Macroeconomics 3

Hubbard Garnett Lewis O’Brien

MyEconLab is a personalised online learning program designed to save lecturers’ time and improve students’ results. KEY STUDENT FEATURES MyEconLab gives you all the tools you need to succeed in your course. It includes: n tests to identify what concepts you know and have already mastered n an adaptive study plan, to focus on the specific concepts you need to revise or practise further n interactive revision tools, including practice questions that are automatically graded and come with instant feedback. KEY EDUCATOR FEATURES MyEconLab can be used to engage your students both inside and outside the classroom. It includes: n a customisable homework and test manager you can use to assign and manage quizzes and tests n automatically graded assignments, saving you marking time n real-time access to students’ progress and results through a gradebook n integration with selected Learning Management Systems. MyEconLab is available when you need it: 24 hours a day, 7 days a week

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Macroeconomics

BREAK THROUGH to improving results with MyEconLab

3

Hubbard Garnett Lewis O’Brien

Macroeconomics 3 Copyright © Pearson Australia (a division of Pearson Australia Group Pty Ltd) 2015 – 9781486010233 - Hubbard/Macroeconomics 3e

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H u b b a r d G a r n e t t Le w i s O ’ B r i e n

Macroeconomics 3

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ANNE M. GARNETT For Anton and my family PHILIP LEWIS For my family, friends, colleagues and students R. GLENN HUBBARD For Constance, Ralph and Will ANTHONY PATRICK O’BRIEN For Cindy, Matthew, Andrew and Daniel

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H u b b a r d G a r n e t t Le w i s O ’ B r i e n

Macroeconomics 3

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Copyright © Pearson Australia (a division of Pearson Australia Group Pty Ltd) 2015 Pearson Australia Unit 4, Level 3 14 Aquatic Drive Frenchs Forest NSW 2086 www.pearson.com.au Authorised adaptation from Macroeconomics, 4th edition, ISBN: 9780132817257 by Hubbard, R. Glenn; O’Brien, Anthony Patrick, published by Pearson Education, Inc, Copyright © 2013. First adaptation edition published by Pearson Australia Group Pty Ltd, Copyright © 2015 The Copyright Act 1968 of Australia allows a maximum of one chapter or 10% of this book, whichever is the greater, to be copied by any educational institution for its educational purposes provided that that educational institution (or the body that administers it) has given a remuneration notice to Copyright Agency Limited (CAL) under the Act. For details of the CAL licence for educational institutions contact: Copyright Agency Limited, telephone: (02) 9394 7600, email: [email protected] All rights reserved. Except under the conditions described in the Copyright Act 1968 of Australia and subsequent amendments, no part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior permission of the copyright owner. Learning Architect: Joanne Hobson Development Editors: Camille Layt/Katherine Horsey Project Manager: Rebecca Pomponio Media Content Developer: Adam Catarius Content Coordinator: Germaine Silva Copyright and Pictures Editor: Emma Gaulton Production Controller: Caroline Stewart Copy Editor: Maryanne Phillips Proofreader: Jennifer Coombs Indexer: Olive Grove Indexing Cover and internal design by Natalie Bowra Cover illustration © somchaij/Shutterstock Typeset by Midland Typesetters, Australia Printed in China 1 2 3 4 5 19 18 17 16 15 National Library of Australia Cataloguing-in-Publication Data Author: Hubbard, Glenn R., author. Title: Macroeconomics / Hubbard, Garnett, Lewis, O’Brien. Edition: 3rd edition. ISBN: 9781486010233 (paperback) ISBN: 9781486011735 (Vital Source) Subjects: Macroeconomics. Other Authors/Contributors: Garnett, Anne, author. Lewis, Philip, 1945– author. O’Brien, Anthony Patrick, author. Dewey Number: 339 Every effort has been made to trace and acknowledge copyright. However, should any infringement have occurred, the publishers tender their apologies and invite copyright owners to contact them. Due to copyright restrictions, we may have been unable to include material from the print edition of the book in this digital edition, although every effort has been made to minimise instances of missing content.

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abou t the au thors ANNE GARNETT Anne Garnett is a Senior Lecturer in Economics at Murdoch University. She has extensive teaching experience at the undergraduate and postgraduate level, both in Australia and many parts of Southeast Asia. Her research areas include regional economics, labour economics, international trade and agricultural economics. Anne has been an adviser to the federal government on rural and regional economics. She has published numerous chapters in books and articles in international journals. She has taught in all areas of economics at all levels; however, over the past 15 years her primary teaching focus has been to teach first-year introductory economics. Anne is also co-author of the widely used Essentials of Economics undergraduate text published by Pearson Australia.

PHILIP LEWIS Phil Lewis is the Foundation Professor of Economics and the Canberra Director of the Centre for Labour Market Research at the University of Canberra. He is among the best-known economists in the area of employment, education and training in Australia and Asia. He is the author of over 120 publications including journal articles, book chapters and books. He is the editor of The Australian Journal of Labour Economics. Phil has also worked extensively in government and has produced a number of major reports for the private and public sectors. He has served as the National President of the Economic Society of Australia. In 2008 Phil was presented with the Honorary Fellow Award by the Economic Society of Australia for exceptional service to the economics profession.

GLENN HUBBARD Glenn Hubbard is the Dean and Russell L. Carson Professor of Finance and Economics in the Graduate School of Business at Columbia University and Professor of Economics in Columbia’s Faculty of Arts and Sciences. He is also a research associate of the National Bureau of Economic Research and a director of Automatic Data Processing, Black Rock Closed-End Funds, KKR Financial Corporation and MetLife. From 2001 to 2003 he served as chairman of the White House Council of Economic Advisers and chairman of the OECD Economy Policy Committee, and from 1991 to 1993 he was deputy assistant secretary of the US Treasury Department. He currently serves as co-chair of the non-partisan Committee on Capital Markets Regulation. Glenn’s fields of specialisation are public economics, financial markets and institutions, corporate finance, macroeconomics, industrial organisation and public policy. He is the author of more than 100 articles in leading journals.

TONY O’BRIEN Anthony Patrick (Tony) O’Brien is a Professor of Economics at Lehigh University. He has taught principles of economics for more than 15 years. He received the Lehigh University Award for Distinguished Teaching. He was formerly the director of the Diamond Center for Economic Education and was named a Dana Foundation Faculty Fellow and Lehigh Class of 1961 Professor of Economics. He has been a visiting professor at the University of California, Santa Barbara, and the Graduate School of Industrial Administration at Carnegie Mellon University. Tony’s research has dealt with such issues as the evolution of the US car industry, sources of US economic competitiveness, the development of US trade policy, the causes of the Great Depression and the causes of black–white income differences. His research has been published in leading journals. Tony also serves on the editorial board of the Journal of Socio-Economics.

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preface When George Lucas was asked why he made Star Wars, he replied, ‘It’s the kind of movie I like to see, but no one seemed to be making them. So I decided to make one.’ We realised that no one seemed to be writing the kind of textbook we wanted to use in our courses. So, after years of supplementing texts with fresh, lively, real-world examples from websites, newspapers, magazines and professional journals, we decided to write an economics text that delivers complete economics coverage with many real-world examples.

NEW TO THE THIRD EDITION The core ideas of economics remain unchanged: opportunity costs, demand and supply, comparative advantage, marginal analysis, the role of the entrepreneur in markets, aggregate demand and aggregate supply, the importance of long-run economic growth to rising living standards and the role of economic incentives in the design of policy. What does change is the context in which lecturers and instructors present these ideas in class and the policy debates of the time. In the past few years, to take just a few examples relevant to macroeconomics, we have witnessed renewed policy debate on issues such as education, immigration and the environment, experienced the wide-spread economic contractions and recessions that followed the global financial crisis, and debated the effectiveness of economic policies aimed at minimising the impact of these contractions and recessions. This new edition helps students understand these changing economic realities. In this third edition we retain the focus of presenting economics in the context of real-world businesses and real-world policy debates that proved effective for teaching and learning. We have made a number of important improvements, which include suggestions from lecturers currently using the text, and from reviewers. The third edition includes the following key changes: • Increased coverage of the growing use of offshoring in Chapter 1. • Discussion of potential problems when using GDP for international comparisons of living standards in Chapters 4 and 5. • Updated coverage of the economic contractions and recessions that followed the global financial crisis in a number of chapters, including features in Chapters 5, 7, 12, 13 and 15. • A change in chapter order, with Chapter 7, ‘Unemployment’ and Chapter 8, ‘Inflation’, now preceding the chapters which model aggregate expenditure and aggregate demand and aggregate supply. • New discussion on how the Reserve Bank of Australia measures inflation when determining monetary policy in Chapter 12. • Expanded coverage of government loan defaults in Europe in Chapters 13 and 15. • Updated and new chapter-opening cases for every chapter. • A new special feature at the beginning and end of each chapter—Economics in Your Life—which asks students to consider how economics affects their own lives. • A number of new and substantially revised Making the Connection features, with others containing updated data and information, to help students tie economic concepts to current events and policy debates. • All new An Inside Look news articles and analysis, to enable students to apply economic concepts to current events and policy debates. • Updated figures and tables, using the latest data available. • Many new, revised and updated end-of-chapter Problems and Applications. • End-of-chapter summaries, Review Questions and Problems and Applications grouped according to learning objectives.

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the foundation CONTEXTUAL LEARNING AND MODERN ORGANISATION We believe a course is a success if students can apply what they have learned in both personal and business settings and if they have developed the analytical skills to understand what they read in the media. That’s why we explain economic concepts by using many real-world business and economic policy examples and applications, in both Australia and other countries, in the chapter openers, graphs, Making the Connection features, An Inside Look features and end-of-chapter problems. This approach helps students become educated consumers, voters and citizens. In addition, we also have a modern organisation and place interesting policy topics early in the book to pique student interest. Students come to study macroeconomics with a strong interest in understanding events and developments in the economy. We try to capture that interest and develop students’ economic intuition and understanding in this text. We present macroeconomics in a way that is modern and based in the real world of business and economic policy. And we believe we have achieved this presentation without making the analysis more difficult. We avoid the recent trend of using simplified versions of intermediate models, which are often more detailed and more complex than is necessary to allow students to understand the basic macroeconomic issues. Instead, we use a more realistic version of the familiar aggregate demand–aggregate supply model to analyse short-run fluctuations and monetary and fiscal policy. We also avoid the ‘alternative schools of thought’ approach often used to teach macroeconomics at the principles level, while providing some of this material in selected appendices for those who want to investigate further. We emphasise the many areas of macroeconomics where most economists agree, which gives students a better context for understanding those issues where disagreements have not yet been resolved. And throughout the book we present many diverse real-world business and policy situations to develop students’ intuition. The following points illustrate our approach: • A strong set of introductory chapters. Our introductory chapters provide students with a solid foundation in the basics. We emphasise the key issues of scarcity, trade-offs, marginal analysis and economic efficiency. In Chapter 1 we introduce students to the economic way of thinking through the growing use by Australian businesses of offshoring to the Philippines, the debate on minimum wages and the debate on immigration to Australia. Chapter 2 examines the trade-offs and marginal analysis that managers and economies have to face, presented in the context of BMW deciding on the mix of vehicles to produce. Chapter 3 introduces demand and supply and how the market works, using the examples of demand for and supply of tablet computers, the changing nature of demand due to population ageing and the effects of technology on the supply and price of Blu-ray players, to help contextualise the issues and concepts. The macroeconomic chapters continue this approach by relating concepts, principles and models to relevant examples and current economic policy and events. • Early coverage of long-run topics. We place key macroeconomic issues in their long-run context in Chapter 5, ‘Economic growth, the financial system and business cycles’, and Chapter 6, ‘Long-run economic growth: sources and policies’. Chapter 5 puts the business cycle in the context of underlying long-run growth. In this chapter we discuss what actually happens during the phases of the business cycle. We believe this material is important if students are to have the understanding of business cycles they will need to interpret economic events, yet this material is often discussed only briefly or omitted entirely in other books. We know that many lecturers prefer to have a short-run orientation to their macroeconomic courses, with a strong emphasis on policy. Accordingly, we have structured Chapter 5 so that its discussion of long-run growth would be sufficient for instructors who want to move quickly to short-run analysis. Chapter 6 uses a simple neo-classical growth model to understand important growth issues. We apply the model to topics such as the decline of the Soviet economy, and the importance of the consistent enforcement of property rights to enable continued economic growth in China. And we challenge students with a discussion of ‘Why isn’t the whole world rich?’

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THE FOUNDATION

• A broad discussion of macro statistics. Many students pay at least some attention to the financial news and know that the release of statistics by government departments can cause movements in share and bond prices. A background in macroeconomic statistics helps clarify some of the policy issues encountered in later chapters. In Chapter 4, ‘GDP: measuring total production, income and economic growth’, Chapter 7,‘Unemployment’, and Chapter 8, ‘Inflation’, we provide students with an understanding of the uses and potential shortcomings of the key macroeconomic statistics, without getting bogged down in the finer points of how the statistics are constructed. • A dynamic model of aggregate demand and aggregate supply. We take a fresh approach to the standard aggregate demand–aggregate supply (AD–AS) model. We realise there is no good, simple alternative to using the AD–AS model when explaining movements in the price level and in real GDP. But we know that more instructors are dissatisfied with the AD–AS model than with any other aspect of the macroeconomics principles course. The key problem, of course, is that the AD–AS model is a static model that attempts to account for dynamic changes in real GDP and the price level. Our approach retains the basics of the AD–AS model, but makes it more accurate and useful by making it more dynamic. We emphasise two points: first, changes in the position of the short-run (upward-sloping) aggregate supply curve depend mainly on the state of expectations of the inflation rate; second, the existence of growth in the economy means that the long-run (vertical) aggregate supply curve shifts to the right every year. This ‘dynamic’ AD–AS model provides students with a more accurate understanding of the causes and consequences of fluctuations in real GDP and the price level. We introduce this model in Chapter 10, ‘Aggregate demand and aggregate supply analysis’, and use it in Chapter 12, ‘Monetary policy’ and Chapter 13, ‘Fiscal policy’. • Extensive coverage of monetary policy. Because of the central role money and monetary policy plays in the economy and in students’ curiosity about business and financial news, we devote two chapters— Chapters 11 and 12—to these topics. We emphasise the way in which monetary policy is carried out in Australia through interest rate targeting (not the outdated approach of targeting the money supply that still appears in some textbooks) and the role of credit in the economy. • Coverage of both the demand-side and supply-side effects of fiscal policy. Our discussion of fiscal policy in Chapter 13 carefully distinguishes between automatic stabilisers and discretionary fiscal policy. We also have significant coverage of the supply-side effects of fiscal policy. • A self-contained—but thorough—discussion of the Keynesian 45º line aggregate expenditure model. The Keynesian aggregate expenditure approach (the ‘45º line diagram’ or ‘Keynesian cross’) is a useful way of introducing students to the short-run relationship between spending and production. Many instructors, however, prefer to omit this material. Therefore, we use the income-expenditure approach only in Chapter 9, ‘Aggregate expenditure and output in the short run’. The discussion of monetary and fiscal policy in later chapters uses only the dynamic AD–AS model, making it possible to omit the material in Chapter 9. • Extensive international coverage. We include two chapters devoted to international topics: Chapter 14, ‘Macroeconomics in an open economy’, and Chapter 15, ‘The international financial system’. Having a good understanding of the international trading and financial systems is essential to an understanding of the macroeconomy and to satisfying students’ curiosity about the economic world around them. In addition to the material in our two international chapters, we weave international comparisons into the narrative of several chapters, including our discussions of unemployment, inflation, central banking and government debt. • Flexible chapter organisation. Because we realise that there are a variety of approaches to teaching principles of macroeconomics, we have structured our chapters for maximum flexibility. For example, our discussion of long-run economic growth in Chapter 5 makes it possible for instructors to omit the more thorough discussion of these issues in Chapter 6. Our discussion of the Keynesian 45° line model is confined to Chapter 9, so that instructors who do not use this approach can proceed directly to aggregate demand–aggregate supply analysis in Chapter 10. While we devote two chapters to money and monetary policy, the first of these—Chapter 11—is a self-contained discussion focusing on the role of money and the creation of money. So instructors may safely omit the material in Chapter 11 if they choose to. Finally, instructors may choose to omit the material in the two international chapters (Chapters 14 and 15) or cover just Chapter 14, ‘Macroeconomics in an open economy’. Please refer to the flexibility chart on page xxv of this preface to help you select the chapters and order best suited to your course needs.

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special features A Real-World, Hands-on Approach to Learning Economics

OPENING CASES AND AN INSIDE LOOK NEWS ARTICLES Each chapter-opening case provides a real-world context for learning, sparks students’ interest in economics and helps to unify the chapter. The case describes real situations facing actual companies and countries. The company or economic issue is integrated into the narrative, graphs and pedagogical features in the chapter. Here are a few examples of chapter opening cases: WHY IS THE UNEMPLOYMENT RATE IMPORTANT TO WOOLWORTHS? CHAPTER

7

UNEMPLOYMENT

LEARNING OBJECTIVES After studying this chapter you should be able to: 7.1 Define the unemployment rate and the labour force participation rate, and understand how they are calculated. 7.2 Explain the economic costs of unemployment. 7.3 Identify the types of unemployment. 7.4 Explain what factors determine the unemployment rate. 7.5 Describe the changes that have occurred in the determination of wages in Australia and discuss the possible effects on unemployment.

WOOLWORTHS LIMITED IS one of Australia’s biggest companies in the service sector—the sector where over 70 per cent of people are employed. Woolworths’ primary activity is supermarket operations. Other operations include the sale of petrol through Caltex Woolworths co-branded service stations and Woolworths Plus Petrol, Woolworths Liquor Group, Big W, Masters Home Improvement, general merchandise stores, hotels and pubs. While high unemployment had been a feature of the Australian labour market since the mid-1970s, by the mid2000s the concern among many economists was that a major emerging problem was a shortage of labour. This caused vacancies to rise and put pressure on wages as employers sought to retain and attract workers. During the economic contraction of 2008, unemployment began to rise again and it became easier for many employers to find workers, easing the pressure on wages. By early 2014, the unemployment rate had risen to 6 per cent and participation in the labour market had fallen. Many young people, fearing unemployment, enrolled in higher and further education, which created a greater pool of part-time and casual workers, particularly for the retail sector. An increase in unemployment affects Woolworths’ sales in two different ways. The demand for groceries and petrol is relatively less responsive to income so unemployment normally has a smaller effect on grocery chains such as Woolworths supermarkets and fuel outlets such as Caltex than on other retail industries. During economic contractions, many households cut back on eating out in restaurants and sales of groceries usually increase as more families increase expenditure on home-cooked meals. In contrast, the demand for furniture, electrical and other household items found in Big W is responsive to income, which means rising unemployment normally has a significant effect on sales. However, the strong Australian dollar during the 2008 economic contraction and the subsequent below-trend growth period led to lower wholesale prices of imported goods such as electrical and furniture items. This meant that retailers could either pass on the cost savings to consumers through lower prices or increase their profits, or both. Woolworths is a very large employer of labour in Australia, particularly of relatively unskilled workers, students and married women. Like other retailers, the wages bill is a large proportion of Woolworths’ costs, so even moderate increases in wage rates have a major impact. Also, it is difficult for Woolworths to pass on wage costs in higher prices because it is in competition with other retailers. When economic recovery occurs, if a shortage of labour once again arises and leads to an increase in wage rates, this would be a major concern to Woolworths.

© Newspix / News Ltd / 3rd Party Managed Reproduction & Supply Rights

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ECONOMICS IN YOUR LIFE

SHOULD YOU CHANGE YOUR CAREER PLANS IF YOU GRADUATE DURING A RECESSION? Suppose that you are in your first year at university majoring in either economics or finance and you plan to find a job in the financial sector after you graduate. However, the economy is in a severe recession and the unemployment rate is the highest in your lifetime. Sizeable layoffs in the financial sector have occurred. Should you change your major? Should you still consider a job in the financial sector? As you read the chapter, see if you can answer these questions. You can check your answers against those we provide on page 194 at the end of this chapter.

SOURCE: Murdoch, Scott, ‘Skills shortage, wages pushing prices higher’, The Australian, April 30th 2007, News Limited.

• The role of entrepreneurs and the market in China’s economic growth. (Chapter 6). • How does unemployment affect Woolworths? (Chapter 7). • How is Canon affected by economic booms and contractions? (Chapter 10). • Rising interest rates and the housing industry. (Chapter 12). • How do exchange rates affect Australian universities? (Chapter 14).

An Inside Look is a two-page feature that shows students how to apply the concepts of a chapter to the analysis of a news article. Articles are from sources such as The Sydney Morning Herald, The Age, The Financial Review, The Australian and sometimes overseas news articles. The An Inside Look feature presents analysis of the article, graphs and critical thinking questions. 290

PART 5 SHORT-RUN FLUCTUATIONS

CHAPTER 10 AGGREGATE DEMAND AND AGGREGATE SUPPLY ANALYSIS

A N I NS I DE LO O K G HERALD SYDNEY MORNIN

13 AUGUST 2013

JB Hi-Fi’s $116m slump

profit defies

By Eli Greenblat

s and gadgets, pipeline of product continue JB Hi-Fi said a new consoles, should tum that took such as TVs and gaming electronics ed sales momen growth in the wider for fiscal A Strong and sustain JB Hi-Fi defy the to drive interest and as has helped now tipping sales hold after Christm sector to post its market, with the retailer and 8 per cent on rn across the retail between 6 per cent by rise general downtu to years. 2014 growth in three $116.4 million, the previous year. first full-year profit at a time when 11.2 per cent to up comes in profit, growth The raised comparable sales s downturn as B The positive slightly by lower s, suffering an earning busines are was held back doing of retailers ics and home most a jump in the cost to spend. The electron Work Australia New Zealand and consumers refuse retailer to report bills driven by Fair was the first large namely higher wages as fatter rent bills. entertainment group expected to surprise as well 5.8 per cent full-year earnings, but not all are award increases ance, built on a upside. The full-year perform billion, surpassed analysts’ said the the market on the Simotas $3.308 Michael to analyst d the retailer, lift in sales Deutsche Bank better 2014 the market rewarde statement implied cent higher, expectations and positive outlook was expecting, more than 4 per than the market sending its shares or 3.2 per cent, at $19.12—a recently he financial year sales 60¢, performing well before closing up levels. h with the stock nt althoug in the price at current stateme largely 27-month high. outlook was the tions due to news in believed this ahead of our expecta There was also good that hit JB Hi-Fi ‘Sales were slightly a pick-up in sales gross margin was from new stores, for investors, with new financial year, said. higher contribution pushing into the s was higher,’ he stores in January of doing busines 8 per cent and likein line, but cost for July touching with sales growth cent. per 2.2 up for-like growth

Key points in the article The Australian economy experienced economic recovery in the late 2000s following the GFC. Retail stores experienced growth but at a rate much slower than before the GFC, although stronger growth rates were achieved by the telecommunications, computers and other electronics retailers. As the article discusses, in particular electronics stores such as JB Hi-Fi experienced rapid growth in sales. This was partly due to the ability of JB Hi-Fi to move into new products.

Analysing the news A After the shock of the GFC, which led to an economic contraction in Australia and a short period of negative economic growth, the economy began to recover in the second half of 2009 and onwards. Economic growth was positive, with an improvement in consumer confidence leading to renewed retail spending, particularly for electronics products such as those sold by JB Hi-Fi. Investment spending also grew, in large part due to the  minerals and energy boom. As shown in Figure 1, the economic recovery shifted the AD curve to the right, from AD1 to AD2. At the same time, investment spending increased economic capacity, thereby shifting both the short-run and long-run aggregate supply curves to the right. Australian retailing firms also expanded supply by using more innovative management techniques, and taking advantage of lower wholesale prices dues to low production costs of suppliers in Asia (particularly China) and a higher value of the Australian dollar.

FIGURE 1 A RETURN TO A HEALTHIER RATE OF ECONOMIC GROWTH IN AUSTRALIA FOLLOWING THE GFC

Price level

LRAS1

LRAS2 SRAS1 SRAS2

SYDNEY

MORNING HERALD

P2

AD2

AD1

SOURCE: Eli Greenblat (2013), ‘JB Hi-Fi’s $116m profit defies slump’, The Sydney Morning Herald, 13 August, at , viewed 15 January 2014.

B The increased aggregate demand included the rapid growth in demand for the types of goods sold by JB Hi-Fi, including computers, mobile phones, sound systems, DVDs and video games. However, by late 2010 and into 2014, it was apparent that although the Australian economy was recovering, consumers were far more cautious with their spending than they had been during the 17-year period of continual economic growth in the lead-up to the GFC. Not all parts of the economy were benefiting from the recovery equally, and the increase in aggregate demand was not as rapid as some analysts had originally anticipated. The article points out that while retailers like JB Hi-Fi were recording large increases in profits during the second half of 2013, others were not expected to have such positive profit increases. Therefore, while the economy appeared briefly to be close to, or at, its long-run equilibrium as depicted in Figure 1 in the early stages of its GFC recovery, after 2010 the economy was once again in equilibrium below potential GDP. Thinking critically 1 Explain whether investment spending is likely to increase more rapidly in a country with a rapidly growing population than in a country with a slowly growing population. Does your answer depend on whether the country is a high-income industrial country or a low-income developing country? 2 In 2013 the Australian dollar was high compared to the historical average. Would a fall in the value of the Australian dollar be good news or bad news for companies such as JB Hi-Fi?

Here are some examples of the articles features in An Inside Look: • ‘Manufacturers jump ship from China to Cambodia’, The Sydney Morning Herald (Chapter 6). • ‘Singapore’s economy grew by 3.7% in 2013, says PM Lee’, Asean Affairs (Chapter 9). • ‘JB Hi-Fi’s $116m profit defies slump’, The Sydney Morning Herald (Chapter 10).

B A

P1

0

291

Y1

Y2

Real GDP

• ‘Bank of England holds record low rates’, SBS News (Chapter 12).

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SPECIAL FEATURES

ECONOMICS IN YOUR LIFE After the chapter-opening real-world case, we have added a personal dimension to the chapter opener, with a new feature titled Economics in Your Life, which asks students to consider how economics affects their own lives. This feature piques the interest of students and emphasises the connection between the material they are learning and their own experiences.

HOW CANON RODE THE ECONOMIC CYCLE CANON AUSTRALIA WAS established in 1978 and is a market-leading supplier of consumer and business imaging products and services. During Australia’s extended period of economic growth, from the early 1990s until 2007, Canon, like other producers of digital devices, experienced huge growth in demand. This came partly from households which, with rising incomes, showed an almost insatiable appetite for these goods. Demand also grew from businesses because as their own output expanded they needed more capital, including computer screens, faxes and photocopiers to meet extra consumer demand and to cut production costs through the use of the latest technologies. Sales of digital devices grew much faster than sales for the retail industry sector as a whole—an average of almost nine times as fast. When the effects of the global financial crisis (GFC) hit the Australian economy in 2008, which led to an economic contraction, there were expectations that demand for digital devices would fall as uncertainty about employment reduced expected income. Flat-screen TVs and DVD recorders were thought to be luxury items and therefore it was anticipated that demand would fall as expected income fell. However, this proved not to be the case. While price falls of many electronic goods contributed to rising demand, there were other important contributing factors during the economic contraction. While households cut their expenditure on luxuries such as overseas holidays, white goods and going out, they increased expenditure on home entertainment systems, quality meals cooked at home and bottled wine. There was a perceived need to cut back on big expenditure items but households were still ‘cashed up’ enough to enjoy consuming less expensive luxuries at home. In the post-GFC period, although retail sales recovered, they did not return to their previous high rate of growth. In contrast demand for electronic goods and devices continued to grow very strongly. During this period, although investment in industries other than mining was slow to pick up, investment by businesses in computers, peripherals, electrical and electronic equipment continued to grow strongly. What this demonstrates is that economic contractions and expansions affect different industries in very different ways. While the sales of many electronic items remained firm during the 2008–2009 economic downturn, industries such as tourism, transport, restaurants and motor vehicles suffered from falling sales and significant losses, with some firms ending up in bankruptcy. The subsequent recovery was also uneven, with some firms going out of business and others significantly restructuring.

At the end of the chapter, we use the chapter concepts to answer the questions asked at the beginning of the chapter.

10

Another world of close

Canon Australia Pty Ltd.

ECONOMICS IN YOUR LIFE 288

IS YOUR EMPLOYER LIKELY TO REDUCE YOUR PAY DURING A RECESSION?

PART 5 SHORT-RUN FLUCTUATIONS

Price level

LRAS1973

LRAS1974 SRAS1974

Suppose that you have worked as a barista for a local coffee house for two years. From on-the-job training and experience, you have honed your coffeemaking skills and mastered the perfect latte. Then the economy moves into a recession and sales at the coffee house decline. Is the owner of the coffee house likely to cut the prices of lattes and other drinks? Suppose the owner asks to meet with you to discuss your wages for next year. Is the owner likely to cut your pay? As you read the chapter, see if you can answer these questions. You can check your answers against those we provide on page 288 at the end of this chapter.

SRAS1973

AD

25.0 21.5

0

$341.9 342.8 344.0

350.0

Real GDP (billions of dollars)

STEP 3: Explain your graph. LRAS1973 and LRAS1974 are at the levels of potential GDP for each year. Macroeconomic equilibrium

for 1973 occurs where the AD curve intersects the SRAS1973 curve, with real GDP of $342.8 billion and a price level of 21.5. Macroeconomic equilibrium for 1974 occurs where the AD curve intersects the SRAS1974 curve, with real GDP of $341.9 billion and a price level of 25.0.

The following are examples of the topics we cover in the Economics in Your Life feature: • Has the rise of China affected your job opportunities? (Chapter 6). • Should you change your career plans if you graduate during a recession? (Chapter 7).

[ YOUR TURN ✱

For more practice do related problem 4.6 on page 295 at the end of this chapter.

ECONOMICS IN YOUR LIFE (continued from page 267)

IS YOUR EMPLOYER LIKELY TO REDUCE YOUR PAY DURING A RECESSION? At the beginning of this chapter, we asked you to consider whether during a recession your employer is likely to reduce your pay and cut the prices of the products he or she sells. In this chapter, we saw that even during a recession, the price level rarely falls. In fact, in Australia, the general price level has not fallen for a sustained period since the early twentieth century. A typical firm is therefore unlikely to cut its prices during a recession. So the owner of the coffee house you work in will probably not cut the price of lattes unless sales have declined drastically. We also saw that most firms are reluctant to cut wages because this can have a negative effect on worker morale and productivity; they instead may not increase wages by as much as they otherwise would have. Given that you are a highly skilled barista, your employer is particularly unlikely to cut your wages for fear that you might quit and work for a competitor.

• What would you do with $500? (Chapter 13). • The Australian dollar and your new car price (Chapter 14).

CHAPTER 11 MONEY, BANKS AND THE RESERVE BANK OF AUSTRALIA

303

it to buy what they wanted. When money is available families will be less likely to produce everything or nearly everything they need themselves and are more likely to specialise. Most people in modern economies are highly specialised. They do only one thing—work as a nurse, an accountant or an engineer—and use the money they earn to buy everything else they need. As we discussed in Chapter 2, people become much more productive by specialising because they can pursue their comparative advantage. The high income levels in modern economies are based on the specialisation that money makes possible. We can now answer the question ‘Why do we need money?’. By making exchange easier, money allows for specialisation and higher productivity.

MONEY IN A WORLD WAR II PRISONER OF WAR CAMP

M

Prisoners set up small businesses in the camp, using cigarettes for money: ‘There was a coffee stall owner who sold tea, coffee or cocoa at two cigarettes a cup, buying his raw materials at market prices and hiring labour to gather fuel and to stoke; he actually enjoyed the services of a chartered accountant at one stage.’ Even a restaurant was organised ‘where food and hot drinks were sold while a band…performed.’

C

A K I N G THE

R.A. Radford has described his experiences as a captured British soldier in a German prisoner of war camp during World War II. At first, the prisoners traded the goods they received in packages from the Red Cross or from relatives at home on a barter basis, but the usual inefficiencies of barter led the prisoners to begin using cigarettes as money. Cigarettes were included in the Red Cross packages. According to Radford, ‘Everyone, including non-smokers, was willing to sell for cigarettes, using them to buy at another time and place. Cigarettes became the normal currency.’ Even a labour market developed: ‘Laundrymen advertised at two cigarettes a garment. Battle-dress [uniform] was scrubbed and pressed and a pair of trousers lent for the interim period for twelve…Odd tailoring and other jobs similarly had their prices.’

Reg Speller / Stringer / Getty Images

In January 1945, near the end of the war, the Red Cross ration of cigarettes was During World War II cigarettes were used as money in some prisoner of war camps eliminated. Given that some of the prisoners were heavy smokers, most of the rest of the cigarette money disappeared from circulation—a disadvantage of this particular commodity money—and the camp went back to barter trading until it was liberated by the US 30th Infantry Division in April 1945. SOURCE: R.A. Radford (1945), ‘The economic organization of a P.O.W. camp’, Economica, Vol. 12, No. 48, pp. 189–201.

The functions of money Anything used as money—whether rum, a seashell or a $10 dollar note—should fulfil the following four functions: 1 Medium of exchange 2 Unit of account 3 Store of value 4 Standard of deferred payment

Medium of exchange Money serves as a medium of exchange when sellers are willing to accept it in exchange for goods or services. When the local supermarket accepts your $10 note in exchange for bread

11.1

ONNECTION

MAKING THE CONNECTION In each chapter Making the Connection features present relevant, stimulating and provocative cases from various countries, including applications to businesses and other significant world economic events or policy issues. These features link the concepts and models covered in the chapter with a real-world application. Here are some examples of the Making the Connection features: • Why did the global financial crisis occur? (Chapter 5). • Does technological change create unemployment? (Chapter 10). • Coca-Cola dries up as the Zimbabwe currency no longer serves as money. (Chapter 11). • Why does the share market care about monetary policy? (Chapter 12).

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SPECIAL FEATURES

xi

SOLVED PROBLEMS Many students have great difficulty handling applied economics problems. We help students overcome this hurdle by including worked-out problems tied to select chapter learning objectives and the associated quantitative information. Our goals are to keep students focused on the main ideas of each chapter and to give students a model of how to solve an economic problem by breaking it down step by step. Additional exercises in the end-of-chapter material are tied to every Solved Problem.

276

PART 5 SHORT-RUN FLUCTUATIONS

SOLVED PROBLEM 10.1 MOVEMENTS ALONG THE AGGREGATE DEMAND CURVE VERSUS SHIFTS OF THE AGGREGATE DEMAND CURVE Suppose the current price level is 110 and the current level of real GDP is $1120 billion. Illustrate each of the following situations on a graph: 1 2

The price level rises to 115, while all other variables remain constant. Firms become pessimistic and reduce their investment. Assume that the price level remains constant.

Solving the problem STEP 1: Review the chapter material. This problem is about understanding the difference between movements along an AD curve

and shifts of an AD curve, so you may want to review the section ‘Shifts of the AD curve versus movements along it’, which begins on page xxx. STEP 2: To answer question 1 draw a graph showing a movement along the aggregate demand curve. Because there will be a

movement along the AD curve, but no shift of the AD curve, your graph should look like the following: Price level

115

110

AD

0

$1100

Real GDP (billions of dollars)

1120

We don’t have enough information to be certain what the new level of real GDP will be. We only know that it will be less than the initial level of $1120 billion—the graph shows the value as $1100 billion. STEP 3: To answer question 2 draw a graph showing a shift of the AD curve. We know that the AD curve will shift to the left, but we

don’t have enough information to know how far to the left it will shift. Let’s assume the shift is $30 billion. In that case your graph should look like the following: Price level

110

AD1 AD2 0

$1090

Real GDP (billions of dollars)

1120

The graph shows a parallel shift in the AD curve, so that at every price level the quantity of real GDP demanded declines by $30 billion. For example, at a price level of 110, the quantity of real GDP demanded declines from $1120 billion to $1090 billion.

270

PART 5 SHORT-RUN FLUCTUATIONS

The international-trade effect: how a change in the price level affects net exports Net exports equal spending by foreign households and firms on goods and services produced in Australia minus spending by Australian households and firms on goods and services produced in other countries. If the price level in Australia rises relative to the price levels in other countries, Australian exports will become relatively less profitable to produce compared to those produced for the domestic market, and foreign imports will become relatively less expensive. Some consumers in foreign countries will shift from buying Australian products to buying domestic products. Some Australian firms will also shift from producing export goods to producing goods for the Australian market. Australian imports will rise and export earnings will fall, causing net exports to fall. A lower price level in Australia relative to other countries has the reverse effect, causing net exports to rise. This impact of the price level on net exports is known as the international-trade effect, and is a third reason why the AD curve is downward sloping.

DON’T LET THIS HAPPEN TO YOU

Be clear why the aggregate demand curve is downward sloping The aggregate demand curve and the demand curve for a single product are both downward sloping—but for different reasons. When we draw a demand curve for a single product, such as apples, we know that it will slope downwards because as the price of apples rises apples become more expensive relative to other products—such as oranges— and consumers will buy fewer apples and more of the other products. In other words, consumers substitute other products for apples. When the overall price level in the economy rises, the prices of many domestically produced goods and services are rising, so consumers have few or no other domestic products to which they can switch. A lower price level raises the real value of household wealth (which increases consumption), lowers interest rates (which increases investment and consumption) and increases earnings from Australian exports and decreases foreign imports as they become more expensive (which increases net exports).

[ YOUR TURN ✱

Test your understanding by doing related problem 1.6 on page 292 at the end of this chapter.

Shifts of the aggregate demand curve versus movements along it An important point to remember is that the AD curve tells us the relationship between the price level and the quantity of real GDP demanded, holding everything else constant. If the price level changes, but other variables that affect the willingness of households, firms and the government to spend are unchanged, the economy will move up or down a stationary AD curve. If any variable other than the price level changes, the AD curve will shift. For example, if government purchases increase and the price level remains unchanged, the AD curve will shift to the right at every price level. Or, if firms become pessimistic about the future profitability of investment and cut back spending on factories and machinery, the AD curve will shift to the left, ceteris paribus.

DON’T LET THIS HAPPEN TO YOU We know from many years of teaching which concepts students find most difficult. Each chapter contains a box feature called Don’t Let This Happen to You that alerts students to the most common pitfalls in that chapter’s material. We follow up with a related question in the end-of-chapter Problems and Applications section.

GRAPHS AND SUMMARY TABLES Graphs are an indispensable part of principles of economics courses but are a major stumbling block for many students. Every chapter includes end-of-chapter problems that require students to draw, read and interpret graphs. Interactive graphing exercises can be found on the book’s supporting MyEconLab website. We use four devices to help students read and interpret graphs: 1. Detailed captions 2. Boxed notes 3. Colour-coded curves 4. Summary tables with graphs

280

CHAPTER 10 AGGREGATE DEMAND AND AGGREGATE SUPPLY ANALYSIS

PART 5 SHORT-RUN FLUCTUATIONS

281

Technological change FIGURE 10.3

Price level

How expectations of the future price level affect the short-run aggregate supply The SRAS curve shifts to reflect workers’ and firms’ expectations of future prices. 1 If workers and firms expect the price level to rise by 3 per cent from 100 to 103, they will adjust their wages and prices by that amount. Holding constant all other variables that affect aggregate supply, the SRAS curve will shift to the left. If workers and firms expect the price level to be lower in the future, the SRAS curve will shift to the right 2

1. If firms and workers expect the price level to be 3% higher in year 2 than in year 1 . . .

SRASyear 2 SRASyear 1

103 2. . . . the SRAS curve will shift to the left to reflect worker and firm expectations of rising costs.

100

0

$1000

Real GDP (billions of dollars)

contract. The higher wages the workers receive under the new contract will increase the company’s costs and result in the company needing to receive higher prices to produce the same level of output. If workers and firms across the economy are adjusting to the price level being higher than expected, the SRAS curve will shift to the left. If they are adjusting to the price level being lower than expected, the SRAS curve will shift to the right.

Unexpected changes in the price of an important natural resource

Supply shock An unexpected event that causes the short-run aggregate supply curve to shift.

As technological change takes place the productivity of workers and machinery increases, which means that firms can produce more goods and services with the same amount of labour and machinery. This improvement reduces the firms’ costs of production and therefore allows them to produce more output at every price level. As a result, the short-run and longrun aggregate supply curves shift to the right. In Australian agriculture extreme weather conditions, such as droughts, have also been important in reducing productivity of land, while favourable climatic conditions have improved the productivity of land in much the same way as technological change. Table 10.2 summarises the most important variables that cause the SRAS curve to shift. It is important to note that the table shows the shift in the SRAS curve which results from an increase in each of the variables. A decrease in these variables would cause the SRAS curve to shift in the opposite direction.

Unexpected increases or decreases in the price of an important natural resource can cause firms’ costs to be different from expected costs. Oil prices can be particularly volatile. Some firms use oil in the production process. Other firms use products, such as plastics, that are made from oil. If oil prices rise unexpectedly the costs of production will rise for these firms. Some utilities also burn oil to generate electricity, so electricity prices will rise. Rising oil prices lead to rising petrol prices, which increases transportation costs for many firms. Because firms face rising costs they will only supply the same level of output at higher prices, and the SRAS curve will shift to the left. An unexpected event that causes the SRAS curve to shift is known as a supply shock. Supply shocks are often caused by unexpected increases or decreases in the prices of important natural resources. Because the Australian economy has experienced inflation in almost every year since the 1930s, workers and firms always expect next year’s price level to be higher than this year’s price level. Holding everything else constant, this will cause the SRAS curve to shift to the left. But everything else is not constant, because every year the Australian labour force and the Australian capital stock expand and changes in technology occur, which cause the SRAS curve to shift to the right. Whether in any particular year the SRAS curve shifts to the left or to the right depends on which of these variables has the largest impact during that year.

Variables that shift the short-run and long-run aggregate supply curves Increases in the labour force and in the capital stock and resources A firm will supply more output at every price if it has more workers and more physical capital. The same is true of the economy as a whole. So as the labour force and the capital stock grow, firms will supply more output at every price level, and the short-run and long-run aggregate supply curves will shift to the right. In Japan the population is ageing and the labour force is decreasing. Holding other variables constant, this decrease in the labour force causes the shortrun and long-run aggregate supply curves in Japan to shift to the left. With respect to resources, historically for Australia new discoveries of minerals and energy have also shifted the short-run and long-run aggregate supply curves to the right.

TABLE 10.2

Variables that shift the short-run aggregate supply curve

AN INCREASE IN … the labour force or the capital stock or resources

SHIFTS THE SHORT-RUN AGGREGATE SUPPLY CURVE … Price level

0

productivity

Price level

0

the expected future price level

Price level

workers and firms adjusting to having previously underestimated the price level

Price level

0

0

the expected price of an important natural resource

Price level

0

SRAS1

SRAS2

BECAUSE … more output can be produced at every price level

Real GDP SRAS1

SRAS2

costs of producing output fall

Real GDP SRAS2

SRAS1

costs of producing output rise

Real GDP SRAS2

SRAS1

workers and firms increase wages and prices

Real GDP SRAS2

SRAS1

costs of producing output rise

Real GDP

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SPECIAL FEATURES

REVIEW QUESTIONS AND PROBLEMS AND APPLICATIONS—GROUPED BY LEARNING OBJECTIVE TO IMPROVE ASSESSMENT All the end-of-chapter material—Summary, Review Questions and Problems and Applications—is grouped under learning objectives. This is a new feature of the third edition. The goals of this organisation are to make it easier for instructors to assign problems based on learning objectives, both in the book and in MyEconLab, and to help students efficiently review material that they find difficult. If students have difficulty with a particular learning objective, an instructor can easily identify which end-of-chapter questions and problems support that objective and assign them as homework or discuss them in class. Similar exercises to every exercise in a chapter’s Problems and Applications section are available in MyEconLab. Using MyEconLab, students can complete these and many other exercises online, get tutorial help and receive instant feedback and assistance on exercises they answer incorrectly. Also, student learning will be enhanced by having the summary material and problems grouped together by learning objective, which will allow students to focus on the parts of the chapter they found most challenging. Each major section of the chapter, paired with a learning objective, usually has at least two review questions and three problems. As in the previous editions, we include one or more end-of-chapter problems that test students’ understanding of the content presented in the Solved Problem and Don’t Let This Happen to You special features in the chapter. Instructors can cover a feature in class and assign the corresponding problem for homework. 218

PART 4 UNEMPLOYMENT AND INFLATION

CHAPTER 8 INFLATION

CHAPTER SUMMARY AND PROBLEMS

LEARNING OBJECTIVE 8.2

KEY TERMS aggregate demand aggregate supply consumer price index (CPI) cost-push inflation deflation

214 214 205 214 214

demand-pull inflation hyperinflation inflation inflation rate menu costs

214 212 204 204 212

nominal interest rate price level producer price index (PPI) real interest rate

209 204 207 209

LEARNING OBJECTIVE 8.1

2.1

Define price level and inflation rate, and understand how they are calculated.

SUMMARY The price level measures the average prices of goods and services. The inflation rate is equal to the percentage change in the price level from one year to the next. The Australian Bureau of Statistics compiles statistics on three different measures of the price level: the consumer price index (CPI), the GDP deflator and the producer price index (PPI). The consumer price index is an average of the prices of goods and services purchased by the typical urban family. Changes in the CPI are the best measure of changes in the cost of living as experienced by the typical household. Biases in the construction of the CPI cause changes in it to overstate the true inflation rate. The producer price index (PPI) is an average of prices received by producers of goods and services at all stages of production.

1.7

1.8

REVIEW QUESTIONS 1.1 1.2

1.3

1.4

1.5

Briefly describe the major measures of the price level. Which measure is used most frequently in Australia to measure changes in the cost of living? Explain the difference and the link between the price level and the rate of inflation. What potential biases exist in calculating the consumer price index? What steps has the Australian Bureau of Statistics taken to reduce the size of the biases? What is the difference between the consumer price index and the producer price index?

PROBLEMS AND APPLICATIONS 1.6

[Related to Don’t let this happen to you] Briefly explain whether you agree or disagree with the following statement: ‘I don’t believe the government price statistics. The CPI for 2014 was 106, but I know that the inflation rate couldn’t have been as high as 6 per cent in 2014.’

Use price indexes to adjust for the effects of inflation.

SUMMARY

2.4

Price indexes are designed to measure changes in the price level over time, not the absolute level of prices. To correct for the effects of inflation we can divide a nominal variable by a price index and multiply by 100 to obtain a real variable. The real variable will be measured in dollars of the base year for the price index.

REVIEW QUESTIONS

MEASURING INFLATION, PAGES 204–208

1.9

At times, Apple has introduced a new version of its iPhone, with new and improved features, but sold it at the same or similar price as the previous model. How does the introduction of a new, improved iPhone sold at a similar price as an earlier model affect the consumer price index? In each of the following explain whether you think the CPI would overestimate, underestimate or accurately estimate the general price level, assuming all else remains constant. a A severe drought reduces the production of tropical fruit, causing the price of tropical fruit to rise significantly. b Consumers switch to buying front-loading clothes washing machines instead of the less water-efficient top-loading washing machines, even though frontloading washing machines are more expensive. c New technology significantly decreases the price of 3D televisions. Consider a simple economy that produces only three products. Use the information in the following table to calculate the inflation rate for 2015 as measured by the consumer price index.

DVDs 1.10

What is the difference between a nominal variable and a real variable? Briefly explain how you can use data on nominal wages for 2005 to 2015 and data on the consumer price index for the same years to calculate the real wage for these years.

2.5

PROBLEMS AND APPLICATIONS 2.3

[Related to Solved problem 8.1] In 1924, the famous US novelist F. Scott Fitzgerald wrote an article for the widely read US weekly magazine The Saturday Evening Post titled ‘How to live on $36,000 a year’,1 in which he wondered how he and his wife had managed to spend all of that very high income without saving any of it. The CPI in the United States in 1924 was 17, and the CPI in 2013 was 233. What income would a person have needed in 2013 to have had the same purchasing power that Fitzgerald’s $36 000 had in 1924? Be sure to show your calculation.

ANNUAL WAGE RISE, %

3.41%

Private sector

3.46%

Public sector

3.51%

CPI 2.6

2011–2012

All sectors

100.4

2012–2013 5.3% 5.65% 4.46% 102.8

Suppose that James and Frank both retire this year. For his retirement income James will rely on his superannuation,

TOTAL BOX OFFICE RECEIPTS RANKING

FILM

($US)

YEAR RELEASED

CPI3

1

Avatar

$2 783 918 982

2009

214.5

2

Titanic

$2 185 672 302

1997

160.5

3

Marvel’s The Avengers

$1 514 279 547

2012

229.6

4

Harry Potter and the Deathly Hallows: Part II

$1 328 111 219

2011

224.9

2015

5

Iron Man 3

$1 211 992 272

2013

233.0

PRICE

PRICE

PRICE

6

Lord of the Rings: Return of the King

$1 141 408 667

2003

184.0

2

$20.00

$22.00

$25.00

7

Transformers: Dark of the Moon

$1 123 794 076

2011

224.9

4.00

4.20

4.50

8

Skyfall

$1 108 694 081

2012

229.6

6

15.00

15.00

14.00

9

The Dark Knight Rises

$1 079 343 943

2012

229.6

10

Toy Story 3

$1 063 759 456

2010

218.1

21

The Lion King

$952 880 140

1994

148.2

43

ET: The Extra-Terrestrial

$792 965 326

1982

96.5

122

Shrek

$491 812 794

2001

177.1

171

Rain Man

$412 800 000

1988

118.3

187

Raiders of the Lost Ark

$389 925 971

1981

90.9

250

Close Encounters of the Third Kind

$337 700 000

1977

60.6

2012

Hamburgers

2.2

The table at the foot of the page shows the world’s top 10 films of all time up to 2013,2 as measured by box office receipts worldwide, as well as several other films further down the list. The annual average CPI in the United States was 233 in 2013. Use this information and the data in the table to calculate the box office receipts for each film in 2013 dollars. Assume that each film generated all of its box office receipts during the year it was released. Use your results to prepare a new list of the top 10 films based on their earnings in 2013 dollars. [Related to Solved problem 8.1] The following table4 shows the average percentage rises in full-time adult ordinary time earnings during the years 2011–2012 and 2012–2013, and also the CPI for these years (as at June). Use these data to discuss what happened to wages negotiations and wages growth over the period 2011–2012 to 2012–2013.

10

BASE YEAR PRODUCT

Haircuts

QUANTITY

2014

When would you choose to use the consumer price index or the producer price index as a measure of the price level?

219

USING PRICE INDEXES TO ADJUST FOR THE EFFECTS OF INFLATION, PAGES 208–209

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resources for educators and s tudent s SOLUTIONS MANUAL The Solutions Manual, which is now organised by learning objective, includes solutions to all end of chapter review questions, and problems and applications questions in the textbook.

TEST BANK The Test Bank includes over 2000 multiple-choice questions, true/false, short-answer and essay questions. The Test Bank has undergone a full academic technical edit to ensure quality. The Test Bank has been structured by learning objective with questions to support each learning objective in the book. Each test question has been mapped to AACSB standards in addition to being annotated with the following information: • Level of difficulty: 1 for straight recall, 2 for some analysis, 3 for complex analysis • Type: multiple-choice, true/false, short-answer, essay • Topic: the term or concept the question supports • Learning objective

TESTGEN This computerised package allows instructors to customise, save and generate classroom tests. The test program permits instructors to edit, add or delete questions from the test banks; edit existing graphics and create new graphics; analyse test results; and organise a database of tests and student results. This software allows for extensive flexibility and ease of use. It provides many options for organising and displaying tests, along with search and sort features.

POWERPOINT® LECTURE PRESENTATION The Australian authors have prepared a comprehensive set of PowerPoint® slides that cover the text’s key concepts, and include graphs, tables and equations from the textbook. The PowerPoint slides also include worked examples.

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RESOURCES FOR EDUCATORS AND STUDENTS

MyEconLab for Hubbard/Garnett/Lewis/O’Brien Macroeconomics, 3rd edition

A guided tour for students and educators

Auto-generated tests and assignments Each MyLab comes with preloaded assignments, all of which are automatically graded and include selected end-of-chapter questions and problems from the textbook.

Unlimited Practice Many Study Plan and Instructor-assigned exercises contain algorithms to ensure students get as much practice as they need. As students work though Study Plan or Homework exercises, instant feedback and tutorial resources guide them towards understanding.

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RESOURCES FOR EDUCATORS AND STUDENTS

MyEconLab www.pearson.com.au/hubbard3 Learning resources To further reinforce understanding, Study Plan and Homework problems link to additional learning resources. • Step-by-step Guided Solutions • Graphing Tool • eText linked to sections for all Study Plan questions

Study plan A Study Plan is generated from each student’s results on quizzes and tests. Students can clearly see which topics they have mastered and, more importantly, which they need to work on.

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reviewers Assistant Professor Ishita Chatterjee, University of Western Australia Mark Buchanek, Deakin University Peter Schuwalow, Monash University Andrea Henderson, RMIT University

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brief content s PART 1 INTRODUCTION CHAPTER 1

Economics: foundations and models

2

CHAPTER 1

APPENDIX Using graphs and formulae

21

CHAPTER 2

Choices and trade-offs in the market

32

PART 2 HOW THE MARKET WORKS CHAPTER 3

Where prices come from: the interaction of demand and supply

56

PART 3 MACROECONOMIC FOUNDATIONS AND ECONOMIC GROWTH CHAPTER 4

GDP: Measuring total production, income and economic growth

88

CHAPTER 5

Economic growth, the financial system and business cycles

110

CHAPTER 6

Long-run economics growth: sources and policies

142

PART 4 UNEMPLOYMENT AND INFLATION CHAPTER 7

Unemployment

174

CHAPTER 8

Inflation

202

PART 5 SHORT-RUN FLUCTUATIONS CHAPTER 9

Aggregate expenditure and output in the short run

CHAPTER 9

APPENDIX The algebra of macroeconomic equilibrium

224 263

CHAPTER 10 Aggregate demand and aggregate supply analysis

266

CHAPTER 10 APPENDIX Macroeconomic schools of thought

296

PART 6 MONETARY AND FISCAL POLICY CHAPTER 11 Money, banks and the Reserve Bank of Australia

300

CHAPTER 12 Monetary policy

328

CHAPTER 13 Fiscal policy

358

CHAPTER 13 APPENDIX 1 Is there a short-run trade-off between unemployment and inflation?

390

CHAPTER 13 APPENDIX 2 A closer look at the multiplier

396

PART 7 THE INTERNATIONAL ECONOMY CHAPTER 14 Macroeconomics in an open economy

402

CHAPTER 15 The international financial system

434

CHAPTER 15 APPENDIX The gold standard and the Bretton Woods System

454

Glossary Index

460 465

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det ailed content s Preface The foundation Special features Resources for educators and students Reviewers

PART 1 INTRODUCTION

vi vii ix xiii xvi

1

CHAPTER 1

Economics: foundations and models

2

THREE KEY ECONOMIC IDEAS

4

People are rational People respond to economic incentives Optimal decisions are made at the margin

4 5 5

• Solved problem 1.1

Apple makes a decision at the margin SCARCITY, TRADE-OFFS AND THE ECONOMIC PROBLEM THAT EVERY SOCIETY MUST SOLVE

What goods and services will be produced? How will the goods and services be produced? Who will receive the goods and services produced? Centrally planned economies versus market economies The modern ‘mixed’ economy Efficiency and equity ECONOMIC MODELS

The role of assumptions in economic models Forming and testing hypotheses in economic models Normative and positive analysis

6 6

7 7 7 7 8 9 10

10 10 11

• Don’t let this happen to you

Don’t confuse positive analysis with normative analysis Economics as a social science

12 12

• Making the connection 1.1

Economics doesn’t always mean good politics

12

MICROECONOMICS AND MACROECONOMICS CONCLUSION

13 14

15 17

Graphs of one variable Graphs of two variables Formulae APPENDIX PROBLEMS

PRODUCTION POSSIBILITY FRONTIERS AND REAL-WORLD TRADE-OFFS

Graphing the production possibility frontier Increasing marginal opportunity costs

32 34

34 35

• Making the connection 2.1

Trade-offs and emergency aid relief Economic growth

36 37

COMPARATIVE ADVANTAGE AND TRADE

38

Specialisation and gains from trade 38 Absolute advantage versus comparative advantage 39 • Don’t let this happen to you

Don’t confuse absolute advantage and comparative advantage Comparative advantage and the gains from trade

40 40

• Solved problem 2.1

Comparative advantage and the gains from trade 41 THE MARKET SYSTEM

The gains from free markets The market mechanism

42

42 43

• Making the connection 2.2

Story of the market system in action: I, pencil The role of the entrepreneur THE LEGAL BASIS OF A SUCCESSFUL MARKET SYSTEM

Protection of private property

43 44 45

45

• Making the connection 2.3

Illegal downloads from cyberspace Enforcement of contracts and property rights CONCLUSION

46 47 47

• An inside look

Expansion and production mix at BMW CHAPTER SUMMARY AND PROBLEMS

PART 2 HOW THE MARKET WORKS

48 50

55

Where prices come from: the interaction of demand and supply 56 THE DEMAND SIDE OF THE MARKET

CHAPTER 1 APPENDIX

Using graphs and formulae

Choices and trade-offs in the market

CHAPTER 3

• An inside look

The case for ‘offshoring’ is quite clear: it works CHAPTER SUMMARY AND PROBLEMS

CHAPTER 2

21 22 22 27 29

58

Demand schedules and demand curves 58 The law of demand 59 Holding everything else constant: the ceteris paribus condition 59 What explains the law of demand? 59 Variables that shift market demand 60

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DETAILED CONTENTS

• Making the connection 3.1

The ageing of the baby boom generation A change in demand versus a change in quantity demanded THE SUPPLY SIDE OF THE MARKET

Supply schedules and supply curves The law of supply Variables that shift supply A change in supply versus a change in quantity supplied

• Solved problem 4.1

62 63 64

64 64 65 67

MARKET EQUILIBRIUM: PUTTING DEMAND AND SUPPLY TOGETHER

68

How markets eliminate surpluses and shortages Demand and supply both count Shifts in a curve versus movements along a curve

68 69 70

THE EFFECT OF DEMAND AND SUPPLY SHIFTS ON EQUILIBRIUM

CONCLUSION

PART 3 MACROECONOMIC FOUNDATIONS AND ECONOMIC GROWTH

DOES GDP MEASURE WHAT WE WANT IT TO MEASURE?

Shortcomings in GDP as a measure of total production Shortcomings of GDP as a measure of wellbeing

93

93 95

96 96 96

97 98

How the underground economy hurts developing countries 99 How else can we measure economic wellbeing? 100 REAL GDP VERSUS NOMINAL GDP

Calculating real GDP The GDP deflator CONCLUSION

101

101 102

102 103

• An inside look

74

Can we measure happiness? CHAPTER SUMMARY AND PROBLEMS

104 106

CHAPTER 5

75 77

• An inside look

PC sales plunge as consumers look to tablets, smartphones CHAPTER SUMMARY AND PROBLEMS

Remember what economists mean by ‘investment’ An equation for GDP and some actual values

CALCULATING THE ECONOMIC GROWTH RATE

72

92

• Don’t let this happen to you

• Making the connection 4.2

• Solved problem 3.2

Demand and supply both count: the Australian housing market

Production, income and the circular-flow diagram Components of GDP

70 71 71 72

• Making the connection 3.2

The falling price of blu-ray players

METHODS OF MEASURING GROSS DOMESTIC PRODUCT

• Making the connection 4.1

• Solved problem 3.1

Demand and supply both count: pharmacists and accountants

Calculating GDP

70

• Don’t let this happen to you

Remember: a change in a good’s price does not cause the demand or supply curve to shift The effect of shifts in supply on equilibrium The effect of shifts in demand on equilibrium The effect of shifts in demand and supply over time

xix

78 80

87

Economic growth, the financial system and business cycles LONG-RUN ECONOMIC GROWTH IS THE KEY TO RISING LIVING STANDARDS

110 112

• Making the connection 5.1

The connection between economic prosperity and health Calculating growth rates and the rule of 70 What determines the rate of long-run economic growth?

114 115 115

• Solved problem 5.1

The role of technological change in growth

CHAPTER 4

GDP: Measuring total production, income and economic growth GROSS DOMESTIC PRODUCT MEASURES TOTAL PRODUCTION

Measuring total production: gross domestic product Measuring GDP using the value-added method Other measures of total production and total income

117

• Making the connection 5.2

88 90

91 91 92

What explains rapid economic growth in Botswana? Potential GDP SAVING, INVESTMENT AND THE FINANCIAL SYSTEM

An overview of the financial system The macroeconomics of saving and investment The market for loanable funds

117 118 119

120 121 122

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DETAILED CONTENTS

New growth theory Joseph Schumpeter and creative destruction

• Making the connection 5.3

Ebenezer Scrooge: accidental promoter of economic growth?

124

• Solved problem 5.2

How would a consumption tax affect saving, investment, the interest rate and economic growth? THE BUSINESS CYCLE

Some basic business cycle definitions What happens during the business cycle

126 127

127 128

• Don’t let this happen to you

Don’t confuse short-run fluctuations with long-run trends

131

• Making the connection 5.4

Why did the global financial crisis occur? 133 Why are business cycle fluctuations less severe? 134 CONCLUSION

135

• An inside look

Industrial downturn CHAPTER SUMMARY AND PROBLEMS

136 138

CHAPTER 6

Long-run economic growth: sources and policies

142

ECONOMIC GROWTH OVER TIME AND AROUND THE WORLD 144

Economic growth from BC to the present Small differences in growth rates are important

147 148 148 148

149 150 151 151

• Making the connection 6.3

What explains the economic failure of the Soviet Union?

152

• Solved problem 6.1

Using the economic growth model to analyse the failure of the Soviet Union’s economy

156

157 157 158 159

159 159 162 162

• Making the connection 6.4

Globalisation and the spread of technology in Bangladesh CONCLUSION

163 165

• An inside look

Manufacturers jump ship from China to Cambodia CHAPTER SUMMARY AND PROBLEMS

166 168

PART 4 UNEMPLOYMENT AND INFLATION

173

146

• Making the connection 6.2

Technological change The per-worker production function Which is more important for economic growth: more capital or technological change? Technological change: the key to sustaining economic growth

Are the developing countries catching up to the industrialised countries? Why don’t more low-income countries experience rapid growth? The benefits of globalisation Is economic growth good or bad?

MEASURING THE UNEMPLOYMENT RATE AND THE LABOUR FORCE PARTICIPATION RATE

Don’t confuse average annual percentage change with total percentage change 147

WHAT DETERMINES HOW FAST ECONOMIES GROW?

WHY ISN’T THE WHOLE WORLD RICH?

CHAPTER 7

• Don’t let this happen to you

Is income all that matters? Why do growth rates matter? ‘The rich get richer and . . .’

Economic growth and labour productivity in Australia since 1940 What caused the productivity slowdown of the 1970s and 1980s? Can Australia maintain high rates of productivity growth?

144 145

• Making the connection 6.1

Why did the industrial revolution begin in Britain?

ECONOMIC GROWTH IN AUSTRALIA

154 155

Unemployment

174 176

The labour force survey 176 Problems with measuring the unemployment rate 178 • Solved problem 7.1

Correctly interpreting labour force data Trends in labour force participation How long are people usually unemployed?

178 179 180

• Making the connection 7.1

What explains the increase in welfare recipients? Job creation and job destruction THE COSTS OF UNEMPLOYMENT

Costs to the economy Costs to the individual The distribution of unemployment TYPES OF UNEMPLOYMENT

Cyclical unemployment Frictional unemployment and job search Structural unemployment Full employment

182 183 184

184 185 185 186

186 187 188 188

• Making the connection 7.2

153

How should we categorise unemployment in Australia?

189

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DETAILED CONTENTS

PART 5 SHORT-RUN FLUCTUATIONS 223

• Don’t let this happen to you

Don’t confuse ‘ full employment’ with a zero unemployment rate EXPLAINING FRICTIONAL AND STRUCTURAL UNEMPLOYMENT

189 190

Government policies and the unemployment rate 190 Social security and other payments to the unemployed 190 LABOUR MARKET REGULATION AND DEREGULATION

Minimum wages Trade unions Efficiency wages

191

192 192 192

• Making the connection 7.3

Why did Henry Ford pay his workers twice as much as other car manufacturers? CONCLUSION

193 194

• An inside look

Youth jobless rate up in Sydney’s south-west CHAPTER SUMMARY AND PROBLEMS

195 197

CHAPTER 8

Inflation MEASURING INFLATION

The consumer price index Is the CPI accurate?

202 204

205 206

• Don’t let this happen to you

Don’t confuse the price level and the inflation rate The producer price index USING PRICE INDEXES TO ADJUST FOR THE EFFECTS OF INFLATION

207 207 208

• Solved problem 8.1

Calculating real average weekly earnings

208

REAL VERSUS NOMINAL INTEREST RATES DOES INFLATION IMPOSE COSTS ON THE ECONOMY?

209

Inflation affects the distribution of income The problem with anticipated inflation The problem with unanticipated inflation Hyperinflation

211 211 212 212

211

WHAT CAUSES INFLATION? CONCLUSION

213 214 214 215

• An inside look

Why inflation is not the monster it’s thought to be CHAPTER SUMMARY AND PROBLEMS

CHAPTER 9

Aggregate expenditure and output in the short run THE AGGREGATE EXPENDITURE MODEL

Aggregate expenditure The difference between planned investment and actual investment Macroeconomic equilibrium Adjustments to macroeconomic equilibrium DETERMINING THE LEVEL OF AGGREGATE EXPENDITURE IN THE ECONOMY

224 226

226 227 227 227 229

Consumption The relationship between consumption and national income Income, consumption and saving Planned investment Government purchases Net exports

229 232 234 234 236 236

GRAPHING MACROECONOMIC EQUILIBRIUM

239

Showing a contraction or recession on the 45° line diagram The important role of inventories

242 243

• Making the connection 9.1

Business attempts to control inventories, then … and now A numerical example of macroeconomic equilibrium

244 244

• Don’t let this happen to you

Don’t confuse aggregate expenditure with consumption spending

245

• Solved problem 9.1

Determining macroeconomic equilibrium THE MULTIPLIER EFFECT

A formula for the multiplier

246 246

249

• Making the connection 9.2

The multiplier in reverse: the Great Depression of the 1930s Summarising the multiplier effect

250 251

• Solved problem 9.2

• Making the connection 8.1

Why a lower inflation rate is like a tax cut for Wesfarmers bond holders Deflation

xxi

216 218

Using the multiplier formula The paradox of thrift?

251 252

CHANGES IN THE PRICE LEVEL CONCLUSION

253 255

• An inside look

Singapore’s economy grew by 3.7% in 2013, says PM Lee CHAPTER SUMMARY AND PROBLEMS

256 258

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DETAILED CONTENTS

CHAPTER 9 APPENDIX

The algebra of macroeconomic equilibrium APPENDIX PROBLEMS

263 264

CHAPTER 10

Aggregate demand and aggregate supply analysis AGGREGATE DEMAND

Why is the aggregate demand curve downward sloping?

266 268

268

270

Money, banks and the Reserve Bank of Australia

• Making the connection 11.2

Coca-Cola dries up as the Zimbabwe currency no longer serves as money

306

274

307 307

275

• Don’t let this happen to you

278

• Solved problem 11.1

MACROECONOMIC EQUILIBRIUM IN THE LONG RUN AND THE SHORT RUN

280

275 275 276 277

280

A DYNAMIC AGGREGATE DEMAND AND AGGREGATE SUPPLY MODEL

283

What is the usual cause of inflation?

284

• Making the connection 10.2

286

Showing the oil shock of 1974 on a dynamic aggregate demand and aggregate supply graph 287 289

• An inside look

Showing how banks create money The simple deposit multiplier versus the real-world deposit multiplier THE RESERVE BANK OF AUSTRALIA

How the RBA manages financial liquidity and interest rates Exchange rate management Connecting money and prices: the equation of exchange The quantity theory explanation of inflation High rates of inflation

308 309

309 310 312 313 315 315

316 317 318

318 318 319

• Making the connection 11.3

The German hyperinflation of the early 1920s CONCLUSION

290 292

CHAPTER 10 APPENDIX

The monetarist model

Don’t confuse money with income or wealth HOW DO FINANCIAL INSTITUTIONS CREATE MONEY?

THE QUANTITY THEORY OF MONEY

• Solved problem 10.2

Macroeconomic schools of thought

306

M1: the narrowest definition of the money supply Broader definitions of money

277

JB Hi-Fi’s $116m profit defies slump CHAPTER SUMMARY AND PROBLEMS

303 303 304

HOW DO WE MEASURE MONEY TODAY?

Bank balance sheets Using T-accounts to show how a bank can create money The simple deposit multiplier

CONCLUSION

302

302

• Making the connection 11.1

The long-run aggregate supply curve Shifts in the long-run aggregate supply curve The short-run aggregate supply curve Shifts of the short-run aggregate supply curve versus movements along it Variables that shift the short-run aggregate supply curve Variables that shift the short-run and long-run aggregate supply curves

Does technological change create unemployment?

300

WHAT IS MONEY AND WHY DO WE NEED IT?

271

• Solved problem 10.1

Recessions, expansions and supply shocks

299

CHAPTER 11

270

Should Germany reduce its reliance on exports? 273

AGGREGATE SUPPLY

PART 6 MONETARY AND FISCAL POLICY

Money in a World War II prisoner of war camp The functions of money What can serve as money?

• Making the connection 10.1

Movements along the aggregate demand curve versus shifts of the aggregate demand curve

296 297 297

Barter and the invention of money

• Don’t let this happen to you

Be clear why the aggregate demand curve is downward sloping Shifts of the aggregate demand curve versus movements along it The variables that shift the aggregate demand curve

The new classical model The real business cycle model Karl Marx: capitalism’s severest critic

320 321

• An inside look

An Australasian currency? CHAPTER SUMMARY AND PROBLEMS

322 324

296 296

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DETAILED CONTENTS

• Don’t let this happen to you

CHAPTER 12

Monetary policy

328

WHAT IS MONETARY POLICY?

330

The goals of monetary policy

330

THE DEMAND FOR AND SUPPLY OF MONEY

332

The demand for money Shifts in the money demand curve How the RBA manages the supply of cash Equilibrium in the money market A tale of two interest rates

332 332 333 335 336

MONETARY POLICY AND ECONOMIC ACTIVITY

How interest rates affect aggregate demand The effects of monetary policy on real GDP and the price level Can the RBA eliminate contractions and recessions? Using monetary policy to fight inflation

337

337 338 339 340

341

• Solved problem 12.1

The effects of monetary policy Is monetary policy always effective and fair?

343 344

• Making the connection 12.2

Why does the share market care about monetary policy?

345

• Don’t let this happen to you

Remember that with monetary policy it’s the interest rate—not the money—that counts SHOULD THE RBA TARGET INFLATION?

346 346

• Making the connection 12.3

How does the RBA measure inflation? IS THE INDEPENDENCE OF THE RESERVE BANK OF AUSTRALIA A GOOD IDEA?

The case for RBA independence The case against RBA independence CONCLUSION

347 349

349 349

WHAT IS FISCAL POLICY?

What fiscal policy is and what it isn’t Automatic stabilisers versus discretionary fiscal policy An overview of government spending and taxes USING FISCAL POLICY TO INFLUENCE AGGREGATE DEMAND

Expansionary fiscal policy Contractionary fiscal policy

The effect of changes in tax rates Taking into account the effects of aggregate supply The multipliers work in both directions

365

368 368 369

• Solved problem 13.1

Fiscal policy multipliers THE LIMITS OF USING FISCAL POLICY TO STABILISE THE ECONOMY

Does government spending reduce private spending? Crowding out in the short run Crowding out in the long run

369 370

371 371 372

• Making the connection 13.1

DEFICITS, SURPLUSES AND FEDERAL GOVERNMENT DEBT

How the federal budget can serve as an automatic stabiliser

372 373

375

• Solved problem 13.2

The effect of economic fluctuations on the budget deficit Should the federal budget always be balanced? Is government debt a problem?

376 377 377

• Making the connection 13.2

Government bankruptcy in Europe THE EFFECTS OF FISCAL POLICY IN THE LONG RUN

The long-run effects of tax policy Tax simplification The economic effect of tax reform How large are supply-side effects? CONCLUSION

• An inside look

351 353

In infrastructure, they don hard hats for a reason CHAPTER SUMMARY AND PROBLEMS

378 379

380 380 381 382 382

383 385

CHAPTER 13 APPENDIX 1

CHAPTER 13

Fiscal policy

GOVERNMENT PURCHASES AND TAX MULTIPLIERS

350

• An inside look

Bank of England holds record low rates CHAPTER SUMMARY AND PROBLEMS

Don’t confuse fiscal policy and monetary policy 365

Why was the United States recession of 2007–2009 so severe?

• Making the connection 12.1

Too low for zero: a cash rate of almost zero in the United States

xxiii

358 360

360 360 361 363

363 364

Is there a short-run trade-off between unemployment and inflation? 390 The Phillips curve Explaining the Phillips curve with aggregate demand and aggregate supply curves Is the Phillips curve a policy menu? Is the short-run Phillips curve stable? The long-run Phillips curve The role of expectations of future inflation Do workers understand inflation? APPENDIX QUESTIONS AND PROBLEMS

390 391 392 392 392 393 394 395

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DETAILED CONTENTS

CHAPTER 13 APPENDIX 2

A closer look at the multiplier An expression for equilibrium real GDP A formula for the government purchases multiplier A formula for the tax multiplier The ‘balanced budget’ multiplier The effects of changes in tax rates on the multiplier The multiplier in an open economy APPENDIX PROBLEMS

PART 7 THE INTERNATIONAL ECONOMY

396 396 397 397 398 398 399 400

401

THE BALANCE OF PAYMENTS: LINKING AUSTRALIA TO THE INTERNATIONAL ECONOMY

404

The current account The capital account The financial account Why is the balance of payments always zero?

404 407 407 408

• Don’t let this happen to you

409

Equilibrium in the market for foreign exchange

409

410 412

• Don’t let this happen to you

Don’t confuse what happens when a currency appreciates with what happens when it depreciates How do shifts in demand and supply affect the exchange rate? Some exchange rates are not determined by the market How movements in the exchange rate affect exports and imports

THE INTERNATIONAL SECTOR AND NATIONAL SAVING AND INVESTMENT

Current account balance equals net foreign investment Domestic saving, domestic investment and net foreign investment

Monetary policy in an open economy Fiscal policy in an open economy CONCLUSION

Stevens’ murky dollar premonitions CHAPTER SUMMARY AND PROBLEMS

The international financial system EXCHANGE RATE SYSTEMS

423 424

424 424 425

426 428

434 436

• Don’t let this happen to you

Remember that modern currencies are fiat money THE CURRENT EXCHANGE RATE SYSTEM

437 437

The floating dollar 437 What determines exchange rates in the long run? 438 The four determinants of exchange rates in the long run 439 The Big Mac theory of exchange rates The euro Can the euro survive the recessions? Pegging against the US dollar

440 441

Coping with fluctuations in the value of the Australian dollar

412

• An inside look

413

The float Australia had to have? CHAPTER SUMMARY AND PROBLEMS

414

442 443

• Solved problem 15.1

INTERNATIONAL CAPITAL MARKETS CONCLUSION

446 447 448

449 451

CHAPTER 15 APPENDIX

414

The Gold Standard and the Bretton Woods System

454

415 416

The gold standard The end of the gold standard The Bretton Woods system The collapse of the Bretton Woods system APPENDIX QUESTIONS AND PROBLEMS

454 454 454 456 458

• Solved problem 14.2

The effect of changing exchange rates on the prices of imports The real exchange rate

International debt relief for poor countries MONETARY POLICY AND FISCAL POLICY IN AN OPEN ECONOMY

• Making the connection 15.2 410

• Making the connection 14.1

Exchange rates listings

• Making the connection 14.2

• Making the connection 15.1

• Solved problem 14.1

THE FOREIGN EXCHANGE MARKET AND EXCHANGE RATES

420

420

CHAPTER 15

Macroeconomics in an open economy 402

Understanding the arithmetic of open economies

Is Australia’s current account deficit a problem?

• An inside look

CHAPTER 14

Don’t confuse the balance of trade, the current account balance and the balance of payments

THE EFFECT OF A GOVERNMENT BUDGET DEFICIT ON INVESTMENT

417

417

Glossary Index

460 465

418

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f lexibili t y char t The following is a suggested way to organise your syllabus into core and optional teaching plans.

CORE

OPTIONAL

CHAPTER 1 Economics: foundations and models

CHAPTER 1 APPENDIX Using graphs and formulae

Introduces the concepts of scarcity and trade-offs, marginal analysis and the issue of offshoring in Australia to discuss the role of models in economic analysis.

CHAPTER 2 Choices and trade-offs in the market Includes coverage of the production possibility frontier, opportunity cost, comparative advantage, the market system and the role of the legal system in a market.

