the workforce, can help to increase the level of GDP per person, because there would be a bigger workforce and any skill shortages could be alleviated. The educational level of immigrants will matter as this will determine how much they can contribute to the labour force. It may also be a cost to the economy if they need to be trained or educate when they arrive. With reference to the European migration crisis, governments must ensure the protection of all migrants. A coherent, long-term and comprehensive strategy that maximises the benefits of migration and minimises its human and economic costs should also be implemented.

The Australian government tries to encourage advances in technological knowledge via its direct funding of the Commonwealth Scientific and Industrial Research Organisation (CSIRO), by providing research grants through the Australian Research Council and the National Health and Medical Research Council, with tax breaks for firms engaging in research and development and through the patent system.

Multiple choice 1. c

2. d

3. c

4. a

Problems and applications 1

2

3

a

2015-2016 : (1230-1185)/1185*100= 3.79% 2016-2017: (1270-1230)/1230*100= 3.25% 2017-2018: (1285-1270)/1270*100= 1.18% 2018-2019: (1310-1285)/1285*100= 1.95% b Average annual economic growth rate = 2.54% It can be observed that the economic growth rate has slowed since 2017. An explanation could be due to diminishing returns to physical capital in more recent times. a More investment would lead to faster economic growth in the short run but not in the long run. b To be beneficial to future generations the investment should be in capital goods that increase the productive capacity of the economy. c The change would benefit many people in society who would have higher incomes as the result of faster economic growth. However, there might be a transition period in which workers and owners in consumption-goods industries would get lower incomes and workers and owners in investment-goods industries would get higher incomes. d Saving more now also means consuming less now, so even though the increased saving will lead to long-term benefits it may not enhance the politicians’ chances of re-election.

Today’s standard of living differs from those of our great-grandparents because of improved transportation, communications, entertainment, machinery for household work and computers, among other things. Whether the standard of living is higher in every regard depends on an individual – how relaxed or stressed one feels with daily life.

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a b

When a Japanese firm opens a factory in Australia, it represents foreign direct investment.

The investment increases Australia’s GDP since it increases production in Australia. The effect on Australian GNP would be smaller since the owners would get paid a return on their investment that would be part of Japan’s GNP rather than Australia’s GNP. Free trade can improve the economic wellbeing of a country’s citizens. It is in some way, a type of technology. The country will experience the same kind of growth that would occur after a major technological advance. The amount that a nation trades with others is determined by government policy and geography. a If governments everywhere decrease the number of years a patent lasts, then all countries would be equally attractive for investment. b A reduction in the number of years the patent lasts could decrease the incentive to undertake research. Research costs can be high and a company needs to be assured of getting a return to cover the costs of their research. Less research decreases the supply of new capital and technology and hence decreases the growth of GDP in the long run. a Political stability can lead to strong economic growth by making the country attractive to investors. The increased investment would raise economic growth. b Strong economic growth can lead to political stability because when people have high incomes they tend to be satisfied with the political system and are less likely to overthrow or change the government.

R&D promotes an improvement in technology. The primary reason why living standards have improved over time has been due to large increases in technological knowledge. The Australian government promotes the creation of new technological information by providing research grants and providing tax incentives for firms engaged in research. The patent system also encourages research by granting an inventor the exclusive right to produce the product for a specified number of years. The patent system might also discourage innovation by wasting resources on expensive legal battles, or deter research areas where simultaneous discoveries are common.

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Principles of Macroeconomics – 8th edition

Chapter 8 Saving, investment and the financial system Learning objectives After reading this chapter, students should be able to: • identify important financial institutions in the Australian and world economy • discuss the role of the financial system and its relationship to key macroeconomic variables • analyse how the interest rate is determined, and how market forces and economic policies impact equilibrium saving and investment • examine how government budget deficits and surpluses affect the Australian and world economy.

Key points •

•

•

•

The Australian financial system is made up of many types of financial institutions, such as the bond market, the stock market, banks and managed funds. All of these institutions act to direct the resources of households who want to save some of their income into the hands of households and firms who want to borrow.

National income accounting identities reveal some important relationships among macroeconomic variables. In particular, for a closed economy, national saving must equal investment. Financial institutions are the mechanism through which the economy matches one person’s saving with another person’s investment.

The interest rate is determined by the supply and demand for loanable funds. The supply of loanable funds comes from households who want to save some of their income and lend it out. The demand for loanable funds comes from households and firms who want to borrow for investment. To analyse how any policy or event affects the interest rate, one must consider how it affects the supply and demand for loanable funds.

National saving equals private saving plus public saving. A government budget deficit represents negative public saving and, therefore, reduces national saving and the supply of loanable funds available to finance investment. When a government budget deficit crowds out investment, it reduces the growth of productivity and GDP.

Chapter outline Introduction •

•

This chapter discusses how the financial system works. We look at the large variety of institutions that make up the financial system, the relationship between the financial system and key macroeconomic variables and develop a model of the supply of and demand for funds in financial markets.

Financial system: the group of institutions in the economy that help to match one person’s saving with another person’s borrowing.

Financial institutions in the Australian economy Financial markets • •

Financial markets: financial institutions through which savers can directly provide funds to borrowers.

The bond market: 0801 Copyright 2021 Cengage Learning Australia Pty Limited

Principles of Macroeconomics – 8th edition

– – –

•

Bond (security): a certificate of indebtedness (an IOU).

A bond identifies the date of maturity and the rate of interest that will be paid.

One important characteristic that determines a bond’s value is its term. The term is the length of time until the bond matures. All else equal, long-term bonds pay higher rates of interest than short-term bonds. A perpetuity pays interest forever but never repays the principal.

– Another important characteristic of a bond is its credit risk, which reveals the probability that the borrower will fail to pay some of the interest or principal. All else being equal, the more risky a bond is, the higher its interest rate.

– The relationship between risk and return for different assets is shown in Figure 8.1.

– Bond holders receive interest on the bonds. The interest received is taxable income, i.e. the bond owner pays a proportion of interest in income tax.

The stock market – Shares: a claim to partial ownership in a firm.

– The sale of shares (stock) to raise money is called equity finance and the owner of shares is a part owner of the company; the sale of bonds to raise money is called debt finance and the owner of bonds is a creditor of the corporation.

– Shares are sold on stock exchanges (like the Australian Stock Exchange, the New York Stock Exchange, or NASDAQ) and the prices of shares are determined by supply and demand.

Generally prices reflect the perception of a company’s future profitability.

– A share index, such as the Australian All Ordinaries Share Index, is used to monitor the overall level of share prices. The index is calculated as an average of a group of share prices.

– In the news: Key numbers for stock watches This discusses a number of important pieces of information relating to shares, including price, volumes traded, dividends and the priceearnings ratio. The table provides this information for a number of company shares listed on the ASX.

Financial intermediaries • •

•

Financial intermediaries: financial institutions through which savers can indirectly provide funds to borrowers.

Banks – The primary role of banks is to take in deposits from people who want to save and then lend them out to others who want to borrow.

– Banks pay savers interest on their deposits and charge borrowers a higher rate of interest to cover the costs of running the bank and provide the bank owners with some amount of profit.

– Banks also play the important role of facilitating the purchase of goods and services in the economy. Cheques can be written against deposits held by the banks to enable purchases to be made.

Managed funds – Managed fund: a financial investment that allows investors to own a portfolio of shares and bonds without buying them individually. A manager or trustee decides which shares or bonds to buy. However, the investor assumes all the risk.

– The primary advantage of a managed fund is that it allows individuals with small amounts of money to diversify. The fund acquires a mix of shares using the collective funds invested.

Summing up • •

•

There are many financial institutions in the Australian economy. In addition to the institutions discussed above, there are also credit unions and insurance companies.

These institutions all serve the same goal: moving funds from savers to borrowers.

In the news: Financial institutions in trouble: To bail or let them sink?

– The article presents two opposing viewpoints on the debate about whether or not the government should have provided liquidity to banks which were in danger of failing or allow them to collapse as in the case of the Lehman Brothers in 2008.

– The pro-bailout argument argues that liquidity and confidence in the financial markets are crucial to the smooth operations of the economy. Paul Krugman argues that to prevent panic and contagion, bailout acts like a fire brigade for the financial system.

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–

Those against argue that bailouts create the wrong incentives, and that government can make reckless behaviour in the future more likely.

Saving and investment in the national income accounts Make sure that you work through all of the algebraic steps here. Students will not understand this material if you skip steps.

Some important identities •

Remember that GDP can be divided up into four components: consumption, investment, government purchases and net exports.

Y = C + I + G + NX •

We will assume that we are dealing with a closed economy (an economy that does not engage in international trade). This implies that GDP can now be divided into only three components:

Y = C + I + G •

To isolate investment, we can subtract C and G from both sides:

Y - C - G = I • • •

The left-hand side of this equation (Y – C – G) is the total income in the economy after paying for consumption and government purchases. This amount is called national saving.

National saving (saving): the total income in the economy that remains after paying for consumption and government purchases.

Substituting saving (S) into our identity gives us:

S = I • •

This equation tells us that saving equals investment.

Let’s go back to our definition of national saving once again:

S = Y - C - G •

We can add taxes (T) and subtract taxes (T):

S = (Y - C - T) + (T - G) •

The first part of this equation (Y – T – C) is called private saving; the second part (T – G) is called public saving.

– Private saving: the income that households have left after paying for taxes and consumption.

– Public saving: the tax revenue that the government has left after paying for its spending.

– Budget surplus: an excess of tax revenue over government spending.

– Budget deficit: a shortfall of tax revenue from government spending.

The important point to make here is that with a government budget deficit, public saving is negative and the public sector is thus ‘dis-saving’. To make up for this shortfall, it must go to the loanable funds market and borrow the money. This will reduce the supply of loanable funds available for investment.

•

The fact that S = I means that for the economy as a whole saving must be equal to investment.

The meaning of saving and investment •

In macroeconomics, investment refers to the purchase of new capital, such as equipment or buildings.

You will have to keep reminding students what the term ‘investment’ means to macroeconomists. Outside of the economics profession, most people use the terms ‘saving’ and ‘investing’ interchangeably.

•

If an individual spends less than he earns and uses the rest to buy stocks or mutual funds, economists call this saving.

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The market for loanable funds Market for loanable funds: the market in which those who want to save supply funds and those who want to borrow to invest demand funds.

• FYI: Present value.

– To compare amounts of money at different points in time, economists use the concepts of present and future value. The present value of any future sum of money is the amount today that would be needed, at current interest rates, to produce that sum.

– If r is the interest rate and N is the period in the future than a $100 today will become $100× (1+r)N in N periods. For example if r = 5% and N = 10, then the future value is calculated as $100 × (1.05)10 = 163.

– Conversely to compute a present value we divide by the factor (1+r)N. For example the value today of receiving $200 in 10 years’ time at 5% interest is $200 / (1.05)10 = $123.

– The concept of present value is useful in many applications, including the decision of evaluating investment projects. It illustrates why investment and the quantity of loanable funds demanded declines when the interest rate rises.

– The general formula of present value is that if r is the interest rate, then an amount ($X) to be received in N years has a present value of:

present value =

$X (1+r)N

It would be useful to illustrate the change in present value for higher interest rates, or ask students to perform some simple present value calculations. What is the present value in the previous example if the interest rate was 10% instead of 5%? (= $77)

Supply of and demand for loanable funds • • •

The supply of loanable funds comes from those who spend less than they earn. The supply can occur directly through the purchase of some stock or bonds or indirectly through a financial intermediary.

The demand for loans comes from households and firms who wish to borrow funds to make investments. Families generally invest in new homes while firms may borrow to purchase new equipment or to build factories.

The price of loanable funds is the interest rate.

Students will wonder which interest rate is the price of loanable funds. Explain to them that interest rates in the economy do vary because of the things discussed earlier (term, risk and tax treatment), but that these interest rates tend to move together when changes in the loanable funds market occur. Thus it is appropriate to talk of one interest rate.

– –

All else being equal, as the interest rate rises, the quantity of loanable funds supplied will increase.

All else being equal, as the interest rate rises, the quantity of loanable funds demanded will fall.

Make sure that you spend time discussing why the demand for loanable funds is downward sloping and why the supply of loanable funds is upward sloping. It is important for students to understand the relationships between the interest rate, saving and investment.

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Text Figure 8.2 Interest rate

Supply (saving)

r*

Demand (investment) Loanable funds

1200

 At equilibrium, the quantity of funds demanded is equal to the quantity of funds supplied.

1. If the interest rate in the market is greater than the equilibrium rate, the quantity of funds demanded will be smaller than the quantity of funds supplied. Lenders will compete for borrowers, driving the interest rate down.

2. If the interest rate in the market is less than the equilibrium rate, the quantity of funds demanded will be greater than the quantity of funds supplied. The shortage of loanable funds will result in upward pressure on the interest rate.

It is a good idea to remind students that the supply of loanable funds comes from saving and the demand for loanable funds comes from investment by putting ‘(saving)’ next to the supply curve and ‘(investment)’ next to the demand curve as shown above.



The supply and demand for loanable funds depends on the real interest rate because the real rate reflects the true return to saving and the true cost of borrowing.

How government policies can affect saving and investment When examining the next three sections on different policies, encourage students to follow the three-step process developed in chapter 4. First, determine which curve is affected. Then, decide which way it shifts to determine the effects on the equilibrium interest rate and quantity of funds.

Policy 1: Taxes and saving • •

Savings rates in Australia are relatively low when compared with other countries, such as Japan and Germany.

Suppose that the government changes the tax code to encourage greater saving.

– This will cause an increase in saving, shifting the supply of loanable funds to the right.

– The equilibrium interest rate will fall and the equilibrium quantity of funds will rise.

Thus, the result of the new tax laws would be a decrease in the equilibrium interest rate and greater saving and investment.

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Principles of Macroeconomics – 8th edition

Text Figure 8.3 Interest rate

S1 S2

5% 4%

Demand 1200 1600

Loanable funds

If you would like, now would be a good time to discuss the debate in chapter 18 concerning whether the tax laws should be reformed to encourage saving.

Policy 2: Taxes and investment •

Suppose instead that the government passed a new law lowering taxes for any firm building a new factory (through the use of an investment tax credit).

– This will cause an increase in investment, causing the demand for loanable funds to shift to the right.

– The equilibrium interest rate will rise and the equilibrium quantity of funds will increase as well.

Thus, the result of the new tax laws would be an increase in the equilibrium interest rate and greater saving and investment.

Point out that both Policy 1 (a law to increase saving) and Policy 2 (a law to increase investment) each lead to an increase in both saving and investment. The difference between these two policies lies in their effects on the interest rate.

Text Figure 8.4 Interest rate

Supply

6% 5%

D2

D1 1200

1400

Loanable funds ($)

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Policy 3: Government budgets: deficit or surplus • •

A budget deficit occurs if the government spends more than it receives in tax revenue.

This implies that public saving (T – G) falls, which will lower national saving.

– The supply of loanable funds will shift to the left.

– The equilibrium interest rate will rise and the equilibrium quantity of funds will decrease.

Text Figure 8.5 Interest rate

S2

S1

6% 5%

Demand Loanable funds

$800 $1200

• • • •

When the interest rate rises, the quantity of funds demanded for investment purposes falls.

Crowding out: a decrease in investment that results from government borrowing.

When the government reduces national saving by running a budget deficit, the interest rate rises and investment falls.

Government budget surpluses work in the opposite way. The supply of loanable funds increases, the equilibrium interest rate falls and investment rises.

Now might be a good time to move to the section in chapter 18 concerning the debate on whether or not the government should balance its budget.

What do Australian economists think?

– Most Australian economists support balanced budgets on average over the business cycle, but also support deviations in or order to reduce short-term fluctuations of the economy.

Conclusion •

The financial system coordinates all borrowing and lending activity. The price of loanable funds, the interest rate, is governed by the forces of supply and demand. When financial markets bring the supply of and demand for loanable funds into balance, they help allocate the economy’s scarce resources to their most efficient uses.

Adjunct teaching tips and warm-up activities 1

After discussing the section on the bond market and the stock market, have the students build portfolios. You can then ask them to report on the performance of the portfolio each week. Award a small prize (such as a chocolate bar) each week to the student with the highest return. Permit students to change their portfolios each week if desired, but subtract a small transaction fee from their returns if they do so.

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Check your understanding solutions LO8.1 Financial institutions in the Australian economy Q. What are the three important characteristics of a bond? Can you construct a diagram for the saying: ‘the higher risk, the higher the reward’?

A: The term, credit risk and tax treatment are the three important characteristics of a bond.

Q. How can a firm raise capital to finance investment projects? What are the main differences between shares and bonds? Highlight and compare A: A company can raises money directly from the public by selling bonds, selling shares in the company or borrowing from banks. A share is a claim to partial ownership in a firm. A bond is a certificate of indebtedness. They are different in numerous ways: (1) a bond pays interest (a fixed payment determined when the bond is issued), while a share pays dividends (a share of the firm’s profits that can increase if the firm is more profitable); (2) a bond has a fixed time to maturity, while a share never matures; and (3) if a company that has issued both shares and bonds goes bankrupt, the bondholders get paid off before the shareholders, so shares have greater risk and potentially greater return than bonds. Shares and bonds are similar in that both are financial instruments that are used by companies to raise money for investment, both are traded on exchanges, both are subject to credit risk and the returns to both are taxed (usually).

Q. What are the differences between banks and managed funds?

A: Banks take in deposits from people who want to save and then lend them out to others who want to borrow. Banks pay savers interest on their deposits and charge borrowers a higher rate of interest to cover the costs of running the bank and provide the bank owners with some amount of profit. Banks also play the important role of facilitating the purchase of goods and services in the economy. Cheques can be written against deposits held by the banks to enable purchases to be made.

Managed funds are an institution that allows investors to own a portfolio of shares and bonds without buying them individually. A manager or trustee decides which shares or bonds to buy. However, the investor assumes all the risk. The primary advantage of a managed fund is that it allows individuals with small amounts of money to diversify. The fund acquires a mix of shares using the collective funds invested.

Q. What is your view of the bailout debate? If you were in change of economic policy in the United States would you have let the Lehman Brothers collapse in September 2008?

How would you deal with the too-big-to-fail problem going forward?

A: Many answers possible, but it essentially comes down to a choice between whether the panic and contagion effect of a collapse like Lehman Brothers can be contained with a bailout package, or if risky behaviour by financial intermediaries (such as that by Lehman Brothers) gives rise to bailouts in the first place.

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LO8.3 The market for loanable funds Q. What are loanable funds? Why do firms demand loanable funds? Who supplys loanable funds?

A: Loanable funds are savings that can be loaned out as investment. The market for loanable funds is a virtual place where those who supply and demand funds interact. Firms demand loanable funds for investment purposes (for example, to purchase new equipment or build factories). The supply of loanable funds comes from those who spend less than they earn. The supply can occur directly through the purchase of some stock or bonds or indirectly through a financial intermediary.

LO8.4 How government policies can affect saving and investment Q. Assume the Australian government wants to increase human capital by providing an additional $1.5 billion dollars to fund tertiary education. Assuming there is no change in tax revenues, what happens to the demand and supply of loanable funds? How will this affect the real interest rate and the quantity of investment? Is the change in equilibrium investment the same, more or less than the initial change (horizontal shift) in government spending? Why? Demonstrate your answers using a diagram.

A: The increase in government spending and no change in tax revenues leads to an decrease in public saving (and increased deficit). The supply of loanable funds decreases and will shift to the left, while the demand for loanable funds remains the same. The equilibrium interest rate will rise and the equilibrium quantity of funds will decrease. The change in the equilibrium investment is less than the change in government spending as the higher interest rate will encourage some saving, and leads to an inflow of additional saving in the market, which offsets the drop in public saving.

Interest rate

S2

S1

6% 5%

Demand Loanable funds

$800 $1200

Q. Watch the video-interview of Dr Jan Libich with Dr Stephen Kirchner titled ‘The Public Debt Crisis and Its Solutions’: (http://youtube.be/4XW4J3oTCig/). Summarise the debt problem facing advanced countries, and suggest some possible solutions.

A: The increase in the age-dependency ratio in many advanced countries can lead to a public debt problem where current expenditures will rise and tax revenues will fall. Some of the suggested solutions include fiscal rules such as a balanced budget with ±2 per cent of GDP; a net debt rule of under 10 per cent of GDP and a cap on expenditure and revenues of 25 per cent of GDP. In terms of microeconomic reforms, one suggestion is to means-test Medicare.

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Case study solutions Key numbers for stock watchers 1. Based on the data provided in the above table, which company has the lowest daily volume? What does a lower daily volume generally mean?

A: CSL Limited has the lowest daily volume (0.369). A lower daily volume generally means that shares may not be sold as easily, if they needed to be sold by investors.

2. Which company has the highest price-earnings ratio? What does a higher priceearnings ratio generally mean?

A: Based on the table, Atlassian has the highest P/E ratio. However, this could be due to the fact that it hasn’t paid a dividend yet. A higher P/E ratio indicates that a corporation’s shares are expensive relative to its recent earnings. This could mean that people expect earnings to rise in the future or that the shares are overvalued.

Government debt and the sustainability of public finances 1. Why is rising public debt a risk to the economy?

A: Rising public debt can be a risk to the economy as it can cause economic imbalances and cripple an economy. When the government does not have any money of its own, the country’s taxpayers are ultimately liable for this debt.

2. Why are demographic trends important for understanding a country’s debt level?

Explain A: Demographic trends can help to predict and analyse the implications of an ageing population on a country’s debt level. For example, there can be issues in the pay as you go system of public finances where government expenditures are paid for by the tax revenues in the same year. A reduction in worker-per-retiree ratio means higher expenditures on pensions and health care, but lower tax revenues. This then makes it more difficult for governments to balance their books.

Practice questions solutions Questions for review 1

2

3

4

5

The financial system’s role is to help match one person’s saving with another person’s investment.

Investment will fuel productivity and longer term growth in an economy. Two financial intermediaries are banks, which take in deposits and use the deposits to make loans, and managed funds, which sell shares to the public and use the proceeds to buy a portfolio of financial assets.

National saving is the amount of a nation’s income that isn’t spent on consumption or government purchases. Private saving is the amount of income that households have left after paying their taxes and paying for their consumption. Public saving is the amount of tax revenue that the government has left after paying for its spending. The three variables are related because national saving equals private saving plus public saving. The fact that S = I means that for the economy as a whole saving must be equal to investment.

Investment refers to the purchase of new capital, such as equipment or buildings that are used to produce other goods. It is equal to national saving by an accounting identity.

I = Y – C – G and S = Y – C – G, hence I = S. A change in the tax laws that might increase private saving is the introduction of a consumption tax to replace the income tax. Since a consumption tax wouldn’t tax the returns to saving, it would increase the supply of loanable funds, thus lowering interest rates and increasing investment.

A government budget surplus arises when the government spends less than it receives in tax revenue. Since a government budget surplus increases national saving, it lowers interest rates which encourages private investment and thus improves economic growth. A budget deficit reduces

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6

national saving, raises interest rates, crowds out private investment and thus reduces economic growth.

An increase in the supply for loanable funds will shift out the supply curve to the right, and with no change in demand, decrease the equilibrium interest rate and increase the quantity of loanable funds. The increase in quantity is less than the initial increase in supply as the lower interest rate discourages some saving.

Multiple choice 1. d

2. d

3. c

4. b

5. c

6. a

Problems and applications 1

2

3

a

The bond of a war torn country would pay a higher interest rate than the bond of the Australian government because there would be a greater risk of default. b A bond that repays the principal in 2040 would pay a higher interest rate than a bond that repays the principal in 2030 because it has a longer term to maturity, so there is more risk to the principal. c A bond from a software company you run in your garage would pay a higher interest rate than a bond from Coles group because your software company has more credit risk. d A bond issued by the federal government may pay a lower interest rate than a bond issued to finance the construction of a new airport in Brisbane because the new airport in Brisbane could have marginally higher credit risk.

Many answers possible but some examples are S&P Global Ratings, Fitch Australia, Equifax Australasia and Moody’s Investor Services. They can be public or private. Credit rating agencies are supposed to provide investors with reliable information on the riskiness of various kinds of debt, but these agencies have instead been accused of exacerbating the financial crisis and defrauding investors by offering overly favourable evaluations of insolvent financial institutions and approving extremely risky mortgage-related securities. There have been reforms such as the Credit Rating Reform act to regulate and monitor agencies.

Following the collapse of the Lehman Brothers in 2008, and the resulting Global Financial Crisis the supply of global loanable funds decreased shifting supply to the left. It resulted in higher global interest rates as shown in Figure 8.1 (see below). This higher interest rate led to higher borrowing cost. When Australian banks had to borrow from the global financial markets, the high borrowing cost in the global financial markets resulted in higher home loan rates over and above the increases in the cash rate announced by the Reserve Bank of Australia.

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Figure 8.1

4

5

6

7

Many answers possible, but typically an index fund (e.g. Vanguard) tracks changes in the overall market; an actively managed fund (e.g. Platinum) is a diversified portfolio that may offer returns higher or lower than the overall market, but over the long term typically will not outperform the market.

Companies encourage their employees to hold shares in the company because it gives the employees the incentive to care about the firm’s profits, not just their own salary. Then, if employees see waste, or see areas in which the firm can improve, they’ll take actions that benefit the company because they know the value of their share will rise as a result. And it also gives employees an additional incentive to work hard, knowing that if the firm does well, they will profit.

But from an employee’s point of view, owning shares in the company for which she or he works can be risky. Employees’ wages or salaries are already tied to how well the firm performs. If the firm experiences difficulties, the employee could be laid off or have her or his salary reduced. If the employee owns shares in the firm, then there’s a double whammy – the employee is unemployed or gets a lower salary and the value of the shares falls as well. So owning shares in your own company is a very risky proposition. Most employees would be better off diversifying – owning shares or bonds in other companies – so their fortunes wouldn’t depend so much on the firm for which they work.

Investing in companies with a low price-earnings ratio means that shares are purchased when the company is not performing strongly and profits are low. However, if the company has good prospects, future earnings and hence the price-earnings ratio would be expected to increase. The risk is that the company does not experience growth.

Investing in the shares of companies that are in strongly growing industries means that profits are expected to rise in the future. The firm’s shares price will be high relative to its current earnings, so the price-earnings ratio will be higher than it is for other companies. The disadvantage of buying such shares is that if those future profits don’t materialise, the high price-earnings ratio means the shares are overvalued and you’ll get a lower-than-average return on your investment.

To a macroeconomist, saving occurs when a person’s income exceeds her consumption, while investment occurs when a person or firm purchases new capital, such as a house or business equipment. a When your family refinances their mortgage to buy a new car, that’s investment, because it’s a purchase of new capital. b When you use your $350 pay cheque to buy shares in Apple Inc, that’s saving, because your income of $350 isn’t being spent on consumption goods. c When your sister earns $150 and deposits it in her account at a bank, that’s saving, because the money isn’t spent on consumption goods.

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d 8

9

When you borrow $1500 from a bank to buy a scooter to use as an Uber Eats delivery driver, that’s investment, because the car is a capital good.

If more Australians adopted a ‘live for today’ approach to life, they’d spend more and save less. This would shift the supply curve to the left in the market for loanable funds, causing the interest rate to rise. In equilibrium, there would be less saving and investment and a higher interest rate. a Figure 8.2 illustrates the effect of the $7 billion increase in government borrowing. Initially, the supply of loanable funds is curve S1, the equilibrium real interest rate is i1 and the quantity of loanable funds is L1. The increase in government borrowing by $7 billion reduces the supply of loanable funds for each interest rate by $7 billion, so the new supply curve, S2, is shown by a shift to the left of S1 by exactly $7 billion. As a result of the shift, the new equilibrium real interest rate is i2. The interest rate has increased as a result of the increase in government borrowing.

Figure 8.2

b

c

d

Since the interest rate has increased, investment and national saving decline and private saving increases. The increase in government borrowing reduces public saving. From the figure you can see that total loanable funds (and thus both investment and national saving) decline by less than $7 billion, while public saving declines by $7 billion and private saving rises by less than $7 billion.

The more elastic is the supply of loanable funds, the flatter the supply curve would be, so the interest rate would rise by less and thus national saving would fall by less, as Figure 8.3 shows.

The more elastic the demand for loanable funds, the flatter the demand curve would be, so the interest rate would rise by less and thus national saving would fall by more, as Figure 8.4 shows.

If households believe that greater government saving today implies lower taxes since there will be less government debt in the future, then people will save less and private saving will decrease, as will the supply of loanable funds. This will offset the increase in public saving, thus reducing the amount by which the equilibrium quantity of investment and national saving increase and thus the amount that the interest rate changes. If the decrease in private saving was exactly equal to the increase in government saving, there would be no shift in the national saving curve. Thus, investment, national saving and the interest rate would all remain unchanged. This is the case of Ricardian equivalence.

Lower government debt may lead to lower interest rates and from the loanable funds market this suggest that there will be lower private savings

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Figure 8.3

Figure 8.4

10 The main reasons for the ageing population trend is declines in fertility rates combined with longer life-expectancy. One important implication is that the supply of loanable funds will decrease as retired people use up their savings for consumption. Another is that there are fewer workers relative to the number of people dependent on government transfers. Reductions in tax revenue will reduce the level of public savings. Political implications can cover a wide range of issues, but concern the electoral power of a large group of elderly voters, who could vote for measures that improve their welfare at the expense of others. The motivation for making voting optional for people of retired age is to reduce the power of this elderly electoral block. Other options might be to try to bring in, by bipartisan agreements, policies that are more equitable.

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Chapter 9 The natural rate of unemployment Learning objectives After reading this chapter, students should be able to: • find out what unemployment means, what the natural rate of unemployment is, and discuss its various types and causes • consider how ‘classical’ unemployment can result from the real wage being too high due to minimum-wage laws, union wage bargaining, or efficiency wages • get to know how ‘frictional’ unemployment is driven by the process of job search • discover how ‘structural’ unemployment arises from a mismatch between the skills that workers have and the skills that employers need.

Key points • •

• • • • •

• •

The unemployment rate is the percentage of those who would like to work but do not have jobs.

The ABS calculates this statistic monthly based on a survey of thousands of households.

The unemployment rate is an imperfect measure of joblessness. Some people who call themselves unemployed may actually not want to work and some people who would like to work have left the labour force after an unsuccessful search. Others may be working less hours that they prefer.

In the Australian economy, most people who become unemployed find work within a short period of time. Nonetheless, most unemployment observed at any given time is attributable to the few people who are unemployed for long periods of time.

One reason for unemployment is ‘classical’ unemployment resulting from the real wage being too high due to minimum-wage laws, union wage bargaining, or efficiency wages.

By raising the wage of unskilled and inexperienced workers above the equilibrium level, minimum-wage laws raise the quantity of labour supplied and reduce the quantity demanded. The resulting excess supply of labour represents unemployment.

A second reason for ‘classical’ unemployment is the market power of unions. When unions push the wages in unionised industries above the equilibrium level, they create an excess supply of labour.

A third reason for ‘classical’ unemployment is suggested by the theory of efficiency wages.

According to this theory, firms find it profitable to pay wages above equilibrium level. High wages can improve worker health, lower worker turnover, increase worker effort and raise worker quality.

Frictional unemployment is the time it takes for workers to search for jobs that best suit their skills and tastes. The unemployment benefit is a government policy that, while protecting workers’ incomes, increases the amount of frictional unemployment.

Structural unemployment arises when the skills demanded by employers are not matched by the skills of workers.

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Chapter outline Introduction 

When a country’s workers are fully employed, the country achieves a higher level of GDP than if its workers stand idle.



A worker’s productivity also matters for the country’s prosperity.



Natural rate of unemployment: the normal rate of unemployment, accounted for by structural factors, around which the unemployment rate fluctuates.



The difference between the natural rate of the employment and the rate of unemployment is cyclical unemployment. Cyclical unemployment: the deviation of unemployment from its natural rate. The unemployment that results from a slowdown in the level of output (real GDP) in the economy.



We discuss three components of the natural rate of unemployment: structural, frictional and classical.

Identifying unemployment How is unemployment measured?

• •

The Australian Bureau of Statistics (ABS) surveys around 0.33 per cent of households every month.

The ABS places each adult into one of three categories: employed, unemployed, or not in the labour force.

See text Figure 9.1 Ask students which category they are in. Remind them that to be considered to be unemployed they must be without a job and be looking for work. Many students are not in the labour force, but may consider themselves to be unemployed simply because they do not have a job. Explain to students that the unemployment rate is a useful statistic because it answers the following question: Of those in the economy who want to work, what percentage cannot find a job?

•

Labour force: the total number of workers, including both the employed and the unemployed.

Labour force = Number of employed + Number of unemployed •

Unemployment rate: the percentage of the labour force that is unemployed.

 Number of unemployed  Unemployment rate =    100% Labour force   •

Labour-force participation rate: the percentage of the adult population that is in the labour force.

 Labour force  Labour-force participation rate =    100%  Adult population  –

Example: data from October 2019. In that year, there were 12.94 million employed people and 0.72 million unemployed people.  Labour force = 12.94 + 0.72 = 13.66 million.  Unemployment rate = (0.72 / 13.66) × 100 per cent = 5.3 per cent.  If the adult population was 20.68 million, the labour-force participation rate was: labour-force participation rate = (13.66 / 20.68) × 100 per cent = 66.1 per cent.

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Again, make sure that students understand where these numbers come from when going through this material. Make sure that the formula is written on the board while covering these calculations. Update these figures using the latest ABS monthly labour force survey data.

ALTERNATIVE CLASSROOM EXAMPLE The country of Bada has collected the following information: Population 240 000 Employed 180 000 Unemployed 30 000 Labour Force = 180 000 + 30 000 = 210 000 Unemployment rate = (30 000 / 210 000) × 100 per cent = 14.3 per cent Labour-force participation rate = (210 000 / 240 000) × 100 per cent = 87.5 per cent

See text Table 9.1 •

Table 9.1 shows the labour market experiences of various demographic groups including the unemployment and labour-force participation rates.

See text Figure 9.2 •

Figure 9.2 shows the unemployment rate for each state, along with an estimate of its NAIRU. – Those states that have an unemployment rate close to its NAIRU are more likely to see wages growth as employment increases.

Discuss how the age composition of the labour force and other demographic and social factors can cause the natural rate of unemployment to vary over time.

See text Figure 9.3 •

Figure 9.3 shows this rise in the labour-force participation rate of women and also reveals that the labour-force participation rate for men has actually fallen over the same time period.

Is unemployment measured correctly?

• •

• •

•

Measuring the unemployment rate is not as straightforward as it may seem.

There is a tremendous amount of movement into and out of the labour force.

– Many of the unemployed are new entrants or re-entrants looking for work.

– Many unemployment spells end with a person leaving the labour force as opposed to actually finding a job.

There may be some individuals who are calling themselves unemployed to receive government assistance, yet they are not trying hard to find work. These individuals are more likely not a part of the true labour force, but they will be counted as unemployed.

Discouraged workers: individuals who would like to work but have given up looking for a job.

– These individuals will not be counted as part of the labour force.

– Thus, while they are likely a part of the unemployed, they will not show up in the unemployment statistics.

In the news: Is true Australian unemployment double the official rate?

– Roy Morgan Research estimates that in May 2016, the unemployment rate was 10.7 per cent, which was more than double the official rate. Further it was estimated that 7.4 per cent of the workforce to be underemployed. The discrepancy is partly due to some people being reclassified as permanently disabled.

How long are the unemployed without work?

• •

Another important variable that policymakers may be concerned with is the duration of unemployment.

Most spells of unemployment are short and most unemployment observed at any given time is long term.

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Why is there unemployment?

• •

In an ideal labour market, wages would adjust so that the quantity of labour supplied and the quantity of labour demanded would be equal.

