ECON1102 Complete Notes

ECON1102  Study  Notes  –  Macroeconomics  1     Chapter  1  –  Measuring  Macroeconomic  Performance:  Output  and  Prices       Key  Issues   • Indicators  of  macroeconomic  performance   • Measuring  output  (GDP)   • Measuring  prices  and  inflation     Criteria  for  Evaluating  Macroeconomic  Performance   1.  Rising  Living  Standards  –  economic  growth   • Tendency  for  the  level  of  output  (i.e.  quantity  and  quality  of  goods  and  services)   to  increase  over  time.   • Material  wellbeing.   2.  Stable  Business  Cycle     • Low  volatility  in  fluctuation  of  expansionary  and  contractionary  gaps.   3.  Relatively  Stable  Price  Level  (real  currency  value)  –  low  (positive)  rate  of  Inflation.   • Inflation  –  rise  in  prices.   • Deflation  -­‐  fall  in  prices.   4.  Sustainable  Levels  of  Public  and  National  Debt   • Public  debt  –  borrowing  by  public  sector  from  private  sector  (budget   deficits/surpluses).   • National  debt  –  borrowing  by  domestic  residents  from  foreign  countries   (Influenced  by  an  economy’s  current  account  deficits/surpluses).   5.  Balance  between  Current  and  Future  Consumption   • Expenditure  vs.  need  to  provide  resources  for  future  (saving)   6.  Full  Employment   • Provision  of  employment  for  all  individuals  seeking  work       Measuring  National  or  Aggregate  Output   • GDP:  the  market  value  of  the  final  goods  and  services  produced  in  the  domestic   market  in  a  given  period.  It  measures  aggregate  output  or  production.  –  flow   variable  as  it  is  a  function  of  time.  Also  a  lag  indicator.   • Final  goods  or  services:  goods  or  services  consumed  by  the  ultimate  user  –   because  they  are  the  end  products  of  the  production  processes  they  are  counted   as  part  of  GDP.  Intermediated  goods  or  services:  goods  or  services  used  up  in   the  production  of  final  goods  or  services  and  therefore  not  counted  as  part  of   GDP.       GDP  Measurement  Methods   Expenditure  Method   • Expenditure  on  Final  Goods  and  Services  by  the  ultimate  user  equals  value  of   production    

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Amount  consumers  spend  should  equal  market  value  (economic  agent)   Computed  by  adding  total  amount  spent  by  4  groups   o Household  consumptions  (durables  and  non-­‐durables)   o Firms  (Business  fixed  investment  (Capital)  and  NEW  residential   investment,  inventory.)   o Government  spending  (Not  government  transfers  e.g.  unemployment   benefits,  social  security,  welfare  payments,  interest  paid  of  gvt.  Debt)   o Net  purchases  in  foreign  market     • National  accounting  Identity:  Aggregate  Expenditure  =  Y  =  C  +  I  +  G  +  NX   Production  Method   • Aggregate  Market  Value  of  final  goods  and  services  given  indirectly  by  summing   the  value  added  of  all  firms  in  the  economy.       • GDP  =  Amount  x  Market  value     • Note:  Intermediate  goods  and  services:  G+S  used  up  in  production  are  not   counted  in  GDP  e.g.  flour  in  bread,  services  provided  that  only  give  value  to  final   product  (or)   • Value  added:  market  Value  of  the  production  less  the  cost  of  inputs  from  other   firms,  of  each  firm  (=  summation  of  value  of  final  goods),  Allows  value  to  be   accurately  distributed  over  periods.     • Represents  portion  of  value  to  final  G+S  added  by  each  firm   o Value  added  =  Revenue  –  Market  Value   Income  Method   • GDP  is  also  given  by  aggregate  income  paid  to  capital  and  labour  in  production  of   Goods  and  services   • Revenue  from  sales  is  distributed  to  worker  and  owner  of  capital     • GDP  =  Labour  income  (wages,  salaries,  self-­‐employed)  +  Capital  Income  (Physical   capital  -­‐made  to  owner  of  factories,  machinery,  office  building,  Intangible   Capitals  –  trademarks,  copyrights,  patents,  interest  to  bondholder,  income  to   owners,  rent  for  land,  royalties)       • Despite  a  slight  statistical  discrepancy  between  these  methods  in   theory/conceptually  all  three  should  produce  the  same  result.  GDP  is  usually   given  by  the  average  of  these  three  outcomes     • Some  items  with  no  observed  market  prices  are  included  in  GDP:  national   defence  –  use  costs  of  provisions,  whilst  some  are  excluded:  unpaid  housework.   • •

 

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Nominal  GDP:  measures  current  dollar  value  of  production  by  valuation  of   quantities  at  current  market  prices.  Calculated  by  the  multiplying  the  quantity  of   each  good  produced  in  the  economy  by  current  year  prices  and  summing   Real  GDP:  values  quantities  of  goods  and  services  produced  at  base  year  prices  –   measure  of  the  actual  physical  volume  of  production.  Calculated  using  Laspeyres   index,  Paasche  Index  or  Chain  weighted  Index.  

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Real  Growth  Rate  calculates  the  growth  in  the  physical  volume  of  production   between  periods.  Real  Growth  in  GDP  can  be  calculated  using  Laspeyres  index,   Paasche  Index  or  Chain  weighted  Index.   o Lespeyres  Index  involves  calculating  the  value  of  GDP  in  current  year   (here,  2006)  and  base  year  using  a  base  year  prices  (here,  2005),  by   multiplying  the  quantities  of  each  good  produced  in  a  each  year  by  the   corresponding  price  in  2005.  Then  commute  the  growth  rate  of  real  GDP.   o Paasche  Index  involves  calculating  the  value  of  GDP  in  current  year   (2006)  and  pervious  year  (2005)  using  current  year  prices  (2006).  The   change  in  GDP,  which  is  the  Real  GDP  in  2006  less  the  Real  GDP  is  2005,  is   divided  by  the  Real  GDP  in  2005.       o The  Chain  Weighted  Index  averages  the  percentage  growth  of  GDP  given   by  the  Laspeyres  Index  and  the  Paasche  Index  to  accurately  determine   GDP.  

  Is  GDP  A  Good  Measure  of  Economic  Wellbeing?   • Economic  welfare  refers  to  the  general  economic  wellbeing  and  interests  of  the   population.   • GDP  only  accounts  for  the  goods  and  services  sold  in  the  market  which  to  some   extent  is  a  general  indication  of  economic  wellbeing  –  positive  correlation  is   expected   • The  following  factors  effect  economic  welfare  by  are  not  accounted  for  in  GDP:   • Leisure  Time   o Having  more  time  to  enjoy  worthwhile  activities  like  family,  friends,   sport,  hobbies  is  a  major  benefit  of  wealthy  societies.     • Non-­‐market/home  Production       o No  acknowledgment  of  unpaid  house  work.   o Particularly  in  poorer  countries  where  citizens  trade  and  are  self   sufficient  –  their  economic  activity  is  undervalued.   o Underground  economy  –  legal  and  illegal  transactions  not  recorded  in   government  data  e.g.  baby  sitting,  drug  dealing.     • Quality  of  Life   o Factors  of  life  like  traffic  congestion,  crime  rate,  open  space  and   public  organisations  which  are  not  sold  in  markets  but  still  add  to   quality  of  life.   • Inequality  and  Poverty   o GDP  does  not  convey  the  distribution  of  wealth.   o There  could  be  extremes  of  rich  and  poor.     • Environmental  degradation  and  Pollution     o Despite  the  difficulty  in  valuing  this  intangible  factor,  decline  in  air   and  water  quality  (pollution)  negatively  affect  quality  of  life.  

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Note:  Although,  GDP  doesn’t  capture  all  factors  influencing  economic  wellbeing,   higher  GDP  per  capita  is  positively  related  to  increased  wellbeing.  For  example   countries  have  better  health  care,  medicine,  driven  by  technology  

    Measures  of  the  Price  Level   • Consumer  Price  Index:  For  any  period,  measures  the  cost  in  that  period  of  a   standard  basket  of  goods  and  services  relative  to  the  cost  of  the  same  based  of   goods  and  services  in  a  fixed  year  (called  the  base  year).  CPI  is  a  tool  used  to   measure  the  price  level  and  inflation  in  the  economy   CPI  =  Cost  of  basket  in  current  year  /  Cost  of  basket  in  base  year   • Rate  of  inflation:  the  annual  percentage  change  in  price  level  measured  by  the   CPI,  mathematically  represented  by:     •

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The  change  in  relative  prices  is  not  inflation.  They  are  changes  in  response  to   demand  and  supply.  Recall  that  inflation  is  a  sustained  change  the  economy’s   price  level  –  not  simply  a  price  rise.  It  must  be  a  general  price  change,  not  a   specific  one.   Cost  of  inflation:   Shoe  leather  costs   o Money  functions  as  a  medium  of  exchange,  thus  inflation  raises  cost  of   holding  money.  Inflation  reduces  the  real  purchasing  power  of  a  given   amount  of  money  -­‐  longer  it  is  hold,  the  larger  reduction.     o Insulate  this  loss  by  holding  money  in  bank  with  interest  paid,  but  this  is   associated  with  inconvenience  of  frequent  bank  visits.  Businesses   employ  extra  staff  to  make  trips.  Bank  employ  extra  staff  for  increased   transaction.     Menu  costs   o Act  of  changing  prices.  Publicly  lists  prices  need  to  change.  E.g.  change   coins,  menu,  signs.   Distortion  of  the  tax  system   o Taxes  are  not  indexed  to  rate  of  inflation  they  are  based  on  nominal   magnitudes.  For  example,  inflation  may  raise  peoples  nominal  incomes   (to  compensate  for  rise  in  cost  of  living)  moving  them  into  higher  bracket   even  though  their  real  incomes  may  not  have  increased   Unexpected  redistribution  of  wealth       o Inflation  causes  redistribution/transfers  wealth  between  parties   § Employers  and  employees   § Borrowers  and  lenders.   o If  inflation  is  higher  than  expected,  real  wages  of  predetermined  wages   will  fall  à  workers  lose  buying  power.  This  is  offset  buy  gain  in  employers   buying  power,  since  real  cost  of  paying  workers  has  declined.  If  inflation   is  lower  than  expected,  real  wages  will  increase,  meaning  workers  with  