CHAPTER 3 Where prices come from: the interaction of demand and supply Introduces the model of demand and supply, and illustrates equilibrium in the market.

CHAPTER 4 GDP: measuring total production, income and economic growth Covers how total production is measured, the limitations of using GDP as a measure of economic wellbeing, the difference between real and nominal variables and how to measure economic growth.

CHAPTER 5 Economic growth, the financial system and business cycles Provides an overview of key macroeconomic issues by discussing the business cycle in the context of long-run growth. Discusses the roles of entrepreneurship, financial institutions and policy in economic growth.

CHAPTER 7 Unemployment Discusses the types of unemployment and the associated economic costs, measurement issues and the role of the labour market in the economy.

CHAPTER 8 Inflation Introduces how inflation is measured, and the causes and potential economic costs of inflation.

CHAPTER 10 Aggregate demand and aggregate supply analysis Carefully develops the AD–AS model and then makes the model dynamic to account better for actual movements in real GDP and the price level.

CHAPTER 12 Monetary policy Uses the dynamic aggregate demand and aggregate supply model to show the effects of monetary policy on real GDP and the price level. Provides an up-to-date coverage of the operation of monetary policy in Australia.

CHAPTER 13 Fiscal policy Uses the dynamic aggregate demand and aggregate supply model to show the effects of fiscal policy on real GDP and the price level.

CHAPTER 14 Macroeconomics in an open economy

Includes various graphing techniques such as times series and multiple variable graphs, the calculation of the slopes of linear and non-linear curves and several useful formulae commonly used in economics.

CHAPTER 6 Long-run economic growth: sources and policies Highlights the importance of institutions, policies and technological change for long-run economic growth, and analyses why some countries have not achieved long-run economic growth.

CHAPTER 9 Aggregate expenditure and output in the short run Uses the Keynesian 45º line aggregate expenditure model to introduce students to the short-run relationship between spending and production. The discussion of monetary and fiscal policy in later chapters uses only the aggregate demand and aggregate supply model, which allows lecturers to omit the material in Chapter 9.

CHAPTER 9 APPENDIX The algebra of macroeconomic equilibrium Uses equations to represent the aggregate expenditure model described in Chapter 9.

CHAPTER 10 APPENDIX Macroeconomic schools of thought Covers the monetarist, new classical and real business cycle models.

CHAPTER 11 Money, banks and the Reserve Bank of Australia Explores the role of money in the economy, the creation of money and the role of the Reserve Bank of Australia. Contains worked examples of the various types of multipliers.

CHAPTER 13 APPENDIX 1 Is there a short-run trade-off between unemployment and inflation? Covers the short-run relationship between unemployment and inflation and the view that in the long-run no trade-off exists.

CHAPTER 13 APPENDIX 2 A closer look at the multiplier Contains worked examples of the various types of multipliers.

CHAPTER 15 The international financial system Covers the international financial system and explores the roles central banks play in the system.

CHAPTER 15 APPENDIX The gold standard and the Bretton Woods System Provides a summary of earlier exchange rate systems which assists in understanding the reasons why the current systems exist.

Explains the linkages between countries at the macroeconomic level and how policy-makers take account of these linkages when conducting monetary and fiscal policy. Includes the balance of payments, foreign debt and exchange rates.

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PA RT

1

I NT RO DUC TIO N

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CHAPTER

1

ECONOMICS: FOUNDATIONS AND MODELS LEARNING OBJECTIVES After studying this chapter you should be able to: 1.1 Explain these three important economic ideas: people are rational; people respond to incentives; optimal decisions are made at the margin. 1.2 Understand the issues of scarcity and trade-offs, and how the market makes decisions on these issues. 1.3 Understand the role of models in economic analysis. 1.4 Distinguish between microeconomics and macroeconomics.

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OFFSHORING TO THE PHILIPPINES— GOOD OR BAD? MANY AUSTRALIAN, US, Japanese and European firms have for decades been moving the production of goods and services to other countries where wages are lower. This process of firms producing goods and services outside of their home country is called offshoring (sometimes also referred to as outsourcing). In recent years, it is not only simple manufacturing that is being offshored, but also jobs that require high skill levels. High-technology manufacturing, research and development and IT systems analysis are now outsourced to countries like China and India where skilled workers, such as software engineers, typically receive salaries that are 75 per cent lower than those of software engineers in Australia or the United States. A more recent development is the outsourcing of customer services. A large number of Australian companies—including Telstra, Vodafone, ANZ, Westpac, Jetstar, Foxtel and Macquarie Bank—are offshoring services to companies in the Philippines—known as business-process outsourcing (BPO) companies—to make or receive Australian calls or to respond to customer queries via the Internet. Over 638 000 Filipino BPO workers are employed in crowded, open-planned offices across the Philippines. The industry is estimated to generate over $11 billion a year for the poor Southeast Asian country, with forecasts by the government of the Philippines that this will more than double over the next three or four years. Smaller Australian companies are also using Filipinos for services, including insurance, loans and accounting services, writing software and debt collection. The Philippines is overtaking India as the biggest call centre operator in the world. Most BPO workers have a tertiary degree or are students, and have the advantage that their English accent is often more easily understood than BPOs in India, making them more customer-friendly. Although Filipino call centre workers are paid much more than the average wage in the Philippines, their daily salary is much less than for similar Australian workers. The focus of the debate on offshoring has been the questions: ‘Has offshoring been good or bad for the Australian economy?’ ‘Does it move Australian jobs to other countries, or does it reduce production costs for Australian businesses, leading to job creation?’ These questions are some of many that cannot be answered without using economics. In this chapter, and throughout this book, we will see how economics helps in answering important questions such as offshoring, as well as many other issues. SOURCE: Summarised from Lindsay Murdoch (2013), ‘Ready to answer Australia’s call’, The Sydney Morning Herald, 13 January, at , viewed 21 March 2013.

© Rolex Dela Pena/epa/Corbis

1

ECONOMICS IN YOUR LIFE

ARE YOU LIKELY TO LOSE YOUR JOB TO OFFSHORING? Around 20 000 jobs in Australia’s service sector are being outsourced each year to other countries, according to a report by the National Institute of Economic and Industry Research.1 This seems like a large number. Suppose you plan on working as an accountant, a software engineer, a business consultant, a financial analyst or in another industry where some jobs have already been offshored. Is it likely that during your career your job will be outsourced to China, the Philippines, India or some other country? As you read this chapter, see if you can answer this question. You can check your answer with the one we provide at the end of the chapter.

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4

PART 1 INTRODUCTION

ECONOMICS IS USED to answer questions such as the following: 1 2 3 4

How are the prices of goods and services determined? How does pollution affect the economy, and how should government policy deal with these effects? Why do firms engage in international trade, and how do government policies affect international trade? Why does government control the prices of some goods and services, and what are the effects of those controls?

Economists do not always agree on the answers to every question. In fact, as we will see, economists engage in lively debates on many issues. In addition, economics is a dynamic field with new problems and questions constantly arising. Therefore economists are always at work developing new methods to analyse economic issues.

Scarcity The situation in which unlimited wants exceed the limited resources available to fulfil those wants. Resources Inputs used to produce goods and services, including natural resources (such as land, water and minerals), labour, capital and entrepreneurial ability. These are also referred to as the factors of production. Economics The study of the choices people and societies make to attain their unlimited wants, given their scarce resources. Economic models Simplified versions of reality used to analyse real-world economic situations.

All the issues we discuss in this book reflect a basic fact of life: people must make choices as they try to attain their goals. The choices reflect the trade-offs people face because we live in a world of scarcity, which means that although our wants are unlimited the resources available to fulfil those wants are limited. You might like to own five MercedesBenz cars and spend three months each year in five-star European hotels, but unless you are a close relative of James Packer you probably lack the money to fulfil these dreams. Every day you must make choices about how to spend your limited income on the many goods and services available. The finite amount of time available to you also limits your ability to attain your goals. If you spend an hour studying for your economics test, you have one less hour available to study for your statistics test. Firms and the government are in the same situation that you are: they have limited resources available to them as they attempt to attain their goals. Economics is the study of the choices people and societies make to attain their unlimited wants, given their scarce resources. We begin this chapter by discussing three important economic ideas that we will return to many times in the book: people are rational; people respond to incentives; optimal decisions are made at the margin. Then we consider the three fundamental questions that any economy must answer: What goods and services will be produced? How will the goods and services be produced? Who will receive the goods and services? Next we consider the role of economic models in helping us to analyse the many issues presented throughout this book. Economic models are simplified versions of reality used to analyse real-world economic situations. Later in this chapter we explore why economists use models and how they construct them. Finally, we discuss the difference between microeconomics and macroeconomics.

THREE KEY ECONOMIC IDEAS 1.1 Explain these three important economic ideas: people are rational; people respond to incentives; optimal decisions are made at the margin. LEARNING OBJECTIVE

Market A group of buyers and sellers of a good or service and the institution or arrangement by which they come together to trade.

As you try to achieve your goals, whether buying a new computer or finding a part-time job, you will interact with other people in markets. A market is a group of buyers and sellers of a good or service and the institution or arrangement by which they come together to trade. Much of economics involves analysing what happens in markets. Throughout this book, as we study how people make choices and interact in markets, we will return to three important ideas: 1 People are rational. 2 People respond to economic incentives. 3 Optimal decisions are made at the margin.

People are rational Economists generally assume that people are rational. This assumption does not mean that economists believe that everyone knows everything or always makes the ‘best’ decision. It

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does mean that economists assume that consumers and firms use as much of the available information as they can to achieve their goals. Rational individuals weigh the benefits and costs of each action, and they choose an action only if the benefits outweigh the costs. For example, if a computer store charges a price of $60 for the latest Windows upgrade, economists assume that the managers at the store have estimated that a price of $60 will earn the most profit. The managers may be wrong; perhaps a price of $65 would be more profitable, but economists assume that the managers have acted rationally on the basis of the information available to them in choosing the price. Of course, not everyone behaves rationally all the time. Still, the assumption of rational behaviour is very useful in explaining most of the choices that people make.

People respond to economic incentives Human beings act from a variety of motives, including religious belief, envy and compassion. Economists emphasise that consumers and firms consistently respond to economic incentives. This fact may seem obvious, but it is often overlooked as the following example illustrates. The Pharmaceutical Benefits Scheme (PBS) is an Australian government initiative under which more than 80 per cent of prescriptions are dispensed in Australia. At 1 January 2014 patients pay up to $36.90 for most PBS medicines or $6.00 if they have a concession card. The Australian government pays the remaining cost. Under current arrangements these amounts are adjusted in line with inflation on 1 January each year. The government’s expenditure on the PBS—currently around $9 billion annually—has been increasing rapidly, mainly due to the high cost of subsidising new and expensive prescription medicines to make them available at prices people can afford. The government paid part of the price of around 197 million prescriptions for subsidised medicines supplied up to the year ending June 2013. That’s over eight prescriptions every year for each Australian. The scheme accounts for over 15 per cent of the total Australian government’s health budget. For a medicine to be available on the PBS it must not only satisfy the criterion that it has a significant impact on patient health but also be cost-effective in that the extra benefit to patients must be worth the cost to government (the taxpayer). Many Australians do not fully understand this second criterion and believe that if a medicine improves your health it must be worth taking no matter what the cost! Some also think that it is unfair to pay for something as important as medicine as it is vital for one’s health. However, economists argue, and this is accepted by government, that if medicines were free there would be little incentive for patients or doctors to use medicines wisely.

Optimal decisions are made at the margin Some decisions are ‘all or nothing’. For example, an entrepreneur decides whether or not to open a new restaurant: they either start the new restaurant or they don’t. You decide whether to enter university or to take a job. But most decisions in life are not all or nothing. Instead, most decisions involve doing a little more or a little less. If you are trying to decrease your spending and increase your saving, the decision is not really a choice between saving every dollar you earn or spending it all. The choice is actually between buying a cappuccino at a café every day or cutting back to three times per week. Economists use the word marginal to mean an extra or additional benefit or cost of a decision. Should you watch another hour of television or spend that hour studying? The marginal benefit (MB) of watching more television is the additional enjoyment you receive. The marginal cost (MC) is the lower grade you receive from having studied a little less. Should Apple produce an additional 300 000 iPhones? Firms receive revenue from selling goods.  Apple’s marginal benefit is the additional revenue it receives from selling 300 000 more iPhones. Apple’s marginal cost is the additional cost—for wages, parts and so forth— of producing 300 000 more iPhones. Economists reason that the optimal decision is to continue any activity up to the point where the marginal benefit equals the marginal cost—in symbols, where MB = MC. Often we apply this rule without consciously thinking about it. Usually you will know whether the additional enjoyment from watching a television program is worth the additional cost involved in not spending that hour studying without giving it a lot of thought. In business

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Marginal analysis Analysis that involves comparing marginal benefits and marginal costs.

situations, however, firms often have to make careful calculations to determine, for example, whether the additional revenue received from increasing production is greater or less than the additional cost of the production. Economists refer to analysis that involves comparing marginal benefits and marginal costs as marginal analysis. In each chapter of this book you will see a special feature entitled ‘Solved problem’. This feature will increase your understanding of the material by leading you through the steps of solving an applied economic problem. After reading the problem you can test your understanding by working through the related problems that appear at the end of the chapter.

SOLVED PROBLEM 1.1 APPLE MAKES A DECISION AT THE MARGIN Suppose Apple is currently selling 10 million iPhones per year worldwide. Managers at Apple are considering whether to raise production to 11 million iPhones per year. One manager argues, ‘Increasing production from 10 million to 11 million is a good idea because we will make a total profit of $500 million if we produce 11 million.’ Do you agree with her reasoning? What, if any, additional information do you need to decide whether Apple should produce the additional one million iPhones?

Solving the problem STEP 1: Review the chapter material. The problem is about making decisions, so you may want to review the section ‘Optimal

decisions are made at the margin’, which begins on page 5. Remember in economics to think ‘marginal’ whenever you see the word ‘additional’. STEP 2: Explain whether you agree with the manager’s reasoning. We have seen that any activity should be continued to the point

where the marginal benefit is equal to the marginal cost. In this case, that involves continuing to produce iPhones up to the point where the additional revenue Apple receives from selling more iPhones is equal to the marginal cost of producing them. The Apple manager has not done a marginal analysis, so you should not agree with her reasoning. Her statement about the total profit of producing 11 million iPhones is not relevant to the decision of whether to produce the last one million iPhones. You need to know whether the total profit amount of $500 million is the maximum amount that could be earned, or if a different quantity of production is more profitable. To determine this you will need additional information. STEP 3: Explain what additional information you need. You will need to know and compare the additional (marginal) revenue Apple

would earn from selling one million extra iPhones with the additional (marginal) cost of producing them. As long as the marginal revenue for each extra iPhone produced is greater than the marginal cost of producing it, the extra production will add more to total profit. Therefore Apple should continue to produce iPhones right up to the point where marginal revenue is equal to marginal cost. Further, you should note that producing beyond this point, where marginal cost exceeds marginal revenue, will reduce total profits.

[ YOUR TURN Q

For more practice do related problems 1.5, 1.6 and 1.7 on pages 17 and 18 at the end of this chapter.

1.2 Understand the issues of scarcity and trade-offs, and how the market makes decisions on these issues. LEARNING OBJECTIVE

Trade-off   The idea that, because of scarcity, producing more of one good or service means producing less of another good or service.

SCARCITY, TRADE-OFFS AND THE ECONOMIC PROBLEM THAT EVERY SOCIETY MUST SOLVE We have already noted the important fact that we live in a world of scarcity. As a result, any society faces the economic problem that it has only a limited amount of economic resources— such as workers, machines and natural resources—and therefore can produce only a limited amount of goods and services. Therefore, society faces trade-offs: producing more of one good or service means producing less of another good or service. Trade-offs force society to make choices, particularly when answering the following three fundamental questions: 1 What goods and services will be produced? 2 How will the goods and services be produced? 3 Who will receive the goods and services produced?

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Throughout this book we will return to these questions many times. For now, we can briefly introduce each question.

What goods and services will be produced? How will society decide whether to produce more economics textbooks or more Blu-ray players? Should we fund more child care facilities or more university places? Of course, ‘society’ does not make decisions; only individuals make decisions. The answer to the question of what will be produced is determined by the choices made by consumers, firms and governments. Every day you help to decide which goods and services will be produced when you choose to buy an iPhone rather than a Blu-ray player, or a cappuccino rather than tea. Similarly, Apple must choose whether to devote its scarce resources to making more iPhones or more iPads. The federal government must also choose whether to spend more of its limited budget on breast cancer research or on national defence. In each case, consumers, firms and the government face the problem of scarcity by trading off one good or service for another. When analysing the decision to choose between alternative options, economists use the concept of opportunity cost. This is one of the most important concepts in economics. The opportunity cost of any activity is the highest-valued alternative that must be given up to engage in that activity. In the above example, if Apple chooses to make more iPhones it must divert resources from iPads. The opportunity cost of producing more iPhones is the loss of production of iPads. Or, if you choose to buy a cup of coffee, your opportunity cost is the cup of tea that you could have chosen instead. Consider the example of an entrepreneur who could receive a salary of $80 000 per year working as a manager at a firm but opens her own business instead. In that case the opportunity cost of the entrepreneurial services to her own business is $80 000, even though she does not pay herself an explicit salary. We will analyse this important concept of opportunity cost in further detail in the next chapter.

Opportunity cost The highest-valued alternative that must be given up to engage in an activity.

How will the goods and services be produced? Firms choose how to produce the goods and services they sell. In many cases firms face a tradeoff between using more workers and using more machines. For example, a local service station has to choose whether to provide car repair services using more diagnostic computers and fewer car mechanics or more car mechanics and fewer diagnostic computers. Similarly, movie studios have to choose whether to produce animated films using highly skilled animators to draw them by hand or fewer animators and more computers. In deciding whether to move production offshore to China, firms are often choosing between a production method in their home country that uses fewer workers and more machines and a production method in China that uses more workers and fewer machines.

Who will receive the goods and services produced? In Australia, as in most countries, who receives the goods and services produced depends largely on how income is distributed. Those individuals with the highest income have the ability to buy the most goods and services. Often, people are willing to give up some of their income—and therefore some of their ability to purchase goods and services—by donating to charities to increase the incomes of poorer people. An important policy question, however, is whether the government should intervene to make the distribution of income more equal. Such intervention occurs in Australia, because people with higher incomes pay a larger fraction of their incomes in taxes and because the government makes payments to people with low incomes. There is disagreement over whether the current attempts to redistribute income are sufficient or whether there should be more or less redistribution.

Centrally planned economies versus market economies To answer the three questions—what, how and who—societies organise their economies in two main ways. A society can have a centrally planned economy in which the government decides how economic resources will be allocated. Or a society can have a market economy in which the decisions of households and firms interacting in markets allocate economic resources. The most important centrally planned economy in the world used to be the former Soviet Union. The government decided what goods to produce, how to produce them and who

Centrally planned economy   An economy in which the government decides how economic resources will be allocated. Market economy   An economy in which the decisions of households and firms interacting in markets allocate economic resources.

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Consumer sovereignty The concept that in a market economy it is ultimately consumers who decide what goods and services will be produced. This occurs because firms must produce goods and services that meet the wants of consumers or the firms will go out of business.

would receive them. Government employees managed factories and stores. The objective of these managers was to follow the government’s orders, rather than to satisfy the wants of consumers. Centrally planned economies like the former Soviet Union have not been successful in producing low-cost, high-quality goods and services. As a result, the standard of living of the average person in a centrally planned economy tends to be quite low. All centrally planned economies have also been political dictatorships. Dissatisfaction with low living standards and political repression finally led to the collapse of the Soviet Union in 1991. Today, only a few small countries, such as Cuba and North Korea, still have largely centrally planned economies. All the high-income democracies, such as Australia, the United States, Canada, Japan and many European countries, are in large part market economies. Market economies rely primarily on privately owned firms to produce goods and services and to decide how to produce them. Markets, rather than the government, determine who receives the goods and services produced. In a market economy, firms must produce goods and services that meet the wants of consumers or the firms will go out of business. In that sense, it is ultimately consumers who decide what goods and services will be produced. This concept is referred to as consumer sovereignty. Because firms in a market economy compete to offer the highest quality products at the lowest price, they are under pressure to use the lowest-cost methods of production. For example, in the past 20 years some firms in Australia, the United States and elsewhere, particularly in the electronics and furniture industries, have been under pressure to reduce their costs to meet the low-cost competition of Chinese and Indian firms. In a market economy the income of an individual is determined by the payments received for what they have to sell. If an individual is a civil engineer and firms are willing to pay a salary of $90 000 per year for engineers with training and skills, that is the amount of income they will have to purchase goods and services and pay taxes. If the engineer also owns a house that is rented out, their income will be even higher. One of the attractive features of markets is that they reward hard work. Generally, the more extensive the training a person has received and the longer the hours the person works, the higher the person’s income will be. Of course, luck (both good and bad), inheritance and other factors may also play a role here. We can conclude that market economies answer the question ‘Who receives the goods and services produced?’ with the answer ‘Those who are most willing and able to buy them’.

The modern ‘mixed’ economy

Mixed economy   An economy in which most economic decisions result from the interaction of buyers and sellers in markets, but in which the government plays a significant role in the allocation of resources.

In the nineteenth and early twentieth centuries the governments in market economies engaged in relatively little regulation of markets for goods and services. Beginning in the middle of the twentieth century, government intervention in the economy dramatically increased in every market economy. This increase was primarily caused by the high rates of unemployment and business bankruptcies during the Great Depression of the 1930s. Some government intervention was also intended to raise the incomes of the elderly, the sick and people with limited skills. For example, in 1910 Australia established the Social Security System, which now provides government payments to the retired, the disabled, the unemployed and others including those with children. Governments also provide goods and services that the market does not provide, such as roads, street lighting and national defence, or that the market fails to provide in sufficient quantities or at affordable prices, such as education and health services. In more recent years government intervention in the economy has also expanded to meet such goals as protection of the environment and the promotion of equal opportunity. Some economists argue that the extent of government intervention makes it no longer accurate to refer to Australian, US, Canadian, Japanese and most European economies as market economies. Instead, they should be referred to as mixed economies. In a mixed economy most economic decisions result from the interaction of buyers and sellers in markets, but the government plays a significant role in the allocation of resources. As we will see in later chapters, economists continue to debate the role government should play in a market economy. One of the most important developments in the international economy in recent years has been the movement of China from being a centrally planned economy to being a more mixed

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economy. The Chinese economy had suffered decades of economic stagnation. Although China does not have a democratically elected government, production of most goods and services is now determined in the market, albeit with substantial government intervention. The result has been rapid economic growth.

Efficiency and equity Market economies tend to be more efficient than centrally planned economies. There are three types of efficiency: productive efficiency (sometimes referred to as technical efficiency), allocative efficiency and dynamic efficiency. Productive efficiency occurs when a good or service is produced using the least amount of resources. Allocative efficiency occurs when production reflects consumer preferences and resources are allocated throughout the economy to produce what consumers demand. Dynamic efficiency occurs when new technologies and innovation are adopted over time. Markets tend to be efficient because they promote competition and facilitate voluntary exchange. Voluntary exchange refers to the situation in which both the buyer and seller of a product are made better off by the transaction. We know that the buyer and seller are both made better off because otherwise the buyer would not have agreed to buy the product or the seller would not have agreed to sell it. Productive efficiency is achieved when competition between firms in markets forces the firms to produce goods and services using the least amount of resources and therefore at the lowest cost. Allocative efficiency is achieved when the combination of competition between firms and voluntary exchange between firms and consumers results in firms producing the mix of goods and services that consumers prefer most. Similarly, competition can lead to dynamic efficiency, as firms seek to adapt their product and use new technologies over time to secure their share of sales in the market. Competition will force firms to continue producing and selling goods and services as long as the additional benefit to consumers is greater than the additional cost of production. In this way, the mix of goods and services produced will reflect consumer preferences, achieving consumer sovereignty. Although markets promote efficiency, they don’t guarantee it. Inefficiency can arise from various sources. For example, water is a scarce resource which may be overused if government restrictions on water usage and pricing are set at levels that are too low, leading to allocative inefficiency. Or, if we look at productive efficiency, it may take some time to achieve an efficient outcome. For example, when Blu-ray players were introduced productive efficiency was not achieved instantly. It took several years for firms to discover the lowest-cost method of producing this good. Governments sometimes reduce efficiency by interfering with voluntary exchange in markets. For example, many governments limit the imports of some goods from foreign countries. This limitation reduces efficiency by keeping goods from being produced at the lowest cost. The production of some goods damages the environment. In this case, government intervention can increase efficiency, because without such intervention firms may ignore the costs of environmental damage, and thereby fail to produce the goods at the lowest possible cost from society’s perspective. Just because an economic outcome is efficient this does not necessarily mean that society finds it desirable. Many people prefer economic outcomes that they consider fair or equitable, even if these outcomes are less efficient. Equity is harder to define than efficiency, but it usually involves a ‘fair’ distribution of economic benefits. For some people equity involves a more equal distribution of economic benefits than would result from an emphasis on efficiency alone. For example, some people support taxing people with higher incomes to provide the funds for programs that aid the poor. Although equity may be increased by reducing the incomes of high-income people and increasing the incomes of the poor, efficiency may be reduced. People have less incentive to open new businesses, to supply labour and to save if the government takes a significant amount of the income they earn from working or saving. The result is that fewer goods and services are produced and less saving takes place. As this example illustrates, there is often a trade-off between efficiency and equity. In this case, the total amount of goods and services produced falls, although the distribution of the income to buy those goods and services is made more equal. Government policy-makers have to confront this trade-off.

Productive efficiency   When a good or service is produced using the least amount of resources. Allocative efficiency   When production reflects consumer preferences; in particular, every good or service is produced up to the point where the last unit provides a marginal benefit to consumers equal to the marginal cost of producing it. Dynamic efficiency When new technologies and innovation are adopted over time. Voluntary exchange   Occurs in markets when both the buyer and seller of a product are made better off by the transaction.

Equity The fair distribution of economic benefits between individuals and between societies.

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ECONOMIC MODELS 1.3 Understand the role of models in economic analysis. LEARNING OBJECTIVE

Economists rely on economic theories or models (the words ‘theory’ and ‘model’ are used interchangeably) to analyse real-world issues. As mentioned earlier, economic models are simplified versions of reality used to analyse real-world economic situations. Economists are certainly not alone in relying on models: an engineer may use a computer model of a bridge to help test whether it will withstand high winds, or a biologist may make a physical model of a nucleic acid in order to understand its properties better. One purpose of economic models is to make economic ideas sufficiently explicit and concrete to be used for decision making by individuals, firms or the government. For example, we see in Chapter 3 that the model of demand and supply is a simplified version of how the prices of products are determined by the interactions between buyers and sellers in markets. Economists use economic models to answer questions. For example, consider the question arising from the opening case of this chapter: Has offshoring reduced jobs in the Australian economy? For a complicated issue such as the effects of offshoring, economists often use several models to examine different aspects of the issue. For example, they may use an economic model of how wages are determined to analyse how offshoring affects wages in particular industries. They may use a model of international trade to analyse how offshoring affects income growth in the countries involved. Sometimes economists use an existing model to analyse an issue, but in other cases they must develop a new model. To develop a model, economists generally follow these steps: 1 Decide on the assumptions to be used in developing the model. 2 Formulate a testable hypothesis. 3 Use economic data to test the hypothesis. 4 Revise the model if it fails to explain well the economic data. 5 Retain the revised model to help answer similar economic questions in the future.

The role of assumptions in economic models Any model is based on making assumptions because models have to be simplified to be useful. We cannot analyse an economic issue unless we reduce its complexity. For example, economic models make behavioural assumptions about the motives of consumers and firms. Economists assume that consumers will buy those goods and services that will maximise their wellbeing or their satisfaction. Similarly, economists assume that firms act to maximise their profits. These assumptions are simplifications because they do not describe the motives of every consumer and every firm. How can we know if the assumptions in a model are too simplified or too limiting? We discover this when we form hypotheses based on these assumptions and test these hypotheses using real-world information.

Forming and testing hypotheses in economic models Economic variable Something measurable that relates to resource use that can have different values, for example wages, prices or hours worked.

A hypothesis in an economic model is a statement that may be either correct or incorrect about an economic variable. An economic variable is something measurable that can have different values, such as the wages paid to IT workers. An example of a hypothesis in an economic model is the statement that ‘Outsourcing to offshore locations reduces wages of IT workers in Australia’. An economic hypothesis is usually about a causal relationship; in this case, the hypothesis states that offshoring causes, or leads to, lower wages for IT workers in Australia. Before accepting a hypothesis we must test it. To test a hypothesis we must analyse statistics on the relevant economic variables. In our example, we must gather statistics on the wages paid to IT workers, and perhaps on other variables as well. Testing a hypothesis can be tricky. For example, showing that the wages paid to IT workers fell, or did not rise by as much as average wages, at a time when offshoring was increasing, would not be enough to demonstrate that offshoring caused the wage changes. Just because two things are correlated—that is, they are associated with each other—does not mean that one caused the other. For example, suppose that the number of workers trained in IT greatly increased at the same time that offshoring was increasing. In that case, the fall in wages paid to IT workers in Australia might have been caused by the increase in supply of IT workers increasing competition for jobs, rather than by the

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effects of relocating some IT jobs overseas in the Philippines or India. Over a period of time, many economic variables will be changing, which complicates testing hypotheses. In fact, when economists disagree about a hypothesis it is often because of disagreements over interpreting the statistical analysis used to test the hypothesis. Note that hypotheses must be statements that could in principle turn out to be incorrect. Statements such as ‘offshoring is good’ or ‘offshoring is bad’ are value judgments, rather than hypotheses, because it is not possible to prove or disprove them. Economists accept and use an economic model if it leads to hypotheses that can be confirmed by statistical analysis. In many cases the acceptance is tentative, however, pending the gathering of new data or further statistical analysis. In fact, economists often refer to a hypothesis having been ‘not rejected’, rather than being ‘accepted’, by statistical analysis. But what if statistical analysis clearly rejects a hypothesis? For example, what if a model leads to a hypothesis that offshoring by Australian firms leads to lower wages for Australian IT workers, but this hypothesis is rejected by the data? In that case, the model needs to be reconsidered. It may be that an assumption used in the model was too simple or too limiting. For example, perhaps the model used to determine the effect of offshoring on wages paid to IT workers assumed that IT workers in the Philippines and India had the same training and experience as IT workers in Australia. If, in fact, Australian IT workers have more training and experience than Philippine or Indian IT workers, this difference may explain why our hypothesis was rejected by economic statistics. The process of developing models, testing hypotheses and revising models occurs not just in economics but also in disciplines such as physics, chemistry and biology. It is often referred to as the scientific method. Economics is a social science because it applies the scientific method to the study of the interactions between individuals.

Normative and positive analysis Throughout this book as we build economic models and use them to answer questions, we need to bear in mind the distinction between positive analysis and normative analysis. Positive analysis is concerned with what is, and involves value-free statements that can be checked by using the facts. For example, the statement that ‘a reduction in taxation rates will lead to an increase in spending by individuals’ is a positive statement and can be confirmed or negated by factual data. Normative analysis is concerned with what ought to be, and involves making value judgments, which cannot be tested. For example, ‘individuals should receive reductions in taxation as they are able to decide how to spend money to maximise their satisfaction better than the government’ is a normative statement as it cannot be tested. Economics is about positive analysis, which measures the costs and benefits of different courses of action. We can use the minimum wage laws in Australia to compare positive and normative analysis. In early 2015 it was illegal for an employer to hire an adult worker at a wage of less than $18.70 per hour or $640.90 per week. Without the minimum wage law some firms and some workers would voluntarily agree to a lower wage. Because of the minimum wage, some workers have difficulty finding jobs and some firms end up paying more for labour than they otherwise would have. A positive analysis of the federal minimum wage uses an economic model to estimate how many workers have lost their jobs because of the minimum wage, its impact on the costs and profits of businesses and the gains to workers receiving the minimum wage. After economists complete this positive analysis, the decision as to whether the minimum wage law is a good idea or a bad idea is a normative one and depends on how people assess the trade-offs involved. Supporters of the law believe that the losses to employers and to workers who are unemployed as a result of the law are more than offset by the gains to those workers who receive higher wages than they would have without a minimum wage. Opponents of the minimum wage believe the losses are greater than the gains. The assessment by any individual would depend, in part, on that person’s values and political views. The positive analysis provided by an economist would play a role in the decision but can’t by itself decide the issue one way or the other. In each chapter you will see a ‘Don’t let this happen to you’ box like the one that follows. The goal of these boxes is to alert you to common pitfalls in thinking about economic ideas. After reading the box, test your understanding by working through the related problem that appears at the end of the chapter.

Positive analysis   Analysis concerned with what is and involves valuefree statements that can be checked by using the facts. Normative analysis Analysis concerned with what ought to be and involves making value judgments, which cannot be tested.

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DON’T LET THIS HAPPEN TO YOU

Don’t confuse positive analysis with normative analysis ‘Economic analysis has shown that the minimum wage is a bad idea because it causes unemployment.’ Is this statement accurate? If there were no minimum wage law some workers who currently cannot find any firm willing to hire them at the minimum wage would be able to find employment at a lower wage. Therefore, positive economic analysis indicates that the minimum wage causes unemployment (although economists disagree about how much unemployment is caused by the minimum wage). But, those workers who still have jobs benefit from the minimum wage because they are paid a higher wage than they would otherwise be. In other words, the minimum wage law creates both losers (the workers who become unemployed and the firms that have to pay higher wages) and winners (the workers who receive higher wages). Do the gains to the winners more than offset the losses to the losers? The answer to that question involves normative analysis. Positive economic analysis can only show the consequences of a particular policy; it cannot tell us whether the policy is ‘good’ or ‘bad’. So, the statement at the beginning of this box is inaccurate.

[ YOUR TURN Q

Test your understanding by doing related problem 3.7 on page 19 at the end of this chapter.

Economics as a social science Because economics studies the actions of individuals and societies it is a social science. Economics is therefore similar to other social science disciplines, such as psychology, political science and sociology. As a social science, economics considers human behaviour—particularly decision-making behaviour—in every context, not just in the context of business. Economists have studied such issues as how families decide the number of children to have, why people  have difficulty losing weight or attaining other desirable goals and why people often ignore relevant information when making decisions. Economics also has much to contribute to questions of government policy. As we will see throughout this book, economists have played an important role in formulating government policies in areas such as the environment, health care and poverty. In each chapter the feature entitled ‘Making the connection’ discusses a business news story, or other application, related to the chapter material. Read Making the connection 1.1 for a discussion on what positive economics suggests about the effect of immigration on unemployment levels and how economic analysis can differ from widely held public views and subsequent political policy decisions.

M

C

A K I N G THE

1.1

ONNECTION

globevista.com

Immigration is good for the economy, but not always good for politics. The Abruzzese Emigrant Association monument near Lake Vasto, Perth

ECONOMICS DOESN’T ALWAYS MEAN GOOD POLITICS Economic theories and models have had a huge influence on government policy. However, even when economic evidence is very strong, this doesn’t mean that it will be adopted by politicians. Most economists agree that immigrants into Australia do not create unemployment, that is, they do not take jobs from existing Australian residents. Instead, immigration creates demand for goods and services, brings skills into Australia and contributes positively to economic growth. This conclusion is based on vast amounts of theory and economic modelling using evidence from many countries, including Australia. In other words, it is based on positive economics. However, politicians are acutely aware of conclusions voters believe to be correct but which may not be supported by positive analysis. Political decisions regarding immigration (and many other issues) are often based not only on positive economics but also on deeply held public views. In Australia, between 2006 and 2013, net overseas migration (the difference

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CHAPTER 1 ECONOMICS: FOUNDATIONS AND MODELS

between people migrating to Australia and those leaving Australia to live overseas), increased significantly. The increase in the volume of immigration that occurred largely during the global financial crisis years led to public concern that new immigrants would worsen the rate of unemployment in Australia. Between 2007 and 2008, net overseas migration increased from just over 244 000 to over 314 600. After a significant reduction in 2010 for perceived political gain, to just under 169 000 (despite continuing skills shortages), net overseas migration again began to rise, to an estimated 244 400 in 2013. Of particular concern was the growth of temporary migrants under the ‘457 visa’ program. This program is designed to get skilled workers into Australia relatively quickly to fill vacancies where there is a shortage of Australian workers, which in recent years has occurred particularly in the rapidly growing mining sector. 457 workers do not have to go through the extensive, and often lengthy, processes that permanent migrants must go through. The 457 visa program exposes the difference between positive economics and normative views held by the public. In 2013, the then Prime Minister, Julia Gillard, announced that the government wanted to ‘stop foreign workers being put at the front of the queue, with Australian workers at the back’. Specific examples of rorts of the system were used as the reason she argued it should be harder for employers to bring in overseas workers on 457 visas. Ms Gillard stated that she wanted to protect Australian jobs and rejected claims her stance could be damaging to economic growth or national harmony. In response, the Australian Chamber of Commerce and the Australian Industry Group both predicted continued skills shortages and argued for a steady migration policy instead of major fluctuations. Attacks on skilled migration have also been questioned by economist Professor Phil Lewis, Director of the Centre for Labour Market Research at the University of Canberra. When interviewed by the Weekend Australian he stated: ‘You simply won’t get Australians to work on many of these projects, so if we don’t allow migrants to work on them then we are giving up on creating wealth.’ He said that the higher wages being offered to Australians was still insufficient to entice enough tradespeople to move to isolated mining regions with few services. He argued that Ms Gillard’s stance was seen as vote-winning policy based on views held by much of the Australian public, rather than on sound economic modelling and positive analysis. SOURCE: Australian Bureau of Statistics (2013), Australian Demographic Statistics, Cat. No. 3101.0, June quarter, Table 16, at viewed 4 April 2013; Sid Maher (2013), ‘PM faces internal revolt on visas’, The Australian, 8 March; James Frost (2012), ‘Migrants matter as clock ticks on boom’, The Weekend Australian, 2 June.

MICROECONOMICS AND MACROECONOMICS Economic models can be used to analyse decision making in many areas. We group some of these areas together as microeconomics and others as macroeconomics. Microeconomics is the study of how households and firms make choices, how they interact in markets and how the government attempts to influence their choices. Microeconomic issues include explaining how consumers react to changes in product prices and how firms decide what prices to charge. Microeconomics also involves policy issues, such as analysing the most efficient way to reduce teenage smoking, analysing the costs and benefits of approving the sale of a new prescription drug and analysing the most efficient way to reduce air pollution. Macroeconomics is the study of the economy as a whole, including topics such as inflation, unemployment and economic growth. Macroeconomic issues include explaining why economies experience periods of contraction and increasing unemployment and why over the long run some economies have grown much faster than others. Macroeconomics also involves policy issues, such as whether government intervention is capable of reducing the severity of economic contractions. The division between microeconomics and macroeconomics is not hard and fast. Many economic situations have both a microeconomic and a macroeconomic aspect. For example,

1.4 Distinguish between microeconomics and macroeconomics. LEARNING OBJECTIVE

Microeconomics The study of how households and firms make choices, how they interact in markets and how the government attempts to influence their choices. Macroeconomics The study of the economy as a whole, including topics such as inflation, unemployment and economic growth.

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PART 1 INTRODUCTION

the level of total investment by firms in new machinery and equipment helps to determine how rapidly the economy grows—which is a macroeconomic issue. But to understand how much new machinery and equipment firms decide to purchase, we have to analyse the incentives individual firms face—which is a microeconomic issue.

ECONOMICS IN YOUR LIFE (continued from page 3)

ARE YOU LIKELY TO LOSE YOUR JOB TO OFFSHORING? At the beginning of the chapter we posed the question: ‘Is it likely that during your career your job will be outsourced to China, the Philippines, India or some other country?’ It is important to remember that the number of jobs offshored as a proportion of total employment in Australia is very small. Also, offshoring enables firms to lower their production costs, which keep prices lower for consumers, allowing consumers to spend more on other goods and services, potentially creating more jobs. Further, in a market economy, new jobs are constantly being created as old jobs disappear or become redundant. So while you may lose or change your job one or more times during your career, it will probably not be due to offshoring.

CONCLUSION The best way to think of economics is as a group of useful ideas about how individuals make choices. Economists have put these ideas into practice by developing economic models. Consumers, business managers and government policy-makers use these models every day to help them make choices. In this book we explore many key economic models and give examples of how to apply them in the real world. Most students taking an introductory economics course do not major in economics or become professional economists. Whatever your major may be, the economic principles you will learn in this book will improve your ability to make choices in many aspects of your life. These principles will also improve your understanding of how decisions are made in business and government. Reading newspapers, websites and magazines is an important part of understanding the current economic climate and learning how to apply economic concepts to a variety of realworld events. At the end of each chapter you will see a feature entitled ‘An inside look’. This feature consists of an excerpt of an article that relates to the concepts we have discussed throughout the chapter. A summary and analysis and supporting graph highlight the economic key points of the article. Read ‘An inside look’ on the next page to learn how economic analysis and economic policy is used to address the issue of offshoring jobs. Test your understanding by answering the ‘Thinking critically’ questions that follow.

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CHAPTER 1 ECONOMICS: FOUNDATIONS AND MODELS

AN INSIDE LOOK L 2012 SS DAY 20 APRI

THE AGE, BUSINE

’ g n i r o h s f f o ‘ The case for : r a e l c e t i u q s i It works by Donal Graham

d horing easier, an have made offs es to gi lo es no ic ch rv te se w broad range of ry around Ne an increasingly media commenta d nt le ce ab re at lower labour en of t lo a g r countries, and sed offshorin he There has been ot ea cr m in fro on ed ng id si Increasing be prov ring, focu domestic costs. ith s. w the perils of offsho st d co re m pa tri m to co offshoring is sts es as a way also means that ately it will co as tim se ul of financial servic er r; ov ea m cl fro is y g wages. capabilit offshorin A The case for y and create more highly skilled, offering much more than simply loweris an implication om te ds, offshoring deba benefit our econ fshoring succee ated or less Underneath the r Australians. If of fo d bs ue jo in e nt t as: ‘Less educ ag re co rp -w s te ha in high it le as op r pe some Australians, timately prospe mbers of that ill take over from w nu s e ce rg Australia will ul ur la so as re s services.’ well-trained st three decade ality goods and qu . er re w lo ho to do for the pa fs in of lt t su en fshoring will re acturing jobs w ples of bad of g gains which am rin ex ho fs ly traditional manuf of in rta as e ce her major e are to do the sam milar to any ot a high- Ther si As g, . rin or We can continue ct ho fs se Of es . atical in riences ion in our servic can be problem mpete expe co n, io ot at nn rm increasing tract ca fo ns lia tra d nation, Austra d business wage develope nations. Instea ng s. pi ge sterical lo ta ve  s de rly s in by the more hy g the ea in ed ud st cl si in as with wage cost s, , ic nd C The publ rting, sees offshoring as a threat, te on other grou n. tio va no we must compe in and edia repo of our workforce ve tabloid m ha s m ralians. ra og excellent skills pr fshoring g jobs from Aust of lin d ea te st d sophistication en em , pl ce ce of change an ch as finan pa B Well im su ng s ni or ke ct ic se qu in e Th r boards to have benefits , offshoring it is imperative fo ed ns already yielded de In ea m s. g ce rin ur ho so several years to of offs gy and re plans. It can take r current skills engineering, ener ou rm re -te he ng w lo ity on ss g. clarity lute nece execute offshorin nsion. has been an abso ully prepare and growth and expa sf il in coming es d rta cc cu an e su w is no rw , e lia he t includ in Austra ke m ar le m crisis would ot ob n pr lia al ra re st e Yet th bs—it will be a e West Au not be a lack of jo r significant ill Examples in th fo w s e ill er sk th g at in th er s, is ng of engine the right skills. oil and year overseas sourci kers and a lack of re fabrication of or ho w fs of of ck d la an ts resources projec ts. . gas capital projec e increasing fast for offshoring ar s tie ni rtu po op The

THE AGE

SOURCE: Donal Graham (2012), ‘The case for ‘offshoring’ is quite clear: It works’, The Age, Business Day, at , viewed 14 March 2013. Copyright © Pearson Australia (a division of Pearson Australia Group Pty Ltd) 2015 – 9781486010233 - Hubbard/Macroeconomics 3e

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PART 1 INTRODUCTION

Key points in the article

Thinking critically

This article discusses the media attention given to Australian businesses who have offshored some of their services. The article focuses on the potential benefits from offshoring, including lower wages and providing the required labour and skills in areas where shortages exist in Australia. It is also pointed out that there is a perception held by some that offshoring is a threat to Australian jobs and can lead to lower quality services.

1 There are limits to the number of jobs that can move from developed countries to the Philippines, India and China. What determines those limits? 2 Offshoring can reduce production costs and increase economic efficiency. What impacts might offshoring have on equity?

Analysing the news A The article likens the growth in offshoring services by Australian businesses to Australia’s move over previous decades to locate manufacturing plants in overseas countries that could produce goods relatively cheaper than in Australia. It is argued that the offshoring of services will lead to higher wages and increased prosperity for Australia, just as moving manufacturing production overseas did. This may at first glance seem counter-intuitive. How can moving the provisions of goods and services to another country, such as the Philippines, India or China, increase jobs and wages in Australia? It is true that some jobs will be lost, and there is debate among economists about whether workers who lose their jobs will eventually find comparable or better jobs. However, the article is referring to the lower production costs that cheaper overseas labour can provide for Australian businesses, making these businesses more profitable, and therefore in a position to invest in other areas of the economy and create new jobs which require more highly skilled and more highly paid Australian workers. Table 1 provides a list of the top 25 offshoring destinations for 2014 by city and country. It shows that the Philippines was ranked second in 2014 forecasts, moving ahead of Mumbai, India, in 2013.

TABLE 1 RANK 2014

Top 25 outsourcing destinations

RANK 2013

REGION

COUNTRY

CITY

1

1

South Asia

India

Bangalore

2

3

Southeast Asia

Philippines

Manila (NCR)

3

2

South Asia

India

Mumbai

4

4

South Asia

India

Delhi (NCR)

5

5

South Asia

India

Chennai

6

6

South Asia

India

Hyderabad

7

7

South Asia

India

Pune

8

8

Southeast Asia

Philippines

Cebu City

9

10

Eastern Europe

Poland

Kraków

10

9

Western Europe

Ireland

Dublin

11

11

East Asia

China

Shanghai

12

12

East Asia

China

Beijing

13

13

Central America

Costa Rica

San José

14

15

East Asia

China

Dalian (Dairen)

15

14

East Asia

China

Shenzhen

16

17

Eastern Europe

Czech Republic

Prague

17

16

Southeast Asia

Vietnam

Ho Chi Minh City

18

19

Southeast Asia

Malaysia

Kuala Lumpur

19

20

South Asia

Sri Lanka

Colombo

C We have seen in this chapter that economists use

20

18

South America

Brazil

São Paulo

models to analyse economic issues such as the effects of offshoring. One advantage of economic models is that they make explicit the assumptions being made. Models are based on hypotheses that can be tested against the real world. According to the article, some people fear that offshoring is taking jobs from Australian citizens. People who make this argument are implicitly using a model which assumes that ‘the number of jobs is fixed, so if some of them go overseas, there must be fewer jobs left at home’. However, we know that this model and assumption is not useful, because hundreds of thousands of new jobs are created in Australia each year.

21

22

Middle East and Africa

South Africa

Johannesburg

22

23

Southeast Asia

Vietnam

Hanoi

23

25

South Asia

India

Chandigarh

24

21

South America

Chile

Santiago

25

26

South Asia

India

Kolkata

B The article argues that offshoring will increase Australia’s economic prosperity rather than harm it. It points out that in some industries, such as financial services and engineering, where skills shortages might otherwise limit production and growth, offshoring enables businesses to provide services that they might otherwise not be able to.

SOURCE: Tholons (2013), 2014 Tholons top 100 offshoring destinations: Rankings, December, at , viewed 7 March 2014. © Tholons Inc 2006.

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17

CHAPTER SUMMARY AND PROBLEMS KEY TERMS allocative efficiency centrally planned economy consumer sovereignty dynamic efficiency economic models economic variable economics equity

9 7 8 9 4 10 4 9

macroeconomics marginal analysis market market economy microeconomics mixed economy normative analysis opportunity cost

THREE KEY ECONOMIC IDEAS,

13 6 4 7 13 8 11 7

positive analysis productive efficiency resources scarcity trade-off voluntary exchange

11 9 4 4 6 9

PAGES 4–6

L E A R N I N G O B J E C T I V E 1 . 1 Explain these three important economic ideas: people are rational; people respond to incentives; optimal decisions are made at the margin.

SUMMARY Economics is the study of the choices consumers, business managers and governments make to attain their goals, given their scarce resources. We must make choices because of scarcity which means that, although our wants are unlimited, the resources available to fulfil those wants are limited. Resources are inputs used to produce goods and services, including natural resources (such as land, water and minerals), labour, capital and entrepreneurial ability. Economists assume people are rational in the sense that consumers and firms use all available information as they take actions intended to achieve their goals. Rational individuals weigh the benefits and costs of each action, and choose an action only if the benefits outweigh the costs. Although people act from a variety of motives, ample evidence indicates that they respond to economic incentives. Economists use the word ‘marginal’ to mean extra or additional. The optimal decision is to continue any activity up to the point where the marginal benefit equals the marginal cost.

1.4

1.5

REVIEW QUESTIONS 1.1

1.2

Briefly discuss each of the following economic ideas: people are rational; people respond to incentives; optimal decisions are made at the margin. What is scarcity? Why is scarcity central to the study of economics?

1.6

PROBLEMS AND APPLICATIONS 1.3

In interviews with Australian university economics graduates2 they spoke of how the study of economics provided a solid grounding that was helpful in their subsequent careers, which included working in government departments, private banks, other financial institutions and large private companies such as Shell. The students commented that studying economics enabled them to:

1.7

• Think logically and critically. • Develop a way of problem solving that they could apply to most decision making. • Consider alternative policy solutions and their consequences. Why might studying economics be particularly good preparation for being a top manager of a corporation, running your own business, working in international public organisations or having a leading role in government? Do you agree or disagree with the following assertion: ‘The problem with economics is that it assumes consumers and firms always make the correct decision. But we know everyone’s human, and we all make mistakes.’ [Related to Solved problem 1.1] Suppose Dell is currently selling 250 000 Inspiron laptops per month. A manager at Dell argues: ‘The last 10 000 laptops we produced increased our revenue by $8.5 million and our costs by $8.9 million. However, because we are making a substantial total profit of $25 million from producing 250 000 laptops, I think we are producing the optimal number of laptops.’ Briefly explain whether you agree with the manager’s reasoning. [Related to Solved problem 1.1] From 2009 onwards movie studios began to release a number of films in 3D format. To show films in this format cinemas have to purchase 3D equipment that costs around $75 000 for each projector. Usually, cinema owners charge about $4 more for a ticket to a 3D movie than for a movie in the conventional 2D format. If you owned a cinema discuss how you would go about deciding whether to invest in 3D equipment. [Related to Solved problem 1.1] Two students are discussing Solved problem 1.1. Joe: ‘I think the key additional information you need to know in deciding whether to produce one million more

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PART1 INTRODUCTION

iPhones is the amount of profit you are currently making while producing 10 million. Then you can compare the profit earned from selling 11 million iPhones with the profit earned from selling 10 million. This information is more important than the additional revenue and additional cost of the last one million iPhones produced.’

1.8

Late in the semester a friend tells you, ‘I was going to drop my psychology unit so that I could concentrate on my other units, but I had already put so much time into the unit that I decided not to drop it.’ What do you think of your friend’s reasoning and what economic concepts are involved in your friend’s reasoning? Would it make a difference to your answer if your friend has to pass the psychology unit at some point to graduate? Briefly explain.

Jill: ‘Actually, Joe, knowing how much profits change when you sell one million more iPhones is exactly the same as knowing the additional revenue and the additional cost.’ Briefly evaluate their arguments.

SCARCITY, TRADE-OFFS AND THE ECONOMIC PROBLEM THAT EVERY SOCIETY MUST SOLVE, PAGES 6–9 LEARNING OBJECTIVE 1.2

issues.

Understand the issues of scarcity and trade-offs, and how the market makes decisions on these

SUMMARY

PROBLEMS AND APPLICATIONS

At any point in time in any country, resources such as labour, natural resources, equipment and machinery are in limited or fixed supply, that is, they are scarce. However, the wants of people are unlimited. Therefore choices must be made between alternative uses for the resources. This involves trade-offs, as with scarce resources an economy cannot produce unlimited goods and services to meet unlimited wants. The concept of opportunity cost is used by economists when evaluating the alternative choices available. The opportunity cost of any activity is the highestvalued alternative that must be given up to engage in that activity. Therefore opportunity cost enables us to see what is forgone when a choice is made; that is, it enables us to understand the trade-offs. In a market economy, most economic decisions are made by consumers and firms. In a market economy, firms must produce goods and services that meet the wants of consumers or the firms will go out of business. In that sense, it is consumers who decide what goods and services will be produced, which is referred to as consumer sovereignty. In a centrally planned economy, most economic decisions are made by the government. Most economies, including that of Australia, are mixed economies in which most economic decisions are made by consumers and firms, but in which the government also plays a significant role.

2.5

Does Bill Gates, one of the richest people in the world, face scarcity? Does everyone? Are there any exceptions?

2.6

In a market economy, why does a firm have a strong incentive to be productively, allocatively and dynamically efficient? What does the firm earn if it is efficient, and what happens if it is not?

2.7

Would you expect new and better machinery and equipment to be adopted more rapidly in a market economy or in a centrally planned economy? Briefly explain.

2.8

Centrally planned economies have been less efficient than market economies.

REVIEW QUESTIONS 2.1

Explain how the concept of opportunity cost arises from the central economic problem of scarce resources and unlimited wants.

2.2

What are the three economic questions that every society must answer? Briefly discuss the differences in how centrally planned, market and mixed economies answer these questions.

2.3

What is the difference between productive, allocative and dynamic efficiency?

2.4

What is the difference between efficiency and equity? Why do government policy-makers often face a trade-off between efficiency and equity?

a Has this happened by chance or is there some underlying reason? b If market economies are more economically efficient than centrally planned economies, would there ever be a reason to prefer having a centrally planned economy rather than a market economy? 2.9

When it comes to health care we usually want everything medical technology can offer. Why then do governments limit services such as health care and, furthermore, why don’t governments make health care free for everyone?

2.10

Assume that the state and territory governments throughout Australia increase the price of water in an attempt to reduce consumption for domestic use. What are the equity considerations with this policy?

2.11

Suppose that your local police recover 100 tickets to a big football match in a drug raid. It decides to distribute these to residents and announces that tickets will be given away at 10 am on Monday at the Town Hall. a What groups of people will be most likely to try to get the tickets? Think of specific examples and then generalise. b What is the opportunity cost of distributing the tickets this way?

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c Productive efficiency occurs when a good or service (such as the distribution of tickets) is produced at the lowest possible cost. Is this an efficient way to distribute the tickets? If possible, think of a more efficient method of distributing the tickets.

ECONOMIC MODELS, LEARNING OBJECTIVE 1.3

d Is this an equitable way to distribute the tickets? Explain.

PAGES 10–13

Understand the role of models in economic analysis.

SUMMARY An economic variable is something measurable that relates to resource use that can have different values, for example wages, prices, hours worked. Economists rely on economic models when they apply economic ideas to real-world problems. Economic models are simplified versions of reality used to analyse real-world economic situations. Economists accept and use an economic model if it leads to hypotheses that are confirmed by statistical analysis. In many cases the acceptance is tentative, however, pending the gathering of new data or further statistical analysis. Economics is a social science because it applies the scientific method to the study of the interactions between individuals. Economics is concerned with positive analysis rather than normative analysis. Positive analysis is concerned with what is. Normative analysis is concerned with what ought to be. There are three types of  efficiency: productive, allocative and dynamic. Productive efficiency occurs when a good or service is produced using the least amount of resources. Allocative efficiency occurs when production is in accordance with consumer preferences. Dynamic efficiency occurs when new technologies and innovation are adopted over time. Voluntary exchange occurs in markets when both the buyer and seller of a product are made better off by the transaction. Equity involves the fair distribution of economic benefits. Policy-makers often face a trade-off between equity and efficiency.

3.6

3.7

3.8

REVIEW QUESTIONS 3.1

3.2

3.3

Why do economists use models? How are economic data used to test models? Describe the five steps by which economists arrive at a useful economic model. What is the difference between normative analysis and positive analysis? Is economics concerned mainly with normative analysis or mainly with positive analysis? Briefly explain.

PROBLEMS AND APPLICATIONS 3.4

3.5

19

Suppose an economist develops an economic model and finds that ‘it works well in theory, but it fails in practice’. What should the economist do next? Dr Strangelove’s theory is that the price of mushrooms is determined by the activity of subatomic particles that exist

3.9

in another universe parallel to ours. When the subatomic particles are emitted in profusion, the price of mushrooms is also high. When subatomic particle emissions are low, the price of mushrooms is also low. How would you go about testing Dr Strangelove’s theory? Discuss whether or not this theory is useful. [Related to the opening case] Some firms have begun offshoring work to the Philippines. a Why have firms done this? b Is offshoring work to lower paid workers in the Philippines a risk-free proposition for firms? [Related to Don’t let this happen to you] Explain which of the following statements represent positive analysis and which represent normative analysis. a A $2 per-packet tax on cigarettes will reduce smoking by teenagers by 12 per cent. b The federal government should spend more on cancer research. c Rising paper prices will increase textbook prices. d The price of coffee at a café is too high. [Related to Making the connection 1.1] The Making the connection explains that the debate over immigration has both positive and normative elements. What economic statistics would be most useful in evaluating the positive elements in this debate? Assuming that these statistics are available or could be gathered, are they likely to resolve the normative issues in this debate? If you want to buy or sell a home, land or investment property you will have to sign a sale contract. The legal work involved in preparing the sale contract, mortgage and other related documents is called conveyancing. Until fairly recently in New South Wales (NSW) this work had to be carried out by a solicitor. The NSW government abolished this restriction and allowed licensed conveyancers, who were not qualified lawyers, to do conveyancing. a How might the old system have protected consumers? b Why did critics of the old system argue that it protected lawyers more than it did consumers? c Briefly discuss whether you think changing the law was a good idea.

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PART1 INTRODUCTION

MICROECONOMICS AND MACROECONOMICS, LEARNING OBJECTIVE 1.4

Distinguish between microeconomics and macroeconomics.

SUMMARY Microeconomics is the study of how households and firms make choices, how they interact in markets and how the government attempts to influence their choices. Macroeconomics is the study of the economy as a whole, including topics such as inflation, unemployment and economic growth.

REVIEW QUESTIONS 4.1

Briefly discuss the difference between microeconomics and macroeconomics.

PROBLEMS AND APPLICATIONS 4.2

PAGES 13–14

Briefly explain whether each of the following is primarily a microeconomic issue or a macroeconomic issue. a The effect of higher cigarette taxes on the quantity of cigarettes sold.

4.3

b The effect of higher income taxes on the total amount of consumer spending. c The reasons for the economies of East Asian countries growing faster than the economies of sub-Saharan African countries. d The reasons for low rates of profit in the airline industry. Briefly explain whether you agree with the following assertion: Microeconomics is concerned with things that happen in one particular place, such as the unemployment rate in one city. In contrast, macroeconomics is concerned with things that affect the country as a whole, such as how the rate of teenage smoking in Australia would be affected by an increase in the tax on cigarettes.

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CHAPTER 1 ECONOMICS: FOUNDATIONS AND MODELS APPENDIX

APPENDIX USING GRAPHS AND FORMULAE Graphs are used to illustrate key economics ideas. Graphs appear not just in economics textbooks but also in news and magazine articles that discuss business and economic ideas. Why are graphs used so commonly? Because they serve two useful purposes: (1) they simplify economic ideas and (2) they make the ideas more concrete so that they can be applied to realworld problems. Economic and business issues can be complicated, but a graph can help cut through complications and highlight the key relationships needed to understand a business issue. In that sense, a graph can be like a street map. For example, suppose you take a bus from the airport to see the Sydney Opera House. After arriving at Circular Quay you will probably use a map similar to the one shown below to find your way to the Opera House.

Review the use of graphs and formulae. LEARNING OBJECTIVE

Reproduced with the kind permission of NRMA Motoring & Services

Maps are very familiar to just about everyone, so we don’t usually think of them as being simplified versions of reality, but they are. This map does not show much more than the streets in this part of Sydney and some of the most important landmarks. The names, addresses and telephone numbers of the people who live and work in the area aren’t given. Almost none of the stores and buildings those people work and live in are shown either. It doesn’t tell you which streets allow roadside parking and which don’t. In fact, the map tells you almost nothing about the messy reality of life in this section of Sydney, except how the streets are laid out and the essential information you need to get from Circular Quay to the Opera House. Think about someone who says, ‘I know how to get around in the city, but I just can’t work out how to read a map’. It is certainly possible to find your destination in a city without a map

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PART 1 INTRODUCTION

but it’s a lot easier with one. The same is true of using graphs in economics. It is possible to arrive at a solution to a real-world problem in economics and business without using graphs, but it is usually a lot easier if you do use them. Often the difficulty students have with graphs and formulae is just a lack of familiarity. With practice, all the graphs and formulae in this text will become familiar to you. Once you are familiar with them you will be able to use them to analyse problems that would otherwise seem very difficult. What follows is a brief review of how graphs and formulae are used.

Graphs of one variable Figure 1A.1 displays values for Australian merchandise exports (goods) by destination using two common types of graphs. Export shares show the percentage of exports accounted for by different countries. Panel (a) displays the information on export shares as a bar graph, where the market share of each country is represented by the height of its bar. Panel (b) displays the same information as a pie chart, with the export share of each destination represented by the size of its slice of the pie. FIGURE 1A.1 BAR GRAPHS AND PIE CHARTS Values for an economic variable are often displayed as a bar graph or as a pie chart. In this case Figure 1A.1(a) shows export share data for Australia as a bar graph, where the export share of each country is represented by the height of its bar. Figure 1A.1(b) displays the same information as a pie chart, where the export share of each country is represented by the size of its slice of the pie 35

All other countries 25.3%

Per cent

30 25

China 29.1%

20 15

United States of America 3.7%

10 5

N

an d ep u of b Ko lic re a Ta U iw ni an te d Ki ng U do ni m te d of St a Am te er s i Al ca lo co th un er tri es

n

R

Ze

al

pa

a

ew

Ja

di In

C

hi

na

0

(a) Bar graph

United Kingdom 3.0% Taiwan 3.3%

Republic of Korea 8.3%

India 5.0% Japan New Zealand 19.4% 2.9% (b) Pie chart

SOURCE: Created from Australian Bureau of Statistics (2013), International Trade in Goods and Services, Australia, Cat. No. 5368.0, Canberra, derived from Table 14, viewed 4 March 2013.

Information on economic variables is also often displayed in time-series graphs. The date, often the year, in which the variable is measured is depicted along the horizontal axis (or x-axis), and the value of the variable is measured on the vertical axis (or y-axis). In Figure 1A.2 we measure the rate of unemployment in Australia on the vertical axis, and we measure time on the horizontal axis. In time-series graphs the height of the line at each date shows the value of the variable measured on the vertical axis. Both panels of Figure 1A.2 show Australia’s unemployment rate for each year from 1980 to 2013. The difference between panels (a) and (b) illustrates the importance of the scale used in a time-series graph. In panel (a) the scale on the vertical axis begins at 4 per cent (i.e. it does not start at zero) and finishes at 12 per cent. In panel (b) the scale begins at zero and finishes at 20 per cent. In panel (b) the fluctuations in the rate of unemployment appear smaller than in panel (a).

Graphs of two variables We often use graphs to show the relationship between two variables. For example, suppose you are interested in the relationship between the price of a pepperoni pizza and the quantity of pizzas sold per week in a small town. A graph showing the relationship between the price of a good and the quantity of the good demanded at each price is called a demand curve. (As we will discuss later, in drawing a demand curve for a good we have to hold constant any variables

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FIGURE 1A.2 TIME-SERIES GRAPHS Both panels of Figure 1A.2 show Australia’s unemployment rate for each year from 1980 to 2013. Panel (a) begins the vertical axis at 4 per cent (i.e. it does not start at zero) and finishes at 12 per cent, while panel (b) begins the vertical axis at zero and finishes at 20 per cent. As a result, the fluctuations in the rate of unemployment appear smaller in panel (b) than in panel (a) Panel a

Panel b

12

20

11

18 16 14

9

Per cent

Per cent

10

8 7

12 10 8 6

6

4 0

19 80 19 82 19 84 19 86 19 88 19 90 19 92 19 94 19 96 19 98 20 00 20 02 20 04 20 06 20 08 20 10 20 12

2

4

19 80 19 82 19 84 19 86 19 88 19 90 19 92 19 94 19 96 19 98 20 00 20 02 20 04 20 06 20 08 20 10 20 12

5

SOURCE: Created from Australian Bureau of Statistics (2013), Labour Force, Australia, Table 01, Cat. No. 6202.0, Time Series Workbook, viewed 18 March 2013.

other than price that might affect the willingness of consumers to buy the good.) Figure 1A.3 shows the data you have collected on price and quantity. The figure shows a two-dimensional grid on which we measure the price of pizza along the y-axis and the quantity of pizza sold per week along the x-axis. Each point on the grid represents one of the price and quantity combinations listed in the table. We can connect the points to form the demand curve for pizza for the town. Notice that the scales on both axes in the graph are truncated. In this case, truncating the axes allows the graph to illustrate more clearly the relationship between price and quantity by excluding low prices and quantities.

Price $16 (dollars per pizza) 15

Price (dollars per pizza)

Quantity (pizzas per week)

$15

50

14

55

13

60

12

65

11

70

FIGURE 1A.3 PLOTTING PRICE AND QUANTITY POINTS ON A GRAPH The figure shows a two-dimensional grid on which we measure the price of pizza along the vertical axis (y-axis) and the quantity of pizza sold per week along the horizontal axis (x-axis). Each point on the grid represents one of the price and quantity combinations listed in the table. By connecting the points by a line we can illustrate better the relationship between the two variables

Points A

B

C D E

A B

14

C

13

D

12

E

11 0

Demand curve 50

55

60

65

70

75

Quantity (pizzas per week) The slashes (//) indicate that the scales on the axes are truncated, which means that numbers are omitted: on the horizontal axis numbers jump from 0 to 50, and on the vertical axis numbers jump from 0 to 11.

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PART 1 INTRODUCTION

Slopes of lines Once you have plotted the data in Figure 1A.3 you may be interested in how much the quantity of pizza sold increases as the price decreases. The slope of a line tells us how much the variable we are measuring on the y-axis changes as the variable we are measuring on the x-axis changes. We often use the Greek letter delta (∆) to stand for the change in a variable. Slope =

∆y change in value on the vertical axis = change in value on the horizontal axis ∆x

Figure 1A.4 reproduces the graph from Figure 1A.3. Because the slope of a straight line is the same at any point, we can use any two points in the figure to calculate the slope of the line. For example, when the price of pizza decreases from $14 to $12, the quantity of pizza sold increases from 55 per week to 65 per week. Therefore, the slope is: Slope =

∆ price of pizza ($12 – $14) –2 = = = – 0.2 ∆ quantity of pizza 65 – 55 10

The slope of this line gives us some insight into how responsive consumers are to changes in the price of pizza. The larger the value of the slope (ignoring the negative sign), the steeper the line will be, which indicates that not many additional pizzas are sold when the price falls. The smaller the value of the slope, the flatter the line will be, which indicates a greater increase in pizzas sold when the price falls.

Taking into account more than two variables on a graph The demand curve graph in Figure 1A.4 shows the relationship between the price of pizza and the quantity of pizza sold, but we know that the quantity of any good sold depends on more than just the price of the good. For example, the quantity of pizza sold in a given week can be affected by such other variables as the price of burgers, whether an advertising campaign by local pizza parlours has begun that week and so on. Allowing the values of any other variables to change will cause the position of the demand curve in the graph to change. Suppose, for example, that the demand curve for pizzas in Figure 1A.4 was drawn holding the price of burgers constant at $1.50. If the price of burgers rises to $2.00 some consumers will switch from buying burgers to buying pizza and more pizzas will be sold at every price. The result on the graph will be to shift the line representing the demand curve to the right. Similarly, if the price of burgers falls from $1.50 to $1.00, some consumers will switch from buying pizza to buying burgers and fewer pizzas will be sold at every price. The result on the graph will be to shift the line representing the demand curve to the left. The table in Figure 1A.5 shows the effect of a change in the price of burgers on the quantity of pizza demanded. For example, suppose at first we are on the line labelled Demand curve1. If the price of pizza is $14 (point A) an increase in the price of burgers from $1.50 to $2.00 increases the quantity of pizza demanded from 55 to 60 per week (point B), and shifts us to FIGURE 1A.4 CALCULATING THE SLOPE OF A LINE We can calculate the slope of a line as the change in the value of the variable on the y-axis divided by the change in the value of the variable on the x-axis. Because the slope of a straight line is constant, we can use any two points in the figure to calculate the slope of the line. For example, when the price of pizza decreases from $14 to $12 the quantity of pizza demanded increases from 55 per week to 65 per week. So, the slope of this line equals –2 divided by 10, or –0.2

Price $16 (dollars per pizza) 15 (55, 14)

14 13

12 – 14 = –2 (65, 12)

12

65 – 55 = 10

11 0

Demand curve 50

55

60

65

70

75

Quantity (pizzas per week)

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FIGURE 1A.5 SHOWING THREE VARIABLES ON A GRAPH The demand curve for pizza shows the relationship between the price of pizzas and the quantity of pizza demanded, holding constant other factors that might affect the willingness of consumers to buy pizza. If the price of pizza is $14 (point A), an increase in the price of burgers from $1.50 to $2.00 increases the quantity of pizzas demanded from 55 to 60 per week (point B) and shifts us to Demand curve2. Or, if we start on Demand curve1, and the price of pizza is $12 (point C), a decrease in the price of burgers from $1.50 to $1.00 decreases the quantity of pizzas demanded from 65 to 60 per week (point D), and shifts us to Demand curve3

Quantity (pizzas per week) Price (dollars per pizza)

When the price of burgers = $1.00

When the price of burgers = $1.50

When the price of burgers = $2.00

$15

45

50

55

14

50

55

60

13

55

60

65

12

60

65

70

11

65

70

75

Price $16 (dollars per pizza) 15 A

14

25

B

13 12

C

D

11

Demand curve3

10

Demand curve1

Demand curve2

9 0

45

50

55

60

65

70

75

80

Quantity (pizzas per week)

Demand curve2. Or, if we start on Demand curve1 and the price of pizza is $12 (point C), a decrease in the price of burgers from $1.50 to $1.00 decreases the quantity of pizza demanded from 65 to 60 per week (point D) and shifts us to Demand curve3. By shifting the demand curve, we have taken into account the effect of changes in the value of a third variable—the price of burgers. We will use this technique of shifting curves to allow for the effects of additional variables many times in this book.

Positive and negative relationships We can use graphs to show the relationships between any two variables. Sometimes the relationship between the variables is negative, meaning that as one variable increases in value the other variable decreases in value. This was the case with the price of pizza and the quantity of pizza demanded. The relationship between two variables can also be positive, meaning that the values of both variables increase together. This positive co-movement is the case, for example, with the level of disposable personal income (income from all sources less tax) received by households and the level of total consumption spending, which is spending by households on all types of goods and services, apart from houses. The table in Figure 1A.6 shows hypothetical values for income and consumption spending for the years 2013–2016 (the values are in billions of dollars). The graph plots the data from the table, with disposable personal income measured along the horizontal axis and consumption spending measured along the vertical axis. Notice that the four points do not all fall exactly on the line. This is often the case with real-world data. To examine the relationship between two variables economists often use the straight line that best fits the data.

Slopes of non-linear curves The relationship between some economic variables cannot be represented accurately by a straight line. For example, panel (a) of Figure 1A.7 shows the hypothetical relationship between Apple’s total cost of producing iPods and the quantity of iPods produced. The relationship is curved, rather than linear. In this case the cost of production is increasing at an increasing rate, which often happens in manufacturing. Put a different way, as we move up the curve its slope becomes larger. To see this effect, first remember that we calculate the slope of a curve by dividing the

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PART 1 INTRODUCTION

FIGURE 1A.6 IN A POSITIVE RELATIONSHIP BETWEEN TWO ECONOMIC VARIABLES, AS ONE VARIABLE INCREASES THE OTHER VARIABLE ALSO INCREASES This figure shows the positive relationship between disposable personal income and consumption spending. As disposable personal income has increased so has consumption spending

Year

Disposable personal income (billions of dollars)

Consumption spending (billions of dollars)

2013

$7486

$7055

2015

8159

7760

2014

7827

2016 Consumption spending (billions of dollars)

7376

8632

8229

$8600 8400 8200

2016

8000 7800

2015

7600 7400

2014

7200

2013

7000 0

$7400

7600

7800

8000

8200

8400

8600

8800

Disposable personal income (billions of dollars)

FIGURE 1A.7 THE SLOPE OF A NON-LINEAR CURVE The relationship between the quantity of iPods produced and the total cost of production is curved, rather than linear. In Figure 1A.7(a), in moving from point A to point B, the quantity produced increases by one million iPods, while the total cost of production increases by $50 million. Further up the curve, as we move from point C to point D the change in quantity is the same—one million iPods—but the change in the total cost of production is now much larger: $250 million. Because the change in the y-variable has increased, while the change in the x-variable has remained the same, we know that the slope has increased. In Figure 1A.7(b), we measure the slope of the curve at a particular point by the slope of the tangent line. The slope of the tangent line at point B is 75, and the slope of the tangent line at point C is 150 Total cost of production (millions of dollars)

Total cost

Total cost of production (millions of dollars)

Total cost

D

$1000

Δy = 250

$900 Δy = 150

C

750

350 300

750

Δx = 1

B A

Δy = 50

3

4

Δx = 1

B

350

Δy = 75

275

Δx = 1

0

C

8

9

0

Quantity produced (millions per month) (a) The slope of a non-linear curve is not constant

Δx = 1 3

4

8

9

Quantity produced (millions per month) (b) The slope of a non-linear curve is measured by the slope of the tangent line

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Figure 1A.7 a&b

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change in the variable on the y-axis by the change in the variable on the x-axis. In moving from point A to point B, the quantity produced increases by one million iPods, while the total cost of production increases by $50 million. Further up the curve, as we move from point C to point D, the change in quantity is the same—one million iPods—but the change in the total cost of production is now much larger: $250 million. Because the change in the y-variable has increased, while the change in the x-variable has remained the same, we know that the slope has increased. To measure the slope of a non-linear curve at a particular point we must measure the slope of the tangent line to the curve at that point. A tangent line will only touch the curve at that point. We can measure the slope of the tangent line just as we would the slope of any straight line. In Figure 1A.7(b), the tangent line at point B has a slope equal to:

∆ cost 75 = = 75 ∆ quantity 1 The tangent line at point C has a slope equal to:

∆ cost 150 = = 150 ∆ quantity 1 Once again we see that the slope of the curve is larger at point C than at point B.

Formulae We have just seen that graphs are an important economic tool. In this section we will review several useful formulae and show how to use them to summarise data and to calculate important relationships.

Formula for a percentage change One important formula is the percentage change. The percentage change is the change in some economic variable, usually from one period to the next, expressed as a percentage. An important macroeconomic measure is the ‘real’ gross domestic product, or RGDP. RGDP is the value of all the final goods and services produced in a country during a year. RGDP is corrected for the effects of inflation. When economists say that the Australian economy grew by 3.4 per cent during 2012, they mean that RGDP was 3.4 per cent higher in 2012 than it was in 2011. The formula for making this calculation is:

 RGDP2012 − RGDP2011   × 100  RGDP2011   or, more generally for any two periods:

 value in the second period – value in the first period Percentage change =   × 100 value in the first period  Suppose RGDP was $1452 billion in 2012 and $1404 billion in 2011. The growth rate of the economy during 2012 would have been:

$1452 – $1404 × 100 = 3.4%  $1404  Notice that it didn’t matter that in using the formula we ignored the fact that RGDP is measured in billions of dollars. In fact, when calculating percentage changes, the units don’t matter. The percentage increase from $1404 billion to $1452 billion is exactly the same as the percentage increase from $1404 to $1452.