However, there is always unemployment even when the economy is doing well. The unemployment rate is never zero; it fluctuates around the natural rate.  Reasons for the labour market to depart from full employment include: – frictional unemployment – unemployment associated with searching for a job.

– structural unemployment – results from a mismatch in the skills that business require and the skills that workers have.

– classical unemployment – the real wage in the labour market is above the market-clearing real wage, which equates demand and supply of labour.

Classical unemployment •

The three main reasons for classical unemployment are minimum wage laws, union bargaining and efficiency wages.

Minimum-wage laws Unemployment can occur because of minimum-wage laws.

• The minimum wage is a price floor.  If the minimum wage is set above the equilibrium wage in the labour market, a surplus of labour will occur.  However, this is a binding constraint only when the minimum wage is set above the equilibrium wage.  Most workers in the economy earn a wage above the minimum wage.



Minimum-wage laws therefore have the largest effect on workers with low skill and little experience (such as teenagers).

Text Figure 9.4 Wage Surplus of labour = unemployment

Labour supply

Minimum wage WE

Labour demand LD

LE

LS Quantity of labour

•

Any time a wage is kept above the equilibrium level for any reason, the result is unemployment.  Other causes of this situation include unions and efficiency wages.  This situation is different from frictional unemployment where the process for the ‘right’ job is the cause for unemployment.

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Unions and collective bargaining • • •

Union: a worker association that bargains with employers over wages and working conditions.

Collective bargaining: the process by which unions and firms agree on the terms of employment.

Unions play a smaller role in the Australian economy today than they did in the past.  Figure 9.5 shows that both trade union membership as a proportion of the workforce and the numbers of workers in unions have declined over the past three decades.

The economics of unions • • • •

Unions try to negotiate for better wages, better benefits and better working conditions than the firm would offer if there was no union.

Strike: the organised withdrawal of labour from a firm by a union.

The workers who remain employed (insiders) are better off at a higher rate and the unemployed (outsiders) are worse off.

FYI: Why do strikes occur?

See text Figure 9.6 •

The number of strikes has decreased dramatically since 1986. Strikes are costly to both workers and firms. So why do they occur? On both sides, strikes result from the wish to demonstrate resolve in the hope of achieving long-term benefits, which outweigh short-term costs.

The theory of efficiency wages • • •

Efficiency wages: above-equilibrium wages paid by firms in order to increase worker productivity.

Efficiency wages raise the wage above the market equilibrium wage, resulting in unemployment.

There are several reasons why a firm may pay efficiency wages.

Worker health • •

Better-paid workers can afford to eat better and can afford good medical care.

This is not applicable in rich countries such as Australia, but can raise the productivity of workers in less-developed countries.

Worker turnover • •

A firm can reduce turnover by paying a wage greater than its workers could receive elsewhere.

This is especially helpful for firms that have high hiring and training costs.

Worker effort • •

Again, if a firm pays a worker more than he or she can receive elsewhere, the worker will be more likely to try to protect his or her job by working harder.

This is especially helpful for firms who have difficulty monitoring their workers.

Worker quality • •

Offering higher wages attracts a better pool of applicants.

FYI: The economics of asymmetric information: Adverse selection and moral hazard.  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.  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.

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Frictional unemployment • •

Job search: the process by which workers find appropriate jobs given their tastes and skills.

Because workers differ from one another in terms of their skills and tastes and jobs differ in their attributes, it is often difficult for workers to match with the appropriate job.

The inevitability of frictional unemployment •

•

Search unemployment often occurs because of a change in the demand for labour among different firms.

– When workers decide to stop buying a good produced by Firm A and instead start buying a good produced by Firm B, some workers at Firm A will likely lose their jobs.

– New jobs will be created at Firm B, but it will take some time to move the displaced workers from Firm A to these openings.

– The result of this transition is temporary unemployment.

– The same type of situation can occur across industries as well.

This implies that because the economy is always changing, search unemployment is inevitable.

Workers in declining industries will find themselves looking for new jobs and firms in growing industries will be seeking new workers.

Public policy and job search • • • •

Government programs can help to reduce the amount of search unemployment.

These programs include: – government-run employment agencies – public training programs.

Critics of these programs argue that the private labour market will do a better job of matching workers with employers and therefore the government should not be involved in the process of job search.

Most job search in the economy takes places without government intervention. For example, newspaper advertisements, job newsletters, university placement offices and the internet have improved information flows.

Unemployment benefits • • •

Unemployment benefits: a government program that partially protects workers’ incomes when they become unemployed.

Because unemployment benefits reduce the hardship of unemployment, they potentially increase the amount of unemployment that exists.

Empirical evidence in the US and Australia tends to support this conclusion.

Structural unemployment • • • • •

Structural unemployment arises when the skills demanded by employers are not matched by the skills of workers.

This sort of unemployment is inevitable as the economy is always changing. For example, a century ago the largest employment sectors in Australia were agriculture and mining. Today it is service industries such as retail trade and health care services.

In the news: The Terminator’s move from the big screen to the labour market near you.  Economists Laurence Kotlikoff and Jan Libich explore the effect of automation on employment.

Structural unemployment tends to last longer than frictional unemployment as some workers remain unemployed as there are no suitable jobs.

The Australian government spends $2.5 billion each year on job training and related programs to assist workers to acquire new skills.

When discussing the material in this chapter, you may find that students want to begin discussing possible policies to deal with unemployment. Keep the focus on institutional responses such as unemployment benefits or insurance, job training and government-sponsored employment agencies.

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Conclusion •

Unemployment is not a simple problem with a simple solutions.

•

It is affected by public policies and such policies need to consider the impact of these on the economy’s natural rate of unemployment

Adjunct teaching tips and warm-up activities Take a survey of students in your class regarding their labour-force participation. Use the information to show students how the labour force, unemployment rate and labour-force participation rate can be calculated.

Check your understanding solutions LO9.1 Identifying unemployment Q. How do we measure the unemployment rate? Can it overstate or understate the true amount of joblessness?

A: The unemployment rate is measured through a survey of 60 000 households to find out the percentage of the labour force that is unemployed. The unemployment rate overstates the amount of joblessness because some of those who report being unemployed may not, in fact, be trying hard to find a job. But the unemployment rate understates the amount of joblessness because discouraged workers report being out of the labour force even though they want jobs.

LO9.2 Classical unemployment Q. Keynesian economists stress the fact that recipients of the higher minimum wage will spend more, which increases demand for products and services and makes firms hire more labour. How could you incorporate this argument into Figure 9.4? Can you think of some other arguments and important factors not captured in the simple model of Figure 9.4 (including those that could justify minimum wage legislation not only on equity grounds but also on efficiency grounds)? If the level of minimum wages rises, what happens to labour demand, labour supply and the unemployment level? Based on your answer, do you think minimum wages should rise?

A: An increase in the demand for firms’ products and services might lead to an increase in their demand for labour, shifting the labour demand curve to the right. If the labour supply curve does not change, this would reduce the labour surplus in the labour markets. The simple model does not capture underemployment or underutilisation of workers, which could raise efficiency in the economy. If the level of minimum wages rises, labour demand will decrease (as it costs more to hire), labour supply would increase. This would increase the level of unemployment. On these grounds, it may be argued that minimum wages should not rise.

Q. Why might firms pay wages to employees that are above equilibrium wage?

A: There are four reasons that firms might find it profitable to pay wages above the equilibrium age: (1) to ensure that workers are in good health so they’ll be more productive; (2) to reduce worker turnover because it’s costly to hire new workers; (3) to make workers eager to keep their jobs, thus discouraging them from shirking; and (4) to attract a better pool of workers.

LO9.4 Structural Unemployment Q. How would a tax on carbon emissions impact the amount of search unemployment? Is this unemployment necessarily undesirable? What public policies might affect the amount of unemployment caused by this price change?

A: A tax on carbon emissions will discourage firms in production of some goods. This will influence the firm’s production decisions and affect corresponding changes in different sectors’ demand for 0907 Copyright 2021 Cengage Learning Australia Pty Limited

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labour. It is at this point that job search unemployment rises, as some sectors within the economy may gain from such an outcome while others would not and the movement of people from one sector to another is not a frictionless event. As carbon emission is quite significant in the production decisions of so many components of the Australian economy, there could well be a major net short-term adverse shock to the Australian economy. Policies designed to help retrain staff retrenched as a result of the tax of carbon emissions is one response.

Case study solutions Labour-force participation of men and women in the Australian economy 1. What factors have led to the fall in men’s labour-force participation rate?

A: Young men now stay in school longer than their fathers and grandfathers did. With more women employed, more fathers now stay at home to raise their children. As the average age in the Australian population grows due to increases in life expectancy and declines in fertility, more men move into higher age brackets where labour-force participation rates are lower.

2. Will this have an impact on median income? Explain A: Whether these factors have an impact on median income can depend on the roles of women in employment. This may reduce median income in the male labour force, but it may not necessarily reduce median income overall if there has been a matching increase in the labour force participation rate of women.

Henry Ford and the generous $5-a-day-wage 1. Do you think Ford’s high wage was a good predictor of efficiency-wage theory?

A: Yes, it was as the above equilibrium wages paid did increase worker productivity.

2. Do you think the $5 workday improved Ford’s production efficiency?

A: Yes, after instituting this higher wage policy, the company’s production costs actually fell due to reduced turnover, absenteeism and shirking. These are indicators of enhanced efficiency.

The differences in unemployment within Australia and across countries 1. What do you think explains the differences in Australian state and territory unemployment?

A: The differences in the state and territory unemployment can be explained by the type of industries in those areas. Geographical location could also influence labour demand. ACT, NSW and NT have a low rate of unemployment. This could be due to the amount of economic activity in those states, in relation to global trading partners.

2. If global demand for coal falls, will that have an impact on the employment level in Western Australia, which heavily relies on its coal export industry?

A: If global demand for coal falls, there may be less demand for labour in the coal export industry which could increase unemployment in Western Australia.

Practice questions solutions Questions for review 1

2

The Australian Bureau of Statistics categorises each adult (15 years of age and older) as either employed, unemployed, or not in the labour force. The labour force consists of the sum of the employed plus the unemployed. The unemployment rate is the percentage of the labour force that is unemployed. The labour-force participation rate is the percentage of the total adult population that is in the labour force.

Unemployment is typically short term. Most people who become unemployed are able to find new jobs fairly quickly. But some unemployment is attributable to the relatively few workers who are jobless for long periods of time.

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3

4

5

6

7

Minimum-wage laws are a better explanation for unemployment among teenagers than among university graduates. Teenagers have fewer job-related skills than university graduates, so their wages are low enough to be affected by the minimum wage. University graduates’ wages far exceed the minimum wage.

Unemployment data does not reflect underemployment. Underemployed workers are employees who want and are available for more hours of work than they currently have. They are underemployed due to insufficient work available. If people are underemployed, it means resources are underutilised. Slower economic growth would be expected in the future.

The level of unemployment varies from region to region because certain regions have a limited industry base with heavy reliance on one sector. In addition, workers with lower educational attainment tend to be less mobile across jobs due to limited skill sets. To improve the distribution of unemployment, the government can encourage, in the region, a more diversified industry base, thereby easing reliance on a single sector. Further to industrial diversification, subsidised training and education programs can be offered to affected workers to acquire relevant skill sets for jobs that are available in the region.

Four reasons why a firm’s profits might increase when it raises wages are: (1) better paid workers are healthier and more productive; (2) worker turnover is reduced; (3) worker effort is increased; and (4) the firm can attract higher quality workers.

Search unemployment is inevitable because the economy is always changing. Some firms are shrinking while others are expanding. Some regions are experiencing faster growth than other regions. Transitions of workers between firms and between regions are accompanied by temporary (short-term) unemployment.

The government could help to reduce the amount of search unemployment by public policies that provide information about job vacancies in order to match workers and jobs more quickly, and through public training programs that help ease the transition of workers from declining to expanding industries and help disadvantaged groups escape poverty.

Multiple choice 1. a

2. c

3. a

4. c

5. b

6. b

Problems and applications 1

2

3

The labour force consists of the number of employed (12 976 300) plus the number of unemployed (703 600), which equals 13 679 900.

To calculate the number not in the labour force, the total number in the labour force is subtracted from the civilian population over 15 years of age of 20 701 918. The number not in the labour force is 7 022 018.

The unemployment rate is the number of unemployed (703 600) divided by the labour force (13 679 900) times 100 per cent, which equals 5.14 per cent.

The information on the higher increase for men than women in underemployment rate is useful for policymakers. As the larger part of the increase in underemployment arose from jobs undertaken by men, it shows a shift in jobs and skill requirements in jobs related to men. It enables policymakers to develop targeted policies to address skills training in jobs more specific for men than women.

The labour market in its original equilibrium is shown as Figure 9.1. The market clears with a wage rate of WE and at an employment level of LE.

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Figure 9.1: Labour market

a

b

4

a

b

5

a

b

If a minimum wage is above the equilibrium, say at minimum wage (a) as shown in Figure 9.1 above, then number of workers supplied will be LS, the number of workers demanded will be LD. This will create the surplus of labour shown in Figure 9.1. The reason is that more workers will be persuaded to join the labour market in the hope of securing higher wages, while firms are looking to reduce their employment because of the higher labour costs.

If a minimum wage is set below the equilibrium, say at minimum wage (b) as shown in Figure 9.1, then the minimum wage is non-binding. In this case employment levels and wages will stay at the original equilibrium.

If we had perfectly working labour markets, surplus workers in less prosperous sectors will move to sectors experiencing labour shortages. Assuming labour is homogeneous, labour mobility will eliminate labour surpluses and shortages until wages in all sectors are equal.

The high wages in the mining sector results from a shortage of workers who are equipped with the right skills to work in the mining sector. The high level of rural unemployment results from a lack of jobs in the rural areas. The unemployed in the rural areas may not have the right skills to work in the mining sector. The government can introduce programs to encourage the currently unemployed to acquire skill sets relevant to jobs available in the mining sector. At the same time, the government can provide subsidies to employers in the mining industry to provide training on the job.

When landlords require tenants to pay security deposits, landlords are the principals and renters are the agents. Asymmetric information arises because landlords have less than full information about the characteristics of renters and their propensity to adequately take care of the property while renting it out. To reduce the problem of moral hazard that may arise in this circumstance, landlords require tenants to pay security deposits, so tenants must take care of the property to get their money back.

When firms compensate top executives with options to buy company shares at a given price in the future, the firm is the principal and the executives are the agents. Asymmetric information arises because the executives can do things for their own benefit that don’t increase the profitability of the firm. For example, executives might buy many expensive perks for themselves (plush offices, a fleet of corporate jets) that the executives enjoy but that reduce profits. The share options reduce this moral hazard problem by tying the executives’ total compensation directly to the profits of the firm.

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c

6

7

When car insurance companies offer discounts to older drivers or those who have had fewer accidents, the insurance company is the principal and the customers are the agents.

Asymmetric information arises because car insurance companies cannot easily observe the actions of their customers. A moral hazard problem may result if customers don’t take as much care as they should when driving since they know they’re insured. By giving discounts for good driving, the insurance company offsets the potential for moral hazard, making it more likely that people will drive carefully and thus less likely to have an accident.

Raising the price of an insurance policy leads to adverse selection. Healthier people will leave the firm and buy insurance elsewhere. The firm will end up insuring a greater percentage of unhealthy people. Even though the company’s income from selling the insurance will rise, the less healthy people they’re now insuring will make more claims and the firm’s profits will probably decline. a An increase in retirement age will increase supply of labour

b If real wages increase, this will encourage more people to join the labour force and supply of labour will increase (same diagram as a). c Social security benefits are decreased, more people will want to work for income so this also increases the supply of labour (same diagram as a). d In the short run, when Australians decide to have more children, the supply for labour may decrease as women (mainly) stay at home to look after their children.

8

However, in the long run, as the population increases there may be more people in the labour force and as people return to work when their children grow up this will increase the supply of labour (same diagram as part a). a If a firm was providing no such benefits prior to the legislation, the curve showing the demand for labour would shift down by exactly $6 at each quantity of labour, because the firm wouldn’t be willing to pay as high a wage given the increased cost of the benefits. b If employees value the benefit by exactly $6 per hour, they’d be willing to work the same amount for a wage that’s $6 less per hour, so the supply curve of labour shifts down by exactly $6.

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c

Figure 9.3 shows the equilibrium in the labour market. Since the demand and supply curves of labour both shift down by $6, the equilibrium quantity of labour is unchanged and the wage rate declines by $6. Both employees and employers are just as well off as before.

Figure 9.2

d

If the minimum wage prevents the wage from falling, the result will be increased unemployment, as Figure 9.3 shows. Initially, labour supply is L1S and labour demand is L1D, so unemployment is given by L1S – L1D. The downward shift of both the demand and supply curves gives a new equilibrium with labour supply L2S, labour demand L2D and unemployment L2S – L2D. The wage is unchanged, the level of employment declines and the level of unemployment rises. Employers are worse off because they hire less labour at a higher wage (including benefits). The workers who become unemployed are worse off because of the policy, while workers who remain employed are better off, since their wages plus benefits have increased.

Figure 9.3

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e

If the workers don’t value the mandated benefit at all, the supply curve of labour doesn’t shift down. As a result, in part c, the wage rate will decline by less than $6 and the equilibrium quantity of labour will decline, as shown in Figure 9.4. The new wage, w2, will be less than w1, but greater than w1 – $6. Employers are worse off, since they now pay a greater total wage plus benefits for fewer workers. Employees are worse off, since they get a lower wage and work less.

Figure 9.4

9

a b c

With a minimum wage in effect, as in part d, the impact on unemployment isn’t as bad as when the workers valued the benefits. Looking back at Figure 9.3, the only difference is that the labour-supply curve doesn’t shift, so the equilibrium quantity of labour supplied stays the same at L1S. So, the wage stays the same, labour demand declines, labour supply is unchanged and unemployment rises. Employers are worse off since they get less labour at a higher wage plus benefits. Employees are worse off also since there’s less employment at the same wage. structural frictional structural

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Chapter 10 The monetary system Learning objectives After reading this chapter, students should be able to: • explain what money is and what functions money has in the economy • discuss the Reserve Bank of Australia and the tools it uses to influence liquidity conditions in the economy • examine how the banking system influences the amount of money in the economy.

Key points • •

• • • • •

The term money refers to assets that people regularly use to buy goods and services.

Money serves three functions. As a medium of exchange, it provides the item used to make transactions. As a unit of account, it provides the way in which prices and other economic values are recorded. As a store of value, it provides a way of transferring purchasing power from the present to the future.

Commodity money, such as gold, is money that has intrinsic value – it would be valued even if it were not used as money. Fiat money, such as paper dollars, is money without intrinsic value – it would be worthless if it were not used as money.

In the Australian economy, money takes the form of currency and various types of bank deposits, such as savings accounts.

The Reserve Bank of Australia, Australia’s central bank, is responsible for regulating the monetary system. The RBA sets interest rates to reach a target rate of inflation.

In the past the RBA targeted the money supply, but now it targets the cash rate, that is the interest rate that financial intitutions can earn in the overnight money market. The cash rate is the benchmark for other interest rates in the economy.

The primary way in which the RBA targets the cash rate is through open-market operations.

Chapter outline Introduction This is a good chapter to ‘win back’ the students who were bored with national income accounting. Students are generally interested in learning more about the banking system and the RBA. The RBA publishes a range of items on its website http://www.rba.gov.au that discusses the operations of the RBA in more detail if students are interested.

•

This chapter examines the role of money in the economy. We discuss what money is, the various form that money takes, how the banking system helps create money and how the government influences the quantity of money in circulation.

The meaning of money Begin the analysis by asking students ‘What is money?’ Students will likely want to start right in with a discussion of the functions that money serves. Stop them. Ask them instead to describe money. Hold up a $5 note and a piece of paper cut to the same size. Ask the students which they would prefer and why.

•

Money: The set of assets in an economy that people regularly use to buy goods and services from other people.

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The functions of money • • • • •

Money serves three functions in our economy.

Medium of exchange: An item that buyers give to sellers when they want to purchase goods and services.

Unit of account: The yardstick people use to post prices and record debts.

Store of value: An item that people can use to transfer purchasing power from the present to the future.

Liquidity: The ease with which an asset can be converted into the economy’s medium of exchange.

– Money is the most liquid asset available.

– Other assets (such as shares, bonds and real estate) vary in their liquidity.

– When people decide in what forms to hold their wealth, they have to balance the liquidity of each possible asset against the asset’s usefulness as a store of value.

Kinds of money • •

Commodity money: Money that takes the form of a commodity with intrinsic value.

Fiat money: Money without intrinsic value that is used as money because of government decree.

Money in the Australian economy • •

•

The quantity of money circulating in Australia is sometimes called the money supply.

Included in the measure of the money supply are currency, current deposits and other monetary assets.

– Currency: The paper bills and coins in the hands of the public.

– Current deposits: Balances in bank accounts that depositors can access on demand by using a debit card or writing a cheque.

In the news: Banning Bitcoin is stupid. Non-state digital currencies will soon sweep away our monopoly money.

– This article explores the rise of online exchanges that accept virtual money, like Bitcoin.

– Monetary authorities in Thailand have banned the use of Bitcoin because it cannot be subject to capital controls.

– However, the article suggests that greater competition between state and non-state currencies is only a matter of time and it may be that non-state currencies retain value better than state currencies.

Make sure that students realise that the assets included in currency, M3 and broad money differ in terms of their liquidity.

See text Table 10.1 •

Table 10.1 shows the monetary assets included in three important measures of the money supply: currency, M3 and broad money.

The Reserve Bank of Australia • •

•

Reserve Bank of Australia: The central bank of Australia.

Central bank: An institution designed to oversee the banking system and regulate the quantity of money in the economy. The term ‘central’ comes from the fact that our present monetary authority derives its powers from the central (i.e. federal) government and it is the sole agency that determines monetary policy and coordinates our system of private commercial banking.

FYI: Credit cards, debit cards, smart cards and money.

– Credit cards are not a form of money; when a person uses a credit card, he or she is simply deferring payment for the item.

Students are quite curious about whether credit cards are considered money. You can satisfy their curiosity in part by pointing out that credit cards actually lead to a drop in the quantity of money people need to carry because they allow households to consolidate bills for payment once a month.

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– –

Because using a debit card is like writing a cheque, the account balances that lie behind debit cards are included in the measures of money.

Smart cards are similar to debit cards; they either access your cheque or savings account balances or are ‘topped up’ with transfers from your accounts or with cash.

Organisation of the RBA Highlight the RBA’s independence from the federal government. Students are surprised to find that the RBA is actually a corporation that earns more than enough to finance its operations without being funded by Parliament.

• • •

The Reserve Bank of Australia (RBA) was created in 1959.

A board manages the RBA, which is independent of the government. The board is comprised of nine members appointed by the government.

The nine members include the Secretary to the Treasury but the board itself is independent of the government. The current Governor of the RBA is Philip Lowe.

Have someone pull out a $5 or $10 note and confirm that the signatures of the Governor and the Secretary to the Treasury are on the notes.

Changes in the RBA’s role •

• • •

•

The Reserve Bank of Australia has three primary functions in the economy: – Prudential supervision. The RBA monitors the financial conditions of banks and financial institutions. (Under new arrangements introduced in 1998, the Australian Prudential Regulation Authority (APRA) performs many of the functions that the RBA did in the area of prudential supervision.)

– Guarantor of stability of the banking system. Unlike the Federal Reserve in the US, the RBA does not, however, act as the lender of last resort.

– Manager of monetary policy and liquidity conditions in the economy. This is the principal function of the RBA. Monetary policy is determined against a broad range of economic conditions (but principally, under the current inflation targeting regime, the trends in inflation).

Liquidity conditions: the price and availability of funding for the economy’s expenditure.

Monetary policy: the setting of the money supply by policymakers in the central bank.

The objectives of monetary policy are: – stability of the currency – maintenance of full employment – economic prosperity.

The long-run objective of monetary policy is to influence the rate of growth in the economy and the level of prices. For example, when the economy is overheating, the RBA will implement a tightening of monetary policy to slow the economy and avoid upward pressure on prices.

In the news: You Don’t Understand Bitcoin Because You Think Money is Real  This article suggests that money is an illusion.  US dollars are not backed by anything other than the faith of the people who accept it as payment. The writer argues that the illusion of dollars compared to cryptocurrency is more widely and more fiercely believed, for the moment.  There are a few differences between cryptocurrencies and US dollars. Transactions in bitcoin system are recorded in an unfalsifiable ledger that doesn’t rely on authority of banks or governments but on the strength of a public computer network. The supply of bitcoins is ultimately fixed. The anonymity of crypto is not as bulletproof as the anonymity of unmarked cash.  The writer argues that the records produced by a distributed computer network can be made tamperproof, which guarantees the soundness of a currency better than governments can.

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Banks and the money supply The process of money creation in the banking system is one of the more difficult things to teach at the Introductory Economics level. Nearly every aspect of the process will be new to students and nothing is obvious or intuitive. Therefore, it is extremely important that each step in the process is shown through T-accounts so that students can see how the banking system creates money as banks carry out their normal functions of accepting deposits and giving out loans.

The simple case of 100 per cent reserve banking • •

Example: Suppose that currency is the only form of money and the total amount of currency is $100.

A bank is created as a safe place to store currency; all deposits are kept in the vault until the depositor withdraws them.

– Reserves: Deposits that banks have received but have not loaned out.

– Under the example described above, we have 100 per cent reserve banking.

Make sure that you explain why bank reserves are an asset from the bank’s perspective, but customer deposits are a liability.

•

The financial position of the bank can be described with a T-account: FIRST STATE BANK Assets Reserves

Liabilities $100.00

Deposits

$100.00

Students will either catch on to T-accounts immediately or be completely confused. It is a good idea to explain them and then let students work together in small groups of two or three on a problem. You can check each group to identify students who need individual attention.

• •

Note that the money supply in this economy is unchanged.

– Before the bank was created, the money supply consisted of $100 worth of currency.

– Now, with the bank, the money supply consists of $100 worth of deposits.

This means that, if banks hold all deposits in reserve, banks do not influence the supply of money.

Money creation with fractional-reserve banking • • •

Fractional-reserve banking: A banking system in which banks hold only a fraction of deposits as reserves.

Reserve ratio: The fraction of deposits that banks hold as reserves.

Example: Same as above, but First State Bank decides to set its reserve ratio equal to 10 per cent and loan out the remainder of the deposits.

– The bank’s T-account would look like this: FIRST STATE BANK Assets Reserves – – – – –

Liabilities $10.00

Deposits

$100.00

Loans 90.00 When the bank makes these loans, the money supply changes.

Before the bank made any loans, the money supply was equal to the $100 worth of deposits.

Now, after the loans, deposits are still equal to $100, but borrowers now also hold $90 worth of currency from the loans.

Therefore, when banks hold only a fraction of deposits in reserve, banks create money.

Note that, while new money has been created, so has debt. There is no new wealth created by this process.

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The money multiplier • • •

The creation of the money does not stop at this point.

Borrowers usually borrow money to purchase something and then the money likely becomes redeposited elsewhere.

Suppose a person borrowed the $90 to purchase something and the funds then get redeposited in Second State Bank. Here is this bank’s T-account (assuming that it also sets its reserve ratio to 10 per cent): SECOND STATE BANK Assets Reserves

•

Liabilities $9.00

Deposits

$90.00

Loans 81.00 – If the $81 in loans becomes redeposited in another bank, this process will go on and on.

– Each time the money is deposited and a bank loan is created, more money is created.

Money multiplier: the amount of money the banking system generates with each dollar of reserves.

money multiplier = 1 / reserve ratio ALTERNATIVE CLASSROOM EXAMPLE Reserve ratio = 20 per cent Money multiplier = 1 / 0.20 = 5 Spend some time showing students how the multiplier changes as reserve requirements change. Make sure that you explain why the multiplier changes when the reserve ratio changes. Students will catch on to the maths fairly quickly; it is the intuition that is most difficult for them.

Bank capital, leverage and the Global Financial Crisis of 2008–09 • • • •

•

Financial resources that a bank gets from issuing equity to its owners are known as bank capital.

Aside from capital, a bank uses resources from deposits and debt to generate profit for its owners.

The use of debt to supplement existing funds for investment purposes is leverage.

When leverage ratio is 20, for every dollar of capital that the bank owners contribute, the bank has $20 of assets. Of the $20 assets, $19 are financed from either deposits or debt.

– In this case, capital is 5 per cent of liabilitites.

– When the value of assets increases by 5 per cent, the owners’ equity increases by 100 per cent.

– Likewise, a 5 per cent decrease in the value of assets reduces the value of capital by 100 per cent.

– If the reduction in the value of assets is significant, the bank’s assets can fall below its liabilities, making the bank insolvent as the bank is not able to pay off its debt holders and depositors in full.

In 2008 and 2009, many banks in the US fell short of capital after they incurred heavy losses on mortgage loans and securities backed by mortgage loans.

– The capital shortage induced banks to scale back lending, leading to a credit crunch which contributed to a severe downturn in economic activity.

– To address the problem, the US Treasury along with the Federal Reserve injected billions of dollars of public funds into the banking system to increase the amount of bank capital.

– The goal was to recapitalise the banking system so that bank lending can return to a more normal level.

Monetary policy in Australia today • •

Cash: the amount of currency and bank reserves in the economy.

Cash rate: The interest rate that financial institutions can earn on overnight loans of their currency or reserves.

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• •

The RBA sets a target for the cash rate in line with its monetary policy stance and undertakes openmarket operations to achieve that target. Figure 10.1shows that the actual cash rate nearly always equals the target rate.

Open-market operations: The purchase and sale of Australian government securities by the RBA. – If there is an excess supply for funds in the overnight market at the target interest rate the RBA will withdraw funds by selling government securities.

– If there is an excess demand for funds in the overnight market at the target interest rate the RBA will buy government securities increasing cash in the system.

– When the RBA sells government securities it reduces the level of cash in the system. The demand by banks for cash is more than the supply of cash, thus raising the cash rate.

Correspondingly, when the RBA buys government securities it provides cash for these securities thereby increasing the level of cash in the system and reducing the cash rate.

– Open-market operations are easy for the RBA to conduct, by crediting or debiting banks’ Exchange Settlements (ES) accounts and are therefore the tool that the RBA uses most often.

For more information on monetary policy, visit the RBA’s website: http://www.rba.gov./MonetaryPolicy/

Problems in controlling the money supply •

•

The RBA does not control the amount of money that consumers choose to deposit in banks.

– The more money that households deposit, the more reserves the banks have and the more money the banking system can create.

– The less money that households deposit, the smaller the amount of reserves banks have and the less money the banking system can create.

The RBA does not control the amount that bankers choose to lend.

– The amount of money created by the banking system depends on loans being made.

– If banks choose to hold onto a greater level of reserves than required by the RBA (called excess reserves), the money supply will fall.

Conclusion •

The monetary system plays an important role in our daily lives.

Adjunct teaching tips and warm-up activities 1 2

Encourage students to bring interesting forms of money they may have at home like silver dollars or two-dollar notes.

Suggest that students research the RBA using the RBA’s home page. Have students research recent decisions of the Board. Speeches of the Governor and Deputy Governor are also worthwhile downloading as are Statements on Monetary Policy. Students can also write group papers on the individuals on the Board including their training, which prime minister appointed them and the length of time remaining in their term. Examining the changes in the cash rate over the past 12 months is another useful exercise for students, to decide if the RBA has adopted an expansionary or contractionary approach to handling the economy.

Check your understanding solutions LO10.1 The meaning of money Q. List the three functions of money. Why are they important?

A: The three functions of money are: (1) medium of exchange; (2) unit of account; and (3) store of value. Money is used as a medium of exchange because money is the item people use to purchase goods and services. Money is used as a unit of account because it’s the yardstick people use to post prices and record debts. Money is used as a store of value because it’s an item people use to transfer purchasing power from the present to the future

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LO10.2 The Reserve Bank of Australia Q. Historically, what were the RBA’s functions? Why have they changed in the last two decades?

A: Historically, the RBA has had three related jobs. The first is to monitor individual banks and their stability (known as prudential supervision). This has been shifted to APRA. A related role is acting as guarantor of stability in the banking system. The RBA is also responsible for monetary policy. The functions have changed in the last two decades as it was recommended that these three roles should be separated. The APRA performs many of the functions of prudential supervision of banks and other financial institutions. The RBA has been left in charge of monetary policy and operations of the payments system, or the settlement of cheques between banks.

LO10.3 Banks and the money supply Q. How does the RBA ensure that the target rate is in equilibrium? Explain briefly.

A: The RBA uses open-market operations to ensure that its target rate is the equilibrium interest rate in the short term money market. If there is an excess supply of funds in the overnight market, it will withdraw funds by selling government securities. It takes in cash from financial institutions by reducing ES funds and therefore reducing cash in the system. If there is excess demand for funds at the target interest rate, the RBA will buy government securities and increase the ES funds of the financial institutions selling the securities, thus increasing cash in the system. In essence, the RBA is setting the price of cash (setting the price of money) and allowing the quantity to adjust to achieve that price.

Case study solutions Whose currency is the fairest in the land?

1. Why is the US dollar used outside of the United States?

A: The US dollar serves as a reserve currency, as a medium of exchange in countries that do not have a stable monetary system, and as a store of value.

2. What factors make the US dollar a store of value?

A: The US dollar is held as the preferred reserve currency because the US economy is currently the largest in the world. The USA is important in world trade and has open financial markets.

The US currency is easily convertible and several countries peg their currencies to the US dollar.

Bank runs and the money supply 1. Why are bank runs an issue under fractional-reserve banking?

A: Bank runs create a large problem under fractional-reserve banking. Since the bank only holds a fraction of its deposits in reserve, it will not have the funds to satisfy all of the withdrawal requests from its depositors.

2. How do bank runs affect the supply of money?

A: Bank runs complicate the control of the money supply. After bank runs, households and banks become more cautious. Households withdrew their deposits from banks and this decision reversed the process of money creation, and essentially reduced the money supply. Bankers increased reserve ratios to have enough cash on hand to meet depositors’ demands in future bank runs. This higher reserve ratio reduced the money multiplier which also reduced the money supply.

Practice questions solutions Questions for review 1

Money is different from other assets in the economy because it is the most liquid asset available.

Other assets vary widely in their liquidity.

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2

Commodity money is money with intrinsic value, like gold, which can be used for purposes other than as a medium of exchange. Fiat money is money without intrinsic value; it has no value other than its use as a medium of exchange. Our economy today uses fiat money.

3 Current deposits are balances in bank accounts that depositors can access on demand and are included in the supply of money because they can be used to buy goods and services.

4 The three measures of money supply are currency, M3 and broad money. Bitcoin would fall under broad money.

5 The cash rate is the interest rate that financial institutions earn on overnight loans of their currency or reserves. The RBA targets the cash rate under the current inflation-targeting regime. To achieve its cash rate target, the RBA undertakes open-market operations to affect the liquidity conditions of banks through their exchange settlement accounts held at the Reserve Bank. A rise in the cash rate is associated with a fall in the money supply.

6 The cash rate is the foundation rate for all interest rates in the economy. It is the rate financial institutions charge one another for borrowing and lending. When the institutions lend to individuals or businesses, the cash rate is used as the basis for determining the rate to charge.

7 Financial institutions say they no longer strictly follow movements in the cash rate because they borrow in the financial markets and use borrowed funds as leverage to offer loans. If their borrowing costs are higher than the cash rates, these financial institutions would need to charge higher interest rates for the loans they offer.

8 Reserve requirements are regulations on the minimum amount of reserves that banks must hold against deposits. The RBA no longer uses reserve requirements as a tool of monetary policy because the decision about the amount of reserves to hold is more a matter of prudential control.