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have  higher  purchasing  power,  and  employer  will  have  to  pay  a  higher   real  cost.   o High  Inflation  means  real  dollar  value  of  loan  repayment  is  less  than   expected.   o Associated  with  this  process  is  fluctuation  and  volatility  which   discourages  people  from  working  and  saving,  in  an  effort  to  protect  them   against  inflation.     Noise  in  the  price  system   o Price  system  functions  to  allocate  resources  efficiently  à  establish   equilibrium.  However,  inflation  distorts/  creates  static  or  noise  in   interpretation  of  price  system  à  obscuring  information  à  creating   inefficiency.  Suppliers  are  unaware  if  increase  in  price  represents  true   increase  in  prices  by  increase  in  demand,  or  general  rise  in  price  caused   by  inflation  (quantity?)  E.g.  Asset  Price  Bubble.     Interference  with  long-­‐term  planning     o Of  households  and  firms,  makes  it  difficult  to  discern  how  much  funds   need  to  be  saved  for  future  events,  projects   § Save  too  little-­‐  comprise  plan     § Save  too  much  –  sacrificed  pervious  consumption  

Note:  evidence  suggests  inflation  causes  real  consumption,  real  investment  and  real   GDP  to  fall,  accompanied  by  increase  in  budget  deficit.   •

Deflation  is  costly  and  creates  unexpected  redistributions  of  wealth.  However,   the  main  cost  of  deflation  is  is  to  force  the  real  rate  of  inters  higher  than  normal.   This  is  because  the  nominal  interest  rate  cannot  fall  below  zero.  This  acts  to   discourage  certain  types  of  important  expenditure  in  the  economy,  most  notably   firm’s  investment  expenditure.  

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Nominal  Interest  rate:  percentage  change  in  the  nominal  value  (dollar  value)  of   a  financial  asset.   Real  interest  Rate:  percentage  change  in  real  purchasing  power  of  a  financial   asset,  adjusted  for  inflation.   1  +  inom  =  (1  +  ireal)(1+  π)   Real  interest  rate  ≅  inom  –  inflation  rate   Fisher  effect:  r  =  i  −π   For  borrowing  and  lending  the  real  interest  rate  is  most  relevant.  Since,  if   nominal  interest  rates  increase  but  inflation  rises  by  the  same  amount  then  the   cost  of  borrowing  has  stayed  constant.  When  real  (not  the  nominal)  interest  rate   is  low,  borrowers  benefit  from  a  lower  real  cost  of  borrowing.  When  real  interest   rate  is  high,  lenders  benefit  from  receiving  an  increase  in  purchasing  power.  So,   lenders  need  to  protect  themselves  from  the  decline  in  the  real  interest  rate;   therefore  they  must  raise  nominal  interest  rates  in  the  face  of  inflation.      

   

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    Limitation  to  CPI   • Quality  Adjustment  Bias   o Failure  to  adjust  for  Improvement  in  quality  of  goods  and  services,  which   results  in  an  increase  in  prices  and  consequently  inflation.     o For  example,  if  the  CPI  basket  contains  monthly  rent  and  during  one   period  the  rent  increase  because  of  kitchen  renovation,  the  CPI  will   increase  and  incorrectly  display  a  higher  cost  of  living  despite  an  increase   in  price  based  on  quality   o E.g.  larger  data  storage  computer  has  higher  price     • New  Goods  Bias  (New  goods  not  included)   o Extreme  case  of  quality  improvement     o Where  a  new  product  is  introduced,  that  was  not  available  in  the  base   year,  creates  distortions  in  comparisons  (eg.  computers  were  not   common  50  years  ago).   • Substitution  Bias   o CPI  is  a  fixed  basket  of  goods  meaning  it  does  not  account  for  the   substitution  affect  to  relatively  cheaper  goods  and  services  that  are  close   replacements  for  each  other.  Ignores  consumer’s  ability  to  switch   between  products.  E.g.  Coffee  and  Tea     Therefore,  since  CPI  fails  to  account  for  the  above  factors,  CPI  overstates  the  rate   of  inflation  and  cost  of  living.                                                                   6

Chapter  2  –  Saving  and  Wealth     Key  Issues   • Definition  and  Measures  of  Saving   • Saving  and  Wealth   • Motives  for  Saving   • Investment  and  Capital  Accumulation   • Saving,  Investment  and  the  Real  Interest  Rate       Flow:  a  measure  that  is  defined  per  unit  of  time.   Stock:  a  measure  that  is  defined  at  a  point  in  time.       • Savings  is  a  flow  variable  –  measure  that  is  defines  per  unit  of  time.  If  saving  is   positive  then  assets  are  being  accumulated.  If  saving  is  negative  then  assets  are   being  de-­‐cumulated  or  liabilities  (debts)  accumulated  Note:  household  saving  in   Australia  is  declining   Saving  =  current  income  –  current  spending   Saving  rate  =  savings/income       • Capital  gains:  increases  in  the  value  of  existing  assets.  Capital  loses:  decreases  in   values  of  existing  assets.   Wealth  =  assets  –  liabilities   Change  in  Wealth  =  Saving*  +  Capital  gains  –  Capital  losses   W  =  W(-­‐1)  +  S  +  Net  Capital  Gains   A,  L,  W  are  stock  variables  –  measure  defined  at  a  point  in  time   *current  income  –  current  spending;  not  accumulated  savings.         Motives  For  Saving  (why  do  people  save?)   • Life-­‐cycle  saving  -­‐  Saving  to  meet  long  term  objectives.  Saving  during  working  life   for  future  consumption  E.g.  University  fees,  retirement,  home  or  car  purchase.   • Precautionary  Saving  -­‐  Resources  put  aside  for  protection/self  assurance  against   unexpected  circumstances.  E.g.  loss  of  job,  recession,  medical  emergency.   • Bequest  Saving  -­‐  Desire  to  leave  family  heirs  or  dependents  an  inheritance  or   bequest.  Often  by  people  in  higher  income  ladder.  E.g.  children  or  charity.       Saving  and  the  Real  Interest  Rate   • Represent  reward  for  saving  –  increase  in  r  increases  opportunity  cost  of  not   saving.  However,  small  negative  relationship  since  increase  interest  rate  means   people  need  to  save  less  to  reach  target  saving  level  in  future  years.  Net  effect:   Other  things  equal  (ceteris  paribus)  saving  to  increase  with  real  interest  rate   • Saving  is  also  influenced  by  cultural  factors  and  neighborhood  expectations  

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o Lack  of  sufficient  self-­‐control  or  will  power  to  undertake  optimal  savings   level.  The  consumptions  benefits  are  in  the  future,  whilst  the  costs  are   immediate.   o Availability  of  consumer  credit  –  eg.  Home  equity  loans.   o Demonstration  effects  –  conspicuous  spending  by  others  encourages   conspicuous  spending  by  households.   o Government  provision  of  welfare  may  reduce  private  saving  for   retirement.  

    National  Saving   • Measures  aggregate  saving  in  an  economy  by  private  and  public  sectors   (households,  business,  governments).   Y  =  C  +  I  +  G  +  NX   S  =  Y  –  C  –  G   • NX  is  assumed  to  be  zero  and  note  that  saving  is  current  income  –  current   spending,  therefore  I  (investment)  and  is  for  future  needs.  Note:  not  all  G  and  C   are  current  good  (durable  Goods  e.g.  cars,  furniture,  appliances,  roads,  bridges,   schools,  other  infrastructure).  Hence,  the  equation  above  tends  to  overstates   current  spending  and  understates  national  saving.   S  =  Y  –  C  –  G   S  =  Y  –  C  –  G  +  T  –  T   S  =  (Y  –  T  –  C)  +  (T  –  G)   S  =  Private  saving  +  public  saving   o Where:  T  =  T  –  Q  =  net  taxes  =  taxes  paid  by  private  sector  to  government   –  transfer  payments  from  government  to  private  sector  –  interest   payments  from  government  to  private  sector  bond  holders.   o Transfer  payments:  (Q)  payments  the  government  makes  to  the  public   for  which  it  receives  no  current  goods  or  services  in  return   • Government  budget  deficit:  T  <  G        [Receipts  <  Expenditures]   • Government  budget  surplus:  T  >  G   • Government  balanced  budget:  T  =  G   •  National  savings,  not  household  savings,  determines  the  capacity  of  an  economy   to  invest  in  new  capital  goods  and  to  achieve  continued  improvement  in  living   standards.  Australia’s  national  saving  has  showed  slightly  upward  trends  in   recent  years,  despite  a  lower  household  savings  rate.   • Investment  and  Capital  Formation  -­‐  National  saving  provides  the  resources  for   investment.  Investment  is  the  purchase  of  new  capital  goods.  New  capital  goods   increase  productivity.  Influences  on  the  level  of  Investment:   o Cost  of  capital:   § Nominal  interest  rate  (i)   § The  dollar  price/cost  of  the  new  plane  (Pk)   § Physical  depreciation  rate  on  capital  (∂)  