Formulae for the areas of a rectangle and a triangle Areas that form rectangles and triangles on graphs can have important economic meaning. For example, Figure 1A.8 shows the demand curve for Pepsi. Suppose that the price is

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PART 1 INTRODUCTION

currently $2.00 per bottle and that 125 000 bottles of Pepsi are sold at that price. A firm’s total revenue is equal to the amount it receives from selling its product, or the price times the quantity sold. In this case total revenue will equal $2.00 per bottle times 125 000 bottles, or $250 000. The formula for the area of a rectangle is: Area of a rectangle = base × height In Figure 1A.8 the shaded rectangle also represents the firm’s total revenue because its area is given by the base of 125 000 bottles multiplied by the price of $2.00 per bottle. We will see in later chapters that areas that are triangles can also have economic significance. The formula for the area of a triangle is: Area of triangle = 1/2 × base × height The blue-shaded area in Figure 1A.9 is a triangle. The base equals 150 000 – 125 000, or 25 000. Its height equals $2.00 – $1.50, or $0.50. Therefore its area equals 1⁄2 × 25 000 × $0.50, or $6250. Notice that the blue area is only a triangle if the demand curve is a straight line, or linear. Not all demand curves are linear. However, the formula for the area of a triangle will usually still give us a good approximation, even if the demand curve is not linear.

FIGURE 1A.8 SHOWING A FIRM’S TOTAL REVENUE ON A GRAPH The area of a rectangle is equal to its base multiplied by its height. Total revenue is equal to price multiplied by quantity. Here, total revenue is equal to the price of $2.00 per bottle times 125 000 bottles, or $250 000. The area of the shaded rectangle shows the firm’s total revenue

Price of Pepsi (dollars per bottle)

$2.00

Total revenue Demand curve for Pepsi 0

FIGURE 1A.9 THE AREA OF A TRIANGLE The area of a triangle is equal to one-half of its base multiplied by its height. The area of the blue-shaded triangle has a base equal to 150 000 – 125 000, or 25 000, and a height equal to $2.00 – $1.50, or $0.50. Therefore, its area equals 1⁄2 × 25 000 × $0.50, or $6250

Quantity (bottles per month)

125 000

Price of Pepsi (dollars per bottle) Area = 1/2 × base × height = 1/2 × 25 000 × $0.50 = $6250

$2.00 1.50

Demand curve for Pepsi 0

125 000

150 000

Quantity (bottles per month)

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Summary of using formulae You will encounter several other formulae in this book. Whenever you must use a formula, you should follow these steps: 1 Make sure you understand the economic concept that the formula represents. 2 Make sure that you are using the correct formula for the problem you are solving. 3 Make sure that the number you calculate using the formula is economically reasonable. For example, if you are using a formula to calculate a firm’s revenue and your answer is a negative number, you know you have made a mistake somewhere.

APPENDIX PROBLEMS USING GRAPHS AND FORMULAE, PAGES 21–29 LEARNING OBJECTIVE:

Review the use of graphs and formulae.

PROBLEMS AND APPLICATIONS 1A.1

QUANTITY

The following table gives the relationship between the price of pies and the number of pies Bruce buys per week.

(GLASSES OF

QUANTITY

1A.2

PRICE

OF PIES

WEEK

$3.00

6

2 July

2.00

7

9 July

5.00

4

16 July

6.00

3

23 July

1.00

8

30 July

4.00

5

6 August

a Is the relationship between the price of pies and the number of pies Bruce buys a positive relationship or a negative relationship? b Plot the data from the table on a graph similar to the one in Figure 1A.3. Draw a straight line that best fits the points. c Calculate the slope of the line. The following table gives information on the quantity of glasses of lemonade demanded on sunny and overcast days. Plot the data from the table on a graph similar to the one in Figure 1A.5. Draw two straight lines representing the two demand curves—one for sunny days, the other for overcast days.

1A.3

1A.4

1A.5

PRICE (DOLLARS

LEMONADE

PER GLASS)

PER DAY)

$0.80

30

Sunny

0.80

10

Overcast

0.70

40

Sunny

0.70

20

Overcast

0.60

50

Sunny

0.60

30

Overcast

0.50

60

Sunny

0.50

40

Overcast

WEATHER

Using the information in Figure 1A.2, calculate the percentage change in unemployment from one year to the next. Between which years did unemployment rise at the fastest rate? Real GDP in Australia in 2002 was $1 073 336 million and in 2012 real GDP was $1 451 110 million.3 What was the percentage change in real GDP from 2002 to 2012? What do economists call the percentage change in real GDP from one year to the next? Assume the demand curve for Pepsi passes through the following two points: NUMBER OF BOTTLES PRICE PER BOTTLE OF PEPSI

OF PEPSI SOLD

$2.50

100 000

1.25

200 000

a Draw a graph with a linear demand curve that passes through these two points. b Show on the graph the areas representing total revenue at each price. Give the value for total revenue at each price.

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PART 1 INTRODUCTION 1A.6

What is the area of the blue triangle shown in the following figure?

1A.7 Calculate the slope of the total cost curve at point A and at

point B in the following figure. Total cost of production (millions of dollars)

Price of Pepsi (per two-litre bottle)

Total cost $900

$2.25 1.50

B

700

Demand curve for Pepsi 0

115 000

175 000

Quantity of two-litre bottles of Pepsi sold per week

A

300 175

0

5

7

12 14 Quantity produced (millions per month)

ENDNOTES 1

2

National Institute of Economic and Industry Research (2012), Offshore and off work: The future of Australia’s service industries in a global economy. An update. A report for the Australian Services Union and the Finance Sector Union, at . Alumni Profiles, School of Economics, University of Queensland,

3

at , viewed 13 March 2013. Australian Bureau of Statistics (2013), Australian National Accounts: National Income, Expenditure and Product, Cat. No. 5206.0, Time Series Workbook, at .

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CHAPTER

2

CHOICES AND TRADE-OFFS IN THE MARKET LEARNING OBJECTIVES After studying this chapter you should be able to: 2.1 Use a production possibility frontier to analyse opportunity costs and trade-offs. 2.2 Understand comparative advantage and explain how it is the basis for trade. 2.3 Explain the basic idea of how a market system works. 2.4 Understand why property rights are necessary for a well-functioning market.

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MANAGERS MAKING CHOICES AT BMW WHEN YOU THINK of cars that combine fine engineering, high performance and cutting-edge styling, you are likely to think of BMW. The Bayerische Motoren Werke, or Bavarian Motor Works, was founded in Germany in 1916 as a company devoted to manufacturing aircraft engines. In the early 1920s BMW began to make motorcycles. In 1928 it produced its first car. Today, BMW employs over 100 000 workers at 25 sites in 14 countries, and has worldwide sales of more than 1.8 million vehicles. To compete in the car market the managers of BMW must make many strategic decisions, such as whether to introduce new car models. BMW now sells a hydrogen-powered version of the 7 Series sedan and in late 2013 began production of its i3 electric car. Another strategic decision faced by BMW’s managers is where to advertise. In the late 1990s, for example, some of BMW’s managers opposed advertising in mainland China because they did not think they would sell many cars there. Other managers, however, argued that rising incomes were rapidly increasing the size of the Chinese market. BMW decided to advertise in China, and today China has become the company’s largest single market in the world. BMW’s managers have also faced the strategic decision of whether to concentrate production in factories in Germany or to build new factories in its overseas markets. Keeping production in Germany makes it easier for BMW’s managers to supervise production and to employ German workers, who generally have high levels of technical training. BMW has eight production plants in Germany. Building factories in other countries, however, has two benefits. First, the lower wages paid to workers in other countries reduce the cost of manufacturing vehicles. Second, BMW can reduce political friction by producing vehicles in the same country in which they sell them. BMW has production plants in Austria, Brazil, China, South Africa, the United Kingdom and the United States, and assembly plants in Egypt, India, Indonesia, Malaysia, Russia and Thailand. Managers also face smaller-scale—or tactical—business decisions. For instance, until the early 2000s BMW used two workers to attach the gearbox to the engine in each car. The company then developed an alternative method of attaching the gearbox using a robot rather than workers. In choosing which method to use, managers at BMW faced a trade-off because the robot method had a higher cost but installed the gearbox in exactly the correct position, which reduces engine noise when the car is driven. Ultimately, the managers decided to adopt the robot method. A similar type of tactical business decision must be made in scheduling production between different models. For instance, at BMW’s Regensburg plant in Germany a number of different models are built, including both the Z4 Roadsters and the 3 Series. A decision must be made each month on the quantity of each model to be produced. SOURCE: BMW Group, at , viewed 8 April 2013.

© Chatchai Somwat / Shutterstock

2

ECONOMICS IN YOUR LIFE

THE TRADE-OFFS WHEN YOU BUY A CAR When you buy a car, you probably consider factors such as fuel efficiency and safety. One way car manufacturers increase fuel efficiency is by making cars smaller and lighter. In terms of safety, large cars absorb more of the impact during an accident than small cars do. As a result, people are usually safer driving large cars than small cars. What can we conclude from these facts about the relationship between safety and fuel efficiency? Under what circumstances would it be possible for car manufacturers to make cars safer and more fuel efficient? As you read the chapter, see if you can answer these questions. You can check your answers against those provided on page 47 at the end of this chapter.

Reproduced with the permission of BMW Group Australia

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PART 1 INTRODUCTION

Scarcity The situation in which unlimited wants exceed the limited resources available to fulfil those wants.

IN A MARKET system, managers at most firms must make decisions like those made by BMW’s managers. The decisions managers face reflect the key fact of economic life: scarcity requires trade-offs. As we learned in Chapter 1, scarcity exists because we have unlimited wants but only limited resources available to fulfil those wants. Goods and services are scarce. So, too, are the economic resources, or factors of production— workers, capital and machinery, natural resources and entrepreneurial ability—used to make them. Your time is scarce, which means you face trade-offs: if you spend an hour studying for an economics exam you have one less hour to spend studying for a management exam or going to the movies. If your university decides to use some of its scarce budget to buy new computers, those funds will not be available to buy new books for the library or to resurface the student car park. If BMW decides to devote some of the scarce workers and machinery in its Regensburg plant to producing more Z4 Roadster sports cars, those resources will not be available to produce more 3 Series cars. Many of the decisions of households and firms are made in markets. One key activity that takes place in markets is trade. By engaging in trade, people can raise their standard of living. Trade involves the decisions of millions of households and firms spread around the world. In this chapter we provide an overview of how the market system coordinates the independent decisions of these millions of households and firms. We begin our analysis of the economic consequences of scarcity and the working of the market system by introducing an important economic model: the production possibility frontier.

2.1 Use a production possibility frontier to analyse opportunity costs and trade-offs. LEARNING OBJECTIVE

Production possibility frontier A curve showing the maximum attainable combinations of two products that may be produced with available resources.

PRODUCTION POSSIBILITY FRONTIERS AND REAL-WORLD TRADE-OFFS As we saw in the opening case to this chapter, BMW operates a car factory in Regensburg, Germany, where it produces a number of models, including Z4 Roadster sports cars and the 3 Series car range. Because the firm’s resources—workers, machinery, materials and entrepreneurial skills— are limited, BMW faces a trade-off: resources devoted to producing Z4s are not available for producing 3 Series, and vice versa. Chapter 1 explained that economic models can be useful in analysing many questions. We can use a simple model called the production possibility frontier to  analyse the trade-offs BMW faces in its Regensburg plant. A  production possibility frontier is a curve showing the maximum attainable combinations of two products that may be produced with available resources. We will use an example of two BMW products—Z4 Roadsters and 3 Series convertibles. The resources are BMW’s workers, materials, robots and other machinery.

Graphing the production possibility frontier Figure 2.1 uses a production possibility frontier to illustrate the trade-offs facing BMW. The numbers from the table are plotted on the graph. The curve in the graph is BMW’s production possibility frontier. If BMW uses all its resources efficiently to produce Roadsters it can produce 800 per day—point A at one end of the production possibility frontier. If BMW uses all its resources to produce convertibles it can produce 600 per day—point E at the other end of the production possibility frontier. If BMW devotes resources to producing both vehicles it could be at a point like B, where it produces 600 Roadsters and 400 convertibles. All the combinations either on the frontier—like A, B, C, D and E—or inside the frontier— like point F—are attainable with the resources available. Combinations on the  frontier are efficient because all available resources are being fully utilised, and the fewest possible resources are being used to produce a given amount of output. Combinations inside the frontier—like point F—are inefficient because maximum output is not being obtained from the available resources—perhaps because the assembly line is not operating at capacity. For example, at point F only 300 Roadsters and 200 convertibles are being produced, but if the resources were combined efficiently more of both vehicles could be produced, as shown by points on the frontier, such as point B. BMW might like to be beyond the frontier—at a point like G

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FIGURE 2.1

BMW’s production choices per day Choice

Quantity of Roadsters produced

A

800

C

400

B

D E

Quantity of Roadsters produced per day 800

Quantity of convertibles produced 0

600

400

200

575

500 600

    0

A combination that is unattainable with current resources.

A

B

600

G

BMW’s production possibility frontier showing its trade-off between producing Roadsters and convertibles.

C

400 F

300

D

200

BMW’s production possibility frontier BMW faces a trade-off: to build more Roadsters it must build fewer convertibles. The production possibility frontier illustrates the trade-off BMW faces. Combinations on the production possibility frontier—like points A, B, C, D and E—are efficient because the maximum output is being obtained from the available resources. Combinations inside the frontier— like point F—are inefficient because some resources are not being used or are not being used efficiently. Combinations outside the frontier—like point G—are unattainable with the current amount of resources

E 0

100

200

400

500 575 600

A combination that is inefficient because not all resources are being used.

Quantity of convertibles produced per day

where it would be producing 600 Roadsters and 500 convertibles—but points beyond the production possibility frontier are unattainable given the firm’s current resources. To produce the combination at G, BMW would need more machines or more workers. Notice that if BMW is producing efficiently and is on the production possibility frontier, the only way to produce more of one vehicle is to produce less of the other vehicle. Recall from Chapter 1 that the opportunity cost of any activity is the highest-valued alternative that must be given up to engage in that activity. For BMW, the opportunity cost of producing one additional 3  Series convertible is the number of Z4 Roadsters the company will not be able to produce because it has already devoted those resources to producing convertibles. For example, in moving from point B to point C, the opportunity cost of producing 100 more convertibles per day (from 400 to 500 vehicles) is the 200 fewer Roadsters that can be produced (from 600 down to 400). What point on the production possibility frontier is best? We can’t tell without further information. If consumer demand for 3 Series convertibles is greater than demand for Z4 Roadsters the company is likely to choose a point closer to E. If demand for Roadsters is greater than demand for convertibles the company is likely to choose a point closer to A.

Opportunity cost The highest-valued alternative that must be given up to engage in an activity.

Increasing marginal opportunity costs We can also use the production possibility frontier to explore issues concerning the economy as a whole. For example, suppose we assume that an economy produces just two types of goods: wool and wheat. Figure 2.2 shows a production possibility frontier for these two goods. If all the country’s resources are devoted to producing wool, 400 million tonnes can be produced in one year. If all resources are devoted to producing wheat, 500 million tonnes can be produced in one year. Devoting resources to producing both goods results in the economy being at other points along the production possibility frontier. Notice that the production possibility frontier is bowed outwards from the origin. Because the curve is bowed out (concave) the opportunity cost of wheat in terms of wool depends upon

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PART 1 INTRODUCTION

M

C

A K I N G THE

2.1

ONNECTION

TRADE-OFFS AND EMERGENCY AID RELIEF When natural disasters such as earthquakes, hurricanes, floods and droughts strike populated areas substantial amounts of emergency aid from individuals and governments throughout the world are donated. However, both governments and  individuals face limited budgets, and funds used for one purpose are unavailable to be used for another purpose. Unfortunately, there is often a trade-off involved, with an increase in charitable giving to one cause resulting in a decrease in charitable giving to other causes following a disaster. This is not surprising as charities often experience what is sometimes referred to as ‘budget exhaustion’. Budget exhaustion suggests that people who give to charities put aside a certain sum of money to donate, and once given there is no more for other causes.

In October 2012, super-hurricane Sandy struck north-east USA, killing 285 people and damaging over 80 000 homes. During the first three weeks following the Sourced from http://www.ausaid.gov.au/media/gallery/yogya.cfm, AusAID More funds for emergency relief can mean destruction, almost $220 million in donations was given. However, other charities fewer funds for other charities in the New York City region unrelated to the hurricane relief effort found that their usual donations were falling or had stopped altogether. For example, a charity serving wounded military personnel reported that donations had fallen to almost zero and a metropolitan poverty charity saw their donations fall by almost 30 per cent. In January 2010 a massive earthquake struck the island of Haiti, killing more than 230 000 people and causing massive destruction to homes and infrastructure. Non-government aid organisations received substantial donations from individuals and businesses to assist the Haitian people. However, when a devastating earthquake hit Chile about one month later, non-government aid agencies reported that donations were less than hoped for. The Red Cross and the aid programs of churches reported that their regular donation levels to their other causes fell in the months following the two earthquakes. This trade-off was also seen following the December 2004 tsunami disaster, when an earthquake caused a tidal wave—or tsunami—to flood coastal areas of Indonesia, Thailand, Sri Lanka and other countries bordering the Indian Ocean, killing more than 280 000 people and destroying villages and homes. There was an influx of donations following this terrible event, but many charities in other parts of the world saw their donations fall. A difficult trade-off resulted: giving funds to victims of natural disasters meant fewer funds were available to aid other good causes. SOURCES: Anjali Athavaley (2012), ‘Nonprofits fear donors have post-sandy ‘ask’ fatigue’, The Wall Street Journal, 9 December at , viewed 10 April 2013; AllBusiness (2010); ‘Donations to Haiti might deprive local charities’, 26 January at , viewed 11 January 2012; SwissInfo.ch (2005), ‘Charities fear post-tsunami donor fatigue’, 12 January at , viewed 11 April 2013.

where the economy currently is on the production possibility frontier. For example, to increase wheat production from zero to 200 units (millions of tonnes)—moving from point A to point B— the economy only has to give up 50 units of wool. But to increase wheat production by another 200 units—moving from point B to point C—the economy has to give up 150 units of wool. As the economy moves down the production possibility frontier it experiences increasing marginal opportunity costs because increasing wheat production by a given quantity requires larger and larger decreases in wool production. Increasing marginal opportunity costs occur because some workers, machines and other resources are better suited to one use than to another. At point A some resources that are well suited to producing wheat are being forced to produce wool. Shifting these resources into producing wheat by moving from point A to point B allows a substantial increase in wheat production without much loss of wool production. But as the economy moves down the production possibility frontier more and more resources that are better suited to wool production are switched into wheat production. As a result, the increases in wheat production become increasingly smaller while the decreases in wool production become increasingly larger.

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FIGURE 2.2

Increasing wool production by 200 here . . .

Wool (millions of tonnes)

Increasing marginal opportunity cost

. . . only reduces wheat production by 50.

A

400 350

. . . reduces wheat production by 150.

C

200

0

200

As the economy moves down the production possibility frontier it experiences increasing marginal opportunity costs because increasing wheat production by a given quantity requires larger and larger decreases in wool production. For example, to increase wheat production from 0 to 200 units (millions of tonnes)—moving from point A to point B— the economy only has to give up 50 units of wool. But to increase wheat production by another 200 units— moving from point B to point C—the economy has to give up 150 units of wool

Increasing wool production by 200 here . . .

B

400

37

500

Wheat (millions of tonnes)

The idea of increasing marginal opportunity costs illustrates an important economic concept: the more resources already devoted to an activity, the smaller the payoff to devoting additional resources to that activity. The more hours you have already spent studying economics, the smaller the increase in your test grade from each additional hour you spend—and the greater the opportunity cost of using the hour in that way. The more funds a firm has devoted to research and development during a given year, the smaller the amount of useful knowledge it receives from each additional dollar—and the greater the opportunity cost of using the funds in that way.

Economic growth At any given time the total resources available to any economy are fixed. Therefore, if Australia produces more wheat it must produce less of something else—wool in our example. Over time, though, the resources available to an economy may increase. For example, both the labour force and the capital stock—the amount of physical capital available in the country—may increase. The increase in the available labour force and the capital stock shifts the production possibility frontier outwards for the Australian economy and makes it possible to produce both more wheat and more wool. Figure 2.3(a) shows that the economy can move from point A to point B, producing more wool and more wheat. FIGURE 2.3

Economic growth Figure 2.3(a) shows that as more economic resources become available and technological change occurs, the economy can move from point A to point B, producing more wool and more wheat. Figure 2.3(b) shows the results of technological advance in the wheat industry that increases the quantity of wheat that workers can produce per year, while leaving the maximum quantity of wool that can be produced unchanged. Shifts in the production possibility frontier represent economic growth

Wool (millions of tonnes)

Wool (millions of tonnes)

500 400

400 B

300 200

A

0

400 450 500 625

Wheat (millions of tonnes)

(a) Shifting out the production possibility frontier

0

500

800 Wheat (millions of tonnes)

(b) Technological change in the wheat industry

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Similarly, technological advance makes it possible to produce more goods with the same number of workers and the same amount of machinery, which also shifts the production possibility frontier outwards. Technological advance need not affect all sectors equally. Figure 2.3(b) shows the results of technological advance in the wheat industry that increases the quantity of wheat that workers can produce per year, while leaving unchanged the quantity of wool that can be produced. Outward shifts in the production possibility frontier represent economic growth because they allow the economy to increase the production of goods and services, which ultimately raises the standard of living. In Australia and other high-income countries the market system has aided the process of economic growth, which over the past 200 years has greatly increased the health and wellbeing of the average person. It is also possible for a production possibility frontier to shift inwards. This would occur if an economy experienced a reduction in its productive resources, causing the maximum amount of output that could be produced to fall. Disasters such as earthquakes, floods, fire or wars can lead to an inward shift of the production possibility frontier.

COMPARATIVE ADVANTAGE AND TRADE 2.2 Understand comparative advantage and explain how it is the basis for trade. LEARNING OBJECTIVE

Trade The act of buying or selling a good or service in a market.

Having discussed the important ideas of production possibility frontiers and opportunity cost, we can use them to understand the basic economic activity of trade. Markets are fundamentally about trade, which is the act of buying and selling. Many of the trades in which we engage take place indirectly. We sell our labour services as, say, an accountant, salesperson or nurse for money, and then use the money to buy goods and services. Ultimately an accountant, salesperson or nurse is trading their services for food, clothing and other goods and services. One of the great benefits of trade is that it makes it possible for people to become better off by increasing both their production and their consumption.

Specialisation and gains from trade Consider the following situation: you and your neighbour both have fruit trees on your property. Initially, suppose that you only have apple trees and your neighbour only has cherry trees. In this situation, if you both like apples and cherries there is an obvious opportunity for both of you to gain from trade: you trade some of your apples for some of your neighbour’s cherries, making you both better off. But what if there are apple and cherry trees growing on both of your properties? In that case there can still be gains from trade. For example, your neighbour might be very good at picking apples and you might be very good at picking cherries. Therefore, it makes sense that you both can benefit if your neighbour concentrates on picking apples and you concentrate on picking cherries. You can then trade some of your cherries for some of your neighbour’s apples. But what if your neighbour is actually better at picking both apples and cherries than you are? It might not seem that in this case your neighbour has anything to gain from trading with you, but in fact they do. TABLE 2.1

Fruit picked each month without trade YOU APPLES

All time devoted to picking apples All time devoted to picking cherries

YOUR NEIGHBOUR CHERRIES

APPLES

CHERRIES

20 kg

0 kg

30 kg

0 kg

0 kg

20 kg

0 kg

60 kg

Table 2.1 shows how many apples and how many cherries you and your neighbour can pick in one month. If you devote all your time to picking apples and none of your time to picking cherries, you can pick 20 kilograms of apples per month. If you devote all your time to picking cherries, you can pick 20 kilograms per month. Table 2.1 also shows that if your neighbour devotes all their time to picking apples they can pick 30 kilograms. If they devote all their time to picking cherries they can pick 60 kilograms.

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39

Suppose that when you don’t trade with your neighbour you pick and consume 8 kilograms of apples and 12 kilograms of cherries per month. When they don’t trade with you your neighbour picks and consumes 9 kilograms of apples and 42 kilograms of cherries per month. After years of picking and consuming your own apples and cherries suppose your neighbour comes to you one day with the following proposition: they offer next month to trade you 15 kilograms of their cherries for 10 kilograms of your apples. Should you accept this offer? You will have more apples and more cherries to consume if you do. To take advantage of their offer, first, rather than splitting your time between picking apples and picking cherries, you should specialise in picking apples only. We know this will allow you to pick 20 kilograms of apples. You can trade 10 of those 20 kilograms of apples to your neighbour for 15 kilograms of their cherries. The result is that you will be able to consume 10  kilograms of apples and 15 kilograms of cherries. You are clearly better off as a result of trading with your neighbour: you now can consume two more kilograms of apples and three more kilograms of cherries than you were consuming without trading. Your neighbour has also benefited. By specialising in picking only cherries, they can pick 60 kilograms. They trade 15 kilograms of cherries to you for 10 kilograms of apples. The result is that they can consume 10 kilograms of apples and 45 kilograms of cherries. This is one more kilogram of apples and three more kilograms of cherries than they were consuming before trading with you. Table 2.2 summarises the changes in production and consumption that result from your trade with your neighbour. TABLE 2.2

A summary of the gains from trade YOU

YOUR NEIGHBOUR

APPLES (kg)

CHERRIES (kg)

APPLES (kg)

CHERRIES (kg)

8

12

9

42

Production with trade

20

0

0

60

Consumption with trade

10

15

10

45

2

3

1

3

Production and consumption without trade

Gains from trade (increased consumption)

Absolute advantage versus comparative advantage Perhaps the most remarkable aspect of the preceding example is that your neighbour benefits from trading with you even though they are better at picking both apples and cherries than you are. Absolute advantage is the ability to produce more of a good or service than other producers using the same amount of resources. Your neighbour has an absolute advantage over you in producing both apples and cherries because they can pick more of each fruit than you can in the same amount of time. This observation seems to suggest that your neighbour should pick their own apples and their own cherries. We have just seen, however, that they are better off if they specialise in cherry picking and leave the apple picking to you. We can consider further why both you and your neighbour benefit from specialising in picking only one fruit. First, think about the opportunity cost to each of you of picking the two fruits. We saw from Table 2.1 that if you devoted all your time to picking apples you would be able to pick 20 kilograms of apples per month. As you shift time away from picking apples to picking cherries, you have to give up one kilogram of apples for each kilogram of cherries you pick. Therefore, your opportunity cost of picking one kilogram of cherries is one kilogram of apples. By the same reasoning, your opportunity cost of picking one kilogram of apples is one kilogram of cherries. Your neighbour faces a different trade-off. As they shift their time from picking apples to picking cherries, they have to give up 0.5 kilogram of apples for every one kilogram of cherries they pick. As they shift their time from picking cherries to picking apples, they give up two kilograms of cherries for every one kilogram of apples they pick. Therefore, their opportunity cost of picking one kilogram of apples is two kilograms of cherries, and their opportunity cost of picking one kilogram of cherries is 0.5 kilogram of apples.

Absolute advantage The ability of an individual, firm or country to produce more of a good or service than other producers using the same amount of resources.

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Table 2.3 summarises the opportunity costs for you and your neighbour of picking apples and cherries. Note that even though your neighbour can pick more apples in a month than you can, the opportunity cost of picking apples is higher for them than for you because when they pick apples they give up more cherries than you do. So, even though they have an absolute advantage over you in picking apples, it is more costly for them to pick apples than it is for you. The table also shows us that their opportunity cost of picking cherries is lower than your opportunity cost of picking cherries. TABLE 2.3

OPPORTUNITY COST OF PICKING 1 KG OF APPLES

OPPORTUNITY COST OF PICKING 1 KG OF CHERRIES

You

1 kg of cherries

1 kg of apples

Your neighbour

2 kg of cherries

0.5 kg of apples

Comparative advantage is the ability of an individual, firm or country to produce a good or service at a lower opportunity cost than other producers. In apple picking, your neighbour has an absolute advantage over you, but you have a comparative advantage over them. Your neighbour has both an absolute and a comparative advantage over you in picking cherries. As we have seen, you are better off specialising in picking apples, and your neighbour is better off specialising in picking cherries. Another way of thinking about why it would be costly for your neighbour to spend time picking apples is that even though they can pick 1.5 times as many apples in a month as you can—30 kilograms per month for them versus 20 kilograms per month for you—they can pick three times as many cherries—60 kilograms per month for them versus 20 kilograms for you. So, by specialising in picking cherries they are spending their time in the activity where their absolute advantage over you is the greatest.

Comparative advantage The ability of an individual, firm or country to produce a good or service at a lower opportunity cost than other producers.

DON’T LET THIS HAPPEN TO YOU

Opportunity cost of picking apples and cherries

Don’t confuse absolute advantage and comparative advantage First, make sure you know the definitions: 1

Absolute advantage: The ability of an individual, firm or country to produce more of a good or service than other producers using the same amount of resources. In our example, your neighbour has an absolute advantage over you both in picking apples and in picking cherries.

2

Comparative advantage: The ability of an individual, firm or country to produce a good or service at a lower opportunity cost than other producers. In our example, your neighbour has a comparative advantage in picking cherries, but you have a comparative advantage in picking apples.

Keep these two key points in mind: 1

It is possible to have an absolute advantage in producing a good or service without having a comparative advantage. This would be the case with your neighbour picking apples.

2

It is possible to have a comparative advantage in producing a good or service without having an absolute advantage. This would be the case with you picking apples.

[ YOUR TURN Q

Test your understanding by doing related problem 2.3 on page 52 at the end of this chapter.

Comparative advantage and the gains from trade We have just derived an important economic principle: the basis for trade is comparative advantage, not absolute advantage. The fastest apple pickers do not necessarily do much apple picking. If the fastest apple pickers have a comparative advantage in some other activity—picking cherries, playing professional tennis or being industrial engineers—they are better off specialising in that other activity. Individuals, firms and countries are better off if they specialise in producing goods and services for which they have a comparative advantage and obtain the other goods and services they need by trading.

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SOLVED PROBLEM 2.1 COMPARATIVE ADVANTAGE AND THE GAINS FROM TRADE Consider this simple problem. Suppose that Australia and New Zealand both produce cheese and honey. These are the combinations of the two goods that each country can produce in one day: AUSTRALIA

NEW ZEALAND

HONEY (TONNES)

CHEESE (TONNES)

HONEY (TONNES)

CHEESE (TONNES)

0

60

0

50

10

45

10

40

20

30

20

30

30

15

30

20

40

0

40

10

50

0

1

Who has a comparative advantage in producing cheese? Who has a comparative advantage in producing honey?

2

Suppose that Australia is currently producing 30 tonnes of honey and 15 tonnes of cheese and New Zealand is currently producing 10 tonnes of honey and 40 tonnes of cheese. Demonstrate that Australia and New Zealand can both be better off if they specialise in producing only one good and then engaging in trade.

Solving the problem STEP 1: Review the chapter material. This problem concerns comparative advantage, so you may want to review the section

‘Absolute advantage versus comparative advantage’, which begins on page 39. STEP 2: Answer question 1 by calculating who has a comparative advantage in each activity. Remember that a country has a

comparative advantage in producing a good if it can produce the good at the lowest opportunity cost. When Australia produces one more tonne of honey, it produces 1.5 fewer tonnes of cheese. On the one hand, when New Zealand produces one more tonne of honey, it produces one less tonne of cheese. Therefore, New Zealand’s opportunity cost of producing honey—one tonne of cheese—is lower than Australia’s—1.5 tonnes of cheese. On the other hand, when Australia produces one more tonne of cheese, it produces two-thirds less of a tonne of honey. When New Zealand produces one more tonne of cheese, it produces one less tonne of honey. Therefore, Australia’s opportunity cost of producing cheese—two-thirds of a tonne of honey—is lower than that of New Zealand’s—one tonne of honey. We can conclude that New Zealand has a comparative advantage in the production of honey and Australia has a comparative advantage in the production of cheese. STEP 3: Answer question 2 by showing that specialisation makes Australia and New Zealand better off. We know that Australia

should specialise where it has a comparative advantage and New Zealand should specialise where it has a comparative advantage. If both countries specialise, Australia will produce 60 tonnes of cheese and 0 tonnes of honey, and New Zealand will produce 0 tonnes of cheese and 50 tonnes of honey. After both countries specialise, New Zealand could then trade 30 tonnes of honey to Australia (keeping the other 20 tonnes of honey itself) in exchange for 40 tonnes of cheese from Australia (which keeps the other 20 tonnes of cheese for itself). Note that other mutually beneficial trades are possible as well. We can summarise the results in a table: BEFORE TRADE

AFTER TRADE

HONEY (TONNES)

CHEESE (TONNES)

HONEY (TONNES)

CHEESE (TONNES)

Australia

30

15

30

20

New Zealand

10

40

20

40

New Zealand is better off after trade because it can consume the same amount of cheese and 10 more tonnes of honey. Australia is better off after trade because it can consume the same amount of honey and five more tonnes of cheese.

[ YOUR TURN Q

For more practice do related problems 2.4 and 2.5 on page 52 at the end of this chapter.

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PART 1 INTRODUCTION

THE MARKET SYSTEM 2.3 Explain the basic idea of how a market system works. LEARNING OBJECTIVE

Market A group of buyers and sellers of a good or service and the institution or arrangement by which they come together to trade. Product markets Markets for goods—such as computers—and services— such as medical treatment. Factor markets Markets for the factors of production, such as labour, capital, natural resources and entrepreneurial ability. Factors of production Labour, capital, natural resources and entrepreneurial ability used to produce goods and services.

We have seen that households, firms and the government face trade-offs and incur opportunity costs because of the scarcity of resources. We have also seen that trade allows people to specialise according to their comparative advantage. By engaging in trade, people can raise their standard of living. Of course, trade in the modern world is much more complex than the examples we have considered so far. Trade today involves the decisions of billions of people around the world. But how does an economy make trade possible, and how are the decisions of these billions of people coordinated? In Australia and most other countries trade is carried out in markets. Markets also determine the answers to the three fundamental questions discussed in Chapter 1: What goods and services will be produced? How will the goods and services be produced? Who will receive the goods and services that are produced? Recall that the definition of a market is a group of buyers and sellers of a good or service and the institution or arrangement by which they come together to trade. Markets take many forms, such as the local fruit and vegetable market, the stock exchange or eBay. In a market the buyers are demanders of goods or services, and the sellers are suppliers of goods or services. Households and firms interact in two types of markets: product markets and factor markets. Product markets are markets for goods—such as computers—and services—such as medical treatment. In product markets, households are demanders and firms are suppliers. Factor markets are markets for the factors of production. Factors of production are the inputs used to make goods and services. Factors of production are divided into four broad categories: • Labour. This includes all types of work, from the part-time labour of teenagers working at McDonald’s to the work of top managers in large corporations. • Capital. This refers to physical capital, such as machines, tools and computers, that is used to produce other goods. • Natural resources. These include land, water, oil, minerals and other raw materials that are used in producing goods. • Entrepreneurial ability. An entrepreneur is someone who operates a business. Entrepreneurial ability is the ability to bring together the other factors of production to produce and sell goods and services successfully. In factor markets, households are suppliers and firms are demanders. Most people earn most of their income by selling their labour services to firms in the labour market.

The gains from free markets Free market A market with few government restrictions on how a good or service can be produced or sold, or on how a factor of production can be employed.

As we learned in Chapter 1, a free market exists when the government places few restrictions on how a good or a service can be produced or sold, or on how a factor of production can be employed. Relatively few government restrictions are placed on economic activity in Australia, the United States, Hong Kong and Singapore. In countries such as Cuba and North Korea the free market system has been rejected in favour of centrally planned economies with extensive government control over product and factor markets. Countries that come closest to the free market system have been more successful than countries with centrally planned economies in providing their people with rising living standards. The Scottish philosopher Adam Smith is considered to be the father of modern economics because one of his books, An Inquiry into the Nature and Causes of the Wealth of Nations, published in 1776, was an early and very influential argument for the free market system. Smith was writing at a time when extensive government restrictions on markets were still very common. In many parts of Europe the guild system still prevailed. Under this system governments would give guilds, or organisations of producers, the authority to control the production of a good. For example, the shoemakers’ guild controlled who was allowed to produce shoes, how many shoes they could produce and what price they could charge. In France, the cloth makers’ guild even dictated the number of threads that were allowed in the weave of the cloth. Smith argued that such restrictions reduced the income or wealth of a country and its people by restricting the quantity of goods produced. Some people at the time supported the restrictions of the guild system because it was in their financial interest to do so. If you were a

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member of a guild the restrictions served to reduce the competition you would face. But other people sincerely believed that the alternative to the guild system was economic chaos. Smith argued that these people were wrong and that a country could enjoy a smoothly functioning economic system if firms were freed from guild restrictions.

The market mechanism In Smith’s day defenders of the guild system worried that if, for instance, the shoemakers’ guild did not control shoe production either too many or too few shoes would be produced. Smith argued that prices would do a better job of coordinating the activities of buyers and sellers than the guilds could. A key to understanding Smith’s argument is the assumption that individuals usually act in a rational, self-interested way. In particular, individuals take those actions most likely to make themselves better off financially. This assumption of rational, self-interested behaviour underlies nearly all economic analysis. Adam Smith understood—as economists today understand—that people’s motives can be complex. But in analysing people in the act of buying and selling, the motivation of financial reward usually provides the best explanation for the actions people take. For example, suppose that a significant number of consumers switch from buying sedan cars to buying sport utility vehicles (SUVs) as in fact happened in Australia during the 1990s and 2000s. Firms will find that they can charge higher prices for SUVs than they can for sedans. The self-interest of these firms will lead them to respond to consumers’ wishes by producing more SUVs and fewer sedans. Or suppose that consumers decide that they want to eat less bread, pasta and other foods high in carbohydrates, as many did in the 1990s and early 2000s, following the increase in popularity of the Atkins diet. Then the prices firms can charge for bread and pasta will fall. The self-interest of firms will lead them to produce less bread and pasta, which in fact is what happened in the late 1990s and early 2000s. In the case where consumers want more of a product, and in the case where they want less of a product, the market system responds without a guild or anyone else giving orders about how much to produce or what price to charge. In a famous phrase, Smith said that firms would be led by the ‘invisible hand’ of the market to provide consumers with what they wanted. Firms would respond to changes in prices by making decisions that ended up satisfying the wants of consumers. The effect that price changes have on the behaviour of firms and consumers is referred to in economics as the price mechanism.

STORY OF THE MARKET SYSTEM IN ACTION: I, PENCIL The pencil appears to be a very simple product. In fact, its production requires the coordinated activities of many different people, spread around the world. The economist Leonard Read showed how markets achieve this coordination by writing an ‘autobiography’ of a pencil sold by the Eberhard Faber Pencil Company of California. It is one of the most famous accounts of how the market system works. The pencil writes that:

M

Price mechanism The system in a free market where price changes lead to producers changing production in accordance with the level of consumer demand.

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My family tree begins with a [cedar] tree that grows in Northern California and Oregon. Now contemplate all the saws and trucks and rope and the countless other gear used in harvesting and carting the cedar logs to the railroad siding … The logs are shipped to a mill in San Leandro, California … The cedar logs are cut into small, pencil-length slats less than one-fourth of an inch in thickness … Once in the pencil factory each slat is given eight grooves by a complex machine, after which another machine lays leads in every other slat … My ‘lead’ itself—it contains no lead at all—is complex. The graphite is mined in Ceylon … [and] is mixed with clay from Mississippi in which ammonium hydroxide is used in the refining process … To increase their strength and smoothness the leads are then treated with a hot mixture which includes candelilla wax from Mexico, paraffin wax, and hydrogenated natural fats.

The market coordinates the activities of the many people spread around the world who contribute to the making of a pencil

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PART 1 INTRODUCTION My cedar receives six coats of lacquer. Do you know all the ingredients of lacquer? Who would think that the growers of castor beans and the refiners of castor oil are a part of it? They are. My bit of metal—the ferrule—is brass. Think of all the persons who mine zinc and copper and those who have the skills to make shiny sheet brass from these products of nature. Then there’s my crowning glory … the part man uses to erase the errors he makes with me … It is a rubber-like product made by reacting rape-seed oil from the Dutch East Indies with sulfur chloride … Then, too, there are numerous vulcanizing and accelerating agents. The pumice comes from Italy; and the pigment which gives [the eraser] its color is cadmium sulfide. [M]illions of human beings have had a hand in my creation, no one of whom even knows more than a very few of the others … There isn’t a single person in all these millions, including the president of the pencil company, who contributes more than a tiny, infinitesimal bit of know-how … There is a fact still more astounding: the absence of a master mind, of anyone dictating or forcibly directing these countless actions which bring me into being. No trace of such a person can be found. Instead, we find the Invisible Hand at work. SOURCE: Leonard E. Read (1958), I, Pencil, Irvington-on-Hudson, New York: Foundation for Economic Education Inc. Used with permission of the Foundation for Economic Education Inc. Available online at .

The role of the entrepreneur Entrepreneur Someone who operates a business, bringing together the factors of production— labour, capital and natural resources—to produce goods and services.

Entrepreneurs are central to the working of the market system. An entrepreneur is someone who operates a business. Entrepreneurs must first determine what goods and services they believe consumers want, and then decide how those goods and services might be produced most profitably, using the available factors of production—labour, capital and natural resources. Successful entrepreneurs are able to search out opportunities to provide new goods and services. Often these opportunities are created by new technology. Consumers and existing businesses often do not realise at first that the new technology makes new products feasible. For example, even after the development of the internal combustion engine made cars practicable, Henry Ford remarked, ‘If I had asked my customers what they wanted, they would have said a faster horse’. Because consumers often cannot evaluate a new product before it exists, some of the most successful entrepreneurs, such as the late Steve Jobs of Apple, rarely use focus groups, or meetings in which consumers are asked what new products they would like to see. Instead, entrepreneurs think of products that consumers may not even realise they need, such as, in Jobs’s case, an MP3 player—iPod—or a tablet computer—iPad. Entrepreneurs are of great importance to the economy because they are often responsible for making new products widely available to consumers, as Henry Ford did with cars, and Steve Jobs did with the iPod. Table 2.4 lists some of the important products entrepreneurs at small firms introduced during the twentieth century. Entrepreneurs put their own funds at risk when they start businesses. If they are wrong about what consumers want or about the best way to produce goods and services, they can lose those funds. In fact, it is not unusual for entrepreneurs who eventually achieve great success to fail at first. For instance, early in their careers, both Henry Ford of the Ford Motor Company and Sakichi Toyoda, who eventually founded the Toyota Motor Corporation, started earlier companies that quickly failed. The typical entrepreneur earns less than someone who is an employee in a large firm with the same education and characteristics. Few entrepreneurs make the fortunes of Henry Ford, Steve Jobs or Bill Gates. Entrepreneurs make a vital contribution to economic growth through their roles in responding to consumer demand and in introducing new products. Therefore government policies that encourage entrepreneurship are also likely to increase economic growth and raise the standard of living. In the next section, we consider the legal framework required for a successful market in which entrepreneurs can succeed.

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CHAPTER 2 CHOICES AND TRADE-OFFS IN THE MARKET TABLE 2.4

Important products introduced by entrepreneurs at small firms

PRODUCT

INVENTOR

PRODUCT

INVENTOR

Air conditioning

William Haviland Carrier

Optical scanner

Everett Franklin Lindquist

Aeroplane

Orville and Wilbur Wright

Oral contraceptives

Carl Djerassi

Biomagnetic imaging

Raymond Damadian

Overnight delivery service

Fred Smith

Biosynthetic insulin

Herbert Boyer

Personal computer

Steve Jobs and Steve Wozniak

DNA fingerprinting

Alec Jeffries

Quick-frozen foods

Clarence Birdseye

FM radio

Edwin Howard Armstrong

Safety razor

King Gillette

Helicopter

Igor Sikorsky

Soft contact lens

Kevin Tuohy

High-resolution CAT scanner

Robert Ledley

Solid fuel rocket engine

Robert Goddard

Hydraulic brake

Malcolm Lockheed

Supercomputer

Seymour Cray

Integrated circuit

Jack Kilby

Vacuum tube

Philo Farnsworth

Microprocessor

Ted Hoff

Zips

Gideon Sundback

SOURCE: Based on William J. Baumol (2010), The Microtheory of Innovative Entrepreneurship, Princeton University Press, and various sources. Note that the person who first commercially developed a particular product is sometimes disputed by historians.

THE LEGAL BASIS OF A SUCCESSFUL MARKET SYSTEM In a free market government does not restrict how firms produce and sell goods and services, or how they employ factors of production, but the absence of government intervention is not enough for the market system to work well. Government has to provide secure rights to private property for the market system to work at all. In addition, government can aid the working of the market by enforcing contracts between private individuals through an independent court system. Many economists would also say that the government has a role in facilitating the development of an efficient financial system as well as systems of education, transportation and communication. The protection of private property and the existence of an independent court system to enforce the law impartially provide a legal environment that will allow a market system to succeed.

2.4 Understand why property rights are necessary for a well-functioning market. LEARNING OBJECTIVE

Protection of private property For the market system to work well individuals must be willing to take risks. Someone with $250 000 can be cautious and keep it safely in a bank—or even in cash if the person doesn’t trust the banking system. But the market system won’t work unless a significant number of people are willing to risk their funds by investing them in businesses. Investing in businesses is risky in any country. Many businesses fail every year in Australia and other high-income countries. But in high-income, market-based countries someone who starts a new business or invests in an existing business usually doesn’t have to worry that the government, the military or criminal gangs might decide to seize the business or demand payments in return for not destroying the business. Unfortunately, in many poor countries owners of businesses are not well protected from having their businesses seized by the government or from having their profits or assets taken by criminals. Where these problems exist, opening a business can be extremely risky. Cash can be concealed easily, but a business is difficult to conceal and difficult to move. Property rights refer to the rights individuals or firms have to the exclusive use of their property, including the right to buy or sell it. Property can be tangible, physical property, such as a shop or factory. Property can also be intangible, such as the right to an idea. Guarantees exist in every high-income country. Unfortunately, in many developing countries such guarantees do not exist or are poorly enforced.

Property rights The rights individuals or firms have to the exclusive use of their property, including the right to buy or sell it.

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© Claudiodivizia | Dreamstime.com

Recording studios, movie studios and artists worry that the copyrights for their music and films are not being protected on the Internet

ILLEGAL DOWNLOADS FROM CYBERSPACE The development of the Internet has led to new problems in protecting intellectual property rights. People can copy and email songs, newspaper and magazine articles and even entire movies and television programs, or post them on websites. Controlling unauthorised copying is more difficult today than it was when ‘copying’ meant making a physical copy of a book, CD or DVD. Music companies have attempted to combat free downloads of music by offering inexpensive legal downloads. Some of these legal websites, such as Apple’s iTunes, Amazon’s MP3, Google Play, Spotify, Microsoft’s Xbox Music and Sony’s bandit.fm, have been very successful. In fact, global digital music trade revenue rose by 9  per  cent during 2012 reaching around US$5.6 billion, with digital channels generating around 34 per cent of worldwide music sales. Just a decade earlier, revenue from digital sales of music was almost zero. However, according to the International Federation of the Phonographic Industry (IFPI), a very large proportion of music downloads are illegal. It estimates that around one-third of Internet users regularly download from unlicensed sites. The inability to protect the property rights in the music industry fully has not only led to revenue falls for recording studios and music retailers, but has also been linked to reduced investment in potential new artists.

It is not just the music industry that is experiencing problems with unauthorised copying. For example, in 2012, an estimated 8.23 million unauthorised copies of the Batman movie The Dark Knight Rises and 8.11 million copies of The Avengers were downloaded, which is likely to have had a significant impact on the DVD rental market, DVD sales and on-demand movie downloads. Illegal electronic copies of books also appear regularly on the Internet. Music companies and movie studios have been lobbying governments to place legal responsibility on Internet Service Providers (ISPs), requiring them to warn users who download illegally, and then to suspend temporarily the accounts of people who continue with illegal downloads and filesharing. This is known as the ‘graduated response’ approach. In 2011, ISPs in the United States agreed to establish a copyright alert system to notify subscribers of illegal downloading occurring on their Internet accounts. Further, ISPs in 12 countries have been legally required to block users’ access to sites that breach copyright, such as The Pirate Bay, after which usage fell by 69 per cent. These countries include a number in Europe, South Korea, Malaysia, Taiwan and New Zealand. Countries that did not block access experienced an increase in usage of 45 per cent. In 2012, Google announced that it would help users find legitimate sites more easily by changing its search algorithm so that it would take into account the volume of infringements notices it had received from copyright holders regarding certain sites. However, in Australia in 2012, Perth-based ISP iiNet won a High Court case which ruled that iiNet was not liable for the online piracy carried out by its customers, nor was it required to be responsible for policing piracy. The companies in the case against iiNet included Disney, Paramount Pictures, the Seven Network, Sony Pictures Entertainment, Village Roadshow, Warner Bros, Universal Pictures and 20th Century Fox. The issues raised in the lawsuit, which ran for over four years, including numerous rulings and appeals, demonstrate the complexities and difficulties in protecting intellectual property rights. SOURCES: International Federation of the Phonographic Industry (IFPI) (2013), IFPI Digital Music Report 2013, at , viewed 8 April 2013; Comic Book Resources (2012), ‘The Avengers, Dark Knight Rises, The Walking Dead among 2012s most-pirated’, at , viewed 8 April 2013; Andrew Colley (2012), ‘iiNet wins landmark copyright case against Hollywood studios’, The Australian, 21 April, at , viewed 10 April 2013.

In any modern economy intellectual property rights are very important. Intellectual property includes books, films, music, software and ideas for new products or new ways of producing products. To protect intellectual property the federal government will grant a patent that gives an inventor—which is often a firm—the exclusive right to produce and sell a new product for a period of years from the date the product was invented. For instance, because Microsoft has a patent on the Windows operating system, other firms cannot sell their own versions of

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Windows. The government grants patents to encourage firms to spend money on the research and development necessary to create new products. If other companies could freely copy Windows, Microsoft would not have spent the funds necessary to develop it. Just as a new product or a new method of making a product receives patent protection, so books, films, music and software receive copyright protection. Under Australian law the creator of a book, film, software or piece of music has the exclusive right to use the creation during the creator’s lifetime. For books, sheet music and software, the creator’s heirs retain this exclusive right for another 70 years, and for films and music recordings, copyright extends for 70 years from the year which the film or recording was produced.

Enforcement of contracts and property rights Much business activity involves someone agreeing to carry out some action in the future. For example, you may borrow $20 000 to buy a car and promise the bank—by signing a loan contract—that you will pay back the money over the next five years. Or Microsoft may sign a licensing agreement with a small technology company, agreeing to use that company’s technology for a period of several years in return for a fee. Usually these agreements take the form of legal contracts. For the market system to work, businesses and individuals have to rely on these contracts being carried out. If one party to a legal contract does not fulfil its obligations—perhaps the small company had promised Microsoft exclusive use of its technology but then began licensing it to other companies—the other party can go to court to have the agreement enforced. But going to court to enforce a contract or private property rights will only be successful if the court system is independent and judges are able to make impartial decisions on the basis of the law. In Australia and many other high-income countries the court systems have enough independence from other parts of the government and enough protection from intimidation by outside forces—such as criminal gangs—to enable them to make their decisions based on the law. In many developing countries the court systems lack this independence and may not provide a remedy if the government violates private property rights or if a person with powerful political connections decides to violate a business contract. If property rights are not well enforced the production of goods and services will be reduced. This reduces economic efficiency, leaving the economy inside its production possibility frontier.

THE TRADE-OFFS WHEN YOU BUY A CAR In ‘Economics in your life’ at the beginning of this chapter, we asked you to think about two questions. When buying a new car, what is the relationship between safety and fuel efficiency? Under what circumstances would it be possible for car manufacturers to make cars safer and more fuel efficient? To answer the first question, you have to recognise that there is normally a trade-off between safety and fuel efficiency. With the technology that is available at any particular time, a car manufacturer can increase fuel efficiency by making a car smaller and lighter. But driving a lighter car increases your chances of being injured if you have an accident. The trade-off between safety and fuel efficiency would look much like the relationship in Figure 2.1 on page 35. To get more of both safety and fuel efficiency, car manufacturers would have to discover new technologies that allow them to make cars lighter and safer at the same time. Such new technologies would make points like G in Figure 2.1 attainable.

ECONOMICS IN YOUR LIFE (continued from page 33)

CONCLUSION We have seen that the key role of markets is to facilitate trade. In fact, the market system is a very effective means of coordinating the decisions of millions of consumers, workers and firms. At the centre of the market system is the consumer. To be successful, firms must respond to the desires of consumers. These desires are communicated to firms through prices. To explore how markets work we must study the behaviour of consumers and firms. We continue this exploration of markets in Chapter 3 when we develop the model of demand and supply. Before moving on to Chapter 3, read the following ‘An inside look’ to learn how BMW has expanded its production possibility frontier over time.

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PART 1 INTRODUCTION

AN INSIDE LOOK ARCH 2014 BMW GROUP M

n o i t c u d o r p d n Expansion a mix at BMW

e production w vehicle and th ne a of t en pm lo eivable today The deve be quite inconc over the l ld al ou s w te d si ire 25 qu computeries re s are built at twork is facilit al tools such as ne rtu vi n tio of BMW automobile uc e od us pr e simulation ithout th bone of BMW’s s and complex m g, Munich, w ra zi ip og Le world. The back pr g, gn fin si ol ter models of sed de ants in Ding ions and compu well as a ba at ul as m g, si formed by six pl ur 3D nb g ta in ar els. Us le to replicate sslyn and Sp riate, the mod specialists are ab op W pr ap BM Regensburg, Ro r y, ve or re ct he fa e production rtual Shenyang. W tion and simulat to serial a vi in uc s od er pr joint venture in rtn of pa w flo al e reality. In the e entir grates extern to subsequent s to retain th e ue os in cl BMW Group inte nt ry co ve p s ou r cent of all ndition the BMW Gr iles, over 80 pe ng overall co ob ni ai m to nt production. But ai au m of as n l ed in virtual oductio rtise as wel rified and confirm oduction n it comes pr ve he w w the relevant expe no ity e or ar th s au sion-making ing, processe fore the first pr control and deci vance, long be purchasing, test ad n, io in ct ity tru al ns re co ne ally in place. to design, engi facilities are actu y matters. nt ra n ar ig w re diversity, d fo an st e fir ic serv crease in model opened its in W nt BM ta ns at th co e 73 th fficiently B Despite A It was in 19 African town of Rosslyn. Then, in n network is su tio uc od pr s p’ h ut ou rsions at further the BMW Gr plant, in the So models and ve the world over, ts nt ke re ar ffe m di w ild ne y ext is the sembl flexible to bu order to develop ature in this cont ished and joint as fe bl nt ta rta es e po er im w An ts allowing 1994 every plant. production plan e in production, in the 1980s. In lin d y ce bl m en m se m as co n rolina, universal mai ce on one ventures in Asia s in any sequen nburg, in South Ca el ta ar od m Sp in us t rio an va pl the BMW e built assembly of BMW opened its e. This enables , BMW cars wer lin 03 n 20 tio of uc d od en pr e e a e market n with and the sam USA. Towards th fluctuations in th close cooperatio to y in bl a xi in fle Ch d in on g e optimum t Leipzi Group to resp for the first tim ishes, working to 2005, BMW Plan w in er g tin om ar st st cu , al en refers to its oup to an and individu local partner. Th is context, BMW ties of the BMW Gr th ci In . pa ts ca n an pl tio l t al uc y plan capacity at increased prod BMW’s assembl g structures’. l. In early 2007, g in ve le st re er te gh in hi r factories as ‘livin en he ev ot an t ye te to penetra urg and in India served of the Spartanb ns io ns pa ex t began market. In 2012 t, and a new plan ou ed rri ca e er w Rosslyn plants azil in 2013. construction in Br

BMW GROUP

SOURCES: BMW Group (2014), ‘Production worldwide’, at , viewed 10 March 2014; BMW Group, The Fascination of Production (2010), at , viewed 10 March 2014. Reproduced with the permission of BMW Group Australia. Copyright © Pearson Australia (a division of Pearson Australia Group Pty Ltd) 2015 – 9781486010233 - Hubbard/Macroeconomics 3e

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Key points in the article The article discusses the expansion in production of the BMW Group over time, both its expansion of production into other countries and in the capacity of specific plants. Like all vehicle manufacturers, BMW constantly introduces new models, and produces numerous models at the same time. The article discusses BMW’s very flexible production processes which enable it to substitute resources between models, and to produce variations of the same model, on the same assembly line. This allows it to meet the changes in the demand for vehicles while still fully utilising its machinery and equipment.

Analysing the news A We can use the economic model of production possibility frontiers to analyse this article. First, note the expansion of plants over time. For example, the expansion of the production capacity in the Spartanburg and Rosslyn plants in 2012 can be represented by an outward shift in the production possibility frontier. Figure  1 shows a hypothetical production possibility frontier for motor vehicles and motorcycles produced by BMW during its expansion years, from 1951 to 2014. The expansion of production of motorcycles and motor vehicles of the entire BMW Group can be shown by an outward shift of a production possibility frontier.

B The introduction of new models, together with changes in consumer preferences for particular models at various times, means that the types of vehicles made on production assembly lines must change. The article states FIGURE 1 PRODUCTION OF MOTORCYCLES AND MOTOR VEHICLES AT BMW GROUP HAS EXPANDED SIGNIFICANTLY OVER TIME

that the assembly line production at BMW is very flexible, and that production of different models can occur on the same universal assembly line, in any sequence. For example, by 2014 BMW’s largest plant at Dingolfing was producing a number of models, including the 6 Series and 7 Series. Once BMW is on the production possibility frontier at a plant, its opportunity cost of producing, for example, more 7 Series cars is the reduction in the quantity of other vehicles produced, for example, the 6 Series. We can show this in Figure 2 by drawing a production possibility frontier with the quantity of 6 Series produced in the plant on the horizontal axis and the quantity of 7 Series on the vertical axis. Once BMW is on the production possibility frontier for this plant, it can only produce more of one model by producing fewer of the other model. If the demand for the 7 Series became stronger relative to the demand for the 6 Series, this would lead BMW to substitute production between the models, which would lead to a move from point A to point B in Figure 2.

Thinking critically 1 Designing and selling new car models usually boosts sales. Therefore should BMW launch a new line of cars every year? Every month? Explain. 2 Explain what would cause BMW to shift its resources into the production of more 6 Series and fewer 7 Series vehicles? Should BMW continually shift its resources between the production of these two vehicles? Why or why not?

FIGURE 2 ONCE BMW IS ON THE PRODUCTION POSSIBILITY FRONTIER IN ITS DINGOLFING PLANT, A LARGER QUANTITY OF 7 SERIES VEHICLES PRODUCED IS ONLY POSSIBLE IF A SMALLER QUANTITY OF 6 SERIES IS PRODUCED Quantity of 7 Series produced per day

Motorcycles B

Initial quantity of 7 Series

A

2014

B

Final quantity of 7 Series A 1951

0

A

B

Motor vehicles

Initial quantity of 6 Series

Final Quantity of 6 Series quantity produced per day of 6 Series

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CHAPTER SUMMARY AND PROBLEMS KEY TERMS absolute advantage comparative advantage entrepreneur  factor markets factors of production

39 40 44 42 42

free market market opportunity cost price mechanism product markets

42 42 35 43 42

production possibility frontier property rights scarcity trade

34 45 34 38

PRODUCTION POSSIBILITY FRONTIERS AND REAL-WORLD TRADE-OFFS, PAGES 34–38 LEARNING OBJECTIVE 2.1

Use a production possibility frontier to analyse opportunity costs and trade-offs.

SUMMARY The production possibility frontier is a curve showing the maximum attainable combinations of two products that may be produced with available resources. It is used to illustrate the trade-offs that arise from scarcity. Points on the frontier are efficient. Points inside the frontier are inefficient and points outside the frontier are unattainable. The opportunity cost of any activity is the highest-valued alternative that must be given up to engage in that activity. Because of increasing marginal opportunity costs, production possibility frontiers are usually bowed out or concave, rather than straight lines. This illustrates the important economic concept that the more resources that are already devoted to any activity, the smaller the payoff from devoting additional resources to that activity is likely to be.

1.5

1.6

1.7

REVIEW QUESTIONS 1.1

1.2

1.3

What do economists mean by scarcity? Can you think of anything that is not scarce according to the economic definition? What is a production possibility frontier? How can we show economic efficiency on a production possibility frontier? How can we show inefficiency? What causes a production possibility frontier to shift outward? What is meant by increasing marginal opportunity costs? What are the implications of this idea for the shape of the production possibility frontier?

PROBLEMS AND APPLICATIONS 1.4

Draw a production possibility frontier showing the trade-off between the production of wheat and the production of barley. a Show the effect that a prolonged drought would have on the initial production possibility frontier. b Suppose genetic modification makes barley resistant to insects, allowing yields to double. Show the effect of this technological change on the initial production possibility frontier.

1.8

[Related to the opening case] One of the trade-offs faced by BMW is between safety and fuel economy. For example, adding steel to a car makes it safer but also heavier, which results in higher fuel consumption. Draw a hypothetical production possibility frontier facing BMW engineers that shows this trade-off. Suppose you win free tickets to a movie plus all you can eat at the snack bar for free. Would there be a cost to you to attend this movie? Explain. Suppose we can divide all the goods produced by an economy into two types: consumption goods and capital goods. Capital goods, such as machinery, equipment and computers, are goods used to produce other goods. a Use a production possibility frontier graph to illustrate the trade-off to an economy between producing consumption goods and producing capital goods. Briefly explain why the curve is likely to be concave. b Suppose that a technological advance occurs that affects the production of capital goods but not consumption goods. Show the effect on the production possibility frontier. c Suppose that country A and country B currently have identical production possibility frontiers, but that country A devotes only 5 per cent of its resources to producing capital goods over each of the next 10 years, whereas country B devotes 30 per cent. Which country is likely to experience more rapid economic growth in the future? Illustrate using a production possibility frontier graph. Your graph should include production possibility frontiers for country A today and in 10 years, and for country B today and in 10 years. Use the following production possibility frontier for a country to answer the questions.

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B

E

C

1.12 D

A

0

Consumption goods

a b c d

Which point(s) are unattainable? Briefly explain why. Which point(s) are efficient? Briefly explain why. Which point(s) are inefficient? Briefly explain why. At which point is the country’s future growth rate likely to be the highest? Briefly explain why. You have exams in economics and statistics coming up and five hours available for studying. The table shows the trade-offs you face in allocating the time you will spend in studying each subject.

1.9

HOURS SPENT STUDYING ECONOMICS

STATISTICS

ECONOMICS

STATISTICS

A

5

0

95

70

B

4

1

93

78

C

3

2

90

84

D

2

3

86

88

E

1

4

81

90

F

0

5

75

91

1.11

a Use the data in the table to draw a production possibility frontier graph. Label your vertical axis ‘Score on economics exam’ and label your horizontal axis ‘Score on statistics exam’. Make sure you label the values where your production possibility frontier intersects the vertical and horizontal axes. b Label the points representing choice C and choice D. If you are at choice C, what is your opportunity cost of increasing your statistics score? c Under what circumstances would A be a sensible choice? Suppose the federal government is trying to decide whether to spend more on research to find a cure for heart disease. As one of the government’s economic advisors, you are asked to prepare a report discussing the relevant factors that should be considered. Use the concepts of opportunity cost and trade-offs to discuss some of the main issues you would include in your report. Cost-effective analysis looks at the various options that could be used to achieve a goal, with the aim of determining the least-cost strategy. Some individuals oppose costeffectiveness analysis, arguing that you can’t put a price

on health or life. Are health and life priceless? Are there any decisions you make during your everyday life that indicated whether you consider health and life to be priceless? Suppose that the federal government is deciding which of one out of two different cancer treatments it will fund: Treatment A, which will prolong the average lifespan of patients receiving the treatment by 2 years and will cost $750 000 per patient treated; and Treatment B, which will prolong the average lifespan of patients receiving the treatment by 1½ years and will cost $25 000 per patient treated. What factors should the federal government take into account in making its decision? During his 2007 election campaign, the soon to be Prime Minister of Australia, Kevin Rudd (now former Prime Minister), stated that climate change was: the greatest moral, economic and environmental challenge of our generation.1

In 2009 he stated that only ‘political cowards’ argue that a country shouldn’t act on climate change until other countries do. However, in 2010 he announced he would delay the government’s legislation on major environmental policy until at least 2013, when other countries decide what they will do. A director within President Obama’s government in the United States, and former secretary of the treasury in the Clinton government, Lawrence Summers, has been quoted as giving the following moral defence of the economic approach to climate change:

EXAM SCORE

CHOICE

1.10

1.13

51

I don’t think there is anything immoral about seeking to achieve environment benefits at the lowest possible costs.2

1.14

Given that debate on climate change is often argued on moral grounds, would it be more moral to reduce pollution without worrying about the cost or by taking the cost into account? Explain. In The Wonderful Wizard of Oz and his other books about the Land of Oz, L. Frank Baum observed that if people’s wants were modest enough most goods would not be scarce. According to Baum, this was the case in Oz: There were no poor people in the Land of Oz, because there was no such thing as money. Each person was given freely by his neighbors whatever he required for his use, which is as much as anyone may reasonably desire. Some tilled the lands and raised great crops of grain, which was divided equally among the whole population, so that all had enough. There were many tailors and dressmakers and shoemakers and the like, who made things that any who desired them might wear. Likewise there were jewelers who made ornaments which pleased and beautified the people, and these ornaments also were free to those who asked for them. Each man and woman, no matter what he or she produced for the good of the community, was supplied by the neighbors with food and clothing and a house and furniture and ornaments and games. If by chance the supply ever ran short, more was taken from the great storehouses of the Ruler, which were afterward filled up again when there was more of any article than people needed…3

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PART1 INTRODUCTION

Do you agree with Baum that the economic system in Oz wouldn’t work in modern developed economies? Briefly explain why or why not.

You will know, by what I have told you here, that the Land of Oz was a remarkable country. I do not suppose such an arrangement would be practical with us.

COMPARATIVE ADVANTAGE AND TRADE, PAGES 38–41 LEARNING OBJECTIVE 2.2

Understand comparative advantage and explain how it is the basis for trade.

SUMMARY

of both goods that each country can produce in a day, measured in thousands of barrels.

Fundamentally, markets are about trade, which is the act of buying or selling. People trade on the basis of comparative advantage. An individual, firm or country has a comparative advantage in producing a good or service if it can produce the good or service at the lowest opportunity cost. People are usually better off specialising in the activity for which they have a comparative advantage and trading for the other goods and services they need. It is important not to confuse comparative advantage with absolute advantage. An individual, firm or country has an absolute advantage in producing a good or service if it can produce more of that good or service from the same amount of resources. It is possible to have an absolute advantage in producing a good or service without having a comparative advantage.

IRAN

REVIEW QUESTIONS 2.1

2.2

What is absolute advantage? What is comparative advantage? Is it possible for a country to have a comparative advantage in producing a good without also having an absolute advantage? Briefly explain. What is the basis for trade? What advantages are there to specialisation?

2.5

[Related to Don’t let this happen to you] Using the same amount of resources, Australia and New Zealand can both produce apples and oranges as shown in the following table, measured in thousands of tonnes. AUSTRALIA

2.4

NEW ZEALAND

APPLES

ORANGES

APPLES

ORANGES

12

0

6

0

3

3

3

3

0

4

0

6

a Who has a comparative advantage in producing apples? Who has a comparative advantage in producing oranges? Explain your reasoning. b Does either country have an absolute advantage in producing both goods? Explain. c Suppose that both countries are currently producing 3000 tonnes of apples and 3000 tonnes of oranges. Show that both can be better off if they specialise in producing one good and then engage in trade. [Related to Solved problem 2.1] Suppose Iran and Iraq both produce oil and olive oil. The table shows combinations

OIL

OLIVE OIL

OIL

OLIVE OIL

0

8

0

4

2

6

1

3

4

4

2

2

6

2

3

1

8

0

4

0

a Who has the comparative advantage in producing oil? Explain. b Can these two countries gain from trading oil and olive oil? Explain. [Related to Solved problem 2.1] Suppose that France and Germany both produce schnitzel and wine. The following table shows combinations of the goods that each country can produce in a day. FRANCE

PROBLEMS AND APPLICATIONS 2.3

IRAQ

2.6

2.7

GERMANY

WINE

SCHNITZEL

WINE

SCHNITZEL

(BOTTLES)

(kg)

(BOTTLES)

(kg)

0

8

0

15

1

6

1

12

2

4

2

9

3

2

3

6

4

0

4

3

5

0

a Who has a comparative advantage in producing wine? Who has a comparative advantage in producing schnitzel? b Suppose that France is currently producing one bottle of wine and 6 kg of schnitzel and Germany is currently producing three bottles of wine and 6 kg of schnitzel. Demonstrate that France and Germany can both be better off if they specialise in producing only one good and then engage in trade. Can an individual or a country produce beyond its production possibility frontier? Can an individual or a country consume beyond its production possibility frontier? Explain. If country A can produce twice as much coffee as country B, using the same amount of resources, explain how country B could have the comparative advantage in producing coffee.

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2.9

Is specialisation and trade between individuals and countries more about having a job or about obtaining a higher standard of living? Individually, if you go from a situation of not trading with others (you produce everything yourself) to a situation of trading with others, do you still have a job? Does your standard of living increase? Likewise, if a country goes from not trading with other countries to trading with other countries, does it still have jobs? Does its standard of living increase? In the early colonial days of Australia the population was spread thinly over a large area and transportation costs

2.10

53

between the colonies (states) were very high because it was difficult to transport products by road for more than short distances. As a result, most of the population very rarely bought or sold anything from another state. Explain why the incomes of people were likely to rise as transportation costs fell. During the global financial crisis, which began in late 2007, some countries, including the European Union and the United States, passed legislation that encouraged or required the reduction of imported goods in some industries. Do you think that this was good policy? Explain.

THE MARKET SYSTEM, PAGES 42–45 LEARNING OBJECTIVE 2.3

Explain the basic idea of how a market system works.

SUMMARY

PROBLEMS AND APPLICATIONS

A market is a group of buyers and sellers of a good or service and the institution or arrangement by which they come together to trade. Product markets are markets for goods and services, such as computers and medical treatment. Factor markets are markets for the factors of production, such as labour, capital, natural resources and entrepreneurial ability. Adam Smith argued in his 1776 book The Wealth of Nations that in a free market, where the government does not control the production of goods and services, changes in prices lead firms to produce the goods and services most desired by consumers. If consumers demand more of a good its price will rise. Firms respond to rising prices by increasing production. If consumers demand less of a good its price will fall. Firms respond to falling prices by producing less of a good. An entrepreneur is someone who operates a business. In a market system, entrepreneurs are responsible for organising the production of goods and services.

3.5

a George buys a BMW X5 SUV. b BMW increases employment at its Spartanburg plant. c George works 20 hours per week at McDonald’s. d George sells land he owns to McDonald’s so that it can build a new restaurant. 3.6

3.2

3.3

3.4

In The Wealth of Nations Adam Smith wrote the following (Book I, Chapter II): It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest.

a Briefly discuss what he meant by this.

REVIEW QUESTIONS 3.1

Identify whether each of the following transactions will take place in the factor market or in the product market, and whether households or firms are supplying the good or service, or demanding the good or service.

What are the two main categories of participants in markets? Which participants are of greatest importance in determining what goods and services are produced? What is a free market? In what ways does a free market economy differ from a centrally planned economy? What is an entrepreneur? Why do entrepreneurs play a key role in a market system? Under what circumstances are firms likely to produce more of a good or service? Under what circumstances are firms likely to produce less of a good or service?

b Explain what Adam Smith meant when he referred to the ‘invisible hand’ of the market. 3.7

Evaluate the following argument: ‘Adam Smith’s analysis is based on a fundamental flaw: he assumes that people are motivated by self-interest. But this isn’t true. I’m not selfish, and most people I know aren’t selfish.’

3.8

Do you agree that self-interest is an ‘ignoble human trait’? What incentives does a market system provide to encourage self-interest?

THE LEGAL BASIS OF A SUCCESSFUL MARKET SYSTEM, PAGES 45–47 LEARNING OBJECTIVE 2.4

Understand why property rights are necessary for a well-functioning market.

SUMMARY A market system will only work well if there is protection for property rights, which are the rights of individuals and firms to use their property. If firms are to risk their investment to develop a new product they must be awarded some form of protection from

competitors copying their product, in order to reap the rewards and returns on their investment. If the law cannot guarantee this, or the enforcement of the law cannot ensure the protection of property rights, there will be little incentive for firms to invest in research and development of new products. Therefore if property

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PART1 INTRODUCTION

rights do now exist, or are not well enforced, the production of goods and services will be reduced, leaving the economy inside its production possibility frontier and lower living standards.

… there is an intrinsic relationship between property rights and the economic prosperity of any given country. On average, countries in the top quintile of IPRI scores enjoy a per capita income of eight times that of their counterparts in the bottom quintile … and tend to attract more foreign direct investment. Developing countries with stronger property rights protection enjoy, on average, higher GDP growth…4

REVIEW QUESTIONS 4.1

4.2

What are private property rights? What role do they play in the working of a market system? Why are independent courts important for a well-functioning economy?

PROBLEMS AND APPLICATIONS 4.3

4.4

The International Property Rights Index (IPRI) is an annual ranking of the strength of physical and intellectual property rights across 125 countries, representing 97 per cent of the world’s GDP. It is produced by the Property Rights Alliance, who argue that:

How would the creation of property rights be likely to affect the economic opportunities available to people in those countries ranking lowest in property rights protection? There have been a large number of complaints directed at YouTube by major television companies regarding uploaded sports and TV clips. Do you think copyright holders suffer significant financial damage from having their material posted to YouTube? Is there any way copyright holders might benefit from having their material posted, without approval or compensation, on sites such as YouTube?

ENDNOTES 1

2

van Onselen, Peter (2010), ‘Politics trumps a moral challenge’, The Australian, 29 April 2010, News Limited, at , viewed 19 May 2010. Wessel, David (2002) ‘Precepts from Professor Summers’, Wall Street Journal, 17 October.

3 4

L. Frank Baum, The Wonderful Wizard of Oz, pp. 30–31. First edition published in 1910. Property Rights Alliance (2010), 2010 International Property Rights Index Executive Summary, at , viewed 7 March 2014.

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PA RT

2

HOW THE MARKE T WO RKS

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CHAPTER

3

WHERE PRICES COME FROM: THE INTERACTION OF DEMAND AND SUPPLY LEARNING OBJECTIVES After studying this chapter you should be able to: 3.1 Discuss the variables that influence the demand for goods and services. 3.2 Discuss the variables that influence the supply of goods and services. 3.3 Explain how equilibrium in a market is reached, and use a graph to illustrate market equilibrium. 3.4 Use demand and supply graphs to predict changes in prices and quantities.

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THE TABLET COMPUTER REVOLUTION BILL GATES, WHEN chairman of Microsoft, made a famous—but wrong—prediction in 2001. He predicted that tablet computers would make up a majority of personal computer sales within five years. Microsoft had developed new software that made it possible to use a stylus pen to write on a laptop computer screen, and Gates hoped that consumers would respond to these lightweight devices. But many consumers found them awkward to use and thought that the prices, at $2000 or more, were too high. As a result, rather than making up the majority of computer sales five years from Gates’ prediction, tablets made up just 1 per cent of the market by 2006. Fast forward to 2010. After years of stating that his company would not enter the market for netbook computers—lightweight computers smaller than laptops— the then Apple CEO, (the late) Steve Jobs, introduced the iPad. It was an immediate success, selling nearly 20 million units by the end of the year. iPad sales have grown significantly every year since, reaching the 100 million mark by 2012. The iPad is very different from the earlier tablet computers that had failed to sell. While the iPad was more awkward to use for word processing or working on spreadsheets, it was lighter than earlier tablets, and its wireless connectivity and portability made it better for Web surfing, checking emails, texting and watching videos. Although Apple initially had the market for the newstyle tablets largely to itself, competitors rapidly appeared. Toshiba, Samsung, Sony, Dell, LG, Motorola, Leveno, Asus, Microsoft, Google’s Nexus, Amazon and ZTE all introduced tablets. By early 2014, Apple’s market share for tablets was well below 40 per cent. The intense competition among firms selling the new tablets is a striking example of how the market responds to changes in consumer tastes. Many consumers indicated that they would buy tablets if they were smaller and more powerful than those introduced in the early 2000s, therefore firms scrambled to meet this demand. Further, when consumers began demanding even smaller tablets, firms responded by introducing mini-tablets. Although intense competition is not always good news for firms trying to sell products, it is a boon to consumers because it increases the choice of products and lowers the price for those products. SOURCE: Matt Berger and James Niccolai (2001), ‘Gates unveils portable tablet PC’, PC World, 12 November, at , viewed 17 April 2013; Louis Bedigian (2013), ‘Apple reduces 2013 full year orders for iPad’, Forbes, at , viewed 17 April 2013.