Changing reserve requirements can be disruptive to the business of banking. Rather it relies on the more market-oriented cash rate as the tool of monetary policy. Banks do sometimes keep more reserves than required.

9 Bitcoin would hamper the ability of the RBA to administer payments. Unlike banks and other FIs that use the RBA to facilitate transactions between each other with their ES accounts, Bitcoin transactions use a decentralised clearance method. Hence Bitcoin users are not directly affected by the cash rate the RBA charges other FIs. 10 The term ‘prudential supervision’ refers to the monitoring of the financial condition of banks by a central agency. This role was traditionally undertaken by the RBA but is now the preserve of the Australian Prudential Regulation Authority.

Multiple choice 1. a

2. b

3. c

4. d

5. a

Problems and applications 1

a

b

c d

An Australian dollar coin is money in the Australian economy because it is used as a medium of exchange to buy goods or services, it serves as a unit of account because prices in stores are listed in terms of dollars and cents and it serves as a store of value for anyone who holds it over time.

A euro is not money in the Australian economy, because it is not used as a medium of exchange and prices aren’t given in terms of euros, so it isn’t a unit of account. It could serve as a store of value, though.

A Lamborghini isn’t money, because you can’t exchange it for goods or services and prices aren’t given in terms of Lamborghini. It does, however, serve as a store of value.

Apple Pay either accesses a credit or debit card. It is not a medium of exchange but if it accesses a debit card then the balance on this card is accessed. So Apple Pay is not a medium of exchange and therefore not money. It is a tool to access or carry money.

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2

3

4

a

b

5

The RBA would conduct an open market purchase (supplies more funds into the cash market), and this increase in funds will lead to a decrease in the cash rate. A decrease in the cash rate will lead to a decrease in other interest rates in the economy.

For an asset to be useful as a medium of exchange, it must be widely accepted (so all transactions can be made in terms of it), recognised easily as money (so people can perform transactions easily and quickly), divisible (so people can provide change) and difficult to counterfeit (so people won’t print their own money). The family home would not fulfil these tasks easily. A home would not be easily divisible, nor would transactions be able to be made quickly and easily and it could be copied.

For an asset to be useful as a store of value, it must be something that maintains its value over time and something that can be sold when money is needed. The family home could fulfil these tasks. Real estate is a good store of value. The family home is a physical asset, since it can be converted into money relatively easily.

For an asset to be useful as a unit of account, it has to act as a yardstick that people can use to post prices and record debts. The family home would be too big an asset to use to record prices. For example, the price of a shirt would be too small a proportion of the family home to be meaningful. Family homes can also vary in terms of size and quality and hence different homes would provide a different yardstick.

If more shops starting accepted bitcoin and this lead to greater use of the alternative means of payment, this could affect the ability of the RBA to set monetary policy and target the cash rate as the Australian (dollar) currency would decline in use as a method of payment. This would reduce the RBA’s ability to influence the money supply and the credit creation process.

If someone in Australia discovered an easy way to counterfeit bitcoin, they could flood the country with counterfeit currency, thus reducing its value. The result might be a switch to a different type of currency that could prevent the counterfeiting.

When your aunt repays a $100 loan from Third State Bank (TSB) by writing a cheque from her TSB cheque account, the result is a change in the assets and liabilities of both your aunt and TSB, as shown in these T-accounts:

Your aunt Assets Liabilities _____________________________________________ Before: Cheque account $100 | Loans $100 **************************************************************** After: Cheque account $ 0 | Loans $0 Third State Bank Assets Liabilities _____________________________________________ Before: Loans $100 | Deposits $100 **************************************************************** After: Loans $ 0 | Deposits $ 0

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6

By paying off the loan, your aunt simply eliminated the outstanding loans using the assets in her cheque account. Your aunt’s wealth hasn’t changed; she simply has fewer assets and fewer liabilities. a Here is IB’s T-account:

Iron Bank Assets Liabilities _____________________________________________ Reserves $35 million | Deposits $350 million Loans $315 million | b

When IB’s largest depositor withdraws $10 million in cash and IB reduces its loans outstanding to maintain the same reserve ratio, its T-account is now:

Beleaguered State Bank Assets Liabilities _____________________________________________ Reserves $34 million | Deposits $340 million Loans $306 million | c

7

8

Since IB is cutting back on its loans, other banks will find themselves short of reserves and they may also cut back on their loans as well. d IB may find it difficult to cut back on its loans immediately, since it can’t force people to pay off loans. Instead, it can stop making new loans. But for a time it might find itself with more loans than it wants. It could try to attract additional deposits to get additional reserves, or borrow from another bank or from the RBA. Money supply would decrease by the amount of coins in circulation that are no longer accepted as legal tender. Since coins make up a small proportion of total currency in circulation and currency does not participate in the credit creation process, the decrease in money supply is likely to be small. Regardless of the money demand elasticity, the impact on the interest rate may also be relatively small. a The balance sheet of Happy Bank:

Happy Bank Assets Liabilities _____________________________________________ Reserves $ 64 | Bank capital $200 Loans $ 936 | Deposits $800 b Happy Bank’s leverage ratio = 5. c 10 per cent of loan default implies $93.6 of loan amount becoming worthless. Loan value now = $842.4.

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d The bank’s total assets declined by 9.36 per cent and bank capital declined by 46.8 per cent. The change is larger for bank capital by the level of leverage ratio.

9 a If a loan of $200 000 is repaid, the bank’s liabilities increase by $200 000 since the money is deposited into the bank. No loans are made, hence reserves increase by $200 000. Loans, however, are reduced by $200 000. b With no loans being taken out the money supply will be constant since no additional deposit will be made.

10 a With a reserve ratio of 5 per cent and no excess reserves, the money multiplier is 1 / 0.05 = 20. If the RBA sells $1 million of government securities, reserves will decline by $1 million and the money supply will contract by 20 x $1 million = $20 million. b Banks might wish to increase their reserves to 10 per cent if they find they need to hold more for their day-to-day operations, such as paying other banks for customers’ transactions, making change, cashing paycheques and so on. If banks increase reserves to 10 per cent the money multiplier is 1 / 0.10 = 10. Reserves will increase by $1 million with the sale of government securities and the money supply will contract by 10 x 1 = 10 million.

11 a The balance sheet for WhichBank will show an increase in loans of $100m, while That Bank will show deposits increasing $100m. b The Exchange Settlement Account for WhichBank will reduce while the amount held by That Bank will increase. c WhichBank is more likely to have to borrow funds since it has to pay That Bank.

12 a If people hold all money as demand deposits at banks with 100 per cent reserves, the quantity of money is $3000. b If people have $1500 in currency and $1500 in current deposits, the quantity of money is $3000. c If banks have a reserve ratio of 10 per cent, the money multiplier is 1 / 0.10 = 10. So if people hold all money as demand deposits, the quantity of money is 10 x $3000 = $30 000. d If people hold equal amounts of currency (C) and current deposits (D) and the money multiplier for reserves is 10, then two equations must be satisfied: (1) C = D, so that people have equal amounts of currency and current deposits; and (2) 10 x ($3000 – C) = D, so that the money multiplier (10) times the number of dollar notes that aren’t being held by people ($3000 – C) equals the amount of current deposits (D).

Using the first equation in the second gives 10 x ($3000 – D) = D, or $30 000 – 10 D = D, or $30,000 = 11 D, so D = $2727.27. Then C = $2727.27.

The quantity of money is C + D = $5454.54.

13 1) The RBA does not control the amount of money that consumers choose to deposit in banks. The more money that households deposit, the more reserves the banks have and the more money the banking system can create. The less money that households deposit, the smaller the amount of reserves banks have and the less money the banking system can create. 2) The RBA does not control the amount that bankers choose to lend. The amount of money created by the banking system depends on loans being made. If banks choose to hold onto a greater level of reserves than required by the RBA (called excess reserves), the money supply will fall.

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Chapter 11 Inflation: Its causes and costs Learning objectives After reading this chapter, students should be able to: • discuss the causes of inflation and hyperinflation, and explain the principle of monetary neutrality • discuss the various costs that inflation imposes on society.

Key points •

•

• •

• •

The overall level of prices in an economy adjusts to bring money supply and money demand into balance. When the central bank increases the supply of money, it causes the price level to rise.

Persistent growth in the quantity of money supplied leads to continuing inflation.

The principle of monetary neutrality asserts that changes in the quantity of money influence nominal variables but not real variables. Most economists believe that monetary neutrality approximately describes the behaviour of the economy in the long run.

A government can pay for some of its spending simply by printing money. When countries rely heavily on this ‘inflation tax’, the result is hyperinflation.

One application of the principle of monetary neutrality is the Fisher effect. According to the Fisher effect, when the inflation rate rises, the nominal interest rate rises by the same amount, so that the real interest rate remains the same.

Many people think that inflation makes them poorer because it raises the cost of what they buy. This view is a fallacy, however, because inflation also raises nominal incomes.

Economists have identified six costs of inflation: shoeleather costs associated with reduced money holdings; menu costs associated with more frequent adjustment of prices; increased variability of relative prices; unintended changes in tax liabilities due to non-indexation of the tax code; confusion and inconvenience resulting from a changing unit of account; and arbitrary redistributions of wealth between debtors and creditors. Many of these costs are large during hyperinflation but the size of these costs for moderate inflation is less clear.

Chapter outline Introduction •

This chapter examines what and how much inflation is through the development of the quantity theory of money. It also looks at the costs of inflation.

The causes of inflation Start off the chapter by differentiating between a ‘once-and-for-all’ increase in the average level of prices and a continuous increase in the price level. Also make sure that students realise that inflation means that the average level of prices in the economy is rising rather than the prices of all goods.

It is instructive to review the inflation history of Australia. While your students may be fully aware of inflation, they may not realise that Australia has experienced several periods of deflation. Also point out to the students that the rate of inflation has varied significantly since the Second World War.

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The level of prices and the value of money • • •

When the price level rises, people have to pay more for the goods and services that they purchase.

A rise in the price level also means that the value of money is now lower because each dollar now buys a smaller amount of goods and services.

If P is the price level as measured by the CPI or the GDP deflator, then the quantity of goods and services that can be purchased with $1 is equal to 1 / P. If P increases, value of money (purchasing power) decreases.

Money supply, money demand and monetary equilibrium • •

•



•

The value of money is determined by the supply and demand for money.

There are many determinants of the demand for money.

– One variable that is very important in determining the demand for money is the price level.

– The higher prices are, the more money that is needed to perform transactions.

– Thus, a higher price level leads to a higher quantity of money demanded.

For the most part, the supply of money is determined by the central bank.

– The RBA no longer targets the money supply, as discussed in the chapter 10.

– Instead it targets the interest rates and inflation.

– Assuming the central bank targets the money supply, the supply of money will be vertical (perfectly inelastic).

In the long run, the overall price level adjusts to the level at which the demand for money and the supply of money are equal.

– If the price level is above the equilibrium level, people will want to hold more money than is available and prices will have to decline.

– If the price level is below equilibrium, people will want to hold less money than that available and the price level will rise.

We can show the supply and demand for money using a graph.

– The left-hand vertical axis is the value of money, measured by 1 / P. – The right-hand vertical axis is the price level (P). Note that it is inverted because a high value of money means a low price level and vice versa.

– At the equilibrium, the quantity of money demanded is equal to the quantity of money supplied.

– The money demand curve is downward sloping indicating that as the value of money decreases, i.e. P rises, people demand more money to buy goods and services.

Text Figure 11.1

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The effects of a monetary injection • • • •

Assume that the economy is currently in equilibrium and the central bank suddenly increases the supply of money.

The supply of money shifts to the right.

The equilibrium value of money falls (from V1 to V2) and the price level rises (from P1 to P2).

When an increase in the money supply makes dollars more plentiful, the result is an increase in the price level that makes each dollar less valuable.

Text Figure 11.2

•

Quantity theory of money: A theory asserting that the quantity of money available determines the price level and that the growth rate in the quantity of money available determines the inflation rate.

A brief look at the adjustment process • •

The immediate effect of an increase in the money supply is to create an excess supply of money.

People try to get rid of this excess supply in a variety of ways.

– They may buy goods and services with the funds.

– They may use these excess funds to make loans to others. These loans are then likely used to buy goods and services.

– In either case, the increase in the money supply leads to an increase in the demand for goods and services.

– Because the supply of goods and services has not changed, the result of an increase in the demand for goods and services will be higher prices.

The classical dichotomy and monetary neutrality • •

• • • • •

In the eighteenth century, David Hume and other economists wrote about the relationship between monetary changes and important macroeconomic variables such as production, employment, real wages and real interest rates.

They suggested that economic variables should be divided into two groups: nominal variables and real variables.

– Nominal variables: variables measured in monetary units.

– Real variables: variables measured in physical units.

Classical dichotomy: the theoretical separation of nominal and real variables.

Prices in the economy are nominal but relative prices are real.

Hume suggested that different forces influence real and nominal variables.

According to Hume, changes in the money supply affect nominal variables but not real variables.

Monetary neutrality: the proposition that changes in the money supply do not affect real variables.

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Mankiw’s analogy of changing the length of a metre from 100 centimetres to 50 centimetres is a useful way to explain the confusion a change in a unit of measurement (or a unit of account) can cause.

Velocity and the quantity equation •

Velocity of money: the rate at which money changes hands.

velocity = nominal GDP / money supply •

To calculate velocity, we divide nominal GDP by the quantity of money.

– If P is the price level (the GDP deflator), Y is real GDP and M is the quantity of money:

velocity = –

P  Y M

Rearranging, we get the quantity equation.

M V = P Y ALTERNATIVE CLASSROOM EXAMPLE Suppose that: Real GDP = $5000 Velocity = 5 Money supply = $2000 Price level = 2 We can show that: MxV=PxY $2000 x 5 = 2 x $5000 $10,000 = $10,000

•

•

Quantity equation: The equation M × V = P × Y, which relates the quantity of money, the velocity of money and the dollar value of the economy’s output of goods and services.

– The quantity equation shows that an increase in the quantity of money must be reflected in one of the other three variables.

– Specifically, the price level must rise, output must rise, or velocity must fall.

We can now explain how an increase in the quantity of money affects the price level using the quantity equation.

– Assume the velocity of money is relatively stable over time.

– When the central bank changes the quantity of money (M), it will proportionately change the nominal value of output (P × Y).

– The economy’s output of goods and services (Y) is determined primarily by available resources and technology.

– Because money is neutral, changes in the money supply do not affect output.

– This must mean that P increases proportionately with the change in M. If you want to, now would be a good time to introduce the debate in chapter 18 on whether monetary policy should be made by rule or discretion.

•The inflation tax • Some countries use money creation to pay for spending instead of using tax revenue.

• Inflation tax: the revenue the government raises by creating money.

• The inflation tax is a tax on everyone who holds money. When the government prints money, the price level rises and hence money held becomes less valuable.

Point out that an inflation tax is a more subtle form of taxation than the standard forms of taxation (income tax, sales tax etc.).

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•

Almost all hyperinflations follow the same pattern.

– The government has a high level of spending and inadequate tax revenue to pay for its spending.

– The government’s ability to borrow funds is limited.

– As a result, it turns to printing money to pay for its spending.

– The large increases in the money supply lead to large amounts of inflation.

– The hyperinflation ends when the government cuts its spending eliminating the need to create new money.

The Fisher effect • •

Recall that the real interest rate is equal to the nominal interest rate minus the inflation rate.

This, of course, means that:

nominal interest rate = real interest rate + inflation rate – –

The supply and demand for loanable funds determines the real interest rate.

Growth in the money supply determines the inflation rate.

ALTERNATIVE CLASSROOM EXAMPLE Real interest rate = 5 per cent Inflation rate = 2 per cent This means that the nominal interest rate will be 5 per cent + 2 per cent = 7 per cent.

If the inflation rate rises to 3 per cent, the nominal interest rate will rise to 5 per cent + 3 per cent = 8 per cent.

– • •

When the RBA increases the rate of growth of the money supply, the inflation rate increases.

This in turn will lead to an increase in the nominal interest rate.

Fisher effect: the one-for-one adjustment of the nominal interest rate to the inflation rate.

In the news: Fighting the war … on inflation?

– The articles highlight the effects of war on inflation.

– The article shows how the war in Syria led to price increases.

– The Ramadan period is normally a busy shopping time; however the recent hyperinflation has eroded the value of the Syrian pound and consumers’ purchasing power. The Syrian pound had lost 70% of its value over 12 months, and estimates of inflation range from 120 per cent to 213 per cent.

– The hyperinflation is due to declining production and a sharp increase in the money supply.

See text Figure 11.5 •

Figure 11.5 shows the nominal interest rate and the inflation rate since 1970.

The costs of inflation A fall in purchasing power? The inflation fallacy • •

Most individuals believe that the major problem caused by inflation is that inflation lowers the purchasing power of a person’s income.

However, as prices rise, so do incomes. Thus, inflation does not in itself reduce the purchasing power of incomes.

Point out to students that prices involve both buyers and sellers. This implies that the higher prices paid by consumers are exactly offset by the higher incomes received by the sellers. Also remind students that individuals often get pay increases over time to compensate for increases in the cost of living.

Shoeleather costs • •

Because inflation erodes the value of money that you carry in your pocket, you can avoid this drop in value by holding less money.

However, holding less money generally means more trips to the bank.

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• •

Shoeleather costs: the resources wasted when inflation encourages people to reduce their money holdings.

This cost can be considerable in countries experiencing hyperinflation; see the example from the Wall Street Journal(13 August 1985 issue)..

Menu costs • •

Menu costs: the costs of changing prices.

During periods of inflation, firms must change their prices more often.

Relative-price variability and the misallocation of resources • •

Because prices of most goods change only once in a while (instead of constantly), inflation causes relative prices to vary more than they would otherwise.

When inflation distorts relative prices, consumer decisions are distorted and markets are less able to allocate resources efficiently.

Inflation-induced tax distortions • •

Law-makers rarely take into account inflation when they write tax laws.

The nominal values of interest income and capital gains are taxed (not the real values).

Students find this section to be intriguing. Most have not considered the fact that tax laws do not differentiate between nominal and real interest income and capital gains, and they soon realise that this can lead to effects on rates of saving. Work through an example of the after-tax real interest rate under different inflation scenarios as is done in the text.

See text Table 11.1 – Table 11.1 shows a hypothetical example of two countries both applying the same tax rate of 25 per cent to interest income, but one economy has no inflation and the other lives in a country with 8 per cent inflation.

– Economy 1 with no inflation has a tax reduced real rate of interest = 3 per cent since the 4 per cent rate of interest is taxed at 25 per cent (= 1 per cent).

– Economy 2, with a rate of interest = 4 per cent and inflation = 8 per cent, has a nominal interest rate of 12 per cent as result of the Fisher effect. The government receives 25 per cent from the tax on the interest income, (1 / 4 x 12 per cent = 3 per cent) hence the nominal interest rate after tax interest = 9 per cent, while the real rate of interest = 1 per cent.

– The person living in the country with inflation ends up with a smaller after-tax real interest rate.

• This implies that higher inflation will tend to discourage saving.

ALTERNATIVE CLASSROOM EXAMPLE Homer and Marge each earn a real interest rate on their savings account of 3 per cent. However, Homer lives in a country with a 1 per cent inflation rate, while Marge lives in a country with a 10 per cent inflation rate. Both countries have a 20 per cent tax on income.

Homer Marge Real interest rate 3 per cent 3 per cent Inflation rate 1 per cent 10 per cent Nominal interest rate 4 per cent 13 per cent Reduced interest due to 20 per cent tax 0.8 per cent 2.6 per cent After-tax nominal interest rate 3.2 per cent 11.4 per cent After-tax real interest rate 2.2 per cent 1.4 per cent Note that the after-tax return on saving is lower in Marge’s country than in Homer’s. This means that individuals in Marge’s country will be less likely to save.

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Confusion and inconvenience • •

Money is the yardstick that we use to measure economic transactions.

When inflation occurs, the value of money falls. This alters the yardstick that we use to measure important variables like incomes and profit.

A special cost of unexpected inflation: Arbitrary redistributions of wealth • •

• •

Example: Sam Student takes out $20 000 in loans at 7 per cent interest (nominal). In 10 years, the loan will come due. After his debt has compounded for 10 years at 7 per cent, Sam will owe the bank $40 000.

The real value of this debt will depend on inflation.

If the economy has a hyperinflation, wages and prices will rise so much that Sam would be able to pay the $40 000 out of pocket change.

If the economy has deflation, Sam will find the $40 000 a greater burden than he imagined.

Because inflation is often hard to predict, it imposes risk on both Sam and the bank that the real value of the debt will differ from that expected when the loan is made.

In the news: If inflation is bad, then deflation must be good … right?

– Japan has experienced declining prices for much of 2009 and 2010.

– As consumers delay purchases prompting firms to cut prices and reduce employment, it is argued that deflation may be bad for the economy.

– Some have argued that deflation in the long term can worsen economic growth and government needs to take a more active role to address the problem.

– By contrast, Eisuke Sakakibara, a former top bureaucrat at Japan’s Ministry of Finance has warned against taking extreme measures to correct deflation that could result in undesirable side-effects. He iterated that deflation in Japan was accompanied by economic recovery.

– Given structural changes in the region, a reason to explain Japan’s deflation is the access to cheaper imports from China as the region experiences economic integration.

Conclusion •

This chapter discussed the causes and costs of inflation. The main cause is a growth in the quantity of money. The costs of inflation include shoeleather costs, menu costs, increased variability of relative prices, unintended changes in tax liabilities, confusion and inconvenience and arbitrary redistributions of wealth.

Adjunct teaching tips and warm-up activities 1

2

Bring marbles (or something else that can be used as currency) to class. Pick 10 students and give them five marbles each. Auction off a chocolate. Then give each student 10 marbles. Show students how the price of the sweet rises when the amount of ‘money’ in the market increases.

Before discussing the section on the costs of inflation, ask students if they believe that inflation is a big problem. Ask them to explain how inflation affects their lives.

Check your understanding solutions LO11.1 The causes of inflation Q. If a government of a country increases the growth rate of the money supply from 10 per cent per year to 50 per cent per year, what happens to the price level? What happens to nominal interest rates? Why might a government choose this course of action?

A: When the government of a country increases the growth rate of the money supply from 10 per cent per year to 50 per cent per year, prices and nominal interest rates will increase dramatically. The government may be increasing the money supply to finance its expenditures.

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LO11.2 The costs of inflation Q. Briefly describe the six costs of inflation.

A: Six costs of inflation are: (1) shoeleather costs; (2) menu costs; (3) relative-price variability and the misallocation of resources; (4) inflation-induced tax distortions; (5) confusion and inconvenience; and (6) arbitrary redistributions of wealth. Shoeleather costs arise because inflation causes people to spend resources going to the bank more often. Menu costs occur when people spend resources changing their posted prices. Relative-price variability occurs because as general prices rise, a fixed dollar price translates into a declining relative price, so the relative prices of goods are constantly changing as a result of inflation; this causes a misallocation of resources. The combination of inflation and taxation causes distortions because people are taxed on their nominal capital gains and interest income, instead of their real income. Inflation causes confusion and inconvenience because it reduces money’s ability to function as a unit of account. Unexpected inflation redistributes wealth between borrowers and lenders.

Case study solutions The long-lasting effect of printing money 1. How does the quantity theory of money relate to Zimbabwe over the last two decades?

A: When a central bank prints too much money, it can result in hyperinflation. In Zimbabwe, hyperinflation in December 2008 resulted in prices rising by 100 per cent every 24 hours. The Zimbabwe dollar eventually grew in disproportionate denominations and was replaced by the South African Rand and the US dollar as a medium of exchange. Zimbabwe has recently brought back its own currency.

In February, the central bank introduced the RTGS$ and this precipitated a rapid depreciation in both the newly introduced interbank rate and the black market value. Inflation was at 97.9% which is the highest since 2008. According to the quantity theory of money, when the supply of money is increased, the value of money decreases and the price level increases.

Money and prices during four hyperinflations 1. What can explain the almost perfectly synchronised pattern between the price level and money supply in Figure 11.4?

A: The quantity equation can explain the synchronised pattern. As velocity of money is stable over time, when the quantity of money (M) changes, it will proportionately change the nominal value of output (PxY). Output (Y) is determined primarily by available resources and technology and as money is neutral, changes in the money supply do not affect output. This implies that P increases proportionately with the change in M. In other words, the price level and quantity of money (in Figure 11.4) move closely together.

The wonderful Wizard of Oz and the free-silver debate 1. How did the unexpected fall in the price level cause a redistribution of wealth during the 1880s?

A: From 1880 to 1896, the United States experienced deflation, redistributing wealth from farmers (with outstanding loans) to banks.

2. What factors in the early twentieth century led to the price level being restored to the prices prevailing in the 1880s? How did this affect the supply of money?

A: Even though those who wanted to use silver were defeated, the money supply in the United States increased in 1898 when gold was discovered in Alaska and supplies of gold were shipped in from Canada and South Africa. Within 15 years, prices were back up and the farmers were better able to handle their debts.

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Practice questions solutions Questions for review 1

2

3

4

5

6 7

8

When the price level rises, people have to pay more for the goods and services they buy. Therefore, an increase in the price level means a lower value of money because each dollar in your wallet now buys a smaller quantity of goods and services.

According to the quantity theory of money, the effect of a decrease in the quantity of money is a decrease in the price level. If the central bank increases the money supply rapidly, this will cause an increase in the price level and a decrease in the value of money.

The nominal interest rate is the real interest rate plus inflation. The real interest rate is nominal interest rate minus inflation. If nominal interest rate is 8 per cent and real interest rate is 3.5 per cent, then the inflation rate is 4.5 per cent.

Y= (MxV)/P. This means that real output is equal to quantity of money times velocity divided by the price level. If the numerator (MxV) rises faster than the denominator, then real output will increase. If the denominator (or the price level, P) rises faster than the numerator, then real out put will decrease.

Inflation is like a tax because as prices rise, everyone who holds money loses purchasing power. In a hyperinflation, the government uses the inflation tax, instead of taxes on income, to finance its spending. Very rapid money growth leads to high rates of inflation.

According to the Fisher effect, an increase in the inflation rate raises the nominal interest rate by the same amount that the inflation rate increases, with no effect on the real interest rate.

The costs of inflation include shoeleather costs associated with reduced money holdings, menu costs associated with more frequent adjustment of prices, increased variability of relative prices, unintended changes in tax liabilities due to non-indexation of the tax laws, confusion and inconvenience resulting from a changing unit of account and arbitrary redistributions of wealth between debtors and creditors. With a low and stable rate of inflation like Australia experienced 2005–07, none of these costs are very high. Perhaps the most important one is the interaction between inflation and the tax laws, which may reduce saving and investment even with a low inflation rate.

If inflation is greater than expected, debtors benefit and creditors lose. Creditors receive dollar payments from debtors that have a lower real value than was expected.

Multiple choice 1. b

2. d

3. b

4. a

5. a

6. d

Problems and applications 1

2

The case for inflation targeting as a monetary policy objective is made with reference to the quantity theory of money (M x V = P x Y), which relates the quantity of money to the nominal value of output. Assuming the velocity of money is relatively stable over time, if the central bank were to change the quantity of money, it would cause proportionate changes in the nominal value of output.

With output determined by factor inputs and technology, if the central bank alters the money supply and induces parallel changes in the nominal value of output, the changes are reflected in changes in the price level.

The quantity equation can hold for different measures of the money supply because velocity is different for each different money measure. Similarly, the quantity theory of money also holds because an increase in money growth doesn’t affect the money multipliers for each different measure of money, so the rate of money growth is the same for any money measure and is therefore matched by a proportionate rise in inflation.

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3

4

5

6

7 8 9

Lenin is right that governments can confiscate the wealth of citizens with inflation. Inflation acts like a tax on people who hold money, by reducing its value. The government can finance its expenditures by printing money and using it to buy things, which results in a higher money supply and inflation. The result is a transfer of wealth from money-holders to the government.

If a country’s inflation rate increases sharply, the inflation tax on holders of money increases significantly. Wealth in savings accounts isn’t subject to a change in the inflation tax because the nominal interest rate will increase with the rise in inflation. But holders of savings accounts are hurt by the increase in the inflation rate because they are taxed on their nominal interest income, so their real returns are lower.

One reason for coordinating might be to reduce conflicts in fiscal and monetary policy. Thus the RBA may adopt tight monetary policy to offset the inflationary impacts of expansionary fiscal policy, blunting the expansion. Nonetheless, such conflicts are rare and it is likely that fiscal policy is too expansionary for the macro-economic conditions. Independence of the RBA helps keep inflationary expectations low, achieving price stability. The costs of inflation are not trivial. The potential gains from more government control are not compelling given the costs of inflation (which Australia has experienced in the ’70s and early ’80s). a The total cost of purchasing equal amounts of potatoes and carrots equals the quantity of each good times its price, added together for all goods. That is, if x is the quantity of potatoes, which also equals the quantity of carrots, then the cost of potatoes and carrots for the year is x (PP + PC). In the second year, the cost is x (PP’ + PC’), where the ’ mark refers to the price in the second year. Then we can define a price index with a value of one in the first year. In the second year, the price index has the value of the cost of goods in the second year divided by the cost of goods in the first year. Thus the price index in the second year is x (PP’ + PC’) / x (PP + PC) = (PP’ + PC’) / (PP + PC) = ($6 + $7.50) / ($5 + $3) = $13.50 / $8 = 1.687. Nick is worse off because the price of potatoes increased 20 per cent while inflation increased be 68.7 per cent, so the prices of the goods he sells rose slower than the price of the goods (carrots) he buys. Aneta is better off because carrots increased by 150 per cent while inflation was 68.7 per cent, so the prices of the goods she sells rose faster than the price of the goods (potatoes) she buys. b If the price of potatoes rises to $6 and the price of carrots remains at $3, then the price index in the second year is (PB’ + PR’) / (PB + PR) = ($6 + $3) / ($5 + $3) = $9 / $8 = 1.125, so the inflation rate is (1.125 – 1) / 1 x 100 per cent = 12.5 per cent. Nick is better off because the price of potatoes increased 20 per cent while inflation was only 12.5 per cent. Aneta is worse off because inflation was 12.5 per cent, so the prices of the goods she buys rose faster than the price of the goods (carrots) she sells, which did not change. c If the price of potatoes falls to $4 and the price of carrots falls to $2.50, then the price index in the second year is (PB’ + PR’) / (PB + PR) = ($4 + $2.50) / ($5 + $3) = $6.50 / $8 = 0.8125, so the inflation rate is (0.8125 – 1) / 1 x 100 per cent = –18.75 per cent. Nick is worse off because his dollar revenues fall by 20 per cent but overall prices fell by only 18.75 per cent. Anetais better off because her dollar revenues fall by 16.67 per cent, which is less than the deflation of 18.75 per cent, so the prices of the goods she sells didn’t fall as fast as the price of the goods (potatoes) she buys.

Computerisation decreases menu costs since it is easy to change prices. Firms are then more likely to respond to changes in their input prices by increasing their prices. Inflation therefore increases.

If you lived in a low-inflation economy, you would hold wealth in assets such as cash that would lose value only slowly over time. a Unexpectedly low inflation hurts the federal government by providing lower inflation tax revenue and increasing the real value of outstanding government debt. b Unexpectedly low inflation hurts a homeowner with a fixed-rate mortgage because she pays a fixed nominal interest rate that was based on expected inflation and thus pays a higher real interest rate than was expected. c Unexpectedly low inflation neither helps nor hurts a casual worker who has no labour contract because her real wage is the same since his nominal wages, without a binding contract, can be adjusted according to the inflation rate.

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d

Unexpectedly low inflation helps an investor that has invested some of its endowment in Treasury bonds because the lower inflation rate means that she is receiving a higher real interest rate than it had planned.

10 The redistribution from creditors to debtors is something that happens when inflation is unexpected, not when it is expected. The problems that occur with both expected and unexpected inflation include shoeleather costs associated with reduced money holdings, menu costs associated with more frequent adjustment of prices, increased variability of relative prices, unintended changes in tax liabilities due to non-indexation of the tax code and the confusion and inconvenience resulting from a changing unit of account.

11 a The statement that ‘Inflation hurts borrowers and helps lenders, because borrowers must pay a higher rate of interest’ is false. Higher expected inflation means borrowers pay a higher nominal rate of interest but it’s the same real rate of interest, so borrowers aren’t worse off and lenders aren’t better off. Higher unexpected inflation, on the other hand, makes borrowers better off and lenders worse off. b The statement that ‘If prices change in a way that leaves the overall price level unchanged, then no one is made better or worse off’ is false. Changes in relative prices can make some people better off and others worse off, even though the overall price level doesn’t change. See problem 6 for an illustration of this. c The statement that ‘Inflation does not reduce the purchasing power of most workers’ is true.

Most workers’ incomes keep up with inflation reasonably well.

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Chapter 12 Open-economy macroeconomics: Basic concepts Learning objectives After reading this chapter, students should be able to: • define net exports and net foreign investments, and explain how they measure the international flow of goods and capital • explain the meaning of the nominal exchange rate and the real exchange rate • examine purchasing-power parity as a theory of how exchange rates are determined.

Key points •

• •

•

Net exports are the value of domestic goods and services sold abroad minus the value of foreign goods and services sold domestically. Net foreign investment is the acquisition of foreign assets by domestic residents minus the acquisition of domestic assets by foreigners. Because every international transaction involves an exchange of an asset for a good or service, an economy’s net foreign investment always equals its net exports.

An economy’s saving can be used to finance investment at home or buy assets abroad. Thus, national saving equals domestic investment plus net foreign investment.

The nominal exchange rate is the relative price of the currency of two countries and the real exchange rate is the relative price of the goods and services of two countries. When the nominal exchange rate changes so that each dollar buys more foreign currency, the dollar is said to appreciate or strengthen. When the nominal exchange rate changes so that each dollar buys less foreign currency, the dollar is said to depreciate or weaken.

According to the theory of purchasing-power parity, a dollar (or a unit of any other currency) should be able to buy the same quantity of goods in all countries. This theory implies that the nominal exchange rate between the currencies of two countries should reflect the price levels in those two countries. As a result, countries with relatively high inflation should have depreciating currencies and countries with relatively low inflation should have appreciating currencies.

Chapter outline Introduction •

• •

Trade allows people to produce what they produce best and to consume the great variety of goods and services produced around the world. This chapter provides an introduction to open-economy macroeconomics by discussing the key macroeconomic variables that describe an open economy’s interactions in world markets.

Closed economy: An economy that does not interact with other economies in the world.

Open economy: An economy that interacts freely with other economies around the world.

The international flows of goods and capital The flow of goods: Exports, imports and net exports • • •

Exports: Goods and services that are produced domestically and sold abroad.

Imports: Goods and services that are produced abroad and sold domestically.

Net exports (NX): The value of a nation’s exports minus the value of its imports, also called the trade balance.

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NX = Exports - Imports •

Trade balance: The value of a nation’s exports minus the value of its imports, also called net exports.

Make it clear that there are no ‘good’ or ‘bad’ international trade balances, just as there are no good or bad trade balances between states or between a household and a local merchant. Trade simply allows individuals to consume more than they would be able to in the absence of trade.

• • •

Trade surplus: An excess of exports over imports.

Trade deficit: An excess of imports over exports.

Balanced trade: A situation in which exports equal imports.

Point out to students that a trade surplus implies a positive level of net exports, a trade deficit means that net exports are negative and balanced trade occurs when net exports are equal to zero. While this will likely be obvious to most students, some will benefit if you review this.

•

•

Factors that influence a country’s exports, imports and 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 incomes of consumers at home and abroad.

– The cost of transporting goods from country to country.

– The policies of the government toward international trade.