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Over  time  the  price  of  the  plane  may  rise  or  fall  (capital  gain  or   capital  loss)  –  (change  in  Pk)   § Cost  of  capital  =  price  of  capital  (begin  year)  +  interest  cost  -­‐  price   of  (depreciated)  capital  (end  year)     Most  important  influences  on  investment  decision  are  price  of  capital   good  and  real  interest  rate.   Rise  in  the  real  interest  rate  will  make  investment  less  attractive.     Rise  in  the  price  of  capital  goods  will  make  investment  less  attractive.   Cost  vs.  Benefit  Investment  decision:  Value  of  marginal  product  of   capital  (benefit  net  of  expenses  and  taxes)  ≥  Cost  of  capital   §

o o o o

  Saving,  Investment  and  Financial  Markets   • Economy  with  no  access  to  international  capital  markets:  National  Saving  =   Investment.     • S  =  Y  –  C  –  T  =  I   • Saving  is  increasing  function  of  real  interest  rate  –  supply  of  saving,  therefore  it  is   upward  sloping.     • Investment  is  a  decreasing  function  of  the  real  interest  rate  –  demand  for  saving.   Downward  sloping  because  rates  link  to  WACC.                     • New  Technology  à  increased  productivity  à  increase  marginal  product   (investment  more  profitable)  à  increase  investment  à  shift  right  à  increase  in   r  à  higher  real  interest  rate  makes  saving  attractive  à  move  along  the  S  curve.     • Increase  in  Budget  Deficit/  Increase  in  Budget  Deficit  à  decrease  in  national   savings  à  decrease  saving  à  shift  leftà  increase  r  à  higher  real  interest  rate   makes  investment  less  attractive  and  causes  a  move  along  the  I  curve.     • An  increase  in  the  government  budget  deficit  will  reduce  private  investment   spending.  A  larger  deficit  reduces  the  supply  of  saving  (savings  curve  shifts   inwards)  and  drives  up  the  real  interest  rate.  The  higher  real  interest  rate  makes   investment  less  attractive  and  causes  a  move  along  the  I  curve.  The  tendency  of   a  government  budget  deficit  to  reduce  investment  is  called  the  crowding  out   effect.   • Note:  change  in  real  interest  rate  is  a  movement  ALONG  curve.   • In  a  closed  economy  NS  =  I.       Chapter  3  –  Unemployment  and  the  Labour  Market    

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Key  Issues   • Demand  for  labour   • Supply  and  demand  model  of  the  labour  market     • Types  of  unemployment   • Impediments  to  full  employment     Demand  for  Labour   • Diminishing  returns  to  labour:  if  the  amount  of  capital  and  other  inputs  in  use  is   held  constant,  then  the  greater  the  quantity  of  labour  already  employed,  the  less   each  additional  worker  adds  to  production.   • Marginal  Product  of  Labour  (MPL):  additional  output  associate  with  additional   labour  unit.   • Firm  combines  workers  with  a  given  amount  of  capital  (machines  and  buildings)   to  produce  output.   • Based  on  Low-­‐hanging  fruit  principle  and  increasing  opportunity  cost  –  firm  will   assign  worker  to  most  productive  jobs.    Error!  Not  a  valid  embedded  object.     [P  is  general  price  level]     • Firm  will  compare  benefit  (Value  MPL)  of  an  additional  worker  with  cost  of   worker  (Wage  =  W)  [cost-­‐benefit  principle].  Note:  Model  assumes  that  firm   operates  in  a  competitive  market  therefore  cannot  set  the  wage  it  pays  workers   or  price  it  receives  for  its  product.     • Firms  will  continue  to  employ  labour  until  (value  of  MPL  =  money  wage)   • Since  MPL  decreases  as  firm  employs  more  workers,  real  wage  also  has  to  fall  (as   more  workers  are  employed).  This  implies  that  a  firm’s  demand  for  labour  is  a   decreasing  function  of  the  real  wage.   Error!  Not  a  valid  embedded  object.       Shifts  in  Demand  for  Labour   • Higher  relative  price  for  firm’s  output  (e.g.  due  to  increased  demand).  Workers   production  is  more  valuable,  and  therefore  value  of  marginal  product  increases   (shifts  right).   • Higher  marginal  productivity  of  labour  (e.g.  large  increase  of  capital  stock  or   new  technology)  as  this  leads  to  an  increase  in  the  value  of  marginal  product.                 Supply  of  Labour     • At  any  given  wage  people  decide  if  they  are  willing  to  work  –  by  reservation  price   (minimum  payment  that  leaves  you  indifferent  between  working  and  not   working)  à  cost-­‐benefit  principle  application.  Supply  of  labour  is  the   total  number  of  people  willing  to  work  at  each  real  wage,  Wi/P.      Shifts  in  Supply  of  labour   • Size  of  working-­‐age  population  (influenced  by  birth  rate,  retirement  ages,   immigration  rates).  

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•

Participation  rate/Social  changes  –  percentage  of  working  age  population  who   seek  employment  e.g.  women  working  more.  

•

Real  Unit  Labour  Costs  =  Real  average  labour  cost  /  Average  labour  productivity  

                               

  Increasing  Wage  inequality:  Globalisation  and  Technological  change.   Globalisation   • Globalisation  is  the  process  of  breaking  down  national  barriers:     o Free  trade  agreements   o Deregulation   o Reduced  tariffs/taxes   • Open  up  economies  to  international  market  and  encourages  specialization.   • Demand  for  workers  in  industries  with  comparatives  disadvantage  experience   lower  real  wages  and  employment  (shift  demand  left).  This  is  due  to  suffering   from  increased  foreign  competition,  consumer’s  purchase  overseas  (cheaper  or   higher  quality),  which  leads  to  a  decrease  in  the  value  of  marginal  product  and   therefore  a  decrease  in  demand  for  workers.   • Demand  for  workers  in  industries  with  comparatives  advantage  experience   higher  real  wages  and  employment  (shift  demand  right).  This  is  because  there  is   a  greater  demand  for  exports  and  therefore  there  is  an  increase  in  the  value  of   marginal  product  and  an  increase  in  the  demand  for  workers.   • Note:  countries  employing  higher  skilled  worker  do  better  in  international  trade   à  heightening  the  inequality   Technological  Change   • Technological  change  increases  worker  productivity  and  is  the  basic  source  of   rising  living  standards.  However,  technological  change  affects  different  workers   in  different  ways.  Note  worker  mobility  counteracts  trends  of  wage  inequality.  A   policy  of  providing  transition  aid  in  training  workers  with  obsolete  skills  is  useful   response  to  problem.  

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•

Skill-­‐biased  technical  change  (replaces  or  assists):   o Raises  marginal  product  of  high-­‐skill  workers  à  increase  in  productivity   à  increase  in  demand  à  rise  in  real  wages  and  employment.   o Reduces  marginal  product  of  low-­‐skill  workers  (no  longer  required)  à   decrease  in  productivity  à  decrease  demand  à  fall  in  real  wages  and   employment.  

                              Unemployment   • Labour  Force:  total  number  of  people  available  for  work.   • Labour  Force  =  Employed  +  Unemployed   o Employed:  Person  worked  full-­‐time  or  part-­‐time  during  the  past  week  (or   was  on  leave  from  a  regular  job)   o Unemployed:  Person  did  not  work  during  the  preceding  week  and  made   some  effort  to  find  work.   o Not  in  Labour  Force:  Person  did  not  work  in  the  past  week  and  was  not   actively  seeking  work  (e.g.  retirees,  unpaid  homemakers,  full-­‐time   student).     • Unemployment  Rate  =  (Unemployed/Labour  Force)*100   • Participation  Rate  =  (Labour  Force/Working-­‐age  (15+)  Population)*100   • Working-­‐age  (15+)  Population  =  Labour  force  +  Not  in  Labour  force     Costs  of  Unemployment   • Economic  costs:  output  that  is  foregone  since  workforce  is  not  fully  utilised.   • Psychological  costs:  long  periods  of  unemployment  can  lead  to  loss  of  self-­‐ esteem,  unhappiness  and  depression.   • Social  costs:  high  unemployment  can  lead  to  increased  crime  and  associated   social  problems  e.g.  crime,  violence,  alcoholism,  drug  abuse   • Discouraged  Workers:  People  who  have  given  up  looking  for  work  (and  so  a  not   counted  as  unemployed)     Types  of  Unemployment   • Natural  rate  of  employment:  the  part  of  the  total  unemployment  rate  that  is   attributable  to  frictional  and  structural  unemployment;  equivalently,  the  

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• •

• • • •

•

•

employment  rate  when  cyclical  is  zero;  i.e.  the  economy  is  not  in  an   expansionary  or  contracitonary  gap.   Frictional  unemployment:  the  short-­‐term  unemployment  associated  with  the   process  of  workers  searching  for  the  right  job.   Labor  market  is  dynamic  à  driven  by  changes  in  technology,  globalization  and   changing  consumer  tastes.  This  means  new  products  and  companies  (and  thus   jobs)  are  always  being  created.   Cyclical  unemployment  can  improve  efficiency  of  market  à  bring  together  those   seeking  and  offering  employment  (e.g.  left  school  or  change  careers).   Cost  are  low  (short-­‐term  –  physiological  and  direct  economic  affects  low)   Can  be  economically  beneficial/essential  –  negative  costs  (better  fit  of  workers   into  job  positions  à  higher  productivity  à  higher  output  in  long  run).   Structural  unemployment:  the  long-­‐term  and  chronic  unemployment  that  exists   when  the  skills  or  aspirations  of  workers  are  not  matched  to  jobs  available  in  the   economy.   Refers  to  availability  and  distribution  of  jobs  and  can  be  caused  by:  lack  of  skills,   language  barriers  or  discrimination.  Also  unions  and  minimum  wage  laws  can   cause  structural  unemployment.   Cyclical  unemployment:  the  extra  unemployment  that  occurs  during  periods  of   economic  contractions  and  especially  recessions.  Cyclical  unemployment  is   costly  in  terms  of  foregone  output  and  underutilization  of  labour  resources.  

    Factors  that  affect  the  rate  of  unemployment   • Minimum  wage:  legal  minimum  hourly  rate  firms  can  pay  employees  (Award   wages).   o Despite  minimum  wages  raising  the  unemployment  rate  it  benefits  those   workers  who  are  lucky  enough  to  receive  a  job  in  this  market  (0  –  ND)  as   they  will  receive  higher  than  normal  wages.  Of  course,  those  who  are   shut  out  of  the  market  lose  and  are  left  jobless.   o Taxpayers  are  worse  off  –  pay  for  unemployment  insurance  and  support   and  higher  prices.   o Consumers  are  worse  off,  lower  output   o When  minimum  wage  laws  are  below  equilibrium  the  market  is  not   affected,  and  will  continue  to  operate  in  equilibrium.                                

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        •

•

•

Labour  union  –  workers  may  negotiate  on  an  individual  basis  with  a  firm  over   wages  and  conditions.  Alternatively  may  form  labour  unions  to  bargain   collectively.  Unions  tend  to  produce  higher  than  normal  wage  outcomes  (above   equilibrium  clearing).  Outcome  wmin=wunion.   Unemployment  Benefits  –  Government  transfer  payment  paid  to  the   unemployed.  This  is  a  basic  income  to  workers  who  are  unemployed  and   searching  for  work.  Can  have  a  disincentive  effect  on  a  worker’s  search  effort  à   prolong  period  before  individual  accepts  employment.   Other  government  regulations  –  OH&S  or  Anti-­‐discrimination.  