© Pressmaster / Shutterstock

3

ECONOMICS IN YOUR LIFE

WILL YOU BUY AN APPLE IPAD OR A SAMSUNG GALAXY TAB? Suppose you are considering buying a tablet computer and that you are choosing between an Apple iPad and a Samsung Galaxy Tab. Apple products have become very fashionable, and if you buy an iPad, you will have access to many more applications—or ‘apps’— that can increase the enjoyment and productivity of your tablet. One strategy Samsung can use to overcome Apple’s advantages is to compete based on price and value. Would you choose to buy a Galaxy Tab if it had a lower price than an iPad? If your income increased, would it affect your decision about which tablet to buy? As you read this chapter, see if you can answer these questions. You can check your answers against those we provide on page 76 at the end of this chapter.

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IN CHAPTER 1 we explored how economists use models to predict human behaviour. In Chapter 2 we used the model of production possibility frontiers to analyse scarcity and trade-offs. In this chapter we explore the models of demand and supply, which are the most powerful tools in economics, and use them to explain how prices are determined. For example, we could use the models to predict what will happen to the price and demand for alternative fuels when the price of oil rises. Or we could predict what will happen to the price of mobile phones when technology changes. Similarly, if the government decides to build more public housing we can predict the effect on new house prices, the demand for rental accommodation and other related markets. We begin considering the model of demand and supply by discussing consumers and the demand side of the market, before turning to firms and the supply side. As you will see, we will apply the model of demand and supply again and again throughout this book to understand business and the economy.

THE DEMAND SIDE OF THE MARKET 3.1 Discuss the variables that influence the demand for goods and services. LEARNING OBJECTIVE

Chapters 1 and 2 explained that in a market system consumers ultimately determine which goods and services will be produced. This is termed consumer sovereignty. The most successful businesses are generally the ones that respond best to consumer demand. But what determines consumer demand for a product? Certainly, many factors influence the willingness of  consumers to buy a particular product. For example, consumers who are considering buying a tablet computer, such as an Apple iPad or a Samsung Galaxy Tab, will make their decisions based on, among other factors, the income they have available to spend, and the effectiveness of the advertising campaigns of the companies that sell tablets. The main factor in most consumer decisions, though, is the price of the product. So it makes sense to begin with price when analysing the decisions of consumers to buy a product. It is important to note that when we discuss demand we are considering not what a consumer wants to buy but what the consumer is both willing and able to buy.

Demand schedules and demand curves Demand schedule A table showing the relationship between the price of a product and the quantity of the product demanded. Quantity demanded The amount of a good or service that a consumer is willing and able to purchase at a given price. Demand curve A curve that shows the relationship between the price of a product and the quantity of the product demanded. Market demand The demand by all the consumers of a given good or service.

Tables that show the relationship between the price of a product and the quantity of the product demanded are called demand schedules. The table in Figure 3.1 shows the number of tablet computers consumers would be willing to buy in one month at five different prices. The amount of a good or a service that consumers are willing and able to purchase at a particular price is referred to as the quantity demanded. The graph in Figure 3.1 plots the numbers from the table as a demand curve, a curve that shows the relationship between the price of a product and the quantity of a product demanded. Note that in this example the numbers in the table have enabled us to draw the demand ‘curve’ as a straight line. In real markets demand curves are not straight lines but are often drawn as such in economic models for convenience. This is the same for supply curves, which we will study later in this chapter. The demand curve in Figure 3.1 shows the market demand, or the demand by all consumers of a given good or service. The market for a product, such as restaurant meals, that is purchased locally would include all the consumers in a city or a relatively small area. The market for products that are sold internationally, such as tablet computers, would include all the consumers in the world. The demand curve in Figure 3.1 slopes downwards because consumers will buy more tablets as the price falls. When the price of a tablet is $700, consumers will buy 3  million tablets per month. If the price of a tablet falls to $600 consumers will buy 4 million tablets per month. Buyers demand a larger quantity of a product as the price falls because the product becomes less expensive relative to other products and because they can afford to buy more at a lower price.

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59

FIGURE 3.1

Demand schedule and demand curve As the price changes, consumers change the quantity of tablet computers they are willing to buy. We can show this as a demand schedule in a table, or as a demand curve on a graph. The table and graph both show that as the price of tablet computers falls, the quantity demanded increases. When the price of a tablet computer is $700, consumers buy 3 million. When the price drops to $600, consumers buy 4 million. Therefore, the demand curve for tablet computers is downward sloping

Demand schedule Price (dollars per tablet) $700

Quantity (millions of tablets per month)

600 500 400 300

3 4 5 6 7

Price (dollars per tablet)

As the price of tablets falls the quantity demanded rises.

$700 600 500 400 300

0

Demand 3

4

5

6

7

Quantity (millions of tablets per month)

The law of demand The inverse relationship between the price of a product and the quantity of the product demanded is known as the law of demand. Holding everything else constant, when the price of a product falls the quantity demanded of the product will increase, and when the price of a product rises the quantity demanded of the product will decrease. The law of demand holds for almost any market demand curve. Economists have found only a very few exceptions to this law. The market demand curve for tablet computers shown in Figure 3.1 is downward sloping—as the price of tablets falls, the quantity of tablets demanded increases.

Holding everything else constant: the ceteris paribus condition The definition of the law of demand applies when other factors that might affect demand, such as changes in income or changes in advertising, are assumed to be constant or unchanged. In constructing the market demand curve for tablet computers we focused only on the effect that changes in the price of tablets would have on the quantity of tablets consumers would be willing and able to buy. We were holding constant other variables that might affect the willingness of consumers to buy tablets. Economists refer to the necessity of holding all variables other than price constant in constructing a demand curve as the ceteris paribus condition—ceteris paribus is Latin for ‘all else being equal’. We will soon explore what happens when there are changes in the other factors that affect demand.

What explains the law of demand? It makes sense that consumers will buy more of a good or service when the price falls and less of a good or service when the price rises, but let’s look more closely at why this is true. When the price of tablet computers falls consumers buy a larger quantity because of the substitution effect and the income effect.

The substitution effect The substitution effect refers to the change in the quantity demanded of a good or service that results from a change in price, making the good or service less expensive relative to other goods or services that are substitutes. This change leads consumers to buy more of a good or service when its price falls—or less of a good or service when its price rises. When the price of tablet computers fall, consumers will substitute buying tablet computers for buying other goods such as laptop computers, netbook computers or even smartphones.

Law of demand Holding everything else constant, when the price of a product falls the quantity demanded will increase, and when the price of a product rises the quantity demanded will decrease.

Ceteris paribus (‘all else being equal’) The requirement that when analysing the relationship between two variables— such as price and quantity demanded—other variables must be held constant.

Substitution effect The change in the quantity demanded of a good or service that results from a change in price, making the good or service more or less expensive relative to other goods or services that are substitutes.

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The income effect Income effect The change in the quantity demanded of a good or service that results from the effect of a change in price on consumer purchasing power.

The income effect of a price change refers to the change in the quantity demanded of a good or service that results from the effect of a change in the price on consumers’ purchasing power. Purchasing power refers to the quantity of goods or services that can be bought with a fixed amount of income. When the price of a good or service falls, the increased purchasing power of consumers’ incomes will usually lead them to purchase a larger quantity of the good or service. When the price of a good or service rises, the decreased purchasing power of consumers’ incomes will usually lead them to purchase a smaller quantity of the good or service. There are, however, goods and services, known as inferior goods, which we discuss soon, for which as income rises demand falls. Note that although we can analyse them separately, the substitution effect and the income effect happen simultaneously whenever a price changes. So, a fall in the price of tablet computers leads consumers to buy more tablets, both because they are now cheaper relative to substitute products and because the purchasing power of the consumers’ incomes has increased.

Variables that shift market demand What would happen if we allowed a variable—other than price—to change that might affect the willingness of consumers to buy tablet computers? Consumers would then change the quantity they demand at each price. We can illustrate this by shifting the market demand curve. A shift of a demand curve is an increase or decrease in demand. A movement along a demand curve is an increase or decrease in the quantity demanded. As Figure 3.2 shows, we shift the demand curve to the right if consumers decide to buy more of the good or service at each price, and we shift the demand curve to the left if consumers decide to buy less at each price. Many variables other than price can influence market demand. The following five are the most important: • Income • Prices of related goods • Tastes • Population and demographics • Expected future prices We next discuss how changes in each of these variables affect the market demand curve for tablet computers.

Income The income that consumers have available to spend also affects their willingness and ability to buy a good or service. Suppose that the market demand curve in Figure 3.1 reflects the willingness of consumers to buy tablet computers when average household income is $70 000. FIGURE 3.2

Shifting the demand curve

Price (dollars per tablet)

When consumers increase the quantity of a product they wish to buy at a given price, the market demand curve shifts to the right, from D1 to D2. When consumers decrease the quantity of a product they wish to buy at any given price, the demand curve shifts to the left, from D1 to D3

Increase in demand

Demand, D2

Decrease in demand

Demand, D1

Demand, D3 0

Quantity (tablets per month)

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If household income rises to $75 000, the demand for tablets will increase, which we show by shifting the demand curve to the right. A good is a normal good when demand increases following an increase in income and decreases following a decrease in income. Most goods are normal goods, but the demand for some goods falls when income rises, and rises when income falls. For instance, as your income rises you might buy less canned tuna or fewer sausages, and buy more fresh salmon or steak. A good is an inferior good when demand decreases following an increase in income and increases following a decrease in income. So, sausages and canned tuna would be examples of inferior goods, not because they are necessarily of low quality, but because you buy less of them as your income increases.

Prices of related goods The prices of other goods can also affect consumers’ demand for a product. Goods and services that can be used for the same or a similar purpose—like tablet computers and laptop computers—are substitutes. When two goods are substitutes, the more you buy of one, the less you will buy of the other. A decrease in the price of a substitute causes the demand curve for the first good to shift to the left. An increase in the price of a substitute causes the demand curve for the first good to shift to the right. Suppose that the market demand curve in Figure 3.1 represents the willingness and ability of consumers to buy tablet computers during a year when the average price of laptop computers is $800. If the average price of laptops falls to $700, how will the market demand for tablets change? Consumers will demand fewer tablets at every price. We show this by shifting the demand curve for tablets to the left. Products that are used together—such as hot dogs sausages and hot dog buns—are complements. When two goods are complements, the more you buy of one the more you will buy of the other. A decrease in the price of a complement causes the demand curve for the first good to shift to the right. An increase in the price of a complement causes the demand curve for the first good to shift to the left. Many people use applications, or ‘apps’ on their tablet computers. Therefore tablets and apps are complements. Suppose the market demand curve in Figure 3.1 represents the willingness of consumers to buy tablets at a time when the average price of an app is $2.99. If the average price of apps falls to $0.99, consumers will buy more apps and more tablets: the demand curve for tablets will shift to the right.

Normal good A good or service for which the demand increases as income rises and decreases as income falls. Inferior good A good or service for which the demand increases as income falls and decreases as income rises.

Substitutes Goods or services that can be used for the same or a similar purpose.

Complements Goods and services that are used together.

Tastes Consumers can also be influenced by an advertising campaign for a product. If Apple, Samsung and Amazon and other firms making tablet computers begin to advertise heavily, consumers are more likely to buy tablets at every price, and the demand curve will shift to the right. An economist would say that the advertising campaign has affected consumers’ taste for tablet computers. Taste is a broad category that refers to the many subjective elements that can enter into a consumer’s decision to buy a product. A consumer’s taste for a product can change for many reasons. Sometimes trends and fashions play a substantial role. For example, the popularity of low-carbohydrate diets caused a decline in demand for some goods, such as bread and potato chips, and an increase in demand for chicken and beef. Changes in the seasons also affect consumers’ tastes, so that in summer, for example, more ice cream is purchased than in winter. In general, when consumers’ taste for a product increases the demand curve will shift to the right, and when consumers’ taste for a product decreases the demand curve for the product will shift to the left.

Population and demographics Population and demographic factors can affect the demand for a product. As the population of Australia increases so will the number of consumers, and the demand for most products will increase. The demographics of a population refers to its characteristics, with respect to age, race and gender. As the demographics of a country or region change, the demand for particular goods and services will increase or decrease because different categories of people tend to have different preferences for those goods. For instance, the demand for baby food will be greatest when the fraction of the population under the age of two is the greatest.

Demographics The characteristics of a population with respect to age, race and gender.

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Expected future prices Consumers choose not only which products to buy but also when to buy them. For instance, if enough people become convinced that motor vehicles will be selling for lower prices in three months, the demand for vehicles will decrease now, as some consumers postpone their purchase to wait for the expected price decrease. Alternatively, if enough consumers become convinced that the price of motor vehicles will be higher in three months, the demand for vehicles will increase now, as consumers try to beat the expected price increase. Table 3.1 summarises the most important variables that cause market demand curves to shift. Note that the table shows the shift in the demand curve that results from an increase in each of the variables. A decrease in these variables would cause the demand curve to shift in the opposite direction.

M

C

A K I N G THE

3.1

ONNECTION

© Monkey Business Images | Dreamstime.com

The ageing baby boomer generation effects the economy in different ways

THE AGEING OF THE BABY BOOM GENERATION The average age of the Australian population is increasing. So is the average age of populations in many countries throughout the world. After World War II ended in 1945, Australia was one of many countries that experienced a ‘baby boom’ as birth rates rose and remained high until the mid-1960s. Falling birth rates after the mid-1960s mean that the baby boom generation is larger than the generation before it and the generations after it. In addition, average life expectancy has continued to rise significantly. For example, the average life expectancy for females in Australia in the mid-1960s was 74.2 years and this has risen to approximately 84.3 years today; for males this has risen from 67.9 years to 79.9 years over the same period. In 2012 the proportion of Australia’s population aged 65 years and over was 14 per cent. This is very similar to Canada, Hong Kong, New Zealand and the United States. In a number of other countries population ageing has occurred at an even faster rate. For example, in 2012 the proportion of the population aged 65 years and over was 17 per cent in France, 21 per cent in Germany, 19 per cent in Greece, 21 per cent in Italy, 24 per cent in Japan and 17 per cent in the United Kingdom.

The following figure uses data and projections from the Australian Bureau of Statistics and the Australian Treasury to show the significance of Australia’s ageing population. Between 2010 and 2050 the proportion of the total population aged 65 years and over is estimated to rise, from 13.5 per cent to about 23 per cent. What effects will the ageing of the baby boom generation have on the economy? Older people have a greater demand for medical care than do younger people. So in the coming years the demand for doctors, nurses, hospital facilities and aged care facilities should all increase. This will place increased pressure on Medicare and the government’s health budget. As the population ages there will also be increased aged pension requirements—a serious concern which led to the introduction of compulsory superannuation in Australia in 1992.

Percentage of population aged 65 years and over

Population Ageing in Australia, 1970 to 2050 25

20

15

10

5

0 1970

1980

1990

2000

2010

2020

2030

2040

2050

Ageing boomers will also have an effect on the housing market. Older people often ‘downsize’ their housing by moving from large, family homes, to smaller, more easily maintained homes. This could mean that the demand for large homes may decrease, while the demand for smaller homes and apartments may increase.

SOURCE: Australian Bureau of Statistics (2008), Australian Historical Population Statistics, Cat. No. 3105.0.065.001, Table 4.1 and Table 7.1, at , viewed 22 April 2013; Australian Bureau of Statistics (2013), Deaths, Australia, 2011, Cat. No. 3302.0, Table 1.1, at , viewed 10 March 2014; European Commission (2013), ‘Population age structure by major age group, 1991–2011’, Eurostat, at , viewed 22 April 2013; Statistics Bureau Japan (2012), Statistical Handbook of Japan 2012, Chapter 2, at , viewed 22 April 2013; Australian Government (2010), Australia to 2050: Future Challenges, Intergenerational Report 2010, at , viewed 22 April 2013.

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Variables that shift market demand curves

AN INCREASE IN … income (and the good is normal)

SHIFTS THE DEMAND CURVE …

consumers spend more of their higher income on the good

Price

D1 0

income (and the good is inferior)

consumers spend less of their higher income on the good

Price

0

consumers buy less of the substitute good and more of this good

Price

0

consumers buy less of the complementary good and less of this good

Price

0

consumers are willing to buy a larger quantity of the good at every price

Price

0

D2

Quantity

additional consumers result in a greater quantity demanded at every price

Price

D1 0

the expected price of the good in the future

D1

Quantity

D1

population

D2

Quantity

D2

taste for the good

D1

Quantity

D1

the price of a complementary good

D2

Quantity

D2

the price of a substitute good

BECAUSE …

D2

Quantity

consumers buy more of the good today to avoid the higher price in the future

Price

D1 0

D2

Quantity

A change in demand versus a change in quantity demanded It is important to understand the difference between a change in demand and a change in the quantity demanded. A change in demand refers to a shift of the demand curve. A shift occurs if there is a change in one of the variables, other than the price of the product, that affects the

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willingness of consumers to buy the product. A change in the quantity demanded refers to a movement along the demand curve as a result of a change in the product’s price. Figure 3.3 illustrates this important distinction. If the price of tablet computers falls from $700 to $600 per tablet, the result will be a movement along the demand curve from point A to point B—an increase in quantity demanded from 3 million to 4 million. If consumers’ incomes increase, or another factor changes that makes consumers want more of the product at every price, the demand curve will shift to the right—an increase in demand. In this case, the increase in demand from D1 to D2 causes the quantity of tablet computers demanded at a price of $700 to increase from 3 million at point A to 5 million at point C. FIGURE 3.3

A change in demand versus a change in the quantity demanded If the price of tablet computers falls from $700 to $600, the result will be a movement along the demand curve from point A to point B—an increase in quantity demanded from 3 million to 4 million. If consumers’ income increases, or another factor changes that makes consumers want more of the product at every price, the demand curve will shift to the right—an increase in demand. In this case, the increase in demand from D1 to D2 causes the quantity of tablet computers demanded at a price of $700 to increase from 3 million at point A to 5 million at point C

Price (dollars per tablet)

A shift in the demand curve is a change in demand.

600

C

A

$700

B A movement along the demand curve is a change in quantity demanded.

0

D2 Demand, D1 3

4

5

Quantity (millions of tablets per month)

THE SUPPLY SIDE OF THE MARKET 3.2 Discuss the variables that influence the supply of goods and services. LEARNING OBJECTIVE

Quantity supplied The amount of a good or service that a firm is willing and able to supply at a given price.

Supply schedule A table that shows the relationship between the price of a product and the quantity of the product supplied. Supply curve A curve that shows the relationship between the price of a product and the quantity of the product supplied. Market supply The supply by all firms of a given good or service.

Just as many variables influence the willingness and ability of consumers to buy a particular good or service, so many variables also influence the willingness and ability of firms to sell a good or service. As with the demand side of the market, a very important variable is price. The amount of a good or service that a firm is willing and able to supply at a given price is the quantity supplied. Holding other variables constant (i.e. assuming ceteris paribus), when the price of a good rises, producing the good is more profitable and the quantity supplied will increase. When the price of a good falls, the good is less profitable and the quantity supplied will decrease. In addition, as we saw in Chapter 2, devoting more and more resources to the production of a good results in increasing marginal costs. Therefore firms will require higher prices to cover increased costs.

Supply schedules and supply curves A supply schedule is a table that shows the relationship between the price of a product and the quantity of the product supplied. The table in Figure 3.4 is a supply schedule showing the quantity of tablet computers that firms would be willing to supply per month at different prices. The graph in Figure 3.4 plots the numbers from the supply schedule as a supply curve. A supply curve shows the relationship between the price of a product and the quantity of the product supplied. The supply schedule and supply curve both show that, as the price of tablet computers rises, firms will increase the quantity they supply. At a price of $600 per tablet firms will supply 6 million tablets per month. At the higher price of $700 they will supply 7 million.

The law of supply The market supply curve in Figure 3.4 is upward sloping. We expect most supply curves to be upward sloping according to the law of supply, which states that, holding everything else constant,

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FIGURE 3.4

Supply schedule and supply curve As the price changes, Apple, Toshiba, Samsung, LG and other firms producing tablet computers change the quantity they are willing to supply. We can show this as a supply schedule in a table, or as a supply curve on a graph. The supply schedule and supply curve both show that, as the price of tablet computers rises, firms will increase the quantity they supply. At a price of $600 per tablet, firms will supply 6 million tablets. At a price of $700 per tablet firms will supply 7 million tablets

Supply schedule Price (dollars per tablet)

Quantity (millions of tablets per month)

$700

7

500

5

600 400 300

6 4 3

Price (dollars per tablet)

As the price of tablet computers rises the quantity supplied increases.

Supply

$700 600 500 400 300

0

3

4

5

6

7

Quantity (millions of tablets per month)

increases in price cause increases in the quantity supplied, and decreases in price cause decreases in the quantity supplied. The reason for this is that firms plan output, given the price, to enable them to make as much profit as possible. At a higher price, holding everything else constant, profits will be greater than before and firms will want to sell more. In addition, devoting more and more resources to the production of a good results in increasing marginal costs. So, for example, if Apple, Samsung, Toshiba, LG and other firms increase production of tablet computers during a given time period, they are likely to find that the cost of producing the additional tablets increases as they run existing factories for longer hours and pay higher prices for components and higher wages for workers. With higher marginal costs, firms will supply a larger quantity only if the price is higher. Notice that the definition of the law of supply—like the definition of the law of demand— contains the phrase ‘holding everything else constant’. If only the price of the product changes, there is a movement along the supply curve, which is an increase or decrease in the quantity supplied.

Law of supply Holding everything else constant, an increase in the price of a product causes an increase in the quantity supplied, and a decrease in the price of a product causes a decrease in the quantity supplied.

Variables that shift supply There are many variables other than the product’s own price that affect the willingness of firms to supply goods and services. If any of these other variables change, the supply curve will shift, which is an increase or decrease in supply. If, at every price level, firms increase the quantity of a product they wish to sell, the supply curve shifts to the right. In Figure 3.5 the shift from S1 to S3 represents an increase in supply. If, at every price level, firms decrease the quantity of a product they wish to sell, the supply curve shifts to the left. In Figure 3.5 the shift from S1 to S2 represents a decrease in supply. The following are the most important variables that shift market supply: • Prices of inputs • Technological change • Prices of substitutes in production • Number of firms in the market • Expected future prices We will discuss how each of these variables affects the market supply of tablet computers.

Prices of inputs The factor most likely to cause the supply curve for a product to shift is a change in the price of an input. An input is anything used in the production of a good or service. For instance,

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FIGURE 3.5

Shifting the supply curve

Supply, S2

Price (dollars per tablet)

If, at every price level, firms increase the quantity of a product they wish to sell, the supply curve shifts to the right. The shift from S1 to S3 represents an increase in supply. If, at every price level, firms decrease the quantity of a product they wish to sell, the supply curve shifts to the left. The shift from S1 to S2 represents a decrease in supply

Supply, S1 Supply, S3 Decrease in supply Increase in supply

0

Quantity (millions of tablets per month)

if the price of a component of tablet computers, such as flash memory, rises, the cost of producing tablet computers will increase and tablets will be less profitable at every price. The supply of tablets will decline, and the market supply curve for tablets will shift to the left. Similarly, if the price of an input falls, the supply of tablets will increase, and the supply curve will shift to the right.

Technological change Technological change A change in the ability of a firm to produce output with a given quantity of inputs. Productivity The output produced per unit of input.

A second factor that causes a change in supply is technological change. Technological change is a change in the ability of a firm to produce output with a given quantity of inputs. Technological change occurs whenever a firm is able to produce more output using the same amount of inputs. This shift will happen when the productivity of workers or machines increases. If a firm can produce more output with the same amount of inputs, its costs will be lower and the good or service will be more profitable to produce at any given price. As a result, when technological change occurs, the firm will increase the quantity supplied at every price and its supply curve will shift to the right.

Prices of substitutes in production Firms choose which goods or services they will produce. Alternative products that a firm could produce are called substitutes in production. To this point, we have considered the market for all types of tablet computers. A key feature of tablet computers is whether they connect to the Internet just by Wi-Fi or by either Wi-Fi or a cellular network. Suppose we consider as separate markets tablet computers capable of only connecting to the Internet by Wi-Fi and tablet computers that can connect by either Wi-Fi or a cellular network. If the price of tablets that connect by either Wi-Fi or a cellular network increases, these tablets will become more profitable than tablets that connect only by Wi-Fi, and Apple, Samsung, Toshiba and the other firms making tablets will shift some of their productive capacity away from WiFi-only models and toward models that also allow for a cellular connection. The firms will offer fewer WiFi-only models for sale at every price, so the supply curve for these tablets will shift to the left.

Number of firms in the market A change in the number of firms in the market will change supply. When new firms enter a market, the supply curve shifts to the right, and when existing firms leave, or exit, a market, the supply curve shifts to the left. For instance, when Toshiba entered the market for tablet computers in July 2011, the market supply curve for tablet computers shifted to the right.

Expected future prices If a firm expects that the price of its product will be higher in the future than it is today, it has an incentive to decrease supply now and increase it in the future. For instance, if Apple believes

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that prices for tablet computers are temporarily low—perhaps due to an economic downturn— it may store some of its production today to sell later on, when it expects prices to be higher. Table 3.2 summarises the most important variables that cause market supply curves to shift. You should note that the table shows the shift in the supply curve that results from an increase in each of the variables. A decrease in these variables would cause the supply curve to shift in the opposite direction. TABLE 3.2

Variables that shift market supply curves

AN INCREASE IN …

SHIFTS THE SUPPLY CURVE …

BECAUSE …

the price of an input

Price

the costs of producing the good rise

S2

0

productivity

Price

Quantity S1

Price

S2

Price

S1

Price

0

S1

more of the substitute is produced and less of the good is produced

S2

additional firms result in a greater quantity supplied at every price

Quantity

0

the expected future price of the product

the costs of producing the good fall

Quantity

0

the number of firms in the market

S2

Quantity

0

the price of a substitute in production

S1

S2

S1

less of the good will be offered for sale today to take advantage of the higher price in the future

Quantity

A change in supply versus a change in quantity supplied We noted earlier that it is important to understand the difference between a change in demand and a change in the quantity demanded. There is a similar difference between a change in supply and a change in the quantity supplied. A change in supply refers to a shift of the supply curve. The supply curve will shift when there is a change in one of the variables, other than the price of the product, that affects the willingness of suppliers to sell the product. A change in the quantity supplied refers to a movement along the supply curve as a result of a change in the product’s price. Figure 3.6 illustrates this important distinction. If the price of tablet computers rises from $500 to $600 per tablet, the result will be a movement up the supply curve from point A to point B—an increase in the quantity supplied from 5 million to 6 million. If the price of an input decreases or another factor makes sellers supply more of the product at every price change, the

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FIGURE 3.6

A change in supply versus a change in the quantity supplied If the price of tablet computers rises from $500 to $600 the result will be a movement up the supply curve from point A to point B—an increase in quantity supplied by Apple, Samsung, Toshiba and the other firms from 5 million to 6 million tablets. If the price of an input decreases or another factor changes that makes sellers supply more of the product at every price, the supply curve will shift to the right—an increase in supply. In this case, the increase in supply from S1 to S2 causes the quantity of tablets supplied at a price of $600 to increase from 6 million at point B to 8 million at point C

Price (dollars per tablet)

Supply, S1

A movement along the supply curve is a change in quantity supplied.

S2

$600

B

500

0

C

A

5

6

8

A shift in the supply curve is a change in supply.

Quantity (millions of tablets per month)

supply curve will shift to the right—an increase in supply. In this case, the increase in supply from S1 to S2 causes the quantity of tablet computers supplied at a price of $600 to increase from 6 million at point B to 8 million at point C.

3.3 Explain how equilibrium in a market is reached, and use a graph to illustrate market equilibrium. LEARNING OBJECTIVE

Market equilibrium A situation in which quantity demanded equals quantity supplied. Competitive market equilibrium A market equilibrium with many buyers and many sellers.

Surplus A situation in which the quantity supplied is greater than the quantity demanded.

MARKET EQUILIBRIUM: PUTTING DEMAND AND SUPPLY TOGETHER The purpose of markets is to bring buyers and sellers together. As we saw in Chapter 2, instead of being chaotic and disorderly the interaction of buyers and sellers in markets ultimately usually results in firms being led to produce those goods and services consumers desire most. To understand how this process happens we first need to see how markets manage to reconcile the plans of buyers and sellers. In Figure 3.7 we bring together the market demand curve for tablet computers and the market supply curve. Notice that the demand curve crosses the supply curve at only one point. This point represents a price of $500 and a quantity of 5 million tablet computers. Only at this point is the quantity of tablets consumers are willing to buy equal to the quantity of tablets firms are willing to sell. This is the point of market equilibrium. Only at market equilibrium will the quantity demanded equal the quantity supplied. In this case, the equilibrium price is $500 and the equilibrium quantity is 5 million. Markets that have many buyers and many sellers are competitive markets, and equilibrium in these markets is a competitive market equilibrium. In the market for tablet computers, there are many buyers but only about 20 firms. Whether 20 firms is enough for our model of demand and supply to apply to this market is a matter of judgment. In this chapter, we are assuming that the market for tablet computers has enough sellers to be competitive.

How markets eliminate surpluses and shortages A market that is not in equilibrium moves towards equilibrium. Once a market is in equilibrium it remains in equilibrium. To see why, consider what happens if a market is not in equilibrium. For instance, suppose that the price for tablet computers was $600 rather than the equilibrium price of $500. As Figure 3.8 shows, at a price of $600 the quantity of tablets supplied would be 6 million and the quantity of tablets demanded would be 4 million. When the quantity supplied is greater than the quantity demanded, there is a surplus in the market. In this case, the surplus is equal to 2 million tablets (6 million – 4 million = 2 million). When there is a surplus firms have unsold goods piling up, which gives them an incentive to increase their sales by reducing the price. Reducing the price will simultaneously increase the quantity demanded and decrease the quantity supplied. This adjustment will reduce the surplus, but as long as the price is above $500 there will be a surplus and downward pressure on the price will continue. Only when the price has fallen to $500 will the market be in equilibrium.

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Price (dollars per tablet)

$500

Supply

Market equilibrium Where the demand curve crosses the supply curve determines market equilibrium. In this case, the demand curve for tablet computers crosses the supply curve at a price of $500 and a quantity of 5 million. Only at this point is the quantity of tablets consumers are willing to buy equal to the quantity of tablets firms are willing to sell: the quantity demanded is equal to the quantity supplied

Market equilibrium

Equilibrium price

FIGURE 3.7

Demand Equilibrium quantity Quantity (millions of tablets per month)

5

0

If, however, the price were $300, the quantity supplied would be 3 million and the quantity demanded would be 7 million, as shown in Figure 3.8. When the quantity demanded is greater than the quantity supplied there is a shortage in the market. In this case, the shortage is equal to 4 million tablets (7 million – 3 million = 4 million). When a shortage occurs, some consumers will be unable to buy tablet computers at the current price. In this situation, firms will realise that they can raise the price without losing sales. A higher price will simultaneously increase the quantity supplied and decrease the quantity demanded. This adjustment will reduce the shortage, but as long as the price is below $500 there will be a shortage and upward pressure on the price will continue. Only when the price has risen to $500 will the market be in equilibrium. At a competitive market equilibrium all consumers willing to pay the market price will be able to buy as much of the product as they want, and all firms willing to accept the market price will be able to sell as much of the product as they want. As a result there will be no reason for the price to change unless either the demand curve or the supply curve shifts.

FIGURE 3.8

Price (dollars per tablet)

Surplus of 2 million tablets resulting from price above equilibrium.

Supply

$600 500

300

0

Shortage A situation in which the quantity demanded is greater than the quantity supplied.

Demand

3

4

5

6

Shortage of 4 million tablets resulting from price below equilibrium.

7

Quantity (millions of tablets per month)

The effect of surpluses and shortages on the market price When the market price is above equilibrium there will be a surplus. In the figure, a price of $600 for tablet computers results in 6 million being supplied, but only 4 million being demanded, or a surplus of 2 million tablets. As firms cut the price to dispose of the surplus, the price will fall to the equilibrium of $500. When the market price is below equilibrium there will be a shortage. A price of $300 results in 7 million tablets being demanded, but only 3 million being supplied, or a shortage of 4 million. As firms discover that those consumers who are unable to find tablet computers available for sale are willing to pay higher prices to get them, the price will rise to the equilibrium of $500

Demand and supply both count Always keep in mind that it is the interaction of demand and supply that determines the equilibrium price. Neither consumers nor firms can dictate what the equilibrium price will be.

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No firm can sell anything at any price unless it can find a willing buyer, and no consumer can buy anything at any price without finding a willing seller.

Shifts in a curve versus movements along a curve When analysing markets using demand and supply curves it is important to remember that when a shift in a demand or supply curve causes a change in equilibrium price, the change in price does not cause a further shift in demand or supply. For instance, suppose an increase in supply causes the price of a good to fall, while everything else that affects the willingness of consumers to buy the good is constant. The result will be an increase in the quantity demanded, but not an increase in demand. For demand to increase the whole curve must shift. The point is the same for supply: if the price of the good falls but everything else that affects the willingness of sellers to supply the good is constant, the quantity supplied decreases but not the supply. For supply to decrease the whole curve must shift.

3.4 Use demand and supply graphs to predict changes in prices and quantities. LEARNING OBJECTIVE

DON’T LET THIS HAPPEN TO YOU

THE EFFECT OF DEMAND AND SUPPLY SHIFTS ON EQUILIBRIUM We have seen that the interaction of demand and supply in markets determines the quantity of a good that is produced and the price at which it sells. We have also seen that several

Remember: a change in a good’s price does not cause the demand or supply curve to shift Suppose a student is asked to draw a demand and supply graph to illustrate how an increase in the price of oranges would affect the market for apples, other things being constant. He draws the graph on the left below and explains it as follows. ‘Because apples and oranges are substitutes, an increase in the price of oranges will cause an initial shift to the right in the demand curve for apples from D1 to D2. However, because this initial shift in the demand curve for apples results in a higher price for apples, P2, consumers will find apples less desirable and the demand curve will shift to the left from D2 to D3, resulting in a final equilibrium price of P3.’ Do you agree or disagree with the student’s analysis? You should disagree. The student has correctly understood that an increase in the price of oranges will cause the demand curve for apples to shift to the right. But the second demand curve shift the student describes, from D2 to D3, will not take place. Changes in the price of a product do not result in shifts in the product’s demand curve. Changes in the price of a product result only in movements along a demand curve. The graph on the right shows the correct analysis. The increase in the price of oranges causes the demand curve for apples to increase from D1 to D2. At the original price, P1, the increase in demand initially results in a shortage of apples equal to Q3 – Q1. But, as we have seen, a shortage causes the price to increase until the shortage is eliminated. In this case, the price will rise to P2, where the quantity demanded and the quantity supplied are both equal to Q2. Notice that the increase in price causes a decrease in the quantity demanded, from Q3 to Q2, but does not cause a decrease in demand. Price of apples

Price of apples

Supply

P2

Supply

P2

P3 D2

P1

P1

D3

D2 D1

D1 0

Quantity of apples per month

0

Q1

Q2

Q3 Quantity of apples per month

[ YOUR TURN Q

Test your understanding by doing related problems 4.4 and 4.12 on pages 83 and 84 at the end of this chapter.

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71

variables cause demand curves to shift, and other variables cause supply curves to shift. As a result, demand and supply curves in most markets are constantly shifting, and the prices and quantities that represent equilibrium are constantly changing. In this section we see how shifts in demand and supply curves affect equilibrium price and quantity.

The effect of shifts in supply on equilibrium When Toshiba entered the market for tablet computers, the market supply curve for tablet computers shifted to the right. Figure 3.9 shows the supply curve shifting from S1 to S2. When the supply curve shifts to the right, there will be a surplus at the original equilibrium price, P1. The surplus is eliminated as the equilibrium price falls to P2, and the equilibrium quantity rises from Q1 to Q2. If some existing firms decide to exit the market the supply curve will shift to the left, causing the equilibrium price to rise and the equilibrium quantity to fall. Price (dollars per tablet)

S1

FIGURE 3.9

The effect of an increase in supply on equilibrium

S2

1. As Toshiba enters the market for tablet computers, the supply curve shifts to the right ...

P1 P2 2. ... decreasing the equilibrium price ...

Demand

Quantity (millions of tablets per month)

Q1 Q2

0 3. ... and increasing the equilibrium quantity.

If a firm enters a market, as Toshiba entered the market for tablet computers, the equilibrium price will fall and the equilibrium quantity will rise. 1 As Toshiba enters the market for tablets a larger quantity of tablets will be supplied at every price, so the market supply curve shifts to the right, from S1, to S2, which causes a surplus of tablets at the original price, P1 2 The equilibrium price falls from P1 to P2 3 The equilibrium quantity rises from Q1 to Q2

The effect of shifts in demand on equilibrium When population growth and income growth occur, the market demand for tablet computers shifts to the right. Figure 3.10 shows the effect of a demand curve shifting to the right, from D1 to D2. This shift causes a shortage at the original equilibrium price, P1. To eliminate the shortage the equilibrium price rises to P2, and the equilibrium quantity rises from Q1 to Q2. FIGURE 3.10

Price (dollars per tablet)

1. As population and income grow, demand shifts to the right ...

P2 P1 2. ... increasing the equilibrium price ...

D1

0 3. ... and also increasing the equilibrium quantity.

The effect of an increase in demand on equilibrium

Supply

Q1

Q2

D2

Increases in income and population will cause the equilibrium price and quantity to rise. 1 As population and income grow the quantity demanded increases at every price, and the market demand curve shifts to the right, from D1 to D2, which causes a shortage of tablet computers at the original price, P1 2 The equilibrium price rises from P1 to P2 3 The equilibrium quantity rises from Q1 to Q2

Quantity (millions of tablets per month)

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In contrast, if the price of a substitute good, such as laptop computers, were to fall, the demand for tablet computers would decrease, shifting the demand curve for tablets to the left. When the demand curve shifts to the left, the equilibrium price and quantity will both decrease.

The effect of shifts in demand and supply over time Whenever only demand or only supply shifts, we can easily predict the effect on equilibrium price and quantity. But what happens if both curves shift? For instance, in many markets the demand curve shifts to the right over time, as population and income grow. The supply curve also often shifts to the right as new firms enter the market and technological change occurs. Whether the equilibrium price in a market rises or falls over time depends on whether demand shifts to the right by more than does supply. Figure 3.11(a) shows that when demand shifts to the right by more than supply the equilibrium price rises. However, as Figure 3.11(b) shows, when supply shifts to the right by more than demand the equilibrium price falls.

FIGURE 3.11

Shifts in demand and supply over time Whether the price of a product rises or falls over time depends on whether or not demand shifts to the right by more than supply. In Figure 3.11(a), demand shifts to the right by more than supply and the equilibrium price rises. 1 Demand shifts to the right by more than supply. 2 Equilibrium price rises from P1 to P2. In Figure 3.11(b), supply shifts to the right by more than demand and the equilibrium price falls. 1 Supply shifts to the right by more than demand. 2 Equilibrium price falls from P1 to P2

Price (dollars per tablet)

2. ... so the equilibrium price has increased.

S1 New equilibrium

1. Demand has shifted to the right more than supply ...

P2 P1

S2

Price (dollars per tablet)

Initial equilibrium

S2

New equilibrium

P1

Initial equilibrium

1. Supply has shifted to the right more than demand ...

P2 2. ... so the equilibrium price has decreased.

D2 D1 Q1

0

S1

Q2

(a) Demand shifting more than supply

Quantity (millions of tablets per month)

0

D1 Q1

Q2

(b) Supply shifting more than demand

D2

Quantity (millions of tablets per month)

SOLVED PROBLEM 3.1 DEMAND AND SUPPLY BOTH COUNT: PHARMACISTS AND ACCOUNTANTS In Australia there are more than three times more new graduates in accountancy than there are in pharmacy. Graduate Careers Australia conducts a survey of students each year soon after graduation and in 2013 this survey revealed that new accountancy graduates earned, on average, $50 000 per year compared to new pharmacy graduates who earned, on average, $39 000 per year. Why do these salaries differ?

Solving the problem STEP 1: Review the chapter material. This problem is about prices being determined at market equilibrium, so you may want to

review the section ‘Market equilibrium: Putting demand and supply together’, which begins on page 68.

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CHAPTER 3 WHERE PRICES COME FROM: THE INTERACTION OF DEMAND AND SUPPLY STEP 2: Draw supply curves for new pharmacy and new accountancy graduates that illustrate the greater supply of new

accountancy graduates. Begin by drawing two graphs. Label one ‘New accountants’ and the other ‘New pharmacists’. Make sure that the accountants supply curve is much further to the right than the pharmacists supply curve, illustrating the relatively greater supply of accounting graduates. (a)(i)

(a)(ii)

Price (wage in dollars)

New accountants

Price (wage in dollars)

New pharmacists Supply

Supply

Quantity

0

Quantity

0

STEP 3: Draw demand curves that show that the equilibrium price (wage) for accountants is higher than the equilibrium price

(wage) for pharmacists. Based on the supply curves you have just drawn above, think about how it might be possible for the market price of pharmacists to be lower than the market price of accountants. The only way this can be true is if the demand for accountants is much greater than the demand for pharmacists. Draw on your two graphs demand curves for pharmacists and for accountants that will result in an equilibrium price of accountants of $50 000 and an equilibrium price of pharmacists of $39 000. You have now solved the problem. (b)(i)

(b)(ii)

Price (wage in dollars)

New accountants

Price (wage in dollars)

New pharmacists Supply

Supply

$50 000 $39 000 Demand

Demand Quantity

0

0

Quantity

EXTRA CREDIT: The explanation for this puzzle is that both demand and supply count when determining market price. The demand

for accountancy graduates is much greater than the demand for pharmacy graduates, although the supply of accountancy graduates is greater. The upward slope of the supply curves occurs because the higher the wage in a profession the larger the number of students wishing to qualify for that profession.

[ YOUR TURN Q

Test your understanding by doing related problem 4.6 on page 83 at the end of this chapter.

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Table 3.3 summarises all possible combinations of shifts in demand and supply over time and the effects of the shifts on equilibrium price (P) and quantity (Q). For example, the entry in bold in the table shows that if the demand curve shifts to the right and the supply curve also shifts to the right, then the equilibrium quantity will increase, while the equilibrium price may increase, decrease or remain unchanged. TABLE 3.3

M

SUPPLY CURVE UNCHANGED

SUPPLY CURVE SHIFTS TO THE RIGHT

SUPPLY CURVE SHIFTS TO THE LEFT

DEMAND CURVE UNCHANGED

Q unchanged P unchanged

Q increases P decreases

Q decreases P increases

DEMAND CURVE SHIFTS TO THE RIGHT

Q increases P increases

Q increases P increases or decreases

Q increases or decreases P increases

DEMAND CURVE SHIFTS TO THE LEFT

Q decreases P decreases

Q increases or decreases P decreases

Q decreases P increases or decreases

C

A K I N G THE

3.2

ONNECTION

© Piotr Adamowicz | Dreamstime.com

Technological progress often leads to lower prices on goods like Blu-ray players

Price (dollars per Blu-ray player)

Supply S1

$900

100 0 6700

How shifts in demand and supply affect equilibrium price (P) and quantity (Q)

THE FALLING PRICE OF BLU-RAY PLAYERS The technology for playing pre-recorded movies has progressed rapidly over the past 30 years. Video cassette recorders (VCRs) were introduced in Japan in 1976. As the first way of recording television programs or playing pre-recorded movies, VHS recorders became immensely popular. Later, in 1997, digital video disc (DVD) players and recorders became available, and DVDs could store more information and had a crisper picture than VHS tapes played on VCRs. Within a few years, sales of DVD recorders were greater than sales of VCRs, and by 2006 movie studios had stopped releasing films on VHS tapes. In 2006, Blu-ray players were introduced. Because Blu-ray discs can store 25 gigabytes of data, compared with fewer than 5 gigabytes on a typical DVD, Blu-ray players can reproduce highdefinition images DVD players cannot.

When firms first began selling VCRs, DVD players and Blu-ray players, they initially charged high prices that declined rapidly within a few years. As the figure here shows, the average price of a non-recordable Blu-ray player in 2007 in Australia was around $900, but by 2013 this had declined to around $90. Annual sales rose from about 6700 in 2007 to over 500 000 by 2013. The figure shows that the Supply S2 decline in price and increase in quantity resulted from a large shift to the right of the supply curve. The supply curve shifted to the right for two main reasons: first, after Samsung introduced the first Blu-ray player, other firms entered the industry, increasing the quantity supplied at every price. Second, the prices of the parts used in manufacturing Blu-ray players, particularly the Demand laser components, declined sharply. As the cost of Quantity 500 000 manufacturing declined, the quantity supplied at (millions of Blu-ray players) every price increased.

SOURCE: Screen Australia (2012), ‘Retail sales of DVD and Blu-ray players, 1999–2011’, Audiovisual Markets, Video, at , viewed 23 April 2013.

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SOLVED PROBLEM 3.2 DEMAND AND SUPPLY BOTH COUNT: THE AUSTRALIAN HOUSING MARKET Historically, property values in Australia follow cycles, from peak to slowing down to a flat period then up to a new peak. During a period of strongly rising values a number of things happen, but mainly the rate of construction of new property increases. This is because developers and speculators are constantly monitoring the profitability of an investment. They look at land costs, construction costs and other costs such as wages, and they sell for a price higher than these costs on completion, the difference being the profit margin. When values are rising strongly there is greater potential return, hence more developers will commit to development and therefore the rate of construction increases dramatically. Nobody tells builders, developers or speculators when to stop. They keep building when values are rising, to take advantage of the strong market. Then, at some point in time, there will be more dwellings built and placed on the total market than there are people to occupy them. How can values rise any further when there is a surplus of property and not enough buyers in the market to buy or rent them? Accordingly the market will stall. Values tend simply to level off. So the developers and speculators withdraw from the market and the rate of new construction declines over time. However, the population continues to increase, and as children leave home they enter the market in their own right. After a while the excess property is slowly absorbed. And so the pendulum of supply and demand tilts again. Show the effects on the housing market of (a) a growing population and (b) a shortage of rental vacancies.

Solving the problem STEP 1: Review the chapter material. This problem is about how shifts in demand and supply curves affect the equilibrium price, so

you may want to review the section ‘The effects of shifts in demand and supply over time’, which begins on page 72. STEP 2: Draw the demand and supply graph. Draw a demand and supply graph, showing equilibrium in the housing market. Price (dollars)

Supply

P1

Demand

0

Q1

Quantity

STEP 3: Show the shift in the demand curve caused by an increasing population and explain the effect on housing prices. Shift the

demand curve to the right so that the new equilibrium price is higher than before. Show that the new equilibrium is at a higher price than before and there is an increase in the number of houses bought and sold. Price (dollars) Supply

P2 P1

Demand2 Demand1

0

Q1

Q2

Quantity

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PART 2 HOW THE MARKET WORKS STEP 4: Show the shift in the supply curve and the demand curve in the housing market following a shortage of rental vacancies.

Shift the supply curve to the right as developers supply more houses in anticipation of an increase in house prices due to an increase in demand for houses by investors who expect high returns in the rental market. There may also be an expectation by developers of an increase in demand from people buying houses due to the shortage of rentals. Shift the demand curve to the right as investors demand more houses. Price (dollars) Supply1 Supply2

P2 P1

Demand2 Demand1

0

Q1

Q2

Quantity

SOURCE: Jude Watson (2006), ‘The property cycle—where are we now?’, Quartile Research, September, at , viewed 22 April 2013.

[ YOUR TURN Q

For more practice do related problems 4.6, 4.7, 4.8 and 4.9 on pages 83 and 84 at the end of this chapter.

ECONOMICS IN YOUR LIFE (continued from page 57)

WILL YOU BUY AN APPLE IPAD OR A SAMSUNG GALAXY TAB? At the beginning of the chapter, we asked you to consider two questions: Would you choose to buy a Samsung Galaxy Tab if it had a lower price than an Apple iPad? And would your decision be affected if your income increased? To determine the answer to the first question, you have to recognise that the iPad and Galaxy Tab are substitutes. If you consider the two tablets to be very close substitutes, then you are likely to buy the one with the lower price. In the market, if consumers generally believe that the iPad and Galaxy Tab are close substitutes, a fall in the price of Galaxy Tabs will increase the quantity of Galaxy Tabs demanded and decrease the demand for iPads. Suppose that you are currently leaning towards buying the Galaxy Tab because its price is lower than the price of the iPad. If an increase in your income would cause you to change your decision to buy the iPad, then the Galaxy Tab is an inferior good for you.

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CONCLUSION The interaction of demand and supply determines market equilibrium. The model of demand and supply provides us with a powerful tool for predicting how changes in the actions of consumers and firms will cause changes in equilibrium prices and quantities. When many buyers and many sellers participate in the market, the result is a competitive market equilibrium. In a competitive market equilibrium all consumers willing to pay the market price will be able to buy as much of the product as they want, and all firms willing to accept the market price will be able to sell as much of the product as they want. Read ‘An inside look’ to learn of the impact on the demand for personal computers (PCs) following the rise of tablets and smartphones.

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AN INSIDE LOOK APRIL 2013 NG HERALD 20

NI THE SYDNEY MOR

s r e m u s n o c s a e g n u l p s e l PC sa s e n o h p t r a m s , s t e l b a t o t look by Asher Moses

o from ld father of tw r-o ea -y 27 a , PC Joshua Real hased his family ey, said he purc ed dn et of l m Sy al in um n pl ru en y be bl ve rra Na sales ha ill comforta r st te d ul pu co m it co d as an al A Person four years ago e devices such embrace portabl ed games. as -b eb ch year w to as consumers ift his software and ars ago where ea s and sh ye et n bl te ta e d lik st an is or s it w ed to their smartphone ‘I don’t think meant you need les experienced ch sa hi w PC t e ou id e w is m ld th or ca y dayter of software. W new software in the first quar ly do most of m al er on ev rs e pe in ‘I t cl . ke de id ar its, m cause of year-on-year upgrade,’ he sa obile device be to 76.3 million un m nt a ce r on pe ng e 14 si th ng ow the more th. It was year, droppi to-day web br e computer for earlier this mon th d ve rte sa po d d re an C an e , ID researcher the convenienc duced shipments ive quarter of re ore m ith W Ballarat, . st ca fourth consecut re complex tasks.’ developer from eviously fo e pr ar d ha ftw C so ID e a th as a, s, d one of server twice as ba Troy Mcilven t and storage was on cloud-based g en in em nn ag ru e an ar m ng o iti ftw ot ced, lim ther than and more so said digital ph le buying PCs ra s has been redu op ne hi pe ac g m in l ep ca ke lo demand on the last things er hardware. vices. upgrading to fast etely to mobile de ting. pl ke m oc co yr d tablets, ng sk hi e the need to keep itc ar sw blet sales ed for phones an lv ta , so nd is ha m cr le pe he ob ot ex pr On the ‘Once that blet sales are said. rtner reported ta year PC sales will drop even faster,’ he st la n io the recent ill m Research firm Ga 6 s, from 11 not warmed to ar d ye ha o s tw er l ia in um nt le ns ne e expo dically new ted to doub IDC said co n next year. Th ch offered a ra io hi ill w m 8, 6 . s 26 w 17 r do 20 de in the Start illion by to just un launch of W ar features like ili ntinue to 468 m m co fa to t d ou te on ith ec lli w oj bi pr ing. growth is user interface edicted to hit 1 e Macs are declin hone sales are pr en sales of Appl ev t oved to Bu m k n. . Similarly, smartp ee tto ar w bu ye was this illion last n m ei 5 Kl r 67 te m Pe fro O up CF eir de named this year, Microsoft e away from th of Windows, co tim n r io ei rs th ve ift xt sh ne s cus B ‘As consumer artphones, they will no longer see promise the take into account criticisms and fo sm lar Blue, would PC to tablets and place on a regu eaper PCs. they need to re ce vi a more heavily on smaller, ch lin de a ro Ca as nt PC de si their re -p ce vi er research basis,’ said Gartn Milanesi.

RNING HERALD

THE SYDNEY MO

SOURCE: Asher Moses (2013), ‘PC sales plunge as consumers look to tablets, smartphones’, The Sydney Morning Herald, 20 April, at , viewed 22 April 2013. Copyright © Pearson Australia (a division of Pearson Australia Group Pty Ltd) 2015 – 9781486010233 - Hubbard/Macroeconomics 3e

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Key points in the article The article discusses how the widespread and rapid increase in demand for tablet computers and smartphones has significantly reduced the demand for personal computers (PCs). Although households still use PCs, the new technology contained in mobile computer devices reduces the need to replace PCs as often as before.

Analysing the news A Consumer tastes have been changing away from PCs to tablet computers and smartphones. In addition, the article points out that the ability to run software on cloud-based servers rather than on the PC itself has meant that the need to replace PCs regularly has diminished. Previously, using new software—which inevitably needed greater computer power—meant that consumers had to buy new, more powerful, PCs. We can use the economic model of demand and supply developed in this chapter to illustrate this. In Figure 1, we can see that the change in consumer tastes away from PCs shifts the demand curve for PCs to the left, from D1 to D2. This lowers the price of PCs, from P1 to P2, the quantity supplied falls, shown by a movement along the supply curve S, and the equilibrium quantity of PCs falls, from Q1 to Q2.

FIGURE 1 THE CHANGE IN TASTES AWAY FROM PCs SHIFTS THE DEMAND CURVE TO THE LEFT

Price (dollars per PC)

1. The change in tastes away from PCs shifts the demand curve to the left …

B As consumer tastes have been changing to tablet computers and smartphones, this has shifted the demand curve for tablets from D1 to D2, as shown in Figure 2. The shift in demand would have raised the equilibrium price to P2 and equilibrium quantity to Q 2, ceteris paribus, as firms expand output of tablets along the supply curve. However, we know that the price of tablet computers has been falling since they were introduced on the market. We can use our knowledge of the factors that affect supply developed in this chapter to analyse this further. As the demand for tablets increased, new firms entered the market, increasing supply. Further, technological change meant that components in the production of tablets became cheaper. Therefore, as also shown in Figure 2, the supply curve for tablets shifted to the right, from S1 to S2, decreasing equilibrium price to P3 and further increasing equilibrium quantity, to Q 3. Thinking critically 1 If the demand for PCs continues to fall and the demand for tablet computers and smartphones continues to rise, what would you expect producers of computers to do and what would happen to the supply of each type of computer? 2 Suppose that most software could be accessed via cloud-based servers. What would you expect to happen to the price of software for use on PCs?

FIGURE 2 THE CHANGE IN TASTES TO TABLET COMPUTERS SHIFTS THE DEMAND CURVE TO THE RIGHT, WHILE NEW ENTRANTS AND NEW TECHNOLOGY SHIFT THE SUPPLY CURVE TO THE RIGHT

1. The change in tastes to tablet computers shifts the demand curve to the right …

S

Price (dollars per tablet)

P1

P2

P2

P1

S2 2. ... while new entrants and new technology shifts the supply curve to the right …

P3

2. ... decreasing equilibrium price ...

D2 0

S1

Q1

3. ... and also decreasing equilibrium quantity.

Q2

D1

Quantity (millions of PCs)

D2 D1 0

Q1 Q2 3. ... with both shifts increasing equilibrium quantity.

Q3 Quantity (millions of tablets)

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CHAPTER SUMMARY AND PROBLEMS KEY TERMS ceteris paribus (‘all else being equal’) competitive market equilibrium complements demand curve demand schedule demographics income effect inferior good

59 68 61 58 58 61 60 61

law of demand law of supply market demand market equilibrium market supply normal good productivity quantity demanded quantity supplied

59 65 58 68 64 61 66 58 64

shortage substitutes substitution effect supply curve supply schedule surplus technological change

69 61 59 64 64 68 66

THE DEMAND SIDE OF THE MARKET, PAGES 58–64 LEARNING OBJECTIVE 3.1

Discuss the variables that influence the demand for goods and services.

SUMMARY

REVIEW QUESTIONS

The types and quantities of goods and services produced ultimately depend on the desires of consumers. The model of demand and supply is one of the most powerful tools in economics. The quantity demanded is the amount of a good or service that a consumer is able and willing to purchase at a given price. A demand schedule is a table that shows the relationship between the price of a product and the quantity of the product demanded. A demand curve is a graph showing the relationship between the price of a product and the quantity of the product demanded. Market demand is the demand by all consumers of a given good or service. The law of demand states that ceteris paribus—holding everything else constant—the quantity of a product demanded increases when the price falls and decreases when the price rises. Demand curves slope downwards because of the substitution effect and the income effect. The substitution effect is the change in the quantity demanded that results from a change in price, making the good or service more or less expensive relative to other goods or services that are substitutes. The income effect is the change in the quantity demanded that results from the effect of a change in the price of the good or service on consumer purchasing power. Changes in income, the prices of related goods, tastes, population and demographics (the characteristics of a population with respect to age, race and gender) and expected future prices all cause the demand curve to shift. Substitutes are goods or services that can be used for the same or a similar purpose. Complements are goods and services that are used together. A normal good is a good or service for which the demand increases as income rises and decreases as income falls. An inferior good is a good or service for which the demand increases as income falls and decreases as income rises. A change in demand refers to a shift of the demand curve. A change in quantity demanded refers to a movement along the demand curve as a result of a change in the product’s price.

1.1

What is a demand schedule? What is a demand curve?

1.2

What do economists mean when they use the Latin expression ceteris paribus?

1.3

What is the difference between a change in demand and a change in quantity demanded?

1.4

What is the law of demand? Use the substitution effect and income effect to explain why an increase in the price of a product causes a decrease in the quantity demanded.

1.5

What are the main variables that will cause the demand curve to shift? Give an example of each.

PROBLEMS AND APPLICATIONS 1.6

For each of the following pairs of products, state which are complements, which are substitutes and which are unrelated. a Pepsi and Coke b Hot dog sausages and soft bread rolls c Vegemite and strawberry jam d MP3 players and graphics calculators

1.7

[Related to the opening case] When tablet computers based on the Android operating system were first introduced, there were relatively few applications, or ‘apps’, available for them. Now there are many more apps available for Android-based tablets. Are these apps substitutes or complements for tablet computers? How has the increase in the availability of apps for Android-based tablets affected the demand for Apple iPads? Explain.

1.8

State whether each of the following events will result in a movement along the demand curve for McDonald’s Big Mac burgers or whether it will cause the curve to shift. If the demand curve shifts, indicate whether it will shift to the left or to the right and draw a graph to illustrate the shift.

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1.9

a The price of Hungry Jack’s Whopper burgers declines. b McDonald’s distributes vouchers for $1.00 off on a purchase of a Big Mac. c A shortage of potatoes causes the price of fries to increase. d KFC raises the price of a bucket of fried chicken. e The Australian economy enters a period of rapid growth in incomes. Suppose that the following table shows the quantity demanded of UGG boots at five different prices in 2014 and 2015. QUANTITY DEMANDED

1.10

1.11

1.12

a Teenagers b Children under the age of five years c People over the age of 65 years 1.13

[Related to Making the connection 3.1] Since 1979, China has had a policy that allows most couples to have only one child. This policy has caused a change in the demographics of China. Between 2000 and 2010, the share of population under the age of 14 decreased from 23 per cent to 17 per cent, and as many parents attempt to ensure that the lone child is a son, the number of newborn males relative to females has increased. How has the one-child policy changed the relative demand for goods and services in China?1

1.14

Suppose that the data in the following table show the price and quantity of base model Holden Commodore vehicles. Do these data indicate that the demand curve for Commodores is upward sloping? Explain.

PRICE, $

2014

2015

160

5000

4000

170

4500

3500

180

4000

3000

YEAR

PRICE

QUANTITY

190

3500

2500

2010

$35 000

50 000

200

3000

2000

2011

$35 700

51 000

2012

$36 600

52 500

Name two different variables that could cause the quantity demanded of UGG boots to change as indicated from 2014 to 2015. During times of economic downturns and recessions, when unemployment rates are rising, it has been observed that sales of cheap chocolates and other sweets increase. If this is true, are chocolates and sweets normal goods or inferior goods? Briefly explain what characteristics of chocolates and sweets relative to other goods might make them normal goods or inferior goods. Is it possible for a good to be an inferior good for one person and a normal good for another person? If it is possible, can you give some examples? [Related to Making the connection 3.1] Name three goods or services whose demand is likely to increase rapidly if the following demographic groups increase at a faster rate than the population as a whole:

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1.15

Some analysts have suggested that the reduced number of bookshops will not lead to fewer book sales because the rise in the number of online bookshops and e-books will reduce the cost of books and therefore increase the demand for them. Do you agree with this analysis? Briefly explain.

1.16

A financial journalist made the following observation about forecasts of the future demand for tablet computers: The conclusion can only be that the market is too young to sustain a reliable short-, mid- or long-term forecast. If you trust any number at this time, good luck with that. Only a fool would bet the farm and a business on any forecast for the tablet market right now.2

Why might it be particularly difficult to forecast the demand for a new product? Which issues might make it particularly difficult to forecast the demand for table computers?

THE SUPPLY SIDE OF THE MARKET, PAGES 64–68 LEARNING OBJECTIVE 3.2

Discuss the variables that influence the supply of goods and services.

SUMMARY The quantity supplied is the amount of a good or service that a firm is willing and able to supply at a given price. A supply schedule is a table that shows the relationship between the price of a product and the quantity of the product supplied. A supply curve shows on a graph the relationship between the price of a product and the quantity of the product supplied. When the price of a product rises, the product is more profitable, ceteris paribus, and a greater amount will be supplied. Market supply is the supply by all firms of a given good or service. The law of supply

states that, holding everything else constant, the quantity of a product supplied increases when the price rises and decreases when the price falls. Changes in the prices of inputs, technology, the prices of substitutes in production, expected future prices and the number of firms in a market all cause the supply curve to shift. Technological change is a change in the ability of a firm to produce output with a given quantity of inputs. Productivity is the output produced per unit of input. A change in supply refers to a shift of the supply curve. A change in quantity supplied refers to a movement along the supply curve as a result of a change in the product’s price.

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REVIEW QUESTIONS 2.1 2.2

2.3

2.5

Briefly describe whether each of the following statements describes a change in supply or a change in the quantity supplied. a To take advantage of higher prices for umbrellas in winter, Shelter Umbrellas Company decides to increase output. b The success of the Apple iPad-mini leads more firms to begin producing mini tablets. c In the six months following the devastating earthquake and tsunami in Japan in 2011, motor vehicle production in Japan fell by 20 per cent. What would cause a movement from point A to point B on S1 in the following graph for rib eye steak? Provide two variables that would cause a movement from point A to point C.

S2

B C

A

PROBLEMS AND APPLICATIONS 2.4

S1

Price (dollars per steak)

What is a supply schedule? What is a supply curve? What is the difference between a change in supply and a change in the quantity supplied? What is the law of supply? What are the main variables that will cause a supply curve to shift? Give an example of each.

Quantity of rib eye steaks

0

2.6

Suppose that the following table shows the quantity supplied of UGG boots at five different prices in 2014 and 2015. PRICE $

QUANTITY SUPPLIED

160

3000

2000

170

3500

2500

180

4000

3000

190

4500

3500

200

5000

4000

Name two different variables that could cause the quantity supplied of UGG boots to change as indicated from 2014 to 2015.

MARKET EQUILIBRIUM: PUTTING DEMAND AND SUPPLY TOGETHER, PAGES 68–70 LEARNING OBJECTIVE 3.3

Explain how equilibrium in a market is reached, and use a graph to illustrate market equilibrium.

SUMMARY Market equilibrium occurs where the demand curve intersects the supply curve. A competitive market equilibrium has a market equilibrium with many buyers and many sellers. Only at this point is the quantity supplied equal to the quantity demanded. Prices above equilibrium result in surpluses, with the quantity supplied being greater than the quantity demanded. Surpluses cause the market price to fall. Prices below equilibrium result in shortages, with the quantity demanded being greater than the quantity supplied. Shortages cause the market price to rise.

3.5

Nothing is more useful than water: but it will purchase scarce anything; scarce anything can be had in exchange for it. A diamond, on the contrary, has scarce any value in use; but a very great quantity of other goods may frequently be had in exchange for it.3

REVIEW QUESTIONS 3.1 3.2 3.3

What do economists mean by ‘market equilibrium’? What do economists mean by a ‘shortage’. By a ‘surplus’? What happens in a market if the current price is above the equilibrium price? What will happen if the current price is below the equilibrium price?

PROBLEMS AND APPLICATIONS 3.4

eventually give up trying to buy it, so the demand for the good declines, and the price falls until the market is finally in equilibrium’. In the Wealth of Nations, Adam Smith discussed what has become known as the ‘diamond and the water’ paradox.

3.6

Graph the market for diamonds and the market for water. Show how it is possible for the price of water to be much lower than the price of diamonds, even though the demand for water is much greater than the demand for diamonds. If a market is in equilibrium, is it necessarily true that all buyers and all sellers are satisfied with the market price? Explain.

Briefly explain whether you agree with the following statement: ‘When there is a shortage of a good, consumers

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83

THE EFFECT OF DEMAND AND SUPPLY SHIFTS ON EQUILIBRIUM, PAGES 70–76 LEARNING OBJECTIVE 3.4

Use demand and supply graphs to predict changes in prices and quantities.

SUMMARY

Price

S1

In most markets demand and supply curves shift frequently, causing changes in equilibrium prices and quantities. Over time, if demand increases by more than supply, equilibrium price will rise. If supply increases by more than demand equilibrium price will fall.

S2

REVIEW QUESTIONS 4.1

4.2

D

Draw a demand curve and a supply curve to show the effect on the equilibrium price in a market in the following situations: a The demand curve shifts to the right. b The supply curve shifts to the left. If, over time, the demand curve for a product shifts to the right by more than the supply curve does, what will happen to the equilibrium price? What will happen to the equilibrium price if the supply curve shifts to the right by more than the demand curve? For each case, draw a demand and supply graph to illustrate your answer.

Look at the following four graphs and four market scenarios, each of which would cause either a movement along the supply curve for Pepsi or a shift of the supply curve. Match each scenario with the appropriate diagram. a A decrease in the supply of Coca-Cola b Average household income rises c An improvement in soft-drink bottling technology d An increase in the price of sugar

D2 0

4.4

4.5

S

Price

4.6 D2 D1 Quantity

0

Price

S2

4.7

S1

D 0

Quantity

S

Price

PROBLEMS AND APPLICATIONS 4.3

Quantity

0

D1 Quantity

[Related to Don’t let this happen to you] A student writes the following: ‘Increased production leads to a lower price, which in turn increases demand.’ Do you agree with his reasoning? Briefly explain. A study indicated that ‘stricter university alcohol policies, such as raising the price of alcohol or banning alcohol on campus, decrease the number of students who use marijuana’.4 a On the basis of this information, are alcohol and marijuana substitutes or complements? b Suppose that campus authorities reduce the supply of alcohol on campus. Use demand and supply graphs to illustrate the impact on the campus alcohol and marijuana markets. [Related to Solved problem 3.1] The demand for watermelons is highest during summer and lowest during winter. Yet watermelon prices are normally lower in summer than in winter. Use a demand and supply graph to demonstrate how this is possible. Carefully label the curves in your graph and clearly indicate the equilibrium summer price and the equilibrium winter price. [Related to Solved problem 3.2] Recently, the demand for LCD televisions appeared to be falling. At the same time, some industry observers expected that several smaller television manufacturers might exit the market. Use a demand and supply graph to analyse the effects of these factors on the equilibrium price and quantity of LCD televisions. Clearly show on your graph the old equilibrium price and quantity and the new equilibrium price and quantity. Can you tell for certain that the new equilibrium price will be higher or lower than the old equilibrium price? Explain.

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4.9

[Related to Solved problem 3.2] Australia often experiences droughts, causing the production levels of wheat to fall significantly. Draw a demand and supply graph to show the effect of a drought on the price of bread in Australia. [Related to Solved problem 3.2] Some time ago chocolate lovers were horrified by reports of a pending chocolate shortage.

4.12

product may increase or decrease, depending on whether supply or demand has shifted more. [Related to Don’t let this happen to you] A student was asked to draw a demand and supply graph to illustrate the effect on the personal computer (PC) market of a fall in the price of computer hard drives, ceteris paribus. She drew the following graph and explained it as follows: Displays are an input into tablet computers, so a fall in the price of displays will cause the supply curve for tablets to shift to the right (from S1 to S2). Because this shift in the supply curve results in a lower price (P2), consumers will want to buy more tablets and the demand curve will shift to the right (from D1 to D2). We know that more tablets will be sold, but we can’t be sure whether the price of tablets will rise or fall. That depends on whether the supply curve or the demand curve has shifted further to the right. I assume that the effect on supply is greater than the effect on demand, so I show the final equilibrium price (P3) as being lower than the initial equilibrium price (P1).

Manufacturers had met in Panama to discuss ways of averting a projected shortfall in cocoa production in the wake of a poor season. The vulnerability to pests and plant diseases of the cocoa tree, which can only grow in tropical regions within 20 degrees of the equator, and the failure of cocoa production to keep up with growth in consumption, added to concerns. Predictions of a serious shortage within 10 years were widely reported. The Confectionary Manufacturers of Australasia told CHOICE that efforts were being made to develop disease-resistant plants, and the plants are being grown in different regions in the hope of increasing production. In Australia, for example, the Federal Government and the departments of agriculture in Queensland, the NT and WA have teamed up with ‘a leading chocolate manufacturer’ to fund trial plantations in Broome, Darwin and Innesfail.5

Explain whether you agree or disagree with the student’s analysis. Be careful to explain exactly what—if anything— you find wrong with her analysis. Price

S1

Reprinted from the May 2000 edition of CHOICE—with the permission of CHOICE.

4.10

4.11

From the above article, illustrate the following using demand and supply graphs for each of the below. a The effect on the supply of cocoa if the diseases affecting the cocoa tree become worse. b The effect on the demand curve of cocoa if worldwide chocolate consumption continues to rise. c The effect on the world equilibrium price and quantity of cocoa if Australia can successfully cultivate cocoa trees. d The effect on the equilibrium price of chocolate if all firstyear students rush out and purchase chocolate for their economics lecturers. The telecommunications industry in Australia was fully deregulated in July 1997, allowing new competitors into the market. In addition there were dramatic changes in the types of technology available to customers, with the rapid development of mobile networks and Internet technology. Explain and illustrate, using demand and supply graphs, the effect on the equilibrium price and quantity of telecommunications services of: a the full deregulation of the telecommunications industry. b the development of new technology. Briefly explain whether each of the following statements is true or false. a If the demand for and supply of a product both increase, the equilibrium quantity of the product must also increase. b If the demand for and supply of a product both increase, the equilibrium price of the product must also increase. c If the demand for a product decreases and the supply of the product increases, the equilibrium price of the

S2

P1 P3 P2

D1 0

D2 Quantity

Government regulations in Australia on the educational qualifications of those working in child care centres require higher levels of formal training than a few years ago. Suppose that these regulations increase the quality of child care and cause the demand for child care services to increase. At the same time, assume that complying with the government regulations increases the costs of child care businesses. Draw a demand and supply graph to illustrate the effects of these changes in the market for child care services. Briefly explain whether the total quantity of child care services purchased will increase or decrease as a result of the regulations. 4.14. The following are the supply and demand graphs for two markets. One of the markets is for Porsche cars, and the other is for a potentially life-saving cancer-fighting drug. Briefly explain which diagram is most likely to represent which market. 4.13

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CHAPTER 3 WHERE PRICES COME FROM: THE INTERACTION OF DEMAND AND SUPPLY Price

Price

D

85

S

S

D 0

Quantity

0

Quantity

ENDNOTES 1

2

3

The Economist (2011), ‘China’s family planning: illegal children will be confiscated’ and ‘China’s population: Only and lonely: China’s population’, The Economist, 21 July. Wolfgang Gruener (2011), ‘240 million tablets: The gazillion-dollar forecast game’, The Motley Fool, at , viewed 7 November 2013. Adam Smith (1976; original edition 1776), An Inquiry into the Nature and Causes of the Wealth of Nations, Vol. 1, Oxford University Press.

4

5

Jenny Williams, Rosalie Pacula, Frank Chaloupka and Henry Wechsler (2005), ‘Alcohol and marijuana use among college students: Economic complements or substitutes?’, Health Economics, 13(9), September, pp. 825–843. Australian Consumers’ Association (2000), CHOICE, May, p. 9. Reprinted with permission.

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PA RT

3

M ACROECONO MIC F O UNDATION S AND ECONO MIC GROWTH

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CHAPTER

4

GDP: MEASURING TOTAL PRODUCTION, INCOME AND ECONOMIC GROWTH LEARNING OBJECTIVES After studying this chapter you should be able to: 4.1 Explain how total production in an economy is measured. 4.2 Discuss whether GDP is a good measure of economic wellbeing. 4.3 Discuss the difference between real GDP and nominal GDP. 4.4 Understand how the economic growth rate is measured.

NEAR NEIGHBOURS, BUT FAR AWAY INDONESIA IS ONE of Australia’s nearest neighbours and there are important trade and political links between the two countries. However, the two countries are very different in many important aspects. Australia has a population of over 23 million compared to a population of well over 248 million in Indonesia. Despite having almost 11 times the population of Australia, Indonesia had a gross domestic product (GDP)—or total production—around 60 per cent of Australia’s in 2013 $969 billion compared to Australia’s $1.51 trillion. The amount of goods and services available per person in Indonesia is about $3900 compared to $6400 per person in China, $1570 in India and $65 650 in Australia. This means that the average

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Indonesian has a standard of living much lower than the average Australian, but does it mean that the average Australian has a standard of living 17  times that of the average Indonesian? Some economists have questioned the use of GDP statistics to measure welfare or living standards, and argue that Australia’s standard of living estimates are vastly overstated by not including all the costs that accompany a larger GDP, such as stress, pollution and less leisure time. Could any Australians live on $10 per day—the approximate GDP per person per day for Indonesia? Obviously Indonesians can and do live on this. However, there is substantial income inequality in Indonesia, with the income gap between poor and non-poor increasing. While there is a large middle class who can afford good housing, cars and even overseas education for their children, Indonesia still has high levels of people living in poverty. One benchmark that the World Bank uses to define poverty is if people are living on less than $US2 per day. Using this measure, around 106 million people or 42 per cent of the Indonesian population live in poverty. However, the World Bank definition is controversial in Indonesia, because on $US2 a day Indonesians can live a reasonable, but frugal, life especially in rural villages. The major problem with using GDP to measure the wellbeing of households and those in poverty in Indonesia is that GDP measures only market income and does not include non-market income. Market income is all cash income including salaries, wages, business income and non-business income (such as rent, interest and dividends). Non-market income covers all forms of income, such as consumption of the household’s own production, income in-kind and other income. In Indonesia, non-market income is very important in determining the standard of living. Most households are involved in producing goods and services at home, including growing crops or keeping chickens, and producing goods such as cigarettes and noodles. These are consumed at home but not bought and sold in the market. Also, trade takes place between households without any money changing hands, for instance eggs might be traded for milk, so they are not included in GDP. Studies have shown that on average non-market income makes up over 45 per cent of total income (market plus non-market income) and that for the poorest households non-market income makes up almost 90 per cent of total income! Clearly, the inability to include non-market income in GDP calculations can lead to vastly inaccurate estimates of the standard of living in Indonesia. SOURCE: World Bank Development Indicators, at , viewed 15 October 2013; K. Nugraha and P. Lewis (2013), ‘Towards a better measure of income inequality in Indonesia’, Bulletin of Indonesian Economic Studies, Vol. 49, Issue 1, pp. 103–112.

Corbis Australia Pty Ltd

ECONOMICS IN YOUR LIFE

4

WHAT’S THE BEST COUNTRY FOR YOU TO WORK IN? Suppose that an airline offers you a job after graduation. The firm has offices in the United Kingdom (UK) and China, and because you are fluent in English and Mandarin, you get to choose the country in which you will work and live. Gross domestic product (GDP) is a measure of an economy’s total production of goods and services, so one factor in your decision is likely to be the growth rate of GDP in each country. Based on the International Monetary Fund’s forecasts, GDP growth is expected to increase much more in China each year than in the UK. What effect do these two very different growth rates have on your decision to work and live in one country over the other? If China’s much larger growth rate does not necessarily lead you to decide to work and live in China, why not? As you read this chapter, see if you can answer these questions. You can check your answers against those we provide on page 103 at the end of this chapter.

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PART 3 MACROECONOMIC FOUNDATIONS AND ECONOMIC GROWTH

Microeconomics The study of how households and firms make choices, how they interact in markets and how the government attempts to influence their choices. Macroeconomics The study of the economy as a whole, including topics such as inflation, unemployment and economic growth. Economic growth The expansion of society’s productive potential, usually measured by the rate of growth in real GDP. Unemployment rate The percentage of the labour force that is unemployed. Business cycle Alternating periods of economic expansion and economic contraction relative to the trend rate of economic growth. Expansion The period of a business cycle during which total production and total employment are increasing above trend growth. Contraction The period of a business cycle during which total production and total employment are falling below trend growth. Recession The period of a business cycle during which total production and total employment are decreasing. Inflation rate The percentage increase in the general price level in the economy from one year to the next.