In the news: Trade surplus record papers over Australia’s worrying domestic economic trends – Australia has posted its biggest trade surplus on record and is on track to post its first current account surplus since Gough Whitlam was prime minister.  Over the year Australia accumulated trade surpluses totally almost $50 billion.  Iron ore and coal are the biggest contributors to exports.  There is a concern about the 3.6 per cent slump in imports.  The lower Australian dollar may be causing more people to buy Australian products. The other more concerning explanation is that the import slump reflects the fact that Australians are cutting back on spending in general.  Much more concerning was a 9 per cent slump in capital goods import. This may be a sign of weakness in investment and can lead to lower economic and employment growth.

The flow of financial resources: Net foreign investment •

Net foreign investment: The purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners.

NFI = purchases of foreign assets - purchases of domestic assets by domestic residents by foreigners You will likely have to write this equation several times on the board for students when discussing this chapter and the next. Students can grasp the concept of net exports more easily than they can the concept of net foreign investment.

•

•

•

Foreign investment takes two forms: – Foreign direct investment occurs when a capital investment is owned and operated by a foreign entity.

– Foreign portfolio investment involves an investment that is financed with foreign money but operated by domestic residents.

Factors that influence a country’s net foreign investment: – 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.

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     

This articles discusses the implications of child labour.

The boys have come from the impoverished West African nation to Ivory Coast where there are many small cocoa farms which source the world’s cocoa.

Many of these workers are underage but are used illegally.

It is likely that a chocolate bar bought in US is the product of child labour Although it was pledged to eradicate child labour, the companies still cannot identify the farms where all their cocoa comes from and whether child labour was used in producing it.

Buying cocoa that has been certified for ethical business practices by third party groups has been weakened by a lack of rigorous enforcement of child labour rules.

The equality of the current account and the capital and financial accounts •

•

The current account and the capital and financial accounts each measure a type of imbalance in these markets.

– The current account measures the imbalance between a country’s exports and imports in world markets for goods and services (NX) as well as the flow of net income (NY) and net transfers (NT).

The current account balance is: CAB = NX + NY + NT

• •

The capital and financial accounts measure an imbalance between the amount of foreign assets bought by domestic residents and the amount of domestic assets bought by foreigners; that is, net foreign investment (NFI).

For an economy: CAB = NFI

• •

This equation holds as every transaction that affects one side of the equation must affect the other side by the same amount.

Example: Fisher & Paykel, the New Zealand white goods manufacturer, sells refrigerators to a Japanese hotel.

– Fisher & Paykel sells fridges to the Japanese hotel and the Japanese hotel gives yen to Fisher & Paykel. Exports have increased (which raises net exports and hence the current account balance) and New Zealand has acquired some foreign assets in terms of yen (which raises net foreign investment).

– Or, Fisher & Paykel may exchange its yen for New Zealand dollars with another entity that wants yen. Suppose a New Zealand stockbroker wants to buy shares in Sony Corporation. In this case, Fisher & Paykel’s net export of fridges equals the stockbroker’s net foreign investment in Sony shares.

– Or, Fisher & Paykel may exchange its yen with a New Zealand firm that wants to buy computers from Toshiba, the Japanese computer maker. In this case, the imports will exactly offset the exports, so net exports and the CAB are unchanged. Note that net foreign investment remains the same as well.

ALTERNATIVE CLASSROOM EXAMPLE Assume that Australian residents do not want to buy any foreign assets but foreign residents want to purchase some stock in an Australian firm.

How are the foreigners going to get the dollars to purchase the stock? They would do it the same way Australian residents would purchase the stock – they would have to earn more than they spend. In other words, foreigners must sell Australia more goods and services than they purchase from Australia.

This leads to negative net exports for Australia. The extra dollars spent by Australian residents on foreign-produced goods and services would be used to purchase the stock in an Australian firm.

• •

Every international transaction involves exchange. When a seller country transfers a good or service to a buyer country, the buyer country gives up some asset to pay for the good or service.

Thus, the net value of the goods and services sold by a country (net exports) must equal the net value of the assets acquired (net foreign investment).

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Saving, investment and their relationship to the international flows •

Recall that GDP (Y) is the sum of four components: consumption (C), investment (I), government purchases (G) and net exports (NX).

Y = C + I + G  NX •

To take account of earnings from overseas investments we define gross national disposable income: GNDY = GDP + NY + NT

•

Gross national savings equals: S =GNDY -C -G

•

By substituting in the defintion of national disposable income this can be simplified to: S =𝐼 + 𝐶𝐴𝐵

•

Because the current account balance also equals net foreign investment, we can rewrite this as:

S = I + NFI • • •

This implies that saving is equal to the sum of domestic investment (I) and net foreign investment (NFI).

When an Australian citizen saves $1 of his income, that dollar can be used to finance accumulation of domestic capital or it can be used to finance the purchase of capital abroad.

Note that in a closed economy, such as the one we assumed earlier, net foreign investment would equal zero and saving would simply be equal to domestic investment.

The prices for international transactions: Real and nominal exchange rates Nominal exchange rates • •

Nominal exchange rate: The rate at which a person can trade the currency of one country for the currency of another.

An exchange rate can be expressed in two ways.

Example: 80 yen per dollar.

This can also be written as 1 / 80 dollar (or 0.0125 dollar) per yen.

ALTERNATIVE CLASSROOM EXAMPLE $1 = 10 pesos 1 peso = $0.10

• • •

Appreciation: An increase in the value of a currency as measured by the amount of foreign currency it can buy.

Depreciation: A decrease in the value of a currency as measured by the amount of foreign currency it can buy.

When a currency appreciates, it is said to strengthen; when a currency depreciates, it is said to weaken.

Make sure that you emphasise that when the dollar appreciates against a particular currency that currency must depreciate against the dollar. Use an example to illustrate this point.

Real exchange rates • • •

Real exchange rate: The rate at which a person can trade the goods and services of one country for the goods and services of another.

Example: One tonne of Australian rice sells for $100 and one tonne of Japanese rice sells for 14,000 yen. The nominal exchange rate is 90 yen per dollar.

The real exchange rate depends on the nominal exchange rate and on the prices of goods in the two countries measured in the local currencies.

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real exchange rate = 

Nominal exchange rate  Domestic price Foreign price

In our example: real exchange rate = real exchange rate = real exchange rate =

(90 yen / $1) ($100 / tonne of Australian rice) 18,000 yen / tonne of Japanese rice 9,000 yen / tonne of Australian rice 18,000 yen / tonne of Japanese rice 1/2 tonne of Japanese rice / tonne of Australian rice

ALTERNATIVE CLASSROOM EXAMPLE Price of Mexican corn = 50 pesos / bushel Price of Australian corn = $10 / bushel Nominal exchange rate: $1 = 10 pesos real exchange rate = (10 pesos / $1) ($10 / bushel of Australian corn) 50 pesos / bushel of Mexican corn real exchange rate = 100 pesos 50 pesos real exchange rate = 2 bushels of Mexican corn / bushel of Australian corn

• •

The real exchange rate is a key determinant of how much a country exports and imports.

When studying an economy as a whole, economists focus on overall prices instead of the prices of individual goods and services.

– Price indexes are used to measure the level of overall prices.

– Assume that P is the price index for Australia, P* is a price index for prices abroad and e is the nominal exchange rate between the Australian dollar and foreign currencies.

real exchange rate = • • •

e  P P*

The real exchange rate measures the price of a basket of goods and services available domestically relative to the price of a basket of goods and services available abroad.

A depreciation in the Australian real exchange rate means that Australian goods have become cheaper relative to foreign goods. Australian exports will rise, imports will fall and net exports will increase.

Conversely, an appreciation in the Australian real exchange rate means that Australian goods have become more expensive relative to foreign goods. Australian exports will fall, imports will rise and net exports will decline.

A first theory of exchange-rate determination: Purchasing-power parity •

Purchasing-power parity: A theory of exchange rates whereby a unit of any given currency should be able to buy the same quantity of goods in all countries.

The basic logic of purchasing-power parity •

The law of one price suggests that a good must sell for the same price in all locations.

– If a good sold for less in one location than another, a person could make a profit by buying the good in the location where it is cheaper and selling it in the location where it is more expensive.

– The process of taking advantage of differences in prices in different markets is called arbitrage.

– Note what will happen as people take advantage of the differences in prices. The price in the location where the good is cheaper will rise (because the demand is now higher) and the price

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•

in the location where the good was more expensive will fall (because the supply is greater).

This will continue until the two prices are equal.

The same logic should apply to currency.

– An Australian dollar should buy the same quantity of goods and services in Australia and Japan; a Japanese yen should buy the same quantity of goods and services in Australia and Japan.

– Purchasing-power parity suggests that a unit of all currencies must have the same real value in every country.

– If this was not the case, people would take advantage of the profit-making opportunity and this arbitrage would then push the real values of the currencies to equality.

Implications of purchasing-power parity •

Purchasing-power parity means that the nominal exchange rate between the currencies of two countries will depend on the price levels in those countries.

• If a dollar buys the same amount of goods and services in Australia (where prices are measured in dollars) as it does in Japan (where prices are measured in yen), then the nominal exchange rate (the number of yen per dollar) must reflect the cost of goods and services in the two countries. 𝑒=𝑃• Suppose that P is the price of a basket of goods in Australia (measured in dollars), P* is the price of a basket of goods in Japan (measured in yen) and e is the nominal exchange rate (the number of yen each dollar can buy).

In Australia the purchasing power of $1 is 1 / P. – In Japan, $1 can be exchanged for e units of yen, which in turn have the purchasing power of e / P*.

– Purchasing-power parity implies that the two must be equal:

1/P = e /P* –

Rearranging, we get:

1 = (e P) / P * – –

•

• •

Note that the left-hand side is a constant and the right-hand side is the real exchange rate. This implies that if the purchasing power of a dollar is always the same at home and abroad, then the real exchange rate cannot change.

We can rearrange again to see that:

 This means that nominal exchange rates will change when price levels change.

Because the nominal exchange rate depends on the price levels, it must also depend on the money supply and money demand in each country.

– If the central bank increases the supply of money in a country and raises the price level, it also causes the country’s currency to depreciate relative to other currencies in the world.

– When a central bank prints a large amount of money, that 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.

In the news: Purchasing-power parity and the Big Mac. – The Economist, an international news magazine, occasionally compares the cost of a Big Mac in various countries all around the world.

In the news: Purchasing-power parity and the iPod. – Like the Big Mac Index, the iPod index can also be used to indicate whether a currency is over or undervalued.

– Peter Martin of the Sydney Morning Herald reports on whether the Australian dollar is over or undervalued according to the iPod index.

Limitations of purchasing-power parity • •

Exchange rates do not always move to ensure that a dollar has the same real value in all countries.

There are two reasons why the theory of purchasing-power parity does not always hold in practice.

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– –

Many goods are not easily traded (haircuts in Manila versus haircuts in New York). Thus, arbitrage would be too limited to eliminate the difference in prices between the locations.

Tradable goods are not perfect substitutes when they are produced in different countries (Australian beer versus German beer). There is no opportunity for arbitrage here, because the price difference reflects the different values the consumer places on the two products.

Point out to students that, even with its flaws, purchasing-power parity does tell us about exchange rates. Large and persistent movements in nominal exchange rates typically reflect changes in price level at home and abroad.

Conclusion •

This chapter developed basic concepts used to study open economies by exploring macroeconomic variables. These variables offer a starting point for analysing an open economy’s interactions with the rest of the world.

Adjunct teaching tips and warm-up activities Students are curious about the currencies of other countries. Bring in a current list of nominal exchange rates between several currencies and the Australian dollar. Quiz the students to see if they can match up the currencies with the countries where they are used.

Check your understanding solutions LO12.1 The international flows of goods and capital Q. Define net exports and net foreign investment. Explain how they are related A: Net exports are the value of a nation’s exports minus the value of its imports, also called the trade balance. Net foreign investment is the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners. Net exports plus net income and net transfers equal net foreign investment.

LO12.2 The prices for international transactions: Real and nominal exchange rates Q. Define nominal exchange rate and real exchange rate, and explain how they are related. If the nominal exchange rate goes from 100 yen to 80 yen per dollar, has the dollar appreciated or depreciated?

A: The nominal exchange rate is the rate at which a person can trade the currency of one country for the currency of another. The real exchange rate is the rate at which a person can trade the goods and services of one country for the goods and services of another. They are related through the expression: real exchange rate equals nominal exchange rate times domestic price divided by foreign price. If the nominal exchange rate goes from 100 yen to 80 yen per dollar, the dollar has depreciated because a dollar now buys less yen.

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LO12.3 A first theory of exchange-rate determination: Purchasing-power parity Q: If the Reserve Bank of Australia (RBA) decreases the money supply, what happens to the price level? What happens to Australia’s currency relative to the other countries in the world? Use the equation, e=P*/P to help answer these questions A: If the RBA decreases the money supply, this will decrease the price level (according to the quantity theory of money). With a lower price level (P), Australia’s currency will appreciate (rise) relative to other countries in the world.

Case study solutions The importance of trade in the Australian economy 1. After the Second World War, what factor(s) contributed to increased international trade globally? How did these factor(s) change the composition of international trade? Explain A: Figure 12.1 shows the total value of exports and imports (expressed as a percentage of GDP) for Australia since 1950. Both have steadily increased since the mid 1990s, indicating the increasing importance of international trade in goods and services. Advances in transportation, telecommunications and technological progress are some of the reasons why international trade has increased over time. These developments meant that goods that once had to be produced and consumed locally can now be traded around the world, businesses can reach overseas customers more easily and technological progress has also changed the kinds of goods that economies produce. The government’s trade policies have also been a factor in increasing international trade.

2. Economists believe that free trade agreements (FTAs) are mutually beneficial for the global economy. Provide examples of FTAs and briefly explain them. Can you think of arguments against FTAs? A: Examples of FTAs include the North American Free Trade Agreement (NAFTA) and the General Agreement on Tariffs and Trade (GATT). An argument against FTAs are to protect domestic industries and jobs. Also, the benefits to lower developed countries may not be as much as to those higher developed countries.

Saving, investment and net foreign investment of Australia 1. Why did foreign invetsment (NFI) become such a large negative number after 1976?

A: National saving fell after 1975 (in part due to large government budget deficits) but domestic investment did not change by as much. This led to an increase in the size of net foreign investment (in absolute value because it was negative).

2. If the value of exports and imports were $3978 million and $8751 milion, respectively, and income and transfers were -$88 072, what is the current account balance (CAB)? What does it mean if the CAB is negative?

A: CAB=NX+NY+NT. CAB= (3978-8751)-88072= -$92 845 Since net foreign investment was negative (indicating that foreigners were buying more Australian assets than Australians were buying abroad), the current account must have also been negative (indicating that Australia was importing and repatriating more dividend and other income than it was exporting and receiving income).

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The nominal exchange rate during hyperinflation 1. Briefly explain why the price level and nominal exchange rate move together.

A: When the supply of money begins growing, the price level also increases and the German mark depreciates. The quantity theory of money explained that when money supply increases the price level also increases. The theory of purchasing-power parity explains how the price level then affects the nominal exchange rate. When there is an increase in the foreign price level (P*), this will lead to an increase in the nominal exchange rate (e ) i.e an appreciation according to e=P*/P.

Practice questions solutions Questions for review 1

2 3

4

S=I+NFI so NFI=S-I. If S>I, NFI would be a positive number, which means that there is positive net foreign investment (more purchase of foreign assets by domestic residents than purchase of domestic assets by foreigners). If S<I, NFI would be negative.

If Australia decided to save more than it invests domestically, then this would mean that NFI will be positive as S=I+NFI. The economic logic behind the theory of purchasing-power parity is that a good must sell for the same price in all locations, otherwise people would profit by engaging in arbitrage. The problems with this theory is that many goods are not easily traded and also because tradeable goods are not always perfect substitutes when they are produced in different countries.

If the Reserve Bank of Australia started printing large quantities of Australian dollars, the Australian price level would increase and the dollar would buy fewer Japanese yen, fewer US dollars and fewer Chinese RMBs.

Multiple choice 1. a

2. a

3. a

4. a

5. a

Problems and applications 1

a

b

c d e

2

a b c d

When an Australian chef spends the summer touring restaurants in Asia, he spends money buying foreign goods and services, so Australian exports are unchanged, imports increase and net exports decrease.

When department stores in Milan buy clothes designed by Australian designers, foreigners are buying an Australian good, so Australian exports rise, imports are unchanged and net exports increase.

When your older sister buys a new Nissan GT-R, an Australian is buying a foreign good, so Australian exports are unchanged, imports rise and net exports decline.

When Drake sells a million CDs in Australia, Australians are buying foreign goods, so imports increase, exports are unchanged and net exports decrease.

When a Chinese citizen shops in store in Melbourne to avoid the Chinese Goods and Services tax, a foreigner is buying Australian goods, so Australian exports increase, imports are unchanged and net exports increase.

Australia is physically large and well endowed in natural resources such as iron ore and minerals which are the most important exports.

Goods that once had to be produced and consumed locally can now be traded around the world and businesses can reach overseas customers more easily.

Technological progress has changed the kinds of goods that economies produce Free trade agreements have lowered trade barriers like tariffs and import quotas.

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3

4

5

6

7

8

9

a

When an Australian mobile phone company establishes offices in Macedonia, Australian net foreign investment increases, because the Australian company makes a direct investment in capital in the foreign country. b The purchase of Rio Tinto shares by British pensions represents a decrease in Australian net foreign investment. The purchase of shares represents a portfolio investment into a company operating in Australia. c Net foreign investment refers to the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners. When Toyota closes its factory in Altona, Australian net foreign investment will increase, since the foreign company will be purchasing less domestic capital in Australia. d When a Westpac mutual fund sells its News Ltd shares to a Chinese investor, Australian net foreign investment declines (if the Chinese investor pays in Australian dollars), because the Australian company is reducing its portfolio investment in a foreign country.

If national saving is constant and net foreign investment increases, domestic investment must decrease, since national saving equals domestic investment plus net foreign investment. If domestic investment declines, the country’s accumulation of domestic capital declines. a The newspaper and Internet show nominal exchange rates, since they show the number of units of one currency that can be exchanged for another currency. b Many answers are possible. c If Australian inflation exceeds US inflation over the next year, you’d expect the Australian dollar to depreciate relative to the US dollar. a Australian cattle growers who export their beef overseas would be happy if the Australian dollar depreciated. They would then get more Australian dollars for each unit of foreign currency they earned on the sale of their beef. b Australian companies who buy their inputs overseas would not be happy if the Australian dollar depreciated because their goods would cost more Australian dollars to purchase. c Australian students planning to study overseas would not be happy if the Australian dollar depreciated because they would get less units of foreign currency for each Australian dollar. d An Australian firm trying to purchase a plant overseas would not be happy if the Australian dollar depreciated because the plant would cost more Australian dollars to purchase.

All the parts of this question can be answered by keeping in mind the definition of the real exchange rate. The real exchange rate equals the nominal exchange rate times the domestic price level divided by the foreign price level. a If the Australian nominal exchange rate is unchanged but prices rise faster abroad than Australia, the real exchange rate declines. b If the Australian nominal exchange rate is unchanged but prices rise slower abroad than in Australia the real exchange rate rises. c If the Australian nominal exchange rate declines and prices are unchanged in Australia and abroad, the real exchange rate declines. d If the Australian nominal exchange rate declines and prices rise faster abroad than in Australia, the real exchange rate declines.

Three goods for which the law of one price is likely to hold are farm goods like wheat, which are nearly identical no matter where they’re produced, technological goods like computer software, which have low shipping costs because they’re light and clothing, which also has low shipping costs. Three goods for which the law of one price is not likely to hold are: real estate, because you can’t move land or buildings from one country to another; goods that are mainly consumed in one country and so aren’t traded, like frog legs in France; and services like haircuts, which can’t be arbitraged even if the price is very different in different countries.

The nominal exchange rate is 1000 yen per dollar. The real exchange rate is 1 000*20 000/6 000 000 = 3.33 Japanese cars per Australian car. Six million yen for a car in Japan divided by $20 000 for a car in Australia equals an exchange rate of 300 yen per dollar. Since the

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nominal exchange rate between the currencies in two countries does not reflect the different price levels in both countries, the purchasing-power parity does not hold.

10 According to the theory of purchasing-power parity, the nominal exchange rate between the currencies of two countries must reflect the different price levels in those countries. As the value of the Australian dollar rises, more and more people are buying goods from overseas on the Internet and having them shipped to Australia, so the purchasing-power parity is less likely to hold for these goods.

11 a To make a profit, you’d want to buy coal where it’s cheap and sell it where it’s expensive. Since Australian coal sells for $320 per tonne and the exchange rate is 6 RMB per dollar, Australian coal costs $320 x 6 equals 1920 RMB per tonne in China. So, Australian coal at $320per tonne is more expensive than Chinese coal at 1800 RMB per tonne. So you could take $300, exchange them 1800 RMB, buy a tonne of Chinese coal and sell it in Australia for $320, thus making a profit of $20. As people did this, the demand for Chinese coal would rise; raising the price in China and the supply of Australian coal would decrease, reducing the price in Australia. The process would continue until the prices in the two countries were the same. b If coal was the only commodity in the world, the real exchange rate between Australia and China would start out too high, then fall as people buy coal in China and sell it in Australia, until the real exchange became one in the long run. c Goods that are not easily traded or goods that are of different quality are the main factors that prevent the exchange rate from adjusting. In the case of coal, the good can be traded, but transport may be costly, and the quality might differ between the two countries.

12 a The Big Mac is appropriate for comparing across countries because it’s of fairly uniform quality worldwide. So The Economist is clearly comparing the same good sold in different countries. b If prices are different in different countries, arbitrage may not be possible, since you can’t easily move a Big Mac from one country to another. Beef may be significantly more expensive in some countries than others, and restrictions on trade may prevent the price of beef and thus the price of the Big Mac from being the same everywhere. c The UBS index on minutes worked required to buy a Big Mac takes into consideration wage income in the measure of purchasing-power parity. Workers in different countries earn different wage rates, contributing to differences in purchasing powers. However, the UBS index does not address the issue that burgers are not really tradeable goods. d The iPod index is a better measure than either Big Mac index because iPod is a tradeable commodity making arbitrage possible, especially when the purchase of iPods are increasingly made on the Internet.

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Chapter 13 A macroeconomic theory of the open economy Learning objectives After reading this chapter, students should be able to: • build a model to explain an open economy’s trade balance and exchange rate • use the model to analyse the effects of government budget deficits • use the model to analyse the macroeconomic effects of trade policies • use the model to analyse political instability and capital flight.

Key points •

•

•

•

To analyse the macroeconomics of open economies, two markets are central – the market for loanable funds and the market for foreign-currency exchange. In the market for loanable funds, the interest rate adjusts to balance the supply of loanable funds (from national saving) and the demand for loanable funds (from domestic investment and net foreign investment). In the market for foreign-currency exchange, the real exchange rate adjusts to balance the supply of dollars (for net foreign investment) and the demand for dollars (for net exports). Because net foreign investment is part of the demand for loanable funds and provides the supply of dollars for foreign-currency exchange, it is the variable that connects these two markets.

A policy that reduces national saving, such as a government budget deficit, reduces the supply of loanable funds and drives up the interest rate. The higher interest rate reduces net foreign investment, which reduces the supply of dollars in the market for foreign-currency exchange. The dollar appreciates and net exports fall.

Although restrictive trade policies, such as a tariff or quota on imports, are sometimes advocated as a way to alter the trade balance, they do not necessarily have that effect. A trade restriction increases net exports for a given exchange rate and, therefore, increases the demand for dollars in the market for foreign-currency exchange. As a result, the dollar appreciates in value, making domestic goods more expensive relative to foreign goods. This appreciation offsets the initial impact of the trade restriction on net exports.

When investors change their attitudes about holding assets of a country, the ramifications for the country’s economy can be profound. In particular, political instability can lead to capital flight, which tends to increase interest rates and cause the currency to depreciate.

Chapter outline Introduction •

A macroeconomic theory of the open economy is needed to understand what factors determine a country’s trade balance and how government policies can affect it.

•

This chapter covers the forces that determine the economy’s trade balance and exchange rate.

•

The model looks at the market for loanable funds and the market for foreign-currency exchange.

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Supply of and demand for loanable funds and foreign-currency exchange The market for loanable funds •

Whenever a nation saves a dollar of income, it can use that dollar to finance the purchase of domestic capital or to finance the purchase of an asset abroad.

S = I + NFI • • •

The supply of loanable funds comes from national saving.

The demand for loanable funds comes from domestic investment and net foreign investment.

The quantity of loanable funds demanded and the quantity of loanable funds supplied depend on the real interest rate.

– A higher real interest rate encourages people to save and thus raises the quantity of loanable funds supplied.

– A higher interest rate makes borrowing to finance capital projects more costly, discouraging investment and lowering the quantity of loanable funds demanded.

– A higher real interest rate in a country will also lower net foreign investment. All else being equal, a higher domestic interest rate implies that purchases of foreign assets by domestic residents will fall and purchases of domestic assets by foreigners will rise.

You may need to write the equation for net foreign investment on the board to explain its relationship with the real interest rate. Point out that when the real interest rate in Australia rises, purchases of foreign assets by domestic residents fall and purchases of Australian assets by foreigners rise. Thus, net foreign investment is inversely related to the real interest rate.

•

The supply and demand for loanable funds can be shown graphically.

– The real interest rate is the price of borrowing funds and is therefore on the vertical axis; the quantity of loanable funds is on the horizontal axis.

– The supply of loanable funds is upward-sloping because of the positive relationship between the real interest rate and the quantity of loanable funds supplied.

– The demand for loanable funds is downward-sloping because of the inverse relationship between the real interest rate and the quantity of loanable funds demanded.

Text Figure 13.1 Real interest rate

Supply (saving)

r*

Demand (I + NFI)

Quantity of loanable funds

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Put ‘saving’ in parentheses next to ‘supply’ and ‘I + NFI’ next to ‘demand’. Encourage students to do the same. These will serve as reminders of where the supply and demand for loanable funds comes from.

•

•

The interest rate adjusts to bring the supply and demand for loanable funds into balance.

– If the interest rate was below r*, the quantity of loanable funds demanded would be greater than the quantity of loanable funds supplied. This would lead to upward pressure on the interest rate.

– If the interest rate was above r*, the quantity of loanable funds demanded would be less than the quantity of loanable funds supplied. This would lead to downward pressure on the interest rate.

At the equilibrium interest rate, the amount that people want to save is exactly equal to the desired quantities of domestic investment and net foreign investment.

The market for foreign-currency exchange •

The imbalance between the purchase and sale of capital assets abroad must be equal to the imbalance between exports and imports of goods and services and the net flow of income and transfers.

NFI = CAB • •

Net foreign investment represents the quantity of dollars supplied for the purpose of buying assets abroad.

The current account balance represents the quantity of dollars demanded for the purpose of buying Australian net exports of goods and services and net income and transfers.

Point out to students that net exports are considered to be the ‘source’ of the demand for dollars. This means that, when an Australian consumer imports a product, the demand for Australian dollars decreases because net exports fall. Students may wonder why an increase in imports does not increase the supply of dollars. Explain that the model could be derived this way but it would not be as useful to analyse the effects of several policies as is done in this chapter.

•

The real exchange rate is the price that balances the supply and demand in the market for foreigncurrency exchange.

– When the Australian real exchange rate appreciates, Australian goods become more expensive relative to foreign goods, lowering Australian exports and raising imports. Thus, an increase in the real exchange rate will reduce the quantity of dollars demanded.

– The key determinant of net foreign investment is the real interest rate. Thus, as the real exchange rate changes, there will be no change in net foreign investment.

Go back to the list of factors that influence net foreign investment (from chapter 12).

Show students that the exchange rate is not there.

•

We can show the market for foreign-currency exchange graphically.

– The real exchange rate is on the vertical axis; the quantity of dollars exchanged is on the horizontal axis.

– The demand for dollars will be downward-sloping because of the inverse relationship between the real exchange rate and the quantity of dollars demanded.

– The supply of dollars will be a vertical line because of the fact that changes in the real exchange rate have no influence on the quantity of dollars supplied.

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Text Figure 13.2

Real exchange rate

Supply (NFI)

real e*

Demand (CAB) Quantity of dollars Remind students that net exports and net income and transfers represent the demand for dollars by placing ‘CAB’ in parentheses next to the demand curve. Show that net foreign investment represents the supply of dollars by placing ‘NFI’ in parentheses next to the supply curve.

•

•

The real exchange rate adjusts to balance the supply and demand for dollars.

– If the real exchange rate was lower than real e*, the quantity of dollars demanded would be greater than the quantity of dollars supplied and there would be upward pressure on the real exchange rate.

– If the real exchange rate was higher than real e*, the quantity of dollars demanded would be less than the quantity of dollars supplied and there would be downward pressure on the real exchange rate.

At the equilibrium real exchange rate, the demand for dollars to buy net exports exactly balances the supply of dollars to be exchanged into foreign currency to buy assets abroad.

Net foreign investment: The link between the two markets • • •

In the market for loanable funds, net foreign investment is a part of demand.

In the foreign-currency exchange market, net foreign investment is the supply of dollars.

This means that net foreign investment is the variable that links the two markets.

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Text Figure 13.3 Real interest rate

NFI NFI 0

• •

The key determinant of net foreign investment is the real interest rate.

We can show the relationship between net foreign investment and the real interest rate graphically.

– When the real interest rate is high, owning domestic assets is more attractive and thus, net foreign investment is low.

Again, you may need to write the equation for net foreign investment on the board to demonstrate the inverse relationship between the real interest rate and net foreign investment.

•

– This inverse relationship implies that net foreign investment will be downward-sloping.

– Note that net foreign investment can be positive or negative.

FYI: Purchasing-power parity as a special case.

– Purchasing-power parity suggests that a dollar must buy the same quantity of goods and services in every country. As a result, the real exchange rate is fixed and the nominal exchange rate is determined by the price levels in the two countries.

– Purchasing-power parity assumes that international trade responds quickly to international price differences.

– If goods were cheaper in one country than another, they would be exported from the country where they are cheaper and imported into the second country where the prices are higher.

– This would continue until the price differential disappears.

– Because net exports are so responsive to small changes in the real exchange rate, purchasingpower parity implies that the demand for dollars would be horizontal. Thus, purchasing-power parity is simply a special case of the model of the foreign-currency exchange market.

– However, it is more realistic to draw the demand curve downward-sloping.

Simultaneous equilibrium in two markets Students will be frightened by the next diagram showing the market for loanable funds and the market for foreign-currency exchange, with the diagram of net foreign investment linking the two. Go through it very slowly. You will likely have to repeat the equilibrium process several times before students understand it.

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Text Figure 13.4

• • • • • •

The real interest rate is determined in the market for loanable funds.

This real interest rate determines the level of net foreign investment.

Because net foreign investment must be paid for with foreign currency, the quantity of net foreign investment determines the supply of dollars.

The equilibrium real exchange rate brings into balance the quantity of dollars supplied and the quantity of dollars demanded.

Thus, the real interest rate and the real exchange rate adjust simultaneously to balance supply and demand in the two markets. As they do so, they determine the levels of national saving, domestic investment, net foreign investment and net exports.

FYI: The classical dichotomy once again.

– The theory developed above is a classical theory because it uses the classical dichotomy and the assumption of monetary neutrality in long-run analysis of real and nominal variables.

For the next three applications, use the three-step process developed in chapter 4.

First, determine which of the supply and demand curves have been affected. Second, determine in which direction the curves shift and, finally, use the supply and demand diagrams to examine how these shifts alter equilibrium in the two markets.

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Government budget deficits Text Figure 13.5 •

A government budget deficit occurs when the government spending exceeds government revenue . r

S2

r S1

r*2 r*1

D (I+NFI)

Quantity of loanable funds

NFI NFI real e

S2

S1

real e*2 real e*1

D (NX) Quantity of dollars

• • • • • •

Because a government deficit represents negative public saving, it lowers national saving. This leads to a decline in the supply of loanable funds.

The real interest rate rises, leading to a decline in both domestic investment and net foreign investment.

Because net foreign investment falls, people need less foreign currency to buy foreign assets so the supply of dollars declines.

The real exchange rate rises, making Australian goods more expensive relative to foreign goods.

Exports will fall, imports will rise and net exports will fall.

In an open economy, government budget deficits raise real interest rates, crowd out domestic investment, cause the dollar to appreciate and push the trade balance toward deficit.

Because they are so closely related, the budget deficit and the trade deficit are often called the twin deficits. Note that because many other factors affect the trade deficit, these ‘twins’ are not identical.

Need to point out that the federal government maintained a budget surplus for many years. Could reflect on reasons why budget deficits are not favoured.

•

In the news: Aussie dollar takes a rest – The Aussie dollar has declined to low levels not seen for many years.

– This would provide the economy with a bit of a financial cushion in the midst of the trade war between US and China, especially with more tourists entering Australia due to the lower value of the dollar.

– While the falling Australian dollar will provide some support for the economy, the price of iron ore was also falling which will weaken the economy.

– It was suggested that the government should use the increased cash in the economy to stimulate economic activity.

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Trade policy • • • • • • •

Trade policy: a government policy that directly influences the quantity of goods and services that a country imports or exports.

Two common types of trade policies are tariffs (taxes on imported goods) and quotas (limits on the quantity of imported goods).

Example: the Australian government increases the tariff on imported cars.

Note that the tariff will have no effect on the market for loanable funds. Thus, the real interest rate will be unaffected.

The tariff will lower imports and thus increase net exports. Since net exports are a component of the current account balance, which is the source of demand for dollars in the market for foreigncurrency exchange, the demand for dollars will increase.

The real exchange rate will rise, making Australian goods relatively more expensive than foreign goods. Exports will fall, imports will rise and net exports will fall.

In the end, the quota reduces both imports and exports but net exports remain the same.

Text Figure 13.6 r

S (saving)

r

r*

D (I+NFI) NFI Quantity of loanable funds

NFI real e S(NFI) real e*2

real e*1 D2 D1 Q of dollars

• • • •

Thus, trade policies do not affect the trade balance.

Recall that CAB = NFI. Also remember that S = I + NFI. Rewriting, we get: NFI = S – I. Substituting for NFI, we get: CAB = S – I. Since trade policies do not affect national saving or domestic investment, they cannot affect the current account balance.

Trade policies do have effects on firms, industries and countries. But these effects are more microeconomic than macroeconomic.

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Political instability and capital flight • • • •

• • •

Capital flight: a large and sudden reduction in the demand for assets located in a country.

Capital flight often occurs because investors feel that the country is unstable, due to either economic or political problems.

Example: Investors around the world observe political problems in Indonesia and begin selling Indonesian assets and buying Australian assets.

Indonesian net foreign investment will rise because investors are selling Indonesian assets and purchasing assets from another country.

– Since net foreign investment determines the supply of rupiah, the supply of rupiah increases.

– Since net foreign investment is also a part of the demand for loanable funds, the demand for loanable funds rises.

The increased demand for loanable funds causes the equilibrium real interest rate to rise.

The increased supply of rupiah lowers the equilibrium real exchange rate.

Thus, capital flight from Indonesia increases Indonesian interest rates and lowers the value of the rupiah in the market for foreign-currency exchange.

Text Figure 13.7 r

S (saving)

r

r*2 r*1

NFI2

D2 D1

NFI1

Quantity of loanable funds

NFI

real e

S1

S2

real e*1 real e*2 D Quantity of rupiah

•

This is what was observed in 1998, when between January and May the interest rate on short-term Indonesian government bonds rose from 19 per cent to 44 per cent and the rupiah depreciated in value form 5300 to 9000 rupiah per Australian dollar from January to July.

ALTERNATIVE CLASSROOM EXAMPLE Suppose that investors feel very confident about the prospects for investment in Brazilian assets. In this case (from the perspective of Brazil): 1 The demand for loanable funds will shift left because NFI decreases.