                                                                                              Chapter  4  -­‐  Short-­‐run  Economic  Fluctuations       Key  Issues   • What  is  a  recession?   • Business  cycle  fluctuations   • Output  gaps  and  cyclical  unemployment  

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Natural  rate  of  unemployment   Okun’s  law  

    Business  Cycle   • The  business  cycle  refers  to  the  fluctuations  in  economic  activity/GDP  associated   with  periods  of  expansion  (strong  economic  performance)  and  contraction   (weaker  economic  performance).   • Contraction:  period  where  GDP  falls,  moves  from  a  peak  to  a  trough   • Expansion:  period  when  GDP  rises,  moves  from  a  trough  to  a  peak   • Peak  is  the  beginning  of  a  contraction,  end  of  expansion  à  high  point  prior  to  a   downturn   • Trough  is  the  end  of  a  contraction,  beginning  of  expansion  à  low  point  prior  to  a   recovery                                           Note:  “Rule  of  Thumb”  for  a  recession  is  at  least  two  quarters  of  negative  economic   growth  à  i.e.  level  of  GDP  has  to  fall  for  at  least  two  quarters.       Potential  Output  (y*)   • Amount  of  output  (real  GDP)  an  economy  can  produce  when  using  its  resources   (labour  and  capital)  at  normal  rates.   • Not  the  maximum  output.   • Grows  over  time  with  growth  in  labour,  capital  inputs  and  growth  in  technology.   Actual  output  (y)   • Actual  level  of  GDP  produced  in  the  economy   • Vary  (expand  or  contract)  due  to:   o Changes  in  potential  output  (  y*)  e.g.  extreme  weather  conditions  à   decrease  actual  output  à  contractionary  gap  à  recession   o Changes  in  utilization  rate  of  labour  and  capital  e.g.  immigration,  new   technologies  à  increase  actual  output  à  expansionary  gap  /  boom.       • Output  gap  =  y  –  y*  at  a  point  in  time.   • Occurs  when  utilization  of  labor  and  capital  is  above  or  below  normal  rate.  Thus,   y    y*  

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Expansionary  gap:  y*  <  y  (Positive  output  gap)     Contractionary  gap:  y*  >  y  (Negative  output  gap)  

•

Natural  Rate  of  Unemployment  (u*):  the  part  of  the  total  unemployment  rate   that  is  attributable  to  frictional  and  structural  unemployment;  equivalently,  the   unemployment  rate  that  prevails  when  there  is  no  cyclical  unemployment.   Unemployment  rate  (u)  tends  to  co-­‐move  with  the  output  gap  in  economy.   Contractionary  gaps  link  to  high  unemployment  rate   Expansionary  gaps  low  unemployment  rate   Unemployment  =  (frictional  +  structural)  +  cyclical   Cyclical  unemployment  =  u  –  u*   Okun’s  law  is  systematic,  quantitative  relationship  between  output  gap  and   cyclical  unemployment.  Implies,  an  extra  percentage  point  of  cyclical   unemployment  is  associated  with  an  specific  percentage  point  increase  in  the   output  gap.   For  Australia,  the  β  percentage  point  in  approximately  1.5.   Okun’s  law  implies  negatively  proportionality,  meaning:   o Positive  output  gap  (expansionary)  causes  a  reduction  in  cyclical   unemployment.   o Negative  output  gap  (contractionary)  cause  an  increase  in  cyclical   unemployment   o When  output  gap  =  0,  there  is  no  cyclical  unemployment.  

• • • • •

•

    • •

•

-­‐  opportunity  cost   -­‐  inflation  

Policymakers  generally  view  both,  a  persistent  contractionary  or  expansionary  as   problems.   Contractionary  gaps  are  associated  with  capital  and  labour  not  being  fully   utilised  (cost  in  terms  of  forgone  output).   o Reduced  total  economic  value  à  higher  unemployment  à  reduced   livings  standards.     o In  order  to  reduce  cyclical  unemployment  levels,  policy  makers  must   attempt  to  create  an  expansionary  output  gap.  This  can  be  achieved  by   using  resources  at  greater  than  normal  rates.  For  example,  creating  new   infrastructure  projects  is  new  capital  investment,  while  using  resources   such  as  labour  at  higher  rates  than  normal.     o Implies  that  it  is  possible  for  an  economy  to  suffer  from  ‘jobless   recoveries’,  that  is,  output  growth  resumes  however  employment  does   not  grow.  An  increase  in  labour  productivity  can  mean  that  real  net   output  grows  leading  to  an  expansionary  gap  without  net  unemployment   rates  falling,  as  there  is  no  strict  relationship  between  the  two  as  a   variable  β  is  involved.  It  is  this  variable  that  changes  in  such  situations.   Expansionary  gaps  are  associated  with  firms  operating  above  normal  capacity  to   meet  demand.  This  can  lead  them  price  increase  (inflationary),  leading  to   inefficient  market.  

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      Chapter  5  –  Spending  and  Output  in  the  Short-­‐Run     Key  Issues   • A  model  of  output  determination  –  Keynesian  Model   • Planned  verses  actual  expenditure   • A  consumption  function   • Equilibrium  output  in  the  short-­‐run     Keynesian  Model   • Key  Assumption:  Prices  of  goods  are  fixed/sticky  in  the  short-­‐run.  Firms  do  not   change  prices  in  response  to  a  change  in  demand  for  their  products.  Fix  their   price  and  meet  demand  at  this  preset  price  by  varying  their  level  of  production   (labour  and  output).  The  implication:  changes  in  spending  yield  a  change  in   output  above  or  below  potential.  Thus  spending  determines  aggregate  output.   • If  prices  where  fully  flexible,  in  theory  prices  would  be  changing  instantaneously   with  changes  in  demand  –  menu  costs.  Also,  there  will  never  be  excess   production  because  firms  will  cut  prices  to  sell  it  and  never  be  persistent   unemployment  because  workers  will  cut  their  wages  to  keep  and  get  jobs.   Fluctuations  in  demand  will  be  accommodated  by  flexible  prices  and  wages   without  changes  in  output  and  employment.   • In  long-­‐run,  sustained  changes  in  demand  will  eventually  lead  firms  to  change   their  prices  and  cause  production  to  return  to  normal  capacity.     Aggregate  Expenditure   • The  actual  expenditure  in  the  economy  is  equivalent  to  production/GDP  since   aggregate  output  is  determined  by  spending.  Thus:  AE  =  C  +  I  +  G  +  NX.  (Note,  I  =   real  investment  not  financial).   • PAE  is  the  total  level  of  planned  spending  on  goods  and  services  and  may  differ   from  the  actual  level  of  production.  PAE  =  C  +  IP  +  G  +  NX.     • Since  firms  are  meeting  demand  at  preset  prices  they  cannot  control  how  much   they  sell.  Consequently,  differences  arise  when  firms  sell  more  or  less  than   expected.  When  firms  sell  less  output  than  planned,  it  adds  more  than  planned   to  its  inventory  stocks  (investment)  and  hence  actual  investment  will  exceed   planned  (I>Ip).  When  firms  sell  more  output  than  planned,  it  adds  less  than   planned  to  its  inventory  stocks  (investment)  and  hence  actual  investment  will  be   below  planned  (IINJ)  in  the  economy,  and  thus,  firms  find  an  increase  in   their  inventory  (unsold  stock),  such  that  their  actual  investment,  which   includes  inventories,  is  greater  than  their  planned  investment.  This   situation  is  also  known  as  excess  supply.  As  there  are  costs  involved  with   carrying  unsold  stock,  less  income  is  consumed  so  that  withdrawals   exceed  injections.  Firms  attempt  to  remove  this  excess  inventory,   however,  in  the  short  term,  prices  do  not  change,  such  that  the  firm   cannot  dump  their  inventory  and  instead  revise  their  production  levels   downward  in  order  to  avoid  these  costs.  Subsequently,  GDP  will  fall  until   it  reaches  equilibrium  level.  The  reverse  is  also  true  –  firms  cannot  raise   prices  to  satisfy  excess  demand,  and  therefore  the  only  option  is  to   increase  production,  resulting  in  GDP  rising  to  its  equilibrium  level.     [REVIESE  GRAPHS]    

      The  Paradox  of  Thrift   • Consider  a  savings  function  given  by  and  investment  function  IP  where   equilibrium  is  initially  at  Y0e,  that  is  where  savings  equals  investment   • Suppose  there  is  an  exogenous  increase  in  an  agents’  desire  to  save  ().  That  is,  at   every  level  of  income  there  is  an  increase  in  savings  by  a  constant  amount.   Resulting  in  a  parallel  shift  in  savings  function  to  S1.   • Since  the  actions  of  saving  reduce  economic  activity,  the  aggregate  amount  of   savings  actually  remains  unchanged,  but  the  level  of  GDP  will  fall.  Hence,  an   attempt  to  increase  savings  results  in  the  economy  being  worse  off.   • This  decline  in  exogenous  consumption  can  be  explained  using  the  Y=PAE   diagram.  Essentially,  the  decrease  in  PAE  means  there  is  less  actual  expenditure   (Y)  and  lower  levels  of  income  to  ensure  that  savings  again  match  planned   investments.       Four  Sector  Model  

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• • • • •

PAE  =  C  +  IP  +  G  +  NX   Consumption  Function:Error!  Not  a  valid  embedded  object.   Tax  Function:  Error!  Not  a  valid  embedded  object.   Import  Function:  Error!  Not  a  valid  embedded  object.   Error!  Not  a  valid  embedded  object.  