4.1 Explain how total production in an economy is measured. LEARNING OBJECTIVE

AS WE SAW in Chapter 1, we can divide economics into the subfields of microeconomics and macroeconomics. Microeconomics is the study of how households and firms make choices, how they interact in markets and how the government attempts to influence their choices. Macroeconomics is the study of the economy as a whole, including topics such as inflation, unemployment and economic growth. In microeconomic analysis, economists generally study individual markets, such as the market for personal computers. In macroeconomic analysis, economists study factors that affect many markets at the same time. Economic growth refers to the ability of the economy to produce increasing quantities of goods and services. Economic growth is important because an economy that grows too slowly fails to raise living standards. In many countries in Africa very little economic growth has occurred in the past 60 years, and many people remain in extreme poverty. Macroeconomics analyses both what determines a country’s rate of economic growth and the reasons growth rates differ so greatly between countries.

Macroeconomics also analyses what determines the total level of employment and the unemployment rate in an economy. As we will see, the level of employment and the unemployment rates are affected significantly by the business cycle, which refers to the alternating periods of expansion and contraction in economic activity relative to the trend in the economic growth rate that the economy experiences over time. The contraction in economic activity may also lead to a fall in output and employment, which is referred to as a recession. Other factors also help determine the level of employment in the long run. A related issue is why some economies are more successful than others in maintaining high levels of employment over time. Another important macroeconomic issue is what determines the inflation rate, or the percentage increase in the general level of prices from one year to the next. As with employment, inflation is affected both by the business cycle and by other long-run factors. Finally, macroeconomics is concerned with the linkages between economies throughout the world. These linkages involve international trade and international finance, and will be examined in depth in Chapters 14 and 15. Macroeconomic analysis provides information that consumers and firms need in order to understand current economic conditions and to help predict future conditions. A family may be reluctant to buy a house if employment in the economy is declining because some family members may be at risk of losing their jobs. Similarly, firms may be reluctant to invest in building new factories or to undertake major new expenditures on information technology if they expect future sales to be weak. Macroeconomic analysis can also aid the federal government in designing policies that help the economy perform more efficiently. From these important macroeconomic issues we can summarise four main policy objectives of Australian macroeconomic policy: 1 2 3 4

A stable and strong rate of economic growth Low unemployment Stable and low inflation A manageable balance in overseas trade and finance

As we progress through the following chapters we will study each of these in turn. In this chapter we begin our study of macroeconomics by considering how best to measure the key macroeconomic variables of total production and economic growth.

GROSS DOMESTIC PRODUCT MEASURES TOTAL PRODUCTION Why is gross domestic product (GDP) so often the focus of news stories? In this section we explore what GDP is and how it is measured. We also explore why knowledge of GDP is important to consumers, firms and government policy-makers.

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CHAPTER 4 GDP: MEASURING TOTAL PRODUCTION, INCOME AND ECONOMIC GROWTH

91

Measuring total production: gross domestic product Economists measure total production by gross domestic product, or GDP. GDP is the market value of all final goods and services produced in a country during a period of time. In Australia, the Australian Bureau of Statistics (ABS) compiles the data needed to calculate GDP. The ABS issues reports on GDP every three months (quarterly). GDP is a central concept in macroeconomics so we need to consider its definition carefully.

Gross domestic product (GDP) The market value of all final goods and services produced in a country during a period of time.

GDP is measured using market values, not quantities The word value is important in the definition of GDP. In microeconomics, we measure production in terms of quantity: the number of loaves of bread produced by Bakers Delight stores, billions of tonnes of wheat grown by Australian farmers or the number of students produced by Australian universities. When we measure total production in the economy, we can’t just add together the quantities of every good and service because the result would be a meaningless jumble. Tonnes of wheat would be added to packets of cereal and numbers of restaurant meals and so on. Instead, we measure production by taking the value in dollar terms of all the goods and services produced.

GDP includes only the market value of final goods and services In measuring GDP we include only the market value of final goods and services. A final good or service is one that is purchased by its final user and is not included in the production of any other good or service. Burgers or computers purchased by consumers are final goods. Some goods and services, though, are used in the production of other goods and services and are termed intermediate goods and services. For example, Bakers Delight does not produce the flour used in its bread making; it buys the flour from a bread mill. The flour purchased by Bakers Delight stores is an intermediate good, whereas a loaf of bread purchased by a person for their consumption is a final good. In calculating GDP, we include the value of the bread but not the value of the flour. If we included the value of the flour we would be double counting. The value of the flour would be counted once when sold to Bakers Delight stores and a second time when the bread was sold to a customer.

Final good or service A new good or service which is the end product of the production process that is purchased by the final user. Intermediate good or service A good or service that is an input into another good or service.

GDP includes only current production GDP includes only production that takes place during the indicated time period. For example, GDP in 2015 includes only the goods and services produced during that year. In particular, GDP does not include the value of used goods. If you buy a new DVD of Star Trek from Kmart, the purchase is included in GDP. If, six months later, you resell that DVD on eBay, that transaction is not included in GDP since nothing new has actually been produced.

Measuring GDP using the value-added method We have seen that GDP can be calculated by adding together all expenditures on final goods and services. An alternative way of calculating GDP is the value-added method. Value added refers to the additional market value a firm adds to a product and is equal to the difference between the price the firm sells a good for and the price it paid other firms for intermediate goods. Table 4.1 gives a hypothetical example of the value added by each firm involved in the production of a woollen jumper offered for sale by Big W. Suppose a sheep farmer sells $1.00 of raw wool to a woollen mill. If, for simplicity, we ignore any inputs the farmer may have purchased from other firms—such as sheep feed and shearers’ wages—then the farmer’s value added is $1.00. The woollen mill then weaves the raw wool into woollen thread, which it sells to a clothing manufacturer for $3.00. The woollen mill’s value added ($2.00) is the difference between the price it paid for the raw wool ($1.00) and the price for which it can sell the woollen thread ($3.00). Similarly, the clothing manufacturer’s value  added is the difference between the price it paid for the woollen thread ($3.00) and the price it receives for the woollen jumper from Big W ($15.00). Big W’s value added is the difference between the price it pays for the jumper ($15.00) and the price it can sell the jumper for in its stores ($35.00). Notice that the price of the jumper in Big W stores is exactly equal to the sum of the value added by each firm involved in the production of the jumper. Therefore, we can calculate GDP by adding up the market value of every final good and service produced during a particular

Value added The market value a firm adds to a product.

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TABLE 4.1

Calculating value added

FIRM

VALUE OF PRODUCT

VALUE ADDED

Sheep farmer

Value of raw wool = $1.00

Value added by sheep farmer

= $1.00

Woollen mill

Value of raw wool woven into woollen thread = $3.00

Value added by woollen mill = ($3.00 – $1.00)

Clothing manufacturer

Value of woollen thread made into a jumper = $15.00

Value added by clothing manufacturer = ($15.00 – $3.00)

= 12.00

Big W

Value of jumper for sale by Big W = $35.00

Value added by Big W = ($35.00 – $15.00)

= 20.00

Total value added

= 2.00

= $35.00

period. Or, we can arrive at the same value for GDP by adding up the value added of every firm involved in producing those final goods and services.

Other measures of total production and total income National income accounting refers to the methods the ABS uses to keep track of total production and total income in the economy. The statistical tables containing this information are called the Australian System of National Accounts. Every quarter the ABS releases Australian System of National Accounts tables containing data on several measures of total production and total income. We have already discussed the most important measure of total production and total income: GDP. In addition to calculating GDP the ABS calculates the following measures of production and income.

Net Domestic Product (NDP) Net domestic product (NDP) is calculated by measuring GDP and subtracting the value of depreciation on capital equipment. Depreciation is the reduction in the value of capital equipment that results from use or obsolescence.

Gross National Income (GNI) GDP is the market value of final goods and services produced within Australia. Gross national income, or GNI, is Australia’s GDP, plus income generated overseas by Australian residents and  firms, minus the income generated in Australia by non-residents and foreign firms. Australian firms have facilities in foreign countries and foreign firms have facilities in Australia. BHP Billiton (an Australian company), for example, has mines overseas and Campbell’s Soup (a US company) has production plants in Australia. GNI includes foreign production by Australian firms but excludes Australian production by foreign firms.

SOLVED PROBLEM 4.1 CALCULATING GDP Suppose that in 2015 a very simple economy produces only the following four goods and services: eye examinations, pizzas, textbooks and paper. Assume that all of the paper in this economy is used in the production of textbooks. Use the information in the following table to calculate GDP. PRODUCTION AND PRICE STATISTICS (1) PRODUCT Eye examinations Pizzas Textbooks Paper

(2) QUANTITY

(3) PRICE PER UNIT ($)

100

50.00

80

10.00

20

100.00

2000

0.10

Solving the problem STEP 1: Review the chapter material. This problem is about GDP, so you may want to review the section ‘Measuring total production:

gross domestic product,’ which begins on page 91.

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CHAPTER 4 GDP: MEASURING TOTAL PRODUCTION, INCOME AND ECONOMIC GROWTH STEP 2: Determine which goods and services listed in the table should be included in the calculation of GDP. GDP is the market

value of all final goods and services. Therefore, we need to calculate the value of the final goods and services listed in the table. Eye examinations, pizzas and textbooks are final goods. Paper would also be a final good if, for instance, a consumer bought it to use in a printer. However, here we are assuming that publishers purchase all the paper to use in manufacturing textbooks, so the paper is an intermediate good and its value is not included in GDP. STEP 3: Calculate the value of the three final goods and services listed in the table. Value is equal to the quantity produced

multiplied by the price per unit, so we multiply the numbers in column (1) by the numbers in column (2): (1) QUANTITY

(2) PRICE PER UNIT ($)

(3) VALUE ($)

100

50

5000

Pizzas

80

10

800

Textbooks

20

10

2000

PRODUCT Eye examinations

STEP 4: Add the value for each of the three final goods and services to find GDP. GDP = value of eye examinations produced + value

of pizzas produced + value of textbooks produced = $5000 + $800 + $2000 = $7800.

[ YOUR TURN Q

For more practice do related problem 1.11 on pages 106 and 107 at the end of this chapter.

METHODS OF MEASURING GROSS DOMESTIC PRODUCT The ABS produces three different methods of calculating GDP. 1 The production method. The sum of the value of all goods and services produced by industries in the economy in a year minus the cost of goods and services used in the productive process, leaving the value added by the industries. 2 The expenditure method. The sum of the total expenditure on final goods and services by households, investors, government and net exports (the expenditure on exports minus the expenditure on imports). 3 The income method. The sum of the income generated from the production of goods and services, which includes profits, wages and other employee payments, income from rent and interest earned.

Net exports The expenditure on exports minus the expenditure on imports.

The following section will demonstrate how these methods all lead to the calculation of the same level of GDP.

Production, income and the circular-flow diagram When we measure the value of total production in the economy by calculating GDP we are simultaneously measuring the value of total income and the value of total expenditure on goods and services. First, to see why the value of total production is equal to the value of total income, consider what happens to the money you spend on a single product. Suppose you buy a steak meal for $25 at PJ O’Reilly’s pub. All of that $25 must end up as someone’s income. Suppliers of meat, potato chips and salad, plus PJ O’Reilly’s will receive some of the $25 as profits. Workers at the food suppliers will receive some as wages, the waiters who served you the meal will receive some wages, the farms that sell ingredients will receive some as profits, the workers on these farms will receive some as wages and so on: every cent must end up as someone’s income. (Note, however, that any sales tax on the meal will be collected by PJ O’Reilly’s and sent to the government without immediately ending up as anyone’s income.) Therefore, if we add up the value of every good and service sold in the economy, we must get a total that is exactly equal to the value of all the income in the economy.

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The circular-flow diagram is used to illustrate the flow of spending and money in the economy. Firms sell goods and services to three groups: domestic households, foreign (overseas) firms and households, and the government. Expenditure by foreign firms and households (shown as the ‘Rest of the world’ in the diagram) on domestically produced goods and services are called exports. As we note at the bottom of Figure 4.1, we can measure GDP by adding up the total expenditures of these three groups on goods and services. FIGURE 4.1

The circular flow and measurement of GDP The circular-flow diagram illustrates the flow of spending and money in the economy. Firms sell goods and services to three groups: domestic households, foreign firms and households, and the government. To produce goods and services firms use factors of production: labour, capital, natural resources and entrepreneurship. Households supply the factors of production to firms in exchange for income in the form of wages, interest, profit and rent. Firms make payments of wages and interest to households in exchange for hiring workers and other factors of production. The sum of wages, interest, rent and profit is total income in the economy. We can measure GDP as the total income received by households. The diagram also shows that households use their income to purchase goods and services, pay taxes and save. Firms and the government borrow the funds that flow from households into the financial system. We can measure GDP either by calculating the total value of expenditures on final goods and services or by calculating the value of total income

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Firms use the factors of production—labour, capital, natural resources and entrepreneurship— to produce goods and services. Households supply the factors of production to firms in exchange for income. We divide income into four categories: wages, interest, rent and profit. Firms pay wages to households in exchange for labour services, interest for the use of capital and rent for natural resources such as land. Profit is the income that remains after a firm has paid wages, interest and rent. Profit is the return to entrepreneurs for organising the other factors of production and for bearing the risk of producing and selling goods and services. As Figure 4.1 shows, federal, state and local governments make payments of wages and interest to households in exchange for hiring workers and other factors of production. Governments also make transfer payments to households. Transfer payments are payments by the government to individuals and include social security payments to retired and disabled people, unemployment benefits to unemployed workers and a variety of other payments to families. These payments are not included in GDP because they are not received in exchange for production of a new good or service. The sum of wages, interest, rent and profit is total income in the economy. As we note at the top of Figure 4.1, we can measure GDP as the total income received by households. The diagram also allows us to trace the ways that households use their income. Households spend some of their income on goods and services. Some of this spending is on domestically produced goods and services, and some is on foreign produced goods and services. Spending on foreign produced goods and services is known as imports. Households also use some of their income to pay taxes to the government. (Note that firms also pay taxes to the government.) Some of the income earned by households is not spent on goods and services or paid in taxes, but is deposited in savings accounts in banks or is used to buy shares or bonds. Banks and share and bond markets make up the financial system. The flow of funds from households into the financial system makes it possible for the government and firms to borrow. As we will see, the health of the financial system is of vital importance to an economy. Without the ability to borrow funds through the financial system firms will have difficulty expanding and adopting new technologies. No country without a well-developed financial system has been able to sustain high levels of economic growth. The circular-flow diagram shows that we can measure GDP either by calculating the total value of expenditures on final goods and services or by calculating the value of total income. We get the same dollar amount of GDP with either approach.

Transfer payments Payments by the government to individuals for which the government does not receive a good or service in return.

Components of GDP The ABS divides its statistics on GDP into four major categories of expenditures. These are consumption, investment, government and net exports expenditures. Economists use these categories to understand why GDP fluctuates and to forecast future GDP.

Personal consumption expenditures, or ‘consumption’

Consumption Spending by households on goods and services, not including spending on new houses.

Consumption expenditures are made by households and are divided into expenditures on services, such as medical care, education and haircuts; expenditures on non-durable goods, such as food and clothing; and expenditures on durable goods, such as cars and furniture. The spending by households on new houses is not included in consumption. Instead, spending on new houses is included in the investment category, which we discuss next.

Investment Spending by firms on new factories, office buildings, machinery and inventories, plus spending by households on new houses.

Gross private domestic investment, or ‘investment’ Spending on gross private domestic investment, or simply investment, is divided into three categories: business fixed investment is spending by firms on new factories, office buildings and machinery used to produce other goods; residential investment is spending by households on new housing; changes in business inventories are also included in investment. Inventories are goods that have been produced but not yet sold. If a car manufacturer has $20 million worth of unsold cars at the beginning of the year and $35 million worth of unsold cars at the end of the year, then the firm has spent $15 million on inventory investment during the year.

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DON’T LET THIS HAPPEN TO YOU

Remember what economists mean by ‘investment’ Notice that the definition of investment in this chapter is narrower than in everyday use. For example, people often say they are investing in the share market or in rare coins. As we have seen, economists reserve the word investment for purchases of machinery, factories and houses. Economists don’t include purchases of shares or rare coins or deposits in savings accounts in the definition of investment because these activities don’t result in the production of new goods. For example, a Telstra share represents part ownership of that company. When you buy Telstra shares nothing new is produced—there is just a transfer in ownership. Similarly, buying a rare coin or putting $1000 in a savings account does not result in an increase in production. GDP is not affected by any of these activities, so they are not included in the economic definition of investment.

[ YOUR TURN Q

Test your understanding by doing related problem 1.12 on page 107 at the end of this chapter.

Government consumption and gross investment, or ‘government purchases’ Government purchases Spending by federal, state and local governments on goods and services.

Government purchases are spending by federal, state and local governments on goods and services, such as education, roads and aircraft carriers. Again, government spending on transfer payments is not included in government purchases because it does not result in the production of new goods and services.

Net exports of goods and services, or ‘net exports’ Net exports is equal to the expenditure on exports minus the expenditure on imports. Exports are goods and services produced in Australia, but purchased by foreign firms, households and governments. We add exports to our other categories of expenditures because otherwise we would not be including all spending on new goods and services produced in Australia. For example, if Australian universities receive $10 billion in fees from overseas students, those exports are included in GDP because they represent production in Australia. Imports are goods  and services produced in foreign countries, and purchased by Australian firms, households and governments. We subtract imports from total expenditure, because otherwise we would be including spending that does not result in production of new goods and services in Australia. For example, if Australian consumers buy $1 billion worth of furniture manufactured in Indonesia, that spending is included in consumption expenditure. But the value of those imports is subtracted from GDP because the imports do not represent production in Australia.

An equation for GDP and some actual values A simple equation sums up the components of GDP: Y = C + I + G + NX The equation tells us that GDP (denoted as Y ) equals consumption (C) plus investment (I ) plus government purchases (G) plus net exports (NX ). Figure 4.2 shows the values of the components of GDP for the financial year 2012/2013. The graph in the figure highlights the fact that consumption is by far the largest component of GDP. Consumption accounts for almost 55 per cent of GDP, far more than any of the other components. In recent years, net exports typically have been negative, which reduces GDP.

4.2 Discuss whether GDP is a good measure of economic wellbeing. LEARNING OBJECTIVE

DOES GDP MEASURE WHAT WE WANT IT TO MEASURE? Economists use GDP to measure total production in the economy. For that purpose, we would like GDP to be as comprehensive as possible, not overlooking any significant production that

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CHAPTER 4 GDP: MEASURING TOTAL PRODUCTION, INCOME AND ECONOMIC GROWTH

FIGURE 4.2

Table and graph of components of GDP, 2012/13 The table provides a more detailed breakdown and shows several interesting points: 1 Investment in buildings and structures (non-dwellings) was the largest component of investment in 2012/13, followed by machinery and equipment. As we will see in later chapters, spending by firms on equipment such as new computers and machinery can fluctuate significantly. 2 Investment in buildings and structures was considerably more than investment in dwellings. As with all investment components, this too can fluctuate significantly. 3 The government expenditure component is a little less than one-quarter of GDP, which is within the usual average range of government expenditure. 4 Imports are greater than exports, so net exports are negative. This has often been true for the Australian economy, but is not always the case. This is studied further in Chapter 14

Consumption

($ millions)

900 000

834 430

800 000

72 471 142 559 81 715 58 253 2 118 357 116

Government

342 225

Net exports Exports Imports Total

300 806 311 537 –10 731

Total GDP

54.8%

700 000

Investment Dwellings Buildings and structures Machinery and equipment Other Change in inventories Total

600 000 $ millions

Components of GDP, 2012/13

500 000 400 000

23.4%

22.5%

300 000 200 000 100 000 0

–100 000

–0.7% Consumption

Investment

Government

Net exports

1 523 040

Note: Excludes ‘statistical discrepancy’ category for simplicity. SOURCE: Created from Australian Bureau of Statistics (2013), Australian National Accounts: Income, Expenditure and Product, Table 9, Cat. No. 5206.0, at , viewed 13 October 2013.

takes place in the economy. Most economists believe that GDP does a good—but not flawless— job of measuring production. GDP is also sometimes used as a measure of wellbeing. Although it is generally true that the more goods and services people have the better off they are, we will see that GDP is not a comprehensive measure of wellbeing, and nor is it intended to be.

Shortcomings in GDP as a measure of total production When the ABS calculates GDP it does not include the non-observed economy, which refers to economic activities that are missing from the data sources used to calculate GDP. The nonobserved economy includes two types of production: production in the home; and production in the ‘underground’ economy (sometimes referred to as the ‘cash economy’, ‘black economy’ or the ‘shadow economy’).

Household production With few exceptions, the ABS does not attempt to estimate the value of goods and services that are not bought and sold in markets. If a carpenter makes and sells bookcases, the value of those bookcases will be counted in GDP. If the carpenter makes a bookcase for personal use, it will not be counted in GDP. Household production refers to goods and services people produce for

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themselves. The most important type of household production is the services a homemaker provides to the homemaker’s family. If a person has been caring for children, cleaning the house, maintaining the garden and preparing the family meals, the value of such services is not included in GDP. If the person then decides to work outside the home, enrols the children in day care, hires a cleaning service, hires a gardener and begins buying the family’s meals in restaurants, the value of GDP will rise by the amount paid for day care, cleaning services, gardening services and restaurant meals, even though production of these services has not actually increased.

The underground economy

Underground economy Buying and selling of goods and services that is concealed from the government to avoid taxes or regulations or because the goods and services are illegal.

Individuals and firms sometimes conceal the buying and selling of goods and services, in which case their production won’t be counted in GDP. Individuals and firms conceal what they buy and sell for three basic reasons: they are dealing in illegal goods and services, such as drugs or prostitution; they want to avoid paying taxes on the income they earn; or they want to avoid government regulations. This concealed buying and selling is referred to as the underground economy. Estimates of the size of the underground economy in Australia vary widely, but a recent study by the ABS estimated it to be 1.5 per cent of GDP, or around $23 billion. The underground economy in some poorer countries, such as Zimbabwe or Peru, may be more than half of measured GDP. Is not counting household production or production in the underground economy a serious shortcoming of GDP? Most economists would answer ‘no’ because the most important use of GDP is to measure changes in how the economy is performing over short periods of time, such as from one year to the next. For this purpose, omitting household production and production in the underground economy won’t have much effect, because there is not likely to be much change in the amounts of these types of production from one year to the next. We also use GDP statistics to measure how production of goods and services grows over fairly long periods of a decade or more. For this purpose, omitting household production and production in the underground economy may be more important. For example, beginning in the 1970s, the number of women working outside the home increased dramatically. Some of the goods and services—such as child care and restaurant meals—produced in the following years were replacing what had been household production, rather than being true additions to total production.

Shortcomings of GDP as a measure of wellbeing The main purpose of GDP is to measure a country’s total production. GDP is also frequently used, though, as a measure of wellbeing. For example, newspaper and magazine articles will show tables with levels of GDP per person in different countries, with the implication that people in the countries with higher levels of GDP are better off. Although increases in GDP often do lead to increases in the wellbeing of the population, and have been extremely important in reducing poverty in many parts of the world, it is important to be aware that GDP is not a perfect measure of wellbeing for several reasons.

The distribution of GDP When measuring the wellbeing of a county’s population, what is important is not only the level of GDP but also how the income and output are distributed among the population. If the income generated from production is concentrated among only a small part of the population, economic wellbeing may be unchanged or become relatively worse for other sections of the population. This raises the issue of equity in the distribution of income, an issue that taxation, social welfare payments and government intervention can address.

The value of leisure is not included in GDP If an economic consultant decides to retire, GDP will decline even though the consultant may value increased leisure more than the income the consultant was earning running a consulting firm. The consultant’s wellbeing has increased, but GDP has decreased. In 1914 the typical full-time Australian worked 49 hours per week. Today, the typical Australian works fewer than

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HOW THE UNDERGROUND ECONOMY HURTS DEVELOPING COUNTRIES

M

C

A K I N G THE

Estimates of the underground economy in Australia range widely, between 1.5 per cent and 14 per cent of measured GDP. However, the underground economy in some developing countries may be more than 50 per cent of measured GDP. In developing countries the underground economy is often referred to as the informal sector, as opposed to the formal sector, in which output of goods and services is measured. Although it might not seem to matter whether production of goods and services is measured and included in GDP or unmeasured, a large informal sector can be a sign of government policies that are retarding economic growth.

99

ONNECTION

4.1

Because firms in the informal sector are acting illegally they tend to be smaller and have less capital than firms acting legally. The entrepreneurs who start firms in the © Corbis Australia Pty Ltd informal sector may be afraid the government could someday close or confiscate In some developing countries more than half of their firms. Therefore, the entrepreneurs limit their investments in these firms. the workers may be in the underground economy As a consequence, workers in these firms have less machinery and equipment to work with and so can produce fewer goods and services. Entrepreneurs in the informal sector also have to pay the costs of avoiding government authorities. For example, construction firms operating in the informal sector in Brazil have to employ lookouts who can warn workers to hide when government inspectors come around. In many countries, firms in the informal sector have to pay substantial bribes to government officials to remain in business. The informal sector is large in some developing economies because taxes are high and government regulations are extensive. For example, firms in Brazil pay 85 per cent of all taxes collected, as compared with around 20 per cent in Australia. Not surprisingly, about half of all Brazilian workers are employed in the informal sector. In Zimbabwe and Peru the fraction of workers in the informal sector may be as high as 60 per cent or 70 per cent. One estimate put the size of the informal sector in India at nearly 50 per cent. Many economists believe taxes in developing countries are so high because these countries are attempting to pay for government sectors that are as large relative to their economies as the government sectors of industrial economies. Bringing firms into the formal sector from the informal sector may require reductions in government spending and taxes. In most developing countries, however, voters are reluctant to see government services reduced. SOURCE: Australian Government (2013), Economic Statement, August, at , viewed 14 October 2013; The Economist (2010), ‘Dynamic but dirty’, 2 December, at , viewed 14 October 2013; Mary Anastasia O’Grady (2004), ‘Why Brazil’s underground economy grows and grows’, Wall Street Journal, 10 September, at , viewed 14 October 2013.

40 hours per week. If Australians still worked 49-hour weeks GDP would be much higher than it is, but the wellbeing of the typical person may be lower, because less time would be available for leisure activities.

The level and quality of health care and education GDP is a measure of the market value of a country’s production; however, it takes no account of the composition of the goods and services produced. The availability and quality of health care facilities and education are strongly linked to the standard of living in a country. For example, production levels may be high but the availability of health care may be limited, or too expensive for many people to afford. Any measure of wellbeing must include measures of access and affordability of essential goods and services. Further, when examining the composition of GDP, it is possible for GDP to be growing, but the provision of consumer goods and services to be low. Examples of this have been seen during periods of war, when a county’s productive resources have been diverted from consumer goods to the production of armaments.

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GDP is not adjusted for pollution or other negative effects of production When a dry cleaner cleans and presses clothes the value of this service is included in GDP. If the chemicals used by the dry cleaner pollute the air or water, GDP is not adjusted to compensate for the costs of the pollution. Similarly, the value of cigarettes produced is included in GDP with no adjustment made for the costs of the lung cancer that some smokers develop. If a country decided to log all its forests, its GDP would rise but the natural environment would be depleted and atmospheric carbon dioxide would rise. We should note, however, that increasing GDP can lead countries to devote more resources to pollution reduction. Developing countries often have higher levels of pollution than high-income countries because the lower GDPs of the developing countries make them more reluctant to spend resources on pollution reduction. Levels of pollution in China are much higher than in Australia, the United States, Japan or the countries of Western Europe. According to the World Health Organization, seven of the 10 most polluted cities in the world are in China, but as Chinese GDP continues to rise, it is likely to devote more resources to reducing pollution.

GDP is not adjusted for changes in crime and other social problems An increase in crime will reduce wellbeing but may actually increase GDP if it leads to greater spending on police, security guards and alarm systems. GDP is also not adjusted for changes in divorce rates, drug addiction or other factors that may affect people’s wellbeing. To summarise, we can say that a person’s wellbeing depends on many factors that are not taken into account in calculating GDP. Because GDP is designed to measure total production, it is perhaps not surprising that it does an imperfect job of measuring wellbeing.

M

C

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4.2

ONNECTION

HOW ELSE CAN WE MEASURE ECONOMIC WELLBEING? Economists have long used many indicators of economic wellbeing to supplement the use of GDP. These include working hours per week, leisure time, income distribution, longevity, health, education and a number of other indicators. However, in recent years many of these indicators have been combined to produce more formal economic frameworks used to measure wellbeing. These measures still incorporate GDP as an important indicator of economic progress, but also include additional indicators of wellbeing, quality of life and economic sustainability.

© Godfer | Dreamstime.com

There are a number of methods devised to measure economic wellbeing

The Australian Bureau of Statistics produces the ‘Measures of Australia’s Progress (MAP)’, which measures key statistics in three broad groupings—society, the economy and the environment. It uses 17 main indicators and around 80 indicators in total. These indicators provide measures of health, education, unemployment, housing availability and cost, forest and fauna conservation, greenhouse gas emissions, health of oceans and rivers, waste management, life satisfaction, victims of crime, family and social cohesion, democracy and governance, productivity, national income and national wealth. The Australian Treasury produces a ‘Wellbeing Framework’, which includes measures of freedom, current and future opportunity and the distribution of opportunity, choice, consumption levels and the distribution of consumption, risk and the complexity of life.

Many other countries have moved, or are moving, to similarly broader indicators of economic wellbeing. For example, in 2008 the then French President, Mr Nicolas Sarkozy, commissioned a number of the world’s most renowned economists and social scientists, including Economics Nobel Prize winners Joseph Stiglitz and Amartya Sen, to develop the means of measuring wellbeing and economic sustainability. Their work was released in a major report in

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2009, Report by the Commission on the Measurement of Economic Performance and Social Progress (or the Stiglitz Report). The United Nations has been producing a measure of the standard of living since 1990, called the Human Development Index (HDI). The HDI combines data on real GDP per person with data on life expectancy at birth, adult literacy and school enrolment. This index is published annually in the United Nation’s Human Development Report, which is a study that provides information on the standard of living in nearly every country in the world. Some researchers have also developed indexes to measure life satisfaction and happiness, and there are numerous measures of environmental quality and its relation to wellbeing. SOURCE: Australian Bureau of Statistics (2012), Measures of Australia’s Progress: Summary Indicators, 2012, Cat. No. 1370.0.55.001, at , viewed 14 October 2013; S. Gorecki and J. Kelly (2012), ‘Treasury’s Wellbeing Framework’, Economic Roundup, Issue 3, at , viewed 14 October 2013; J. Stiglitz, A. Sen and J.  Fitoussi (2009), Report by the Commission on the Measurement of Economic Performance and Social Progress, at , viewed 14 October 2013; United Nations (2013), Human Development Report 2013, at , viewed 13 October 2013.

REAL GDP VERSUS NOMINAL GDP Because GDP is measured in value terms we have to be careful about interpreting changes over time. To see why, consider interpreting an increase in the total value of coal production from, say, $80 billion in 2014 to $100 billion in 2015. Can we be sure that, because $100 billion is 25 per cent greater than $80 billion, the amount of coal produced in 2015 was 25 per cent greater than the amount produced in 2014? We can draw this conclusion only if the average price of coal did not change between 2014 and 2015. In fact, when GDP increases from one year to the next, the increase is due partly to increases in production of goods and services, and partly due to increases in prices. Because we are mainly interested in GDP as a measure of production, we need a way of separating the price changes from the quantity changes.

4.3 Discuss the difference between real GDP and nominal GDP. LEARNING OBJECTIVE

Calculating real GDP The ABS separates price changes from quantity changes by calculating a measure of production called real GDP. Nominal GDP is calculated by summing the current values of final goods and services. Real GDP is a measure of the volume of final goods and services, holding prices constant. In this sense, real GDP is a measure of the volume of production, rather than the value of production. To determine by how much the volume of GDP changes from one year to the next, we need to measure the value of GDP in each year using the same unit prices. It used to be common for most national statistical organisations, including the ABS, to choose a particular year as the base year for prices. The prices of goods and services in the base year were then used to calculate the value of goods and services in all other years. For instance, if the base year was 2000, real GDP for 2015 would be calculated by using prices of goods and services from 2000. By keeping prices constant, we know that changes in real GDP represent changes in the quantity of goods and services produced in the economy. One drawback to calculating real GDP using base year prices is that, over time, prices change relative to each other. For example, the prices of mobile phones and computers have fallen dramatically while the prices of most goods and services have risen. Because this change is not reflected in the fixed prices from the base year, the estimate of real GDP is somewhat distorted. The further away the current year is from the base year, the worse the problem becomes. To make the calculation of real GDP more accurate, in 1998 the ABS switched to using chain volume measures to estimate real GDP. The details of calculating real GDP using chain volume measures are more complicated than we need to discuss here, but the basic idea is straightforward. Starting with the previous year as the base year, the ABS takes an average of prices in the current year and prices in the previous year. It then uses this average to calculate real GDP in the current year. For the next year, the ABS calculates real GDP by taking an average of prices in that year and the previous

Nominal GDP The market value of final goods and services evaluated at current year prices. Real GDP A measure of the volume of final goods and services, holding prices constant.

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year, and so on. This method is known as the annually reweighted chain volume measure. In this way, prices in each year are ‘chained’ to prices from the previous year, and the distortion from changes in relative prices is minimised. Holding prices constant means that the purchasing power of a dollar remains the same from one year to the next. Ordinarily, the purchasing power of the dollar falls every year as price increases reduce the amount of goods and services that a dollar can buy. Real GDP holds prices constant, which makes it a better measure than nominal GDP of changes in the production of goods and services from one year to the next. In fact, growth in the economy is almost always measured as growth in real GDP. If a headline in The Australian Financial Review states, ‘Economy grew 3.5 per cent last year’, the article will report that real GDP increased by 3.5 per cent during the previous year.

CALCULATING THE ECONOMIC GROWTH RATE 4.4 Understand how the economic growth rate is measured. LEARNING OBJECTIVE

Economic growth rate The rate of change of real GDP from one year to the next.

We saw at the beginning of this chapter that economic growth refers to the ability of the economy to produce increasing quantities of goods and services. If we want to measure the rate of economic growth we usually do so by calculating the rate of change in real GDP from one year to the next. Therefore the economic growth rate is measured as the rate of change of real GDP from one year to the next. Australia has, over time, usually experienced positive economic growth rates, which is essential if standards of living are to rise and employment is to grow, and to ensure that the country can provide for a growing population. Real GDP for Australia in the financial year 2011/12 was $1 451 824 million and in 2012/13 it was $1 493 171 million. From these figures we can calculate the rate of economic growth between those two years as follows: Real GDPcurrent year – Real GDPprevious year × 100 Real GDPprevious year =

$1 493 171 – $1 451 824 × 100 $1 451 824

= 2.8%

We can now say that between 2011/12 and 2012/13 the real value of goods and services in Australia grew by 2.8 per cent.

The GDP deflator Price level A measure of the average prices of goods and services in the economy. GDP deflator A measure of the price level, calculated by dividing nominal GDP by real GDP and multiplying by 100.

Economists and policy-makers are interested not just in the level of total production, as measured by real GDP, but also in the price level. The price level measures the average prices of goods and services in the economy. One of the goals of economic policy is a stable price level. We can use values for nominal GDP and real GDP to calculate a measure of the price level, called the GDP deflator. We can calculate the GDP deflator by using this formula: GDP deflator 

nominal GDP  100 real GDP

To see why the GDP deflator is a measure of the price level, think about what would happen if prices of goods and services rose while production remained the same. In that case, nominal GDP would increase but real GDP would remain constant, so the GDP deflator would increase. In reality, both prices and production usually increase each year, but the more prices increase relative to the increase in production, the more nominal GDP increases relative to real GDP and the higher the value for the GDP deflator. Increases in the GDP deflator allow economists and policy-makers to track increases in the price level over time. The following table gives the values for nominal and real GDP for 2011/12 and 2012/13.

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2012/13

Nominal GDP

$1 474 291 million

$1 510 917 million

Real GDP

$1 451 824 million

$1 493 171 million

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We can use the information from the table to calculate values for the GDP price deflator for 2011/12 and 2012/13. FORMULA

APPLIED TO 2011/12

APPLIED TO 2012/13

GDP = nominal GDP × 100 deflator real GDP

 $1 474 291 million × 100 = 101.5  $1 451 824 million

 $1 510 917 million × 100 = 101.2  $1 493 171 million

From these values for the deflator, we can calculate that the price level barely changed between 2011/12 and 2012/13—in fact, it fell very slightly, by 0.3 per cent: 101.2  101.5  100  0.3% 101.5

This is unusual as in most years the price level rises. However, between 2011/12 and 2012/13 prices for commodity exports fell (by an average of just over 3 per cent) along with falling prices of some other tradable goods. The combination of price falls in some areas of the economy together with price rises in other areas led to the very small negative percentage change in the price level when measured using the GDP deflator. In Chapter 10 we will see that economists and policy-makers also rely on another measure of the price level, known as the consumer price index. In addition, we will discuss the strengths and weaknesses of the two measures.

WHAT’S THE BEST COUNTRY FOR YOU TO WORK IN? At the beginning of the chapter, we posed two questions: What effect should the UK’s and China’s two very different growth rates of GDP have on your decision to work and live in one country or the other? And if China’s much higher growth rate does not necessarily lead you to decide to work and live in China, why not? This chapter has shown that although it is generally true that the more goods and services people have, the better off they are, GDP provides only a rough measure of wellbeing. GDP does not include the value of leisure, nor is it adjusted for the types of goods and services produced, pollution and other negative effects of production, crime and other social problems. So, in deciding where to live and work, you would need to balance China’s much higher growth rate of GDP against these other considerations. You would also need to take into account that although China’s growth rate is higher than the UK’s, the UK’s current level of real GDP is higher than China’s.

ECONOMICS IN YOUR LIFE (continued from page 89)

CONCLUSION In this chapter we have begun the study of macroeconomics by examining an important concept—how a nation’s total production and income can be measured. Understanding GDP is important for understanding the business cycle and the process of long-run economic growth, which we discuss in the next chapter. Read ‘An inside look’ to learn more about the usefulness and limitations in using GDP as a measure of welfare, and some commonly used complementary measures of welfare.

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AN INSIDE LOOK 2013 OUSE 14 JUNE

IDEAS AT THE H

? s s e n i p p a h e r u s a e m e w n Ca

is radical policies ccess of these su a rm ts -te se ng lo d e Th use an many things it’s a noble ca t re bu su ea d, ns m te tio to ba s Na de d ay h found w ignore. The Unite em) but muc Economists have arguing about th t that is hard to of en t ar ed e ec eir own index th pr ed fin (UNDP) have th has eluded s m es ra (and they’ve re in og pp Pr t ha en of n x (HDI) and Developm ible emotio velopment Inde De so far the intang an m Hu e ed at 140; lled th pabilities. Bhutan is rank has long ca of ) e their statistical ca at DP st (G t an uc ay the Himal e HDI attempts estic Prod A Gross Dom strument with which economists while Australia is at number two. Th environmental in and lity and been the blunt performance, e health, equa at ’s or try rp omic and un co in co to a d rd mix of econ the key da it an e st ad have measure e m th s to ha protection in l comparability . its internationa y/growth. rit pe os the UN’s tive calculations pr t/ en lopm ch is in-line with ut and produc hi tp w x ou de t’s in measure of deve l ke fu ar er m fers a HDI is a pow measure of a s and which of al n. As Go tio t ta re en rp But GDP is a lean pm te lo in d Deve es. But ed for such broa set Millennium different countri n w ee ne tw a be ng ei on was never intend se ris it are scholarly compa with GDP: does namics shift we der range of applies here as oa global power dy n br tio a d e es se ud qu ea cl e cr in m in lves the sa erge that If happiness invo towards some s? of indicators em er es rth in in fu pp s er se ha ev ea re h cr measu hich reac chnology, and de variables; and w ing of prosperity. and access to te nd y ly gets us lit ta in rs ua rta de eq ce un it a ed verty, then e value of po th sort of globalis s d gh an ei s w on it si ; is C02 em s activity than GDP. B GDP measure ods and services, but only those clos is more relevant d an er portant and go d education economics is im , k, at or th country’s finishe ew id us sa ho ng Organisation C Havi t. That means le insight. The its grasp. ab nd lu yo va within the marke a be r e fe ar of n does ent (OECD) tal degradatio increase GDP n and Developm t io at no er and environmen do op Co ng hi ic riables, Econom and kids laug used a range of va ’ve preciated for ey ap th d s, Love, free time et an is zn th Ku nds creator, Simon r Life Index. our understa GDP. Even its build their Bette to contribution to t P, ea GD gr g from the in e ud ‘Th cl : ings untries, mainly , and in co em st 34 sy ts en ily GDP’s shortcom m es fa pr as The OECD re made within the eveloped, such t also the less-d stock of utilities, engaged in the bu , nd a ld ki or lls w an d pu m x pe of lo de deve tivities r Life In .’ On the other azil. Their Bette by numerous ac ed Br d ud es cl an in tri a t di un no In co is g a, in s of life, countries, rankin iving less Ch ordinary proces ta from member P—more cars dr da GD of to ft d ilding a unique ra ad s d m ja an l station nchmarks and bu be tro hand, traffic pe ed e ib th cr es to pr ps t s of different agains more tri ental preference pm y? lo rit efficiently means ve pe de os e pr th is th of that makes picture ten. But is rstand what it is d economic de se un new cars more of r ea cr tte in be at to th s artedly this is culture I agree wholehe rd of living, but da an happy. st le r is year. op ou pe se ea topped the list th makes us lia at ra th activity will incr st is Au it d t an ha , w Oh yeah timation of our a very shallow es ore complex than m r fa is s es in pp humans tick; ha cars. d our over-sized an s ue eq pay ch

d by John Treadgol

USE

IDEAS AT THE HO

SOURCE: John Treadgold (2013), ‘Can we measure happiness?’, Ideas at the House, 14 June, at , viewed 17 October 2013. © John Treadgold 2013 Copyright © Pearson Australia (a division of Pearson Australia Group Pty Ltd) 2015 – 9781486010233 - Hubbard/Macroeconomics 3e

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Key points in the article The article summarises arguments made by economists and statisticians regarding the use of GDP to measure economic wellbeing. It maintains that GDP is an important measure of economic performance, but that it has a number of limitations, both as a measure of total production and as a measure of economic wellbeing. It is further pointed out that economists never intended GDP to be a complete measure of wellbeing. The article suggests that measures of GDP should be used in conjunction with a range of other indicators to determine wellbeing.

Analysing the news A John Treadgold, a well-known writer and commentator, puts forward the argument which economists have long recognised, that GDP is not a complete measure of welfare or economic wellbeing, referring to it as a ‘blunt instrument’. He proceeds to outline complementary measures and indexes of wellbeing that can be used in conjunction with GDP.

B The article points out that GDP has some limitations in its ability to measure total production in the economy, particularly its inability to measure the value of production in the home. For example, cleaning, cooking, washing and ironing clothes, gardening, caring for children, assisting elderly relatives and so on are not included in GDP if they are carried out as unpaid work by family members. This leads to a significant underestimate of GDP. The article also highlights that activities that people might normally

105

consider to be negative, such as traffic jams, can increase GDP due to increasing fuel consumption.

C Despite the limitations in GDP as a measure of total production and a measure of wellbeing, GDP should be kept as one measure of wellbeing, but should be complemented by other measures. Table 1 shows the disparities between various measures of economic wellbeing in a selection of countries. As we can see, in developed countries such as Australia an economic growth rate of 3.4 per cent (relatively higher than many other developed countries at that time) is also associated with high life expectancy, high levels of schooling and available communications (telephones) and low rates of unemployment. Other developed economies such as Germany and the United States also have high rates in all areas, although the economic growth rates in 2012 were low due to the after effects of the global financial crisis. However, developing countries such as Bangladesh, or newly industrialised countries such as India, can have good rates of economic growth, but lower rates of wellbeing according to other measures. Thinking critically 1 As GDP has a number of limitations, why do you think economists still recommend the continued use of GDP as a measure of economic wellbeing? 2 Why is it important for governments to consider measures of economic wellbeing in addition to the economic growth rate?

TABLE 1 INDICATORS OF ECONOMIC WELLBEING SHOW THAT DISPARITY CAN OCCUR BETWEEN ECONOMIC GROWTH RATES AND OTHER COMMON MEASURES OF LIVING STANDARDS

ECONOMIC GROWTH RATE (%)

LIFE EXPECTANCY AT BIRTH (YEARS)

PRIMARY SCHOOL ENROLMENT (% OF CHILDREN OF ELIGIBLE AGE)

Australia

3.4

82

97

5.1

46

Bangladesh

6.3

70

85

4.5

1

China

7.8

75

N/A

4.1

21

Germany

0.7

81

98

5.9

62

India

3.2

66

93

3.8

2

Singapore

1.3

82

N/A

2.9

38

Sweden

0.7

82

99

7.5

46

United Arab Emirates

4.4

77

92

4.2

24

UK

0.3

81

100

7.8

53

USA

2.2

79

95

8.9

44

COUNTRY

UNEMPLOYMENT RATE (%)

TELEPHONE LINES PER 100 PEOPLE

Note: Data are for the most recent year consistently available, which is 2011 or 2012 in all cases, except for primary school enrolments, which range from 2007 to 2010. N/A—data not available. SOURCE: World Bank (2013), Data: World Development Indicators, at , viewed 17 October 2013; Trading Economics (2013) at , viewed 17 October 2013.

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CHAPTER SUMMARY AND PROBLEMS KEY TERMS business cycle consumption contraction economic growth economic growth rate expansion final good or service GDP deflator

90 95 90 90 102 90 91 102

government purchases gross domestic product (GDP) inflation rate intermediate good or service investment macroeconomics microeconomics net exports

96 91 90 91 95 90 90 93

nominal GDP price level real GDP recession transfer payments underground economy unemployment rate value added

101 102 101 90 95 98 90 91

GROSS DOMESTIC PRODUCT MEASURES TOTAL PRODUCTION, PAGES 90–96 LEARNING OBJECTIVE 4.1

Explain how total production in an economy is measured.

SUMMARY Total production is measured by gross domestic product (GDP), which is the market value of all final goods and services produced in an economy during a period of time. When we measure the value of total production in the economy by calculating GDP, we are simultaneously measuring the value of total income. GDP is divided into four major categories of expenditure: consumption, investment, government purchases and net exports. Government transfer payments are not included in GDP because they are payments to individuals for which the government does not receive a good or service in return. We can also calculate GDP by adding up the value added of every firm involved in producing final goods and services.

REVIEW QUESTIONS 1.1

1.2

1.3

1.4

1.5

Why in microeconomics can we measure production in terms of quantity, but in macroeconomics we measure production in terms of market value? If the Australian Bureau of Statistics added up the values of every good and service sold during the year, would the total be larger or smaller than GDP? In the circular flow of expenditure and income, why must the value of total production in an economy equal the value of total income? Describe the four major components of expenditures in GDP and write the equation used to represent the relationship between GDP and the four expenditure components. What is the difference between the value of a firm’s final product and the value added by the firm to the final product?

1.7

1.8

1.9

1.10

PROBLEMS AND APPLICATIONS 1.6

Macroeconomic conditions affect the decisions firms and families make. Why, for example, might a university student after graduation enter the job market during an economic expansion but apply for postgraduate study during a recession?

1.11

A student remarks: ‘It doesn’t make sense that intermediate goods are not counted in GDP. A computer chip is an intermediate good, and without it, a PC won’t work. So why don’t we count the computer chip in GDP?’ Provide an answer for the student’s question. Briefly explain whether each of the following transactions represents the purchase of a final good. a The purchase of wheat from a wheat farmer by a bakery. b The purchase of an aircraft carrier by the federal government. c The purchase of French wine by an Australian consumer. d The purchase of a new machine by BHP Billiton for an iron-ore mine in Australia. Which component of GDP will be affected by each of the following transactions? If you believe that none of the components of GDP will be affected by the transactions, briefly explain why. a You purchase a new apartment. b You purchase a second-hand car. c An overseas person studies a degree at an Australian university. d A dairy farmer in Victoria produces milk which is shipped to Singapore. e A Bakers Delight store purchases a new oven. f The government builds new roads to help improve access to mine sites in Western Australia. Is the value of a house built in 2000 and resold in 2015 included in the GDP of 2015? Why or why not? Would the services of the real estate agent who helped sell (or buy) the house in 2015 be counted in GDP for 2015? Why or why not? [Related to Solved problem 4.1] Suppose that a simple economy produces only the following four goods and services: textbooks, hamburgers, shirts and cotton. Assume that all of the cotton is used in the production of shirts. Use

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the information in the following table to calculate nominal GDP for 2015. PRODUCTION AND PRICE STATISTICS FOR 2015 PRODUCT

QUANTITY

PRICE ($)

Textbooks

100

60.00

Hamburgers

100

2.00

50

25.00

800

0.60

Shirts Cotton 1.12

1.13

[Related to Don’t let this happen to you] Briefly explain whether you agree with the following statement: ‘In years when people buy many shares of stock, investment will be high and, therefore, so will GDP.’ For the total value of expenditures on final goods and services to equal the total value of income generated from producing those final goods and services, all the money that a business receives from the sale of its product must

1.14

1.15

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be paid out as income to the owners of the factors of production. How can a business make a profit if it pays out as income all the money it receives? An artist buys scrap metal from the local steel mill as raw material for her metal sculptures. Last year she bought $5000 worth of scrap metal. During the year she produced 10 metal sculptures that she sold for $800 each to the local art gallery. The gallery sold all of them to local art collectors at an average price of $1000 each. For the 10 metal sculptures, what was the total value added of the artist and what was the total value added of the gallery? Suppose a country has many of its citizens temporarily working in other countries and many of its firms have facilities in other countries. Furthermore, relatively few citizens of foreign countries are working in this country and relatively few foreign firms have facilities in this country. In these circumstances, which would you expect to be larger for this country, GDP or GNI? Briefly explain.

DOES GDP MEASURE WHAT WE WANT IT TO MEASURE? PAGES 96–101 LEARNING OBJECTIVE 4.2

Discuss whether GDP is a good measure of economic wellbeing.

SUMMARY GDP does not include the non-observed economy. The nonobserved economy includes household production, which refers to goods and services people produce for themselves, and production in the underground economy, which consists of concealed buying and selling. The underground economy in some developing countries may be more than half of measured GDP. GDP is not a perfect measure of wellbeing, nor is it designed to be, because it does not include the value of leisure, does not account for the distribution of GDP, does not measure access to and affordability of services, is not adjusted for pollution or other negative effects of production and is not adjusted for changes in crime and other social problems.

2.5

2.6

REVIEW QUESTIONS 2.1

2.2

2.3

Why does the size of a country’s GDP matter? How does it affect the quality of life of the country’s people? What is the underground economy? Why do some countries have larger underground economies than do other countries? Why is GDP an imperfect measure of economic wellbeing? What types of production does GDP not measure? Even if GDP included these types of production, why would it still be an imperfect measure of economic wellbeing?

2.7

Informal economic activities pose a particular measurement problem [in calculating GDP], especially in developing countries, where much economic activity may go unrecorded.

PROBLEMS AND APPLICATIONS 2.4

Which of the following are likely to increase measured GDP, and which are likely to reduce it? a The proportion of women working in paid employment outside the home increases.

b There is a sharp increase in the crime rate. c Higher tax rates cause some people to hide more of the income they earn. What would you expect to happen to household production as unemployment rises during a recession? What would you expect to happen to household production as unemployment falls during an economic expansion? Would you therefore expect the fluctuation in actual production— GDP plus household production—to be greater or less than the fluctuation in measured GDP? The typical Australian works less than 40 hours per week today and worked 49 hours per week in 1920. Does this fact make the economic wellbeing of Australians today versus 1920 higher or lower than indicated by the difference in real GDP per capita today versus 1920? Explain. [Related to the opening case] A report by the World Bank,1 an international organisation devoted to increasing economic growth in developing countries, included the following statement:

2.8

What does the World Bank mean by ‘informal economic activities’? Why would these activities make it harder to measure GDP? Why might they make it harder to evaluate the standard of living in developing countries relative to the standard of living in Australia? [Related to Making the connection 4.2] Each year the United Nations publishes the Human Development Report,2 which provides information on the standard of living in

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nearly every country in the world. The report includes data on real GDP per person, but also contains a broader measure of the standard of living called the Human Development Index (HDI). The HDI combines data on real GDP per person with data on life expectancy at birth, adult literacy and school enrolment. The following table shows values for real GDP per person and the HDI for several countries. Prepare one list ranking countries from highest real GDP per person to lowest, and another list ranking countries from highest HDI to lowest. Briefly discuss possible reasons for any differences in the rankings of countries in your two lists. (All values in the table are for the year 2012 expressed in 2005 US dollar terms.)

COUNTRY Australia

REAL GDP PER PERSON

HDI

$34 340

0.938

Brazil

10 152

0.730

China

7 945

0.699

Germany

35 431

0.920

Greece

20 511

0.860

3 285

0.554

Norway

48 688

0.955

Singapore

52 613

0.895

9 594

0.629

United Arab Emirates

42 716

0.818

UK

32 538

0.875

USA

43 480

0.937

India

South Africa

REAL GDP VERSUS NOMINAL GDP, PAGES 101–102 LEARNING OBJECTIVE 4.3

Discuss the difference between real GDP and nominal GDP.

SUMMARY Nominal GDP is the market value of final goods and services evaluated at current year prices. Real GDP is a measure of the volume of final goods and services, holding prices constant. By keeping prices constant, we know that changes in real GDP represent changes in the quantity of goods and services produced in the economy. The Australian Bureau of Statistics (ABS) calculates real GDP using an annually reweighted chain volume measure.

REVIEW QUESTIONS 3.1

3.2

Why does inflation make nominal GDP a poor measure of the increase in total production from one year to the next? How does the ABS deal with the problem inflation causes with nominal GDP? What is the main problem arising from the use of base year prices to measure real GDP?

PROBLEMS AND APPLICATIONS 3.3

3.4

If the quantity of final goods and services produced decreased, could real GDP increase? Could nominal GDP increase? If so, how? Briefly explain whether you agree or disagree with the following statements. a ‘If nominal GDP is less than real GDP, then the price level must have fallen during the year.’

3.5

b ‘Whenever real GDP declines, nominal GDP must also decline.’ c ‘If a recession is so severe that the price level declines, then we know that both real GDP and nominal GDP must decline.’ Some years ago, the movie Avatar overtook Titanic as the highest grossing movie of all time. An article published by Forbes.com at the time noted that ‘the average ticket price in 2008 (Avatar was released in 2009) was $US7.18, up 56% from prices in 1997 when Titanic was in theaters.’ The article stated that ‘A look at domestic grosses (box-office receipts) adjusted for inflation shows a more realistic view of Avatar’s performance.’3 a Why would adjusting for inflation show a more realistic view of Avatar’s performance at the box office? b Which would be a more accurate measure of how well a movie has performed at the box office: the dollar value of tickets sold or the number of tickets sold? Why don’t newspapers report the number of tickets sold rather than the dollar value of tickets sold? Would comparing the total number of tickets sold by all movies in 1939 with the total number of tickets sold by all movies in 2015 be a good way to measure how the relative importance of movies in the economy has changed over time? Briefly explain.

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CALCULATING THE ECONOMIC GROWTH RATE, PAGES 102–103 LEARNING OBJECTIVE 4.4

Understand how the economic growth rate is measured.

SUMMARY Economic growth refers to the ability of the economy to produce increasing quantities of goods and services over time. We measure the rate of economic growth by first converting nominal GDP to real GDP and then calculating the rate of change of real GDP from one year to the next. The price level is the average prices of goods and services in the economy. The GDP deflator is a measure of the price level, and is calculated by dividing nominal GDP by real GDP and multiplying by 100. It is used to convert nominal GDP to real GDP.

REVIEW QUESTIONS 4.1 4.2

What is the economic growth rate and how is it calculated? What is the GDP deflator and how is it calculated?

PROBLEMS AND APPLICATIONS 4.3

Assume that real GDP in a country grew from $2 300 000 million in 2014 to $2 360 000 million in 2015. Calculate the rate of economic growth over that time period.

4.4

4.5

Briefly explain whether you agree or disagree with the following statement: ‘Nominal GDP in a country declined between 2014 and 2015, therefore the GDP deflator must also have declined.’ Use the data in the following table to calculate the GDP deflator for each year (values are in billions of dollars): NOMINAL GDP

REAL GDP

$

$

2011

13 377

12 959

2012

14 029

13 206

2013

14 292

13 162

2014

13 939

12 703

2015

14 527

13 088

Which year from 2011 to 2015 saw the largest percentage increase in the price level as measured by the GDP deflator? Briefly explain.

ENDNOTES 1 2 3

The World Bank (2003), World Development Indicators, 2003, Washington DC, The World Bank, p. 189. United Nations Development Programme (2013), Human Development Report 2013, New York, Palgrave Macmillan. Based on Dorothy Pomerantz (2010), ‘Is Avatar really king of the box office?’, 27 January at , viewed 20 October 2013.

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5

ECONOMIC GROWTH, THE FINANCIAL SYSTEM AND BUSINESS CYCLES LEARNING OBJECTIVES After studying this chapter you should be able to: 5.1 Discuss the importance of long-run economic growth and its impact on living standards. 5.2 Discuss the role of the financial system in facilitating long-run economic growth. 5.3 Understand what happens during the business cycle.

GROWTH AND THE BUSINESS CYCLE AT GENERAL MOTORS HOLDEN JA HOLDEN AND Co was founded in 1856 as a saddlery business in Adelaide. It began producing motorcycle bodies in 1913 and car bodies in 1914. By 1925 it was the largest car body producer outside the United States  and Europe. It was later bought by the US car giant General Motors and renamed General Motors Holden (GMH). In 1948 GMH produced Australia’s first locally manufactured car. Over time, GMH’s fortunes have often mirrored those of the Australian economy. Two key macroeconomic facts are that in the long run the Australian economy has experienced economic growth and in the short run the economy has experienced a series of business cycles. Living standards in Australia have increased enormously because, in the long run, growth in the production of goods and services has been faster than the growth in population. But the increase in living standards has been interrupted by periods of business cycle recession during which

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production of goods and services has declined. GMH has also experienced growth over the long run, but has been greatly affected by the business cycle. Economic growth is produced by technological progress that makes possible the production of greater quantities of goods and services, and—even more importantly—the production of new and better goods and services. In the early twentieth century, personal transportation relied largely on horse-drawn carriages and trucks. Horse-drawn carriages and trucks were slow, unreliable and uncomfortable, and cleaning up after the horses was itself a major problem in big cities. GMH’s first cars were not a huge step forward because they were relatively slow, unreliable, difficult to repair and expensive. In 1908, in the United States, the Ford Motor Company introduced one of the most innovative products in business history—the Model T. Because the Model T used parts that were interchangeable, it was much easier to repair than any previous car. When Henry Ford began producing Model Ts on a moving assembly line, he increased the number of cars his workers could produce each day to such an extent that his costs fell dramatically, and he made a profit even after cutting the price to US$250 per car. All other car producers were to follow Ford’s lead in mass producing cars. While GMH remained an important force in the Australian economy until the closure of its manufacturing plants in 2016, it also remained vulnerable to the effects of the business cycle and economic shocks. Early in its history, during the recession of 1920–1921 and again during the Great Depression of the 1930s, Holden came close to bankruptcy as falling sales led to large losses. The recession in Australia in 1990 cut sharply into the demand for GMH’s cars, but this was followed by a long period of economic growth, culminating in an economic boom in the mid-2000s. During the boom, companies had large profits, household incomes were high and credit was easily available, and GMH’s car sales soared. The global financial crisis of 2007–2008 caused a short economic downturn in Australia, which led to the slowing of new car sales as credit became harder to get and company profits fell, and some people were put on reduced working hours and  unemployment levels rose. In 2009, Holden made a net loss, after which it briefly recovered, but returned to a loss in 2013 due in part to an economic contraction, but also due to increasing competition from overseas, where motor vehicles could be manufactured far more cheaply than in Australia. In this chapter we look at long-run growth and the business cycle and why they are important for individual firms and the economy as a whole. SOURCE: Holden (2013), ‘About Holden’, at , viewed 21 October 2013. © GM Holden Ltd.

5 ECONOMICS IN YOUR LIFE

Courtesy of GM Holden Ltd

DO YOU HELP THE ECONOMY MORE IF YOU SPEND OR SAVE? Suppose that you have received an income tax refund from the government. One of your friends tells you that if you want to help the economy, you should save all the money because a country’s economic growth depends on the amount of saving by households. Another friend disagrees and advises you to spend all the money because consumer spending is a major component of gross domestic product (GDP), and your spending would help increase production and create more jobs. Which of your two friends is right? As you read this chapter, see if you can answer this question. You can check your answer against the one we provide on page 135 at the end of this chapter.

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A SUCCESSFUL ECONOMY is capable of increasing the production of goods and services faster than the growth in population. Increasing production faster than population growth is the only way that the standard of living of the average person in a country can increase. Unfortunately, many economies around the world are not growing at all, or are growing very slowly. In many countries in sub-Saharan Africa, living standards are barely higher, or in some cases are even lower, than they were 50 years ago. Most people in countries with little or no economic growth live in the same grinding poverty as their ancestors did decades or even centuries ago. In Australia and other developed countries, however, living standards increase during most years and are much higher today than they were 50 years ago. An important macroeconomic question is why some countries grow much faster than others. As we will see, one determinant of economic growth is the ability of firms to expand their operations, buy additional equipment, train workers and adopt new technologies. To carry out these activities, firms must acquire funds from households, either directly through financial markets—such as the share and bond markets—or indirectly through financial intermediaries—such as banks. Financial markets and financial intermediaries together comprise the financial system. In this chapter we present an overview of the financial system and see how funds flow from households to firms through the market for loanable funds.

Business cycle Alternating periods of economic expansion and economic contraction relative to trend growth.

Dating back to at least the early nineteenth century, the Australian economy has experienced periods of expanding production and employment that is greater than the long-term trend, followed by periods of economic contraction where production and employment growth is lower than the long-term trend. At times, production and employment have fallen, and the economic growth rate has become negative, which is referred to as a recession. As we noted in Chapter 4, these alternating periods of expansion and contraction around the long-term trend in economic growth are called the business cycle. The business cycle is not uniform: each period of expansion is not the same length, nor is each period of contraction, but every period of expansion in Australian history has been followed by a period of contraction, and every period of contraction has been followed by a period of expansion. After the recession of 1990, Australia experienced around 17 years of positive economic growth without a significant contraction or recession. However, by 2008 the effects of the global financial crisis (GFC) caused a contraction, with rising unemployment, a slowdown in production and a brief period of negative economic growth in the latter part of 2008. Australia recovered from the GFC much more quickly than many other countries, with economic growth once again approaching the long-term trend by 2010. In this chapter we begin the exploration of these two key aspects of macroeconomics— the long-run growth that has steadily raised living standards in Australia and the shortrun fluctuations of the business cycle.

5.1 Discuss the importance of long-run economic growth and its impact on living standards. LEARNING OBJECTIVE

LONG-RUN ECONOMIC GROWTH IS THE KEY TO RISING LIVING STANDARDS Most people in Australia, Western Europe, the United States, Japan and other advanced countries expect that over time their standard of living will improve. They expect that year after year firms will introduce new and improved products and new prescription drugs, better surgical techniques will overcome more diseases, and their ability to afford these goods and services will increase. For most people these are reasonable expectations. When the states of Australia formed a federation in 1901, Australia was already enjoying one of the highest standards of living in the world. Yet in that year only 3 per cent of homes

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had electricity and almost no homes had indoor flush toilets. Diseases such as smallpox, typhus, dysentery and cholera were still menacing the health of Australians. In 1901 there were, of course, no televisions, radios, computers, air conditioners or refrigerators. Most homes were heated in the winter by burning wood or coal, which contributed to pollution. There were no modern appliances, and most women worked inside the home at least 80 hours per week. The typical Australian homemaker in 1901 baked half a tonne of bread per year! The process of long-run economic growth brought the typical Australian from the standard of living of 1901 to the standard of living of today. The best measure of the standard of living is real GDP per person, which is usually referred to as real GDP per capita. So we measure long-run economic growth by increases in real GDP per capita. We use real GDP rather than nominal GDP to adjust for changes in the price level over time. Figure 5.1 shows real GDP per capita in Australia from 1901 to 2013. From the figure we can see that although real GDP per capita fluctuates because of the business cycle, over the long run the trend is strongly upward, notably from the 1960s onward. The values in Figure 5.1 are measured in prices of the financial year 1966/67, so they represent constant amounts of purchasing power. In 1901 real GDP per capita was about $1150. Over a century later, in 2013, it had risen to about $6222, which means that the average Australian in 2013 could purchase more than five times as many goods and services as the average Australian in 1901. Large as it is, this increase in real GDP per capita actually understates the true increase in the standard of living of Australians in 2013 compared with 1901. Many of today’s goods and services were not available in 1901. For example, if you lived in 1901 and became ill with a serious infection, you would have been unable to purchase antibiotics to treat your illness no matter how high your income. You might have died from an illness for which even a very poor person in today’s society could receive effective medical treatment. Of course, the quantity of goods and services that a person can buy is not a perfect measure of how happy

Long-run economic growth The process by which rising productivity increases the average standard of living.

FIGURE 5.1

Real GDP per capita, 1901–2013 Measured in 1966/67 dollars, real GDP per capita in Australia grew from about $1150 in 1901 to about $6222 in 2013. The average Australian in the year 2013 could buy more than five times as many goods and services as the average Australian in the year 1901

7000

1966/67 prices (dollars)

6000 5000 4000 3000 2000 1000 0 1901

1911

1921

1931

1941

1951

1961

1971

1981

1991

2001

2011

SOURCE: Created from D. Meredith and B. Dyster (1999), Australia in the Global Economy: Continuity and Change, Cambridge University Press. Data for 1999–2013 derived from Australian Bureau of Statistics (2013), Australian National Accounts, Cat. No. 5206.0, Time Series Workbook, Table 1: Key National Accounts Aggregates, at , viewed 21 October 2013.

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5.1

ONNECTION

THE CONNECTION BETWEEN ECONOMIC PROSPERITY AND HEALTH We can see the direct effect of economic growth on living standards by looking at improvements in health in the high-income countries over the past 100 years. Research has highlighted the close connection between economic growth, improvements in technology and improvements in human physiology. One important measure of health is life expectancy at birth. As the following graph shows, life expectancy in 1900 was around 50 years or less in Australia, the United States, United Kingdom and France. By 2013 life expectancy was around 80 years in these countries. Although life expectancies in the lowest-income countries remain very short, some countries that have begun to experience economic growth have seen dramatic increases in life expectancies. For example, life expectancy in India has more than doubled from 27 years in 1900 to 67 years today.

© Nikhil Gangavane | Dreamstime.com

Life expectancy at birth

Because of technological advance these children from a low-income country will live longer, be healthier and may work less than their parents and grandparents

90

1900

80

2013

70 60 50 40 30 20 10 0

Australia

France

United Kingdom

United States

India

SOURCE: Central Intelligence Agency (2013), ‘Country comparison: Life expectancy at birth’, The World Factbook, at , viewed 21 October 2013; Australian Bureau of Statistics (2011), Australian Social Trends, Cat. No. 4102.0, at , viewed 21 October 2013; Robert Fogel (2004), The Escape from Hunger and Premature Death, 1700–2100, Cambridge University Press, New York.

Many economists believe there is a link between health and economic growth. In Australia, the United States and Western Europe during the nineteenth century, improvements in agricultural technology and rising incomes led to dramatic improvements in the nutrition of the average person. The development of the germ theory of disease and technological progress in the purification of water in the late nineteenth century led to sharp declines in sickness from waterborne diseases. As people became stronger and less susceptible to disease they also became more productive. Today, economists studying economic development have put increasing emphasis on the need for low-income countries to reduce disease and increase nutrition if they are to experience economic growth. Many researchers believe that the state of human physiology will continue to improve as technology advances. In high-income countries, life expectancy at birth is expected to rise from about 80 years today to about 90 years by the middle of the century. Technological advances will continue to reduce the average number of hours worked per day and the number of years the average person spends in the paid workforce. Not only will technology and economic growth allow people in the near future to live longer lives, but a much smaller fraction of those lives will need to be spent at paid work.

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115

or contented that person may be. As we saw in the previous chapter, the level of pollution, the level of crime, the amount of leisure time, spiritual wellbeing and many other factors ignored in calculating GDP contribute to a person’s happiness. Nevertheless, economists rely heavily on comparisons of real GDP per capita because it is the best means of comparing the performance of one economy over time or the performance of different economies at any particular time.

Calculating growth rates and the rule of 70 As we learned in Chapter 4, the economic growth rate is equal to the percentage change in real GDP from one year to the next. For example, real GDP equalled approximately $1.452 trillion in 2012 and rose to $1.493 trillion in 2013 (for financial years ending 30 June). We calculate the economic growth rate between 2012 and 2013 as: $1.493 trillion  $1.452 trillion  100  2.8% $1.452 trillion

For longer periods of time we can use the average annual economic growth rate. For example, real GDP in Australia was approximately $236 billion in 1960 and $1493 billion in 2013. To find the average annual growth rate during this 53-year period we calculate the growth rate that would result in $236 billion growing to $1493 billion over 53 years. (This involves a lot of calculations so a compounding calculator is used to do this). In this case the growth rate is 3.7 per cent. That is, if $236 billion grows at an average rate of 3.54 per cent per year, after 53 years it will have grown to $1493 billion. For shorter periods of time, we can calculate average economic growth rates in real GDP by averaging the growth rate for each year. For example, real GDP in Australia grew by approximately 2.4  per cent in 2011, 3.4 per cent in 2012 and 2.8 per cent in 2013. So, the average annual growth rate of real GDP for the period 2011–2013 was 2.9 per cent, which is the average of the three annual growth rates: 2.4% 1 3.4% 1 2.8% 5 2.9% 3

When discussing long-run economic growth we will usually shorten ‘average annual growth rate’ to ‘growth rate’. We can judge how rapidly an economic variable is growing by calculating the number of years it would take to double. For example, if real GDP per capita in a country doubles, say, every 20 years, most people in the country will experience significant increases in their standard of living over the course of their lives. If real GDP per capita doubles only every 100 years, increases in the standard of living will occur too slowly to notice. One easy way to calculate approximately how many years it will take real GDP per capita to double is to use the rule of 70. The formula for the rule of 70 is as follows: Number of years to double 

70 growth rate

For example, if real GDP per capita is growing at a rate of 5 per cent per year, it will double in 70/5 = 14 years. If real GDP per capita is growing at a rate of 2 per cent per year, it will take 70/2 = 35 years to double. These examples illustrate an important point that we will discuss further in Chapter 6: small differences in growth rates can have large effects on how rapidly the standard of living in a country increases. Finally, notice that the rule of 70 applies not just to growth in real GDP per capita but to growth in any variable. For example, if you invest $1000 in the share market and your investment grows at an average annual rate of 7 per cent your investment will double to $2000 in 10 years.

What determines the rate of long-run economic growth? In Chapter 6 we explore the sources of economic growth in more detail and discuss why long-run growth in Australia and other high-income countries has been so much faster than growth in poorer countries. For now, we will focus on the basic point that increases in real GDP

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Labour productivity The quantity of goods and services that can be produced by one worker or by one hour of work.

per capita depend on increases in labour productivity. Labour productivity is the quantity of goods and services that can be produced by one worker or by one hour of work. In analysing longrun growth, economists usually measure labour productivity as output per hour of work to avoid fluctuations in the length of the working day and in the proportion of the population employed. If the quantity of goods and services consumed by the average person is to increase, the quantity of goods and services produced per hour of work must also increase. Why in 2013 was the average Australian able to consume more than five times as many goods and services as the average Australian in 1901? Because the average Australian worker in 2013 was more than five times as productive as the average Australian worker in 1901. If increases in labour productivity are the key to long-run economic growth, what causes labour productivity to increase? Economists believe two key factors determine labour productivity: the quantity of capital (both physical and human capital) per hour worked and the level of technology. Therefore, economic growth occurs if the quantity of capital per hour worked increases and if technological change occurs.

Increases in capital per hour worked Capital Manufactured goods that are used to produce other goods and services.

Human capital The accumulated knowledge and skills workers acquire from education and training or from their life experiences.

Workers today in high-income countries such as Australia have more physical capital available than workers in low-income countries  or  workers in the high-income countries of 100 years ago. Recall that physical capital (or just capital) refers to manufactured goods that are used to produce other goods and services. Examples of capital are computers, factory buildings, machines, tools, warehouses and trucks. The total amount of physical capital available in a country is known as the country’s capital stock. As the capital stock per hour worked increases, worker productivity increases. A secretary with a personal computer can produce more documents per day than a secretary who has only a typewriter. A worker with a backhoe can excavate more earth than a worker who has only a spade. Human capital refers to the accumulated knowledge and skills workers acquire from education and training or from their life experiences. For example, workers with a tertiary education generally have more skills and are more productive than workers who have only a high school qualification. Increases in human capital are particularly important in stimulating economic growth.

Technological change Economic growth depends more on technological change than on increases in capital per hour worked. Technology refers to the processes a firm uses to turn inputs into outputs of goods and services. Technological change is an increase in the quantity of output firms can produce using a given quantity of inputs. Technological change can come from many sources. For example, a firm’s managers may rearrange a factory floor or the layout of a retail store, thereby increasing production and sales. Technological change, however, is generally embodied in new machinery, equipment or software. A very important point is that just accumulating more inputs—such as labour, capital and natural resources—will not ensure that an economy experiences economic growth unless technological change also occurs. For example, the former Soviet Union failed to maintain a high rate of economic growth, even though it continued to increase the quantity of capital available per hour worked, because it experienced very little technological change. In implementing technological change, entrepreneurs are of crucial importance. Recall from Chapter 2 that an entrepreneur is someone who operates a business, bringing together the factors of production—labour, capital and natural resources—to produce goods and services. In a market economy entrepreneurs make the crucial decisions about whether or not to introduce new technology to produce better or lower-cost products. Entrepreneurs also decide whether to allocate the firm’s resources to research and development that can result in new technologies. Finally, an additional requirement for economic growth is that the government must provide secure rights to private property. As we saw in Chapter 2, a market system cannot function unless rights to private property are secure. In addition, the government can help the market work and aid economic growth by establishing an independent court system that enforces contracts between private individuals. Many economists would also say that the government has a role in facilitating the development of an efficient financial system, as well as systems of education, transportation and communication. We examine these issues further in Chapter 6. Copyright © Pearson Australia (a division of Pearson Australia Group Pty Ltd) 2015 – 9781486010233 - Hubbard/Macroeconomics 3e

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SOLVED PROBLEM 5.1 THE ROLE OF TECHNOLOGICAL CHANGE IN GROWTH Between 1960 and 1995 real GDP per capita in Singapore grew at an average annual rate of 6.2 per cent. This very rapid growth rate results in the level of real GDP per capita doubling about every 11.3 years. In 1995 economist Alwyn Young published an article in which he argued that Singapore’s growth depended more on increases in capital per hour worked, increases in the labour force participation rate and the transfer of workers from agricultural to non-agricultural jobs than on technological change. If Young’s analysis was correct, predict what was likely to happen to Singapore’s growth rate in the years after 1995.

Solving the problem STEP 1: Review the chapter material. This problem is about what determines the rate of long-run economic growth, so you may want

to review the section ‘What determines the rate of long-run economic growth?’, which begins on page 115. STEP 2: Predict what happened to the growth rate in Singapore after 1995. As countries begin to develop, they often experience

an increase in the labour force participation rate, as workers who were not part of the paid labour force respond to rising wage rates. Many workers also leave the agricultural sector—where output per hour worked is often low—for the non-agricultural sector. These changes increase real GDP per capita, but they are ‘one-shot’ changes that eventually come to an end, as the labour force participation rate and the fraction of the labour force outside agriculture both approach the levels found in high-income countries. Similarly, as we already noted, increases in capital per hour worked cannot sustain high rates of economic growth unless they are accompanied by technological change. We can conclude that Singapore was unlikely to sustain its high growth rates in the years after 1995. In fact, from 1996 to 2013 the growth of real GDP per capita slowed to an average rate of 2.9 per cent per year. Although this growth rate is comparable to rates experienced in high-income countries, it leads to a doubling of real GDP per capita only every 24.4 years rather than every 11.3 years. SOURCE: Alwyn Young (1995), ‘The tyranny of numbers: Confronting the statistical realities of the East Asian growth experience’, Quarterly Journal of Economics, Vol. 110, No. 3, August, pp. 641–680; International Monetary Fund (IMF) (2013), World Economic Outlook Database, April, at , viewed 21 October 2013.

[ YOUR TURN Q

For more practice do related problems 1.12 and 1.13 on page 139 at the end of this chapter.

WHAT EXPLAINS RAPID ECONOMIC GROWTH IN BOTSWANA?