2 The NFI curve will also shift left.

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3 4 5 6

The real interest rate in Brazil will fall.

The supply of Reals (the ‘Real’ is the currency of Brazil) will shift left.

The real exchange rate will rise.

Brazilian net exports will fall.

Conclusion • •

The study of international economics is valuable. It is important to note that policymakers and commentators are often quick to blame foreigners for problems facting the Australian economy.

Economists view these problems as home-grown.

In the news: The rise of Asia … but the US dollar is still the reserve currency … for now.

– The US dollar as the world’s reserve currency has been challenged and it is argued that it could be replaced by a global digital alternative.

Adjunct teaching tips and warm-up activities Encourage students to bring their books to class so that they can look at the graphs up close while redrawing them in their notes. This will help them to understand the model panel by panel.

Check your understanding solutions LO13.1 Supply of and demand for loanable funds and foreign-currency exchange Q. If the demand for loanable funds increases, what happens to the real equilibrium interest rate in the market for loanable funds and the market for foreign-currency exchange? What do you notice about the equilibrium quantity in both markets?

A: The real interest rate in the market for loanable funds will increase. All else being equal, a higher domestic interest rate implies that purchases of foreign assets by domestic residents will fall and purchases of domestic assets by foreigners will rise, which means that NFI will be lower. The equilibrium quantity in the market for loanable funds will increase but the equilibrium quantity in the market for foreign currency exchange will decrease.

Q. In the model of the open economy just developed, two markets determine two relative prices. What are the markets? What are the two relative prices? If the supply of loanable funds shifts to the right, what happens to the equilibrium value in the market for foreigncurrency exchange?

A: The two markets in the model of the open economy are the market for loanable funds and the market for foreign-currency exchange. These markets determine two relative prices: (1) the market for loanable funds determines the real interest rate; and (2) the market for foreign-currency exchange determines the real exchange rate. If the supply of loanable funds shifts to the right, this will lower the real interest rate.

A lower interest rate will mean that there is more NFI so the supply curve in the market for foreigncurrency exchange will shift to the right. This will result in a lower real exchange rate.

LO13.4 Political instability and capital flight Q. Suppose that Australians decided to spend a larger fraction of their incomes. What would be the effect on saving, investment, interest rates, the real exchange rate and the trade balance?

A: If Australians decided to spend a larger fraction of their incomes, the decrease in saving would shift the supply curve for loanable funds to the left. The increase in the real interest rate reduces net foreign investment and shifts the supply of dollars to the left in the market for foreign-currency exchange. The result is a rise in the real exchange rate. Since the real interest rate is higher, domestic investment decreases. Since net foreign investment decreases, the trade balance also deceases. Overall, saving and domestic investment decrease, the real interest rate and real exchange rate increase and the trade balance decreases.

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Figure 13.1

Practice questions solutions Questions for review 1

2

3 4

The supply of loanable funds comes from national saving. The demand for loanable funds comes from domestic investment and net foreign investment. The supply of dollars in the market for foreign exchange comes from net foreign investment. The demand for dollars in the market for foreign exchange comes from net exports. The link between the two markets is net foreign investment.

The identity equation for the market for foreign currency exchange states that the imbalance between the purchase and sale of capital assets abroad (NFI) equals the imbalance between exports and imports of goods and services and the net flow of income and transfers (CAB). For example, when the CAB is negative, we are buying more foreign goods and services than foreigners are buying Australian goods and services, and we are sending more income and transfers overseas than foreigners are sending to Australia. Foreigners are using the Australian currency to add to their holdings of Australian assets. These purchases of assets abroad are reflected in a negative value of NFI. A government budget deficit leads to decreased national saving, which causes the interest rate to increase thus decreasing net foreign investment, which in turn decreases net exports.

If China bans imports of Australian beef, our net exports would be reduced for any given exchange rate. Hence demand for foreign exchange would be less, resulting in the demand curve in the market for foreign exchange, such as shown in Figure 13.2, to shift to the left, resulting in a decrease in the real exchange rate. The beef industry in Australia would suffer a decrease in demand for their product, while other industries, such as the Chinese apparel industry, would export more of their product because of the lower real exchange rate.

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Figure 13.2

5

If the Parliament removes all restrictions on foreign direct investment and foreign investment increases in Australia, net foreign investment will decline. The decline in net foreign investment reduces the supply of dollars in the market for foreign exchange, raising the real exchange rate. The trade balance also declines, since net exports will be lower. The higher real interest rate also increases the quantity of national saving. In summary, saving increases, domestic investment increases, net foreign investment declines, the real interest rate increases, the real exchange rate increases and the trade balance decreases.

Multiple choice 1. d

2. a

3. b

4. b

5. b

Problems and applications 1

Australia generally has a trade deficit, with the value of the goods and services imported exceeding the value of the goods and services exported. Changes in Australia's trade balance have been influenced by the types of the goods and services Australia exports and imports, as well as the prices that are received or paid for these goods and services. Australia has a comparative advantage in the export of resource and agricultural commodities. These commodities account for a relatively large share of our exports and have more volatile prices than those of the goods and services Australia imports. The factor that the trade deficit is most related to is likely to be lower structural barriers against imports into Australia. Lower structural barriers enable more trade and higher imports into Australia.

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2

3

4

5

If the US dollar stops being the reserve currency then other countries will want to hold less US dollars. Other countries selling their US dollars will increase the US net foreign investment position. In the market for foreign exchange, the supply of US dollars will shift to the right and the real exchange rate will depreciate. a An Australian government budget deficit decreases national saving, shifting the supply curve of loanable funds to the left (see textbook Figure 13.5). This increases the real interest rate in Australia, thus reducing net foreign investment and increasing the real exchange rate. Thus the real value of the dollar increases. That the value of the Australian dollar has risen since the GFC is also due to the relative strength of the Australian economy compared to the US, Europe and Japan, where interest rates are at record lows. In addition to this is the strong export demand from China that has helped to maintain a strong Australian dollar. b When the Australian government budget returned to deficit due to the stimulus package, national savings decreased, shifting the supply curve of loanable funds to the left. This would raise the real interest rate in Australia, thus decreasing net foreign investment and increasing the real exchange rate. Along with a higher net export demand largely from China, shifting the demand for the Australian dollar to the right, the Aussie dollar appreciated and reached parity with the US dollar.

A decrease in saving will shift the supply of loanable funds in the market for loanable funds to the right, and the real interest rate will increase. This will attract more foreigners wanting to hold Australian financial assets. The net foreign investment position will be reduced. This reduces the supply of Australian dollars that can be exchanged for foreign currency in the market for foreigncurrency exchange. This in turn causes the real exchange rate to appreciate. a A decline in the quality of Australian goods at a given real exchange rate would reduce net exports, reducing the demand for dollars, thus shifting the demand curve for dollars to the left in the market for foreign exchange, as shown in Figure 13.3 below. b The shift to the left of the demand curve for dollars leads to a decline in the real exchange rate.

Since net foreign investment is unchanged and net exports equals net foreign investment, there is no change in equilibrium in net exports or the trade balance. c The claim in the popular press is incorrect. A change in the quality of Australian goods cannot lead to a rise in the trade deficit. The decline in the real exchange rate means that we get fewer foreign goods in exchange for our goods, so our standard of living may decline.

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Figure 13.3

6

7

8

9

A reduction in restrictions of imports would reduce net exports at any given real exchange rate, thus shifting the demand curve for dollars to the left. The shift of the demand curve for dollars leads to a decline in the real exchange rate, which increases net exports. Since net foreign investment is unchanged and net exports (a component of the CAB) equals net foreign investment, there is no change in equilibrium in net exports or the trade balance. But both imports and exports rise, so export industries benefit. a When New Zealand develop a strong desire to buy their wool from Australia, the demand for dollars in the foreign-currency market increases at any given real exchange rate, as shown by a shift of the demand curve from D2 to D1 in Figure 13.3 above. b The result of the increased demand for dollars is a rise in the real exchange rate. c The quantity of net exports is unchanged.

Tariffs and trade barriers on China will mean nothing happens in the loanable funds market in panel (a) or to net foreign investments in panel (b). See Figure 13.8 in text. The only effect is a rise in the current account balance (exports minus imports plus net income and transfers) for any given real exchange rate. As a result, the demand for dollars in the market for foreign-currency exchange rises, as shown by a shift from D1 to D2 in panel (c). (See Figure 13.8 in text). This increase in the demand for dollars causes the value of the dollar to appreciate from E1 to E2, which offsets the effect of the tariff on the trade balance.

Higher real interest rates abroad and lower real interest rate in Australia relative to the rest of the world lead to increased Australian net foreign investment. Higher net foreign investment leads to higher net exports, since in equilibrium net exports, a component of the current account balance, is equal to net foreign investment (CAB = NFI). Figure 13.4 shows that the increase in net foreign investment as shown by a shift from NFI1 to NFI2 leads to a lower real exchange rate, higher real interest rate and increased net exports.

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Figure 13.4

10 a

If the elasticity of Australian net foreign investment with respect to the real interest rate is very high, the lower real interest rate that occurs because of the increase in private saving will increase net foreign investment a lot, so Australian domestic investment won’t increase much. b Since an increase in private saving reduces the real interest rate, inducing an increase in net foreign investment, the real exchange rate will decline. If the elasticity of Australian exports with respect to the real exchange rate is very low, it will take a large decline in the real exchange rate to increase Australian net exports by enough to match the increase in net foreign investment.

11 Many answers are possible for free trade agreements. One agreement with a long history is CER, which came into force between Australia and NZ in 1983. a The Net Foreign Investment position may depend on the size of Australian’s trading partner. If Australia is the much larger economy, Australian firms and investors may invest more in the smaller economy, than is reciprocated. Australia’s net foreign investment would tend to increase. If the relationship is reversed, then Australia may be the smaller trading partner and end up decreasing their net foreign investment. Nonetheless, this assumes that there are no differences in other macroeconomic variables, such as budget deficits, between the two countries. b If the US company decides not to set up production in Australia, then foreign direct investment is lower than it would otherwise be. This means that the net foreign investment position will be more positive than with the plant. This will cause the real exchange rate to be lower than if the plant was built.

12 a If the Chinese decided they want to buy less Australian assets, Australian net foreign investment would increase, decreasing the demand for loanable funds, as shown by a shift from D1 to D2 in Figure 13.4. The result is an increase in Australian interest rates, an increase in the quantity of Australian saving (because of the higher interest rate) and lower Australian domestic investment. b In the foreign exchange market, the real exchange rate decreases and the balance of trade increases.

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13 The models suggest that national saving can be quite different than domestic investment. When governments run large budget deficits, the models suggest that net foreign investment will be low, so national saving will be less than domestic investment. Thus the finding that national saving equals domestic investment seems to contradict the models. a If investors are unwilling to accumulate too many assets from a single foreign country, then net foreign investment won’t be very responsive to changes in a country’s real interest rate. Thus a government budget deficit would lead to a large enough increase in the real interest rate so that it would reduce domestic investment, with little change in net foreign investment. Thus national saving and domestic investment would move closely together, reconciling fact and the models. b If investors are unwilling to accumulate too many assets from the US, the US trade deficit wouldn’t be very high even if the US budget deficit remains large. Instead, US domestic investment would remain low.

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Chapter 14 Aggregate demand and aggregate supply Learning objectives After reading this chapter, students should be able to: • explain three key facts about short-run economic fluctuations • discuss how the economy in the short run differs from the economy in the long run • develop a short-run theory called the model of aggregate demand and aggregate supply • understand how shifts in either aggregate demand or aggregate supply can cause recessions.

Key points • • •

• •

•

•

All societies experience short-run economic fluctuations around long-run trends. These fluctuations are irregular and largely unpredictable. When recessions do occur, real GDP and other measures of income, spending and production fall and unemployment rises.

Economists analyse short-run economic fluctuations using the model of aggregate demand and aggregate supply. According to this model, the output of goods and services and the rate of inflation adjust to balance aggregate demand and aggregate supply.

The aggregate-demand curve slopes downward for three reasons. First, a lower inflation rate raises the real value of households’ money holdings, which stimulates consumer spending. Second, a lower inflation rate reduces the quantity of money households demand; as households try to convert money into interest-bearing assets, interest rates fall, which stimulates investment spending. Third, as a lower inflation rate reduces interest rates, the dollar depreciates in the market for foreigncurrency exchange, which stimulates net exports.

The long-run aggregate-supply curve is vertical. In the long-run, the quantity of goods and services supplied depends on the economy’s labour, capital and technology but not on the rate of inflation.

The short-run aggregate curve is upward-sloping. There are three theories to explain short-run aggregate supply. According to the new classical misperceptions theory, an unexpected fall in the inflation rate leads suppliers to mistakenly believe that they need to respond to relative prices that have fallen, which induces them to reduce production. According to the Keynesian sticky-wage theory, an unexpected fall in the rate of inflation temporarily raises real wages, which induces firms to reduce employment and production. According to the new Keynesian sticky-price theory, an unexpected fall in the rate of inflation leaves some firms with higher-than-desired prices, depressing sales and inducing firms to reduce the production of goods and services.

One possible cause of recessions is a fall in aggregate demand. When the aggregate-demand curve shifts to the left, output and inflation rate fall in the short run. Over time, as perceptions, wages and prices adjust, the short-run aggregate-supply curve shifts to the right and the economy returns to its natural rate of output at a new, lower rate of inflation.

A second possible cause of recessions is an adverse change in aggregate supply. When the aggregate-supply curve shifts to the left, the short-run effect is falling output and a rising inflation rate – a combination called stagflation. Over time, as perceptions, wages and prices adjust, the inflation rate falls back to its original level and output recovers.

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Chapter outline Introduction • • • •

Economic activity fluctuates from year to year.

Recession: A period of declining real incomes and rising unemployment.

Depression: A severe recession.

This chapter introduces the aggregate-demand curve and the aggregate supply curve. The focus from this chapter on will be on the economy’s short-run fluctuations around its long run trend.

Three key facts about economic fluctuations See text Figure 14.1

Fact 1: Economic fluctuations are irregular and unpredictable • Fluctuations in the economy are often called the business cycle.

• • •

Economic fluctuations correspond to changes in business conditions.

These fluctuations are not at all regular and are almost impossible to predict.

Panel (a) of Figure 14.1 shows real GDP since 1978. The shaded areas represent recessions, defined as two consecutive periods of negative growth in real GDP.

Fact 2: Most macroeconomic quantities fluctuate together • • •

Real GDP is the variable that is most often used to examine short-run changes in the economy.

However, most macroeconomic variables that measure some type of income, spending, or production fluctuate closely together.

Panel (b) of Figure 14.1 shows how investment changes over the business cycle. Note that investment falls during recessions just as real GDP does.

Fact 3: As output falls, unemployment rises • Changes in the economy’s output level will have an effect on the economy’s utilisation of its labour force.

• When firms choose to produce a smaller amount of goods and services, they lay off workers, and hence the unemployment rate increases.

• Panel (c) of Figure 14.1 shows how the unemployment rate changes over the business cycle. Note that during recessions, unemployment generally rises. Note also that the unemployment rate never approaches zero but instead fluctuates around its natural rate of about 5 per cent.

• FYI: Okun’s law.

– According to Okun’s law, when real GDP grows at its average rate of 3 per cent, the unemployment rate remains unchanged.

– When the economy expands more rapidly than 3 per cent, the unemployment rate falls by about half as much.

– There is a strong correlation between GDP and unemployment.

Explaining short-run economic fluctuations How the short run differs from the long run • • •

Most economists believe that the classical theory describes the world in the long run but not in the short run.

Beyond a period of several years, changes in the money supply affect nominal variables but do not affect real GDP, unemployment, or other real variables.

However, when studying year-to-year fluctuations in the economy, the assumption of monetary neutrality is not appropriate. In the short run, most real and nominal variables are intertwined.

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The basic model of economic fluctuations Begin by reviewing demand, supply and equilibrium. Make it clear that the microeconomic variables of price and quantity can be aggregated into the inflation rate (either the GDP deflator or the CPI) and total output (real GDP).

• •

Model of aggregate demand and aggregate supply: The model that most economists use to explain short-run fluctuations in economic activity around its long-run trend.

We can show this model using a graph.

See text Figure 14.2

• •

– On the vertical axis is the inflation rate in the economy.

– On the horizontal axis is the overall quantity of goods and services, real GDP. Aggregate-demand curve: A curve that shows the quantity of goods and services that households, firms and the government want to buy at different rates of inflation.

Aggregate-supply curve: A curve that shows the quantity of goods and services that firms choose

to produce and sell at different rates of inflation.

•

In this model, the inflation rate and the quantity of output adjust to bring aggregate demand and aggregate supply into balance.

The aggregate-demand curve Why the aggregate-demand curve is downward-sloping •

Recall that GDP (Y) is made up of four components: consumption (C), investment (I), government purchases (G) and net exports (NX).

Y = C + I + G + NX •

Each of the four components is a part of aggregate demand.

Government purchases are assumed to be fixed by policy.

– This means that to understand why the aggregate-demand curve slopes downward, we must understand how changes in the rate of inflation affect consumption, investment and net exports.

You will likely need to remind students of the difference between changes in quantity demanded (movements along the demand curve) and changes in demand (shifts in the demand curve).

Text Figure 14.3

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•

• •

•

The inflation rate and investments: interest-rate effect: – A lower inflation rate induces the RBA to reduce the interest rate, which encourages greater spending on investment goods.

– It therefore increases the quantity of goods and services demanded.

The inflation rate and wealth: Pigou’s wealth effect: – A decrease in the inflation rate makes consumers feel wealthy.

– In turn, it encourages them to spend more.

The inflation rate and net exports: Mundell-Fleming’s exchange-rate effect: – A lower inflation rate lowers the interest rate in Australia.

– Australian investors will seek higher returns by investing abroad, increasing Australian net foreign investment.

– The increase in net foreign investment raises the dollar supply, lowering the real exchange rate.

– Australian goods become relatively cheaper compared to foreign goods. Exports rise, imports fall and net exports increase.

– Therefore, when a fall in the Australian inflation rate causes Australian interest rates to fall, the real exchange rate depreciates and Australian net exports rise, thereby increasing the quantity of goods and services demanded.

All three of these effects imply that, all else being equal, there is an inverse relationship between the rate of inflation and the quantity of goods and services demanded.

Highlight the fact that all three of these effects begin with a decrease (or increase) in the inflation rate and end with an increase (decrease) in aggregate quantity demanded.

Remind students that the aggregate demand curve (like all demand curves) is drawn assuming that all else is held constant.

Why the aggregate-demand curve might shift Get the students involved in suggesting factors that might shift the aggregate demand curve. Relate changes in aggregate demand to changes in consumption, investment, government purchases and net exports. Show students that if any of these four components of GDP change (for reasons other than a change in the rate of inflation) the aggregate demand curve will shift.

•

Shifts arising from consumption: – Australians become more concerned with saving for retirement and reduce current consumption. This will decrease aggregate demand.

– •

•

•

When the government cuts taxes, it encourages people to spend more, resulting in an increase in aggregate demand.

Shifts arising from investment: – The computer industry introduces a faster line of computers and many firms decide to invest in new computer systems. This will lead to an increase in aggregate demand.

– If firms become pessimistic about future business conditions, they may cut back on investment spending, shifting aggregate demand to the left.

– An investment tax credit increases the quantity of investment goods that firms demand, which results in an increase in aggregate demand.

– An increase in the supply of money lowers the interest rate in the short run. This leads to more investment spending, which causes an increase in aggregate demand.

Shifts arising from government purchases: – The federal government decides to reduce purchases of new weapon systems. This will decrease aggregate demand.

– If governments decide to build more state highways, aggregate demand will shift to the right.

Shifts arising from net exports: – When Europe experiences a recession, it buys fewer Australian goods, which lowers net exports. Aggregate demand will shift to the left.

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–

If the exchange rate of the Australian dollar increases, Australian goods become more expensive to foreigners. Net exports fall and aggregate demand shifts to the left.

The aggregate-supply curve •

The relationship between the inflation rate and the quantity of goods and services supplied depends on the time horizon.

Why the aggregate-supply curve is vertical in the long-run • •

In the long-run, an economy’s supply of goods and services depends on its supplies of resources along with the available production technology.

Because the inflation rate does not affect the determinants of output in the long-run, the long-run aggregate-supply curve is vertical at the natural rate of output.

Why the long-run aggregate-supply curve might shift • • •

The position of the aggregate supply curve occurs at an output level sometimes referred to as potential output or full-employment output.

This is the level of output that the economy produces when unemployment is at its natural rate.

Any change in the economy that alters the natural rate of output shifts the long-run aggregatesupply curve.

Text Figure 14.4

•

•

•

•

Shifts arising from labour: – Increases in immigration increase the number of workers available. The long-run aggregatesupply curve would shift to the right.

– Any change in the natural rate of unemployment will alter long-run aggregate supply as well.

Shifts arising from capital: – An increase in the economy’s capital stock raises productivity and thus shifts long-run aggregate supply to the right.

– This would also be true if the increase occurred in human capital rather than physical capital.

Shifts arising from natural resources: – A discovery of a new mineral deposit increases long-run aggregate supply.

– A change in weather patterns that makes farming more difficult shifts long-run aggregate supply to the left.

– A change in the availability of imported resources can also affect long-run aggregate supply.

Shifts arising from technological knowledge: – The invention of the computer has allowed us to produce more goods and services from any given level of resources. Thus, it has shifted the long-run aggregate-supply curve to the right.

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– •

Opening up international trade has similar effects to inventing new production processes.

Therefore, it also shifts the long-run aggregate-supply curve to the right.

A new way to depict long-run growth and inflation: Inflation Rate

LRAS

LRAS

LRAS

1

2

3

AD3

AD2 AD1 0

•

• •

Quantity of output

Two important forces that govern the economy in the long-run are technological progress and monetary policy.

– Technological progress shifts long-run aggregate supply to the right.

– The RBA increases the money supply over time, which raises aggregate demand.

The result is growth in output and continuing inflation (increases in the inflation rate).

Although the purpose of developing the aggregate demand/aggregate supply model is to describe short-run fluctuations, these short-run fluctuations should be considered to be deviations from the long-run trends developed here.

Why the aggregate-supply curve is upward-sloping in the short-run Text Figure 14.5

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Three theories have been proposed for the upward sloping short-run aggregate supply curve: • The new classical misperceptions theory: – Changes in the inflation rate can temporarily mislead suppliers about what is happening in the markets in which they sell their output.

– As a result of these misperceptions, suppliers respond to changes in the level of prices, and thus the short-run aggregate-supply curve is upward-sloping.

– Example: The inflation rate falls below the level that people expected. Suppliers may mistakenly believe that as the prices of their products fall, it is a drop in the relative prices of their products. Suppliers may then believe that the reward of supplying their product has fallen and thus they decrease the quantity that they supply. The same misperception may happen if workers see a decline in their nominal wage (caused by a fall in the rate of inflation).

– Thus, a lower inflation rate causes misperceptions about relative prices and these misperceptions lead suppliers to respond to the lower rate of inflation by decreasing the quantity of goods and services supplied.

• The Keynesian sticky-wage theory: – Nominal wages are often slow to adjust in the economy due to long-run contracts between workers and firms.

– Example: Suppose a firm has agreed in advance to pay workers a certain amount and then the inflation rate falls below the level that was expected. This implies that the firm is now paying a real wage that is larger than it intended, raising the costs of production. Thus, the firm hires less labour and produces a smaller quantity of goods and services.

– Therefore, because wages do not adjust immediately to the inflation rate, a lower rate of inflation makes employment and production less profitable, leading firms to lower the quantity of goods and services supplied.

• The new Keynesian sticky-price theory: – The prices of some goods and services are also sometimes slow to respond to changes in the economy. This is often blamed on menu costs.

– If the inflation rate falls unexpectedly and a firm does not change the price of its product quickly, its relative price will rise and this will lead to a loss in sales.

– When sales decline, firms will produce a lower quantity of goods and services.

– Because not all prices adjust instantly to changing conditions, an unexpected fall in inflation rate leaves some firms with higher-than-desired prices, which depress sales and induce firms to lower the quantity of goods and services supplied.

• Note that each of these theories suggest that output deviates from its natural rate when the inflation rate deviates from the rate that people expected.

• Note also that the effects of the change in the inflation rate will be temporary. Eventually people will adjust their expectations of the inflation rate and output will return to its natural level; thus, the aggregate-supply curve will be vertical in the long-run.

Why the short-run aggregate-supply curve might shift • • • •

Events that shift the long-run aggregate-supply curve will shift the short-run aggregate-supply curve as well.

However, people’s expectations of the inflation rate will affect the position of the short-run aggregate-supply curve even though it has no effect on the long-run aggregate-supply curve.

A higher expected inflation rate will decrease the quantity of goods and services supplied and shift the short-run aggregate-supply curve to the left. A lower expected inflation rate increases the quantity of goods and services supplied and shifts the short-run aggregate-supply curve to the right.

In the news: Can productivity keep increasing.

– Discusses and links to the Australian Productivity Commission report on Australian productivity.

– In 2017-18, Australia had an economy-wide growth in productivity of less than 1 per cent.

– Mining productivity has fallen. Administrative services, finance and insurance and professional services has shown strong productivity growth.

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Two causes of recession • • •

Long-run equilibrium is found where the aggregate-demand curve intersects with the long-run aggregate-supply curve.

Output is at its natural rate.

Also at this point, perceptions, wages and prices have all adjusted so that the short-run aggregatesupply curve intersects at this point as well.

Text Figure 14.7

The effects of a shift in aggregate demand • • • • •

•

Example: Pessimism, for example, following a worldwide downturn in the stock market, causes household spending and investment to decline.

This will cause the aggregate demand curve to shift to the left – see Text Figure 14.8 below.

In the short run, both output and the inflation rate fall. This drop in output means that the economy is in a recession.

It is possible that policymakers may want to eliminate the recession by boosting government spending or increasing the money supply. Either way, these policies could shift the aggregate demand curve back to the right.

However, even if policymakers do nothing, the economy will eventually move back to the natural rate of output.

– People will correct the misperceptions, sticky wages and sticky prices that cause the aggregatesupply curve to be upward-sloping in the short-run.

– The expected inflation rate will fall, shifting the short-run aggregate-supply curve to the right.

In the long run, the decrease in aggregate demand can be seen solely by the drop in the rate of inflation. Thus, the long-run effect of a change in aggregate demand is a nominal change (in the inflation rate) but not a real change (output is the same).

Students will be confused by the graphs showing the adjustment process that occurs when aggregate demand shifts. Take the time to walk them through step-by-step several times, summarising what moves the economy from one point to the next.

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Text Figure 14.8

•

In the news: Despite the photo-op, the RBA knows the economy needs more stimulus – Australia’s economy was once described as the energizer bunny economy (it just keeps going).

Ross Gittens describes how the energizer bunny may be running out of energy.

– Gittens argues that the weak economy is in need of budgetary stimulus.

– He states that governors or treasurers of the economy would not admit that a recession is impending, as they like to exude calm and confidence in the economy.

– The point is that budget (fiscal policy) should be moving in the same direction as monetary policy and help to stimulate the economy. However, this does not appear to be the case.

The effects of a shift in aggregate supply Text Figure 14.9

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•

•

Example: Firms experience a sudden increase in their costs of production.

– This will cause the short-run aggregate-supply curve to shift to the left. (Depending on the event, long-run aggregate supply may also shift. We will assume that it does not.)

– In the short-run, output will fall and the inflation rate will rise. The economy is experiencing stagflation.

Stagflation: A period of falling output and rising prices..

– Policymakers will have a more difficult time with this situation. Policymakers can shift the aggregate-demand curve but cannot simultaneously offset the drop in output and inflation. If they increase aggregate demand, the recession will end but the inflation rate will be permanently higher.

– If policymakers do nothing, inflation expectations will adjust, causing the short-run aggregatesupply curve to shift back to the right.

Text Figure 14.10

Conclusion •

This chapter discussed important facts about short-run fluctuations in economic activity and introduced the aggregate demand and aggregate supply model to explain those fluctuations.

Adjunct teaching tips and warm-up activities Have students create their own ‘study guide’ for the material in this chapter. First, have them draw a graph of an increase in aggregate demand. Next to the graph they should list as many things that they can think of that could cause this increase. Have them repeat the exercise for a decrease in aggregate demand as well as for changes in aggregate supply.

Check your understanding solutions LO14.1 Three key facts about economic fluctuations Q. What are three important properties that describe short-run fluctuations in year-toyear economic activity?

A: Three important properties that describe short-run fluctuations are: (1) economic fluctuations are irregular and unpredictable; (2) most macroeconomic quantities fluctuate together; and (3) as output falls, unemployment rises.

Economic fluctuations are irregular and unpredictable, as you can see by looking at a graph of real GDP over time. Some recessions are close together and others are far apart. There appears to be no recurring 1410 Copyright 2021 Cengage Learning Australia Pty Limited

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pattern. Most macroeconomic quantities fluctuate together. In recessions, real GDP, consumer spending, investment spending, corporate profits and other macroeconomic variables decline or grow much more slowly than during economic expansions. However, the variables fluctuate by different amounts over the business cycle, with investment varying much more than other variables. As output falls, unemployment rises, because when firms want to produce less, they do so by laying off workers, thus causing a rise in unemployment.

LO14.3 The basic model of economic fluctuations Q. Draw the model of aggregate demand and aggregate supply. What variables are on the two axes? How does the short run differ from the long run?

A: The economy in the short run differs from its behaviour in the long run because the assumption of monetary neutrality applies to the long run, not the short run. In the short run, real and nominal variables are highly intertwined.

Text Figure 14.5 shows the model of aggregate demand and aggregate supply. The horizontal axis shows the quantity of output and the vertical axis shows the inflation rate.

Q. What are the three important factors that determine a downward-sloping aggregate demand curve? If the Australian government decided to reduce individual income tax, would this shift the aggregate demand curve? If so, in which direction will it shift?

Explain.

A: The aggregate-demand curve slopes downward for three reasons. First, when prices fall, the value of dollars in people’s wallets and bank accounts rises, so they’re wealthier. As a result, they spend more, so aggregate demand increases. Second, when prices fall, people need less money to make their purchases, so they lend more out, which reduces the interest rate. The lower interest rate encourages businesses to invest more, raising aggregate demand. Third, since lower prices lead to a lower interest rate, investors move money from domestic investment to foreign investment, supplying dollars to the foreign-exchange market, thus causing the dollar to depreciate. The decline in the real exchange rate causes net exports to increase, which raises aggregate demand.

If the Australian government reduced individual income tax, this may increase consumption spending as people have more disposable income. This will shift the aggregate demand curve to the right. An indirect effect of this could be less government expenditure due to less tax revenue which may shift the aggregate demand curve to the left, and offset the increase in aggregate demand from increased consumption.

Q. Explain why the long-run aggregate-supply curve is vertical. Give an example of how it can shift.

A: The long-run aggregate-supply curve is vertical because the inflation rate does not affect the long-run determinants of real GDP, which include supplies of labour, capital and natural resources. This is just an application of the classical dichotomy and monetary neutrality. Any change in the economy that alters the natural rate of output shifts the long-run aggregate-supply curve. An increase in the economy’s capital stock will increase productivity and the quantity of goods and services supplied. This would results in a shift to the right of the long run aggregate supply curve.

LO14.4 Two causes of recession Q. Suppose the economy is in long-run equilibrium. Suppose a law is passed which increases the number of migrant workers in Australia. How will this affect the short-run and long run equilibrium level?

A: A law which increases the number of migrant workers in Australia will increase the natural rate of output and shift the long run aggregate supply curve to the right. This will decrease the price level, so inflation is lower. With a lower price level, costs of production are lower so the short run aggregate supply curve will shift to the right. This leaves the economy with an overall higher quantity of output and lower inflation in the long run.

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Case study solutions No recession in Australia during or post GFC? 1. While most economists agree that Australia avoided the GFC, can you provide some statistics that may prove contrary to this belief?

A: Unemployment rose from 5 per cent in January 2008 to a high of 5.8 per cent in September 2009. Alterations to existing buildings went down by over 10 per cent during the same period.

2. Do you think two quarters of negative growth is an adequate definition of a recession?

A: While it is a good indicator, it may not be an adequate definition of a recession. The NBER in the US use several factors to determine whether the US economy is in recession or not. It has been described by them that a recession is when there is a significant decline in economic activity and can last from a few months to more than a year.

Practice questions solutions Questions for review 1

Figure 14.1 shows aggregate demand, short-run aggregate supply and long-run aggregate supply.

Figure 14.1

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2

3

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5

The aggregate-demand curve is downward sloping because: (1) a decrease in the inflation rate makes consumers feel more wealthy, which in turn encourages them to spend more, so there’s a larger quantity of goods and services demanded (Pigou’s wealth effect); (2) a lower inflation rate reduces the interest rate, encouraging greater spending on investment, so there’s a larger quantity of goods and services demanded (Keynes’s interest-rate effect); and (3) a fall in the Australian inflation rate causes Australian interest rates to fall, so the real exchange rate depreciates, stimulating Australian net exports, so there’s a larger quantity of goods and services demanded (Mundell–Fleming’s exchange-rate effect).

The long-run aggregate supply curve is vertical because in the long run, an economy’s supply of goods and services depends on its supplies of capital and labour and on the available production technology used to turn capital and labour into goods and services. If any of these factors change, the long-run aggregate-supply curve will shift. The inflation rate does not affect these long-run determinants of real GDP. The three theories that explain why the short-run aggregate-supply curve is upward-sloping are: (1) the new classical misperceptions theory, in which a lower than expected inflation rate causes misperceptions about relative prices and these misperceptions induce suppliers to respond to the lower than expected inflation rate by decreasing the quantity of goods and services supplied; (2) the Keynesian sticky-wage theory, in which a lower than expected inflation rate makes employment and production less profitable because wages do not adjust immediately to the lower inflation rate, so firms reduce the quantity of goods and services supplied; and (3) the new Keynesian sticky-price theory, in which an unexpected fall in the inflation rate leaves some firms with higher-than-desired prices because not all prices adjust instantly to changing conditions, which depresses sales and induces firms to reduce the quantity of goods and services they produce.

The aggregate-demand curve might shift to the left when something (other than a rise in the inflation rate) causes a decrease in consumption spending (such as increased individual taxation), a decrease in investment spending (such as increased taxes on the returns to investment), decreased government spending (such as reducing funding to the public education sector), or decreased net exports (such as when foreign economies demand less of our exports).

Figure 14.2 traces through the steps of such a shift in aggregate demand. The economy begins in equilibrium, with short-run aggregate supply, AS1, intersecting aggregate demand, AD1, at point A. When the aggregate-demand curve shifts to the right to AD2, the economy moves from point A to point B, decreasing the inflation rate and the quantity of output. Over time, costs of production decrease, shifting the short-run aggregate-supply curve to AS2 and moving the economy from point B to point C, which is back on the long-run aggregate supply curve but at a lower rate of inflation.

Figure 14.2

6

The aggregate-supply curve might shift to the left because of a decrease in the economy’s capital stock, population, or productivity, all of which shift both the long-run and short-run aggregate supply curves to the left, or because of a higher than expected inflation rate, which shifts just the short-run aggregate-supply curve (not the long-run aggregate-supply curve) to the left.

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Figure 14.3 traces through the effects of such a shift. The economy starts in equilibrium at point A. The aggregate-supply curve then shifts to the left from AS1 to AS2. The new equilibrium is at point B, the intersection of the aggregate-demand curve and AS2. As time goes on and expectations adjust, the economy returns to long-run equilibrium at point A, as the short-run aggregate supply curve shifts back to its original position.