                        The  Multiplier   • Multiplier  is  the  effect  of  a  one-­‐unit  increase  in  exogenous  expenditure  on  short   run  equilibrium  output.  The  multiplier  suggests  that  an  additional  dollar  of   exogenous  PAE  results  in  more  than  a  dollar’s  worth  of  GDP.   • For  example,  if  the  multiplier  is  5  and  increase  of  10  units  in  exogenous   expenditure  results  in  a  50  units  increase  in  output.     • In  general,  a  change  in  exogenous  expenditure  produces  a  larger  change  in   short-­‐run  output  since  actions  to  spend  by  one  party,  results  in  successive   rounds  of  changes  in  income  and  spending  for  others  –  which  results  in  a  larger   change  in  short-­‐run  output.   • For  example,  if  consumer’s  increase  spending  this  increases  sales  directly,  but   also  inadvertently  increases  the  income  of  workers  and  firm  owners.  This   enables  workers  and  owners  to  increase  their  own  spending,  which  results  in  a   recursive  process.   • As  the  marginal  propensity  to  consume  is  typically  less  than  1,  the   income/expenditure  benefit  of  each  round  decreases  as  less  of  diminishing   proportion  transfers  between  parties.     • 2-­‐sector  Model   Multiplier  =  1  /  1  –  c    [M>1  since  0T),  and   the  level  of  public  debt  grows  (implies  Bt  >  Bt-­‐1).  Conversely,  public  debt  falls  with   a  government  surplus.   • Since  fiscal  policy  involves  decisions  about  G,  Q,  T  the  government  budget   constraint  demonstrates  how  these  choices  influence  the  level  of  public  debt.       Costs  of  Public  Debt   • Crowding  Out:  High  levels  of  government  borrowing  may  raise  real  interest  rates   à  crowd-­‐out  private  investment  and  capital  formation  (S  &  I  model).  Thus  one   reason  a  government  may  drop  debt  is  to  encourage  investment  expenditure  by   the  private  sector.   • Intergenerational  Equity:  the  concept  that  the  current  generation  should  not   impose  an  unfair  burden  on  future  generations.  Borrowing  because  deficit   budgets  can’t  be  sustained  forever  à  surpluses  required  in  order  to  reduce   debt.  Thus,  we  should  not  enjoy  benefits  of  budget  deficits  now  and  pass  on   costs  of  those  deficits  to  future  generations.  Recent  budget  surplus’  and  sales  of  

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assets  such  as  Telstra  have  allowed  the  government  to  help  pay  off  debts   accumulated  as  a  result  of  past  budget  deficits  –  the  GFC  has  forced  the   government  budget  back  into  deficit.  

  Benefits  of  Public  Debt   • One  use  of  public  debt  is  to  finance  the  provision  of  public  infrastructure.  Where   infrastructure  has  the  characteristics  of  a  public  good  it  will  be  under-­‐supplied  by   the  private  sector.   • Some  estimates  suggest  that  the  returns  to  investment  in  infrastructure  are   relatively  high.   • Thus  it  is  possible  that  public  debt  may  have  a  net  benefit  for  the  economy,  even   when  allowing  for  crowding  out  and  intergenerational  equity  effects.       Fiscal  Policy  Challenges  –  Demographic  Change   • Demographic  changes  are  alterations  to  structure  of  population.   • Australia’s  population  is  expected  to  increase  from  20.5m  in  2006  to  24.5m  in   2048.   • Declining  fertility  rates  and  increases  longevity  means  that  people  65  and  over   are  likely  to  go  from  13%  of  population  to  22%  in  that  time.   • This  has  implications  for  government  expenditure,  as  health,  aged  care  and   pension  spending  will  increase  over  that  time.   • Government  budget  deficits  are  predicted  from  2025  onwards  based  on   government  revenue  being  about  22%  of  GDP.   • Coincidently,  senior  citizen  typically  pay  minimal  tax,  therefore  the  Australian   government  must  borrow  more  in  order  to  finance  expenditure  as  per  the   budget  constraint.  Recall,  that  the  budget  constraint  refers  to  concept  that   government  spending  in  any  period  has  be  financed  by  taxes  or  government   borrowing.  Additional  measures  to  address  this  issue  include  raising  the   retirement  age,  increasing  taxes,  or  encouraging  younger  people  to  being   working  earlier  rather  than  study  for  longer  –  there  is  a  cost-­‐benefit  trade-­‐off   here.   • Tax  smoothing:  a  theory  that  states  that  the  government  should  run  a  budget   surplus  now  if  it  anticipates  higher  government  spending  in  the  future.       Distribution  of  Income   • Key  function  of  fiscal  policy  -­‐  influence  distribution  of  income  changing   disposable  income  available  to  households,  through  net  taxes.   • Net  taxes  =  tax  paid  by  a  household  less  transfer  payments  received.   • Progressive  Taxes:  a  system  of  taxation  that  levies  higher  tax  rates  on  additional   dollars  earned  as  income  increases  à  less  unequal  distribution  of  income.   • Government  transfer  payments  are  also  targeted  toward  low-­‐income  earners  as   they  are  ‘means  tested’.   • Gini  Coefficient:  summary  measure  of  income  inequality.  

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Error!  Not  a  valid  embedded  object.   Lorenz  curve:  graphical  representation  of  income  inequality.   A  Gini  coefficient  of  0  implies  perfect  income  equality  and  larger  coefficients   imply  higher  income  inequality.     • Note:  Fiscal  policy  is  not  often  used  these  days  to  stablise  the  economy.  This  is   because  of  supply  side  issues  (undesirable  long-­‐run  consequences),  excessive   national  debt,  and  is  relatively  inflexible  as  discretionary  changes  to  the  budget   take  time  to  approve.   • Fiscal  policy  is  not  often  used  as  a  stablisation  tool.  However,  fiscal  policy  does   have  important  roles  in  the  economy.  Three  of  these  roles  are:   1. To  influence  the  distribution  of  disposable  income  across  households.   2. The  management  of  the  likely  pressures  on  government  expenditure  implied  by   the  ageing  of  the  population.   3. The  management  of  the  government’s  public  debt.   • •

    Chapter  7  -­‐  Money,  Prices  and  the  Reserve  Bank       Key  Issues   • Money  and  its  uses   • Private  banks  and  money  creation   • Money  and  prices   • Reserve  Bank  of  Australia     • Cash  rate  and  exchange  settlement  funds       • Money:  an  asset  that  can  be  used  in  making  purchases.     • Functions  of  money:   o Medium  of  exchange  (asset  used  in  purchases)  –  money  removes  the   problem  associated  with  barter  (direct  trade)  by  eliminating  the  double   coincidence  of  wants  problem.  Thus  money  significantly  reduces  search   costs.   o Unit  of  account  (basic  measure  of  economic  value)  –  standardized  value   comparisons.   o Store  of  Value  (means  of  holding  or  transferring  wealth.  Many  assets  hold   this  property  but  do  not  posses  the  first  2  functions  e.g.  stock,  loans  and   bonds).     • Currency  =  notes  and  coin  on  issue  (less  what  is  held  by  banks  and  RBA).   • M1  =  Currency  +  Current  deposits  with  banks  (cheque  and  savings  accounts).   • M3  =  M1  +  all  other  bank  deposits  of  non-­‐bank  private  sector   • Broad  Money  =  M3  +  borrowings  from  private  sector  by  non-­‐bank  depository   corporations  less  what  these  non-­‐banks  hold  with  banks.  

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  •

The  sources  of  money  in  a  modern  economy  are  governments  (currency)  and  the   banking  system  (deposits).  

  Banks  as  Creators  of  Money   • Households  and  firms  deposit  all  currency  in  banking  system   • Bank  reserves:  reserves  of  cash  kept  by  banks  to  meet  their  customers’  deposit   withdrawal  demands.  A  100  %  reserve  banking  system  means  all  deposits  are   kept  in  form  of  cash  reserves.       Assets             Liabilities     Reserves  =  $100m       Deposits  =  $100m                   • Reserve-­‐deposit  ratio:  the  ratio  of  reserves  to  total  deposits  held  by  a  bank.   • Fractional-­‐reserve  banking  system:  a  banking  system  in  which  the  reserve  –   deposit  ratio  is  less  than  100%.  Some  reserves  are  left  for  regular  withdrawals;   the  rest  (excess  over  R/D)  can  be  loaned  to  households  and  firms  that  demand   additional  currency.  Banks  are  now  intermediaries.  E.g.  R/D=10%;  reserves  =   10M,  loans  =  90M  and  deposits  =  100M.       Assets             Liabilities     Reserves  =  $10m       Deposits  =  $100m               Loans              =  $90m           • Assume  that  private  citizen  prefer  bank  deposits  to  cash  for  making  transactions,   therefore  loans  will  ultimately  be  redeposited  into  the  banking  system  again   after  each  round.     Assets             Liabilities     Reserves  =  $100m     Deposits  =  $190   Loans              =  $90m           • Here,  after  re-­‐deposits,  R/D  =  0.53  (too  high,  so  more  lending  rounds  occur  to   get  R/D  =  0.10).  Thus,  banks  make  additional  loans  and  they  re-­‐deposited.     Assets             Liabilities     Reserves  =  $19m       Deposits  =  $100          +  $  81m                +  $90m   Loans              =  $90m                  +  $81m  

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          •

• •

•

         +  $81m         Here,  after  reserves  =  $100m  and  deposits  =  $271m,  thus  R/D  =  0.37  (too  high,   so  more  lending  rounds  occur  to  get  R/D  =  0.10).  Thus,  Banks  Make  Additional   Loans  and  they  Re-­‐Deposited.   Continue  process  expanding  loans  and  deposits  until  R/D  =  required  ratio   Thus,  the  banking  system  creates  money  through  the  process  of  holding  deposits   and  lending  out  excess,  which  affects  the  money  Supply.  An  increase  in  deposits   driving  ratio  downwards.   To  solve  for  total  deposits  (D)  recall  that,  Money  supply  =  currency  held  by  public   +  bank  deposits.  When  the  public  withdraws  cash  from  the  banks,  the  overall   money  supply  declines.  Deposit  multiplier:     Error!  Not  a  valid  embedded  object.    