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Economic growth in much of sub-Saharan Africa has been very slow. As desperately poor as most of these countries were in 1960, some are even poorer today. The growth rate in one country in this region stands out, however, as being exceptionally rapid. Look at the graph showing the average annual growth rate in real GDP per capita between 1960 and 2009 for Botswana and the six most populous sub-Saharan countries. You can see that Botswana’s average annual growth  rate over this 49-year period was three times as great as that of Tanzania and South Africa, which were the second-fastest and third-fastest growing countries in the group. Botswana may seem like an unlikely country to experience growth because it has been hard hit by the HIV epidemic. Despite the tragic and disruptive effects of the epidemic, growth in real per capita GDP continued to be positive at a time when many countries throughout the world were experiencing economic contractions and recessions, with increases in real GDP per capita averaging 3.1% between 2010 and 2013.

ONNECTION

5.2

David Reed/Panos Pictures

Firms like the Botswana Meat Company benefit from government policies that protect private property

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PART 3 MACROECONOMIC FOUNDATIONS AND ECONOMIC GROWTH Annual growth rate 6% 5 4 3 2 1 0

Kenya

Nigeria

Ethiopia

–1

South Africa

Tanzania

Botswana

–2 –3 –4

Democratic Republic of Congo

–5

Note: Data for Democratic Republic of Congo are for 1970–2004. SOURCE: Authors’ calculations from data in Alan Heston, Robert Summers and Bettina Aten (2011), Penn World Table Version 7.0, Center for International Comparisons of Production, Income and Prices at the University of Pennsylvania, June.

What explains Botswana’s rapid growth rate since 1960? Several factors have been important. Botswana avoided the civil wars that plagued other African countries during these years. The country also benefited from earnings from diamond exports. But many economists believe the pro-growth policies of its government are the most important reason for the country’s success. Economists Shantayanan Devarajan of the World Bank, William Easterly of New York University and Howard Pack of the University of Pennsylvania have summarised these policies: The government [of Botswana] made it clear it would protect private property rights. It was a ‘government of cattlemen’ who were attuned to commercial interests…The relative political stability and relatively low corruption also made Botswana a favourable location for investment. Botswana’s relatively high level of press freedom and democracy (continuing a pre-colonial tradition that held chiefs responsible to tribal members) held the government responsible for any economic policy mistakes.

These policies—protecting private property, avoiding political instability and corruption and allowing press freedom and democracy—may seem a straightforward recipe for providing an environment in which economic growth can occur. However, in practice these are policies many countries have difficulty implementing successfully. SOURCE: International Monetary Fund (IMF) (2013), World Economic Outlook Database, April, at , viewed 21 October 2013; Shantayanan Devarajan, William Easterly and Howard Pack (2003), ‘Low investment is not the constraint on African development’, Economic Development and Cultural Change, Vol. 51, No. 3, April, pp. 547–571.

Potential GDP Potential GDP The level of GDP attained when all firms are producing at normal capacity.

Because economists take a long-run perspective in discussing economic growth, the concept of potential GDP is useful. Potential GDP is the level of real GDP attained when all firms are producing at capacity. Every firm has a certain capacity to produce goods and services. The capacity of a firm is not the maximum output the firm is capable of producing. A car assembly plant could operate 24 hours per day for 52 weeks per year and would be at its maximum production level. The plant’s capacity, however, is measured by its production when operating on normal hours,

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using a normal workforce. If all firms in the economy were operating at normal capacity, the level of total production of final goods and services would equal potential GDP. Potential GDP will increase over time as the labour force grows, new factories and office buildings are built, new machinery and equipment are installed and technological change takes place. Growth in potential GDP is estimated to be about 3.5 per cent per year. In other words, each year the capacity of the economy to produce final goods and services expands by 3.5 per cent. The actual level of real GDP may increase by more or less than 3.5 per cent as the economy moves through the business cycle (or suffers an economic shock). That is, there are short-run variations in the rates of economic growth around the long-run growth path of potential GDP. Figure 5.2 shows movements in actual and potential GDP for the years since 1960. The smooth red line represents potential GDP and the blue line represents actual real GDP. Notice that during economic contractions and recessions, actual real GDP falls below potential GDP. This can be seen for the 1982–1983 recession, the 1990 recession, during the 2007–2008 GFC and the subsequent period of below-trend growth.

FIGURE 5.2

400

Actual and potential GDP, Australia, 1960–2013

Real GDP (billions of dollars)

350 300 250 200 150 100 50 0 1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

2010

Potential GDP increases every year as the labour force and the capital stock grow and technological change occurs. The smooth red line represents potential GDP and the blue line represents actual real GDP. Because of the business cycle or economic shocks, actual real GDP has sometimes been greater than potential GDP and sometimes less

SOURCE: Created from Australian Bureau of Statistics (2013), Australian National Accounts: National Income, Expenditure and Product, Cat. No. 5206.0, Sept., Table 2, Time Series Workbook. © Commonwealth of Australia.

SAVING, INVESTMENT AND THE FINANCIAL SYSTEM The process of economic growth depends on the ability of firms to expand their operations, buy additional equipment, train workers and adopt new technologies. Firms can finance some of these activities from retained earnings, which are profits that are reinvested in the firm rather than taken out of the firm and paid to the firm’s owners. For many firms, retained earnings are not sufficient to finance the rapid expansion required in economies experiencing high rates of economic growth. Firms acquire funds from households, either directly through financial markets—such as the share and bond markets—or indirectly through financial intermediaries— such as banks. Financial markets and financial intermediaries together comprise the financial system. Without a well-functioning financial system, economic growth is impossible because firms will be unable to expand and adopt new technologies. This was made very clear with the collapse of a number of financial institutions in the United States and Europe, in 2007 and 2008, and the near collapse of many others, which led to the GFC. Accessing credit became difficult and costly, and many businesses could no longer borrow sufficient funds. Australia was

5.2 Discuss the role of the financial system in facilitating long-run economic growth. LEARNING OBJECTIVE

Financial system The system of financial markets and financial intermediaries through which firms acquire funds from households.

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much less affected than many other countries, but still faced an increased difficulty in accessing funds overseas. As we noted earlier, no country without a well-developed financial system has been able to sustain high levels of economic growth.

An overview of the financial system

Financial intermediaries Firms such as banks and non-bank financial intermediaries (NBFIs) (which include credit unions, building societies, managed funds, superannuation funds and insurance companies) that borrow funds from savers and lend them to borrowers.

The financial system channels funds from savers to borrowers and channels returns on the borrowed funds back to savers. In financial markets, such as the share market or the bond market, firms raise funds by selling financial securities directly to savers. A financial security is a document—often in electronic form—that states the terms under which funds pass from the buyer of the security (who is lending funds) to the seller. Shares are financial securities that represent partial ownership of a firm. If you buy a Telstra share you become one of thousands of owners of that firm. Bonds are financial securities that represent promises to repay a fixed amount of funds. When a firm sells a bond the firm promises to pay the purchaser of the bond an interest payment each year for the term of the bond, as well as a final payment of the amount of the loan. Financial intermediaries, such as banks and non-bank financial intermediaries (NBFIs) (which include credit unions, building societies, managed funds, superannuation funds and insurance companies), act as go-betweens for borrowers and lenders. When you deposit funds in your bank account the bank may lend the funds (together with the funds of other savers) to an entrepreneur who wants to start a business. Suppose Lisa wants to open a laundromat. Rather than you lending money directly to Lisa’s Laundromat, the bank acts as a go-between for you and Lisa. Intermediaries pool the funds of many small savers to lend to many individual borrowers. The intermediaries pay interest to savers in exchange for the use of savers’ funds and earn a profit by lending money to borrowers and charging borrowers a higher rate of interest on the loans. For example, a bank might pay you as a depositor a 5  per cent rate of  interest, while it lends the money to Lisa’s Laundromat at a 10 per cent rate of interest. Financial institutions also make profits from charging fees for carrying out borrowing and lending transactions. Banks and NBFIs also make investments in shares and bonds on behalf of savers. For example, unit trusts sell shares to savers and then use the funds to buy a portfolio of shares, bonds, mortgages and other financial securities. Some NBFIs hold a wide range of shares or bonds; others specialise in securities issued by a particular industry or sector, such as technology; and others invest as an index fund in a fixed market basket of securities such as shares of the Australian Securities Exchange’s top 100 firms. Over the past 30 years the role of NBFIs in the financial system has increased dramatically. Today, competition between numerous NBFIs gives investors a number of funds from which to choose, although it is argued by many that the major four banks in Australia still have too much market power. In addition to matching households that have excess funds with firms that want to borrow funds, the financial system provides three key services for savers and borrowers: risk sharing, liquidity and information. Risk is the chance that the value of a financial security will change relative to what you expect. For example, you may buy a Qantas share at a price of $2.50, only to have the price fall to $2.00. Most individual savers are not gamblers and seek a steady return on their savings rather than erratic swings between high and low earnings. The financial system provides risk sharing by allowing savers to spread their money over many financial investments. For example, you can divide your money between a bank certificate of deposit, individual bonds, shares and a managed fund. Liquidity is the ease with which a financial security can be exchanged for cash. The financial system provides the service of liquidity by providing savers with markets in which they can sell their holdings of financial securities. For example, savers can easily sell their holdings of the shares and bonds issued by large corporations on the major share and bond markets. A third service that the financial system provides savers is the collection and communication of information, or facts about borrowers and expectations about returns on financial securities. For example, Lisa’s Laundromat may want to borrow $10 000 from you. Finding out what Lisa intends to do with the funds and how likely she is to pay you back may be costly and time consuming. By depositing $10 000 in the bank, you are, in effect, allowing the bank to gather this information for you. Because banks specialise in gathering information on borrowers they

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are able to do it faster and at a lower cost than can individual savers. The financial system plays an important role in communicating information. If you read a news story announcing that a car firm has invented a car with an engine that runs on water, how would you determine the effect of that discovery on the firm’s profits? Financial markets do the job for you by incorporating information into the prices of shares, bonds and other financial securities. In this example, the expectation of higher future profits would boost the price of the car firm’s shares.

The macroeconomics of saving and investment As we have seen, the funds available to firms through the financial system come from saving. When firms use funds to purchase machinery, factories and office buildings they are engaging in investment. In this section we explore the macroeconomics of saving and investment. A key point we will develop is that the total value of saving in the economy must equal the total value of investment. We saw in Chapter 4 that national income accounting refers to the methods the Australian Bureau of Statistics (ABS) uses to keep track of total production and total income in the economy. We can use some relationships from national income accounting to understand why total saving must equal total investment. We begin with the relationship between GDP and its components, consumption (C), investment (I ), government purchases (G ) and net exports (NX): Y = C + I + G + NX Remember that GDP is a measure of both total production in the economy and total income (Y ). In an open economy there is interaction with other economies in terms of both trading of goods and services and borrowing and lending. Nearly all economies today are open economies, although they vary significantly in the extent of their openness. In a closed economy there is no trading or borrowing and lending with other economies. For simplicity, we will develop the relationship between saving and investment for a closed economy. This allows us to focus on the most important points in a simpler framework. We will consider the case of an open economy in Chapter 14. In a closed economy net exports are zero, so we can rewrite the relationship between GDP and its components as: Y=C+I+G If we rearrange this relationship, we obtain an expression for investment in terms of the other variables: I=Y–C–G This expression tells us that in a closed economy investment spending is equal to total income minus consumption spending and minus government purchases. We can also derive an expression for total saving. Private saving is equal to what households retain of their income after purchasing goods and services (C ) and paying taxes (T ). Here taxes refers to net taxes, which are equal to taxes paid minus transfer payments received. Recall that transfer payments to households include social security payments and unemployment benefits. Households receive income for supplying the factors of production to firms. This portion of household income is equal to Y. We can write an expression for private saving (Sprivate): Sprivate = Y – C – T The government also engages in saving. Public saving (Spublic) equals the amount of net tax revenue the government retains after paying for government purchases: Spublic = T – G So total saving in the economy (S) is equal to the sum of private saving and public saving: S = Sprivate + Spublic or, S = (Y – C – T ) + (T – G)

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or, S=Y–C–G The right-hand side of this expression is identical to the expression we derived earlier for investment spending. So we can conclude that total saving must equal total investment: S=I When the government spends the same amount that it collects in taxes there is a balanced budget. When the government spends more than it collects in taxes there is a budget deficit. In the case of a deficit, T is less than G, which means that public saving is negative. Negative saving is also known as dissaving. How can public saving be negative? When the federal government runs a budget deficit, the Reserve Bank of Australia sells government financial securities such as bonds to borrow the money necessary to fund the gap between taxes and spending. In this case, rather than adding to the total amount of saving available to be borrowed for investment spending, the government is subtracting from it. (Note that if households borrow more than they save the total amount of saving will also fall.) With less saving, investment must also be lower. We can conclude that, holding all other factors constant, there is a lower level of investment spending in the economy when there is a budget deficit than when there is a balanced budget. When government spending is less than its net taxes there is a budget surplus. A budget surplus increases public saving and the total level of saving in the economy. A higher level of saving results in a higher level of investment spending. Therefore, holding all other factors constant, there is a higher level of investment spending in the economy when there is a budget surplus than when there is a balanced budget. The Australian federal government has experienced dramatic changes in the state of its budget over the past 18 years. In 1996 the federal budget deficit was $5 billion, which, together with pre-existing debts from previous budget deficits, meant that federal government net debt totalled $96 billion. In 1997 there was a budget surplus of $2.6 billion. The surplus was more than $17 billion by 2007. The surpluses were used to pay back previous borrowings and by 2006 the $96 billion debt had been fully repaid and the federal government was, for a short time, a net saver, making it one of the few governments in the world to be a net saver. By 2008, the federal government had again begun to spend more than it received in taxation revenue, operating budget deficits in an attempt to stimulate the economy during the GFC. The deficit peaked at over $54 billion in 2010, with deficits continuing for years even after the main effects of the GFC were over.

The market for loanable funds

Market for loanable funds The interaction of borrowers and lenders that determines the market interest rate and the quantity of loanable funds exchanged.

We have seen that the value of total saving must equal the value of total investment, but we have not yet discussed how this equality is actually brought about in the financial system. We can think of the financial system as being composed of many markets through which funds flow from lenders to borrowers: the market for certificates of deposit at banks, the market for shares, the market for bonds, the market for managed fund shares and so on. For simplicity, we can combine these markets into a single market for loanable funds. In the model of the market for loanable funds, the interaction of borrowers and lenders determines the market interest rate and the quantity of loanable funds exchanged. As we discuss in Chapter 15, firms can also borrow from savers in other countries. For the remainder of this chapter we will assume there are no interactions between households and firms in Australia and those in other countries.

Demand and supply in the loanable funds market The demand for loanable funds is determined by the willingness of firms to borrow funds to engage in new investment projects, such as building new factories or engaging in research and development of new products. In determining whether or not to borrow funds, firms compare the return they expect to make on an investment with the interest rate they must pay to borrow the necessary funds. For example, if Bunnings is considering opening several new stores and expects to earn a return of 10 per cent on its investment,

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the investment will be profitable if it can borrow the funds at an interest rate of 5 per cent but will not be profitable if the interest rate is 15 per cent. In Figure  5.3, the demand for loanable funds is downward sloping because the lower the interest rate the more investment projects firms can profitably undertake, and the greater the quantity of loanable funds they will demand. The supply of loanable funds is determined by the willingness of households to save and by the extent of government saving or dissaving. When households save they reduce the amount of goods and services they can consume and enjoy today. The willingness of households to save rather than consume their incomes today will be determined in part by the interest rate they receive when they lend their savings. The higher the interest rate the greater the reward for saving and the larger the amount of funds households will save. Therefore, the supply curve for loanable funds in Figure 5.3 is upward sloping to reflect the fact that the higher the interest rate the greater the quantity of saving supplied. A distinction must be made between the nominal interest rate and the real interest rate. The nominal interest rate is the stated interest rate on a loan. The real interest rate corrects the nominal interest rate for the impact of inflation and is equal to the nominal interest rate minus the inflation rate. Because both borrowers and lenders are interested in the real interest rate they will receive or pay, equilibrium in the market for loanable funds determines the real interest rate rather than the nominal interest rate.

FIGURE 5.3

Real interest rate (per cent)

Supply of loanable funds

Equilibrium interest rate

Demand for loanable funds Equilibrium quantity of loanable funds

The market for loanable funds The demand for loanable funds is determined by the willingness of firms to borrow funds to engage in new investment projects. The supply of loanable funds (in a closed economy) is determined by the willingness of households to save, and by the extent of government saving or dissaving. Equilibrium in the market for loanable funds determines the real interest rate and the quantity of loanable funds exchanged

Loanable funds (dollars per year)

Explaining movements in saving, investment and interest rates Equilibrium in the market for loanable funds determines the quantity of loanable funds that will flow from lenders to borrowers each period. It also determines the real interest rate that lenders will receive and that borrowers must pay. We draw the demand curve for loanable funds by holding constant all factors, other than the interest rate, that affect the willingness of borrowers to demand funds. We draw the supply curve by holding constant all factors, other than the interest rate, that affect the willingness of lenders to supply funds. A shift in either the demand curve or the supply curve will change the equilibrium interest rate and the equilibrium quantity of loanable funds. If, for example, the profitability of new investment increases due to technological change, firms will increase their demand for loanable funds. Figure 5.4 shows the impact of an increase in demand in the market for loanable funds. As in the markets for goods and services we studied in Chapter 3, an increase in demand in the market for loanable funds shifts the demand curve to the right. In the new equilibrium the interest rate increases from i1 to i2, and the equilibrium quantity of loanable funds increases from L1 to L2. Notice that an increase in the quantity of loanable funds means that both the quantity of saving by

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FIGURE 5.4

An increase in the demand for loanable funds An increase in the demand for loanable funds increases the equilibrium interest rate from i1 to i2, and increases the equilibrium quantity of loanable funds from L1 to L2. As a result, saving and investment both increase

1. Technological change increases the demand for loanable funds . . .

Real interest rate (per cent)

Supply

i2 2. . . . increasing the equilibrium interest rate . . .

i1

D2

Demand, D1

L1

L2

Loanable funds (dollars per year)

3. . . . and increasing the equilibrium quantity of loanable funds.

M

C

A K I N G THE

5.3

ONNECTION

EBENEZER SCROOGE: ACCIDENTAL PROMOTER OF ECONOMIC GROWTH? Ebenezer Scrooge’s name has become synonymous with miserliness. Before his reform at the end of Charles Dickens’s novel, A Christmas Carol, Scrooge is extraordinarily reluctant to spend money. Although he earns a substantial income he lives in a cold, dark house that he refuses to heat or light properly, and he eats a meagre diet of gruel (watery porridge) because he refuses to buy more expensive food. Throughout most of the book Dickens portrays Scrooge’s behaviour in an unfavourable way. Only at the end of the book, when the reformed Scrooge begins to spend lavishly on himself and others, does Dickens praise his behaviour.

Let us consider whether the actions of the pre-reform Scrooge or the actions of the post-reform Scrooge are more helpful to economic growth. Pre-reform Scrooge spends very little, putting most of his income in the financial markets. These funds became available for firms to borrow to build new factories and carry © Bettman/CORBIS out research and development. Post-reform Scrooge spends much more—and Who was better for economic growth: Scrooge saves much less. Funds that he had previously saved are now spent on food for the saver or Scrooge the spender? Bob Cratchit’s family and on ‘making merry’ at Christmas. In other words, the actions of post-reform Scrooge contributed to more consumption goods being produced and fewer investment goods. We can conclude that Scrooge’s reform caused economic growth to slow down—if only by a little. The larger point is, of course, that savers provide the funds that are indispensable for the investment spending that economic growth requires, and the only way to save is not to consume. SOURCE: Based on Steven E. Landsburg (2004), ‘What I like about Scrooge’, Slate, 9 December, at , viewed 28 October 2013.

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households and the quantity of investment by firms have increased. Increasing investment increases the capital stock and the quantity of capital per hour worked, helping to increase economic growth. We can also use the market for loanable funds to examine the impact of a government budget deficit. Putting aside the effects of foreign saving—which we will consider in Chapter  14— recall that if the government runs a budget deficit it reduces the total amount of saving in the economy. Suppose the government increases spending, which results in a budget deficit. We illustrate the effects of the budget deficit in Figure 5.5 by shifting the supply curve for loanable funds to the left. In the new equilibrium the interest rate is higher and the equilibrium quantity of loanable funds is lower. Running a deficit has reduced the level of total saving in the economy and, by increasing the interest rate, has also reduced the level of investment spending by firms. By borrowing to finance its budget deficit the government will have crowded out some firms that would otherwise have been able to borrow to finance investment. Crowding out refers to a decline in private expenditure as a result of an increase in government purchases. In Figure 5.5 the decline in investment spending due to crowding out is shown by the movement from L1 to L2. Lower investment spending means that the capital stock and the quantity of capital per hour worked will not increase as much. A government budget surplus has the opposite effect to a deficit. A budget surplus increases the total amount of saving in the economy, shifting the supply of loanable funds to the right. In the new equilibrium the interest rate will be lower and the quantity of loanable funds will be higher. We can conclude that a budget surplus increases the level of saving and investment. In practice, however, the impact of government budget deficits and surpluses on the equilibrium interest rate is relatively small. This finding reflects in part the importance of global saving in determining the interest rate. However, this small effect on interest rates does not imply that we can ignore the effect of deficits on economic growth. Also, if government spending puts upward pressure on inflation, a country’s central bank—in Australia, the Reserve Bank of Australia—may increase interest rates to reduce inflationary pressures, which will reduce private investment. Further, paying off government debt in the future will require higher taxes, which can depress economic growth.

Real interest rate (per cent)

2. . . . increasing the equilibrium interest rate . . .

Supply, S1

1. When the government begins running a budget deficit, the supply of loanable funds is reduced . . .

i1

Crowding out A decline in private expenditure as a result of an increase in government purchases.

FIGURE 5.5

S2

i2

125

The effect of a budget deficit on the market for loanable funds When the government begins running a budget deficit the supply of loanable funds shifts to the left. The equilibrium interest rate increases from i1 to i2, and the equilibrium quantity of loanable funds falls from L1 to L2. As a result, saving and investment both decline

Demand

L2

L1

Loanable funds (dollars per year)

3. . . . and decreasing the equilibrium quantity of loanable funds.

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SOLVED PROBLEM 5.2 HOW WOULD A CONSUMPTION TAX AFFECT SAVING, INVESTMENT, THE INTEREST RATE AND ECONOMIC GROWTH? Some economists and policy-makers have suggested that the federal government should shift from relying on an income tax to relying on a consumption tax. Under the income tax, households pay taxes on most income earned. Under a consumption tax households pay taxes only on the income they spend. Households would pay taxes on saved income only if they spend the money at a later time. Use the market for loanable funds model to analyse the effect on saving, investment, the interest rate and economic growth of switching from an income tax to a consumption tax.

Solving the problem STEP 1: Review the chapter material. This problem is about applying the market for loanable funds model, so you may want to

review the section ‘Explaining movements in saving, investment and interest rates’, which begins on page 123. STEP 2: Explain the effect of switching from an income tax to a consumption tax. Households are interested in the return they

receive from saving after they have paid their taxes. For example, consider someone who puts their savings in a term deposit at an interest rate of 4 per cent and whose tax rate is 25 per cent. Under an income tax, this person’s after-tax return to saving is 3 per cent (4 × (1 – 0.25)). Under a consumption tax, income that is saved is not taxed, so the return rises to 4 per cent. We can conclude that moving from an income tax to a consumption tax would increase the return to saving, causing the supply of loanable funds to increase. STEP 3: Draw a graph of the market for loanable funds to illustrate your answer. The supply curve for loanable funds will shift to

the right as the after-tax return to saving increases under the consumption tax. The equilibrium interest rate will fall, and the levels of saving and investment will both increase. Because investment increases, the capital stock and the quantity of capital per hour worked will grow and the rate of economic growth should increase. Note that the size of the fall in the interest rate and the increase in loanable funds shown in the graph are larger than the effects that most economists expect would actually result from the replacement of the income tax with a consumption tax. Real interest rate (per cent)

S1 S2

i1 i2

D

L1

L2

Loanable funds (dollars per year)

[ YOUR TURN Q

For more practice do related problem 2.15 on page 140 at the end of this chapter.

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THE BUSINESS CYCLE Figure 5.1 illustrates the tremendous increase during the past 113 years in the standard of living of the average Australian. But close inspection of the figure reveals that real GDP per capita did not increase every year during this time. For example, from 1928–1931 real GDP per capita fell for several years in a row. What accounts for these fluctuations around the longrun upward trend?

5.3 Understand what happens during the business cycle. LEARNING OBJECTIVE

Some basic business cycle definitions The fluctuations in real GDP per capita shown in Figure 5.1 reflect the underlying fluctuations in real GDP. Dating back at least to the early nineteenth century, the Australian economy has experienced a business cycle, consisting of alternating periods of expanding and contracting economic activity. Because real GDP is our best measure of economic activity, the business cycle is usually illustrated using movements in real GDP, that is, the economic growth rate. During the expansion phase of the business cycle, production, employment and income are increasing above the trend in growth that the economy experiences over time. The period of expansion ends with a business cycle peak. Following the business cycle peak, production, employment and income are falling below the trend in growth as the economy enters the contraction phase of the cycle. The contraction phase may be followed by a recession, which occurs when total production and employment are decreasing and the rate of economic growth is negative. The contraction or recession comes to an end with a business cycle trough, after which another period of expansion begins. Figure 5.6 helps to illustrate the phases of the business cycle as shown by fluctuations in real GDP during the period 1980 to 2013. The figure shows that in 1982–1983 the Australian economy entered a recession, quickly recovered to reach a

FIGURE 5.6

Movements in real GDP, Australia, 1980–2013 In 1982–1983 the Australian economy entered a recession, quickly recovered to reach a peak in 1985 only to go into an economic contraction in 1986. The subsequent expansion was short lived with a fall in the rate of economic growth commencing in 1990, with the economy then entering a recession. The expansion that began after 1991 continued throughout the late 1990s until 2008–2009, when a short contraction occurred—the result of the effects of the GFC. Since then, economic growth has occurred, although mostly below trend 7 6 5 4

Per cent

3 2 1 0 –1 –2 –3

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012

SOURCE: Created from Australian Bureau of Statistics (2013), Australian National Accounts: National Income, Expenditure and Product, Cat. No. 5206.0, Time Series Workbook, at , viewed 30 October 2013.

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peak in 1985, only to go into an economic contraction in 1986. The subsequent expansion phase was short lived with a fall in the rate of economic growth commencing in 1990, with the economy then entering a recession. The expansion that began after 1991 largely continued throughout the 1990s until 2008–2009, when a short contraction occurred—the result of the effects of the GFC. Since then, economic growth has occurred, although mostly below trend. A recession is a significant decline in economic activity spread across the economy, lasting more than a few months, visible in industrial production, employment, real income and wholesale– retail trade. A ‘technical recession’ is sometimes defined as two successive quarters (six months) of negative economic growth. From Figure 5.6 a recession can be seen in 1983 and in 1991. As a result of the GFC many countries experienced severe recessions in 2008 and 2009. Australia’s economy contracted but economic growth was negative for only one quarter (December 2008), and therefore arguably Australia did not experience a recession. By 2010 Australia’s economy was again growing at close to trend rates, although this slowed from 2011 onwards.

What happens during the business cycle Each business cycle is different. The lengths of the expansion and contraction phases and which sectors of the economy are most affected will rarely be the same in any two cycles. But most business cycles share certain characteristics, which we will discuss in this section. As the economy nears the end of an expansion interest rates are usually rising, and the wages of workers are usually rising faster than prices. As a result of rising interest rates and rising wages, the profits of firms will be falling. Typically, towards the end of an expansion both households and firms will have substantially increased their debts. These debts are the result of firms and households borrowing to help finance their spending during the expansion. An economic contraction will often begin with a decline in spending by firms on capital goods, such as machinery, equipment, new factories and new office buildings, or by households on new houses and consumer durables, such as furniture and cars. As spending declines, firms selling capital goods and consumer durables will find their sales declining. As sales decline, firms cut back on production and begin to lay off workers. Rising unemployment and falling profits reduce income, which leads to further declines in spending, and a recession may occur. As the contraction or recession continues, economic conditions gradually begin to improve. The declines in spending eventually come to an end; households and firms begin to reduce their debt, thereby increasing their ability to spend; and interest rates decline, making it more likely that households and firms will borrow to finance new spending. Firms begin to increase their spending on capital goods as they anticipate the need for additional production during the next expansion. Increased spending by households on consumer durables and by businesses on capital goods will finally bring the recession to an end and begin the next expansion.

The effect of the business cycle on car sales Durables are goods that are expected to last for three or more years. Consumer durables include furniture, appliances and cars, while producer durables include machines, tools, vehicles and some computer equipment. Non-durables are goods that are expected to last for fewer than three years. Consumer non-durables include goods such as food and clothing or services such as haircuts and medical care. Durables are affected more by the business cycle than are nondurables. During an economic contraction or recession workers reduce spending if they lose their jobs, fear losing their jobs or suffer wage reductions. Because people can often continue using their existing furniture, appliances or cars, they are more likely to postpone spending on durables than spending on other goods. Cars are among the most expensive products consumers buy, so consumers are very likely to postpone buying a new one during a recession. We saw in our discussion of GMH at the beginning of this chapter that the firm’s sales have been significantly affected by the business cycle. Figure 5.7 shows that this is true for the car industry in Australia as a whole. The sustained economic expansion during the 1990s and into the 2000s led to a trend increase in car sales. However, there are also noticeable cycles associated with changes in economic growth and fluctuations in car sales. One of the most important of these fluctuations was the introduction of the Goods and Services Tax (GST) in 2000, after which the prices of new cars fell due to the removal of other sales taxes on cars. In anticipation of this people delayed buying cars until the GST had come in after which there

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FIGURE 5.7

The effect of the business cycle on new car sales, Australia, 1994–2013 The sustained economic expansion during the 1990s and into the 2000s led to a trend increase in car sales; however, there are also noticeable cycles associated with changes in real GDP and fluctuations in car sales 65 000

60 000

Car sales

55 000

50 000

45 000

40 000

35 000

13

12

20

11

20

10

20

09

20

08

20

07

20

06

20

05

20

04

20

03

20

02

20

01

20

00

20

99

20

98

19

97

19

96

19

95

19

19

19

94

30 000

SOURCE: Created from Australian Bureau of Statistics (2013), Sales of New Motor Vehicles, Australia, Cat. No. 9314.0, Time Series Workbook, Table 1: New Motor Vehicles Sales by Type, All Series, at , viewed 30 October 2013.

was a boom in sales as soon as it was introduced. The economic contraction in 2008, which carried with it forecasts and expectations of a worse economic outcome, led to a significant fall in buying new cars, which was followed by a period of short recovery, before another downturn that largely trended with the rate of economic growth.

The effect of the business cycle on the inflation rate The price level measures the average prices of goods and services in the economy, and the inflation rate is the percentage increase in the price level from one year to the next. This will be discussed in greater detail in Chapter 8. An important fact about the business cycle is that during economic expansions the inflation rate usually increases, particularly near the end of the expansion, and during contractions the inflation rate usually decreases. The exception to this is if the expansion is due to rising productivity levels and an expansion of potential GDP, or if the contraction is caused by high prices for production inputs, such as very high oil prices, or if real wages rise at a rate that is faster than the rate at which labour productivity increases. Figure 5.8 illustrates the fact that the inflation rate fell significantly during Australia’s recessions of 1982–1983 and 1990–1991. Prior to the 1982–1983 recession the inflation rate was over 11 per cent, which then fell to just over 4 per cent during the recession. Prior to the 1990–1991 recession the inflation rate was over 8 per cent, as it had been for many years. The recession of 1990–1991 caused the inflation rate to fall back to 1 per cent by 1992. This result is not surprising. During a business cycle expansion spending by businesses and households is strong and producers of goods and services find it easier to raise prices. As spending declines during a recession firms have a more difficult time selling their goods and services and are likely to increase prices less than they otherwise might have. A substantial fall in the inflation

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FIGURE 5.8

The impact of a recession on the inflation rate During the 1982–1983 recession the inflation rate fell from over 11 per cent to around 4 per cent. In the late 1980s the inflation rate had once again risen to a high level of over 8 per cent. The recession of 1990 caused the inflation rate to fall back to 1 per cent by 1992. Economic contractions at other times also led to the inflation rate falling 14

12

Per cent

10

8

6

4

2

0 1980

1983

1986

1989

1992

1995

1998

2001

2004

2007

2010

2013

Note: The points on the figure represent the annual inflation rate measured by the change in the CPI for the year ending December. SOURCE: Created from Reserve Bank of Australia (2013), Statistics: Consumer Price Index, All Goods, at , viewed 28 October 2013.

rate can also be seen in 1996 and 1997, when Australia entered a short economic contraction as a result of the Asian financial crisis of that time. The inflation rate also dipped for a short time during the economic contraction resulting from the GFC of 2007–2008, after which time it remained low for many years due to below-average economic growth.

The effect of the business cycle on the unemployment rate Contractions and recessions cause the unemployment rate to increase while expansions and booms cause the unemployment rate to decrease. During a contraction firms see their sales decline and they begin to reduce production and lay off workers. From Figure 5.9, we can clearly see the impact of the 1982–1983 recession and the 1990 recession on the unemployment rate. For example, as the 1990–1991 recession began, the economic growth rate fell below 0 per cent from June 1990, and the unemployment rate started to rise, and more than doubled by 1992. The rate of unemployment continued to rise even after the end of the recession in December 1991. This pattern is typical and is due to two factors. First, during the business cycle discouraged workers (unemployed people who have given up hope of finding a job and stopped looking for one) drop out of and then return to the labour force. When discouraged workers drop out of the labour force during a recession, they keep the measured unemployment rate from increasing by as much as it otherwise would because they are no longer looking for jobs and therefore are not counted as unemployed. When discouraged workers return to the labour force as the recession ends, they increase the measured unemployment rate because they are now counted as being unemployed. Second, firms continue to operate well below their capacity even after a recession has ended and production has begun to increase. As a result, at first firms may not re-hire all of the workers they have laid off and may even continue for a while to lay off more workers.

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FIGURE 5.9

The impact of a recession on the unemployment rate The reluctance of firms to hire new employees during the early stages of a recovery means that the unemployment rate usually continues to rise even after the recession has ended 12

11

10

Per cent

9

8

7

6

5

4 1980

1983

1986

1989

1992

1995

1998

2001

2004

2007

2010

2013

SOURCE: Created from Australian Bureau of Statistics (2013), Labour Force: Electronic Delivery, Cat. No. 6203.0, at , viewed 21 October 2013.

The period of continual economic growth from 1991 to 2007 was associated with a significant and almost continual decline in the rate of unemployment from around 11 per cent in 1992 to 4 per cent by early 2008. The economic contraction of 2008 associated with the GFC led to an increase in the unemployment rate from around 4 per cent to close to 6 per cent. This rise in unemployment was not as significant as it might have been had it not been for the flexible work practices of both employers and employees. Many employers preferred not to sack workers and lose their investment in their skills, and were also fresh from experiencing labour shortages. Instead, many employees worked fewer hours or days per week, while keeping their jobs during the contraction.

Don’t confuse short-run fluctuations with long-run trends It is important to understand that, although economies often experience economic booms and recessions, these are short-run occurrences. If a recession continues for a year or more it may be tempting to assume that long-run growth will start to decline. However, even in the Great Depression of 1929–1933, when economic growth rates in Australia and most other industrialised countries were negative for an extended period of time, history has demonstrated that the long-run growth path of potential real GDP continued to trend upwards. It is not the shortrun fluctuations that determine long-run economic growth. Rather, it is technology, capital stock and the education and skill levels of human capital which, in most countries, have increased over time.

DON’T LET THIS HAPPEN TO YOU

[ YOUR TURN Q

For more practice do related problem 3.5 on page 141 at the end of this chapter.

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Recessions are partly due to business cycles and partly due to shocks Although today the Australian economy still experiences business cycles, the cycles have become milder. The biggest downturns in economic growth rates and high unemployment in Australia have largely been due to ‘shocks’ to the economy because of, sometimes, international factors and, sometimes, events specific to Australia such as poor economic management. The most recent of these shocks was the GFC, which had devastating effects on the US, European, Japanese and many other economies. Although Australia also felt the effects of the GFC its impact was far less severe. Figure 5.10 shows the rate of economic growth since 1960. Although earlier data are not exactly comparable, prior to 1960 economic growth rates were subject to much greater fluctuations than since 1960 in Australia. During World War I the economic growth rate fell to –0.2 per cent, recovered to 3.7 per cent in the 1920s before again plunging to –3.0 per cent between 1928 and 1931—the period of the worldwide Great Depression. Unemployment rates in Australia were as high as 25 per cent during the Great Depression. The ‘Long Boom’ from the late 1940s to the early 1970s was a time of generally strong rates of economic growth. Australia developed its manufacturing sector during World War  II and also expanded its services sector and agricultural land areas. There was an export boom during the early 1950s with wool export prices soaring due to high demand caused by the Korean War, followed by a series of mineral discoveries in the 1950s and 1960s. The growth in new technologies also contributed to the increased productivity and strong economic growth rates. The major world oil shock that occurred in 1974 when oil-exporting countries formed a cartel—the Organization of the Petroleum Exporting Countries (OPEC)—to increase oil prices by over 300 per cent, from US$3 per barrel to US$10 per barrel, together with rapidly rising wage inflation in Australia, led to the next serious economic shock in Australia. This was

FIGURE 5.10

Fluctuations in economic growth, Australia, 1960–2013 From the 1960s to the early 1990s economic growth had much more severe swings than it has had since the early 1990s

9 8 7 6 5

Per cent

4 3 2 1 0 –1 –2 –3 1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

2010

SOURCE: Created from Australian Bureau of Statistics (2013), Australian National Accounts: National Income, Expenditure and Product, Cat. No. 5206.0, Time Series Workbook, at , viewed 30 October 2013.

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a period of rapidly rising inflation and rising unemployment. As seen in Figure 5.10, economic growth rates fell significantly in 1974. This economic downturn required considerable structural adjustment which was hindered by excessive regulation, including tariff protection, plus lack of labour market flexibility, particularly downward wage rigidity and, possibly, inappropriate macroeconomic policy. In the late 1980s the federal government of the time raised interest rates to very high levels, with the intent of reducing spending and lowering the rate of inflation. This proved to be an excessive policy measure and caused the recession of 1990–1991. This recession is clearly evident in Figure 5.10. After this recession Australia experienced 17 years of extraordinary, by OECD standards, economic growth rates, accompanied by a decline in the unemployment rate to 4.1 per cent by 2008. The economic contraction that resulted from the GFC saw the rate of economic growth fall to –0.2 per cent in December 2008, and the unemployment rate rise to 5.8 per cent in mid-2009. By 2010 the economic growth rate had risen quite quickly, and the unemployment rate was slowly beginning to decline. However, by 2012, economic growth had fallen a little below trend and by early 2014 the unemployment rate had reached 6 per cent. Three observations are clear. First, macroeconomic policy can be very effective in increasing unemployment, as witnessed by the government-induced recession in 1990–1991. Second, there is hysteresis in unemployment, that is, once unemployment rises it is difficult to reverse, so policy-makers must be extremely careful in setting policy instruments. Third, as was evident from the period of 17 years of continuous economic growth, unemployment is not going to be solved by macroeconomic policy alone, nor should it be expected to. Microeconomic reforms are credited by economists as having contributed to increasing labour productivity and therefore employment growth.

WHY DID THE GLOBAL FINANCIAL CRISIS OCCUR? The global financial crisis (GFC) began in late 2007, with the full impact plunging many economies into severe recessions by 2008 and 2009. The GFC originated in the United States as the result of very poor credit standards, high levels of borrowing—arguably assisted by the low interest rate policy of the US Federal Reserve Bank and enabled by China’s surplus of funds—and asset price bubbles (shares and real estate priced higher than their underlying value). The lack of financial regulation by both the US government and its financial industry allowed home loans to be made to an enormous number of households that were not in a position to repay them. People were able to buy homes with no deposit, very low incomes, poor credit histories, sometimes even when they were unemployed, and could, in some instances, borrow up to 110 per cent of the value of their properties. The risk associated with these ‘sub-prime mortgages’ was spread as they were repackaged and sold as financial assets to other financial institutions in many parts of the world. Therefore, when the inevitable loan defaults began to emerge towards the end of 2007 the impact spread throughout much of the world.

M

C

A K I N G THE

ONNECTION

5.4

© Norman Chan | Dreamstime.com

The global financial crisis caused the collapse of some major banks and financial institutions in many parts of the world, and led to some governments being unable to repay their debts

Australia’s financial system had minimal exposure to ‘toxic’ debts due to existing prudential regulations, which were tightened by the then Treasurer, Peter Costello, and due to more responsible lending behaviour and low exposure to risky assets by the majority of Australian banks and financial institutions. By 2009 the GFC triggered (or hastened) a problem of public debts of unprecedented proportions, with some European governments in danger of defaulting. This was due to massive financial institution bailouts, which converted much private debt to government debt, a history of a lack of financial restraint and budget deficits by some governments, and large fiscal stimulus measures during the GFC. In 2010 the governments of Greece and Ireland would have defaulted on debts without huge financial bailouts by the European Union (EU) and the International Monetary

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Fund. By 2011 the governments of a number of other countries, including Spain, Portugal, Iceland, Italy and Cyprus, were considered by the EU to be at risk of defaulting on loans. When compared with the severe recessions experienced by the United States, the United Kingdom and Europe, and parts of Asia, the Australian experience of an economic contraction in 2008–2009, followed by recovery in 2010, was remarkable. SOURCE: A. Garnett and P. Lewis (2010), ‘The economy’, in C. Aulich and M. Evans (eds), The Rudd Government: Australian Commonwealth Administration 2007–2010, Chapter 10, p. 182, ACT, ANU Press.

Why are business cycle fluctuations less severe? Shorter recessions, longer expansions and less severe fluctuations in real GDP have resulted in a significant improvement in the economic wellbeing of Australians. Economists have offered four explanations for why the economy has been more stable since 1950. 1 The increasing importance of services and the declining importance of goods. As services, such as medical care or investment advice, have become a much larger fraction of GDP, there has been a corresponding relative decline in the production of goods. For example, in 1901 services accounted for about 58 per cent of GDP, in 1960 services had only risen slightly as a proportion of GDP, to 59 per cent, while today they account for over 70 per cent. Manufacturing production, particularly production of durable goods such as cars, fluctuates more than the production of services. Because durable goods are more expensive, during a contraction or recession households will cut back more on purchases of them than they will on purchases of services. Also, agricultural and mining production fluctuates with international supply and demand and domestic climatic factors, making it potentially unstable. While the absolute volume and value of agriculture has greatly increased over time, it has fallen significantly as a proportion of GDP. In 1901 agriculture comprised almost 20 per cent of Australia’s GDP; by 1960 this had fallen to 13 per cent and by 2013 to around 3 per cent. In 1901 mining exports were around 10 per cent of GDP, became less significant between the 1950s and 1990s, and rose again in the 2000s due to the minerals and energy boom, and by 2013 had increased to over 9 per cent of GDP. 2 The establishment of unemployment benefits and other government transfer programs that provide funds to the unemployed. Before the 1930s, programs such as unemployment benefits, which provide government payments to workers who lose their jobs, and social security, which provides government payments to retired and disabled workers, were haphazard. In 1944 the federal government committed itself to an Australia-wide system of welfare under the Commonwealth Unemployment and Sickness Benefits Act. These and other government programs make it possible for workers who lose their jobs during contractions and recessions to have higher incomes and therefore to spend more than they would otherwise. This additional spending may have helped to shorten contraction phases. 3 Active federal government and central bank policies to stabilise the economy. Before the Great Depression of the 1930s the federal government did not attempt to end recessions or prolong expansions. Because the Great Depression was so severe, with the unemployment rate rising to more than 25 per cent of the labour force and real GDP declining by almost 30 per cent, public opinion began favouring attempts by the government to stabilise the economy. Since that time the federal government has actively tried to prevent contractions, end recessions and prolong expansions. Today the central bank, in Australia the Reserve Bank of Australia (RBA), also plays a role in economic stabilisation through its control of interest rates. Many economists believe that these government and central bank policies have played a key role in stabilising the economy in the years since 1950. For example, it has been argued that the increased economic spending by the government during the GFC reduced the severity of the effects on the Australian economy. Other economists, however, argue that active government policy has little effect, and in the case of increased government spending imposes long-run debt burdens on governments and

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future constraints on economic growth. During the GFC the RBA was also very active in lowering interest rates fast, which most economists credit with reducing the severity of the GFC effects. This macroeconomic debate is an important one, so we will consider it further in Chapters 12 and 13 when we discuss the federal government’s fiscal policies and the RBA’s monetary policies. 4 The stability of the financial system. The severity of the Great Depression of the 1930s was caused in part by the instability of the financial system in the United States. In 1929 many banks in the United States failed (over 5000), and the subsequent shortage of money and credit spread to many other countries, including Australia. The inflow of foreign borrowings to Australia, largely from London, suddenly stopped. Since Australian businesses and government were no longer able to borrow from overseas, private investment and government spending both fell by around 30 per cent between June 1929 and June 1930, causing major unemployment and falls in real GDP. The GFC of 2007–2008, which plunged many countries throughout the world into recessions, originated in the United States in 2007, caused by poor credit standards, high levels of borrowing and the lack of financial regulation by both the US government and the financial sector (see Making the connection 5.4 for details). Australia’s financial system had relatively little exposure to the ‘toxic’ debts held by financial institutions in other parts of the world, due to existing prudential regulations and more responsible lending practices by Australian financial institutions. Australia’s stable and sound financial system in large part shielded the economy from the severity of the GFC. If the United States and most European countries are to return to macroeconomic stability they will first have to stabilise their financial systems.

DO YOU HELP THE ECONOMY MORE IF YOU SPEND OR SAVE? At the beginning of the chapter, we posed a question: Which of your two friends is right—the one who argues that you would help the economy more by saving your tax refund, or the one who argues that you should spend it? In this chapter, we have seen that consumption spending promotes the production of more consumption goods and services, such as jeans and haircuts, and fewer investment goods and services, such as physical capital and worker education. Saving—and, therefore, not consuming—is necessary to fund investment expenditure. So, saving your tax refund will help the economy over the long run. But if the economy is in a contraction or recession, spending your refund will spur more production of consumption goods. In a sense, then, both of your friends are correct: spending your refund will help stimulate the economy during a contraction or recession, while saving it will help the economy grow over the long run.

ECONOMICS IN YOUR LIFE (continued from page 111)

CONCLUSION The Australian economy remains a remarkable engine for improving the wellbeing of Australians. The standard of living of Australians today is much higher than it was 100 years ago. But households and firms are still subject to the ups and downs of the business cycle and economic shocks which occur around this long-run upward trend. In the following chapters we continue our analysis of the basic observation that increasing long-run prosperity is often accompanied by short-run instability. Read ‘An inside look’ to learn of the growth trends in the Indian car industry and its links to the business cycle.

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AN INSIDE LOOK AUGUST 2013 THE HINDU 14

n r u t n w o d l a i r t Indus ekhar by C.P. Chandras

out the ething to say ab m so s ha n ur nt Rather that dow y. high growth stor us downturn. rio se a of st id m nability of India’s e ai th st in su e stimulus that is th of ry r of st to e e becaus lead indica Indian indu tru e th ly al n, ci tio pe uc es od This is construction strial Pr oduction and pr gistered factory The Index of Indu re g e rin th tu in ac s uf nd an tion tre , after a drove m ars. industrial produc nt in June 2012 ce r a’s high growth ye pe di 2 In 2. g ed rin at ct du th ra nt is g co ce housing , in or ry ct or w se went to finan . What is ay at M th in it e in ed cl cr g de durable acturin C Retail 2.8 per cent rchases and cting key manuf pu fe af ile is ob nd m tre to r ry au the passenge investment, this recessiona those years with g rapidly growing rin ce du on e ed th g om in an consumption bo sectors, includ Society of Indi from around 20 cording to the it to GDP rising Ac ed st . la cr ry e st nk th du ba in er of r ca ), ov ratio is private debt acturers (SIAM cent. It was th uf r r an pe M pe 50 69 ile 6. an ob y th m (b Auto s fell an important to more 2–13), car sale mand that was de 01 (2 in n ar io ye ns al pa ci ex finan passenger financed e in a decade. the case of the In tim . a st om fir of e bo rt th e r th pa fo ) of s cent demand th seem explanation l factor driving pa ci leration in grow – in ce pr 10 de e 20 th is d o, Th an A 05–06 car industry to nd. Between 20 to credit. th era, ow gr gh medium term tre hi s les was access a’ di sa In d an of ine in demand t os m rs is that the decl per cent is .2 th 15 of g 11, which cove in ry ch lla or ro A co en growth in les grew at a sc –12, e the credit-driv 11 us 20 ca in be nt passenger car sa ce be r y pe rtl problem with must pa had fallen to 4.7 to sustain. The lt cu ffi di per annum. That g . in ar ov ds when s is pr g last financial ye s on itself. Perio ding to sale ed on fe sp it re at before collapsin e th ar is rs ading it boom manufacture ts confidence, le asked a cred os y bo dl g rte in Not surprisingly, po om re bo s the economy is convinced that Maruti Suzuki ha the recession. ision by lenders Manesar plant to ov a pr at it rs ed ke cr or w ss ce porary pansion of the not to ex some of its tem is leads to an ex ta Kirloskar is Th yo y. To el le lik hi un w is e leav the proporfault ployees. Some de an extent where go on indefinite em to s ry er ra w po rro m bo te borrowers cts of n universe of renewing contra rs or subprime ended productio te sp ul fa su de a l di ia In nt ki ce of pote i Suzu is capable of tion of hen either eviden W time back Marut ch l. hi ve w le t, l an ca pl iti cr n e Gurgao exceeds some fault emerge, th for a day at its units every day. gns of rising de si 00 or 30 is of re at su ds Th ar . po w ex en delivering up trend in the over ers can be sudd asons why this overexposed lend re of y at an tre m e re e th ar r e fo B Ther disconcerting ing in India. dustry must be sector could child possibly happen er st po e th passenger car in e the automobile ns in se e a nc in rie as w pe ry ex indust d to keep What the th performance, government. The nfidence require ow co gr e th gh hi at st th ju is t to ing no w products, be pointing of reform, deliver n investment, ne ig re is waning. fo g nt in ca go at ifi th th gn n grow but also si competitio d an rts po ex e , som is industry is better technology e setback in th th So n. w do wnturn. kept prices sector-specific do a an th nt ca ifi far more sign THE HINDU

SOURCE: C. P. Chandrasekhar (2013), ‘Industrial downturn’, The Hindu, 14 August, at , viewed 24 October 2013.

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Key points in the article This article discusses the fast-growing Indian car industry during the period of economic expansion and boom between 2005/06 and 2010/11, and its subsequent decline during the economic contraction that began in 2011/12. This contraction in the Indian economy resulted in a severe downturn in the car industry. The article also discusses how the financial system, through the market for loanable funds, can contribute to the business cycle.

Analysing the news A The experience of India in the article shows stages in the business cycle which were discussed in this chapter. A contraction or recession will often begin with a decline in spending by households on consumer durables, such as cars. As spending declines, firms selling capital goods and consumer durables will find their sales declining. As sales decline, firms cut back on production and begin to lay off workers. Rising unemployment and falling profits reduce income, which leads to further declines in spending.

B Since 1991, when the Indian government introduced market-oriented economic reforms, the Indian economy has grown dramatically. This economic growth spurred a rapidly growing car industry in a relatively short timeframe. India remains an emerging economy, with low labour productivity and a low standard of living. Nonetheless, as countries develop, they tend to move from manufacturing simple goods like textiles to more complex goods like cars. And, in the case of India, car producers have enjoyed a competitive advantage over their overseas counterparts in part because labour costs in India remain extremely low.

137

C The article explains that the expansion phase of the business cycle in India was partly due to what was happening in the financial sector. High levels of bank loanable funds (increased liquidity) resulted in a shift in the supply curve for loanable funds. Figure 1 shows the rightward shift in the supply curve for loanable funds, which leads to a lower real rate of interest. This led to increased consumer spending on housing and consumer durables such as cars. The subsequent high level of debt also partly explains the subsequent contraction in the Indian economy and the downturn in the car industry. As debt increases the risk of default on some loans increases. (Note that in the United States during the global financial crisis, actual defaults were extensive.) Lenders become reluctant to lend and less loans are available for consumption, particularly for the purchase of cars. Also, households wishing to reduce their debt during an economic downturn cut back on demand. The result is a contraction in the economy and large falls in sales and production in the car industry. Thinking critically 1 Suppose the Indian government imposed restrictions on lending by Indian banks to limit the level of household debt relative to income. What effect would this policy have on India’s car production? What effect could it have on India’s long-run rate of economic growth? 2 India is in a stage of development where higher levels of GDP per capita drive demand for durable goods such as cars. Why might this make India more prone to severe business cycles compared to Australia?

FIGURE 1 AN INCREASE IN THE SUPPLY OF LOANABLE FUNDS LOWERS THE REAL RATE OF INTEREST, ENCOURAGING BORROWING FOR CONSUMPTION SPENDING ON CONSUMER DURABLES SUCH AS CARS Real interest rate (per cent)

S1 S2

i1 i2

D

L1

L2

Loanable funds (dollars per year)

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CHAPTER SUMMARY AND PROBLEMS KEY TERMS business cycle capital crowding out financial intermediaries

112 116 125 120

financial system human capital labour productivity long-run economic growth

119 116 116 113

market for loanable funds potential GDP

122 118

LONG-RUN ECONOMIC GROWTH IS THE KEY TO RISING LIVING STANDARDS, PAGES 112–119 LEARNING OBJECTIVE 5.1

Discuss the importance of long-run economic growth and its impact on living standards.

SUMMARY

PROBLEMS AND APPLICATIONS

The Australian economy experiences both long-run economic growth and the business cycle. The business cycle refers to alternating periods of expansion and contraction in economic activity relative to the trend in growth that the economy experiences in the long run. Long-run economic growth is the process by which rising productivity increases the standard of living of the typical person. Because of economic growth, the typical Australian today can buy more than five times as much as the typical Australian of 1900. Long-run growth is measured by increases in real GDP per capita. Increases in real GDP per capita depend on increases in labour productivity. Labour productivity is the quantity of goods and services that can be produced by one worker or by one hour of work. Economists believe two key factors determine labour productivity—the quantity of capital per hour worked and the level of technology. Physical capital refers to manufactured goods that are used to produce other goods and services. Human capital is the accumulated knowledge and skills workers acquire from education, training or their life experiences. Economists often discuss economic growth in terms of growth in potential GDP, which is the level of GDP attained when all firms are producing at normal capacity.

1.6

1.7

1.8

1.9

BILLIONS OF DOLLARS IN

REVIEW QUESTIONS 1.1

1.2

1.3

1.4

1.5

By how much did real GDP per capita increase in Australia between 1901 and 2013? Discuss whether the increase in real GDP per capita is likely to be greater or smaller than the true increase in living standards. What is the ‘rule of 70’? If real GDP per capita grows at a rate of 7 per cent per year, how many years will it take to double? What is the most important factor in explaining increases in real GDP in the long run? What supportive government policies are crucial for long-run economic growth? What two key factors cause labour productivity to increase over time? What is potential GDP? Does potential GDP remain constant over time?

Briefly discuss whether you would rather live in the Australia of 1901 with an income of $100 000 per year or the Australia of 2015 with an income of $50 000 per year. Assume the incomes for both years are measured at constant prices. After reading about economic growth in this chapter, elaborate on the importance of growth in GDP, particularly real GDP per capita, to the quality of life of a country’s population. [Related to Making the connection 5.1] Think about the relationship between economic prosperity and life expectancy. What implications does this relationship have for the size of the health care sector of the economy? In particular, is this sector likely to expand or contract in coming years? Use the table to answer the following questions.

1.10

1.11

YEAR

CONSTANT PRICES

2011

1075

2012

1120

2013

1160

2014

1175

2015

1200

a Calculate the economic growth rate for each year from 2011 to 2015. b Calculate the average annual economic growth rate for the period 2011 to 2015. a If Australian GDP per capita continued to grow at a rate of 3 per cent per year, how many years will it take for real GDP per capita to double? b The economy of China has boomed since the late 1970s, having periods of double-digit economic growth rates. At an 8 per cent growth rate in real GDP, how many years would it take for China’s economy to double? Labour productivity in the agricultural sector of Australia is more than 30 times higher than in the agricultural sector

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1.12

1.13

of China. What factors would cause Australian labour productivity to be so much higher than Chinese labour productivity? [Related to Solved problem 5.1] An article in The Economist magazine compares Panama to Singapore. It quotes Panama’s president as saying: ‘We copy a lot from Singapore and we need to copy more.’ The article observes that: ‘Panama is not even one-fifth as rich as its Asian model on a per-person basis. But Singapore would envy its growth: from 2005 to 2010 its economy expanded by more than 8% a year, the fastest rate in the Americas.’1 Judging from the experience of Singapore, if Panama is to maintain these high growth rates, what needs to be true about the sources of Panama’s growth? [Related to Solved problem 5.1] Two reasons for the rapid economic growth of China over the past two to three decades have been the massive movement of workers from

1.14

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agriculture to manufacturing jobs and the transformation of parts of its economy into a market system.2 In China, labour productivity in manufacturing substantially exceeds labour productivity in agriculture, and as many as 150 million Chinese workers will move from agriculture to manufacturing over the next decade or so. In 1978 China began to transform its economy into a market system, and today nearly 40 per cent of Chinese workers are employed in private firms (up from 0 per cent in 1978). In the long run, which of these two factors—movement of workers from agriculture to manufacturing or transformation of the economy into a market system—will be more important for China’s economic growth? Briefly explain. [Related to Making the connection 5.2] If the keys to Botswana’s rapid economic growth seem obvious, why have other countries in the region had so much difficulty achieving strong economic growth?

SAVING, INVESTMENT AND THE FINANCIAL SYSTEM, PAGES 119–126 LEARNING OBJECTIVE 5.2

Discuss the role of the financial system in facilitating long-run economic growth.

SUMMARY Financial markets and financial intermediaries together comprise the financial system. A well-functioning financial system is an important determinant of economic growth. Firms acquire funds from households, either directly through financial markets— such as the share and bond markets—or indirectly through financial intermediaries—such as banks. The funds available to firms come from saving. There are two categories of saving in the economy: private saving by households and public saving by the government. The value of total saving in the economy is always equal to the value of total investment spending. In the model of the market for loanable funds, the interaction of borrowers and lenders determines the market interest rate and the quantity of loanable funds exchanged.

2.6

A sound financial system is…essential for supporting economic growth.3 2.7

REVIEW QUESTIONS 2.1

2.2

2.3

2.4

Why is the financial system of a country important for long-run economic growth? Why is it vital for economic growth that firms have access to adequate sources of funds? How does the financial system—either financial markets or financial intermediaries—provide risk sharing, liquidity and information for savers and borrowers? Briefly explain why the total value of saving in the economy must equal the total value of investment. What are loanable funds? Why do businesses demand loanable funds? Why do households supply loanable funds?

PROBLEMS AND APPLICATIONS 2.5

Suppose you can receive an interest rate of 3 per cent on a term deposit at a bank that is charging borrowers 7 per cent on new car loans. Why might you be unwilling to

loan money directly to someone who wants to borrow from you to buy a new car, even if that person offers to pay you an interest rate higher than 3 per cent? A statement from the International Monetary Fund (IMF) made the following observation:

2.8

Do you agree with this observation? Briefly explain. Consider the following data for a closed economy: Y = $11 trillion C = $8 trillion I = $2 trillion TR = $1 trillion T = $3 trillion Use the data to calculate the following: a Private saving b Public saving c Government purchases d The government budget deficit or budget surplus Consider the following data for a closed economy: Y = $12 trillion C = $8 trillion G = $2 trillion Spublic = –$0.5 trillion T = $2 trillion Use the data to calculate the following: a Private saving b Investment spending c Transfer payments d The government budget deficit or budget surplus

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2.10

In problem 2.8, suppose that government purchases increase from $2 trillion to $2.5 trillion. If the values for Y and C are unchanged, what must happen to the values of S and I? Briefly explain. Use the following graph to answer the questions: Real interest rate (per cent)

2.12

S2 S1

i1 i2

D1

2.13 0

2.11

L2

Loanable funds (dollars per year)

L1

a Does the shift from S1 to S2 represent an increase or a decrease in the supply of loanable funds? b With the shift in supply, what happens to the equilibrium quantity of loanable funds? c With the change in the equilibrium quantity of loanable funds, what happens to the quantity of saving? What happens to the quantity of investment? Use the following graph to answer the questions. Real interest rate (per cent)

S1 C

i2

2.15

A

B

i1

D1 0

2.14

L1

L2

L3

D2 Loanable funds (dollars per year)

2.16

a With the shift in the demand for loanable funds, what happens to the equilibrium real interest rate and the equilibrium quantity of loanable funds? b How can the equilibrium quantity of loanable funds increase when the real interest rate increases? Doesn’t the quantity of loanable funds demanded decrease when the interest rate increases? c How much would the quantity of loanable funds demanded have increased if the interest rate had remained at i1?

d How much does the quantity of loanable funds supplied increase with the increase in the interest rate from i1 to i2? Suppose the economy is currently in a recession and that economic forecasts indicate that the economy will soon enter an expansion. What is the likely effect of the expansion on the expected profitability of new investment in plant and equipment? In the market for loanable funds, graph and explain the effect of the forecast of an economic expansion, assuming borrowers and lenders believe the forecast is accurate. What happens to the equilibrium real interest rate and the quantity of loanable funds (ceteris paribus)? What happens to the quantity of saving and investment? Firms care about their after-tax rate of return on investment projects. In the market for loanable funds, graph and explain the effect of an increase in taxes on business profits. (For simplicity, assume no change in the federal budget deficit or budget surplus.) What happens to the equilibrium real interest rate and the quantity of loanable funds? What will be the effect on the quantity of investment by firms and the economy’s capital stock in the future? Use market for loanable funds graphs to explain and illustrate what happens to the equilibrium real interest rate and the quantity of loanable funds, and the quantity of saving and investment in both of the following cases: a The effect of the federal budget surpluses in Australia that occurred from the late 1990s to 2007. b The federal budget deficits from 2008 onwards. [Related to Solved problem 5.2] Savers are taxed on the nominal interest payments they receive rather than the real interest payments. Suppose the government shifted from taxing nominal interest payments to taxing only real interest payments. Use a market for loanable funds graph to analyse the effects of this change in tax policy. What happens to the equilibrium real interest rate and the equilibrium quantity of loanable funds? What happens to the quantity of saving and investment? Making the Connection 5.3 claims that Ebenezer Scrooge promoted economic growth more when he was a miser and saved most of his income than when he reformed and began spending freely. Suppose, though, that most of his spending after he reformed involved buying food for the Cratchits and other poor families. Many economists believe that there is a close connection between how much very poor people eat and how much they are able to work and how productive they are while working. Does this fact affect the conclusion about whether the pre-reform or post-reform Scrooge had a more positive impact on economic growth? Briefly explain.

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THE BUSINESS CYCLE, PAGES 127–135 LEARNING OBJECTIVE 5.3

Understand what happens during the business cycle.

SUMMARY A business cycle consists of alternating periods of expansion and contraction in economic activity relative to the trend in growth that the economy experiences in the long run. During the expansion phase of a business cycle, production, employment and income are increasing above trend growth. The period of expansion ends with a business cycle peak. Following the business cycle peak, the growth in production, employment and income falls below the trend growth rate during the contraction phase. The contraction in economic activity may also lead to a fall in output and employment, which is referred to as a recession. The contraction or recession comes to an end with a business cycle trough, after which another period of expansion begins. The unemployment rate declines during the later part of an expansion and increases during a contraction or recession. The unemployment rate often continues to increase even after an expansion has begun. Economists have not found a method to predict when recessions will begin and end. Recessions are difficult to predict because they have more than one cause.

REVIEW QUESTIONS 3.1

What are the names of the following events in the business cycle? a The high point of economic activity b The low point of economic activity c The period between the high point of economic activity and the following low point d The period between the low point of economic activity and the following high point

3.2

3.3

Briefly describe the effect of the business cycle on the inflation rate and the unemployment rate. Why might the unemployment rate continue to rise during the early stages of a recovery? Briefly compare the severity of recessions in the first half of the twentieth century with recessions in the second half in Australia. Do economists agree on how to explain this difference?

PROBLEMS AND APPLICATIONS 3.4

3.5

3.6

3.7

Briefly explain whether production of each of the following goods is likely to fluctuate more or less during the business cycle than does real GDP. a Toyota cars b McDonald’s Big Macs c Westinghouse refrigerators d Huggies nappies e Boeing passenger aeroplanes [Related to Don’t let this happen to you] ‘GDP in 2014 was over $1.6 trillion. This value is a large number. Therefore, economic growth must have been high during 2014.’ Briefly explain whether you agree or disagree with this statement. Imagine you own a business and that during the next economic contraction you lay off (sack) 10 per cent of your workforce. Once economic activity picks up, why might you not immediately start re-hiring workers? From the history of the business cycle, do you think that the Australian economy will have another contraction within the next 20 years?

ENDNOTES 1 2 3

The Economist (2011), ‘A Singapore for Central America?’, 14 July, at , viewed 30 October 2013. Federal Reserve Bank of Dallas (2003), ‘China: Awakening giant’, Southwest Economy, September/October, p. 2. International Monetary Fund (IMF) (2009), ‘Financial system soundness’, Factsheet, April.

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6

LONG-RUN ECONOMIC GROWTH: SOURCES AND POLICIES LEARNING OBJECTIVES After studying this chapter you should be able to: 6.1 Describe global trends in economic growth. 6.2 Use the economic growth model to explain why economic growth rates differ between countries. 6.3 Discuss the fluctuations in productivity growth in Australia. 6.4 Explain economic catch-up and discuss why many poor countries have not experienced rapid economic growth.

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GOOGLE’S DILEMMA IN CHINA GOOGLE WAS FOUNDED in 1998 by Larry Page and Sergey Brin. By 2014, Google employed over 46 000 people and had annual revenues exceeding $55 billion. But Google encountered problems when expanding into China in 2006. The Chinese government insisted on regulating how people in that country access the Internet. In setting up Google.cn, Google had to agree to block searches of sensitive topics, such as the 1989 pro-democracy demonstrations in Tiananmen Square. In late 2009, hackers stole some of Google’s most important intellectual property by breaking into its computer system. Company executives suspected that Chinese government officials were involved in the theft. In January 2010, Google decided it would no longer cooperate with the Chinese government to censor Internet searchers and moved its Chinese search service from the mainland to Hong Kong. Google’s problems highlight one of the paradoxes of China in recent years: very rapid economic growth occurring in the context of government regulations that can stifle that growth. Throughout the first half of the twentieth century China was wracked by revolution and war. From the time the Communist Party seized control of China in 1949 until the late 1970s, the government controlled production and the country experienced very little economic growth. Mao Tse Tung, the Community Party leader, died in 1976, and two years later Deng Xiaoping, the new leader of the Party, began moving China away from a centrally planned economy towards a more market-oriented system. Statistics on the Chinese economy are not considered completely reliable, particularly for the period before 1978. However, the best estimates available indicate that real GDP per capita grew at an average annual rate of 1.8 per cent between 1952 and 1978. Between 1979 and 1995, real GDP per capita grew at a rate of 6.5 per cent per year; it grew at the white-hot rate of more than 9 per cent per year between 1996 and 2010, before slowing to between 7 and 8 per cent in the three years that followed. These rapid growth rates have transformed the Chinese economy: real GDP per capita today is 10 times higher than it was 50 years ago. But, as the experience of Google has shown, China is not a democracy, and the Chinese government has failed to fully establish the rule of law, particularly with respect to the consistent enforcement of property rights. This is a problem for the long-term prospects of the Chinese economy because, without the rule of law, entrepreneurs cannot fulfil their role in the market system of bringing together the factors of production—labour, capital and natural resources—to produce goods and services.

Getty Images Australia Pty Ltd

6

ECONOMICS IN YOUR LIFE

HAS THE RISE OF CHINA AFFECTED YOUR JOB OPPORTUNITIES? Prior to 1978, the Chinese economy was growing very slowly and its people were very poor. However, China has been experiencing very rapid economic growth over the past two decades. How does it affect you as someone about to start a career? Also, how does the current high-growth, high-export Chinese economy affect you as a consumer? As you read the chapter, see if you can answer these questions. You can check your answers against those we provide on page 164 at the end of this chapter.

SOURCE: Based on Steven Levy (2011), ‘Inside Google’s China misfortune’, Fortune, 15 April; Kathrin Hille (2011), ‘China renews Google’s website license’, The Financial Times, 7 September; Google Investor Relations (2014), 2014 Financial Tables, at , viewed 23 April 2014. Copyright © Pearson Australia (a division of Pearson Australia Group Pty Ltd) 2015 – 9781486010233 - Hubbard/Macroeconomics 3e

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ECONOMIC GROWTH IS not inevitable. For most of human history no sustained increases in output per capita occurred and, in the words of the philosopher Thomas Hobbes, the lives of most people were ‘poor, nasty, brutish and short’. Sustained economic growth first began with the Industrial Revolution in Britain in the late eighteenth century. From there, economic growth spread to the United States, Canada and the countries of Western Europe. Following World War II, rapid economic growth also began in Japan, but the economies of most other countries stagnated, leaving their people mired in poverty. Why have countries such as Australia, the United Kingdom and the United States, which had relatively high standards of living at the beginning of the twentieth century, continued to grow? Why have countries such as Argentina, which at one time had relatively high standards of living, failed to keep pace? Why was the former Soviet Union unable to sustain the rapid growth rates of its early years? Why are some countries that were very poor at the beginning of the twentieth century still very poor today? And why have some countries, such as South Korea and Japan, that were once very poor now become much richer? What explains China’s very rapid recent growth rates? We need to ask what factors explain these significantly different outcomes if we are to understand what leads to economic growth and improved standards of living, and what sometimes prevents it from happening. In this chapter we develop a model of economic growth that helps us to answer these important questions.

6.1 Describe global trends in economic growth. LEARNING OBJECTIVE

ECONOMIC GROWTH OVER TIME AND AROUND THE WORLD You live in a world that is very different from the world your grandparents lived in when they were young. You can listen to music on your smartphone, while your grandparents played vinyl records on a record player. You can buy a DVD and watch your favourite movies as many times as you want to, or download a movie from the Internet, while your grandparents could see movies only in a cinema. You can send an email to someone in another city, state or country, while your grandparents posted letters that took days or weeks to arrive. More importantly, you have access to health care and medicines that have prolonged life and improved its quality. In many poorer countries, however, people endure grinding poverty and some do not even have the bare necessities of life, just as their great-grandparents did not. The difference between you and people in poor countries is that you live in a country that has experienced substantial economic growth. With economic growth—growth in real gross domestic product (GDP)—an economy produces increasing quantities and types of goods and services. Real GDP per capita is the best measure of a country’s standard of living because it represents the ability of the average person to buy goods and services. We recognised in Chapter 4 that economic growth is not the only contributing factor to an increased standard of living; leisure time, health, education, environmental quality and other factors are also very important. However, it is only through economic growth that living standards can increase. Through most of human history no economic growth took place. Even today, billions of people are living in countries where economic growth is extremely low.

Economic growth from BC to the present For thousands of years BC our ancestors survived by hunting animals and gathering edible plants. Farming was many years in the future, and production was limited to food, clothing, shelter and simple tools. Economist Bradford DeLong estimated that in these primitive circumstances GDP per capita was only the bare amount necessary to sustain life, and remained that way until the year 1300 AD. In other words, no sustained economic growth occurred for thousands and thousands of years. Peasants toiling on farms in France in the year 1300 were no

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better off than their ancestors thousands of years before. In fact, for most of human existence the typical person had the bare minimum of food, clothing and shelter necessary to sustain life. Few people survived beyond the age of 40, and most people suffered from severe tooth decay, lice and debilitating illnesses. Significant economic growth did not begin until the Industrial Revolution, which started in Britain during the mid to late 1700s. The production of cotton cloth in factories using machinery powered by steam engines marked the beginning of the Industrial Revolution. Before that time production of goods had relied almost exclusively on human or animal power. The use of mechanical power spread to the production of many other goods, greatly increasing the quantity of goods each worker could produce. First Britain, and then other countries, such as the United States, France and Germany, experienced long-run economic growth, with sustained increases in real GDP per capita that eventually raised living standards in these countries to the high levels of today. Australia was colonised by the British in 1788, from which time onwards production techniques and mechanisation from Britain was adopted, which became the major contributor to Australia’s path of long-run economic growth. Figure 6.1 shows how growth rates of real GDP per capita for the world have changed over long periods. Prior to 1300 AD there were no sustained increases in real GDP per capita. Over the next 500 years to 1800 there was very slow growth. Significant growth began in the nineteenth century as a result of the Industrial Revolution. A further acceleration in growth occurred during the twentieth century as the average annual growth rate increased from 1.3 per cent per year to 2.3 per cent per year.

145

Industrial Revolution The application of mechanical power to the production of goods, beginning in Britain during the 1700s.

Small differences in growth rates are important The difference between 1.3 per cent and 2.3 per cent may seem trivial but, over long periods, small differences in growth rates can have a large impact. For example, suppose you have $100 in a savings account earning an annual interest rate of 1.3 per cent, which means you will receive an interest payment of $1.30 this year. If the interest rate on the account is 2.3 per cent you will earn $2.30. The difference of an extra $1.00 interest payment seems insignificant. But if you leave the interest as well as the original $100 in your account for another year, the difference becomes greater because now the higher interest rate is applied to a larger amount—$102.30—and the lower interest rate is applied to a smaller amount—$101.30. This process, known as compounding, magnifies even small differences in interest rates over long periods of time. Over a period of 50 years, your $100 would grow to $312 at an interest rate of 2.3 per cent but to only $191 at an interest rate of 1.3 per cent.

FIGURE 6.1

Rates of long-run growth in real GDP per capita 2.5%

2.3%

2.0

1.5

1.3%

1.0

World economic growth was essentially zero in the years before 1300, and very slow—an average of only 0.2 per cent per year—before 1800. The Industrial Revolution made possible the sustained increases in real GDP per capita that have allowed some countries to attain high standards of living SOURCE: J. Bradford DeLong (1998), Estimating World GDP, One Million B.C.–Present, Working Paper, University of California, Berkeley.

0.5 0.2% 0

Average annual growth rates for the world economy

0% BC–1300

1300–1800

1800–1900

1900–2000

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The principle of compounding applies to economic growth rates as well as interest rates. For example, in 1950 real GDP per capita in Argentina was $5474 (measured in US 2005 dollars), which was larger than Italy’s real GDP per capita of US$5361. Over the next 60 years the economic growth rate in Italy averaged 2.8 per cent per year, while in Argentina the growth rate was only 1.4 per cent per year. Although this difference in growth rates of only 1.4 percentage points may seem small, in 2010 real GDP per capita in Italy had risen to US$27 930, while real GDP per capita in Argentina was only US$12 931. In other words, because of a relatively small difference in the growth rates of the two economies the standard of living of the typical person in Italy went from being below that of the typical person in Argentina to being much higher. The important point to keep in mind is this: in the long run, small differences in economic growth rates result in big differences in living standards.

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6.1

ONNECTION

WHY DID THE INDUSTRIAL REVOLUTION BEGIN IN BRITAIN? The Industrial Revolution was a key turning point in human history. Before the Industrial Revolution economic growth was slow and halting. After the Industrial Revolution economic growth became rapid and sustained. Historians and economists have not reached a consensus on the key question: why did the Industrial Revolution occur where and when it did? Why the eighteenth century and not the sixteenth century or the twenty-first century? Why Britain and not China or India or Africa or Japan?

There is always a temptation to read history backwards. We know when and where the Industrial Revolution occurred, therefore it had to happen where it did and when it did. But what was so special about Britain in the eighteenth century? Douglass North, a winner of the Nobel Prize in Economics, has argued that institutions in Britain differed significantly from those in other Getty Images Australia Pty Ltd countries in ways that greatly aided economic growth. North believes that The British government’s guarantee of property the Glorious Revolution of 1688 was a key turning point. After that date the rights set the stage for the Industrial Revolution British parliament, rather than the king, controlled the government. The British court system also became independent of the king. As a result, the British government was credible when it committed to upholding private property rights, protecting wealth and eliminating arbitrary increases in taxes. These institutional changes gave entrepreneurs the incentive to make the investments necessary to use the important technological developments of the second half of the eighteenth century—particularly the spinning wheel and the water frame, which were used in the production of cotton textiles, and the steam engine, which was used in mining and in the manufacture of textiles and other products. Without the institutional changes entrepreneurs would have been reluctant to risk their property or their wealth by starting new businesses. Although not all economists agree with North’s specific argument about the origins of the Industrial Revolution, we will see that most economists accept the idea that economic growth is not likely to occur unless a country’s government provides the type of institutional framework North describes. SOURCE: Douglass C. North (2005), Understanding the Process of Economic Change, Princeton University Press; Douglass C. North and Barry R. Weingast (1989), ‘Constitutions and commitment: The evolution of institutions governing public choice in seventeenth-century England’, Journal of Economic History, Vol. 49, No. 4, December.