Figure 14.3

Multiple choice 1. d

2. d

3. a

4. c

5. c

Problems and applications 1

2

Investment is more variable than consumer spending over the business cycle because firms put off buying capital (they don’t expand factories or buy new equipment) in recessions. People are also less likely to build new houses in recessions. Much of consumer spending is on necessities, such as food, which don’t decline as much in recessions. Durable goods, such as furniture and car purchases, are more volatile over the business cycle than non-durable goods, such as food and clothing, or services, such as haircuts and medical care, for the same reason. People put off buying durable goods and just make do with older cars and furniture when economic times are bad. a The current state of the economy is shown in Figure 14.4. The aggregate-demand curve and short-run aggregate-supply curve intersect at a point to the right of long-run aggregate supply.

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Figure 14.4

Okun’s law suggests that for every percentage point that real GDP growth is below its potential growth rate of 3 per cent, the unemployment rate will rise by half a percentage point. So if real GDP has increased by 1.5 per cent, GDP growth is 1.5 percentage points below potential growth of 3 per cent, so the unemployment rate will be 1.5 x 1/2 = 0.75 percentage point less than last year. c With employment being underutilised, capital will also be underutilised. In a boom, capacity utilisation is above its long-run average. a New technology which reduces the cost of production will increase the short run aggregate supply. b When the price of oil rises, this will decrease the short run aggregate supply. c A sudden rise in the numbers of people in the labour force will increase the short run aggregate supply. d When households expect their future incomes to increase, this will have no effect on short run aggregate supply. a In Text Figure 14.7, if the demand for iron ore and coal decreases dramatically, AD will shift to the left. Inflation rate will fall and output produced will be below the natural rate. b If robots replace workers then wages (hence household consumption) may decline. This would shift the AD curve to the left. The improvement in technology however, would shift the LAS and SAS to the right. Assuming technology is the dominant effect, the inflation rate will rise and in the short run, output will be above the natural rate. c Curing many cancers would reduce the mortality rates in Australia and the labour force would be larger than before. This would shift AD back to the right. a The statement that ‘the aggregate-demand curve slopes downward because it is the horizontal sum of the demand curves for individual goods’ is false. The aggregate-demand curve slopes downward because a fall in the inflation rate raises the overall quantity of goods and services demanded through Pigou’s wealth effect, Keynes’s interest-rate effect and Mundell–Fleming’s exchange-rate effect. b The statement that ‘the long-run aggregate-supply curve is vertical because economic forces do not affect long-run aggregate supply’ is false. Economic forces of various kinds (such as b

3

4

5

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6

7

population and productivity) do affect long-run aggregate supply. The long-run aggregatesupply curve is vertical because the inflation rate doesn’t affect long-run aggregate supply. c The statement that ‘if firms adjusted their prices every day, then the short-run aggregate-supply curve would be horizontal’ is false. The short-run aggregate-supply curve would be vertical in that case, not horizontal. d The statement that ‘whenever the economy enters a recession, its long-run aggregate-supply curve shifts to the left’ is false. An economy could enter a recession if the aggregate supply curve or aggregate demand curve shift to the left. a According to the new classical misperceptions theory, the economy is in a recession when the inflation rate is below what was expected. Over time, as people observe the lower inflation rate, their expectations will adjust and the economy will return to the long-run aggregate-supply curve.

According to the Keynesian sticky-wage theory, the economy is in a recession because the inflation rate has declined so that real wages are too high, thus labour demand is too low. Over time, as nominal wages are adjusted so that real wages decline, the economy returns to full employment.

According to the new Keynesian sticky-price theory, the economy is in a recession because not all prices fall enough. Over time, firms are able to adjust their prices more fully and the economy returns to the long-run aggregate-supply curve. b The speed of the recovery in each theory depends on how quickly inflation expectations (in the new classical misperceptions theory), wages (in the Keynesian sticky-wage theory) and prices (in the new Keynesian sticky-price theory) adjust.

Figure 14.5 depicts an economy experiencing high levels of inflation. The short-run aggregate supply curve is AS1 and the economy is at equilibrium at point A, which is to the right of the longrun aggregate-supply curve (LAS). If policymakers take no action, the high inflation rate and output gap will mean real wages will rise. The higher wages mean the costs of production increase, hence the short-run aggregate-supply curve shifts to the left to AS2. The economy will return to the longrun aggregate-supply curve over time. The economy’s new equilibrium is at point B, at the natural rate of unemployment, but with a higher rate of inflation.

Figure 14.5

The RBA would not want to let the economy adjust on its own because of the time involved in the adjustment and also the impact the adjustment would have on the price levels.. To make the recovery quicker, the RBA could increase interest rates to decrease AD and restore equilibrium, at for example, point C, where output is at the natural rate and the inflation rate has decreased.

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8

a

b

c

If people believe that inflation will be high over the next year, workers will want higher nominal wages. If inflation doesn’t rise as much as wages do, real wages will increase, so firms won’t hire as many workers.

Figure 14.6 (below) shows the economy starting out at point A on short-run aggregate-supply curve AS1. With higher nominal wages, the short-run aggregate-supply curve will shift to the left to AS2. The new equilibrium is at point B, with output less than long-run aggregate supply. In the short run, the inflation rate rises and output falls. In the long run, the economy will return to point A, as the decline in output eventually leads to a decline in the inflation rate and the shortrun aggregate-supply curve returns to AS1.

In the short run, expectations of higher inflation were somewhat accurate, as the inflation rate is higher at point B than at point A. But they were wrong in the long run.

Figure 14.6

9

a As there is limited supply, the price of oil will increase. b A significant and permanent increase in oil price reduces short-run aggregate supply. c To correct for the impact of increase in oil price, the government can undertake expansionary fiscal or monetary policy to reduce unemployment and decline in output. d The policies could result in a permanent rise in the inflation rate. e This will increase G as the tax rebate is a form of government spending and will increase AD. 10 a If there is a reduction in income tax, households may spend more on consumer goods, so the aggregate-demand curve shifts to the right. The rate of inflation increases and output increases.

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b

If a cyclone destroys the year’s wheat crop, the short-run aggregate-supply curve shifts to the left. The rate of inflation rises and output declines.

c

If households decide to have less children, this could lead to a lower population. This will decrease AD. More people may enter the workforce (as opposed to leaving the workforce to give birth) so this may increase short run AS. The reduced population overall will lead to a decreased labour force, which decreases aggregate supply in the long run.

d

A significant amount of iron ore is found in Western Australia, this increases the ability to produce more goods and services and will shift the short run and long-run aggregate-supply curve to the right.

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11 a

b

c

If there is a decline in firms’ expectations of future profitability of investment, the result is shown in Figure 14.7. The economy begins at point A with aggregate-demand curve AD1 and short-run aggregate-supply curve AS1. The inflation rate is π1 and output level is at Y1. A decrease in expectations of profitability leads to reduced investment, so the aggregate-demand curve shifts to AD2. Now the economy is at point B, with inflation rate π2 and output level Y2.

The aggregate quantity of output supplied decreases because the inflation rate has decreased and people have misperceptions about the price level, and/or wages are sticky, and/or prices are sticky, all of which cause output supplied to increase.

Over time, as the misperceptions of the price level disappear, and/or wages adjust, and/or the inflation rate adjusts, the short-run aggregate-supply curve shifts down to AS2 and the economy gets to equilibrium at point C, with inflation rate π3 and output level Y1. The quantity of output demanded increases as the inflation rate decreases because of Pigou’s wealth effect, Keynes’s interest-rate effect and Mundell–Fleming’s exchange-rate effect.

The disinvestment might affect the long-run aggregate-supply curve because lower investment today means a smaller capital stock in the future, thus lower productivity and output.

Figure 14.7

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12 a b c d e f g h

Firms would engage in proportionately more innovation-type investments because they benefit from a lower tax rate.

Increased investment expenditure leads to an increase in the demand for loanable funds, resulting in a higher interest rate.

Overall quantity of investment could increase when firms are motivated by the lower tax rate on innovation activities.

Firm cost increases with an increase in overall quantity of investment leading to a decrease in short-run aggregate supply.

Long-run aggregate supply increases resulting from larger production capacity and improved production methods because of innovation.

The higher interest rate reduces net foreign investment and a decline in the supply of dollars. As a result, the value of the dollar increases.

As the value of the dollar increases, exports become relatively more expensive and imports become relatively cheaper, resulting in a decrease in the quantity of net exports demanded.

The decline in net exports decreases aggregate demand.

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Chapter 15 The influence of monetary and fiscal policy on aggregate demand Learning objectives After reading this chapter, students should be able to: • analyse how monetary policy affects aggregate demand through interest rates • analyse how fiscal policy affects aggregate demand • discuss the debate over whether policymakers should try to stabilise the economy • reconsider how the economy behaves differently in the short run and the long run.

Key points • •

•

• •

•

•

In developing a theory of short-run economic fluctuations, Keynes proposed the theory of liquidity preference to explain the determinants of the interest rate. According to this theory, the interest rate adjusts to balance the supply and demand for money.

An increase in the price level raises money demand and increases the interest rate that brings the money market into equilibrium. Because the interest rate represents the cost of borrowing, a higher interest rate reduces investment and, thereby, the quantity of goods and services demanded. The downward-sloping aggregate-demand curve expresses this negative relationship between the price level and aggregate quantity demanded.

Policymakers can influence aggregate demand with monetary policy. A lower inflation rate induces the RBA to decrease interest rates, which stimulates investment spending and the aggregate-demand curve shifts to the right. Conversely, higher inflation induces the RBA to increase the interest rate and shifts the aggregate-demand curve to the left.

Policymakers can also influence aggregate demand with fiscal policy. An increase in government purchases or a cut in taxes shifts the aggregate-demand curve to the right. A decrease in government purchases or an increase in taxes shifts the aggregate-demand curve to the left.

When the government alters spending or taxes, the resulting shift in aggregate demand can be larger or smaller than the fiscal change. The multiplier effect tends to amplify the effects of fiscal policy on aggregate demand. The crowding-out effect tends to dampen the effects of fiscal policy on aggregate demand.

Because monetary and fiscal policy can influence aggregate demand, the government sometimes uses these policy instruments in an attempt to stabilise the economy. Economists disagree about how active the government should be in this effort. According to the advocates of active stabilisation policy, changes in attitudes by households and firms shift aggregate demand; if the government does not respond, the result is undesirable and causes unnecessary fluctuations in output and employment. According to critics of active stabilisation policy, monetary and fiscal policy work with such long lags that attempts at stabilising the economy often end up being destabilising.

The effects of monetary and fiscal policy depend on the time horizon. The aggregate-demand effects on output emphasised in this chapter hold only in the short run, over which prices are sticky.

In the long run, output is determined by factor supplies and technology.

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Chapter outline Introduction •

This chapter examines how the government’s tools of monetary and fiscal policy influence aggregate-demand.

How monetary policy influences aggregate demand Students are very interested in the way in which the RBA changes interest rates.

Review what they learned about the RBA and its tools to change the money supply covered in chapter 10.

The effects of monetary policy are easy to show graphically. Begin with money supply, money demand and an equilibrium interest rate. Show how both an increase and a decrease in the money supply affect interest rates.

•

•

•

The aggregate-demand curve is downward-sloping for three reasons.

Pigou’s wealth effect Keynes’s interest-rate effect Mundell–Fleming’s exchange-rate effect.

All three effects occur simultaneously but are not of equal importance.

Because a household’s money holdings are a small part of total wealth, the wealth effect is relatively small.

Because imports and exports are a small fraction of Australian GDP, the exchange-rate effect is also fairly small for Australia.

Thus, the most important reason for the downward-sloping aggregate-demand curve is the interestrate effect.

Figure 15.1 shows how monetary policy works to impact on aggregate demand.

The downward slope of the aggregate-demand curve Figure 15.2

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•

The interest-rate-effect can be used to explain the downward slop of the appregate-demand curve.

A higher inflation rate (π1 to π2) induces the RBA to increase the interest rate.

A higher interest rate reduces the quanitity of goods and services demanded (Y1 to Y2).

•

•

At a higher interest rate, the cost of borrowing increases and the return on saving increases. Thus, consumers will choose to spend less and will be less likely to invest in new housing. Firms will be less likely to borrow funds for new equipment or structures. In short, the quantity of goods and services purchased in the economy will fall.

That is, there is a negative relationship between the inflation rate and the quantity of goods and services.

Point out the circumstances under which the RBA is likely to increase the interest rate.

Then discuss the circumstances under which the RBA is likely to decrease the interest rate. Discuss the short-run and long-run effects of each.

The theory of liquidity preference • • •

This theory is an explanation of the supply and demand for money and how they relate to the interest rate.

Keynes’s theory of how the interest rate is determined is called the theory of liquidity preference.

Keynes’s theory of liquidity preferences is that the interest rate adjusts to bring money supply and money demand into balance Money supply and interest rates in the liquidity preference theory:

See text Figure 15.3 The money supply is assumed to be controlled by the central bank.

Since the money supply is fixed by the central bank and does not depend on other economic variables, the supply of money is a vertical line.

• Money demand: See text Figure 15.4

•

An asset’s liquidity refers to the ease with which the asset can be converted into a medium of exchange. Thus, money is the most liquid asset in the economy.

The liquidity of money explains why people choose to hold money instead of other assets that could earn them a higher return.

However, the return on other assets (the interest rate) is the opportunity cost of holding money. All else equal, as the interest rate rises, the quantity of money demanded will fall. Therefore, the demand for money will be downward-sloping.

Equilibrium in the money market:

See text Figure 15.5 According to the theory of liquidity preference the interest rate adjusts to bring quantity of money demand and money supply into balance.

If the interest rate is above the equilibrium level, the quantity of money that people want to hold is less than the quantity supplied by the central bank. Those holding the surplus money will want to get rid of it by buying interest-bearing deposits (or bonds). This lowers the interest rate and the amount of money people are willing to hold. The converse happens if the interest rate is below the equilibrium.

So whether the central bank sets the interest rate (the cash rate in Australia) or sets the money supply, the impact on economic activity is the same – the interest rate in the money market has an impact on real economic ativity in the short run because prices are sticky in the short run.

Make sure that students understand that a loosening of, or an ‘expansionary monetary policy’ means interest rates are lowered to encourage increased spending and hence shift aggregate demand to the right, while a tightening of or a ‘contractionary monetary policy’ refers to an increase in interest rates and reduced spending thus shifting the aggregate demand left.

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How fiscal policy influences aggregate demand •

Fiscal policy refers to the government’s choices regarding the overall level of government purchases or taxes.

Changes in government purchases • •

When the government changes the level of its purchases, it influences aggregate demand directly.

An increase in government purchases shifts the aggregate-demand curve to the right, while a decrease in government purchases shifts the aggregate-demand curve to the left.

There are two macroeconomic effects that cause the size of the shift in the aggregate-demand curve to be different from the change in the level of government purchases. They are called the multiplier effect and the crowding-out effect.

The multiplier effect •

• • •

When the government buys a product from a company, the immediate impact of the purchase is to raise profits and employment at that firm. As a result, owners and workers at this firm will see an increase in income and will therefore likely increase their own consumption. Thus, total spending rises by more than the increase in government purchases.

Multiplier effect: The additional shifts in aggregate demand that result when expansionary fiscal policy increases income and thereby increases consumer spending.

The multiplier effect goes on and on. When consumers spend part of their additional income, it provides additional income for other consumers. These consumers then spend some of this additional income, raising the incomes of yet another group of consumers.

The multiplier effect can be strengthened by the response of investment to the increase in demand.

The postive feedback from higher demand to investment is referred to as the investment accelerator.

Text Figure 15.6 Price level

AD 3

AD 2

AD 0

1

Quantity of output

The crowding-out effect • • •

•

The crowding-out effect works in the opposite direction to the multiplier effect.

Crowding-out effect: The offset in aggregate demand that results when expansionary fiscal policy raises the interest rate and thereby reduces investment spending.

As we discussed earlier, when the government buys a product from a company, the immediate impact of the purchase is to raise profits and employment at that firm. As a result, owners and workers at this firm will see an increase in income and will therefore likely increase their own consumption.

If consumers want to purchase more goods and services, they will need to increase their holdings of money. This shifts the demand for money to the right, pushing up the interest rate.

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Text Figure 15.7

• •

•

•

The higher interest rate raises the cost of borrowing and the return to saving. This discourages households from spending their incomes for new consumption or investing in new housing. Firms will also decrease investment, choosing not to build new factories or purchase new equipment.

Thus, even though the increase in government purchases shifts the aggregate demand curve to the right, the increase in the cash rate reduces demand, and we move up the aggregate demand curve, and end up with a higher inflation rateThus, aggregate demand increases by less than the increase in government purchases.

Therefore, when the government increases its purchases by $X, the aggregate demand for goods and services could rise by more or less than $X, depending on whether the multiplier effect or the crowding-out effect is larger.

If the multiplier effect is greater than the crowding-out effect, aggregate demand will rise by more than $X. If the multiplier effect is less than the crowding-out effect, aggregate demand will rise by less than $X. FYI: A formula for the government-purchases multiplier.

Some basic algebra allows us to derive a formula for the size of the multiplier.

The marginal propensity to consume (MPC) is the fraction of extra income that a household consumes rather than saves.

Example: The government spends $5 billion on a contract for new submarines. Assume that MPC = 3/4.

Incomes will increase by $5 billion, so consumption will rise by MPC × $5 billion. The second increase in consumption will be equal to MPC × (MPC × $5 billion) or MPC2 × $5 billion.

To find the total impact on the demand for goods and services, we add up all of these effects: Change in government purchases = $5 billion First change in consumption = MPC × $5 billion Second change in consumption = MPC2 × $5 billion Third change in consumption = MPC3 × $5 billion X X X X X X ____________________________________________________ Total Change = (1 + MPC + MPC2 + MPC3 + . . .) × $20 billion This means that the multiplier can be written as: Multiplier = (1 + MPC + MPC2 + MPC3 + . . . ) 1505 Copyright 2021 Cengage Learning Australia Pty Limited

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Because this expression is an infinite geometric series, it also can be written as:

multiplier = 1 / (1-MPC)

•

Note that the size of the multiplier depends on the size of the marginal propensity to consume. If the MPC is 3/4, the government purchase multiplier is 1 / 1 – 0.75 which is 4. Thus government spending of $5b generates $20b of demand for goods and services.

Other applications of the multiplier effect: The multiplier effect applies to any event that alters spending on any component of GDP (consumption, investment, government purchases, or net exports).

Examples include a reduction in net exports due to a recession in another country or a stock market boom that raises consumption.

Changes in taxes •

•

• •

Changes in taxes affect a household’s take-home pay. If the government reduces taxes, households will likely spend some of this extra income, shifting the aggregate-demand curve to the right. If the government raises taxes, household spending will fall, shifting the aggregate-demand curve to the left.

The size of the shift in the aggregate-demand curve will also depend on the sizes of the multiplier and crowding-out effects.

When the government lowers taxes and consumption increases, earnings and profits rise, which further stimulates consumer spending. This is the multiplier effect.

Higher incomes lead to greater spending, which means a higher demand for money. Interest rates rise and investment spending falls. This is the crowding-out effect.

Another important determinant of the size of the shift in aggregate demand due to a change in taxes is whether people believe that the tax change is permanent or temporary. A permanent tax change will have a larger effect on aggregate demand than a temporary one.

FYI: How fiscal policy might affect aggregate supply.

Because people respond to incentives, a decrease in tax rates may cause individuals to work more, because they get to keep more of what they earn. If this occurs, the aggregate-supply curve would increase (shift to the right).

Changes in government purchases may also affect supply. If the government increases spending on capital projects or education, the productive ability of the economy is enhanced, shifting aggregate supply to the right.

Using policy to stabilise the economy The case for active stabilisation policy • • •

• •

From the above discussion it appears that policymakers should be able to achieve any level of aggregate demand and GDP that they wish. And it is this belief that causes many to advocate an active and even aggressive policy of macroeconomic stabilisation.

The level of aggregate demand can be influenced by a change in government spending or taxation (fiscal policy) or a change in the interest rate (monetary policy). This line of reasoning asserts that active monetary and fiscal intervention is necessary to tame an inherently unstable private sector.

The Reserve Bank Act of 1959 requires the RBA to be accountable for the short-run macroeconomic performance of the economy. The RBA is also required to respond to changes in the private economy in order to stabilise demand. There is a strong history of central bank involvement in stabilisation policy.

The General Theory of Employment, Interest and Money, by John Maynard Keynes, puts forward the view that the private sector is inherently unstable and contains no mechanism to assure an automatic return to full employment.

Fluctuations in aggregate expenditures lead to wide fluctuations in output and periodic episodes of inflation. According to this view, the central government can and should play a direct and active role in trying to stabilise the economy.

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• •

Keynesians believe that it is necessary for the central government to use its tax and spending policies aggressively to stimulate the economy during recession and slow the economy down during inflationary times.

In the news: To balance or not to balance – that was the question – before Coronavirus – When Coronavirus hit, the government quickly put together a stimulus package to keep the economy afloat.

– The article explains the government’s initial reaction to the pandemic.

– The 17.6 billion stimulus package sought to keep people employed and quickly inject money into the economy.

– The aim of the stimulus package was to head off a looming recession and prevent large-scale unemployment that often accompanies a recession.

The case against active stabilisation policy • • • • •

Some economists believe that fiscal and monetary policy tools should only be used to help the economy achieve long-run goals, such as low inflation and economic growth.

The primary argument against active policy is that these policy tools may affect the economy with a large time lag.

With monetary policy, the change in the interest rates affects investment spending. However, investment decisions are usually made well in advance, so the effects from changes in investment will not likely be felt in the economy very quickly.

The lag in fiscal policy is generally due to the political process. Changes in spending and taxes must be approved by both the House and the Senate.

By the time these policies take effect, the condition of the economy may have changed. This could lead to even larger problems.

Automatic stabilisers • •

•

Automatic stabilisers: Changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policymakers having to take any deliberate action.

The most important automatic stabiliser is the tax system.

When the economy falls into a recession, incomes and profits fall.

The personal income tax depends on the level of households’ incomes and the corporate income tax depends on the level of firm profits.

This implies that the government’s tax revenue falls during a recession. This tax cut stimulates aggregate demand and reduces the magnitude of this economic downturn.

Government spending is also an automatic stabiliser.

More individuals become eligible for transfer payments during a recession.

These transfer payments provide additional income to recipients, stimulating spending.

Thus, just like the tax system, our system of transfer payments helps to reduce the size of short-run economic fluctuations.

The economy in the long run and the short run • •

•

Interest rates adjust to balance both the supply and demand for money and for the supply and demand for loanable funds.

Classical macroeconomic theory says these variables are determined as follows: Output is determined by the supplies of capital and labour and the available production technology for turning capital and labour into output.

For any given level of output the interest rate adjusts to balance the supply and demand of loanable funds.

The inflation rate adjusts to balance the supply and demand for money. Changes in the supply of money lead to proportionate changes in the price level.

Many economists argue these three principles do a good job of describing the economy in the long run.

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•

• •

However, these propositions do not hold in the short run because many prices are slow to adjust.

When thinking in terms of the short run it is best to reverse the order of analysis:  The inflation rate is stuck at some level in the short run and is relatively unresponsive to changing economic conditions.  The RBA sets the interest rate and money supply adjusts to satisfy money demand at that interest rate.  The level of output responds to changes in the aggregate demand for goods and services, which is in part determined by the interest rate that the RBA sets.

When thinking about interest rates in the long run, it is best to think of the loanable funds theory.

This theory highlights the importance of an economy’s saving propensities and investment opportunities.

When thinking about interest rates in the short run, it is best to keep in mind the interest-rate effect.

This theory highlights the importance of monetary policy.

See text Figure 15.8 •

FYI: The long run and the short run: An algebraic explanation. = If you have students who are good at maths, cover this box on the IS – LM model and emphasise how much economists use mathematical theory in their day-to-day work.

As a matter of fact, if you have maths majors in your class who have enjoyed economics, advise them that they might think about changing majors.

Conclusion •

This chapter examined the short-run effects of monetary and fiscal policy. These policy instruments can change the aggregate demand for goods and services and change the economy’s production and employment in the short run.

Adjunct teaching tips and warm-up activities Check to see how much your students remember about the RBA from chapter 10. Divide the class in half and give them a ‘pretend’ pop quiz. Don’t let them use their book or notes. Ask half of the class to list the three ways that a central bank could increase the money supply and ask the other half to list three ways that it could decrease the money supply. After a few minutes, have students report what they remembered.

Check your understanding solutions LO15.1 How monetary policy influences aggregate demand Q. If the cash rate decreased by 50 basis points from 2.5 per cent to 2 per cent, how would this affect the aggregate demand curve?

A: A decrease in the cash rate induces banks to decrease the rate of interest they charge their customers for loans. Decreasing the cost of borrowing for consumption or investment spending increases aggregate demand. Households buy more houses, increasing the demand for residential investment and firms spend more on new factories and new equipment, increasing business investment.

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LO15.2 How fiscal policy influences aggregate demand Q. If the government decides to increase spending on transport infrastructure by $12 billion over the next five years, in which direction does the aggregate-demand curve shift? Can the shift be more than $12 billion? Explain why the shift might be smaller than $12 billion?

A: If the government increases spending on transport infrastructure by $12 billion, the aggregate-demand curve shifts to the right because government purchases are higher. The shift to the right of the aggregatedemand curve could be more than $12 billion because of the multiplier effect or it could be less than $12 billion because of the crowding-out effect.

LO15.3 Using policy to stabilise the economy Q. Suppose a positive wave of business optimism filters through the economy. How will this affect aggregate demand?

A: If there is a positive wave of business optimism, this means firms will spend more and investment will increase. This will cause the aggregate-demand curve to shift to the right.

LO15.4 The economy in the long run and the short run Q. What is the difference between long run and short run macroeconomics? Can the theory of interest rates explain the economy in the long run? Is there a theory for the short run? Explain A: Long-run macroeconomic analysis is concerned with how factor inputs and technology determine output. Short-run analysis is concerned with fluctuations in output, brought about by changes in aggregate demand. In the long run the interest rate adjusts to balance the demand and supply of loanable funds, while in the short run the RBA sets the interest rate.

Case study solutions Why 2-3 per cent?

1. Briefly explain the important factors in which inflation is harmful.

A: Inflation interacts with the tax system with the tendency to overstate the real value of both interest receipts and payments. Inflation is a source of uncertainty making economic decisionmaking more difficult. Inflation redistributes wealth from those who own monetary assets to those who owe money.

2. Why shouldn’t we just aim for a target inflation rate of zero? Can you think of any country that has zero, or close to zero, inflation?

A: Despite arguments pointing to a general conclusion that inflation is harmful to economic performance, aiming for a zero inflation rate might be unnecessary for the following reasons: Small amounts of inflation may help to make price systems more flexible; and biases may be present in the measurement of inflation in which true inflation is overstated by standard measures. Sweden, Denmark and Japan are examples of countries with zero, or close to zero, inflation.

Keynesian thinking today 1. Can tax changes influence aggregate supply? Provide an example and illustrate your answer with an aggregate-demand/aggregate-supply model.

A: Taxes can alter the aggregate supply of goods and services. For example, an investment tax credit can give a tax break to firms that invest in new capital. This would incentivise firms to invest more. Not only would it stimulate aggregate demand immediately, but it would also increase the economy’s productive capacity over time.

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2. During the Global Financial Crisis, many governments around the world implemented some type of ‘stimulus package’. Why did governments do this?

Show the impact of this using an aggregate-demand/aggregate-supply model A: Governments have implemented stimulus packages to combat unemployment, or to address low consumption and investment in the economy. These would in turn increase AD, and stimulate the economy, encouraging economic growth.

Practice questions solutions Questions for review 1

2

3

The aggregate-demand curve is downward-sloping for three reasons: (1) Interest rate effect: a lower inflation rate leads to lower interest rate through Reserve Bank policy and lower interest rates stimualtes investment spending; (2) Wealth effect: A lower inflation rate raises the real value of households’ money holdings and other assets, and higher real wealth stimulates consumer spending; and (3) Exchange rate effect: When a lower inflation rate leads to lower interest rates, investors move some of their funds overseas which causes a deprecation of the currency and an increase in net exports.

If people become wealthier, this means that there is an increase in the real value of households’money holdings and other assets and will stimulate consumer spending. This will increase aggregate demand and shift the aggregate demand curve to the right.

If the government decides not to spends $10 billion to build a new high-speed bullet train, aggregate demand might decrease by more than $10 billion because of the multiplier effect on aggregate demand. Aggregate demand might decrease by less than $10 billion because of the crowding-out effect on aggregate demand.

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4

If pessimism sweeps the country, households decrease consumption spending and firms decrease investment, so aggregate demand decreases. If the RBA wants to stabilise aggregate demand, it must target a lower cash interest rate, which will spread to other interest rates and induce households to spend more and save less and encourage firms to invest more, both of which will increase aggregate demand. If the RBA doesn’t change the interest rates, the government could increase government purchases or lower taxes to increase aggregate demand.

5 Government policies that act as automatic stabilisers include the tax system and government spending through the unemployment-benefit system. The tax system acts as an automatic stabiliser because when incomes are high people pay more in taxes, so they can’t spend as much. When incomes are low, so are taxes; thus people can spend more. The result is that spending is stabilised somewhat. Government spending through the unemployment-benefit system acts as an automatic stabiliser because in recessions the government transfers money to the unemployed so their incomes don’t fall as much and thus their spending won’t fall as much.

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. The most important automatic stabiliser is the tax system.When the economy falls into a recession, incomes and profits fall. The personal income tax depends on the level of households’ incomes and the corporate income tax depends on the level of firm profits. This implies that the government’s tax revenue falls during a recession. This tax cut stimulates aggregate demand and reduces the magnitude of this economic downturn. Government spending is also an automatic stabiliser. More individuals become eligible for transfer payments during a recession.These transfer payments provide additional income to recipients, stimulating spending. Thus, just like the tax system, our system of transfer payments helps to reduce the size of short-run economic fluctuations.

Multiple choice 1. b

2. d

3. c

4. a

5. d

Problems and applications 1

a

When business investment declines, money demand decreases from MD2 to MD`1 in Figure 15.1.

The decrease in money demand decreases the interest rate.

Figure 15.1

b c

d

When the RBA suggests banks decrease the size of housing loans, the money supply decreases, so the money-supply curve shifts to the left. The result is an increase in the interest rate.

When a decrease in oil prices shifts the short-run aggregate-supply curve rightward, the decreased price level reduces money demand. The money-demand curve shifts to the left. The result is a decrease in the interest rate.

When households decide to hold more money, the money-demand curve shifts to the right. The result is a rise in the interest rate.

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2

a

b

c

The use of ‘smart cards’ would increase the velocity of money. Less money would be required to undertake transactions, allowing the same money to be used for a greater number of transactions.

If more shops start accepting smart cards, there would be no change in the money supply.

Money supply is composed of bank deposits and notes and coins. The cards are a way to access deposits in banks.

With smart cards decreasing the demand for money, the money-demand curve will shift to the left from MD1 to MD2, as shown in Figure 15.2. With no change in the money supply, which is at MS1, the interest rate will decline from r1 to r2.

Figure 15.2

3

4

5

A tax cut that is permanent will have a bigger impact on consumer spending and aggregate demand.

If the tax cut is permanent, consumers will view it as adding substantially to their financial resources and they will increase their spending substantially. If the tax cut is temporary, consumers will view it as adding just a little to their financial resources, so they won’t increase spending as much. A reduction in the GST rate will impact on all spending on goods and services which attract the tax. A reduction in income tax rates increases disposable income and the impact of spending will reflect the MPC. Low interest rates in Australia should increase aggregate demand through increased consumption spending (as lower interest rates mean lower reward for saving) and increased investment (as cost of borrowing is lower).

a

Legislation allowing banks to pay interest on cheque account deposits increases the return to money relative to other financial assets, thus increasing money demand.

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b

If the money supply remained constant (at MS1), the increase in the demand for money would have raised the interest rate, as shown in Figure 15.3. The rise in the interest rate would have reduced consumption and investment, thus reducing aggregate demand and output.

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Figure 15.3

c

To maintain a constant interest rate, the RBA would need to increase the money supply from MS1 to MS2. Then aggregate demand and output would be unaffected (as shown in Figure 15.4).

Figure 15.4

6

7

8

a Avalon would have a more effective monetary policy. In Eternia, two problems in controlling the money supply are encountered by the central bank. Firstly, the central bank does not control the amount of money that consumers choose to deposit in banks. Secondly, the central bank does not control the amount that bankers choose to lend. b Because Eternia has a less effective monetary policy, it would experience higher inflation. c By targeting interest rates, money supply interacts with money demand in the market to determine equilibrium quantity of money. When money supply is targeted, the money supply interacts with money demand to determine equilibrium interest rate. It is not possible to control both interest rate and the money supply as shifts in money demand can change the interest rate and quantity of money at equilibrium.

The demand for net exports is stimulated by expansionary monetary policy through the Mundell– Fleming exchange-rate effect. The decline in the interest rate increases net foreign investment, thus increasing net exports. a Not enough information is provided to know if crowding-out is occurring. b If no crowding-out, then the multiplier equals 1 / (1 – MPC). Since the multiplier is 3, then MPC = 2/3.

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c

If there’s crowding-out, then the MPC would be larger than 2/3. An MPC that’s larger than 2/3 would lead to a larger multiplier than 3, which is then reduced down to 3 by the crowding-out effect.

9 a The initial effect of the tax reduction of $30 billion is to increase aggregate demand by $30 billion x 2 / 3 (the MPC) = $20 billion. The cut in taxes increases consumption spending depending on the MPC. b Additional effects follow this initial effect as the added incomes get spent. The second round leads to increased consumption spending of $20 million x 2 / 3 = $13.34 million. The third round gives an increase in consumption of $13.34 million x 2 / 3 = $8.89 billion. The effects continue indefinitely. Adding them all up gives a total effect that depends on the multiplier.

With an MPC of 2 / 3, the multiplier is 1 / (1 – 2 / 3) = 3. So the total effect is $20 million x 3 = $60 million. c Government purchases have an initial effect of the full $30 billion, since they increase aggregate demand directly by that amount. The total effect of an increase in government purchases is thus $30 billion x 3 = $90 billion. So government purchases lead to a bigger effect on output than a tax cut does.

10 If consumers become more optimistic about their future incomes and purchase $40 million more of additional goods and services, there will be a ‘multiplier’ effect on total output. As they increase spending, firm owners see higher profits and workers receive higher wages. These respond by increasing their own spending on consumer goods. As a result the increase in consumer purchases creates positive feedbacks, increasing aggregate demand even further.

11 When the Abbott government proposes to cut government expenditure by $15b, aggregate demand would decrease by the multiplier times the $15b. However, a $40b income tax cut will increase disposable incomes and hence increase aggregate demand. However, the impact on aggregate demand will depend on what proportion of the extra income is spent. Since some will be saved, the increase in aggregate demand from the tax cut will not be the multiplier times $40b, but rather the multiplier times the extra spending resulting from the tax reduction. Hence the net impact on aggregate demand is not a net increase of $25b.

12 If government spending declines, aggregate demand falls, decreasing output. Decreased output decreases the demand for money demand. The decrease in money demand leads to a fall in the interest rate. However if the RBA targets a decrease in interest rates at the same time, money supply will be increased, reducing interest rates. Aggregate demand will increase. The impact on aggregate demand depends on how responsive money demand is to changes in the interest rate (i.e. the slope of the MD line) as well as the extent to which money supply shifts.