  Money  and  Prices   • The  long  run  supply  of  money  and  the  general  price  level  are  closely  linked.   • Velocity:  a  measure  of  the  amount  of  expenditure  that  can  be  financed  from  a   given  amount  of  money  over  a  particular  time  period  (What  is  the  average  value   of  transitions  that  a  dollar  can  be  used  for  in  a  given  period  of  time?  How  fast   does  currency  circulate?).  This  is  only  approximate  –  recall  second  hand  sales  are   not  included  in  GDP  –  yet  these  have  some  effect  on  velocity.   V  =  P  x  Y/M  =  nominal  GDP/money  stock   • Quantity  theory  derives  the  relationship  between  price  level  and  the  amount  of   money  circulating  the  economy.  The  quantity  theory  is  based  on  the  quantity   equation  (M  x  V  =  P  x  Y),  which  states  that  the  money  stock  times  velocity  equals   nominal  GDP  –  which  is  true  by  definition  (M  (money  stock),  V  (velocity  of  money   circulation),  P  x  Y  (nominal  GDP)).   • Key  assumptions:  velocity  is  constant  and  output  is  constant,  i.e.  current   payment  methods  and  production  technologies  are  fixed.   • Therefore,  quantity  theory  equation  is:     Error!  Not  a  valid  embedded  object.   This  can  be  algebraically  manipulated  to:     Error!  Not  a  valid  embedded  object.   This  implies  that  price  level  is  proportional  to  the  money  stock.   • Therefore,  a  specific  percentage  increase  in  money  stock  yields  the  same   percentage  increase  in  price  level  and  thus,  growth  rate  of  money  supply  equals   rate  of  inflation.  Although,  this  relationship  is  only  approximate  and  does  not   always  hold.   • Implications:  quantity  theory  links  the  growth  rate  of  money  to  price  levels  (the   inflation  rate).  Intuitively  this  make  sense,  since  an  increase  in  the  supply  of  

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•

•

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•

•

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•

•

money  with  a  relatively  fixed  supply  of  goods  and  services  will  bid  up  in  prices,   hence  resulting  in  a  higher  price,  that  is  inflation.     The  central  bank’s  is  responsible  for  the  operation  of  monetary  policy  and   stability  and  efficiency  of  the  financial  markets.  In  Australia,  the  RBA  Act  (1959   Cmwlth),  stated  that  the  RBA’s  operations  should  contribute  to  the  stability  of   the  Australian  currency,  maintenance  of  full  employment  and  economic   prosperity  and  welfare  of  the  people  of  Australia.   RBA  has  a  2-­‐3%  target  inflation  band.     The  Reserve  Bank’s  action  of  buying  and  selling  bonds  is  known  as  Open  Market   Operations  (OMO).  OMO  provides  a  means  by  which  the  RBA  can  influence  the   overall  level  of  cash  (via  exchange  settlement  funds)  and  provides  a  means  by   which  the  RBA  can  ensure  the  overnight  cash  rate  is  equal  to  its  target  rate   Each  commercial  bank  has  an  exchange  settlement  account  with  the  RBA,  which   is  used  to  manage  flow  of  funds  with  other  commercial  banks  generated  by   commercial  activities  of  their  customers.  ESA  must  always  be  in  credit  and  can   never  be  overdrawn.   The  financial  system  that  helps  manage  and  maintain  exchange  settlement   accounts  by  facilitating  borrowing  and  lending  of  funds  for  periods  of  less  than   24  hours  is  called  the  overnight  cash  market.  The  interest  rate  on  these  loans  is   called  the  overnight  cash  rate.   Note:  government  spending  and  private  sector  tax  payments  also  have  an  effect   on  overall  level  of  exchange  settlement  funds.   Open  market  purchase:  the  purchase  of  government  bonds  from  the  public  by   the  Reserve  Bank  for  the  purpose  of  increases  the  balances  in  the  banks’   exchange  settlement  accounts.  [Cr  ESA]   Open  market  sale:  the  sale  by  the  Reserve  Bank  of  government  bonds  to  the   public  for  the  purpose  of  reducing  the  balances  in  banks’  exchange  settlement   accounts.  [Dr  ESA]   Bank  with  exchange  settlement  account  surplus’  or  deficits’  can  borrow  and  lend   money  between  each  other  in  the  overnight  cash  market,  at  the  overnight  cash   rate.  The  return  on  ESA  funds  are  quite  low  so  there  is  incentive  to  not   accumulate  too  many  funds,  however  they  must  also  never  be  overdrawn.   If  there  is  excess  cash  in  the  system  so  that  there  is  pressure  for  the  cash  rate  to   fall  below  targets,  RBA  will  sell  bonds  and  this  will  reduce  the  supply  of  cash.   If  there  is  a  shortage  of  cash  in  the  system  so  that  there  is  pressure  for  the  cash   rate  to  rise  above  the  target,  RBA  will  buy  bonds  and  this  will  increase  the  supply   of  cash.   These  conditions  hold  because  the  level  of  funds  held  in  the  exchange   settlement  accounts  affect  the  supply  and  demand  of  borrowing  the  overnight   cash  market,  and  therefore  the  cash  rate.   Since  the  money  supply  is  given  by  currency  held  by  public  +  bank  reserves  /   desired  reserve-­‐deposit  ratio,  the  level  of  bank  reserves  directly  influences  the  

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money  supply  –  that  is  an  increase  in  bank  reserves,  increases  by  a  greater   amount  the  money  supply  and  a  decrease  in  bank  reserves,  decreases  by  a   greater  amount  the  money  supply.   In  its  OMO  the  RBA  rarely  buys  and  sells  government  securities  outright.  Rather   it  uses  repurchase  agreements  (repos).  Here  purchases  and  sales  of  securities   are  only  for  a  certain  period  (say  a  week),  after  which  the  original  transaction  is   reversed.  

      Channel  Cash  Rate     • RBA  pays  interest  in  funds  held  in  ESA  accounts  at  rate  which  is  0.25%  below  its   cash  rate  target.  à  Lower  bound.   • Banks  can,  at  any  time,  borrow  cash  from  the  RBA  at  a  rate  that  is  0.25%  above   target  cash  rate  à  Upper  bound.   • Demand  for  Cash  and  the  Target  cash  rate  –  At  any  interest  above  4.75  banks   have  zero  demand  for  a  stock  of  cash,  since  they  can  always  get  what  they   require  from  the  RBA  for  4.75%.  At  any  interest  rate  below  4.25  banks  will   demand  an  infinite  amount  of  cash,  since  they  can  always  earn  4.25%  from  their   exchange  settlement  accounts.  Between  4.75  and  4.25  we  just  assume  banks   demand  for  cash  is  negatively  related  to  the  cash  rate.                             • Note  –  cash  rates  are  annual  effective  rates.                     30

                    Chapter  8:  The  Reserve  Bank  and  the  Economy     Key  Issues   • Demand  for  money   • Bond  prices  and  yields   • Money  Market   • Cash  Rate  and  Bond  Rates   • PAE  and  the  Real  Interest  Rate   • Policy  Reaction  Function       • Demand  for  Money  is  the  amount  of  wealth  an  individual  chooses  to  hole  in   form  of  money.  Risk  vs.  Expected  Return:  Risky  assets  need  to  pay  a  higher   expected  return  to  induce  individuals  to  hold  them.     Benefits  and  Costs  of  Holding  Money:   • Main  benefit  from  holding  money  is  its  usefulness  in  making  transactions  –   medium  of  exchange  function.  Transactions  demand  for  money  can  be  affected   by  financial  innovation  e.g.  credit  cards,  ATM  –  reduced  need  to  hold  money   • Cost  -­‐  many  forms  of  money  pay  zero  interest  (currency)  or  very  low  rates  of   interest  (transactions  accounts)  à  opportunity  cost  of  holding  money  -­‐  return   earned  by  holding  wealth  in  the  form  of  other  assets  e.g.  Bonds  pay  a  fixed   amount  of  interest  each  period,  Equities  pay  dividends,  capital  gain   • Assume:   o Money  pays  a  zero  nominal  interest  rate.   o Nominal  expected  return  on  other  assets  is  positive.   o Nominal  interest  rate  is  represented  as  i.   • Demand  for  money  by  households  and  firms  is  affected  by:   o Nominal  interest  rate,  (i)  -­‐  negatively  related  to  i.  Increasing  nominal   interest  rate,  increase  the  opportunity  cost  of  holding  money  and  reduce   the  amount  demanded.   o Real  output  (or  GDP),  (y)  -­‐  positively  related  to  y.  Larger  GDP  means   higher  incomes  and  greater  transactions  volumes  are  likely  to  lead  to   increased  demand  more  money.  

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o Price  level,  (P)  -­‐  positively  related  to  P.  Inflation  means  the  dollar  value  of   general  G+S  increase,  require  more  money  for  transactions  

  Money  Demand  Curve   • Nominal  Demand    [Link  shape  to  opportunity  costs  of  money]   Error!  Not  a  valid  embedded  object.   • Real  Demand     Error!  Not  a  valid  embedded  object.       Shifts  in  the  Demand  for  Money   • Real  income  (y)   • Price  level  (P)  (only  if  we  measure  nominal  money  on  horizontal  axis)     • Technological  Change  and  Financial  Innovation  (E.g.  Development  and  spread  of   ATMs  –  decrease  demand  –  shift  left)   • Stock  market  volatility  can  increase  demand  for  safer  assets.   • Political  instability  can  lead  people  to  worry  about  inflation  and  hoard  currency.     Supply  of  Money   • The  supply  curve  for  money  is  vertical  -­‐  position  is  determined  by  the  actions  of   the  RBA  (OMO),  independent  of  i.  No  change  in  money  supply.     • Or,  the  supply  curve  for  money  is  horizontal  -­‐  RBA  supplies  money  on  demand   (at  a  given  i).   • Recall,  RBA  is  able  to  control  the  money  supply  (currency  and  deposits)  by  OMO   with  the  public.       Asset  Prices  and  Yields   • Yield  or  return  on  a  financial  asset  is  inversely  related  to  the  asset’s  price.   • Bond:  type  of  financial  asset,  issued  by  someone  seeking  to  borrow  money.   • Principal  amount:  amount  of  money  lent  by  purchaser  of  bond.   • Coupon  rate:  the  interest  rate  attached  to  a  bond  (=  Coupon  Payment/Principal).   • Coupon  payment:  the  dollar  amount  of  interest  payments  on  a  bond.     Consider,  RBA  reduces  Ms  which  to  raise  interest  rates:  

   

(Vertical  Ms  is  exogenous?)   32

• OMO:  RBA  sells  bonds  to  the  public  in  exchange  for  M  (reduces  M)   • [!]  D  is  downward  sloping  because  a  low  interest  rate  would  not  promote  lending   between  banks,  so  banks  are  more  inclined  to  leave  money  in  their  ESA,  thus   reducing  the  demand  for  base  money.  Supply  is  controlled  by  RBA  OMO,  and   inelastic  wrt.  cash  rate.  Higher  target  cash  rate  shifts  demand  to  the  right   (expands  demand).   • At  the  initial  (old  equilibrium)  interest  rate  there  will  be  an  excess  demand  for   money  and  an  excess  supply  of  bonds  as  bond  will  be  over-­‐valued  at  this  lower   interest  rate.   • The  excess  supply  of  bonds  will  put  downward  pressure  on  bond  prices,  which   raises  the  interest  rate.  This  process  will  continue  until  the  demand  for  money   has  been  reduced  to  equal  the  lower  supply.  