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DON’T LET THIS HAPPEN TO YOU

Don’t confuse average annual percentage change with total percentage change When economists talk about growth rates over a period of more than one year, the numbers are always average annual percentage changes and not total percentage changes. For example, real GDP in Australia was approximately $236 billion in 1960 and $1493 billion in 2013. The percentage change in real GDP between these two years is: $1493 billion – $236 billion × 100 = 533% $236 billion Averaging 533 per cent over 53 years would give an incorrect measure of the annual growth rate of 10.1 per cent. However, this is not the growth rate between the two years. As we discussed in Chapter 5, the growth rate between these two years is the rate at which $236 billion in 1960 would have to grow on average each year to end up as $1493 billion in 2013, which is 3.54 per cent (calculated by using a compounding calculator).

[ YOUR TURN Q

Test your understanding by doing related problem 1.6 on page 168 at the end of this chapter.

IS INCOME ALL THAT MATTERS? The more income you have, the more goods and services you can buy. When people are surviving on very low incomes of $2 per day or less, their ability to buy even minimal amounts of food, clothing and housing is limited. So, most economists argue that unless the incomes of the very poor increase significantly, they will be unable to attain a higher standard of living. In some countries— primarily those coloured yellow in Figure 6.2—the growth in average income has been very slow, or even negative, over a period of decades. Many economists and policy-makers have concluded that the standard of living in these countries has been largely unchanged for many years.

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ONNECTION

6.2

Recently, however, some economists have argued that if we look beyond income to other measures of the standard of living, we can see that even the poorest countries have made significant progress in recent decades. For example, Charles © Stephanie Rabemiafara/Art in All of Us/Corbis Kenny, an economist with the World Bank, argues that ‘those countries with the In sub-Saharan Africa and other parts of the world, lowest quality of life are making the fastest progress in improving it—across a increases in technology and knowledge are range of measures including health, education, and civil and political liberties.’ leading to improvements in health care and the For example, between 1960 and 2010, deaths among children declined, often by standard of living more than 50 per cent, in nearly all countries, including most of those with the lowest incomes. Even in sub-Saharan Africa, where growth in incomes has been very slow, the percentage of children dying before age five has decreased by more than 30 per cent over the past 50 years. Similarly, the percentage of people able to read and write has more than doubled in sub-Saharan Africa since 1970. Many more people now live in democracies where basic civil rights are respected than at any other time in world history. Although some countries, such as Somalia, the Democratic Republic of the Congo and Afghanistan, have suffered from civil wars, political instability has also decreased in many countries in recent years, which has reduced the likelihood of dying from violence. What explains these improvements in health, education, democracy and political stability? Economist William Easterly has found that although at any given time, countries that have a  higher income also have a higher standard of living, over time increases in income within a particular country typically have very little effect on the country’s standard of living in terms of health, education, individual rights, political stability and similar factors. Kenny’s argument and

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Easterly’s finding are connected: some increases in living standards do not require significant increases in income. The key factors in raising living standards in low-income countries have been increases in technology and knowledge—such as the development of inexpensive vaccines that reduce epidemics or the use of mosquito-resistant netting that reduces the prevalence of malaria—that are inexpensive enough to be widely available. Changes in attitudes, such as placing a greater value on education, particularly for girls, or increasing support for political freedoms, have also played a role in improving conditions in low-income countries. There are limits, of course, to how much living standards can increase if incomes stagnate. Ultimately, much higher rates of economic growth will be necessary for low-income countries to close the gap in living standards significantly with high-income countries. SOURCE: Charles Kenny (2011), Getting Better, New York, Basic Books; Ursula Casabonne and Charles Kenny (2011), ‘The best things in life are (nearly) free: Technology, knowledge and global health,’ Centre for Global Development, Working Paper No. 252, at , viewed 6 November 2013; William Easterly (1999), ‘Life during growth,’ Journal of Economic Growth, Vol. 4, No. 3, September, pp. 239–276.

Why do growth rates matter? Why should anyone care about growth rates? Growth rates matter because an economy that grows too slowly fails to raise living standards. In some countries in Africa and Asia very little economic growth has occurred in the past 50 years, so many people remain in severe poverty. In high-income countries only four out of every 1000 babies die before the age of one. In the poorest countries more than 100 out of every 1000 babies die before the age of one, and millions of children die each year from diseases that could be avoided by having access to clean water or cured by using medicines that cost only a few dollars. Although their problems are less dramatic, countries that experience slow growth have also missed an opportunity to improve the lives of their citizens. For example, the failure of Argentina to grow as rapidly as the other countries that had similar levels of GDP per capita in 1950 has left many of its people in poverty. Life expectancy in Argentina is several years lower than in Australia and other high-income countries, and almost three times as many babies in Argentina die before the age of one.

‘The rich get richer and . . .’ We can divide the world’s economies into groups: the high-income countries, sometimes also referred to as the industrialised countries, and poorer countries or developing countries. The high-income countries include the countries of Western Europe, Australia, Canada, Japan, New Zealand and the United States. The developing countries include most of the countries of Asia, Africa and Latin America. In the 1980s and 1990s a small group of countries, mostly East Asian countries such as the Republic of Korea (South Korea), Malaysia, Taiwan and Singapore, experienced high rates of growth and were sometimes referred to as the newly industrialising countries. Of these, Hong Kong, Singapore, South Korea and Taiwan are now classified as high-income countries. Among those currently classified as newly industrialising countries are Mexico, Brazil, China, India, Malaysia, Thailand and the Philippines. Figure 6.2 shows the levels of GDP per capita around the world in 2010. GDP is measured in US dollars, corrected for differences between countries in the cost of living. In 2010 GDP per capita ranged from a high of over US$82 600 in Luxembourg to a low of US$300 in the African countries of Burundi and the Democratic Republic of the Congo. To understand why the gap between rich and poor countries exists we need to look at what causes economies to grow.

6.2 Use the economic growth model to explain why economic growth rates differ between countries. LEARNING OBJECTIVE

WHAT DETERMINES HOW FAST ECONOMIES GROW? To explain changes in economic growth rates over time within countries, and differences in growth rates between countries, we need to develop an economic growth model. An economic

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FIGURE 6.2

GDP per capita, 2012 GDP per capita is measured in US dollars, corrected for differences between countries in the cost of living

Greater than $20 000 Between $10 000 and $20 000 Between $2500 and $10 000 Less than $2500

growth model explains growth rates in real GDP per capita. As we noted in Chapter 5, the average person can buy more goods and services only if the average worker produces more goods and services. Labour productivity is the quantity of goods and services that can be produced by one worker or by one hour of work. Because of the importance of labour productivity in explaining economic growth, the economic growth model focuses on the causes of long-run increases in labour productivity. How can a country’s workers become more productive? As we saw in Chapter 5, economists believe two key factors determine labour productivity: the quantity of capital per hour worked and the level of technology. Therefore, the economic growth model will focus on technological change and changes over time in the quantity of capital per hour worked in explaining changes in real GDP per capita. Recall that technological change is a change in the ability of a firm to produce output with a given quantity of inputs.

Economic growth model A model that explains changes in real GDP per capita in the long run. Labour productivity The quantity of goods and services that can be produced by one worker or by one hour of work. Technological change A change in the ability of a firm to produce output with a given quantity of inputs.

Technological change There are three main sources of technological change: 1 Better machinery and equipment. Beginning with the steam engine during the Industrial Revolution, the invention of new machinery has been an important source of rising labour productivity. Today, continuing improvements in computers, factory machines, tools, electric generators and many other machines contribute to increases in labour productivity. 2 Increases in human capital. Capital refers to physical capital, including computers, factory buildings, machines, tools, warehouses and trucks. The more physical capital workers have available, the more output they can produce. Human capital is the accumulated knowledge and skills that workers acquire from education and training or from their life experiences. As workers increase their human capital through education or on-the-job training, their

Human capital The accumulated knowledge and skills workers acquire from education and training or from their life experiences.

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productivity will also increase. The more educated workers are the greater is their human capital. 3 Better means of organising and managing production. Labour productivity will increase if managers can do a better job of organising production. For example, the just-in-time system, first developed by Toyota Motor Corporation, involves assembling goods from parts that arrive at the factory at exactly the time they are needed. With this system Toyota needs fewer workers to store and keep track of parts in the factory, so the quantity of goods produced per hour worked increases. Note that technological change is not the same thing as more physical capital. New capital can embody technological change, such as when a faster computer chip is embodied in a new computer. But simply adding more capital that is the same as existing capital is not technological change. To summarise, we can say that a country’s standard of living will be higher the more capital workers have available, the better the capital, the more human capital workers have and the better job business managers do in organising production.

The per-worker production function

Per-worker production function The relationship between real GDP, or output, per hour worked and capital per hour worked, holding the level of technology constant.

The economic growth model explains increases in real GDP per capita over time as resulting from increases in just two factors: the quantity of physical capital available to workers and technological change. Often when analysing economic growth we look at increases in real GDP per hour worked and increases in capital per hour worked. We use measures of GDP per hour and capital per hour rather than per person so we can analyse changes in the underlying ability of an economy to produce more goods with a given amount of labour without having to worry about changes in the proportion of the population working or in the length of the working day. We can illustrate the economic growth model using the per-worker production function, which is the relationship between real GDP, or output, per hour worked and capital per hour worked, holding the level of technology constant. Figure 6.3 shows the per-worker production function as a graph. In the figure we measure capital per hour worked along the horizontal axis and real GDP per hour worked along the vertical axis. Letting K stand for capital, L stand for labour and Y stand for real GDP, real GDP per hour worked is Y/L and capital per hour worked is K/L. The curve represents the production function. Notice that we do not explicitly show technological change in the figure. We assume that as we move along the production function the level of technology remains constant. As we will see, we can illustrate technological change using this graph by shifting up the curve representing the production function.

FIGURE 6.3

The per-worker production function The per-worker production function shows the relationship between capital per hour worked and real GDP per hour worked, holding technology constant. Increases in capital per hour worked increase output per hour worked, but at a diminishing rate. For example, an increase in capital per hour worked from $20 000 to $30 000 increases real GDP per hour worked from $200 to $350. An increase in capital per hour worked from $30 000 to $40 000 increases real GDP per hour worked only from $350 to $475. Each additional $10 000 increase in capital per hour worked results in progressively smaller increases in output per hour worked

Real GDP per hour worked, Y/L

Per-worker production function

2. . . . lead to diminishing increases in output per hour worked.

$575 475 350 1. Equal increases in capital per worker . . .

200

0

$20 000

30 000

40 000

50 000

Capital per hour worked, K/L

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151

The figure shows that increases in the quantity of capital per hour worked result in movements up the per-worker production function, increasing the quantity of output each worker produces. When holding technology constant, however, equal increases in the amount of capital per hour worked lead to diminishing increases in output per hour worked. For example, increasing capital per hour worked from $20 000 to $30 000 increases real GDP per hour worked from $200 to $350, an increase of $150. Another $10 000 increase in capital per hour worked, from $30 000 to $40 000, increases real GDP per hour worked from $350 to $475, an increase of only $125. Each additional $10 000 increase in capital per hour worked results in progressively smaller increases in real GDP per hour worked. In fact, at very high levels of capital per hour worked further increases in capital per hour worked will not result in any increase in real GDP per hour worked. This effect results from the law of diminishing returns, which states that as we add more of one input—in this case, capital—to a fixed quantity of another input—in this case, labour—output increases by smaller additional amounts. Why are there diminishing returns to capital? Consider a simple example in which you own a photocopying store. At first you have 10 employees but only one photocopier, so each of your workers is able to produce relatively few copies per day. When you buy a second photocopier your employees will be able to produce more copies. Adding additional photocopiers will continue to increase your output but by increasingly smaller amounts. For example, adding a twentieth photocopier to the 19 you already have will not increase the copies each worker is able to make by nearly as much as adding a second photocopier did. Eventually, adding additional photocopying machines will not increase your output at all.

Which is more important for economic growth: more capital or technological change? Technological change helps economies avoid diminishing returns to capital. Let’s consider two simple examples of the effects of technological change. First, suppose you have 10 photocopiers in your photocopying store. Each of the photocopiers can produce 30 copies per minute. You don’t believe that adding an eleventh machine, identical to the 10 you already have, will significantly increase the number of copies your employees can produce in a day. Then you find out that a new photocopier has become available that produces 60 copies per minute. If you replace your existing machines with the new machines the productivity of your workers will increase. The replacement of existing capital with more productive capital is an example of technological change. Or suppose you realise that the layout of your store could be improved. Perhaps the paper for the machines is on shelves at the back of the store, which requires your workers to spend time walking back and forth whenever the machines run out of paper. By placing the paper closer to the photocopiers you will also improve the productivity of your workers. Reorganising how production takes place in order to increase output is also an example of technological change.

Technological change: the key to sustaining economic growth Figure 6.4 shows the impact of technological change on the per-worker production function. Technological change shifts up the per-worker production function and allows an economy to produce more real GDP per hour worked with the same quantity of capital per hour worked. For example, if the current level of technology puts the economy on Production function1, then when capital per hour worked is $50 000, real GDP per hour worked is $575. Technological change that shifts the economy to Production function2 makes it possible to produce $675 in goods and services per hour worked with the same level of capital per hour worked. Further increases in technology that shift the economy to higher production functions result in further increases in real GDP per hour worked. Because of diminishing returns to capital, continuing increases in real GDP per hour worked can be sustained only if there is technological change. Remember that a country will experience increases in its standard of living only if it experiences increases in real GDP per hour worked. Therefore, we can draw the following important conclusion: in the long run, a country will experience an increasing standard of living only if it experiences continuing technological change.

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FIGURE 6.4

Real GDP per hour worked, Y/L

Technological change increases output per hour worked Technological change shifts up the production function and allows more output per hour worked with the same amount of capital per hour worked. For example, along Production function1 with $50 000 in capital per hour worked the economy can produce $575 in real GDP per hour worked. However, an increase in technology that shifts the economy to Production function2 makes it possible to produce $675 in real GDP per hour worked with the same level of capital per hour worked

C

A K I N G THE

6.3

ONNECTION

Production function3

775

Production function2

675

Production function1

575 Technological change causes the per-worker production function to shift up.

0

M

Production function4

$875

$50 000

Capital per hour worked, K/L

WHAT EXPLAINS THE ECONOMIC FAILURE OF THE SOVIET UNION? The economic growth model can help explain one of the most striking events of the twentieth century: the economic collapse of the Soviet Union. The Soviet Union was formed from the old Russian Empire following the communist revolution of 1917. Under Communism the Soviet Union was a centrally planned economy where the government owned nearly every business and made all production and pricing decisions. In 1960 Nikita Khrushchev, the leader of the Soviet Union, addressed the United Nations in New York City. He declared to the United States and the other democracies, ‘We will bury you. Your grandchildren will live under Communism.’ Many people at the time took Khrushchev’s boast seriously. Capital per hour worked grew rapidly in the Soviet Union from 1950 to the 1980s. At first, these increases in capital per hour worked also produced rapid increases in real GDP per hour worked. Rapid increases in real GDP per hour worked during the 1950s caused some economists in the United States to predict incorrectly that the Soviet Union would someday surpass the United States economically. In fact, diminishing returns to capital meant that the additional factories the Soviet Union was building resulted in smaller and smaller increases in real GDP per hour worked.

© Bettmann/CORBIS

The fall of the Berlin Wall in 1989 symbolised the failure of Communism

The Soviet Union did experience some technological change, but at a rate much slower than in the United States and other high-income countries. Why did the Soviet Union fail the crucial requirement for growth: implementing new technologies? The key reason is that in a centrally planned economy the people in charge of running most businesses are government employees and not entrepreneurs or independent business people, as is the case in market economies. Soviet managers had little incentive to adopt new ways of doing things. Their pay depended on producing the quantity of output specified in the government’s economic plan, not on discovering new, better and lower-cost ways to produce goods. In addition, these managers did not have to worry about competition from either domestic or foreign firms.

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In contrast, entrepreneurs and managers of firms in market economies such as Australia, Hong Kong and the United States are under intense competitive pressure from other firms. They must constantly search for better ways of producing the goods and services they sell. Developing and using new technologies is an important way to gain a competitive edge and higher profits. The drive for profit provides an incentive for technological change that centrally planned economies are unable to duplicate. In market economies decisions about which investments to make and which technologies to adopt are made by entrepreneurs and managers with their own money on the line. In the Soviet system these decisions were usually made by salaried bureaucrats trying to fulfil a plan formulated in Moscow. Nothing concentrates the mind like having your own funds at risk. In hindsight, it is clear that a centrally planned economy, such as the Soviet Union’s, could not, over the long run, grow faster than a market economy. The Soviet Union collapsed in 1991, and contemporary Russia now has a more market-oriented system, although the government continues to play a much larger role in the economy than governments in many other market economies.

SOLVED PROBLEM 6.1 USING THE ECONOMIC GROWTH MODEL TO ANALYSE THE FAILURE OF THE SOVIET UNION’S ECONOMY Use the economic growth model and the information in Making the connection 6.3, ‘What explains the economic failure of the Soviet Union?’, to analyse the economic problems the Soviet Union encountered.

Solving the problem STEP 1: Review the chapter material. This problem is about using the economic growth model to explain the failure of the Soviet economy,

so you may want to review Making the connection 6.3, ‘What explains the economic failure of the Soviet Union?’ on page 152. STEP 2: Draw a graph like Figure 6.3 to illustrate the economic problems of the Soviet Union. For simplicity we can assume that the

Soviet Union experienced no technological change. Real GDP per hour worked, Y/L

2. . . . led to only diminishing increases in output per hour worked.

Y/L1980 Y/L1970

Production function

Y/L1960

1. Continuing rapid increases in capital per hour worked . . .

Y/L1950

0

K/L1950

K/L1960

K/L1970

K/L1980

Capital per hour worked, K/L

The Soviet Union experienced rapid increases in capital per hour worked from 1950 to the 1980s, but its failure to implement new technology meant that output per hour worked grew at a slower and slower rate. EXTRA CREDIT: The Soviet Union hoped to raise the standard of living of its citizens above that enjoyed in high-income market

economies. Its strategy was to make continuous increases in the quantity of capital available to its workers. The economic growth model helps us understand the flaws in this policy for achieving economic growth.

[ YOUR TURN Q

For more practice do related problems 2.6 and 2.7 on page 170 at the end of this chapter.

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New growth theory

New growth theory A model of long-run economic growth that emphasises that technological change is influenced by economic incentives, and so is determined by the working of the market system.

Patent The exclusive right to produce a product for a period of time from the date the product was invented.

The economic growth model we have been using was first developed in the 1950s by Robert Solow, a winner of the Nobel Prize in Economics. According to this model productivity growth is the key factor in explaining long-run growth in real GDP per capita. In recent years some economists have become dissatisfied with this model because it does not explain the factors that determine productivity growth. What has become known as the new growth theory (or endogenous growth theory) was developed by economist Paul Romer to provide a better explanation of the sources of productivity change. Romer argues that the rate of technological change is influenced by how individuals and firms respond to economic incentives. Earlier accounts of economic growth left technological change unexplained or attributed it to factors such as chance scientific discoveries. Romer argues that the accumulation of knowledge capital is a key determinant of economic growth. Firms contribute to an economy’s stock of knowledge capital when they engage in research and development or otherwise contribute to technological change. We have seen that accumulation of physical capital is subject to diminishing returns: increases in capital per hour worked lead to increases in real GDP per hour worked, but at a decreasing rate. Romer argues that the same is true of knowledge capital, at the firm level. As firms add to their stock of knowledge capital they will increase their output, but at a decreasing rate. At the level of the entire economy rather than just individual firms, however, Romer argues that knowledge capital is subject to increasing returns. Increasing returns can exist because knowledge, once discovered, becomes available to everyone. The use of physical capital, such as a computer or machine factory, is rival because if one firm uses it other firms cannot, and excludable because the firm that owns the capital can keep other firms from using it. The use of knowledge capital, such as the chemical formula for a drug that cures cancer, is non-rival, however, because one firm’s use of this knowledge does not prevent another firm from using it. Knowledge capital is also non-excludable because, once something like a chemical formula becomes known, it becomes widely available for other firms to use (unless, as we will soon discuss, the government gives the firm that invents a new product the legal right to its exclusive use). Because knowledge capital is non-rival and non-excludable, firms can free ride on the research and development of other firms. Firms free ride when they benefit from the results of research and development they did not pay for. For example, transistor technology was first developed at Western Electric’s Bell Laboratories in the 1950s and served as the basic technology of the information revolution. Bell Laboratories, however, received only a tiny fraction of the immense profits that were eventually made by all the firms that used this technology. Romer points out that firms are unlikely to invest in research and development up to the point where the marginal cost of the research equals the marginal return from the knowledge gained because much of the marginal return will be gained by other firms. Therefore there is likely to be an inefficiently small amount of research and development, slowing the accumulation of knowledge capital and economic growth. Government policy can help increase the accumulation of knowledge capital in three ways: 1 Protecting intellectual property with patents and copyrights. Governments can increase the incentive to engage in research and development by giving firms the exclusive rights to their discoveries for a period of years. The Australian federal government, through its Department of Intellectual Property, Australia, grants patents to companies that develop new products or new ways of making existing products. A standard patent gives a firm the exclusive legal right to produce a new product for a period of time (20 years in Australia) from the date the product was invented. For example, a pharmaceutical firm that develops a drug can secure a patent on the drug, keeping other firms from manufacturing the drug without permission. The profits earned during the period the patent is in force provide an incentive for undertaking the research and development. The patent system has drawbacks, however. In filing for a patent, firms must disclose information about the product or process. This information enters the public record and may help competing firms develop products or processes that are similar but that do not infringe on the patent. To avoid this problem some firms try to keep the results of their research a trade secret, without patenting it. A famous example of a trade secret is the formula for

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Coca-Cola. Tension also arises between the government’s objectives of providing patent protection that give firms the incentive to engage in research and development and making sure that the knowledge gained by the research is widely disseminated for the greatest impact on the economy. Economists debate the characteristics of an ideal patent system. Just as a new product or a new method of making a product receives patent protection, so books, movies, music and software receive copyright protection. The Australian Copyright Council awards the creator of a book, movie, piece of music or software program the exclusive right to use the creation during the creator’s lifetime. If the creation was published before 2005 the creator’s heirs retain this exclusive right for 50 years after the creator’s death or 50 years from when the material was first published. Following a change in copyright law, this period of time was extended to 70 years if the creation occurred after 1 January 2005. 2 Subsidising research and development. The government can use subsidies to increase the quantity of research and development that takes place. For example, the federal government’s National Health and Medical Research Council subsidises research institutes and universities to carry out medical research. The government also provides tax benefits to firms that invest in research and development. 3 Subsidising education. People with technical training carry out research and development. If firms are unable to capture all the profits from research and development, the wages and salaries paid to technical workers will be reduced. These lower wages and salaries reduce the incentive to workers to receive this training. If the government subsidises education it can increase the number of workers with technical training. In Australia the government subsidises education by directly providing free education from kindergarten to Year 12, and by providing substantial financial support for Technical and Further Education (TAFE) colleges and universities. The government also pays a portion of the full cost of student tertiary education fees and provides interest-free student loans, the repayments of which are indexed to inflation. Further, there is a range of schemes and subsidies for apprenticeships and on-the-job training.

155

Copyright The legal right of the creator of a book, movie, piece of music or software program to the exclusive right to use the creation during the creator’s lifetime, plus an additional period of time for their heirs.

These government policies can bring the accumulation of knowledge capital closer to the optimal level.

Joseph Schumpeter and creative destruction The new growth theory has revived interest in the ideas of Joseph Schumpeter. Born in Austria in 1883 he served briefly as that country’s finance minister before becoming an economics professor at Harvard University in 1932. Schumpeter developed a model of growth that emphasised his view that new products unleash a ‘gale of creative destruction’ that drives older products—and often the firms that produced them—out of the market. According to Schumpeter, the key to rising living standards is not small changes to existing products but, rather, products that meet consumer wants in qualitatively better ways. For example, in the early twentieth century the car displaced the horse-drawn carriage by meeting consumer demand for personal transportation in a way that was qualitatively better. In the early twentyfirst century, the DVD and the DVD player displaced the VHS tape and the VCR by meeting consumer demand for watching movies in a higher quality format at home. Downloading or streaming movies from the Internet may be the process of displacing the DVD. To Schumpeter, the entrepreneur is central to economic growth: The function of entrepreneurs is to reform or revolutionise the pattern of production by exploiting an invention or, more generally, an untried technological possibility for producing new commodities or producing an old one in a new way.1 The profits an entrepreneur hopes to earn provide the incentive for bringing together the factors of production—labour, capital and natural resources—to start new firms and introduce new goods and services. Successful entrepreneurs can use their profits to finance the development of new products and are better able to attract funds from investors.

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ECONOMIC GROWTH IN AUSTRALIA 6.3 Discuss the fluctuations in productivity growth in Australia. LEARNING OBJECTIVE

The above theories of economic growth can also help us understand the record of growth in Australia. Figure 6.5 shows the average annual economic growth rates and labour productivity from 1861 to 2012. Prior to British colonisation Australia comprised a small, subsistence Aboriginal population. The economy consisted almost entirely of hunter– gatherer activities. British settlement of Australia began in 1788, with the establishment of a colony in Botany Bay. Until the early 1800s the principal economic activities involved small-scale farming and public sector activities associated with the management of penal institutions. Throughout the nineteenth century more rapid economic development occurred with the expansion of agricultural land and the discovery of mineral deposits. The labour force also expanded rapidly due to high birth rates and high rates of immigration. Capital was accumulated from domestic savings and borrowed from overseas. New technologies that were developed overseas, such as the steam engine, railroads and the telegraph, were brought to Australia. These factors contributed to the increase in the quantity of capital per hour worked, fuelling rising labour productivity growth rates and economic growth. Between 1861 and 1891 labour productivity growth averaged an annual rate of 1.5 per cent and economic growth averaged an annual rate of 4.7 per cent. On the demand side of the market, strong demand for goods and services arose from a booming export market, particularly for wool in the 1820s, 1830s and 1860s, and gold

FIGURE 6.5

Average annual economic growth rates and labour productivity in Australia, 1861–2012 Economic growth and labour productivity growth between the late 1940s and early 1970s averaged 4.6 per cent and 2.3 per cent respectively. Then the unexpected happened: for almost 20 years, from 1973 to 1991, labour productivity growth rates in Australia fell substantially, closely mirroring the experiences of other developed countries. Economic growth and labour productivity growth in Australia began to commence another long period of growth from the early 1990s following a period of significant structural reforms and market deregulation in the economy, and increased technological change. From the mid-2000s to 2012, a significant productivity growth slow-down occurred 5.0 4.5

Real GDP

4.0

Productivity

3.5

Per cent

3.0 2.5 2.0 1.5 1.0 0.5 0.0 1861–1891

1890s–1940s

1940s–1974

1975–1990

1991–1994

1995–2000

2001–2005

2006–2012

Note: The labour productivity values until 1991 are real GDP per worker, after which they are real GDP per hour worked. SOURCE: Created from E.A. Boehm (1993), Twentieth Century Economic Development in Australia, 3rd edition, Melbourne, Longman Cheshire. Data from 1991 onwards were derived from: Australian Bureau of Statistics (2007), Experimental Estimates of Industry Multifactor Productivity, 2006–07, Table 3, Cat. No. 5260.0.055.002 at , viewed 28 November 2013; Australian Bureau of Statistics (2012), Estimates of Industry Multi-factor Productivity, Table 2, Cat. No. 5260.0.055.002 at , viewed 28 November 2013.

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in the 1850s, and also from high population growth rates. For example, the population grew from 15 000 in 1815 to four million by 1900. Following droughts in the late 1890s and early 1900s, the negative economic growth effect of World War I and the Great Depression of the early 1930s, the average annual rate of economic growth fell to 2.2 per cent between 1891 and 1939, with labour productivity averaging 0.4 per cent per year. It was not until the ‘Long Boom’ from 1940 to 1970 that Australia entered a period of significant industrialisation and strong growth in labour productivity.

Economic growth and labour productivity in Australia since 1940 Australia entered a period of industrialisation following the Great Depression, which accelerated during World War II. Investment in manufacturing, services and rural land development, together with technological change, allowed the growth rate of the Australian economy to accelerate over time until the early 1970s. As Figure 6.5 shows, economic growth and labour productivity growth between the late 1940s and early 1970s averaged 4.6 per cent and 2.3 per cent respectively. Then the unexpected happened: for almost 20 years, from 1973 to 1991, labour productivity growth rates in Australia fell substantially, closely mirroring the experiences of other developed countries. The average economic growth rate during these years was 1.5 per cent per year lower than during the Long Boom, with labour productivity growth falling by almost one percentage point, to an annual average of 1.2 per cent. Economic growth and labour productivity growth in Australia began another long period of growth from the early 1990s to the mid-2000s, following a period of significant structural reforms in the economy, market deregulation and increased technological change. However, from 2006 to 2012 labour productivity growth rates again declined, averaging an annual rate of around 1.7 per cent. This prompted calls for increased government investment in infrastructure, particularly in the transport and utilities industries, to provide capital and technology to enable future productivity growth. It also led many economists to argue for reducing market regulations, particularly in the labour market, since reregulation had occurred between 2007 and 2012.

What caused the productivity slowdown of the 1970s and 1980s? Several explanations have been offered for the productivity slowdown of the 1970s and 1980s: • High oil prices • Regulated markets • Trade protection

Was it the effect of high oil prices? In 1973 the Organization of Petroleum Exporting Countries (OPEC) increased the price of a barrel of oil from less than US$3 to more than US$10. A second sharp increase in oil prices occurred in the late 1970s, when the price of a barrel of oil rose from about US$20 to more than US$35. These higher oil prices increased production costs for many firms in Australia. Some firms use oil directly in the production process. Other firms use products, such as plastics, that are made from oil. Some utilities burn oil to generate electricity, so electricity prices rose. Rising oil prices led to rising petrol prices, which raised transportation costs for many firms. To conserve oil and use less energy firms reorganised production in ways that reduced output per hour worked. In the early 1980s many economists thought the oil price increases explained the productivity slowdown, but the productivity slowdown continued after Australian firms had adjusted to high oil prices. In fact, it continued into the late 1980s when oil prices declined.

Was it due to highly regulated markets? Until the 1980s many areas of Australian industry were subject to quite restrictive government regulations on the number of firms allowed to operate, the behaviour of firms (including trading hours), the marketing of products and the level of foreign investment. Economists

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believe that competition in the market was stifled by excessive regulation, discouraging innovation and preventing new investment (particularly from overseas), leading to low rates of productivity growth. During the 1980s and particularly during the 1990s Australia experienced quite rapid removal of the regulations that had restricted competition and reduced flexibility in the market. New competitors were allowed in the formerly monopolised telecommunications industry, and other industries such as banking, transport, utilities and agricultural marketing were also deregulated, allowing for more competition. Many formerly owned government business enterprises were either sold to the private sector or remained under government ownership but were made to operate more in line with commercial principles. Most economists agree that too much regulation stifles competition.

Was it the result of trade protection? Tariff A tax imposed by the government on imported goods.

Australia has used trade protection, particularly tariffs (taxes on imported goods), as a means of protecting local industry since the early 1900s. However, during the 1950s and 1960s very high levels of tariffs were introduced, particularly for manufacturing goods, with the intent of protecting the developing manufacturing sector from international competition during its early stages of growth. Economists now know that the effect of shielding domestic manufacturing from international competition was to reduce the necessity to be innovative and efficient. The result was higher-cost production processes, higher output prices and cost disadvantages to other industries that purchased either domestic manufactures as inputs or relied on imported inputs which were priced at higher levels due to tariffs. The reduction in the levels of tariff protection began in 1973, but tariffs remained at very high levels until the late 1980s and 1990s, after which significant reductions are attributed to increasing economic efficiency and productivity growth rates.

Can Australia maintain high rates of productivity growth? The labour productivity slowdown began abruptly in the early 1970s and ended in the early 1990s. Labour productivity growth in Australia in the 1990s was faster than before the growth slowdown. For example, between 1993/94 and 1998/99 labour productivity averaged an annual growth rate of 3.3 per cent. This compares with the Productivity Commission’s estimate of Australia’s long-term (50 year) average annual labour productivity growth rate of a little over 2 per cent. As we discussed earlier, many economists attribute some of the increase in labour productivity to microeconomic reforms such as industry and labour market deregulation. Economists also argue that the higher labour productivity growth that began in the 1990s reflected the development of a new economy based on information technology. The spread of ever faster and ever cheaper computers made communication and data processing easier and faster than ever before. Today, a single desktop computer has more computing power than all the mainframe computers NASA used to control the Apollo spacecrafts that landed on the moon in the late 1960s and early 1970s. Faster data processing has a major impact on nearly every firm. Business record keeping, once done laboriously by hand, is now done more quickly and accurately by computers. The increase in Internet use during the 1990s brought changes to the ways firms sell to consumers and to each other. Mobile phones, laptop and tablet computers and wireless Internet access allow people to work away from the office, both at home and while travelling. These developments have significantly increased labour productivity. Many economists are optimistic that some of the increases in productivity that occurred from 1995 to 2005 will continue. The use of computers, and information and communications technology generally, has increased as prices continue to fall. By 2010 well-equipped desktop computers could be purchased for less than $600. Further innovations in information and communications technology, together with continued research into agricultural methods, may continue to contribute to strong productivity growth. Some economists are more sceptical, however, about the ability of the economy to continue to sustain high rates of productivity growth. These economists argue that innovations in information and communications technology are having a greater impact on consumer products, such as mobile phones, than on the processes internal to firms that would lead to higher labour productivity. As shown earlier, there is evidence of a productivity growth

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slowdown in more recent years. Between 1995 and 2000 multifactor productivity (MFP) growth averaged 1.7 per cent per year and labour productivity averaged 3.6 per cent. From 2001 to 2005 MFP growth averaged close to 1 per cent per year and labour productivity averaged 2.4 per cent. From 2006 to 2012 MFP growth was negative, at –0.5 per cent per year, while labour productivity growth fell to 1.7 per cent, The most recent productivity measures should be treated with some caution, as unusual events such as droughts in agriculture, and large capital projects in some industries (particularly in mining) which were not yet fully operational, pushed productivity growth rates down. Nonetheless, in recent years, economists have been focusing on the need for new investment in infrastructure and reforms in areas including water, transport, energy and the labour market if productivity growth is to improve in Australia.

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Multifactor productivity (MFP) The quantity of goods and services produced per combined input of labour and capital.

WHY ISN’T THE WHOLE WORLD RICH? The economic growth model tells us that economies grow when the quantity of capital per hour worked increases and when technological change takes place. This model seems to provide a good blueprint for developing countries to become rich: (1) increase the quantity of capital per hour worked and (2) use the best available technology. There are economic incentives for both of these things to happen in poor countries. The profitability of using additional capital or better technology is generally greater in a developing country than in a high-income country. For example, replacing an existing computer with a new, faster computer will generally have a relatively small payoff for a firm in Australia. In contrast, installing a new computer in a Zambian firm where records have been kept by hand is likely to have an enormous payoff. This observation leads to the following important conclusion: the economic growth model predicts that poor countries will grow faster than rich countries. If this prediction is correct we should observe poor countries catching up to the rich countries in levels of GDP per capita (or income per capita). Has this catch-up—or convergence—actually occurred? Here we come to a paradox: of all the countries that are classified as higher-income countries, the relatively lower income countries among these have been catching up to the relatively higher income countries, but the developing countries as a group have not been catching up to the higher-income countries as a group.

Are the developing countries catching up to the industrialised countries?

6.4 Explain economic catch-up and discuss why many poor countries have not experienced rapid economic growth. LEARNING OBJECTIVE

Catch-up The prediction that the level of GDP per capita (or income per capita) in poor countries will grow faster than in rich countries.

There does not appear to be a consistent relationship between the level of real GDP in the mid-twentieth century and economic growth in developing countries since then. For example, countries such as Niger, Madagascar and the Democratic Republic of the Congo had low levels of real GDP per capita in 1960, but have actually since experienced negative economic growth: they had lower levels of real GDP per capita in 2012 than in 1960. Other countries that started with low levels of real GDP per capita, such as Malaysia and South Korea, have grown rapidly. Some middle-income countries, such as Venezuela, have hardly grown at all since the mid-twentieth century, while others, such as Brazil, have experienced significant growth.

Why don’t more low-income countries experience rapid growth? Why are many low-income countries growing so slowly? There is no one answer, but most economists point to five key factors: • Failure to enforce the rule of law • Wars and revolutions • Poor public education and health • Slow technological development • Low rates of saving and investment

Failure to enforce the rule of law In the years since 1960 increasing numbers of developing countries, including China, have abandoned centrally planned economies in favour of more market-oriented economies.

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Property rights The rights individuals or businesses have to the exclusive use of their property, including the right to buy or sell it.

Rule of law The ability of a government to enforce the laws of the country, particularly with respect to protecting private property and enforcing contracts.

For entrepreneurs in a market economy to succeed the government must guarantee private property rights and enforce contracts. Unless entrepreneurs feel secure in their property they will not risk starting a business and investors are unlikely to lend their funds to entrepreneurs. It is also very difficult for businesses to operate successfully in a market economy unless they can use an independent court system to enforce contracts. Many developing countries do not have a functioning, independent court system. Even if a court system does exist a case may not be heard for many years. In some countries bribery of judges and political favouritism in court rulings are common. If firms cannot enforce contracts through the court system they will insist on carrying out only face-to-face cash transactions. For example, a shoe manufacturer will wait until the leather producer brings the hides to the factory and will then buy them for cash. The wholesaler will wait until the shoes have been produced before making plans for sales to retail stores. Production still takes place, but it is carried out more slowly and inefficiently. In these circumstances firms have difficulty finding investors willing to provide them with the funds they need to expand. Further, in many developing countries the rule of law and property rights are undermined by corruption. With corruption, government officials may require bribes to carry out their obligations or steal government property and resources. For example, in some developing countries it is impossible for an entrepreneur to obtain a permit to start a business without paying bribes, often to several different officials. In some countries tax revenues and foreign aid also frequently end up in the pockets of government officials. Research has shown that countries where corruption is most widespread grow much more slowly than countries where corruption is less of a problem. Property rights are unlikely to be secure in countries that are afflicted by wars and civil strife. For a number of countries increased political stability is a necessary prerequisite to economic growth. The rule of law refers to the ability of a government to enforce the laws of the country, particularly with respect to protecting private property and enforcing contracts. The World Bank is an agency of the United Nations whose role is to provide financial aid and policy advice to low-income countries. Economists at the World Bank have developed an index that ranks countries of the world from those with the strongest rule of law (the least corrupt) to those with the weakest rule of law (the most corruption). Figure 6.6 shows the difference in GDP per capita between the 20 countries that do the best job of enforcing the rule of law and the 20 countries that do the worst job. They found that GDP per capita in the 20 countries with the least corruption was more than 10 times higher than in the 20 countries with the most corruption.

Wars and revolutions Many of the countries that were very poor in 1960 have experienced extended periods of war or violent changes of government during the years since. These wars made it impossible for countries such as Afghanistan, Angola, Ethiopia, the Central African Republic and the Congo

FIGURE 6.6

The rule of law and growth The 20 countries that have the strongest rule of law have GDP per capita that is 10 times more than the 20 countries that have the weakest rule of law SOURCE: Created from David Dollar and Aart Kraay (2000), ‘Property Rights, Political Rights, and the Development of Poor Countries in the Post-Colonial Period’, World Bank Development Research Group Working Paper, October.

GDP per capita

$45 000 40 000 35 000 30 000 25 000 20 000 15 000 10 000 5000 0

Least corrupt countries

Most corrupt countries

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to accumulate capital or adopt new technologies. In fact, conducting any kind of business was very difficult. The positive effect on growth of the end of war was shown in Mozambique, which suffered through almost two decades of civil war and declining real GDP per capita. With the end of civil war Mozambique experienced a healthy annual average growth rate of 3.6 per cent in real GDP per capita from 1990 to 2012.

Poor public education and health We have seen that human capital is one of the determinants of labour productivity. Many lowincome countries have weak public school systems, so many workers are unable to read and write. Few workers acquire the skills necessary to use the latest technology. We discussed earlier in this chapter Paul Romer’s argument that there are increasing returns to knowledge capital. Robert Lucas, another winner of the Nobel Prize in Economics, has made a similar argument that there are increasing returns to human capital. Lucas argues that productivity increases as the total stock of human capital increases, but that these productivity increases are not completely captured by individuals as they decide how much education to purchase. Therefore, the market may produce an inefficiently low level of education and training unless education is supported by the government. Some researchers have been unable to find evidence of increasing returns to human capital, but many economists believe that government subsidies to education have played an important role in promoting economic growth. As we saw in Chapter 5, research shows the important interaction between health and economic growth. As people’s health improves and they become stronger, and less susceptible to disease, they also become more productive. People who are sick work less and are less productive when they do work. Poor nutrition or exposure to certain diseases in childhood can leave people permanently weakened and can affect their intelligence as adults. Poor health has a significant negative impact on the human capital of workers in developing countries. Many low-income countries suffer from diseases that are either non-existent or treated readily in high-income countries. For example, few people in developed countries suffer from malaria but more than half a million Africans die from it each year. Recent initiatives in developing countries to increase vaccinations against infectious diseases, to improve access to treated water and to improve sanitation have begun to reduce rates of illness and death. Treatments for AIDS have greatly reduced deaths from this disease in Australia, the United States and Europe, but millions of people in low-income countries continue to die from AIDS. Low-income countries often lack the resources, and their governments are often too ineffective to provide even routine medical care, such as childhood vaccinations.

Slow technological development One of the lessons from the economic growth model is that technological change is more important than increases in capital in explaining long-run growth. Government policies that facilitate access to technology are crucial for low-income countries. The easiest way for developing countries to gain access to technology is through foreign direct investment in which foreign firms are allowed to build new facilities or to buy domestic firms. Recent economic growth in India has been greatly aided by the Indian government’s relaxation of regulations on foreign investment. Relaxing these regulations made it possible for India to have access to the technology of Dell, Microsoft and other multinational corporations. In the high-income countries government policies can aid the growth of technology by subsidising research and development. As we noted previously, in Australia the federal government conducts some research and development on its own, through organisations such as the Commonwealth Scientific and Industrial Research Organisation (CSIRO) and also provides grants to researchers in universities. Tax concessions to firms undertaking research and development also facilitate technological change.

Low rates of saving and investment For economic growth to occur a country must have a well-functioning financial system. To invest in factories, machinery and computers firms need funds. Some of the funds can come from the owners of the firm and from their friends and family, but, as we noted in Chapter 5,

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firms in high-income countries raise most of their funds from bank loans and selling shares and bonds in financial markets. In most developing countries share and bond markets do not exist and often the banking system is very weak. In high-income countries the funds that banks lend to businesses come from the savings of households and many households are able to save a significant portion of their income. In developing countries many households barely survive on their incomes and therefore have little or no savings. The low savings rates in developing countries contribute to a vicious cycle of poverty. Because households have low incomes they save very little. Because households save very little, there are very few funds are available for firms to borrow. Lacking funds, firms do not invest in the new factories, machinery and equipment needed for economic growth. Because the economy does not grow, household incomes remain low, as do their savings, and so on. As we also discussed in Chapter 5, tax incentives can lead to increased savings. In Australia workers are required by law to save for retirement by placing funds in superannuation accounts, and withdrawals for most people are tax free if the money is not withdrawn until after the age of 60 years. Because the funds can be withdrawn free of tax and the contributions are taxed at a relatively low rate, this raises the incentive to save. Governments also increase incentives for firms to engage in investment in physical capital by allowing expenditure on capital to be deducted from gross company income, thereby reducing the amount of taxation payable on profits earned. Investment tax credits allow firms to deduct from their income some fraction of the funds they have spent on investment. Reductions in the taxes firms pay on their profits also increase the after-tax return on investments.

The benefits of globalisation Foreign direct investment The ownership of, or controlling interest in, assets, such as a factories, businesses or farms, in a foreign country. Foreign portfolio investment The purchase by an individual or firm of financial securities, such as shares or bonds issued in another country.

Globalisation The interaction and integration between businesses, governments and people of different countries as they become open to foreign investment and international trade.

We have seen that one way for a developing country to break out of the vicious cycle of low saving and investment and low growth is through foreign investment. Foreign direct investment occurs when corporations build or purchase facilities, such as factories, in foreign countries. Foreign portfolio investment occurs when an individual or firm buys financial securities, such as shares or bonds issued in another country. Foreign direct investment and foreign portfolio investment can give a low-income country access to funds and technology that would otherwise not be available. Until recently, many developing countries were reluctant to take advantage of this opportunity. From the 1940s to the 1970s many developing countries sealed themselves off from the global economy. They did this for several reasons. During the 1930s and early 1940s the global trading and financial system collapsed as a result of the Great Depression and World War II. Developing countries that relied on exporting to high-income countries were hurt economically. Also, many countries in Africa and Asia achieved independence from the colonial powers of Europe during the 1950s and 1960s and were afraid of being dominated by them economically. As a result, many developing countries imposed high tariffs on foreign imports and strongly discouraged or even prohibited foreign investment. This made it difficult to break out of the vicious cycle of poverty. The policies of high tariff barriers and avoiding foreign investment failed to produce much growth, so by the 1980s many developing countries began to change policies. The result was globalisation, which refers to the interaction and integration between businesses, governments and people of different countries as they become open to foreign investment and international trade. If we measure globalisation by the fraction of a country’s GDP accounted for by exports, we see that globalisation and growth are strongly positively associated. Figure 6.7 shows that developing countries that were more globalised grew faster during the 1990s than developing countries that were less globalised. Globalisation has benefited developing countries by making it easier for them to get investment funds and technology.

Is economic growth good or bad? In this chapter we have assumed that economic growth is desirable and that governments should undertake policies that will increase growth rates. It seems undeniable that increasing the growth rates of very low income countries would help relieve the daily suffering that many people in these countries endure. But some people are unconvinced that, at least in the highincome countries, further economic growth is desirable.

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FIGURE 6.7

Average annual growth rate of real GDP per capita, 1990–1999

Globalisation and growth Developing countries that were more open to foreign trade and investment grew much faster during the 1990s than developing countries that were less open

6% 5 4

SOURCE: Data from David Dollar (2005), ‘Globalization, inequality, and poverty since 1980’, World Bank Research Observer, Vol. 20, No. 2, Fall, pp. 145–175.

3 2 1 0 –1

More globalised countries Less globalised countries

–2

GLOBALISATION AND THE SPREAD OF TECHNOLOGY IN BANGLADESH

M

Today Bangladesh exports more than US$3 billion worth of shirts and other clothing. But the manufacture of clothing in factories only began in Bangladesh in 1978 when a local entrepreneur, Noorul Quader, started Desh Garments Ltd. This firm had just one shirt factory that employed 40 workers and produced only US$55 550 worth of shirts its first year. Initially, Quader relied on an agreement with Daewoo Corporation of the Republic of Korea (South Korea). Daewoo could export only limited amounts of shirts from South Korea to the United States and Europe because the US and European governments placed restrictions on clothing imports from South Korea in an effort to protect their own clothing producers. These restrictions did not apply to imports from Bangladesh.

C

A K I N G THE

ONNECTION

6.4

AP Photo/Manish Swarup

Under the agreement with Daewoo, Quader was responsible for setting up and The spread of technology spurred Bangladesh’s running the clothing factory. Daewoo would provide the most critical ingredient: booming clothing industry six months of training for 130 Desh workers at one of Daewoo’s plants in Korea. In return Quader would pay Daewoo an 8 per cent royalty on each shirt sold. The business was a tremendous success for Quader, with production soaring from 43 000 shirts in 1980 to 2.3 million in 1987, to over 10 million only 10 years later. It was an even greater success for Bangladesh. Almost all of the 130 Desh workers trained in South Korea eventually left Desh to set up their own firms. In addition to making shirts these new firms began producing coats, pants and other clothing. The Desh workers, trained by Daewoo in garment-making technology, became the basis of Bangladesh’s booming clothing industry. This story illustrates not only how globalisation can aid the spread of technology to the developing world, but also the important difference between capital and technology: although there are diminishing returns to capital, there may actually be increasing returns to technology. The investment Daewoo made in developing the best way to manufacture clothing and export it  to high-income countries provided a return not only to Daewoo but also to Desh, and then to the other companies in Bangladesh founded by workers who left Desh. Unlike a piece of machinery, there is no limit to the number of people who can use knowledge about the best way to produce a good. As we discussed previously, the idea that there may be increasing returns to technology has been an important part of recent developments in the theory of economic growth.

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From this perspective, technological advance is not just a matter of new scientific discoveries but also depends upon the incentives given to entrepreneurs to find new and better ways of producing goods and services. SOURCE: The story of Noorul Quader is from William Easterly (2001), The Elusive Quest for Growth: Economists’ Adventures and Misadventures in the Tropics, Cambridge, MA, MIT Press, pp. 146–150; Desh Group (2013), ‘History of Desh Group’, at , viewed 28 November 2013.

Some people believe that globalisation has undermined the distinctive cultures of many countries, as imports of food, clothing, movies and other goods displace domestically produced goods. We have seen that allowing foreign direct investment is an important way in which low-income countries can gain access to the latest technology. Some people, however, see multinational firms that locate in low-income countries as paying very low wages and failing to follow the same safety and environmental regulations they are required to follow in highincome countries. The arguments against further economic growth tend to be motivated either by concern about the effects of growth on the environment or by concern about the effects of the globalisation process that has accompanied economic growth in recent years. In 1973 the Club of Rome published a controversial book titled The Limits to Growth, which predicted that economic growth would be likely to grind to a halt in high-income countries because of increasing pollution and the depletion of natural resources, such as oil. Although these dire predictions have not yet come to pass, there is increasing concern that economic growth may be contributing to global warming, deforestation and other environmental problems. However, rather than reduce economic growth and lower living standards, many economists advocate using the market to encourage alternative production methods and technologies. For example, the use of carbon trading permits or a carbon tax would raise the relative cost of electricity generated from coal, thereby making cleaner alternatives relatively cheaper. The search for economic growth that is sustainable has, in the twenty-first century, come to the forefront of economic policy in high-income countries and also in the rapidly growing countries such as China and India. As with many other normative questions, economic analysis can contribute to the ongoing political debate over the consequences of economic growth, but it cannot settle the issue.

ECONOMICS IN YOUR LIFE (continued from page 143)

HAS THE RISE OF CHINA AFFECTED YOUR JOB OPPORTUNITIES? At the beginning of the chapter, we asked whether your job opportunities in your own country have been affected by the rapid economic growth experienced by China. How does it affect you as someone about to start a career? We also asked how the current high-growth, high-export Chinese economy affects you as a consumer. It’s impossible to walk into stores in Australia or any developed economy without seeing products imported from China. Some of these products, like clothing and footwear, were once made in Australia. Imports from China replace domestically produced goods when the imports are either less expensive or of higher quality than the domestic goods they replace. As you begin your career, there are some Australian industries that, because of competition from Chinese firms, will have fewer jobs to offer. However, it is important to understand that expanding trade changes the types of products each country makes and therefore the types of jobs available, but it does not reduce the total number of jobs. Also, the rapid economic growth that has enabled Chinese firms to be competitive with firms in developed countries has benefited you as a consumer, because you have lower-priced goods and better goods available for purchase than you would have had if China had remained very poor.

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CONCLUSION For much of human history most people have had to struggle to survive. Although there have been substantial reductions in extreme poverty over the past 30 years, even today around 20 per cent of the world’s people live in extreme poverty. The differences in living standards between countries today are the result of many decades of sharply different rates of economic growth. According to the economic growth model, increases in the quantity of capital per hour worked and increases in technology determine how rapidly real GDP per hour worked and a country’s standard of living will increase. The keys to higher living standards seem straightforward enough: establish the rule of law, provide basic education and health care for the population, increase the amount of capital per hour worked, adopt the best technology and participate in the global economy. However, for many countries these policies have proved very difficult to implement. Read ‘An inside look’ for a discussion of the role investment is playing in the economic growth in Cambodia.

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AN INSIDE LOOK NG SYDNEY MORNI

RIL 2013 HERALD 10 AP

p i h s p m u j s r Manufacture ambodia C o t a n i h C m o r f

utheast Asia to factories in So w ne g in ild fast-growing are bu in China. China’s ond-polishing ns io am at di er a op g t in en ild pplem huge industrial quietly bu associated su population and e rly rg Tiffany & Co is la la pu t, po ke ar try m panies, while domestic dia, a coun e for many com baubles. iv an ct th factory in Cambo tra at es it in e m ak nd st as wages se still m fields and la ing almost as fa turers are ba ris ac is uf more with killing a an in m Ch t in es pan’s bigg productivity A Some of Ja up operations in Phnom Penh to industries. a, where t se s and in many y low in Cambodi en el re m sc tre h also rushing to ex uc e to ar d s dollars, Because cost esses for cars an panies only a couple of m st co co an ay make wiring harn pe m ro or Eu ct a visit to the do for cellphones. r is still less than vibration motors s and microfiber n for each worke oe io at sh e ns nc pe da m g co in l , mak overal n-run company are not far behind Pactics, a Belgia At . th on m a . fiber sleeves $US130 lasses t maker of micro Cambodia for a es sleeves for sung rg to la g ’s in ld ck or w flo e e es ar same tasks at that is th Foreign compani orkers doing the r overwhelming w , ei th es it ss la lim ng to su t a month, r luxury They wan $US560–$US640 rn are multiplying fo simple reason: s ea m ai le gh ob an Pr Sh a. in s, said Piet ctory in ies in Ch dated allowance -collar wages a fa an reliance on factor ue t-m Bl en a. in m rn Ch ve in investors as a including go fast for foreign ’s president. the last decade in g fewer in pl ru ad lten, the company qu Ho g , in ed an rg w 15 to 30 per cent su ith w w ve se d ha rs de ci ke in or w co s an ts, but ion boom ha C Cambodi ghai counterpar ctory jobs. an fa Sh r in factory construct ei th ed st an re th te y g people in gun sleeves per da catching up. numbers of youn bodia has been e has actually be m rc fo l Ca ur in bo ity la tiv e uc th , ic Zone in centra ing prod Starting last year Special Econom policy and an ag ’ nh ild Pe ch m by ne ‘o no rs e Ph th ke e e of At th g to attract wor shrinking becaus Minebea is tryin a, di bo m ry for 2000 Ca n. populatio n below ur-story dormito ai fo m n, re er n n te od of m s a building a large recreatio and benefit B While wages ovide proper housing and balanced people with six beds to a room and ood houses with pr from the plyw foreign direct levels needed to dians still g investment— ll—a big change rin ha tu ac uf ar an ye m illions of Cambo e st m la ch nt hi ce w diets, th r in pe s year, to ed roof mbodia rose 70 is doubling this le out thatch ne op zo pe e th of at investment in Ca ns t io en ill m 40 000 live. Employm starting to raise d to redouble to te ec oj pr is d from 2011—is an , e 20 000 workers shi Uematsu, th years, said Hiro tly in low-tech l of destitution. os ra m , ve es se ni xt pa ne m e g of co ring, are in th Only a smatterin g director. shoe manufactu d an t zone’s managin en rm ga es ni pa m co e or sectors like any m China entirely. M seeking to leave

G HERALD

SYDNEY MORNIN

SOURCE: Business Day (2013), ‘Industrial downturn’, Sydney Morning Herald, 10 April, at , viewed 4 November 2013.

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Key points in the article This article discusses Cambodia’s increased economic growth since the government has moved its economy closer to market capitalism. Cambodia has opened up to foreign investment and welcomed globalisation. It is also a relatively low-cost country compared to China where wages and other costs have risen with economic development. The article suggests that further foreign investment could continue to assist economic growth, enabling the reduction of poverty.

Analysing the news A In the article, flows of foreign investment to Cambodia have created many jobs by allowing the increase in capital investment in things such as factories. Investment will increase the ratio of capital per hour worked, thereby increasing real GDP per hour worked, as shown in Figure 1. Foreign investment is also likely to bring new technology to Cambodia which will further increase real GDP per hour worked. As we learned in this chapter, sustained longrun economic growth requires not only capital but also technology. Without technological change, diminishing returns will reduce the rate of increase in capital per hour worked as further capital is added. We can see the effect of new technology in Figure 2, with a higher production function at every level of capital.

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in extreme poverty, the growth of jobs in manufacturing arising from foreign investment has lifted millions out of destitution, as it did in China.

C Foreign investment has given Cambodia access to investment without having to rely exclusively on Cambodians’ savings, which given their low income are very low. Rather, foreign savings in the forms of direct and portfolio investment have given Cambodia access to funds and technology that would otherwise not be available. While productivity is still very low, already increases can be observed as a result of new capital arising from foreign investment. Thinking critically

B Economic growth has significantly reduced global poverty, particularly in the Asian region over the past three decades. Although many Cambodians currently live

1 Suppose that the Cambodian government, in an attempt to increase household disposable income, taxes returns on foreign investment and then transfers this tax revenue to Cambodian households, which use the funds to purchase consumer goods. What effect would this policy have on Cambodia’s long-run economic growth? 2 Suppose the Cambodian government’s policy of welcoming foreign direct investment and portfolio investment is perceived, by the foreign investment community, as weak. For example, assume that the foreign investment community does not believe that the Cambodian government has the political will to maintain this. What effect would this perception have on Cambodia’s long-run economic growth?

FIGURE 1 CAPITAL INVESTMENT WILL ENABLE CAMBODIA TO INCREASE REAL GDP PER HOUR WORKED, BUT DIMINISHING RETURNS WILL OCCUR

FIGURE 2 TECHNOLOGICAL CHANGE WILL MEAN THAT CAMBODIA CAN INCREASE REAL GDP PER HOUR WORKED AT EVERY LEVEL OF CAPITAL

Real GDP per hour worked, Y/L

Real GDP per hour worked, Y/L

C (Y/L)2 (Y/L)2

B

(Y/L)1

A

0

(K/L)1

(K/L)2 Capital per hour worked, K/L

(Y/L)1

A

0

(K/L)1

Capital per hour worked, K/L

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CHAPTER SUMMARY AND PROBLEMS KEY TERMS catch-up copyright economic growth model foreign direct investment foreign portfolio investment globalisation

159 155 149 162 162 162

human capital Industrial Revolution labour productivity multifactor productivity (MFP) new growth theory patent

149 145 149 159 154 154

per-worker production function property rights rule of law tariff technological change

150 160 160 158 149

ECONOMIC GROWTH OVER TIME AND AROUND THE WORLD, PAGES 144–148 LEARNING OBJECTIVE 6.1

Describe global trends in economic growth.

SUMMARY

1.4

Until around 1300 AD most people survived with barely enough food. Living standards began to rise significantly only after the Industrial Revolution began in Britain in the 1700s, with the application of mechanical power to the production of goods. The best measure of a country’s standard of living is its level of real GDP per capita (per person). Economic growth occurs when real GDP per capita increases, thereby increasing the country’s standard of living.

COUNTRY

1.2

1.3

[Related to Making the connection 6.1] Economists Carol Shiue and Wolfgang Keller published a study of ‘market efficiency’ in the eighteenth century in England, other European countries and China.2 If the markets in a country are efficient, a product should have the same price wherever in the country it is sold, allowing for the effect of transportation costs. If prices are not the same in two areas within a country, it is possible to make profits by buying the product where its price is low and reselling it where its price is high. This trading will drive prices to equality. Trade is most likely to occur, however, if entrepreneurs feel confident that their gains will not be seized by the government and that contracts to buy and sell can be enforced in the courts. Therefore, in the eighteenth century, the more efficient a country’s markets, the more its institutions favoured long-run growth. Shiue and Keller found that in 1770 the efficiency of markets in England was significantly greater than the efficiency of markets elsewhere in Europe and in China. How does this finding relate to Douglass North’s argument concerning why the Industrial Revolution occurred in England?

2008

2009

2010

$1295.7

1362.6

1353.8

1455.2

Mexico

8806.7

8911.4

8362.4

8815.3

Thailand

4259.5

4368.4

4265.1

4597.0

Note: All values are in real terms, in billions of US dollars. SOURCE: International Monetary Fund.

Why does a country’s economic growth rate matter? Explain the difference between the total percentage increase in real GDP between 2005 and 2015 and the average annual growth rate in real GDP between the same years.

PROBLEMS AND APPLICATIONS

2007

Brazil

REVIEW QUESTIONS 1.1

Use the data on real GDP in this table to answer the following questions.

1.5

a Which country experienced the highest rate of economic growth during 2008 (that is, for which country did real GDP increase the most from 2007 to 2008)? b Which country experienced the worst economic recession during 2009? Briefly explain. c Which country experienced the highest average annual growth rate between 2008 and 2010? At the beginning of 2015 suppose you deposit $1000 in a one-year term deposit account in each of the banks in the following table. The interest rates on these deposits are shown for a three-year period. BANK

1.6

2015

2016

2017

Commonwealth Bank (CBA)

2%

9%

10%

National Australia Bank (NAB)

7%

7%

7%

At the end of 2015 you take your $1000 and any interest earned and invest it in a term deposit for the following year. You do this again at the end of 2016. At the end of 2017, will you have earned more on your CBA term deposit or on your NAB term deposit? Briefly explain. [Related to Don’t let this happen to you] Use the data in the following table to calculate: a the percentage increase in real GDP per capita between 2010 and 2013. b the average annual growth rate in real GDP per capita between 2010 and 2013. (Remember from the previous

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chapter that the average annual growth rate for relatively short periods can be approximated by averaging the growth rates for each year during the period.)

1.7

YEAR

REAL GDP PER CAPITA, $

2010

61 812

2011

62 459

2012

63 523

2013

64 300

1.8

[Related to Making the connection 6.2] In his book The White Man’s Burden, William Easterly writes that:

169

childhood deaths from diarrhoea? If these events did not increase real GDP per capita, is it still possible that they increased the standard of living in southern Africa and Egypt? Briefly explain. b Which seems more achievable for a developing country: the elimination of measles and childhood deaths from diarrhoea or sustained increases in real GDP per capita? Briefly explain. [Related to Making the connection 6.2] Economist Charles Kenny of the World Bank argued that: The process technologies—institutions like laws and inventory management systems—that appear central to raising incomes per capita flow less like water and more like bricks. But ideas and inventions…really might flow more easily across borders and over distances.4

Routine childhood immunization combined with measles vaccination in seven southern Africa nations starting in 1996 virtually eliminated measles in those countries by 2000. A national campaign in Egypt to make parents aware of the use of oral rehydration therapy from 1982 to 1989 cut childhood deaths from diarrhea by 82 percent over that period.3

If Kenny is correct, what are the implications of these facts for the ability of low-income countries to rapidly increase their rates of growth of real GDP per capita in the decades ahead? What are the implications for the ability of these countries to increase their standards of living? Briefly explain.

a Is it likely that real GDP per capita increased significantly in southern Africa and Egypt as a result of the near elimination of measles and the large decrease in

WHAT DETERMINES HOW FAST ECONOMIES GROW? PAGES 148–155 LEARNING OBJECTIVE 6.2

Use the economic growth model to explain why economic growth rates differ between countries.

SUMMARY An economic growth model explains changes in real GDP per capita in the long run. Labour productivity is the quantity of goods and services that can be produced by one worker or by one hour of work. Economic growth depends on increases in labour productivity. Labour productivity will increase if there is an increase in the amount of capital available to each worker or if there is an improvement in technology. Technological change is a change in the ability of a firm to produce output with a given quantity of inputs. There are three main sources of technological change: better machinery and equipment, increases in human capital and better means of organising and managing production. Human capital is the accumulated knowledge and skills that workers acquire from education and training or from their life experiences. An economy will have a higher standard of living the more capital it has per hour worked, the more human capital its workers have, the better the capital and the better the job its business managers do in organising production. The per-worker production function shows the relationship between capital per hour worked and output per hour worked, holding technology constant. Diminishing returns to capital mean that increases in the quantity of capital per hour worked will result in diminishing increases in output per hour worked. Technological change shifts up the per-worker production function, resulting in more output per hour worked at every level of capital per hour worked. The economic growth model stresses the importance of changes in capital per hour worked and technological change in explaining growth in output per hour worked. New growth theory is a model of long-run economic

growth that emphasises that technological change is influenced by economic incentives. One way governments can promote technological change is by granting patents, which in Australia are exclusive rights to a product for a period of 20 years from the date the product is invented. Similarly, books, movies, music and software receive copyright protection, but copyright is for the entire lifetime of the creator, plus up to 70 years for the creator’s heirs. To Joseph Schumpeter, the entrepreneur is central to the ‘creative destruction’ by which the standard of living increases as qualitatively better products replace existing products.

REVIEW QUESTIONS 2.1

2.2

2.3

Using the per-worker production function graphs from Figure 6.3 and Figure 6.4, show the effect on real GDP per hour worked of an increase in capital per hour worked, holding technology constant. Now, again using the perworker production function graph, show the effect on real GDP per hour worked of an increase in technology, holding the quantity of capital per hour worked constant. What are the consequences for economic growth of diminishing returns to capital? How are some economies able to maintain high growth rates despite diminishing returns to capital? Why are firms likely to under-invest in research and development, which slows the accumulation of knowledge capital, slowing economic growth? Briefly discuss three ways in which government policy can increase the accumulation of knowledge capital.

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What is the new growth theory? How does the new growth theory differ from the growth theory developed by Robert Solow?

PROBLEMS AND APPLICATIONS 2.5

2.6

Which of the following will result in a movement along Japan’s per-worker production function, and which will result in a shift of Japan’s per-worker production function? Briefly explain. a Capital per hour worked increases from ¥5 million per hour worked to ¥6 million per hour worked. b The Japanese government doubles its spending on support of university research. c A reform of the Japanese school system results in more highly trained Japanese workers. [Related to Solved problem 6.1] Use the following graph to answer the questions.

Real GDP per hour worked, Y/L

C

675

0

The most outstanding characteristic of Soviet growth strategy is its consistent policy of very high rates of investment, leading to a rapid growth rate of [the] capital stock.5

2.8

2.9

$775

575

2.7

B

Production function3 Production function2 Production function1

A

$40 000

60 000

a True or False: The movement from point A to point B shows the effects of technological change. b True or False: The economy can move from point B to point C only if there are no diminishing returns to capital. c True or False: To move from point A to point C the economy must increase the amount of capital per hour worked and experience technological change. [Related to Solved problem 6.1] Shortly before the fall of the Soviet Union the economist Gur Ofer of the Hebrew University of Jerusalem wrote this:

Capital per hour worked, K/L

Explain why this turned out to be a very poor growth strategy. Why is the role of the entrepreneur much more important in the new growth theory than in the traditional economic growth model? [Related to Making the connection 6.3] This chapter argues that a key difference between market economies and centrally planned economies, like the former Soviet Union, is that ‘in market economies, decisions on which investments to make and which technologies to adopt are made by entrepreneurs and managers with their own money on the line. In the Soviet system, these decisions were usually made by salaried bureaucrats trying to fulfil a plan formulated in Moscow’. But in large corporations investment decisions are often made by salaried managers who do not have their own money on the line. These managers are spending the money of the firm’s shareholders rather than their own money. Why, then, do the investment decisions of salaried managers in Australia tend to be better for the long-term growth of the economy than were the decisions of salaried bureaucrats in the Soviet Union?

ECONOMIC GROWTH IN AUSTRALIA, PAGES 156–159 LEARNING OBJECTIVE 6.3

Discuss the fluctuations in productivity growth in Australia.

SUMMARY Productivity growth in the early twentieth century was relatively slow, hindered by the effects of World War I and the Great Depression. Productivity in Australia grew rapidly from the beginning of the Long Boom in the 1940s until the early 1970s, with significant investment occurring in industry, along with technological change. Growth then slowed down for almost 20 years, before increasing again in the 1990s. Leading explanations for the productivity slowdown include high oil prices, a possible decline in labour quality, regulated markets which stifled competition and the effects of trade protection. Some economists argue that the development of a ‘new economy’ based on information technology caused higher productivity growth rates from the mid-1990s to the mid-2000s. Other economists argue that these changes may not continue to

boost productivity. The effects of market deregulation and the dismantling of trade protection are also seen to be important contributing policy measures to the increased growth rates in productivity in Australia. Further investment in capital and infrastructure is seen as essential for future growth in productivity rates.

REVIEW QUESTIONS 3.1

3.2

Describe the record of productivity growth in Australia from 1861 to the present. What explains the slowdown in productivity growth from the 1970s to 1990? Why did productivity growth increase during the 1990s? Why do some economists believe that the higher productivity growth rates that began in the mid-1990s can be sustained?

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My interpretation of the [information] revolution is that it is increasingly burdened by diminishing returns. The push to ever smaller devices runs up against the fixed size of the human finger that must enter information on the device. Most of the innovations since 2000 have been directed to consumer enjoyment rather than business productivity, including video games, DVD players, and iPods. iPhones are nice, but the ability to reschedule business meetings and look up corporate documents while on the road already existed by 2003.6

PROBLEMS AND APPLICATIONS 3.3

3.4

3.5

171

Figure 6.5 shows high economic growth rates in Australia between 1861 and 1891 despite productivity growth rates averaging only 1.5 per cent per year. Explain how such strong economic growth was achieved without rapid productivity growth, given that today we know that growth in productivity fuels economic growth. Explain the effect on investment if the government increases the rate at which expenditure on machinery and equipment can be deducted from firms’ income. Economist Robert Gordon has argued that:

If Gordon’s observations about the information revolution are correct, what are the implications for future labour productivity growth rates in Australia?

WHY ISN’T THE WHOLE WORLD RICH? PAGES 159–164 LEARNING OBJECTIVE 6.4

economic growth.

Explain economic catch-up and discuss why many poor countries have not experienced rapid

SUMMARY

PROBLEMS AND APPLICATIONS

The economic growth model predicts that poor countries will grow faster than rich countries, resulting in catch-up. In recent decades some poor countries have grown faster than rich countries, but many have not. Some poor countries do not experience rapid growth for five main reasons: wars and revolutions, poor public education and health, failure to enforce the rule of law, lack of technological development and low rates of saving and investment. Property rights are the rights individuals or businesses have to the exclusive use of their property, including the right to buy or sell it. The rule of law refers to the ability of a government to enforce the laws of the country, particularly with respect to protecting private property and enforcing contracts. Foreign direct investment is the purchase or building by a corporation of a facility in a foreign country. Foreign portfolio investment is the purchase by an individual or firm of shares or bonds issued in another country. Globalisation has aided countries that have opened up their economies to foreign trade and investment.

4.7

GROWTH IN REAL COUNTRY

4.2

4.3

4.4

4.5

4.6

Why does the economic growth model predict that poor countries should catch up to rich countries in income per capita? Have poor countries been catching up to rich countries? How might greater flexibility in labour markets and greater efficiency in financial markets lead to higher growth rates in real GDP per capita? What are the main reasons why many poor countries have experienced slow economic growth? What does globalisation mean? How have developing countries benefited from globalisation? Briefly describe government policies that can increase economic growth. Can economists arrive at the conclusion that economic growth will always improve economic wellbeing? Briefly explain.

REAL GDP PER CAPITA

GDP PER CAPITA,

IN 1960, $US

1960–2009, %

China

363

6.23

Uganda

655

1.16

Madagascar

1268

–0.23

Ireland

6971

3.25

15 438

2.02

USA

Note: Authors’ calculations in $US from data in Alan Heston, Robert Summers and Bettina Aten (2011), Penn World Table Version 7.0, Center for International Comparisons of Production, Income and Prices at the University of Pennsylvania, 3 June. 4.8

REVIEW QUESTIONS 4.1

Briefly explain whether the statistics in the following table are consistent with the economic growth model’s predictions of catch-up.

4.9

4.10

4.11

An opinion column in The Economist argued, ‘Globalisation, far from being the greatest cause of poverty, is its only feasible cure’.7 What does globalisation have to do with reducing poverty? How might multinational corporations that establish facilities in developing countries help break the vicious cycle of poverty in those countries? Does this always happen? In 2013/14 around 16 per cent of Australia’s total overseas aid was designated for the development of governance.8 Why does the Australian government believe that governance is important to the economic development of poor countries? Many economists argue that if you really want to reduce world poverty you should be supporting free-trade negotiations and those investors jetting around the world developing globalisation. What do free-trade negotiations and investors jetting around the world have to do with reducing poverty?

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4.13

The Roman Empire lasted from 27 BC to 476 AD. The empire was wealthy enough to build such monuments as the Roman Colosseum. Roman engineering skill was at a level high enough that aqueducts built during the empire to carry water long distances remained in use for hundreds of years. Yet the empire’s growth rate of real GDP per capita was very low, perhaps zero. Why didn’t the Roman Empire experience sustained economic growth? What would the world be like today if it had? (There are no definite answers to this question; it is intended to get you to think about the pre-conditions for economic growth.) Briefly discuss whether the limits on political freedom in China are likely eventually to become an obstacle to its continued rapid economic growth.

4.14

4.15

Economist George Ayittey, in an interview about economic development in Africa, stated that of the 54 African countries only eight have freedom of the media.9 For Africa’s economic development, Ayittey argues strongly for the establishment of media free from government control and scrutiny. Why would a free media be vital for the enhancing of property rights and the rule of law? How could freedom for the media help reduce corruption? Why might some people in high-income countries be more concerned with certain negative consequences of rapid economic growth than people in low-income countries?

ENDNOTES 1 2

3

4 5 6

Joseph Schumpeter (1942), Capitalism, Socialism and Democracy, New York, Harper and Row, p. 132. Carol H. Shiue and Wolfgang Keller (2007), ‘Markets in China and Europe on the eve of the Industrial Revolution’, American Economic Review, Vol. 97, No. 4, September, pp. 1189–1216. William Easterly (2006), The White Man’s Burden: Why the West’s Efforts to Aid the Rest Have Done So Much Ill and So Little Good, Penguin Press, New York, p. 241. Charles Kenny (2011), Getting Better, Basic Books, New York, p. 117. Gur Ofer (1987), ‘Soviet economic growth, 1928–1985’, Journal of Economic Literature, December, pp. 1, 784. Robert J. Gordon (2010), ‘Revisiting U.S. productivity growth over the past century with a view of the future’, March, NBER Working

7

8

9

Paper Series 15834, National Bureau of Economic Research, Massachusetts, USA, at , viewed 9 December 2013. Clive Crook (2001), ‘Globalisation and its critics’, The Economist, 27 September, at , viewed 9 December 2013. Australian Government (2013), ‘Australia’s International Development Assistance Program 2013–14’, Budget 2013–14, at , viewed 9 December 2013. George Ayittey (2005), ‘Border jumpers’, Anchor Interview Transcript, WideAngle, 24 July, at , viewed 9 December 2013.

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PA RT

4

UNEMP LOYME NT AND I NF LATIO N

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CHAPTER

7

UNEMPLOYMENT

LEARNING OBJECTIVES After studying this chapter you should be able to: 7.1 Define the unemployment rate and the labour force participation rate, and understand how they are calculated. 7.2 Explain the economic costs of unemployment. 7.3 Identify the types of unemployment. 7.4 Explain what factors determine the unemployment rate. 7.5 Describe the changes that have occurred in the determination of wages in Australia and discuss the possible effects on unemployment.

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WHY IS THE UNEMPLOYMENT RATE IMPORTANT TO WOOLWORTHS? WOOLWORTHS LIMITED IS one of Australia’s biggest companies in the service sector—the sector where over 70 per cent of people are employed. Woolworths’ primary activity is supermarket operations. Other operations include the sale of petrol through Caltex Woolworths co-branded service stations and Woolworths Plus Petrol, Woolworths Liquor Group, Big W, Masters Home Improvement, general merchandise stores, hotels and pubs. While high unemployment had been a feature of the Australian labour market since the mid-1970s, by the mid2000s the concern among many economists was that a major emerging problem was a shortage of labour. This caused vacancies to rise and put pressure on wages as employers sought to retain and attract workers. During the economic contraction of 2008, unemployment began to rise again and it became easier for many employers to find workers, easing the pressure on wages. By early 2014, the unemployment rate had risen to 6 per cent and participation in the labour market had fallen. Many young people, fearing unemployment, enrolled in higher and further education, which created a greater pool of part-time and casual workers, particularly for the retail sector. An increase in unemployment affects Woolworths’ sales in two different ways. The demand for groceries and petrol is relatively less responsive to income so unemployment normally has a smaller effect on grocery chains such as Woolworths supermarkets and fuel outlets such as Caltex than on other retail industries. During economic contractions, many households cut back on eating out in restaurants and sales of groceries usually increase as more families increase expenditure on home-cooked meals. In contrast, the demand for furniture, electrical and other household items found in Big W is responsive to income, which means rising unemployment normally has a significant effect on sales. However, the strong Australian dollar during the 2008 economic contraction and the subsequent below-trend growth period led to lower wholesale prices of imported goods such as electrical and furniture items. This meant that retailers could either pass on the cost savings to consumers through lower prices or increase their profits, or both. Woolworths is a very large employer of labour in Australia, particularly of relatively unskilled workers, students and married women. Like other retailers, the wages bill is a large proportion of Woolworths’ costs, so even moderate increases in wage rates have a major impact. Also, it is difficult for Woolworths to pass on wage costs in higher prices because it is in competition with other retailers. When economic recovery occurs, if a shortage of labour once again arises and leads to an increase in wage rates, this would be a major concern to Woolworths.