13 a A decrease in government spending would shift the aggregate demand curve to the left, decreasing output. The reduction in output would decrease consumption spending, since people would have lower incomes and reduce investment spending through the accelerator. But money demand would also decrease, reducing the interest rate. This would tend to increase consumption, as people would save less and increase investment, since the cost of investing would be lower. Overall, the changes in both consumption and investment are ambiguous. b An increase in the corporate taxes would directly decrease investment spending, since the cost of borrowing is higher. Also, since the increase in taxes decreases investment spending, aggregate demand decreases and so total output decreases. c An increase of interest rates decreases aggregate demand and output. The fall in output would reduce consumption spending, since people would have lower incomes and decrease investment spending through the accelerator. The higher interest rate would reduce consumption, as people would save more and decrease investment, since the cost of investing would be higher. Overall, both consumption and investment would decrease.

14 a Tax revenue increases when the economy booms because taxes are closely related to economic activity. In a boom, people’s incomes and wages increase, as do firms’ profits, so taxes on all these things increase. b Government spending declines when the economy has high levels of inflation because fewer people get unemployment benefits, welfare benefits and other forms of income support.

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c

15 a b

c d

16 a

If the government were to operate under a strict balanced-budget rule, it would have to raise government spending in boom times to offset the extra income received from taxes. This would make the boom more extreme via the multiplier effect.

A decrease in interest rates would increase consumer spending in the short run. But in the long run, there would be no effect on consumer expenditures.

The inflation rate would be higher in the long run than in the short run. In the short run, the decrease in interest rate would have no effect on the inflation rate as prices are sticky. But in the long run, the inflation rate would rise.

The interest rate balances the supply of and demand for money in the short run. In the long run, the interest rate adjusts to balance the supply of and demand for loanable funds.

In the short run, the decrease in the interest rate increases aggregate demand and output. But in the long run, output is determined by the supplies of capital and labour and the available technology.

If the RBA decides to increase the interest rate from r2to r1, the money supply will decrease from MS2 to MS1. A higher cash rate is targeted and the supply of funds in the banks’ exchange settlement accounts decrease, hence decreasing the money supply. See Figure 15.5 below.

Figure 15.5

Interest Rate

MS1

MS2

r1

r2 MD

Quantity of Money b

c

In the long run, there will be no effect on the interest rate. The inflation rate will fall, decreasing money demand. Since the interest rate is a real variable, it can’t be affected in the long run because of the classical dichotomy.

The short-run effect differs from the long-run effect because of sticky prices. In the short run, prices can’t adjust to reflect the change in the money supply. But in the long run they do.

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Chapter 16 The short-run trade-off between inflation and unemployment Learning objectives After reading this chapter, students should be able to: • explain why policymakers face a short-run trade-off between inflation and unemployment • discuss why the inflation–unemployment trade-off disappears in the long run • describe how supply shocks can shift the inflation–unemployment trade-off • discuss the short-run cost of reducing the rate of inflation • describe how policymakers’ credibility might affect the cost of reducing inflation.

Key points •

•

•

•

The Phillips curve describes a negative relationship between inflation and unemployment. By expanding aggregate demand, policymakers can choose a point on the Phillips curve with higher inflation and lower unemployment. By contracting aggregate demand, policymakers can choose a point on the Phillips curve with lower inflation and higher unemployment.

The trade-off between inflation and unemployment described by the Phillips curve holds only in the short run. In the long run, expected inflation adjusts to changes in actual inflation and the short-run Phillips curve shifts. As a result, the long-run Phillips curve is vertical at the natural rate of unemployment.

The short-run Phillips curve also shifts because of shocks to aggregate supply. An adverse supply shock, such as the increase in world oil prices during the 1970s, gives policymakers a less favourable trade-off between inflation and unemployment. That is, after an adverse supply shock, policymakers have to accept a higher rate of inflation for any given rate of unemployment, or a higher rate of unemployment for any given rate of inflation.

When the RBA increases the cash rate to reduce inflation, it moves the economy along the shortrun Phillips curve, which results in temporarily high unemployment. The cost of disinflation depends on how quickly expectations of inflation fall. Some economists argue that a credible commitment to low inflation can reduce the cost of disinflation by inducing a quick adjustment of expectations.

Chapter outline Introduction • • •

Inflation and unemployment are two indicators of economic performance.

In the short run, there is a trade-off between unemployment and inflation.

In the long run, unemployment and inflation are based on other determinants as explored in previous chapters.

The Phillips curve Origins of the Phillips curve • •

In 1958, an economist named A. W. Phillips wrote an article discussing the negative correlation between inflation rates and unemployment rates in the United Kingdom.

American economists Paul Samuelson and Robert Solow showed a similar relationship between inflation and unemployment for the United States two years later.

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• •

The belief was that low unemployment is related to high aggregate demand and high aggregate demand puts upward pressure on prices. Likewise, high unemployment is related to low aggregate demand and low aggregate demand pulls price levels down.

Phillips curve: a curve that shows the short-run trade-off between inflation and unemployment.

Text Figure 16.1 Inflation rate

Phillips curve

Unemployment rate

•

Samuelson and Solow believed that the Phillips curve offered policymakers a menu of possible economic outcomes. Policymakers could use monetary and fiscal policy to choose any point on the curve.

Aggregate demand, aggregate supply and the Phillips curve Show how the Phillips curve is derived from the aggregate demand/aggregate supply model step by step. This graph is different from all the other graphs that they have drawn in macroeconomics, because it is not a supply-and-demand diagram.

• •

•

The Phillips curve shows the combinations of inflation and unemployment that arise in the short run due to shifts in the aggregate demand curve.

The greater the aggregate demand for goods and services, the greater the economy’s output and the higher the price level. Greater output means lower unemployment. Whatever the previous year’s price level happens to be, the higher the price level in the current year, the higher the rate of inflation.

Example: The price level is 100 in the year 2020. There are two possible changes in the economy for the year 2021: a low level of aggregate demand or a high level of aggregate demand.

– If the economy experiences a low level of aggregate demand, we would be at a short-run equilibrium like point A. This point also corresponds with point A on the Phillips curve. Note that when aggregate demand is low, the inflation rate is relatively low and the unemployment rate is relatively high.

– If the economy experiences a high level of aggregate demand, we would be at a short-run equilibrium like point B. This point also corresponds with point B on the Phillips curve. Note that when aggregate demand is high, the inflation rate is relatively high and the unemployment rate is relatively low.

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Text Figure 16.2

•

Given that monetary and fiscal policy can both shift the aggregate-demand curve, these types of policies can move the economy along the Phillips curve.

– Increases in government spending, or decreases in taxes all increase aggregate demand and move the economy to a point on the Phillips curve with lower unemployment and higher inflation.

– Decreases in government spending, or increases in taxes all lower aggregate demand and move the economy to a point on the Phillips curve with higher unemployment and lower inflation.

– The central bank can alter interest rates to move the economy up or down the aggregatedemand curve, by increasing interest rates when inflation is high, or decreasing interest rates when inflation is low.

Shifts in the Phillips curve: The role of expectations The long-run Phillips curve • • •

In 1968, economist Milton Friedman argued that monetary policy can only be used to choose a combination of unemployment and inflation for a short period of time. At the same time, economist Edmund Phelps wrote a paper suggesting the same thing.

This is true because, in the long run, monetary growth has no real effects. This means that it cannot affect the factors that determine the economy’s unemployment rate.

Thus, in the long run, we would not expect there to be a relationship between unemployment and inflation. This must mean that, in the long run, the Phillips curve is vertical.

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Text Figure 16.3 Inflation rate

Long-run Phillips Curve

High inflation

B

Low inflation

A

Natural rate of unemployment

Unemployment rate

Text Figure 16.4 Price level

LRAS

Inflation rate

Long-run Phillips curve

B B A A

AD2 AD1 Quantity of output

•

• •

Unemployment rate

The vertical Phillips curve occurs because, in the long run, the aggregate supply curve is vertical as well. Thus, increases in aggregate demand lead only to changes in the price level and have no effect on the economy’s level of output. Thus, in the long run, unemployment will not change when aggregate demand changes, but inflation will.

The long-run aggregate-supply curve occurs at the economy’s natural rate of output; thus, the longrun Phillips curve occurs at the natural rate of unemployment.

The natural rate of unemployment is not constant nor is it the socially desirable rate of unemployment. The natural rate is beyond the influence of monetary policy and is often referred to as the NAIRU (non-accelerating inflation rate of unemployment). Labour market policies are required.

You may want to review what is meant by the ‘natural rate’ of unemployment. Suggest that students re-read chapter 9 if they do not remember this concept.

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Expectations and the short-run Phillips curve •

• • • •

• •

The short-run aggregate supply curve is upward sloping because of misperceptions about relative prices, sticky wages and sticky prices. These perceptions, wages and prices adjust over time, so that the positive relationship between the price level and the quantity of goods and services supplied occurs only in the short run.

This same logic applies to the Phillips curve. The trade-off between inflation and unemployment holds only in the short run.

The expected level of inflation is an important factor in understanding the difference between the long-run and the short-run Phillips curves. Expected inflation measures how much people expect the overall price level to change.

The expected rate of inflation is one variable which determines the position of the short-run aggregate-supply curve. This is true because the expected price level affects the perceptions of relative prices that people form and the wages and prices that they set.

In the short run, people’s expectations are somewhat fixed. Thus, if the RBA increases the money supply (and does not follow a rule of inflation targeting), aggregate demand increases along the upward sloping short-run aggregate-supply curve. Output grows (unemployment falls) and the price level rises (inflation increases).

Eventually, however, people will respond by changing their expectations of the price level.

Specifically, they will begin expecting a higher rate of inflation.

We can relate the actual unemployment rate to the natural rate of unemployment, the actual inflation rate and the expected inflation rate using the following equation:

unemp. rate=natural rate- (actual inflation-expected inflation) – –

Because expected inflation is already given in the short run, higher actual inflation leads to lower unemployment.

How much unemployment changes in response to a change in inflation is determined by the variable α, which is related to the slope of the short-run aggregate-supply curve.

Be sure to discuss why actual inflation always equals expected inflation along the longrun Phillips curve.

– –

Suppose the economy is at point A and policymakers wish to lower the unemployment rate.

Expansionary monetary policy or fiscal policy is used to shift aggregate demand to the right.

The economy moves to point B, with a lower unemployment rate and a higher rate of inflation.

Over time, people get used to this new level of inflation and raise their expectations of inflation. This leads to an upward shift of the short-run Phillips curve. The economy ends up at point C, with a higher inflation rate than at point A, but the same level of unemployment.

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Text Figure 16.5 Inflation rate

LRPC

B

C

SRPC (high expected inflation)

A

SRPC (low expected inflation) Unemployment rate

Natural rate of unemployment

• •

The natural-rate hypothesis: The claim that unemployment eventually returns to its normal, or natural, rate, regardless of the rate of inflation.

In the news: Treasurer leaves RBA’s inflation target intact • This article discusses about how current monetary policy allows for greater flexibility and stabilises inflationary expectations.

Shifts in the Phillips curve: The role of supply shocks • •

Supply shock: An event that directly alters firms’ costs and prices, shifting the economy’s aggregate-supply curve and thus the Phillips curve.

In 1974, OPEC increased the price of oil sharply. This increased the cost of producing many goods and services and therefore resulted in higher prices.

– Graphically, we could represent this supply shock as a shift in the short-run aggregate supply curve to the left.

Text Figure 16.6 Price level

SRA S2

Inflation rate SRA S1

PC2 AD

PC1 Quantity of output

Unemployment rate

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– •

•

The decrease in equilibrium output and the increase in the price level left the economy with stagflation.

Given this turn of events, policymakers are left with a less favourable short-run trade-off between unemployment and inflation.

– If they increase aggregate demand to fight unemployment, they will raise inflation further.

– If they lower aggregate demand to fight inflation, they will raise unemployment further.

This less favourable trade-off between unemployment and inflation can be shown by a shift of the short-run Phillips curve. The shift may be permanent or temporary, depending on how people adjust their expectations of inflation.

The cost of reducing inflation Inflation in Australia hovered around 10 per cent in the 1980s. Two possibilities considered for lowering the inflation rate were to lower aggregate demand using monetary and fiscal policies, and agreements over wage restraint.

The sacrifice ratio •

To reduce the inflation rate, the RBA must follow contractionary monetary policy.

– When the RBA slows the rate of growth of the money supply (the monetary policy instrument used in the 1980s), aggregate demand falls.

– This reduces the level of output in the economy, increasing unemployment.

– The economy moves from point A along the short-run Phillips curve to point B, which has a lower inflation rate but a higher unemployment rate.

– Over time, people begin to adjust their inflation expectations downward and the short-run Phillips curve shifts. The economy moves from point B to point C, where inflation is lower and the unemployment rate is back to its natural rate.

Text Figure 16.7 Inflation rate LRPC

A

B C

SRPC (high expected inflation) SRPC (low expected inflation)

Unemployment rate

• • •

Therefore, to reduce inflation, the economy must suffer through a period of high unemployment and low output.

Sacrifice ratio: the number of percentage points of annual output lost in the process of reducing inflation by 1 percentage point.

A typical estimate of the sacrifice ratio is 5. This implies that for each percentage point inflation is decreased, output falls by 5 per cent.

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Rational expectations and the possibility of costless disinflation • • •

Rational expectations: The theory according to which people optimally use all the information they have, including information about government policies, when forecasting the future.

Proponents of rational expectations believe that when government policies change, people alter their expectations about inflation.

Therefore, if the government makes a credible commitment to a policy of low inflation, people would be rational enough to lower their expectations of inflation immediately. This implies that the short-run Phillips curve would shift quickly without any extended period of high unemployment.

The Accord approach • •

•

•

Australia, like many other countries, experienced a significant recession in 1982–83, largely as a consequence of a worldwide downturn.

In response to the coexistence of high unemployment (10 per cent) and an environment in which inflation remained relatively high, the Hawke Labor Government, in concert with the union movement, introduced the Accord.

– As it evolved over the period 1983 to 1987, the Accord provided for cuts to real wages and a trade-off in terms of tax cuts and reforms to superannuation.

– This resulted in a lowering of inflationary expectations and a reduction in inflation.

In the late 1980s, there were fears of a rise in the inflation rate together with concerns surrounding a rising current account deficit. Restrictive monetary policy resulted in a significant reduction in inflation but unemployment rose significantly – the so called ‘recession we had to have’ as dubbed by then Treasurer Paul Keating.

Figure 16.8 shows the inflation rate and the unemployment rate from 1975 to 2010.

• In the news: Mysterious Demise of the Phillips Curve is Weirdest in Australia.

This article suggests that the Phillips Curve is no longer as relevant as it used to be. Since 2015, it is discussed that the economy was gaining competitiveness and the RBA has aided the transition.

A low-inflation era •

•

Since the disinflation in the early 1990s, inflation has remained very low in Australia. In 2004, unemployment fell to a 10-year low of around 5.5 per cent. The RBA is sufficiently worried about the low unemployment rate and the impact of excess demand pressure on inflation that it has increased interest rates several times in the last decade.

In this period the Phillips curves appears to have shifted. The shift in the Phillips curve is indicated Figure 16.8 from Phillips curve A to B.

Conclusion • •

This chapter examined how economists’ thinking about inflation and unemployment has evolved over time. The Phillips and Solow curves, the natural rate hypothesis and the rational-expectations theory were discussed There is always a temporary trade-off between inflation and unemployment, but there is no permanent trade-off.

Adjunct teaching tips and warm-up activities Bring in several plots of inflation rates and unemployment rates since the Second World War (one for the 1950s, one for the 1960s and so on.). Divide students up into groups and assign each group a different decade. Ask the students to create a story to fit the data. Then go over each group’s analysis with the whole class. Show students how the short-run Phillips curve has shifted over time and provide possible explanations for these shifts.

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Check your understanding solutions LO16.1 The Phillips curve Q. Illustrate the Phillips curve with a diagram. Using the aggregate-demand and aggregate-supply model, show how policy can move the economy from a point on this curve with low inflation to a point with higher inflation.

A: To see how policy can move the economy from a point with high inflation to a point with low inflation, suppose the economy begins at point A in Figure 16.1 below. If policy is used to increase aggregate demand, shifting the aggregate-demand curve from Low aggregate demand to High aggregate demand, the economy moves from point A to point B, with higher inflation.

Figure 16.1

LO16.2 Shift in the Phillips curve: The role of expectations Q. What is the difference between the short-run and the long-run Phillips curve?

Illustrate your answer with a diagram.

A: Figure 16.2 shows the short-run Phillips curve and the long-run Phillips curve. The curves are different because in the long run, monetary policy has no effect on unemployment, which must be at its natural rate, but in the short run, monetary policy can shift aggregate demand, raising or lowering the inflation rate with the opposite effect on the unemployment rate.

Figure 16.2

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LO16.3 Shifts in the Phillips curve: The role of supply shocks Q. If OPEC announced a sudden rise in oil reserves around the world, how would this affect the Phillips curve? Illustrate your answer using the model of aggregate demand and aggregate supply. Would this announcement constitute a shock?

A: A rise in oil reserves will lead to a shift to the right of the aggregate supply curve and a decrease in oil prices. A decrease in oil prices is a supply shock. The shock shifts the aggregate-supply curve to the right, increasing output and decreasing the price level, moving the economy from point A to point B in Figure 16.3. As a result, the Phillips curve shifts to the left, as the figure shows.

Figure 16.3

LO16.5 Rational expectations and the possibility of costless disinflation Q. What is the sacrifice ratio? How might the credibility of the RBA’s commitment to reduce inflation affect the sacrifice ratio?

A: The sacrifice ratio is the number of percentage points of annual output lost in the process of reducing inflation by 1 percentage point. The credibility of the RBA’s commitment to reduce inflation might affect the sacrifice ratio because it affects the speed at which expectations of inflation adjust. If the RBA’s commitment to reduce inflation is credible, people will adjust their expectations of inflation quickly, the Phillips curve will shift left and the cost of reducing inflation will be low. But if the RBA isn’t credible, people won’t adjust their expectations of inflation and the cost of reducing inflation will be high.

Practice questions solutions Questions for review 1

Figure 16.5 shows the short-run trade-off between inflation and unemployment. The RBA can move from one point on this curve to another by changing interest rates. A decrease in the interest rate increases aggregate demand and reduces the unemployment rate and increases the inflation rate, while an increase in the interest rate increases the unemployment rate and reduces the inflation rate.

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Figure 16.5

2

Figure 16.6 shows the long-run trade-off between inflation and unemployment. In the long run, there is no trade-off, as the economy must return to the natural rate of unemployment on the longrun Phillips curve. In the short run, the economy can move along a short-run Phillips curve, like SRPC1 shown in the figure.

The higher the expected rate of inflation, the higher the short run trade-off between inflation and unemployment. For example, if the RBA pursues an expansionary monetary policy, the economy moves up along SRPC1 in the short run. But over time the short-run Phillips curve will shift to return the economy to the long-run Phillips curve, for example, shifting from SRPC1 to SRPC2.

Figure 16.6

3

4

An adverse negative shock to the aggregate demand curve means the curve will shift to the left.

There will be lower output and lower inflation. This results in a movement down along the Phillips curve with a lower inflation and higher inflation rate.

When the RBA decides to increase inflation, the economy moves down along the short-run Phillips curve, as shown in Figure 16.7. Beginning at point A on short-run Phillips curve SRPC1, the economy moves up to point B as inflation increases. As soon as people’s expectations adjust to the higher rate of inflation, the short-run Phillips curve shifts to SRPC2, and the economy moves to point C. The short-run costs of inflation, which arises because the unemployment rate is temporarily below its natural rate, could be reduced if the RBA’s action was credible, so that expectations would adjust more rapidly.

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Figure 16.7

Multiple choice 1. c

2. d

3. a

4. a

5. d

Problems and applications 1

Figure 16.8 shows two different short-run Phillips curves depicting these four points.

Point a has an actual inflation rate of 2.5 per cent and expected inflation of 3.5 per cent.

Point b has an actual inflation rate of 3.5 per cent and expected inflation of 4.5 per cent.

Point c has expected and actual inflation rates of 3.5 per cent Point d has expected and actual inflation rates of 2.5 per cent.

Figure 16.8

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2 a An increase in the natural rate of unemployment shifts the long-run Phillips curve to the right, as shown in Figure 16.9. The economy is initially on LRPC1 and SRPC1 at an inflation rate of 3 per cent, which is also the expected rate of inflation. The increase in the natural rate of unemployment shifts the long-run Phillips curve to LRPC2 and the short-run Phillips curve to SRPC2, with the expected rate of inflation remaining equal to 3 per cent.

Figure 16.9

b

A decrease in the price of imported machinery shifts the short-run Phillips curve up, as shown in Figure 16.10, from SRPC1 to SRPC2. For any given unemployment rate, the inflation rate is higher, since machinery is such a significant aspect of production costs in the economy.

Figure 16.10

c A reduction in government spending represents an increase in aggregate demand, so it moves the economy along the short-run Phillips curve, as shown in Figure 16.11. The economy moves from point A to point B, with a decrease in the unemployment rate and an increase in the inflation rate.

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Figure 16.11 Phillips curve

d An increase in expected inflation causes the short-run Phillips curve to shift up, as shown in Figure 16.12. The higher rate of expected inflation shifts the short-run Phillips curve from SRPC1 to SRPC2.

Figure 16.12

3 a The changes that occur as a result of an increase in people’s inflation expectations is shown in Figure 16.13, using an aggregate-supply/aggregate-demand diagram and the Phillips-curve diagram. Expected inflation measures how much people expect the overall price level to change.

Expected inflation is one factor that determines the position of the short-run aggregate-supply curve. Higher inflationary expectations means when there is a policy change, the Phillips curve will shift by more. In the short run, the Phillips curve is fixed assuming certain inflationary expectations.

Assume the economy begins at full employment, point A in both diagrams, where the expected inflation and the aggregate supply are determined in the short run. If a policy change increases aggregate demand, the aggregate-demand curve will shift to the left from AD1 to AD2. The economy initially remains on the short-run aggregate-supply curve SRAS1, so the new equilibrium occurs at point B. The movement of the aggregate-demand curve along the short-run aggregatesupply curve leads to a movement along short-run Phillips Curve SRPC1, from point A to point B. 1614 Copyright 2021 Cengage Learning Australia Pty Limited

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The lower price level in the aggregate-supply/aggregate-demand diagram corresponds to the lower inflation rate in the Phillips-curve diagram. The lower level of output in the aggregatesupply/aggregate-demand diagram corresponds to the higher unemployment rate in the Phillipscurve diagram.

Figure 16.13

b If expected inflation is higher in the long run, the high unemployment rate eventually cause wages to decrease in the economy. As this occurs, the price of production increases, shifting the shortrun aggregate-supply curve right from SRAS1 to SRAS2 and shifting the short-run Phillips curve down from SRPC1 to SRPC2. In both diagrams, the economy eventually gets to point C, which is back on the long-run aggregate-supply curve and long-run Phillips curve.

If in the long run expected inflation changes in the same direction that actual inflation changes in the short run, the movement of the economy to SRAS2 and SRPC2 happens faster than if the economy adjusts through a decrease in nominal wages. But in either case, the economy eventually gets to point C on both diagrams.

4 a Figure 16.14 shows the economy in long-run equilibrium at point a, which is on both the long-run and short-run Phillips curves.

Figure 16.14

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b An adverse demand side shock will reduce aggregate demand, moving the economy to point b in the figure. The unemployment rate rises and the inflation rate declines. If the RBA undertakes expansionary monetary policy, it can increase aggregate demand, offsetting decrease in aggregate demand and returning the economy to point a, with the initial inflation rate and unemployment rate. c Figure 16.15 shows the effects on the economy if the price of imported oil rises. The higher price of imported oil shifts the short-run Phillips curve up from SRPC1 to SRPC2. The economy moves from point a to point c, with a higher inflation rate and higher unemployment rate. Now if the RBA engages in expansionary monetary policy, it can return the economy to its original unemployment rate at point d, but the inflation rate will be higher. If the RBA engages in contractionary monetary policy, it can return the economy to its original inflation rate at point e, but the unemployment rate will be higher. This situation differs from that in part (b) because in part (b) the economy stayed on the same short-run Phillips curve, but in part (c) the economy moved to a higher short-run Phillips curve.

Figure 16.15

5 a If the RBA focuses on keeping unemployment at its natural rate, inflation in the short run would rise. To maintain unemployment at its natural rate the RBA could use expansionary monetary policy to increase aggregate demand and in doing so, increase inflation. b If the RBA acts on its belief that the natural rate of unemployment is 4 per cent, and the economy is currently at 5 per cent unemployment, the RBA would pursue an expansionary monetary policy to increase AD and increase the pressure on resources. Output would rise, decreasing unemployment and increasing inflationary pressures. Unemployment would be below the natural rate of 6 per cent.

6 a If wage contracts have short durations, the recession will be less severe, since wage contracts are adjusted rapidly to reflect the high inflation rate. b If there is confidence in the RBA’s determination to reduce unemployment, a recession induced by contractionary monetary policy will be less severe. The more confidence people have in the RBA’s willingness to bear the costs of reducing inflation, the shorter time it will take for people’s inflation expectations to adjust downwards, c If expectations of inflation adjust quickly to actual inflation, the recession will be less severe. In this case, people’s expectations adjust quickly, so the short-run Phillips curve shifts quickly to restore the economy to long-run equilibrium at the natural rate of unemployment. In Figure 16.7, the short-run Phillips curve would shift upwards as expectations adjusted and the economy would reach point C quickly.

7 The slope of the short-run Phillips curve is governed by the slope of the short-run aggregate supply, as discussed in chapter 14. How quickly the short-run Phillips curve shifts in response to 1616 Copyright 2021 Cengage Learning Australia Pty Limited

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8

9

10

changes in the economy depends on expected inflation and if there are any shocks to aggregate supply.

With a sacrifice ratio of 5, a reduction of inflation by 2 percentage points requires a loss of output of 5 x 2 = 10 percentage points. Since this will take place over five years, output will have to average 10 / 5 = 2 percentage points per year below its trend level. According to Okun’s Law, the change in unemployment = ½ x (percentage change in real GDP – 3 per cent). Unemployment = ½ x (-2 per cent – 3 per cent) = ½ x -5 per cent, i.e. unemployment will increase 2.5 per cent each year to be 7.5 per cent per annum.

If the sacrifice ratio is 5, the percentage of annual output lost in the process of reducing inflation by 1 percentage point, is 5 per cent. To reduce inflation to 4 per cent (from 8 per cent), would require sacrificing 20 per cent of annual output.

Even though inflation is unpopular, elected leaders don’t always support efforts to reduce inflation because of the short-run costs associated with disinflation. In particular, as disinflation occurs, the unemployment rate rises and when unemployment is high people tend not to vote for incumbent politicians, blaming them for the bad state of the economy. Thus politicians tend not to support disinflation.

Many economists believe that countries with independent central banks can reduce the cost of disinflation because in those countries politicians can’t interfere with central banks’ disinflation efforts. People will believe the central bank when it announces a disinflation because they know politicians can’t stop the disinflation. In countries with central banks that aren’t independent, people may believe that a disinflation could be stopped by politicians who are worried they won’t be re-elected. As a result, the credibility of the central bank is lower and thus the costs of disinflation are higher.

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Chapter 17 Contemporary macroeconomics topics Learning objectives After reading this chapter, students should be able to: • learn about globalisation • learn the main elements of financial crises • identify the main causes of the 2008 Global Financial Crisis • learn about the European debt contagion and the spread of the financial markets crisis • apply the aggregate supply and demand model to describe the crisis and consider optimal responses of monetary and fiscal policies • formulate lessons from the crisis that can help us avoid similar crises in the future • learn about the causes of slow wages growth in Australia.

Key points •

•

•

•

•

•

The main elements of a financial crisis are: a decline in asset prices; insolvencies of financial institutions; a decline in confidence in financial institutions; a credit crunch; a significant economic downturn and a vicious cycle, where the economic downturn reinforces the other elements of the crisis.

The causes of the GFC include a house price bubble in the US and other advanced economies and the consequent rising household debt to finance the increased demand for housing. This was faciliated by mortgage securitisation in the form of financial innovations such as collateralised debt obligations (CDOs), that further stimulated lending to subprime mortgages. It included government failures as a result of policies such as the push for affordable housing in the US and the too-big-tofail problem, where large finanical institutions had an implicit guarantee of bailout funds to avoid bankruptcy. This latter policy created an incentive for excessive risk taking, a form of moral hazard.

In addition, economists have pointed to the expansionary monetary policy settings in the US following the dot.com bubble. This ‘cheap money’ contributed to the build-up in the housing bubble in the US. The GFC was propagated by house prices’ decline in many OECD countries and particularly in the US. The problem of mortgage securitisation led to panic in financial markets, a credit crunch as banks stopped lending and ‘financial contagion’ as the crisis spread around the world. This led to falls in aggregate demand and production, which created a vicious cycle of pessimism and further declines in asset prices, output, production and employment.

The GFC can be illustrated on in the AD/AS model as a shift to the left of the LRAS reflecting a structural gap as a result of damage to the financial system and a shift away from housing. This is accompanied by shifts to the left of the SRAS and AD curves since lower potential output implies lower spending and production. There was a also decline in the AD curve due to reduced output and expenditure.

The economy can self-correct, through changes in prices and wages, which shift the SRAS curve to the right. The optimal policy response in the short run is to increase the AD curve through monetary and fiscal policy.

The lessons from the crisis include: first, a need to use debt more carefully; second, all parties need to correctly assess the risks of new finanical products and innovations; third, governments need to be consistent in dealing with the too-big-too-fail problem and make financial institutions more accountable; fourth, central banks need to be careful in responding to economic shocks and not

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contribute to the build-up of imbalances and asset price bubbles; fifth, governments need to put their long-term fiscal settings on a sustainable path to enable flexibility in responding to economic shocks.

Chapter outline Introduction •

This chapter discusses the benefits and costs of globalisation and how it impacts the Australian economy. The Global Financial Crisis is examined.

What does globalisation mean?

• • •

• •

In this chapter, globalisation means the free movement of goods and services, as well as labour and intellectual property.

We have not always had a globalised economy. Figure 17.1 shows the value of exported goods as a share of GDP. The trend has fluctuated but has seen an upward trend since 1940.

In previous chapters, we saw that countries that are more open to free trade are more likely to have higher average incomes, faster economic growth, respect the rule of law and the protection of property rights.

The Global Financial Crisis changed some economists’ views of globalisation.

In the news: The A380.

– The article discusses the production of the Airbus 380 – There are four million individual parts produced by 1500 companies from 30 countries around the world.

Overview of the main elements of financial crisis •

Common ingredients of most financial crises in the past include (based on the book This Time is Different: Eight Centuries of Financial Folly, by Carmen Reinhart and Ken Rogoff): – A large decline in asset prices, such as real estate in 2008 and 2009.

– Insolvencies of financial institutions, like those in 2008 and 2009 that had placed bets on real estate prices continuing to rise.

– A large decline in confidence in financial institutions.

– A credit crunch, where financial institutions facing difficulties do not lend to prospective borrowers.

– A vicious circle caused by an economic downturn, which reduces profits, and share markets record losses, all reinforcing each other.

The causes of the GFC • •

While there were multiple causes, the trigger point of the crisis was the real estate market in the US. Figure 17.5 in the text shows the rise in real house prices over the period 1975 to 2006 for Australia, France, the United Kingdom and the United States. The rapid rises begin after 1996, and, for example, led to a rise of 185 per cent in the United Kingdom.

Rising household debt • • •

House prices in the economy reflect demand and supply. The data indicate that demand was largely responsible for the increase in house prices.

The increased demand for housing by households led to an increased demand for external funding to finance it.

Figure 17.6 shows the ratio of the average house price relative to average weekly earnings in Australia.

Opaque mortgage securitisation • The growth in household debt was facilitated by financial innovation. Mortgages were bundled into new types of securities, for risk diversification, and traded on a large scale.

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• • •

•

Mortgage securitisation: the process of bundling many mortgage loans together and converting them into tradeable financial instrucments (debt securities).

Two types of borrowers are identified: prime and subprime.

– Prime borrowers are characterised by a good credit history and a high income.

– Subprime borrowers are characterised by a poor credit history and low income.

The risky mortgages from subprime borrowers were converted into safer ones, through a new financial instrument called (mortgage-backed) collateralised debt obligations (CDOs).

– The subprime mortgages were bundled then sliced into tranches each with different credit ratings (e.g. from very safe AAA, to risky BB).

– When the mortgage repayments were made, those with the AAA-rated CDO tranche were paid first, then it spilled progressively into other tranches that were more risky.

However, this income stream was from subprime borrowers and the AAA tranche was a low percentage of the overall security.

In the news: Recipe for disaster: The formula that killed Wall Street. Felix Salmon of Wired magazine looks at the impact of mortgage securitisation in the early 2000s. Uncritical use of the Gaussian copula function, developed by the investment banker Li, led to understimates of both the default and systemic risk of CDOs and CDSs.

Ill-designed government policies •

•

Political interference in the housing market In some countries, including Australia, there was a political conviction that people should be able to own their house.

– In Australia, the tax treatment of negative gearing in combination with a major capital gains discount, marked a trend towards people acquiring investment properties.

– The GSEs’ subprime lending gradually increased leading to a housing bubble: that is, a rapid rise in the prices of real estate not justified by economic fundamentals.

The too-big-to-fail problem The importance of the financial sector to the economy means governments treat it with special care.

– One such policy is the implicit guarantee that a large systematically important financial institution will not be allowed to collapse. It is considered too-big-to-fail.

– If the institution were in danger of bankruptcy it would be offered a government bailout.

– This provides the incentive for excessive risk-taking behaviour, a form of moral hazard.

Loose monetary policy Some economists have suggested that the extended period of loose monetary policy (low interest rates) in the period 2001–07 also contributed to the housing bubble.

Global economic trends and imbalances • • •

The ‘roots’ of the GFC can be traced back to the Asian financial crisis, where investors’ funds left South-East Asian countries for the US, contributing to the dot-com bubble.

More generally, an excess supply of loanable funds over demand created a global saving glut.

In addition, there was a relative price shock whereby the price of manufactured goods coming out of Asia fell relative to the price of natural resources and energy. The Fed kept interest rates low, not recognising that the relative price shock had kept inflation low.

The European debt contagion • •

• • • •

Case study: How did the GFC spread around the world?

Globalisation meant that there was a free flow of financial capital between countries. Banks and governments were loaning each other money and some of these loans were based on the same type of property bubble experienced in the US. As a result of the collapses on Wall Street, banks in Europe were being bailed out by their governments in order to prevent a collapse of their financial systems.

As European economies were interconnected, if one country defaults, a downward cycle would emerge.

Figure 17.7 shows the inter-European debt.

In the end, Germany bailed out Greece and the European debt crisis was averted.

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Policy responses to the GFC •

The policy responses can be analysed using the aggregate-demand and aggregate-supply diagram developed in earlier chapters.

What kind of shock(s) caused the GFC? •

Figure 17.8 in the text gives an interpretation of the developments causing the GFC. – The LRAS curve shifts to the left as a result of damage to the financial system and a structural shift away from the housing sector. The lower potential output and lower income and expenditure means the SRAS and the AD curve also shift to the left.

– The AD shifts further to the left from the contraction in consumption and investment spending and a decline in exports.

– These changes cause falls in both the price level P and real output Y.

It is important to emphasise that this is an interpretation of the GFC, and that there are alternative interpretations. Ask students if they know of any alternative explanations of the crisis and how they might represent this in the AD/AS model.

The self-correction of the GFC shocks: The theory •

Figure 17.9 in the text shows the ‘textbook’ self-correcting mechanism.

– Initially output is below potential at point C. – In the short run, prices and wages are slow to adjust, but once they do output moves back to potential as shown by the rightward shift of the SRAS (SRAS3).

– At the equilibrium level inflation falls to P4 and output is at the new LRAS2 position (point D).

– The LRAS does not return to the pre-crisis position. The major disruptions to world financial system, international trade and structural mismatch in the labour market mean that potential output is lower.