    Consider,  endogenous  money  supply:  Interest  Rate  Target                                           Given  the  demand  for  money  function,  the  RBA  will  supply  whatever   quantity  of  money  that  is  required  to  achieve  its  target  value  for  the   interest  rate.  Thus  at  any  time,  the  RBA  can  either  control  the  money   supply  or  set  a  target  value  for  the  interest  rate.     Monetary  Policy  and  the  Money  Market   • Recall,  RBA  targets  the  very  short-­‐term  interest  rate  (overnight  interbank  rate)   and  undertakes  its  OMO  mainly  with  banks.  What  are  the  implications  of  the   cash  rate  on  longer-­‐term  interest  rates?   • Consider  maker  for  Market  for  90-­‐Day  Bills.                              

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•

•

•

                       

Supply  curve  indicates  the  willingness  of  firms  to  supply/issue  bills  (ie.  to  borrow   for  90-­‐days).  Recall  that  when  bill  price  is  high,  the  interest  rate  on  bills  is  low  so   firms  want  to  supply  more  bills  (ie.  borrow  more).  –  Cost  is  lower.   Demand  curve  indicates  the  willingness  to  lend  to  firms  (ie.  demand  for  90-­‐day   bills).  Recall  that  when  bill  price  is  high,  the  interest  rate  on  bills  is  low,  so  no  one   is  willing  to  lend  much  (ie.  demand  for  bills  is  relatively  low)  –  Return  is  poorer.   Effect  of  an  Increase  in  the  Cash  Rate  on  the  90-­‐Day  Bill  Market  à  RBA  raises  its   target  level  for  the  cash  rate.  Assume  banks  (and  some  other  financial   institutions)  are  able  to  participate  in  both  the  overnight  cash  market  and  in  the   commercial  bill  market.     o [DEMAND]  Lenders  leave  the  bill  market  in  favour  of  higher  returns  in  the   overnight  cash  market  à  Demand  for  commercial  bills  (willingness  to   lend  to  firms)  will  fall:  Demand  curve  shift  left.  HIGH  PRICE  =  LOW   INTEREST  RATE  =  LOW  RETURN  =  LOW  D!   o [SUPPLY]  Borrowers  in  cash  market  will  now  seek  funds  in  the  90-­‐day  bill   market,  due  to  the  higher  cash  rate  à  supply  of  commercial  bills   (demand  for  90-­‐day  loans)  will  rise:  Supply  curve  shift  outwards.  HIGH   PRICE  =  LOW  INTEREST  RATE  =  LOW  COST  =  LOW  S!   [KEY  IDEA:  if  the  RBA  increases  the  funds  in  the  overnight  cash  market,  then   investors  who  previously  dealt  in  the  90-­‐day  bill  market  now  seek  higher  returns   in  the  overnight  cash  market,  and  borrowers  who  obtained  funds  from  the   overnight  cash  market  restructure  their  financing  plans  and  move  to  longer-­‐ maturity  loans  with  a  comparatively  lower  interest  rate.  Think  as  if  the  two   markets  were  mutually  exclusive.  RBA’s  targeting  has  an  indirect  effect  on   longer-­‐term  interest  rates].  

The  price  of  bills  falls  and  the  interest  rate  rises.  

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Thus,  changes  in  cash  rate  eventually  lead  to  changes  in  longer-­‐term  interest   rates.   Market  Rates  =  Cash  Rate  +  Premium  (for  risk  or  liquidity  factors)     Recall,  Error!  Not  a  valid  embedded  object..  Thus,  if  inflation  is  sticky  in  the   short-­‐run,  RBA  can  control  nominal  and  real  interest  rates  (in  SR).  Note:  r  can  be   negative  if  nominal  inflation  is  below  inflation.   Real  interests  move  in  a  direction  of  real  cash  rates  –  however  this  is  no  exact   relationship.   The  RBA  controls  the  nominal  interest  rate  thought  its  targeting  of  the  overnight   cash  interest  rate.  Because  inflation  is  slow  to  adjust,  in  the  short-­‐run  the  reserve   bank  can  control  the  real  interest  rate  as  well.  In  the  long  run,  however,  the  real   interest  rate  is  determined  by  the  balance  of  savings  and  investment.  

  PAE  and  the  Real  Interest  Rate   • Higher  real  interest  rates  will  lead  households  to  defer  current  consumption   (positive  effect  on  saving  and  borrowing  costs  are  higher).  Thus,  Error!  Not  a   valid  embedded  object.     • Higher  real  interest  rates  will  raise  the  cost  of  capital  and  reduce  investment  by   firms.  Thus,  Error!  Not  a  valid  embedded  object.   • (Assume  G,  T  and  X  (N-­‐X-­‐bar,  not  NX-­‐bar)  are  exogenous)  Therefore,     Error!  Not  a  valid  embedded  object.   • The  implication  of  this  is  that  PAE  will  rise  and  fall  with  the  real  interest  rate  (as   set  by  the  RBA  when  inflation  is  sticky)  since  exogenous  expenditure  now   depends  on  the  real  interest  rate.  The  RBA  now  has  a  mechanism  by  which   monetary  policy  can  affect  PAE  and  equilibrium  output.                                                 [CHECK  EXAMPLE  8.4  &  8.5]       • Policy  Reaction  Function:  mathematical  representation  of  how  central  banks   adjust  interest  rates  in  light  of  the  state  of  the  economy.  

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The  model  assumes  that  RBA  will  set  level  of  real  interest  rate  as  a  function  of   the  state  of  the  economy.  Policy  reaction  functions  characterise  the  central   bank’s  behaviour.   Taylor  Rule:  [Output  gap  affects  level  of  interest  rates]   Error!  Not  a  valid  embedded  object.   Simplified  policy  reaction  function:    [Primarily  depends  on  inflation.  R-­‐bar  is   interest  when  inflation  zero.  G  is  how  many  percentage  points  the  interest  rate   rises  with  inflation].   Error!  Not  a  valid  embedded  object.   Simplified  policy  reaction  function  with  inflation  target:    [Target  could  be  2.5,  or   the  mid-­‐point  of  their  target  range].       Error!  Not  a  valid  embedded  object.   o Positive  slope  à  RBA  raises  the  real  rate  as  inflation  rises  (Inflation  is   associated  with  an  expansionary  gap.     In  practice,  the  reserve  bank’s  information  about  the  level  of  potential  output   and  the  size  and  speed  of  the  effects  of  its  actions  is  imprecise.  Thus  monetary   policymaking  is  as  much  an  art  as  a  science.  

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                          Chapter  9:  Aggregate  Demand  and  Aggregate  Supply     Key  Issues   • Aggregate  Demand  (AD)  Curve   • Slope  and  Shifts  in  the  AD  Curve   • Inflation:  Inertia  and  the  Output  Gap   • Aggregate  Supply  (AS)  Curve   • AD-­‐AS  Model   • Applications       • Aggregate  Demand  (AD)  Curve:  Shows  the  relationship  between  short-­‐run   equilibrium  output,  (y),  and  the  rate  of  inflation  (π);  the  name  of  the  curve  that   reflects  the  fact  that  short-­‐run  equilibrium  output  is  determined  by,  and  equals,   total  planned  spending  in  the  economy;  increases  in  inflation  reduce  planned   spending  and  short-­‐run  equilibrium  output,  so  he  aggregate  demand  curve  AD,  is   downward  sloping.   • There  is  a  NEGATIVE  relationship  between  output  and  inflation  (logic  behind   negative  slope):    Error!  Not  a  valid  embedded  object.   • This  relation  occurs  due  to  the  actions  of  the  reserve  bank  to  match  planned   spending  with  capacity,  otherwise  there  will  be  changes  to  the  general  price   level.  When  inflation  is  high,  the  reserve  bank  responds  by  raising  the  real   interest  rate.  The  increase  in  the  real  interest  rate  reduces  consumption  and   investment  spending,  hence  reduces  equilibrium  output.   • Other  reasons  for  the  slope  include  net  wealth  (inflation  distorts  asset  prices  and   affects  people’s  spending  patterns)  –  especially  true  for  money  and  the   purchasing  power  of  money.  Inflation  also  affects  wealth/income  distribution,   inflation  tends  to  affects  those  on  lower  incomes  more,  who  spend  a  greater   proportion  of  their  income.  Inflation  also  crates  greater  uncertainty  amongst   households  and  firms,  reducing  their  spending.  Also,  the  price  of  domestic  good   and  services  changes  on  the  international  market,  leading  to  a  decline  in  exports.        