– The gap between the Y3 and Y2 will close in the longer term through structural adjustments in the economy and technological progress.

Macroeconomic policy response to the GFC shocks: The theory • •

•

First, the government cannot correct the LRAS shock through monetary or fiscal policy.

However, monetary and fiscal policies can be used to stimulate the economy and offset the AD shock, as shown in Figure 17.10 – Fiscal policy, lower taxes or higher government expenditures, can increase aggregate demand.

– Monetary policy can also increase aggregate demand by lowering the official interest rate.

– Both policies increase AD as shown in Figure 17.10, from AD3 to AD4.

– Monetary policy is thought to be better at stimulating AD as it can be implemented very quickly.

There is debate about the appropriate response by government. Should they intervene and stimulate aggregate demand, or wait for the economy’s self-correcting mechanism? This depends on a number of factors including the severity of the downturn, the speed of the self-correcting mechanism and the ability of policymakers to carry out the optimal policy response.

Macroeconomic policy responses to the GFC shocks: The reality •

There is debate among economists and policymakers about the nature of the post-GFC high unemployment. Is it structural unemployment or is it cyclical? It is probably a bit of both as indicated by the data in the policy responses.

Fiscal policy responses during the GFC • Figure 17.11 in the text, shows the size of the fiscal packages for OECD countries in response to the GFC. – Australia had one of the largest fiscal packages in the OECD. – The proportion of government investment in the stimulus package was by far the largest in Australia (see Figure 17.12).

Monetary policy responses during the GFC • Central banks responded to the developments in the housing and financial markets by aggressively lowering interest rates.

– The RBA starting cutting interest rates in September 2008 from 7.25 to 7 per cent. By April 2009 the interest rate was 3 per cent.

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–

The Fed in the US lowered the official rate to its lowest possible level of zero by December 2008.

– The European Central bank settled at 1 per cent in early 2009.

– These low rates were then maintained for several years.

• During the GFC the impact of the expansionary monetary policy did not cause significant stimulus or inflation.

– Banks did not give loans but instead hoarded cash in fear of insolvency.

– The monetary base (currency plus bank reserves with the central bank) increased but the money supply (currency plus deposits at banks) did not change much. So the expansionary effects of policy change was not as strong as is necessary to move aggregate demand from AD3 to AD2 in Figure 17.10.

– This situation is referred to as a liquidity trap.

Unconventional macroeconomic policies • Another policy used was quantitative easing, where central banks buy longer term assets from the private sector. This is to lower the long-term interest rate and stimulate economic activity through investment spending.

• In addition, governments in advanced economies issued more long-term bonds to take advantage of lower interest rates and in doing so put pressure on rates to rise. This had the effect of erasing part of the stimulatory effect of the quantitative easing.

• Case study: How did Australia do during the GFC? – Australia was almost ‘unharmed’ through the GFC. Figure 17.13 compares cumulative GDP for Australia, the US and the UK between 2003 and 2016. It shows that Australia’s GDP grew by more than double that of the US and UK. – The question is why?

– First, the commodity boom provided income during the GFC. – Related to this was the orientation towards Asia, which was less affected by the GFC. – The regulation, monitoring and good governance of the financial system was effective in Australia. Australian banks did not get exposed to problematic financial instruments.

–

The settings of monetary and fiscal policy had a beneficial effect.

Lessons from the GFC • •

•

Some have argued that the boom and bust cycle of markets, like real estate, are due to inefficiencies of the market mechanism and the irrationality of economic agents and the greed of bankers.

However, this boom and bust cycle was often the result of rational behaviour given the incentives.

In particular, perverse incentives that often had unintended consequences of well-intentioned government policies.

– The observed differences suggest there may be many explanations for changes in real estate prices.

What are some of the lessons of the GFC? – First, high debt levels of households, businesses and governments can lead to fragility in the financial system.

– Second, all parties need to be careful in correctly assessing the risks of new financial products and innovations.

– Third, governments need to deal with the too-big-to-fail problem in a consistent manner, to avoid excessive risk taking by large financial institutions.

– Fourth, central banks need to be careful in responding to economic shocks, so as not to contribute to the build-up of imbalances and bubbles. There is evidence with the increase in US stock market indices and continued quantitative easing that this is repeating.

– Fifth, government should make it a priority to bring long-term fiscal settings on a sustainable path to enable flexibility in responses to negative shocks.

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Slow wages growth • • • • •

Since the GFC, Australia has experienced a slowing of wage growth, even though labour productivity has increased.

Lower wages mean firms can produce goods and services more cheaply, but workers have less money to spend. This can result in slower economic growth.

While the GFC is not responsible for slow wage growth, it has contributed to this issue.

Economists suggest that reasons such as underemployment and underutilisation of the labour force reduce pressure on wages, as well as lowered inflation expectations, lower terms of trade and the need for the real exchange rate to adjust to improve international competitiveness.

In the news: Hey pollies: weak wage growth won’t fix itself.

– Slow wages can lead to a slowing economy.

– There doesn’t seem to be any sign of nominal wage growth in the recent years.

– It is suggested that the problem arises with the structure of the economy, specifically that the reform of wage fixing went to far in shifting the balance of industrial bargaining power in favour of employers.

– Keating sees the wages problem as a result of secular stagnation. Distribution of earnings has become more unequal due to technological change and globalisation.

Conclusion • •

It is important that economists and policymakers learn from economic crises.

Economists assess the GFC as either market failure or government failure.

Adjunct teaching tips and warm-up activities Ask students what they know of the GFC, and was anybody they know directly affected (e.g. lost a job, or had to foreclose on a mortgage). This does not need to be confined to Australia. This can make the crisis more real, as in Australia the harm was much less than other countries.

Check your understanding solutions LO17.3 The causes of the GFC Q. Explain what a CDO is, why it was thought to minimise risk, and the events that occurred leading up to the GFC which meant this was not the case.

A: CDOs stand for collateralised debt obligations, which are debt instruments backed up by (i.e. getting income from) some underlying asset; for example, mortgages. The subprime mortgages were bundled then sliced into tranches each with different credit ratings (e.g. from very safe AAA, to risky BB).

When the mortgage repayments were made, those with the AAA-rated CDO tranche were paid first, then it spilled progressively into other tranches that were more risky. However, this income stream was from subprime borrowers and the AAA tranche was a low percentage of the overall security.

Q. Using some online sources, explain what systemic risk means with respect to a particular industry. Why were the assumptions used by David X Li, as well as bankers and investors using his approach, so problematic?

A: Systemic risk refers to the risk of a breakdown of an entire system rather than simply the failure of individual parts. In a financial context, if denotes the risk of a cascading failure in the financial sector, caused by linkages within the financial system, resulting in a severe economic downturn. The main problems with Li’s approach was due to the uncritical use of the Gaussian copula function, which led to understimates of both the default and systemic risk of CDOs and CDSs. The warnings about its limitations were igonored and Li himself was well aware that his approach rested on some fairly strong assumptions that may not hold in practice.

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Practice questions solutions Questions for review 1

2

3

4

5

A more globalised economy means that there are less barriers between countries. This is not limited to increased flows of physical goods, but also financial capital. In a situation where there is financial capital moving easily around the world, a financial crisis in a particular country can have far reaching consequences. Due to the greater interconnectedness, crises such as the GFC cannot be contained to one particular country, because there is no physical border preventing inflows and outflows of capital. Even though an underlying market may be domiciled in a particular country, economic actors participating in that market (i.e. investors) may not be.

Indebtedness of households and financial institutions in the US and elsewhere increased during early 2000s. In the US, debt as a proportion of personnel disposable income increased from below 70 per cent to 135 per cent prior to the crisis. This was a result of the low interest rates and a growing appetite for households to own a house.

The growth in household debt was facilitated by financial innovations such as CDOs, which increased household and financial institutions’ indebtedness. It was the build-up of this indebtedness and the lax lending standards that contributed to the GFC. A housing bubble refers to a rise in house prices not justified by the economic fundamentals. Some of the reasons for the rapid rise in prices were the government policies to create affordable housing.

An example of this is the government-sponsored enterprises (GSEs), such as Fannie Mae and Freddie Mac, which had advantages over private institutions in lending to households to finance real estate. Another reason was that the Fed in the US maintained low interest rates for too long and this contributed to the build-up in real estate prices.

A government bailout of a financial institution is the use of taxpayer funds to prevent bankruptcy.

This might be important to prevent the spread of bankruptcies to other healthy financial institutions.

However, the implicit guarantee of a bailout fund for institutions considered too-big-to-fail creates the incentive for excessive risk-taking behaviour.

Multiple choice 1. a

2. d

3. d

Problems and applications 1

Globalisation has many benefits, such as increases in trade, free movement of investment and ideas.

The opening up of economies to each other gives the consumer a greater variety of goods and services that it can consume, and due to access to new markets and materials, some of these goods can be produced at a lower cost. Increased competition also results in higher quality goods, given a consumer’s ability to seek out alternatives to low quality products. This can lead to overall increased wealth, economic growth, and higher levels of employment for less developed countries.

Some of these benefits may impact negatively on individuals, even if overall levels of wealth and economic activity have increased. Increased economic growth and wealth does not necessarily mean that everybody has benefited equally – workers may lose their jobs if a company decides to use cheaper labour from overseas, and an increased number of unemployed may put downward pressure on average wages, contributing to an increase in income inequality.

2

The main causes of the GFC were rising household debt, mortgage securitisation and government policies, such as the push for affordable housing and incentives for excessive risk taking by large financial institutions. The push for affordable housing, rising household debt and the too-big-toofail problem are instances of government failure. The government policy in the US of providing incentives for government-sponsored enterprises (GSE) to stimulate mortgages contributed to the housing bubble. This was linked to the implicit guarantee to bail out large financial institutions creating the incentive for excessive risk taking. The development of mortgage securitisation in the 1707 Copyright 2021 Cengage Learning Australia Pty Limited

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3

4

5

form of CDOs is a market failure, in that, financial institutions ignored or underestimated the systemic risks associated with these products. a The video highlights how households and investors are brought together through the financial system. Investors seeking higher returns than the 1 per cent offered by the Fed use leverage to increase returns. Households and investors are linked through collateralised debt obligations (CDOs), which are based on the repayments of mortgages of different risk categories. The CDOs are extended to the subprime mortgage market, which carries greater risk. When these households in the subprime mortgage category begin defaulting on loans, this causes house prices to fall, which is the asset that backs the CDOs. This creates a snowball effect of falling house prices, further defaults on loans that eventually spread to the households with prime mortgages. b Households – are the potential homeowners who take out mortgages in order to fulfil their dream to own a home.

Mortgage brokers – connect households to a lender and make a commission for this.

Retail bankers – lend to households and sell mortgages to investors. Their incentive is to sell more mortgages.

Investment bankers – buy mortgages and create CDOs and sell these to investors, and their incentive is to sell more and fulfil the demand from different investors.

Investors – buy the CDOs in the search for high returns.

Insurance companies – provide insurance products such as credit default swaps (CDSs) and have an incentive to sell more of these products.

The Federal Reserve – conducts monetary policy in the US and has an incentive to manage the economy.

China/Japan/Middle East – had the incentive to borrow at low interest rates from the Fed. Rating companies – rate the different levels of risk in the CDOs e.g. AAA safe or BB more risky. c The assumption of rising real estate prices was common to all parties, which encouraged households to take on more debt, while mortgage brokers met demand. The financial sector parties under-estimated the risks because they either assumed lending had an implicit government guarantee (motivated by Government housing policy) or the institutions involved were too big to be allowed to be failed. This led to imprudent levels of risk taking. The Federal Reserve assumed that macroeconomic conditions suited an expansionary monetary policy setting and this lowered borrowing costs, encouraging the expansion in household debt. Foreign lenders assumed that the ratings of the credit-rating organisations were reliable, when they had been negligent and failed to describe these firms accurately. These converged to sustain the increases in household debt through mortgages. The most negatively affected agents were the households, who witnessed the value of their home plummet, and those who lost their job. The large financial institutions and banks, which had the incentive to engage is excessively risk-taking activities were least affected as the government provided bailout funds. a Professor Warwick McKibbin traces the roots of the GFC back to the Asian financial crisis, where investors’ funds left South-East Asian countries for the US, contributing to the dot-com bubble. Further, China, Japan and the countries of the Middle East had an excess supply of loanable funds over the demand, which created a global savings glut. In addition, there was a relative price shock whereby the price of manufactured goods coming out of Asia fell relative to the price of natural resources and energy. The Fed kept interest rates low, not recognising that the relative price shock had kept inflation low. The combination of these global economic trends and imbalances contributed to the build-up of the housing price bubble. b Many answers possible. c Many answers possible. a A negative aggregate demand shock, causes the AD curve to shift to the left as shown in Figure 17.1, from AD1 to AD2. If there is no intervention from policymakers, then prices and wages are slow to adjust and GDP falls and inflation is lower at point B. In the long run, wages and prices adjust and the SRAS curve shift to the right (from SRAS1 to SRAS2). The economy moves to a new equilibrium point C with output at potential and lower inflation.

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Figure 17.1

b

If policymakers respond with optimal fiscal or monetary policy and increase aggregate demand, the AD curve shifts to the right (for example from AD2 back to AD1 in Figure 17.1) to the original equilibrium at point A. Both policies have the identical effect, in that they increase the AD curve. This outcome differs from part a in that inflation returns to the π1 with policy intervention and without policy intervention inflation falls to π3. c and d Figure 17.2 shows the changes from parts a and b in the Phillips curve diagram. The movement from point A to B is the negative demand shock on the SRPC1 and the unemployment rate increases and the inflation rate decreases. In part a, the self-correcting mechanism is a movement to point C on SRPC2, with lower expectations of inflation and unemployment at the natural rate. In part b, the optimal fiscal and monetary policy cause a movement back along SRPC1 to point A. Figure 17.2 Inflation rate

LRPC

A

B C SRPC1 SRPC2 Natural rate of Unemployment

Unemployment rate

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6

a

Figure 17.3 shows the effect of a reduction in potential output, where the LRAS shifts to the left (LRAS2). The shift of the LRAS curve to the left causes a shift to the left of the SRAS and the AD curve, as lower potential output lowers income and expenditure. This is shown by the new SRAS2 and AD2. The new equilibrium output is at point B, where output is lower and inflation could remain unchanged, increase, or decrease depending on the changes in the SRAS and AD curves.

Figure 17.3 Inflation rate

LRAS2

LRAS1

SRAS2 SRAS1

π1 11

B

A

AD1 AD2

Y2 11

Y1 11

Quantity of output

b

7

8

The optimal response of policymakers to this shock is to do nothing in the short run, as increases in aggregate demand will only have a short-term impact on output and unemployment. In the long run these will lead to higher inflation. Policies that improve the long-run productivity of the economy will assist to increase the economy’s potential output (see chapters 7 to 9). c The combination of a negative AD and LRAS shock is the same as the presentation of the shocks of the GFC illustrated in textbook Figure 17.8. This illustrates that output falls significantly below the original potential output and inflation falls in the short run. A potential optimal policy response is to increase AD with fiscal and monetary policy. As noted this will only correct the cyclical gap and not the structural gap (the difference between the old and new LRAS).

Australia, as illustrated in textbook Figure 17.13, did not have the same decrease in output as experienced in other OECD countries such as the US, the UK, Greece, or Spain. In fact Australia was almost ‘unharmed’ through the GFC. A result of globalisation is the moving of jobs in high income countries to low income countries.

This means that employment previously undertaken in Australia has moved offshore over time, which could place downward pressure on wages as a whole. Similarly, the slow wage growth is also impacted by Australia’s level of unemployment and underemployment. The higher the level of unemployment or underemployment, the greater the number of people there are for the jobs that are available. This surplus supply of labour also places downward pressure on wages. Furthermore, slower wage growth results in less disposal income, which results in less economic activity and lower inflation, which in turn reinforces slower wage growth.

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9

a

The changes in the cash rate were motivated by large-scale financial failures in several countries, causing instability and sharp falls in share prices. These are supply-side impacts affecting the ability of firms and banks to borrow and lend. The other main motivation was the demand-side risk that output could be significantly weaker than expected. b The RBA would use open market operations in the interbank overnight money market to reduce the cash rate. In particular the RBA will buy government securities in exchange for increasing financial institutions’ exchange settlement accounts. The increased supply of funds reduces the cash rate. c If the bank left the cash rate unchanged, the AD curve would shift to the left, reducing output and expenditure in the economy. For example see the movement from AD1 to AD2 in Figure 17.1, which leads to lower output and lower inflation. d If the bank lowered the interest rate, this would stabilise aggregate demand in the presence of a negative demand shock. The AD curve would remain constant or not shift by as much, reducing the impact on output and inflation compared to part c.

10 The key lessons of the GFC include the problems that arise when debt builds to unsustainable levels and needs to be carefully managed. The risks of new financial products and innovations need to be properly assessed. Banks need to maintain appropriate lending practices and standards.

Governments need to deal with the too-big-to-fail problem in a consistent manner, to avoid excessive risk taking by large financial institutions. Central banks need to be careful in responding to economic shocks, so as not to contribute to the build-up of imbalances and bubbles. Governments should make it a priority to get long-term fiscal settings on a sustainable path to enable flexibility in responses to negative shocks.

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Chapter 18 Five debates over macroeconomic policy Learning objectives In this chapter, students will: • consider whether policymakers should try to stabilise the economy • consider whether monetary policy should be made by rule rather than by discretion • consider whether the central bank should aim for zero inflation • consider whether the government should balance its budget • consider whether the tax laws should be reformed to encourage saving.

Key points •

• •

•

•

Advocates of active monetary and fiscal policy view the economy as inherently unstable and believe that policy can manage aggregate demand in order to offset the inherent instability. Critics of active monetary and fiscal policy emphasise that policy affects the economy with a lag and that our ability to forecast future economic conditions is quite bad. As a result, attempts to stabilise the economy can end up being destabilising.

Advocates of rules for monetary policy argue that discretionary policy can suffer from incompetence, abuse of power and time inconsistency. Critics of rules for monetary policy argue that discretionary policy is more flexible in responding to changing economic circumstances.

Advocates of a zero-inflation target emphasise that inflation has many costs and few if any benefits.

Moreover, the cost of eliminating inflation – depressed output and employment – is only temporary.

Even this cost can be reduced if the central bank announces a credible plan to reduce inflation, thereby directly lowering expectations of inflation. Critics of a zero-inflation target claim that moderate inflation imposes only small costs on society, whereas the recession necessary to reduce the inflation is quite costly.

Advocates of a balanced government budget argue that budget deficits impose a burden on future generations by raising their taxes and lowering their incomes. Critics of a balanced government budget argue that the deficit is only one small piece of fiscal policy. Single-minded concern about the budget deficit can obscure the many ways in which policy, including various spending programs, affects different generations.

Advocates of tax incentives for saving point out that our society discourages saving in many ways, such as by heavily taxing the income from capital and by reducing benefits for those who have accumulated wealth. They endorse reforming the tax laws to encourage saving, perhaps by switching from an income tax to a consumption tax. Critics of tax incentives for saving argue that many proposed changes to stimulate saving would primarily benefit the wealthy, who do not need a tax break. They also argue that such changes might have only a small effect on private saving.

Raising public saving by eliminating the government’s budget deficit would provide a more direct and equitable way to increase national saving.

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Chapter outline Introduction •

This chapter presents both sides in five leading debates over macroeconomic policy.

Provide supporting facts and figures for each side of the debates. Emphasise that there are no clear right or wrong answers. Do not forget to mention the political dimensions involved with these debates. At the heart of these debates is that there is a great deal of wealth and power at stake and these considerations often are more important than the consensus of economists.

That monetary and fiscal policymakers should try to stabilise the economy Pro: Policymakers should try to stabilise the economy • • • •

When households and firms feel pessimistic, aggregate demand falls. This causes output to fall and unemployment to rise.

There is no reason for the economy to suffer through a recession when policymakers can reduce the severity of economic fluctuations.

Thus, policymakers should take an active role in leading the economy to stability.

When aggregate demand is inadequate to ensure full employment, policymakers should act to boost spending in the economy. When aggregate demand is excessive and there is a risk of inflation, policymakers should act to lower spending.

Con: Policymakers should not try to stabilise the economy • • •

There are substantial difficulties associated with running fiscal and monetary policy. One of the most important problems to remember is the time lag that often occurs with policy.

Economic conditions change over time. Thus, policy effects that occur with a lag may hit the economy at the wrong time, leading to a more unstable economy.

Therefore, policymakers should refrain from intervening and be content with ‘doing no harm’.

That monetary policy should be made by rule rather than by discretion Pro: Monetary policy should be made by rule •

•

Discretionary monetary policy leads to two problems.

– It does not limit incompetence and abuse of power. For example, a central banker may choose to create a political business cycle to help out a particular candidate.

– It may lead to a greater amount of inflation than is desirable. Policymakers often renege on the actions that they promise. If individuals do not believe that the RBA will follow a low inflation policy, the short-run Phillips curve will shift, resulting in a higher level of inflation.

One way to avoid these problems is to force the central bank to follow a monetary rule. This rule could be flexible enough to allow for some information on the state of the economy.

Con: Monetary policy should not be made by rule • • •

Discretionary monetary policy allows flexibility. This gives the RBA the ability to react to unforeseen situations quickly.

It is also unclear that RBA central bankers use policy to help political candidates.

The RBA can gain the confidence of people by following their promises. If they promise to fight inflation and then run policies that keep the growth of the money supply low, there is no reason why inflation expectations would be high. Thus, the economy can achieve low inflation without a policy rule. (This has been shown to be the case in the United States in the 1990s.)

– Note: The RBA adopts an inflation-target ‘rule’. Monetary policy is to be set so that inflation does not rise above the 2–3 per cent range. Beyond this, the setting of monetary policy is not

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precisely specified. Moreover, there is no specific target set for unemployment. Some degree of discretion exists in the current stance of monetary policy.

That the central bank should aim for zero inflation Pro: The central bank should aim for zero inflation •

•

• •

Inflation poses real costs on society: – shoeleather costs – menu costs – increased variability of relative prices – tax distortions – confusion and inconvenience – arbitrary redistributions of wealth.

Reducing inflation usually is associated with higher unemployment in the short run. However, once individuals see that policymakers are trying to lower inflation, inflation expectations will fall and the short-run Phillips curve will shift. The economy will move back to the natural rate of unemployment at a lower inflation rate.

Therefore, reducing inflation is a policy with temporary costs and permanent benefits.

It is not clear that a case could be made for any other level of inflation. Price stability only occurs if the inflation rate is zero.

Con: The central bank should not aim for zero inflation • • • •

The benefits of zero inflation are small relative to the costs. Estimates of the sacrifice ratio suggest that lowering inflation by 1 percentage point lowers output in the economy by 5 per cent. These costs are borne by the workers with the lowest level of skills and experience who lose their jobs.

There is no evidence that the costs of inflation are large. Also, policymakers may be able to lower the costs of inflation (by changing tax laws, for example) without actually lowering the inflation rate.

Although, in the long run, the economy will move back to the natural rate of unemployment, there is no certainty that this will occur quickly. It may take time for the central bank to gain the trust of the people.

Moreover, recessions have permanent effects. Investment falls, lowering the future capital stock.

When workers become unemployed, they lose valuable job skills.

That the government should balance its budget Pro: The government should balance its budget • • •

Future generations of taxpayers will be burdened by the federal government’s debt. This will lower the standard of living for these future generations.

Budget deficits cause crowding out. Reduced national saving raises interest rates and lowers investment. A lower capital stock reduces productivity and thus leads to a smaller amount of economic growth than would have occurred in the absence of this debt.

When the federal budget is in surplus, we should use these surpluses to repay some of the debt the government has accumulated.

Con: The government should not balance its budget • • •

The problems caused by the government debt are overstated. The future generation’s burden of debt is relatively small when compared with their lifetime incomes. Indeed, the debt of the federal government is now relatively small.

It is important that any change in government spending is examined for external effects. If education spending is cut, for example, this will likely lead to lower economic growth in the future.

This will certainly not make future generations better off.

There are times when it is justifiable to run budget deficits, such as in times of war or recession.

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That the tax laws should be reformed to encourage saving Pro: The tax laws should be reformed to encourage saving • •

The greater the amount of saving in an economy, the more funds there are available for investment.

This increases productivity, raising the nation’s standard of living.

Because people respond to incentives, changing the tax laws to make saving more attractive will raise the amount of funds saved.

Con: The tax laws should not be reformed to encourage saving •

•

• • •

Increasing saving is not the only goal of tax policy. Policymakers are interested in using tax policy to redistribute income, making sure that the burden of taxation falls on those who can most afford it.

Any tax change that encourages saving will favour high-income households as they are more likely to be saving in the first place.

Many studies have also shown that saving is not very sensitive to the rate of return. Thus, tax changes to encourage saving may raise the return on saving for those already doing so, but may not actually encourage them to change the amount they save. This means that there would be no increase in the funds available for investment, no new capital stock and no change in the rate of economic growth.

Saving can be increased in other ways. For example, governments could lower the budget deficits (or increase surpluses) to raise public saving.

Lowering the tax on capital income lowers the revenue of the government. This may increase the budget deficit, lower public saving and push national saving down as well.

Australia’s compulsory superannuation scheme provides a strong foundation for saving in the Australian economy.

Conclusion •

This chapter considers the five debates over macroeconomic policy. They each began with a controversial proposition and offered the arguments pro and con.

Adjunct teaching tips and warm-up activities Instead of lecturing, divide the students into groups and have them present the debates discussed in the chapter. Ask them to provide facts and figures to support their positions.

Check your understanding solutions LO18.1 That monetary and fiscal policymakers should try to stabilise the economy Q. Do you think the ‘lagged effect’ minimises the effectiveness of monetary and fiscal policy?

A: The ‘lagged effect’ can minimise the effectiveness of monetary and fiscal policy because if the lags are long, the policies can have little effect in affecting aggregate demand. Also, policy must be set today for future conditions, of which can be unpredictable. Since economic conditions may change between the time a policy is implemented and when it takes effect, policy changes may be destablising.

LO18.2 That monetary policy should be made by rule rather than by discretion Q. What is the difference between monetary policy discretion and rule? Which one do you prefer? Explain A: Monetary policy discretion refers to when monetary policy makers are allowed undisciplined discretion, that is, when central bankers have the authority to set monetary policy with no specific rules o guidelines. Monetary policy conduct by rule is when the central bank has to commit to particular policy rules such as setting interest rates to target 1 per cent inflation. Monetary policy by rule would provide more certainty, however discretion would provide more flexibility. Certainty may be preferable for planning purposes.

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LO18.3 That the central bank should aim for zero inflation Q. Do you think the RBA should aim for zero inflation? List the advantages and disadvantages A: The advantages of reducing inflation to zero include: (1) eliminating shoeleather costs; (2) eliminating menu costs; (3) reducing the variability of relative prices; (4) preventing unintended changes in tax liabilities due to non-indexation of the tax code; (5) eliminating the confusion and inconvenience resulting from a changing unit of account; and (6) preventing arbitrary redistributions of wealth associated with dollar-denominated debts. These benefits are all permanent.

The disadvantages of reducing inflation to zero are the high unemployment and low output needed to reduce inflation; these costs are temporary.

It is argued that there is no professional consensus that costs of inflation are substantial and these costs can be reduced without actually reducting inflation itself. Therefore, it may not be worth the risk to put the economy through a costly, inequitable disinflationary recession to achieve zero inflation which may only have modest benefits.

LO18.4 That the government should balance its budget Q. Why can a budget deficit make future generations worse off? Does reducing a budget deficit also leave future generations worse off?

A: The government finances a budget deficit by issuing government debt. Reducing the government debt makes future generations better off because with lower debt today, future taxes will be lower; in addition, lower debt will reduce real interest rates, causing investment to increase, leading to a larger stock of capital in the future, which means higher future labour productivity and higher real wages. A fiscal policy that might improve the lives of future generations even more than reducing the government debt is increased spending on education, which will also increase incomes in the future.

LO18.5 That the tax laws should be reformed to encourage saving Q. Give three examples of how our society discourages saving. What are the drawbacks of eliminating these disincentives?

A: Our society discourages saving in a number of ways: (1) taxing the return on interest income; (2) taxing some forms of capital twice; (3) taxing bequests; (4) having means tests for welfare and Medicare; and (5) granting financial aid as a function of wealth. The drawback of eliminating these disincentives is that, in most cases [(1) to (3) and (5)], doing so would increase income for wealthy taxpayers and the lost income to the government would require higher taxes on everyone, so there would be a redistribution from rich to poor.

Practice questions solutions Questions for review 1

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The lags in the effect of monetary and fiscal policy on aggregate demand are caused by the fact that many households and firms set their spending plans in advance, so it takes time for changes in interest rates to alter the aggregate demand for goods and services. As a result, it’s more difficult to engage in activist stabilisation policy, because the economy won’t respond immediately to policy changes. Thus the lags favour policy that’s passive rather than active.

Political business cycles are not likely in Australia. The RBA is independent of government.

Changes to monetary policy are made by the board of the RBA. One member does not have complete control.

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Principles of Macroeconomics – 8th edition

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Credibility reduces the cost of inflation by lowering expectations of inflation. If the RBA announces a credible plan to reduce inflation, the short-run Phillips curve will shift down quickly, reducing the cost of disinflation, i.e. reducing the extent to which output and employment are reduced. To improve its credibility, the RBA has a target range of 2–3 per cent per annum for consumer price inflation. It is a range, not a fixed figure and the RBA considers the overall state of the economy when deciding on monetary policy action. Changes to interest rates are announced publicly after the RBA’s monthly board meetings.

The pros of reducing inflation to zero include: (1) eliminating shoeleather costs; (2) eliminating menu costs; (3) reducing the variability of relative prices; (4) preventing unintended changes in tax liabilities due to non-indexation of the tax code; (5) eliminating the confusion and inconvenience resulting from a changing unit of account; and (6) preventing arbitrary redistributions of wealth associated with dollar-denominated debts. These benefits are all permanent. The cons of reducing inflation to zero are the high unemployment and low output needed to reduce inflation; these costs are temporary.

Two ways in which a government budget surplus helps a future worker are: (1) a surplus adds to the level of national savings and hence lowers interest rates and increases investment. Increased investment allows for increased capital stock and increased labour productivity, which increases income and allows for lower taxes; (2) government surpluses also prevent debt being a burden on future workers and lowering living standards. Taxes on future workers would need to be higher to pay off the government debt.

Two situations in which a budget deficit is justifiable are: (1) in wartime, so tax rates won’t have to be increased so much that they lead to large deadweight losses; and (2) during a temporary downturn in economic activity, during which balancing the budget would force the government to increase taxes and cut spending, making the downturn even worse.

An example of how the government might hurt current young generations while reducing the government debt they inherit occurs if the government reduces spending on education. Then the government debt will be smaller, so future generations will pay less in taxes. But they’ll also be less educated, so they’ll have less human capital and thus have lower incomes. So current generations, in future, might be worse off.

Income from capital would be taxed twice if corporate income was initially taxed and then an income tax was applied at the individual level to dividend income.

An example, other than tax policy, of how our society discourages saving is the fact that government benefits are generally means-tested, so people who save get reduced benefits. Tax incentives to increase saving may have the adverse effect of raising the government budget deficit, which reduces public saving. Thus national saving may not increase even though private saving rises.

Problems and applications 1

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Figure 18.1 illustrates the short-run effect of a fall in aggregate demand. The economy starts at point A on aggregate-demand curve AD1 and short-run aggregate-supply curve SRAS1. The decline in aggregate demand shifts the aggregate-demand curve from AD1 to AD2; the economy moves to point B. Total output falls from Y1 to Y2, so income and employment also fall.

With no policy changes, the economy restores itself gradually over time. The recession induces declines in wages, so the cost of production declines and the short-run aggregate-supply curve shifts down to SRAS2. The economy ends up at point C, with a lower price level, but with output back at Y1. However, this process may take years to complete.

The economy does restore itself, but very slowly.

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Principles of Macroeconomics – 8th edition

Figure 18.1

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The US Federal Reserve needed two reductions close together due to the difficulty policymakers experience in choosing the appropriate strength of their actions because of lags between when policy is changed and when it affects aggregate demand, as well as the difficulty in forecasting the economy’s future condition. It could be argued that by cutting interest rates twice in 10 days, their knowledge of the economy was poor, hence reducing their credibility.

If the RBA had to follow a monetary rule it could set interest rates to ensure that the money supply increased exactly by a certain percentage each year. Such a policy would remove flexibility from the RBA’s control over monetary policy and its ability to control the level of economic activity. a If investors believe that capital taxes will remain low, then a reduction in capital taxes leads to increased investment. b After the increase in investment has occurred, the government has an incentive to renege on its policy because it can get more tax revenue by increasing taxes on the higher income from the larger capital stock. c Given the government’s obvious incentive to renege on its promise, firms will be reluctant to increase investment when the government reduces tax rates. The government can increase the credibility of its tax change by somehow committing to low future tax rates. For example, it could write a law that guarantees low future tax rates for all capital income from investments made within the next year, or write a law penalising itself if it raises future taxes. d This situation is similar to the time-inconsistency problem facing monetary policymakers because the government’s incentives change over time. In both cases, the policymaker has an incentive to tell people one thing, then to do another once people have made an economic decision. For example, in the case of monetary policy, policymakers could announce an intention to lower inflation, so firms and workers will enter labour contracts with lower nominal wages, then the policymakers could increase inflation to reduce real wages and stimulate the economy.

The proposed government plan to assist 18-year-olds by giving people in the lowest tax brackets a $1000 government contribution to their savings account for every $5000 saved during a given year may or may not assist the low-income earners to save. The government’s contribution would be attractive to low-income earners and boost their level of savings if they were able to save. Studies have shown that saving is relatively inelastic – that is, the amount of saving is not very sensitive to the return on saving. If this is the case, then the proposal may not help 18-year-olds on low incomes to establish their own superannuation plans.

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Principles of Macroeconomics – 8th edition

If savings were increased as a result of this plan, aggregate demand in the short-run would be less, since consumption expenditure would be less. In the long-run if the plan was successful 18-yearolds on low incomes are able to establish their own superannuation plans, investment and hence aggregate demand would increase. Interest rates could increase as a result.

6 The six costs of inflation are shoeleather costs, menu costs, increased variability of relative prices, tax distortions, confusion and inconvenience and arbitrary redistributions of wealth.

7 a An increase in the budget deficit redistributes income from young to old, since future generations will need to pay higher taxes. b An increase in fees for certain university courses redistributes income from young to old, since future generations do not benefit from having higher human capital. c Payments to people who have lost homes and businesses in the Victorian bushfires do not redistribute income between the young and old. However, if the payments result in budget deficits, then it redistributes income from young to old as future generations will need to pay higher taxes. d The indexation of pension benefits to inflation redistributes income from young to old, since old people get higher benefits than they would in the absence of indexation.

8 The use that government makes of borrowed funds is important. Budget deficits can be justified if the government undertakes investment spending which will increase the productive capacity of the economy in the future. Increasing the productive capacity of the economy will be beneficial in the long run.

9 The government can reduce taxes on capital income but avoid redistributing income from poor to rich by taxing consumption spending rather than income or increasing tax rates on those with higher incomes.

10 The fundamental trade-off that society faces if it chooses to save more is that it will have to reduce its consumption. So society can consume less today and save more if it wants higher future income and consumption. The choice is really one of consumption today versus consumption in the future.

11 a A reduction in the tax rate on income from saving would most directly benefit wealthy people who have a lot of capital income. b The increased incentive to save would reduce the interest rate, thus increasing investment, so the capital stock would be larger. As capital per worker rises, productivity would increase, as well as the real wage paid to workers. c Thus, in the long run, everyone, not just the wealthy, would benefit from reducing the tax rate on income from savings.

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