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Shifts  in  AD  Curve:   • Changes  in  spending  caused  by  factors  other  than  interest  rates  (exogenous   spending).   • Exogenous  change  in  the  RBA’s  policy  reaction  function,  r-­‐bar  component  à   change  in  r  at  every  level  of  AD.                                                 • Note:  a  change  in  inflation  corresponds  to  movement  along  AD  curve,  provide   interest  rate  are  consistent  with  policy  reaction  function.  CHANGES  TO  THE  REAL   INTERST  OR  INFLATION  RATE  DO  NOT  SHIFT  THE  AD  CURVE  -­‐  CHANGES  TO  THE   POLICY  REACTION  FUNCTION  DO!     • Why  does  inflation  move  slow?  Inflation  expectations  and  long-­‐term  wage  price   contracts  (think  of  the  employer  bargaining  future  wages).  The  cycle:  low   inflation  expectations,  slow  increase  in  wage  and  projection  costs,  and  low   inflation.       Inflation  and  Aggregate  Supply  (AS)   • AD  curve  contains  two  endogenous  variables  à  the  output  gap  and  Inflation   shocks.   • Inflation  Inertia  refers  to  the  notion  that  inflation  is  sticky  or  inertial.  This  is   because  the  rate  of  inflation  tends  to  change  relatively  slowly  each  year  in  the   absence  of  adverse  stocks.  Reflects  the  influence  of:   o Inflation  expectations  –  become  a  self-­‐fulfilling  prophecy.  If  a  firm   expects  inflation  to  rise,  they  will  charge  more  to  shield  themselves  from   the  higher  that  is  expect.   o Long-­‐term  nominal  wage  and  price  contracts.  For  example,  a  union   negotiating  in  a  high-­‐inflation  environment  is  much  more  likely  to   demand  a  rapid  increase  in  nominal  wages  over  the  life  of  the  contract   that  it  would  in  a  price  stable  economy.       Output  Gap   Inflation   Expansionary  (y>y*)   Rising   -­‐Sales  exceed  normal  production  rate.    

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-­‐Increase  prices  to  cut  excess  demand.     Contractionary  (yCR.  Current  account  surplus  when  CR>DR.       Account   Debit   Credit   Merchandise   Domestic  purchase  of  Japanese   Sale  of  wheat  to  Russia   trade   car   Services   Domestic  buyer  pays  freight   Overseas  buyer  pays  freight   cost  on  imports   costs  on  exports   Income   Domestic  company  pays   Foreign  company  pays   foreign  employee   domestic  employee   Transfer   Domestic  relative  sends  cash   Over  relative  send  cash  gift  to   gift  to  overseas  resident   domestic  resident.       • Capital  Account:     o Transactions  between  domestic  and  foreign  residents  that  involve  the   acquisition  of  an  asset  or  a  liability     o New  liabilities  are  recorded  as  credits  (as  they  bring  in  foreign  exchange)   –  like  exports  of  goods  and  services    

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o Acquisition  of  assets  are  recorded  as  debits  (as  they  require  foreign   exchange  to  be  given  up  by  domestic  residents)  –  like  imports  of  goods   and  services     o Balance  on  capital  account  is  difference  between  total  credit  items  (sales   of  domestic  assets/acquisitions  of  a  liability  by  a  domestic  resident)  and   total  debit  items  (purchase  of  foreign  assets/discharge  of  a  liability  by  a   domestic  resident)  in  the  capital  account  of  the  balance  of  payments.     The  capital  account  is  divided  between  two  sectors.   o The  official  sector  records  the  transactions  of  the  government  sector  and   the  Reserve  Bank.   o The  non-­‐official  sector  records  the  transactions  of  private  sector  firms,   financial  institutions  and  households.   Balance  on  Financial  Account:     The  important  part  of  the  capital  account  is  the  balance  on  the  financial  account,   which  records:     o Direct  and  portfolio  investment  balances  of  net  foreign  investment  in   Australia  and  Australian  investment  abroad.   o Plus  changes  in  the  RBA’s  holdings  of  foreign  exchange  and  gold.   A  smaller  part  of  the  capital  account  is  the  balance  on  the  capital  account,  which   records:     o The  cancellation  of  debts  of  poor  countries  and  funds  taken  in  and  out  by   migrants.   o Plus,  the  net  acquisition/disposal  of  non-­‐produced,  non-­‐financial  assets,   e.g.  records  sales  of  embassy  land  or  patents  and  copyrights.     Capital  Account:   Net  capital  transfers   +   Net  acquisition/disposal  of  non-­‐produced,  non-­‐financial  assets   =   Balance  on  capital  account     +   Balance  on  financial  account  (foreign  investment)   =   Balance  on  Capital  and  Financial  Account     International  capital  flows:  flows  of  financial  capital  between  countries  as  a   result  of  the  sale  or  purchase  of  one  country’s  assets  by  other  countries.  Capital   inflows:  when  financial  capital  flows  into  a  country  as  the  result  of  a  sale  of  a   domestic  asset.  This  is  equivalent  to  a  domestic  resident  acquiring  a  liability  to   an  overseas  agent.  Capital  outflows:  when  financial  capital  flows  out  of  a  country   as  the  result  f  a  purchase  of  a  foreign  asset.  This  is  equivalent  to  a  foreign   resident  acquiring  a  liability  to  a  domestic  agent.     International  Capital  Flows  –  Purchases  and  sales  of  real  and  financial  assets   across  international  borders  are  called  international  capital  flows.  From  the   perspective  of  a  particular  country:   o Purchases  of  domestic  assets  by  foreigners  are  called  capital  inflows,  

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o Purchases  of  foreign  assets  by  domestic  households  and  firms  are  called   capital  outflows.   Difference  =  net  capital  inflow/outflow   Capital  Flows,  Saving  and  Investment  –  International  capital  flows  allow   countries  to  invest  in  more  productive  investment  opportunities  than  would  be   possible  relying  only  on  national  savings.    In  a  closed  economy,  national  saving   and  investment  are  equal.  In  an  open  economy,  where  capital  flows  are  possible,   savings  from  other  countries  can  finance  investments.   Current  and  Capital  Accounts:  the  balance  on  the  capital  (and  financial)  account   will  be  the  same  value  as  the  balance  on  the  current  account,  though  have  the   opposite  sign.  This  implies  that  (subject  to  recording  errors):   CAB  +  KAB  =  0   CAB  =  -­‐KAB     Note  that  the  above  condition  always  hold  for  a  flexible  exchange  rate,  however   for  a  fixed  exchange  rate,  it  is  possible  to  have  surplus  and  deficits  in  the  CAB   and  KAB  account  due  to  the  purchase/sale  of  currency  by  the  central  bank.     Why  Does  CAB=-­‐KAB?         Suppose  an  Australian  purchases  a  $40,000  Japanese  car,  and  writes  a  cheque   for  $40,000.  The  Japanese  company  has  three  options  with  the  money:     1. They  could  use  the  $40,000  to  buy  Australian  goods  à  Australian  import  =   exports  so  ΔCAB  =  0.   2. Could  buy  a  real  or  financial  Australian  asset  or  simply  leave  the  money  in  the   bank  (an  asset  acquired  by  foreigners).  The  import  would  not  be  offset  by  an   export  so  ΔCAB  =  -­‐$40,000,  and  there  is  a  capital  inflow  of  $40,000,  so  ΔKAB   =  +$40,000.   3. They  could  swap  the  $40,000  with  a  third  party  for  another  currency  (e.g.   yen),  but  the  third  party  would  only  have  the  preceding  two  choices.     The  supply  of  the  Australian  currency  is  related  to  Australian  residents’  demand   for  either  foreign  goods  (DR  current  account)  or  foreign  financial  assets  (DR   capital  account).  The  demand  for  Australian  currency  depends  on  the  demand   for  Australian  exports  (CR  current  account)  or  demand  for  Australian  financial   assets  (CR  capital  account).       Determinants  of  Capital  Flows  –  Why  would  foreigners  want  to  acquire   Australian  assets,  and  conversely,  Australians  want  to  acquire  assets  abroad?   The  factors  that  determine  attractiveness  of  any  asset  are:  return  and  risk.  Other   things  equal  (i.e.  foreign  real  returns  and  the  degree  of  risk)  a  higher  domestic   real  interest  rate  will  tend  to  increase  capital  inflows,  as  foreigners  buy  more   domestic  assets  and  domestic  residents  buy  less  foreign  assets.    

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Capital  Flows  and  Risk:  risk  has  the  opposite  effect  on  capital  flows.  For  a  given   real  interest  rate,  an  increase  in  the  riskiness  of  the  domestic  assets  reduces  the   net  capital  inflows,  as  domestic  assets  become  less  attractive  to  domestic  and   foreign  purchasers.  This  shifts  the  capital  inflow  curve  to  the  left  for  any  given   real  interest  rate  [Relatively  higher  returns  increase  capital  inflows,  “  “  risk   reduce  capital  inflow].   Small  Open  Economies:  In  small  open  economies  (SOE)  like  Australia,  large   capital  flows  would  tend  to  eliminate  any  sustained  differences  in  the  interest   rates  between  the  domestic  and  foreign  interest  rates:  r=r*    

The  domestic  interest  rate  can  deviate  form  the  world  interest  rate  if  either  the   domestic  economy  is  perceived  to  have  some  level  or  risk  or  there  is  an   expectation  that  the  exchange  rate  is  likely  to  change  over  some  point  in  time.     Saving,  Investment  and  Capital  Flows:  In  a  closed  economy,  national  saving  (NS  =   private  +  public  saving)  and  investment  (I)  are  equal.   NS  =  I   In  an  open  economy,  where  capital  flows  (KI)  are  possible,  savings  from  other   countries  can  finance  domestic  investments.   NS  +  KI  =  I  

        Implies  that  shift  in  national  savings  does  no  affect  r  or  r*.  The  Australian   economy  is  a  net  capital  importer,  hence  KI  is  below  equilibrium.  In  a  country   like  Japan,  where  net  savings  <  capital  outflows,  the  KI  line  is  above  the   equilibrium  as  there  is  net  capital  outflow.   52

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Although  capital  inflows  are  generally  beneficial  to  countries  that  receive  them,   they  are  not  costless.  Prospects  of  higher  interest  and  dividends  –  unstable  debt   crisis  result  in  returns  from  capital  investments  going  abroad  rather  than   accruing  to  domestic  savers.     Capital  inflows  can  augment  the  pool  domestic  saving.  This  means  that  in  an   open  economy  investment  need  not  be  confirmed  to  the  size  of  the  available   supply  of  domestic  savings.     Saving,  Investment  and  Net  Exports:  national  accounting  identity  to  show  the   relationship  between  these  variables.     Y=C+I+G+NX     But  recall,  Y-­‐C-­‐G  =  NS   NS-­‐I=NX     Implies  that  low  national  savings  (NS