© Newspix / News Ltd / 3rd Party Managed Reproduction & Supply Rights

7

ECONOMICS IN YOUR LIFE

SHOULD YOU CHANGE YOUR CAREER PLANS IF YOU GRADUATE DURING A RECESSION? Suppose that you are in your first year at university majoring in either economics or finance and you plan to find a job in the financial sector after you graduate. However, the economy is in a severe recession and the unemployment rate is the highest in your lifetime. Sizeable layoffs in the financial sector have occurred. Should you change your major? Should you still consider a job in the financial sector? As you read the chapter, see if you can answer these questions. You can check your answers against those we provide on page 194 at the end of this chapter.

SOURCE: Murdoch, Scott, ‘Skills shortage, wages pushing prices higher’, The Australian, April 30th 2007, News Limited.

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PART 4 UNEMPLOYMENT AND INFLATION

UNEMPLOYMENT AND INFLATION are the macroeconomic problems that are most often discussed in the media and during election campaigns. For many members of the general public the state of the economy is summarised in just two measures: the unemployment rate and the inflation rate. While inflation and unemployment are important problems, we saw in earlier chapters that the long-run success of an economy is also determined by its ability to generate high levels of real gross domestic product (GDP) per person. This chapter is devoted to discussing how the government measures the unemployment rate, the costs associated with unemployment, together with the various types and causes of unemployment. In particular, we look closely at the statistics on unemployment that the Australian Bureau of Statistics (ABS) issues each month. We also examine the effects that government policy has had on unemployment in Australia. In the following chapter we examine how inflation is measured and the economic problems that can be caused by inflation.

7.1 Define the unemployment rate and the labour force participation rate, and understand how they are calculated. LEARNING OBJECTIVE

MEASURING THE UNEMPLOYMENT RATE AND THE LABOUR FORCE PARTICIPATION RATE Each month the ABS reports its estimate of the previous month’s unemployment rate. If the unemployment rate is higher or lower than expected, investors are likely to change their views on the health of the economy. The unemployment rate can also have important political implications. In most federal elections the incumbent government stands a better chance of being re-elected if unemployment is falling in an election year, but less chance if unemployment is rising. The unemployment rate is a key macroeconomic statistic. But how does the ABS prepare its estimates of the unemployment rate? We will explore the answer to this question in this section.

The labour force survey

Unemployment rate The percentage of the labour force that is unemployed. Labour force The sum of employed and unemployed workers in the economy.

Discouraged workers People who are available for work but have not looked for a job during the previous four weeks because they believe no jobs are available for them.

Each month the ABS conducts the labour force survey, to collect data needed to calculate the unemployment rate. The ABS interviews adults in a sample of around 0.33 per cent of  the population about the employment status of everyone in the household aged 15 years and older. People are considered employed if they worked for at least one hour in paid employment in the week before the survey. If they have not, respondents are asked two further questions: first, have they actively sought work in the previous four weeks and, second, are they currently available to start work? Respondents are classified as unemployed only if they answer ‘no’ to the employment status question and ‘yes’ to both of these subsequent questions. The unemployment rate is the percentage of the labour force that is unemployed. The labour force is the sum of the employed and the unemployed. If a respondent does not meet the survey requirements of being either employed or unemployed, the person is classified as not being in the labour force, for example full-time homemakers or non-working retirees. Also not in the labour force are people who are classified as marginally attached to the labour force. These include people who have been looking for work but are not available to start work during the survey week, or are currently available for work  but have not been looking during the past four weeks. Some people have not actively looked for work recently for reasons such as their own ill-health or the ill-health of a family member, child care responsibilities or transportation difficulties. Other people who have not actively looked for work are called discouraged workers. Discouraged workers are available for work but have not looked for a job during the previous four weeks because they believe no jobs are available for them. Figure 7.1 shows the employment status of the population in March 2014. We can use the information in the figure to calculate two important macroeconomic indicators—the unemployment rate and the labour force participation rate.

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CHAPTER 7 UNEMPLOYMENT

FIGURE 7.1

The employment status of the population, Australia, March 2014 In March 2014 the working age population of Australia was over 18.953 million. The working age population is divided into those in the labour force (12.329 million) and those not in the labour force (6.624 million). The labour force is divided into the employed (11.562 million) and the unemployed (0.767 million). Those not in the labour force can be divided into two groups: those not available for work (5.663 million) and those available for work (0.961 million). Finally, those available for work but not in the labour force can be divided into discouraged workers (0.123 million) and those not working for other reasons (0.838 million)

Working age population 18.953 million

Labour force

Not in labour force

12.329 million

6.624 million

Employed

Unemployed

11.562 million

0.767 million

Not available for work (retirees, homemakers, full-time students, institutionalised)

Available for work, but not currently looking 0.961 million

5.663 million

Not currently looking for work due to other reasons(a)

Discouraged workers 0.123 million

0.838 million (a) Includes those wanting to work, but not available to work during the reference week and those unavailable to start work within four weeks.

SOURCE: Created from Australian Bureau of Statistics (2014), Labour Force, Cat. No. 6202.0, March. Author’s calculation derived from the Australian Bureau of Statistics (2013), Persons Not in the Labour Force, Australia, Cat. No. 6220.0, September, at , viewed 24 April 2014.

1 The unemployment rate. The unemployment rate measures the percentage of the labour force that is unemployed: Number of unemployed  100  unemployment rate Labour force

Using the numbers from Figure 7.1, we can calculate the unemployment rate for March 2014: 0.767 million 3 100 5 6.2 12.329 million

2 The labour force participation rate. The labour force participation rate measures the percentage of the working age population—that is, those aged 15 years and over—who are in the labour force:

Labour force participation rate The percentage of the working age population in the labour force.

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Labour force  100  labour force participation rate Working age population

For March 2014, the labour force participation rate was: 12.329 million 3 100 5 65% 18.953 million

The ABS also reports a second, but less commonly used, labour force participation rate, which measures the percentage of those aged 15–64 years who are in the labour force. In March 2014 this rate was 76.7 per cent.

Problems with measuring the unemployment rate Although the labour force survey reports the unemployment rate measured to one-tenth of a percentage point, it is not a perfect measure of the current state of joblessness in the economy. One problem confronting the ABS is distinguishing between the unemployed and people who are not in the labour force. During an economic recession, for example, an increase in discouraged workers usually occurs, as people who have had trouble finding a job stop actively looking. Because these workers are not counted as unemployed, the unemployment rate as measured by the ABS may significantly understate the true degree of joblessness in the economy. The ABS also counts as employed people who hold part-time jobs even though some would prefer to hold full-time jobs. Counting as ‘employed’ a part-time worker who wants to work full time tends to understate the degree of joblessness in the economy and make the employment situation appear better than it is. Not counting discouraged workers as unemployed and counting people as employed who are working part time, although they would prefer to be working full time, has a substantial effect on the measured unemployment rate. For example, in March 2014, if the ABS counted as unemployed all people who were available for work but not able to start work in the ABS survey week, plus discouraged workers, plus all people who were in part-time jobs but wanted full-time jobs, the unemployment rate would have increased from 6.2 per cent to approximately 14.5 per cent. This is known as the extended labour force underutilisation rate. There are other measurement problems, however, that cause the measured unemployment rate to overstate the true extent of joblessness. These problems arise because the labour force survey does not verify the responses of people included in the survey. Some people who claim to be unemployed and actively looking for work may not be actively looking. A person might claim to be actively looking for a job because they are embarrassed or might think they would no longer be eligible for government payments to the unemployed. In this case a person who is actually not in the labour force is counted as unemployed. Other people might be employed but engaged in illegal activity—such as drug dealing—or might want to conceal a legitimate job to avoid paying taxes. In these cases a person who is actually employed is counted as unemployed. These inaccurate responses to the survey cause the unemployment rate as measured by the ABS to overstate the true extent of joblessness. We can conclude that, although the unemployment rate provides some useful information about the employment situation in the country, it is far from an exact measure of joblessness in the economy. Also, remember that the measured unemployment rate is only an estimate based on a small sample, and is therefore subject to sampling error. Although the ABS publishes the standard errors for its monthly estimates, these are rarely reported in the media.

SOLVED PROBLEM 7.1 CORRECTLY INTERPRETING LABOUR FORCE DATA Suppose that between the months of August and September the unemployment rate rose from 4.3 per cent to 4.5 per cent. It might be tempting to assume that this means that some people have lost their jobs, without further investigating what has been happening in the labour market. Use the data in the following table to determine if: 1 2

the size of the labour force has increased or decreased in size and, if so, by how much; fewer people or more people in the economy have become employed.

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AUGUST

SEPTEMBER

Unemployment rate

4.3%

4.5%

Unemployed persons

480 000

510 174

Labour force participation rate

64.0%

65.0%

Solving the problem STEP 1: Review the chapter material. This problem is about understanding and interpreting labour force data, so you may want to

review the section ‘Measuring the unemployment rate and the labour force participation rate’ beginning on page 176. STEP 2: Use the information in the table to determine the change in size of the labour force. The labour force participation rate tells

us what proportion of people of working age—that is, aged 15 years and over—are in the labour force. The increase in the labour force participation rate between August and September, from 64 per cent to 65 per cent, means that the size of the labour force has increased. Recall that the labour force is measured as the number of employed people plus the number of unemployed people. In this example, in August the number of unemployed was 480 000 people, which represents 4.3 per cent of the labour force. The remaining 95.7 per cent were the employed people. Therefore the size of the labour force must have been: 480 000/0.043 (or 4.3%) = 11 162 790 people In September the number of unemployed people had risen to 510 174 people, which represented 4.5 per cent of the labour force. Therefore the size of the labour force was: 510 174/0.045 = 11 337 200 Between August and September the labour force rose by 11 337 200 – 11 162 790 = 174 410 people. STEP 3: Use your calculated results from Step 2 to calculate the change in the number of people employed. The number of

employed in August was 95.7 per cent of the labour force (4.3 per cent are unemployed). Therefore the number of employed people in August is 0.957 × 11 162 790 = 10 682 790. The number of employed in September was 95.5 per cent of the labour force (4.5 per cent are unemployed). Therefore the number of employed people in September is 0.955 × 11 337 200 = 10 827 026. The difference between the September employment figures and the August employment figures is: 10 827 026 – 10 682 790 = 144 236; an increase in employment This shows us that although the unemployment rate may be rising, this does not mean that the number of people with jobs is falling. As we have seen in this example, both the number of unemployed and employed can be rising at the same time. The key is the participation rate, which must be considered when assessing changes in the labour market. New people entering the labour force may be looking for work, increasing the unemployment rate, or they may be employed.

[ YOUR TURN Q

For more practice do related problem 1.5 on page 197 at the end of this chapter.

Trends in labour force participation The labour force participation rate is important because it determines the amount of labour that will be available to the economy from a given population. The higher the labour force participation rate, the more labour will be available and the higher a country’s level of potential GDP. Figure 7.2 highlights two important trends in labour force participation rates of adults aged 15 and over in Australia since 1978—the rising labour force participation rate of females and the falling labour force participation rate of males. The labour force participation rate of males fell from 79 per cent in 1978 to a low of 71.5 per cent in 2004, after which time the rate has remained relatively flat and was 71.2 per cent during 2014. Most of this general decline over time is due to older men retiring earlier

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FIGURE 7.2

Labour force participation by gender, Australia, 1978–2013 The labour force participation rate of adult men has declined gradually since 1978, and levelled off in the 2000s, but the labour force participation rate of adult women has increased rapidly, leaving the overall labour force participation rate today much higher than it was in 1978

85 Males Females

80 75

Per cent

70 65 60 55 50 45

14

12

20

10

20

08

20

06

20

04

20

02

20

00

20

98

20

96

19

94

19

92

19

90

19

88

19

86

19

84

19

82

19

80

19

19

19

78

40

SOURCE: Created from Australian Bureau of Statistics (2014), Labour Force, Australia—Detailed, Electronic Delivery, Table 01, Cat. No. 6291.0.55.001, at , viewed 24 April 2014.

and younger men remaining in school longer. There has also been a decline in labour force participation among males who are too young to retire. The decline in labour force participation among adult men has been more than offset by a sharp increase in the labour force participation rate for adult women, which rose from 44 per cent in 1978 to 59.1 per cent in 2014. As a result, the overall labour force participation rate rose from 61 per cent in 1978 to 65 per cent by 2014. The increase in the labour force participation rate for women has several causes, including changing social attitudes due in part to the women’s movement, federal legislation outlawing discrimination on the basis of gender, increasing wages for women, the desire to increase household income levels, increased availability of goods which reduce the time it takes to do household duties (such as automatic washing machines) and the typical family having fewer children.

How long are people usually unemployed?

Long-term unemployed Those in the labour force who have been continuously unemployed for a year or longer.

The longer a person is unemployed the greater the hardship and the more difficult it is to find a job. In Australia the typical unemployed person stays unemployed for a relatively brief period of time. Table 7.1 shows the percentage of the unemployed who had been unemployed for a given period of time. Around 66 per cent of the people unemployed in March 2014 had been unemployed for fewer than six months. Around 50 per cent had been unemployed for 13  weeks or less. The important conclusion is that, except in severe recessions, the typical person who loses a job finds another one or is recalled to a previous job within a few months. However, of great concern is the number of people who are unemployed for a long time. The percentage of all unemployed who had been continuously unemployed for a year or more, classified as the long-term unemployed, stood at 22.2 per cent in 2014. Figure 7.3 shows

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Duration of unemployment, 2014 PER CENT

Under 4 weeks

21.0

4–13 weeks

29.2

13–26 weeks

15.8

26–52 weeks

11.8

52 weeks and under 104 weeks

12.0

104 weeks and over

10.2

Total

100.0

Data as at March 2014. Percentages derived from total persons. SOURCE: Created from Australian Bureau of Statistics (2014), Labour Force, Australia—Detailed, Electronic Delivery, Cat. No. 6291.0.55.001, Table 14A, at , viewed 24 April 2014.

FIGURE 7.3

Long-term unemployed (%) by highest level of educational attainment Over 50 per cent of the long-term unemployed have the lowest level of education, leaving school having completed high school Year 10 or less

60

50

Per cent

40

30

20

10

0 University degree

Advanced diploma/Diploma

TAFE certificate III/IV

TAFE certificate I/II

Year 10 high school

Note: Approximately 4 per cent of long-term unemployed have non-school qualifications which have not been classified in this figure. SOURCE: Created from Australian Bureau of Statistics (2013), Job Search Experience of Unemployed People, Cat. No. 6222.0, Table 9, at , viewed 10 December 2013.

that of the long-term unemployed, just over 50 per cent have the lowest level of education, leaving school having completed high school Year 10 or less. Age is also an important factor in long-term unemployment. The older a person is the more likely they are to become longterm unemployed. Figure 7.4 clearly shows that of those who are over 55 years of age and unemployed, the majority are long-term unemployed. It is important to note, as we will see in a later section, that the unemployment rate among those over the age of 55 years is lower than the average total rate of unemployment.

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FIGURE 7.4

Average duration of unemployment by age, 2013 The older a person is the more likely they are to become long-term unemployed. This figure clearly shows that of those over 55 years of age who are unemployed, the majority are long-term unemployed

120

100

Weeks

80

60

40

20

0

15–19

20–24

25–34

35–44

45–54

55–-59

60–64

65 and over

Age

SOURCE: Created from Australian Bureau of Statistics (2013), Labour Force, Australia—Detailed, Electronic Delivery, Cat. No. 6291.0.55.001, Data Cube ST UM3_Apr01, Unemployed Persons by Age, Sex, State, Duration of Unemployment from April 2001, at , viewed 13 December 2013. Note: Data calculated via SuperTable was selected as Month by Age by Average Duration Only, and is for October 2013.

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7.1

ONNECTION

WHAT EXPLAINS THE INCREASE IN WELFARE RECIPIENTS? The number of people receiving certain categories of social security benefits, namely the benefit for sole parents, the disability support pension and unemployment benefits, has changed over time. There are some interesting features in terms of the number of recipients at any point in time and with respect to trends over time.

© Elena Elisseeva | Dreamstime.com

The number of people receiving welfare payments has generally increased over time

The number of people receiving unemployment benefits roughly tracks the ABS unemployment estimates, which have fluctuated with the business cycle and economic shocks. The number of people receiving single-parent pensions more than doubled over the 20 years to 2000, and continued to rise up to 2013. Perhaps most interesting is that the number of people receiving disability support pensions has quadrupled since 1980, rising from a little over 200 000 people in 1980 to almost 822 000 people by 2013. This dramatic increase can be clearly seen from the figure on page 183.

Analysis of these trends suggests that the rise in people on disability pensions is inversely related to those receiving unemployment benefit payments, despite Australians being generally healthier over time and accidents in the workplace falling over time. There appears to have been a movement of people from unemployment benefits to pensions. This led to an inquiry by the federal government in 2010.

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183

1000

Thousands

800

600

400

200

0

1980

1985

1990

1995

2000

2005

2010

2013

SOURCE: P. Lewis (2007), ‘The impact of minimum wages: Some considerations for the Australian Fair Pay Commission in its second decision on the minimum wage’, Fair Pay Commission, April; Department of Families, Housing, Community Services and Indigenous Affairs (FaHCSIA) (2013), Annual Report, 2012–13, at , viewed 14 December 2013.

While reducing the figures for those on unemployment benefits, the move from unemployment benefits to pensions is costly for government, since pensions are indexed to average male weekly ordinary time earnings while unemployment benefits are indexed to the consumer price index measure of inflation. Since average weekly earnings have been rising at a rate faster than the rate of inflation, this means that the rate of increase in income received from a pension has been increasing faster than the rate of increase in the income received from the unemployment benefit. It is also more attractive to be on a pension than on unemployment benefits not only because the payments are greater, but because the requirements to look for work are less for people on pensions.

Job creation and job destruction One important fact about employment is not very well known: the Australian economy creates and destroys hundreds of thousands of jobs every year. Job creation and destruction is what we would expect in a vibrant market system where new firms are constantly being started, some existing firms are expanding, some existing firms are contracting and some firms are going out of business. The creation and destruction of jobs result from changes in consumer tastes, technological progress, together with the successes and failures of entrepreneurs in responding to the opportunities and challenges of shifting consumer tastes and technological change. The volume of job creation and job destruction helps explain why during most years the typical person who loses a job is unemployed for a relatively brief period of time. When the ABS announces each month the increases or decreases in the number of persons employed and unemployed, these are net figures. That is, the change in the number of persons employed is equal to the total number of jobs created minus the number of jobs eliminated. Figure 7.5 shows the growth in net jobs for full-time, part-time and total employment in Australia from 1978 to 2013. It is clear that jobs growth has occurred both in full-time and part-time jobs. Total net job growth in Australia accelerated throughout the 2000s before significantly slowing down in 2013. In the decade from 2003 to 2013 total net jobs growth grew by 23 per cent, with the rate of growth in full-time jobs at 21 per cent and part-time jobs at 29 per cent. This compares to an almost identical growth rate in total net jobs of 23.5 per cent in the previous decade, but with full-time jobs growing only 15 per cent and part-time jobs growing at just over 52 per cent during this time.

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FIGURE 7.5

Growth in employment in Australia, 1978–2013 This figure shows the growth in net jobs for full-time, part-time and total employment in Australia from 1978 to 2013. It is clear that until very recently job growth has occurred both in full-time and part-time jobs

12 000

10 000

Full-time employment Part-time employment Total employment

Thousands

8000

6000

4000

2000

0 1978

1983

1988

1993

1998

2003

2008

2013

SOURCE: Created from Australian Bureau of Statistics (2013), Labour Force, Australia, Cat. No. 6202.0, Time Series Workbook, Table 01, Labour Force Status by Sex-Trend at , viewed 14 December 2013.

THE COSTS OF UNEMPLOYMENT 7.2 Explain the economic costs of unemployment. LEARNING OBJECTIVE

There are extremely good economic and social reasons for economic policy to focus on reducing the rate of unemployment. The costs to the individual and to the economy are substantial. Further, the costs to the individual from being unemployed are not equally distributed among the different age, education and socioeconomic groups.

Costs to the economy Loss of GDP For the economy, unemployment means that there is a loss of GDP. If everyone who is willing and able to work could find a job, this would increase total output in the economy.

Loss or deterioration of human capital For the economy and for the individual, unemployment, particularly for lengthy periods of time, can lead to a loss of human capital because a person’s skills may deteriorate when they are not using them.

Retraining costs Unemployment imposes costs in terms of retraining, although retraining may ultimately lead to a more productive workforce. The unemployed may have to retrain due to their skills deteriorating during their period of unemployment, or because their pre-existing skills are no longer required by the economy.

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185

Costs to the government In Australia and many other countries unemployed people can receive a benefit payment from the government. This represents a net drain on the budget of the government, and also carries with it an opportunity cost—namely, the government could have used the funds for other expenditures. The impact on a government’s budget increases during times of rising unemployment, due not only to the increase in unemployment benefits paid by the government, but also to the loss of tax revenue that the government would have received had more people been working and paying personal income tax. Further, given that unemployed people normally have significantly lower incomes than if they were working, they spend less, which means businesses have lower sales and profits than if there had been full employment. Lower business profits translate into less company income tax revenue for the government, and lower consumer spending also means less goods and services tax (GST) revenue to the government.

Costs to the individual Loss of income When a previously employed person becomes unemployed they experience a significant reduction in income, equal to the difference between their previous wage level and the unemployment benefit. Unemployment is one of the main causes of poverty. In Australia in 2014 the unemployment benefit—known as the Newstart Allowance—was 40 per cent of the minimum wage and 17.5 per cent of the average full-time wage for a full-time single adult with no children. However, recipients of Newstart also have access to other allowances for rent assistance, education, children and a number of other areas. For example, when all allowances are considered, a couple with two children would actually receive an income in terms of government benefits that is about 70 per cent of what they would have received if they were earning the minimum wage. Some believe this amount is too high and reduces the incentive to find work as soon as possible. However, it should be remembered that this payment is still much less than the average wage. As we will see later in this chapter, unemployment benefits have been blamed for both encouraging people to remain unemployed and praised for providing income for people enabling them to take the time necessary to search for a suitable job.

Social costs As we discussed earlier, the individual may also experience loss of skills during their period of unemployment, and retraining costs. However, becoming unemployed can also lead to despair and loss of self-esteem. Further, a number of studies have found that unemployment can be a factor in family break-ups, health problems, mental illness, crime and political unrest.

The distribution of unemployment It is important to note that there is an unequal distribution of unemployment throughout society. The rate of unemployment is significantly higher among the youngest in the labour force, higher among those who have relatively lower levels of formal education and had averaged about the same for females as males in recent years. Indigenous Australians also have a higher than average rate of unemployment and generally have lower levels of education than non-Indigenous Australians. Figure 7.6 shows the rate of unemployment by age group in Australia. We can clearly see that the rate of unemployment is significantly higher, 18.5 per cent, among 15–19 year olds than for any other group. This group has little or no skills or work experience. The unemployment rate for people aged 25–34  years is much lower, at 5.7 per cent, and for people aged 35 years and over the rate is even lower, at around 4.8 per cent. Australian economic studies have also found that the chances of being unemployed are much higher if a person lives in a lower socioeconomic income area and if a person’s parents have a lower level of education. Clearly unemployment is a contributing factor to inequity in society.

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FIGURE 7.6

Unemployment rate by age, 2014 The rate of unemployment is significantly higher among 15–19 year olds than for any other group, at 16 per cent. The unemployment rate for people aged 25–34 years is much lower, at a little under 5 per cent, and for people aged 35 years and over the rate is even lower, averaging approximately 4 per cent 20 18 16 14 Per cent

12 10 8 6 4 2 0

15–19

20–24

25–34

35–44

45–54

55–59

60–64

65 and over

Age

SOURCE: Australian Bureau of Statistics (2014), Labour Force, Australia, Detailed—Electronic Delivery, Cat No. 6291.0.55.001, Table 01, at , viewed 24 April 2014. © Commonwealth of Australia.

TYPES OF UNEMPLOYMENT 7.3 Identify the types of unemployment. LEARNING OBJECTIVE

Figure 7.7 illustrates that the unemployment rate follows the business cycle, rising during economic contractions and recessions and falling during economic expansions and booms. The worldwide ‘oil shock’ of the early 1970s, caused when the cartel group of the Organization of Petroleum Exporting Countries (OPEC) significantly increased the price of oil to the rest of the world, required considerable economic structural adjustment in many economies throughout the world, including Australia. In Australia this adjustment was hindered by excessive regulation, including tariff protection, plus lack of labour market flexibility, particularly downward wage rigidity, and possibly inappropriate macroeconomic policy (see Chapter 5). The impact of the federal government’s wages policy, known as the Prices and Incomes Accord, which operated from 1983 to 1996, in reducing real wages, thereby increasing employment, can be seen in the early 1980s. The effects of the government policy of huge rises in interest rates in 1988–1989, which caused Australia’s most severe recession since the Great Depression of 1929–1933, is clearly evident in the early 1990s, where unemployment rose to almost 11 per cent. The economic recovery was followed by 17 years of continuous economic growth, accompanied by a decline in the unemployment rate to 4.2 per cent by 2008—the lowest unemployment rate in 33 years. By the end of 2008 the global financial crisis was impacting on Australia, causing an economic contraction and an increase in unemployment, which reached 5.8 per cent by mid-2009. After that time, some economic recovery occurred, leading to a slow decline in the unemployment rate, but below-trend economic growth saw the unemployment rate reach 6 per cent by early 2014.

Cyclical unemployment When the economy moves into a contraction or recession many firms find their sales falling and cut back on production. As production falls they start laying off workers. Workers who

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FIGURE 7.7

The annual unemployment rate in Australia, 1960–2013 The unemployment rate rises during economic contractions and recessions and falls during economic expansions and booms. The fall in the unemployment rate following the end of a recession often lags behind the economic recovery 12 10

Per cent

8 6 4 2 0 1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

2010

SOURCE: Created from Australian Bureau of Statistics (2013), Labour Force, Australia, Cat. No. 6202.0, at , viewed 12 December 2013; Australian Bureau of Statistics, Labour Force, Australia, Cat. No. 6203.0 (earlier editions), at , viewed 12 December 2013.

lose their jobs because of a contraction or recession are experiencing cyclical unemployment (also known as demand-deficient unemployment). When the economy begins to recover, cyclical unemployment begins to fall, although with a lag. It is important to note that when an economy begins to recover, and the economic growth rate increases, the unemployment rate does not immediately fall. In fact, the rate of unemployment often continues to rise for some time after a recession is over. This is due to two main factors. During a contraction or recession the proportion of discouraged workers increases, as some unemployed people give up looking for work, believing that they won’t find a job. This reduces the participation rate and hides the full extent of unemployment. Once the economy begins to grow again, discouraged workers re-enter the workforce, believing that economic growth will provide jobs. However, until they find work they are unemployed, increasing the unemployment rate. The second factor is that businesses can be reluctant to hire more workers after a recession until they are convinced that the economic recovery is a lasting recovery. Businesses do not enjoy sacking workers during a recession, and they may have had to sack many workers when production levels fall during a recession. Therefore they do not want to go through the sacking process again should the economic recovery only be temporary. Notice, though, that the unemployment rate never falls to zero. To understand why this is true we need to discuss the other types of unemployment: 1 Frictional unemployment 2 Structural unemployment

Cyclical unemployment Unemployment caused by a business cycle contraction.

Frictional unemployment and job search Workers have different skills, interests and abilities, and jobs have different skill requirements, working conditions and pay levels. As a result, workers who have lost their jobs or quit to look for new jobs or workers entering the labour force will probably not find an acceptable job right away. New workers include school leavers and college and university graduates, together with people re-entering the workforce after a period of absence (perhaps due to children). Most workers spend at least some time engaging in job search, just as most firms spend time searching for a new person to fill a job opening. Frictional unemployment is short-term unemployment that arises

Frictional unemployment Short-term unemployment arising from the process of matching workers with jobs.

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Seasonal unemployment  Unemployment due to factors such as weather, variations in tourism and other calendar-related events.

from the process of matching workers with jobs. Some frictional unemployment is unavoidable. The process of job search takes time, so there will always be some workers who are frictionally unemployed because they are between jobs and in the process of searching for new ones. Some unemployment is due to seasonal factors, such as weather or fluctuations in demand during different times of the year. For example, businesses located in beach resort areas reduce their hiring during the winter, just as ski resorts reduce their hiring during the summer. Department stores increase their hiring in November and December, and reduce their hiring after the traditional Christmas and sales periods. In agricultural areas employment increases during harvest season and declines thereafter. Seasonal unemployment refers to unemployment due to factors such as weather, variations in tourism and other calendar-related events. Because seasonal unemployment can make the unemployment rate seem artificially high during some months and artificially low during other months, the ABS reports two unemployment rates each month—one that is seasonally adjusted and one that is not seasonally adjusted. The seasonally adjusted data eliminate the effects of seasonal unemployment. Economists and policy-makers rely on the seasonally adjusted data as a more accurate measure of the current state of the labour market. Would eliminating all frictional unemployment be good for the economy? The answer is no. In fact, some frictional unemployment is good for the economy because it represents workers and firms taking the time necessary to ensure a good match between the attributes of workers and the characteristics of jobs. By devoting time to searching for jobs workers end up with jobs they find satisfying and in which they can be productive. Of course, having more productive and better satisfied workers is also in the best interest of firms. The existence of frictional unemployment also means that there are new people, many with skills (such as graduates), entering the workforce, which is indicative of a dynamic and growing economy.

Structural unemployment

Structural unemployment Unemployment arising from a persistent mismatch between the skills and characteristics of workers and the requirements of jobs.

In Australia the percentage of workers in manual jobs has been declining over several decades with the decline in manufacturing output and increases in productivity in other ‘industrial’ areas such as utilities, telecommunications and agriculture. To become employed again many of the people need to become skilled in other jobs. Until these people are retrained they are unemployed. Others have been unable to find alternative work, particularly older men, since the skills in new jobs that have been created, mainly in the service sector, do not match theirs. Economists consider these people structurally unemployed. Structural unemployment arises from a persistent mismatch between the job skills or attributes of workers and the requirements of jobs. While frictional unemployment is short term, structural unemployment can last for longer periods because workers need time to learn new skills and some may never acquire these. Some workers lack even basic skills, such as literacy, or have addictions to drugs or alcohol, that make it difficult for them to adequately perform the duties of almost any job. These workers may remain structurally unemployed for years.

Full employment

Natural rate of unemployment The unemployment rate that exists when the economy is operating at potential GDP. Non-accelerating inflation rate of unemployment (NAIRU) The level of unemployment below which the rate of inflation will rise.

As the economy moves through the expansion phase of the business cycle, cyclical unemployment will eventually drop to zero. The unemployment rate will not be zero, however, because of frictional and structural unemployment. As Figure 7.7 shows, the unemployment rate in Australia has not fallen below 4 per cent for almost four decades. When the only remaining unemployment is structural and frictional unemployment, the economy is said to be at full employment. Economists often think of frictional and structural unemployment as being the normal underlying level of unemployment in the economy. The fluctuations around this normal level of unemployment, which we see in Figure 7.7, are mainly due to the changes in the level of cyclical unemployment. The normal level of unemployment, which is the sum of frictional and structural unemployment, is referred to as the natural rate of unemployment, and occurs when the economy is operating at potential GDP; there is no cyclical unemployment. Economists disagree on the exact magnitude of the natural rate of unemployment, and there is good reason to believe it varies over time. The natural rate of unemployment is also sometimes called the full-employment rate of unemployment. Another term closely related to the natural rate of unemployment is the non-accelerating inflation rate of unemployment (NAIRU). This is the level of

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unemployment below which the rate of inflation will rise. If the unemployment rate falls below the NAIRU, firms will find it harder to retain and recruit workers without increasing wages. These increases in wages will then flow through to increases in prices.

HOW SHOULD WE CATEGORISE UNEMPLOYMENT IN AUSTRALIA?

M

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A K I N G THE

Take another look at Figure 7.7. You will notice that the historical average for the unemployment rate in Australia until the mid-1970s was about 2 per cent but rose almost continuously until the early 1980s. Two per cent would have been regarded as the ‘natural’ or ‘full employment’ rate of unemployment and the appropriate aim of policy.

ONNECTION

7.2

The oil shock of 1973–1974 significantly increased oil prices worldwide. This greatly increased costs of production, leading to high levels of inflation, falling supply and demand, and rising unemployment. The wages policy encompassed in the Prices and Incomes Accord was very effective in reducing real wages in the early 1980s. The impact was to reduce the unemployment rate significantly. However, the impact of the huge rise in interest © Andrew Kazmierski | Dreamstime.com rates in the late 1980s, which led to a recession, is clearly evident as seen by the How do we categorise unemployment in very large rise in the unemployment rate in the early 1990s. After the recession, Australia? economic growth remained strong until early 2008, and the unemployment rate fell to its lowest level since the early 1970s. The global financial crisis led to an economic contraction in the Australian economy, during which time the unemployment rate rose again, and subsequently remained between 5 per cent and 6 per cent for many years. The persistence of high unemployment after the oil shock was clearly an example of cyclical unemployment as most developed countries experienced a long recession. There was also a large degree of structural unemployment because the Australian economy was incapable of adjusting smoothly to a changed world economic environment. The interest-rate-rise-induced recession in 1990 brought about cyclical unemployment. With unemployment at relatively low levels during most of the 2000s, it is likely that frictional unemployment comprised a larger share of unemployment. However, the persistence of relatively high unemployment rates and the high percentages of people in certain categories not working, such as older unskilled workers, suggest that a large degree of current unemployment is structural.

Don’t confuse ‘full employment’ with a zero unemployment rate At first thought it might seem reasonable to conclude that, if the economy is experiencing ‘full employment’, no one is unemployed, and the unemployment rate must therefore be zero. However, this conclusion is incorrect. As we have learned in this chapter, when economists refer to ‘full employment’ they mean that there is no cyclical unemployment in the economy. No matter how strong an economy’s economic growth rate is, there will always be some natural unemployment.

DON’T LET THIS HAPPEN TO YOU

The natural rate of unemployment includes frictional and structural unemployment, which always exist. In fact, the existence of some frictional and structural unemployment can indicate that an economy is efficient and is adapting to changes in consumer demand, technology and other factors over time. Therefore, the term ‘full employment’ does not mean that the unemployment rate is zero—at full employment the unemployment rate will be positive, but usually relatively low.

[ YOUR TURN Q

Test your understanding by doing related problem 3.8 on page 198 at the end of this chapter.

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7.4 Explain what factors determine the unemployment rate. LEARNING OBJECTIVE

EXPLAINING FRICTIONAL AND STRUCTURAL UNEMPLOYMENT We have seen that some unemployment (cyclical) is caused by the business cycle. In this section we look at what determines the levels of frictional and structural unemployment in Australia. That is, we examine factors that influence the natural rate of unemployment.

Government policies and the unemployment rate

Job Services Australia A national network of private and community recruitment agencies that find jobs for unemployed people and other job seekers.

The process of job search is primarily carried out privately. Workers search for jobs, for example, by sending out résumés, registering with job search agencies, registering on Internet job sites or getting job referrals from friends and relatives. Firms fill job openings in a number of ways, including by advertising on the Internet and in newspapers, and employing the services  of employment agencies. Perhaps surprisingly, many jobs are filled through what is called ‘cold calling’, which is when a person looking for a job contacts a potential employer asking if they have a job available. Government policy can aid these private efforts. Governments can help reduce the level of frictional unemployment by pursuing policies that help speed up the process of matching unemployed workers with unfilled jobs. Governments can help reduce structural unemployment through policies that aid the retraining of workers. Job Services Australia is a nationwide network of private and community recruitment agencies that find jobs for the unemployed and other people seeking to change jobs. Job Services Australia providers receive a range of payments from the government depending on the degree of difficulty in placing the unemployed individual and the degree of success in finding the person a job. Some government policies, however, can add to the level of frictional and structural unemployment. These government policies increase the unemployment rate either by increasing the time workers devote to searching for jobs, by providing disincentives to firms to hire workers or by keeping wages above their market level.

Social security and other payments to the unemployed Suppose you have been in the labour force for a few years but have just lost your job. You could probably find a low-wage job immediately if you needed to—perhaps at Woolworths or McDonald’s. But you might decide to search for a better, higher-paying job by registering with a job search agency, sending out résumés and responding to newspaper advertisements and Internet job postings. Remember from Chapter 1 that the opportunity cost of any activity is the highest-valued alternative that you must give up to engage in that activity. In this case the opportunity cost of continuing to search for a job is the wage you are giving up at the job you could have taken. The longer you search the better your chances of finding a better, higherpaying job, but the longer you search the more wages you have given up by not working, so the greater the opportunity cost. On the other hand, unemployment benefits payments, at least in the short term, might improve job search since there is not the pressure for an unemployed person to take the first job available. Therefore, an unemployed person is better able to find a job they are best suited for and labour market efficiency will be improved. In Australia and most other industrial countries the unemployed are eligible for social security payments from the government. In Australia these payments are equal to about 40 per cent of the minimum wage for a single person, but are considerably higher for a person with children. The unemployed spend more time searching for jobs because they receive these payments. This additional time spent searching raises the unemployment rate. Does this mean that unemployment benefits are a bad idea? Most economists would say no. Unemployment benefits help the unemployed maintain their income and spending, which lessens the personal impact of being unemployed, and enables increased demand for goods and services, which also helps reduce the severity of recessions. In Australia there is no limitation on the length of time for which people can receive unemployment benefits. In the United States typical unemployed workers are eligible to receive unemployment insurance payments equal to about half their previous wage for

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only six months, although this period is typically extended during recessions. After that the opportunity cost of continuing to search for a job rises. In many other high-income countries, such as Canada and most of the countries of Western Europe, workers are eligible to receive unemployment payments for a year or more, and the payments may equal 70 per cent to 80 per cent of their previous wage. Because the opportunity cost of job search is lower in Australia, Canada and Western Europe, unemployed workers in those countries search longer for jobs and therefore the unemployment rates in those countries tend to be higher than in the United States.

LABOUR MARKET REGULATION AND DEREGULATION Australia has moved from a highly centralised wages and industrial relations system to a more decentralised system. A complex system of award wages and working conditions and interlocking federal and state government legislation has been removed or revised, with the goal of increasing labour market flexibility. How, then, does labour market regulation and deregulation relate to employment and unemployment? Economists do not always agree on the effects of regulation or deregulation on job creation and wages. We will explore many of the arguments put forward in this section. Australia had, for most of the twentieth century, a system of wage determination, and of industrial relations more generally, that had only one or two counterparts in the rest of the industrialised world, known as compulsory arbitration. A major distinguishing feature of  the Australian system was the role played by a range of arbitration and conciliation tribunals, the dominant institution being the Australian Industrial Relations Commission (AIRC), although it formerly had other titles. These tribunals set the minimum rates of pay and the conditions of work of employees, set out in awards. Awards originally came about as a result of submissions made by unions and by employers, on which the tribunals arbitrated. In the early 1980s compulsory arbitration was the dominant form of wage determination. In 1991 the AIRC encouraged workers and their employers to bargain directly with each other at the enterprise level. This is known as enterprise bargaining, where wages and working conditions are negotiated between employers and unions, or between employers and  employees at the workplace level. Enterprise bargaining was given a further stimulus by the Industrial Relations Act 1993, which came into force in 1994. This introduction of enterprise bargaining was perhaps the most significant change to industrial relations in Australia’s history. By 2006 about one-half of all employees in the federal jurisdiction were covered by an enterprise agreement. In 2006 the Coalition government enacted legislation for significant change to the workplace relations system. WorkChoices refers to the substantial amendments made to the Workplace Relations Act 1996. Changes included the creation of a national workplace relations system; increasing the capacity of employers, employees and unions to make agreements; reforming the setting of the minimum wage and conditions; the establishment of the Australian Fair Pay Commission (AFPC) to replace the AIRC for the purpose of setting the minimum wages and conditions; union rights of entry to the workplace prohibited from agreements; and reducing the coverage of unfair dismissal laws. WorkChoices proved electorally unpopular, and the change in the federal government in November 2007 to the Australian Labor Party (ALP) led to the abolition of the WorkChoices legislation. Although some of the labour market deregulation remained, some employer groups expressed concern about areas that were reregulated. It is clear that over the past 30 years workers in Australia have their pay determined through less regulated bargaining. What are the advantages of less regulated bargaining? It is argued that it leads to greater labour market flexibility. This flexibility allows labour to move to where it can be used more efficiently, thereby reducing frictional and structural unemployment. Several other advantages are claimed for labour market flexibility. It is argued that it enables workers to identify with the enterprise and its performance because improved work practices should lead to increases in pay. It should also encourage dispute resolution in the workplace.

7.5 Describe the changes that have occurred in the determination of wages in Australia and discuss the possible effects on unemployment. LEARNING OBJECTIVE

Enterprise bargaining Wages and working conditions negotiations between employers and unions or employers and employees at the workplace level.

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A highly regulated labour market may impede the development of good industrial relations in enterprises because the parties may believe that disputes will ultimately be arbitrated. Enterprise and individual bargaining brings with it some disadvantages which have to be weighed against its benefits. These are concerned with equity. The system of compulsory arbitration and minimum wages acted to protect workers in weak bargaining positions and these are, of course, likely to be lower paid workers. The evidence shows that the relative pay of low-paid workers is higher in Australia than in most industrialised countries. Increased labour market flexibility would be expected to cause a decline in the position of low-paid workers. This is recognised by governments in many countries, including Australia, with what are called ‘safety net’ increases in pay for those unable to conclude enterprise bargains. Safety net increases are higher than any increases the individual low-paid worker would have been able to bargain for. Critics of individual contracts also argue that workers bargaining together as a group have greater success in terms of wages and conditions than when workers bargain individually.

Minimum wages In Australia the bulk of workers are covered by minimum wages set by Fair Work Australia, the replacement for the AFPC, and some by minimum wages set by state governments. Although most workers are covered by minimum wage laws, most earn wages that are much higher than the minimum so they are largely unaffected by the minimum wage legislation. Therefore, the effect of imposing a minimum wage is to increase the wages only of those who would otherwise receive the lowest wages. The imposition of minimum wages affects only those in low-skilled, low-paid jobs. These individuals are, generally, very poor substitutes for the majority of the workforce and therefore minimum wages have little impact on the wages and employment of most workers. However, those workers earning just above the minimum wage are highly substitutable for those who would otherwise earn below the minimum. Firms employ less of those who would have earned below the minimum wage and therefore unemployment among this group rises. However, these workers are substituted by more workers earning just above the minimum wage. The net effect on total employment may be difficult to detect. Therefore one view held by some economists is that the effect of minimum wages is to cause a large reduction in employment of workers who could otherwise have earned below the minimum wage. It is argued that minimum wages are all about redistribution. Jobs and income are redistributed away from the worst off— the unemployed. An alternative view, held by a number of economists, is that minimum wages have very little effect on employment, and therefore the protection of workers’ wages offered by minimum wage legislation outweighs any possible small (if any) effect on employment.

Trade unions Trade unions are organisations of workers that bargain with employers for higher wages and better working conditions for their members. In unionised industries wages are usually above what they would otherwise be if wages were left to be determined by the market. Above-market wages result in employers in unionised industries hiring fewer workers. But does it also increase the overall unemployment rate in the economy? Most economists would say the answer is yes. In Australia in 2014 around 18 per cent of workers were members of a union, and over 90 per cent of Australian businesses have no union members at all. This compares with around 40 per cent of workers being in a union in 1990 and 25 per cent in 2000. Unions remain strong in the public sector and in some private sector industries, such as construction, transport and telecommunications. By raising the wage in unionised workplaces above the market rate there are fewer jobs than would be the case at market wages. Also, importantly, by improving conditions for their members and providing other services such as representation in disputes—which is of benefit to members—this increases costs for employers, which means that there will be less employment than there otherwise would be without unions.

Efficiency wages Many firms pay higher-than-market wages, not because the government requires them to or because they are unionised, but because they believe doing so will increase their profits. This

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link may seem like a paradox. Wages are the largest cost for many employers, so paying higher wages seems like a good way for firms to lower profits rather than to increase them. The key to understanding the paradox is that the level of wages can affect the level of worker productivity. Many studies have shown that workers are motivated to work harder if they receive higher wages. An efficiency wage is a higher-than-market wage paid by a firm to motivate workers to be more productive. Can’t firms ensure that workers work hard by supervising them? In some cases they can. For example, telemarketers can be monitored electronically to ensure they make the required number of phone calls per hour. In many business situations, however, it is much more difficult to monitor workers. Many firms must rely on workers being motivated enough to work hard. In fact, the following is the key to the efficiency wage: by paying a wage above the market wage the firm raises the costs to workers of losing their jobs because alternative jobs may pay only the market wage. The increase in productivity that results from paying the high wage can more than offset the cost of the wage, thereby lowering the firm’s costs of production. Because the efficiency wage is above the market wage, it results in the quantity of labour supplied being greater than the quantity of labour demanded, just as do minimum wage laws and unions. So efficiency wages are another reason economies experience some unemployment even when cyclical unemployment is zero.

WHY DID HENRY FORD PAY HIS WORKERS TWICE AS MUCH AS OTHER CAR MANUFACTURERS?

M

193

Efficiency wage A higher-than-market wage paid by a firm to increase worker productivity.

C

A K I N G THE

ONNECTION

7.3

In January 1914 Henry Ford began paying his workers $0.625 per hour, or $5.00 for an eight-hour day, which was more than twice as much as other car manufacturers were paying in the United States. Why would Henry Ford pay his workers more than twice as much as other firms? Ford had recently installed the first moving assembly line in his factory at Highland Park, Michigan. The moving assembly line greatly increased labour productivity, but most Ford workers hated it. Under the old assembly system the cars remained stationary on the factory floor and each worker had several jobs to do as they moved from one car to another. With the moving assembly line, each worker remained in the same spot all day, performing the same task—sometimes just installing a bolt or tightening a nut— over and over. Many workers found this excruciatingly boring, and many left to take less monotonous jobs at other firms. Each time a worker left Ford had the expense of hiring and training a new one. These expenses became very high: of the 15 000 workers employed by the company on 31 December 1913, only 640 had worked at Ford for more than three months. With the introduction of the $5-dollar-a-day wage, Ford went from having difficulty keeping workers to having long lines of men at the factory gate every morning applying for work. The New York Times described the situation the morning Ford first began paying the new wage:

© Underwood & Underwood/Corbis

Henry Ford claimed that paying a wage twice as high as his competitors was the best cost-cutting move he ever made

‘Twelve thousand men…[rushed] the plant which resulted in a riot and turning of a fire hose on the crowd in weather but little different from zero [degrees]…As soon as the job hunters had dried or changed their clothing they came back.’ Ford had begun paying an efficiency wage. According to Ford’s official biographer, paying $5 per day had ‘improved the discipline of the workers, given them a more loyal interest in the institution, and raised their personal efficiency’. Henry Ford himself later wrote: ‘The payment of five dollars a day for an eight-hour day was one of the finest cost-cutting moves we ever made.’ SOURCE: David A. Hounshell (1984), From the American System to Mass Production, 1800–1932, Baltimore, The Johns Hopkins University Press, Ch. 6; Daniel M.G. Raff and Lawrence H. Summers (1987), ‘Did Henry Ford pay efficiency wages?’, Journal of Labor Economics, Vol. 5, No. 4, Part 2, October, pp. S57–S86; and Alan Nevins and Frank Ernest Hill (1954), Ford: The Times, the Man, the Company, New York, Scribner’s, pp. 538, 550.

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ECONOMICS IN YOUR LIFE (continued from page 175)

SHOULD YOU CHANGE YOUR CAREER PLANS IF YOU GRADUATE DURING A RECESSION? At the beginning of this chapter, we asked whether layoffs in the financial sector should cause you to change your major at university and give up your plans to pursue a career in the financial sector. We have learned in this chapter that unemployment rates are higher and layoffs are common during an economic contraction or a recession. Because you are an undergraduate, you will graduate a few years later, when the recession is likely to have ended and the unemployment rate will begin to decline. You might also want to investigate whether the layoffs in the financial sector represent a permanent contraction in the size of the sector or whether they reflect a temporary decline due to the recession. If the reduction of jobs is more likely to be permanent, then you might consider a career in another industry. If the layoffs appear to be related to the current recession, then you probably do not need to change your career plans.

CONCLUSION Unemployment is a key macroeconomic problem and has significant costs attached to it—both to the individuals who are unemployed and to the economy. As we have seen, it is important to remember that the official unemployment rate does not measure the full extent of unemployment, such as those who are discouraged and stop looking for work. As discussed in this chapter, government policy can reduce unemployment by improving the efficiency of the labour market. These policies can be classified as microeconomic policies. These include improving job search through such agencies as those in Job Services Australia, tightening eligibility to unemployment and other benefits and deregulating the labour market. These policies are often referred to as supply-side policies since they attempt to increase the supply of goods and services by firms increasing output and employing more workers. The setting of pay and employment conditions in Australia has changed over time, moving from a regulated system in the 1970s to a more deregulated system in the 2000s. However, typically in economics, much government policy to reduce unemployment has focused on the demand side of the economy. Under this view employment is largely determined by the level of aggregate demand. Hence the focus is on using fiscal policy and monetary policy, which we will learn about in Chapters 12 and 13, to increase aggregate demand, GDP and employment. Supply-side policies are also covered in Chapter 13. Read ‘An inside look’ to learn of the continuing problem of youth unemployment in Australia.

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AN INSIDE LOOK NG SYDNEY MORNI

NE 2013 HERALD 30 JU

n i p u e t a r s Youth jobles -west h t u o s ’s y e Sydn by Rachel Browne

Market ntre for Labour Ce ’s ra er nb Ca tration of University of , said the concen parts is e w m Le so il in Ph , le or op ct re pe rates for young e Research Di worry. Unemployment ost four times th m ployment was a t is al em e ar un h ne ut ur yo bo el un em pl oy m en M d . h ts an ut cu n yo io at uc on of Sydney ed as e B ‘The re rticular suburbs is because these and experts blam area ed ct fe af st national average or ted in pa s. There stown is the w of concentra ith their parent w au re e liv Bu n to lia Canterbury–Bank nd ra te st Au ong the people figures from the employment am ment young un oy of pl ls Em ve n, le in Sydney, with io er at e richer n high partment of Educ education. In th te for are ofte of ra s ls es ve bl le jo er Statistics and De e w th lo g s and e probably Relations showin t four parent The parents wer . os re m al ltu , cu nt a and Workplace ce is r e g people s ther to 24 is 19.1 pe ion is that youn close suburb at d ct an pe nt ex ce e r people aged 15 Th pe . 5 ated l jobless rate of 5. nt. well educ ’ times the nationa te of 11.6 per ce ra s fewer to further study. es bl on jo go h ut ill w yo l na 24 tio Australia meant na to in e 15 s ed ge ag an le to twice th ch op t pe Job marke , most one in five In Melbourne, al t. By comparison es w r te ou -collar jobs. e ue th bl ork in en able to get a cent in r pe 1 4. is looking for w ly ills may have be on sk t is ou te ra ith t w e en pl m st but those ploy ner C ‘Peo the youth unem railways in the pa r cent in the in e th pe 2 on 4. or s, y rb or ct bu said. n su job in a fa rth shore. Sydney’s easter ’ Professor Lewis no e, or er w ym lo e an t th is on ex t r cent arch centre ty, jobs don’ workplace rese west, and 8.3 pe Monash Universi ’s at ty si n io er iv at uc Un Ed of Sydney the rm jobless were Associate Dean said the long-te deplorable given e er er iv w Ol n es ia ur m fig Da e id th n’ of Europe’s analyst Lucas Walsh, sa the ‘lost generatio e lik up ng di en of unbroken at risk of stable economy. longest period e th in of a good start this jobless youth. e ar e A ‘W the opportunity perienced in s is ex m le ve op ha pe e g w th ‘If youn er and harder, Are economic grow extremely low. it just gets hard t, is t ke ar en m m ur oy pl bo em to in the la , every year,’ country. Adult un k, every month being passed on ee s w tie y ni er rtu ev po y, op ent y costs to not every da these employm are just so man e er ‘Th t.’ . no id e sa ar iver they ited job options, Dr Ol teenagers? No, orking].’ education had lim l young people [w na ng vi tio ca ha vo to Cuts he said.

G HERALD

SYDNEY MORNIN

SOURCE: Rachel Browne (2013), ‘Youth jobless rate up in Sydney’s south-west’, Sydney Morning Herald, 30 June, at , viewed 4 December 2013.

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Key points in the article This article discusses how, despite the current low rate of unemployment in Australia, the unemployment rates for young people in certain parts of major cities are very high. It looks at the possible reasons for this and points out the importance of educational attainment as a determinant of employment and unemployment. The article quotes a labour economist as indicating that youth unemployment is structural, because young people with low educational attainment do not have the skills required for the jobs available.

Analysing the news A The article points out that in mid-2013, Australia was experiencing a relatively low rate of unemployment. The relatively low unemployment rate was attributed to more than 22 years of almost continual economic growth—much of which was strong growth. Strong economic growth leads to investment, new businesses, higher consumer incomes and increased spending, which all lead to more jobs. However, many young people still remain unemployed. This is clearly seen here in Figure 1, which shows youth unemployment relative to the total national rate of unemployment since 1980. The unemployment rate among the youngest in the workforce—15 to 19 year olds—ranged from between 8 per cent to 14 per cent higher than the national rate. While not as severe, the unemployment rate among 20 to 24 year olds was also consistently higher than the national average over this time period.

B An economist put forward the view that the reason for high youth unemployment and its concentration in

particular areas is that unemployed youths generally lack basic education and training. In the article, the view is expressed that these unemployed youths do not have a culture of valuing education as do those in richer suburbs, and do not stay on at school or pursue other education and training. Therefore youth unemployment is concentrated in poorer neighbourhoods.

C Youth unemployment is an example of structural unemployment. Structural and technological change in the economy has meant that many low-skilled ‘industrial’ jobs, in industries such as manufacturing, and government services such as the railways, no longer exist, while many more new jobs have been created where education and training are required. There is a mismatch between the jobs (and skills) in demand by employers and the skills of those looking for work. While strong rates of economic growth can create greater demand for labour (reducing cyclical unemployment), it cannot solve the problem of structural unemployment. This requires microeconomic policies to improve the skills of the unemployed. Thinking critically 1 The article quotes an expert as saying, ‘There are just so many costs to not having young people [working].’ What costs do you think governments should take into account when designing policies to reduce youth unemployment? 2 Explain how educational reform could contribute to reducing rates of unemployment.

FIGURE 1 THE YOUTH UNEMPLOYMENT RATE IS CONSISTENTLY MUCH HIGHER THAN THE NATIONAL AVERAGE 30 15–19 years 20–24 years Total

25

Per cent

20 15 10 5 0 1980

1983

1986

1989

1992

1995

1998

2001

2004

2007

2010

2013

SOURCE: Australian Bureau of Statistics (2013), Labour Force, Australia, Detailed—Electronic Delivery, Cat. No. 6291.0.55.001, Table 01, at , viewed 12 December 2013.

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CHAPTER SUMMARY AND PROBLEMS KEY TERMS cyclical unemployment discouraged workers efficiency wage enterprise bargaining frictional unemployment

187 176 193 191 187

Job Services Australia labour force labour force participation rate long-term unemployed natural rate of unemployment

190 176 177 180 188

non-accelerating inflation rate of unemployment (NAIRU) 188 seasonal unemployment 188 structural unemployment 188 unemployment rate 176

MEASURING THE UNEMPLOYMENT RATE AND THE LABOUR FORCE PARTICIPATION RATE, PAGES 176–184 LEARNING OBJECTIVE 7.1

are calculated.

Define the unemployment rate and the labour force participation rate, and understand how they

SUMMARY The Australian Bureau of Statistics (ABS) uses the results of the monthly household survey to calculate the unemployment rate and the labour force participation rate. The labour force is the total number of employed people plus the number of people who do not have jobs but are actively looking for work (the unemployed). The unemployment rate is calculated by the number of unemployed divided by the labour force, multiplied by 100. Discouraged workers are people who are available for work but who are not actively looking for work. Discouraged workers are not counted as unemployed. The labour force participation rate is the percentage of the working age population in the labour force. Since 1950 the labour force participation rate of women has been rising, while the labour force participation rate of men has been falling. Except during severe recessions, the typical unemployed person finds a new job or returns to their previous job within a few months. Each year hundreds of thousands of jobs are created and destroyed in Australia.

WORKING AGE POPULATION Employment Unemployment Unemployment rate

1.2

1.3

1.4

How is the unemployment rate calculated? What are the three conditions someone needs to meet to be counted as unemployed? What are the problems in measuring the unemployment rate? In what ways does the official ABS measure of the unemployment rate understate the true degree of unemployment? In what ways might the official ABS measure overstate the true degree of unemployment? Which groups tend to have above-average unemployment rates, and which groups tend to have below-average unemployment rates? How is the labour force participation rate calculated? In the years since 1980, how have the labour force participation rates of men and women changed?

PROBLEMS AND APPLICATIONS 1.5

[Related to Solved problem 7.1] Calculate the missing values in the table of data collected in the labour force survey.

5.5%

Labour force Labour force participation rate 1.6

1.7

1.8

REVIEW QUESTIONS 1.1

11 million

1.9

1.10

1.11

1.12

62%

What would be some general reasons why a firm would lay off a substantial number of workers? Full-time homemakers are not included in the employment or labour force totals compiled in the ABS labour force survey. They are included in the working age population totals. Suppose that homemakers were counted as employed and included in the labour force statistics. What would be the impact on the unemployment rate and the labour force participation rate? Macroeconomic conditions affect the decisions firms and families make. Why, for example, might a high school graduate enter the job market during an economic expansion, but apply to go to a Technical and Further Education (TAFE) college during a recession? What effect would this decision have on the official measure of the rate of unemployment? Suppose between January 2014 and January 2015 the total number of people employed and the unemployment rate both fell. Briefly explain how this is possible. Figure 7.2 shows that the rapid increases in the labour force participation rate of women slowed down after 1990. Why might this slowdown have occurred? Discuss whether you think the labour force participation rate for women eventually might be equal to the rate for men. Prior to each federal election in Australia, the government always claims that they have created hundreds of thousands of jobs during their term of government. Is this claim correct? Briefly explain your answer. In 2013 hundreds of thousands of jobs were eliminated from the Australian economy. Does this explain why the unemployment rate also rose during this year? Explain.

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THE COSTS OF UNEMPLOYMENT, PAGES 184–186 LEARNING OBJECTIVE 7.2

Explain the economic costs of unemployment.

SUMMARY

2.2

Unemployment represents unused human resources, which, if employed, would increase GDP and living standards. Issues such as loss of taxation revenue, reduced business profits, retraining costs and the drain on the government’s budget from the payment of unemployment benefits all impose costs on the economy. In addition to the costs that unemployment places on the economy, the individual costs of being unemployed can be substantial. The loss of income and loss of self-esteem upon becoming unemployed can impose severe burdens and strains on the individuals involved, and on families. Such personal costs can also ultimately lead to additional costs on society if poor health, family break-ups and other issues result.

2.3

PROBLEMS AND APPLICATIONS 2.4

2.5

2.6

REVIEW QUESTIONS 2.1

Outline the costs to the individual that may occur upon becoming unemployed. Which groups of people usually bear a disproportionate burden of the costs of being unemployed?

Briefly describe the economic costs to the economy that result from unemployment.

What are the costs to individuals of being unemployed? Is the cost to society of unemployment equal to the sum of the costs to the individuals? Why or why not? In addition to the payment of unemployment benefits, discuss why extra costs are borne by the federal government during times of rising unemployment. Explain the distribution of unemployment throughout Australian society on the basis of age, gender, level of education and socioeconomic background.

TYPES OF UNEMPLOYMENT, PAGES 186–189 LEARNING OBJECTIVE 7.3

Identify the types of unemployment.

SUMMARY

PROBLEMS AND APPLICATIONS

There are three main types of unemployment: cyclical, frictional and structural. Cyclical unemployment is caused by a business cycle contraction or recession. Frictional unemployment is short-term unemployment arising from the process of matching workers with jobs. One type of frictional unemployment is seasonal unemployment, which refers to unemployment due to factors such as weather, variations in tourism and other calendar-related events. Structural unemployment arises from a persistent mismatch between the job skills or attributes of workers and the requirements of jobs. The natural rate of unemployment is the normal underlying rate of unemployment in the economy, consisting of structural unemployment and frictional unemployment. The natural rate of unemployment is also sometimes called the full-employment rate of unemployment. The non-accelerating inflation rate of unemployment (NAIRU) is the level of unemployment below which the rate of inflation will rise.

3.5

REVIEW QUESTIONS

3.8

3.1 3.2

3.3

3.4

Outline the three main types of unemployment. What is the relationship between frictional unemployment and job search? What is the natural rate of unemployment? What is the relationship between the natural rate of unemployment and full employment? Why isn’t the natural rate of unemployment equal to zero?

3.6

3.7

3.9

During the 2007–2008 global financial crisis unemployment rates in many countries were at very high levels. By 2010 a number of countries were showing signs of economic recovery. However, their rates of unemployment were remaining high, and in some countries the rates of unemployment were continuing to rise further. Why would the rates of unemployment remain very high or rise even further, even when these economies had begun to grow again? A politician makes the following argument: ‘The economy would operate more efficiently if frictional unemployment were eliminated. Therefore, a goal of government policy should be to reduce the frictional rate of unemployment to the lowest possible level.’ Briefly explain whether you agree with this argument. What advice for finding a job would you give someone who is frictionally unemployed? Someone structurally unemployed? Someone cyclically unemployed? [Related to Don’t let this happen to you] When the Australian economy is at full employment, why isn’t the unemployment rate, as measured by the ABS, equal to zero? According to the ABS, in August 2013 there were 706 100 people unemployed. At the same time there were an estimated 137 900 job vacancies. Why didn’t some of the unemployed workers accept these job openings?

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Recall from Chapter 3 the definitions of normal goods and inferior goods. During an economic expansion, would you rather be working in an industry that produces a normal good or in an industry that produces an inferior good? Why?

199

During an economic contraction or recession, would you rather be working in an industry that produces a normal good or an inferior good? Why?

EXPLAINING FRICTIONAL AND STRUCTURAL UNEMPLOYMENT, PAGES 190–191 LEARNING OBJECTIVE 7.4

Explain what factors determine the unemployment rate.

SUMMARY

PROBLEMS AND APPLICATIONS

Government policies can reduce the level of frictional and structural unemployment by aiding the search for jobs and the retraining of workers. Some government policies, however, can add to the level of frictional and structural unemployment. Unemployment benefit payments can raise the unemployment rate by extending the time that unemployed workers search for jobs. However, unemployment benefits may also enable people to take more time to search for jobs, leading to a better match between employee and employer.

4.3

REVIEW QUESTIONS

4.5

4.1

4.2

What is Job Services Australia and what does it aim to achieve? What effect does the payment of unemployment benefits have on the unemployment rate? On the severity of contractions or recessions?

4.4

4.6

Which type(s) of unemployment is Job Services Australia intended to address? In 2007, Ms Ségolène Royal, who ran unsuccessfully for president of France, proposed that workers who lost their jobs would receive unemployment payments equal to 90 per cent of their previous wage during their first year of unemployment. If this proposal were enacted, what would be the likely effect on the unemployment rate in France? Briefly explain. If the government eliminated unemployment benefit payments, what would be the effect on the level of frictional unemployment? What would be the effect on the level of real GDP? Would wellbeing in the economy be increased? Briefly explain. What is the average amount of time the typical unemployed person in Australia has been out of work? Is the average unemployed person in Australia likely to be out of work for a shorter or longer period of time than the average unemployed person in the United States? Why?

LABOUR MARKET REGULATION AND DEREGULATION, PAGES 191–193 L E A R N I N G O B J E C T I V E 7 . 5 Describe the changes that have occurred in the determination of wages in Australia and discuss the possible effects on unemployment.

SUMMARY

REVIEW QUESTIONS

The determination of wages and working conditions in Australia has changed over time, moving from a highly centralised wages and industrial relations system to a more decentralised system. The once highly regulated market is now more deregulated and wages and working conditions can be determined at the enterprise and individual level. It is argued that this increased level of flexibility will increase businesses’ willingness and ability to hire workers, and reduce the rate of unemployment. However, opponents to deregulation are concerned with the loss of bargaining power of low-skilled workers. Wages above market levels can increase unemployment. Wages may be above market levels because of minimum wage laws, trade unions and efficiency wages. Trade union membership has fallen in Australia over time. An efficiency wage is a higher-than-market wage that a firm pays to increase worker productivity.

5.1

5.2

5.3

In what ways was and is the Australian labour market regulated? How has the level of regulation changed over time? What are the potential advantages and disadvantages of the deregulation of the setting of wages and working conditions? Discuss the effect on the unemployment rate of the following: a The minimum wage b Trade unions c Efficiency wages

PROBLEMS AND APPLICATIONS 5.4

Why would increased labour market flexibility be expected to reduce the unemployment rate?

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5.6

Discuss the likely impact of each of the following on the unemployment rate: a The length of time workers are eligible to receive unemployment benefit payments doubles. b The minimum wage is abolished. c Most workers join trade unions. d More companies make information on job openings easily available on Internet job sites. [Related to Making the connection 7.3] An economic consultant studies the labour policies of a firm where it is

difficult to monitor workers and prepares a report in which she recommends that the firm raise employees’ wages. At a meeting of the firm’s managers to discuss the report, one manager makes the following argument: ‘I think the wages we are paying are fine. As long as enough people are willing to work here at the wages we are currently paying, why should we raise them?’ What argument can the economic consultant make to justify her advice that the firm should increase its wages?

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CHAPTER

8

INFLATION

LEARNING OBJECTIVES After studying this chapter you should be able to: 8.1 Define price level and inflation rate, and understand how they are calculated. 8.2 Use price indexes to adjust for the effects of inflation. 8.3 Distinguish between the nominal interest rate and the real interest rate. 8.4 Discuss the problems that inflation causes. 8.5 Understand the difference between demand-pull and cost-push inflation.

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THE IMPACTS OF INFLATION ON FARM BUSINESSES DOUG AND MARGARET GARNETT own a family farm business in Gnowangerup in Western Australia. The business is a mixed sheep and wheat farm and is fairly typical of many family farms in Australia. One of the major factors affecting all businesses in Australia during the mid-2000s was the raising of interest rates many times by the Reserve Bank of Australia (RBA) as a measure to reduce anticipated inflation in the economy. At this time, the economy was perceived to be reaching full capacity and shortages of labour were putting pressure on wages to rise. When the global financial crisis (GFC) subsequently occurred, this led the RBA to reduce interest rates six times between September 2008 and April 2009. Fears of renewed inflation resulted in the RBA raising interest rates seven times between October 2009 and November 2010. However, from 2011 to 2014, economic growth was not as strong as expected, with the global economic outlook remaining uncertain. Concerns about rising unemployment led the RBA once again to progressively lower interest rates, which by 2013 had reached their lowest levels for 30 years. Inflation is particularly important for farm businesses for several reasons. First, prices of most farm outputs such as wool and wheat are determined on world markets, not by what happens in Australia. This is unlike many Australian firms whose prices rise more or less in line with the inflation rate generally. Second, input costs, such as wages for farm labour and shearing, plus the prices of fuel, chemicals and veterinary services, rise with general increases in prices in the Australian economy as a whole. Since output prices do not, there is a squeezing of profits. Third, if interest rates rise in anticipation of inflation, then because modern farms are so much more capital intensive than most other businesses, the rise in costs of capital have a proportionately heavier burden on farms than on many other businesses. Finally, because the value of the Australian dollar rises when interest rates go up, if the prices of wool and wheat traded are in US dollars the revenue to Australian farmers goes down when inflation and interest rates rise. The Garnetts have run their business for many years and accumulated savings. These are necessary to tide them over during the inevitable lean years that all farmers face from time to time. While inflation reduces the real value of these savings over time, if interest rates increase in line with inflation this compensates them for the losses due to inflation. However, if inflation exceeds the rise in interest rates, the real value of their savings will fall. For the Garnetts, as for other businesses and individuals, there is no ‘good’ or ‘bad’ rate of inflation but it is important that inflation is fully anticipated and interest rates reflect this. Therefore, we can conclude that for farm businesses the rate of inflation and anti-inflationary policy is of very great importance. SOURCE: Glenn Stevens (Governor) (2010), ‘Statement by Glenn Stevens, Governor: Monetary Policy Decision’, Media Release No. 2010-26, 2 November, Reserve Bank of Australia, at www.rba.gov.au, viewed 10 January 2011.

© Patrick Breig | Dreamstime.com

8

ECONOMICS IN YOUR LIFE

HOW DOES INFLATION AFFECT YOU? Suppose the inflation rate, as measured by the change in consumer prices, is currently about 2 per cent. You have been working in your first job for two years and your employer offers you a pay rise of 3 per cent per year for the next three years. You are planning to take out a three-year car loan from a bank which is currently charging a fixed 7 per cent interest rate. What should you consider regarding inflation when deciding to buy your new car? What would be the consequences if inflation turned out to be greater than anticipated? As you read the chapter, see if you can answer these questions. You can check your answers against those we provide on page 215 at the end of this chapter.

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ONE OF THE facts of economic life is that the prices of most goods and services rise over time. As a result, the cost of living continually rises. In the 1960s the price of the daily newspaper was 5 cents, potatoes were 10 cents per kilogram, a new car could be purchased for $2000 and a four-bedroom house in a capital city could be purchased for $25 000 or less. The average weekly wage for a full-time adult was around $60 at the time, compared to around $1500 in 2014. The sustained increase in the general level of prices in the economy is called inflation.

Inflation The sustained increase in the general level of prices in the economy.

In this chapter we will learn how the rate of inflation is measured, the effects inflation can have on consumption, investment and economic activity, and the causes of inflation.

MEASURING INFLATION 8.1 Define price level and inflation rate, and understand how they are calculated. LEARNING OBJECTIVE

Price level A measure of the average prices of goods and services in the economy. Inflation rate The percentage increase in the general price level in the economy from one year to the next.

Just as knowledge of how the employment and unemployment statistics are compiled is important in the interpretation of them, so the same is true of the statistics on the cost of living. As we saw in Chapter 4, the price level measures the average prices of goods and services in the economy. The inflation rate is the percentage increase in the price level from one year to the next. Figure 8.1 shows that in 1970 the annual inflation rate for Australia was below 4 per cent, which it had been throughout the 1960s. The inflation rate peaked at almost 18 per cent in 1974, and remained between 8 per cent and 14 per cent throughout the 1970s. During the recession of 1982–1983 the rate of inflation fell to just over 2 per cent, but then rose to between 6 per cent and 8 per cent until the severe recession of 1990. Since 1990 the annual inflation rate has generally been below 4 per cent (with the exception of the one-off spike in 2000 caused by the introduction of the Goods and Services Tax (GST) in Australia). In Chapter 4 we introduced the GDP deflator as a measure of the price level. The GDP deflator is a very broad measure of the price level because it includes the price of every final

FIGURE 8.1

Annual inflation rate, Australia, 1970–2014 In 1970 the annual inflation rate for Australia was below 4 per cent, which it had been throughout the 1960s. The inflation rate peaked at almost 18 per cent in 1974, and remained between 8 per cent and 14 per cent throughout the 1970s. During the recession of 1982–1983 the rate of inflation fell to just over 2 per cent, but then rose to between 6 per cent and 8 per cent until the severe recession of 1990. Since 1990 the annual inflation rate has generally been below 4 per cent 20 18 16 14

Per cent

12 10 8 6 4 2 0 –2 1970

1975

1980

1985

1990

1995

2000

2005

2010

SOURCE: Created from Reserve Bank of Australia (2014), Statistics, ‘Measures of consumer price inflation’, Table G01, at , viewed 30 April 2014. © Reserve Bank of Australia.

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205

good and service produced in the economy. But, for some purposes, it is too broad. For example, if we want to know the impact of inflation on the typical household, the GDP deflator may be misleading because it includes the prices of products such as large electric generators and machines that are included in the investment component of GDP but are not purchased by the typical household. Further, the GDP deflator measures the prices of only those goods and services produced in Australia. However, as we know, consumers purchase many goods and services produced overseas. In this chapter we focus on measuring the inflation rate by changes in the consumer price index because changes in this index come closest to measuring changes in the cost of living as experienced by the typical household. We will also briefly discuss a third measure of inflation: the producer price index.

The consumer price index To obtain prices of a representative group of goods and services the Australian Bureau of Statistics (ABS) surveys households nationwide on their spending habits. They use the results of this survey to construct a market basket of the types of goods and services purchased by the typical family. Figure 8.2 shows the goods and services in the market basket grouped into 11 broad categories. Almost half of the market basket falls into the categories of housing, transportation and food. Each quarter, ABS employees visit stores in the eight Australian capital cities and record prices of the goods and services in the market basket. (From 2014 onwards, electronic transactions data are being phased in by the ABS to increase the detail of the data collected and reduce the costs associated with personal visits to stores.) Each price in the consumer price index is given a weight equal to the fraction of the typical family’s budget spent on that good or service. The items in the basket and weightings are updated every five or six years, with the most recent update occurring in September 2011. The consumer price index (CPI) is a measure of changes in retail prices of a basket of goods and services representative of consumption expenditure by typical Australian households in capital cities. One year is chosen as the base year, and the value of the CPI is set equal to 100 for that year. In any year other than the base year, the CPI is equal to the ratio of the dollar amount necessary to buy the market basket of goods in that year divided by the dollar amount necessary to buy the market basket of goods in the base year, multiplied by 100. Because the CPI measures the cost to the typical family to buy a representative basket of goods and services, it is sometimes referred to as the cost-of-living index.

Insurance and financial services 5.08% Education 3.18%

FIGURE 8.2

The CPI market basket

Food and non-alcoholic beverages 16.84%

Recreation and culture 12.56% Alcohol and tobacco 7.07%

Communication 3.05%

Clothing and footwear 3.98%

Transportation 11.55%

Health 5.29%

Consumer price index (CPI) A measure of changes in retail prices of a basket of goods and services representative of consumption expenditure by typical Australian households in capital cities.

Goods and services in the CPI market basket are grouped into 11 broad categories. Almost half of the market basket falls into the categories of housing, transportation and food SOURCE: Created from Australian Bureau of Statistics (2011), A Guide to the Consumer Price Index: 16th Series, Cat. No. 6440.0, at , viewed 30 April 2014.

Housing 22.30%

Furnishings, household equipment and services 9.10%

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A simple example can clarify how the CPI is constructed. For the purpose of this example assume the market basket has only three products: eye examinations, pizzas and books. BASE YEAR (2012)

PRODUCT

2015

PRICE

EXPENDITURES (ON BASE YEAR QUANTITIES)

PRICE

EXPENDITURES (ON BASE YEAR QUANTITIES)

QUANTITY

PRICE

Eye examinations

1

$50.00

$50.00

$100.00

$100.00

$85.00

$85.00

Pizzas

20

10.00

200.00

15.00

300.00

14.00

280.00

Books

20

25.00

500.00

25.00

500.00

27.50

550.00

Total

EXPENDITURES

2016

$750.00

$900.00

$915.00

Suppose that during the base year of 2012 a survey determines that each month the typical family purchases one eye examination, 20 pizzas and 20 books. At 2012 prices, the typical family must spend $750.00 to purchase this market basket of goods and services. The CPI for every year after the base year is determined by dividing the amount necessary to purchase the market basket in that year by the amount required in the base year, multiplied by 100. Notice that the quantities of the products purchased in 2015 and 2016 are irrelevant in calculating the CPI, because we are assuming that households buy the same market basket of products each month. Using the numbers in the table we can calculate the CPI for 2015 and 2016: FORMULA CPI =

APPLIED TO 2015

expenditures in the current year = 100 expenditures in the base year

$900 $750

× 100 = 120

APPLIED TO 2016 $915 × 100 = 122 $750

How do we interpret values such as 120 and 122? The first thing to recognise is that they are index numbers, which means they are not measured in dollars or any other units. The CPI is intended to measure changes in the price level over time. We can’t use the CPI to tell us in an absolute sense how high the price level is, only how much it has changed over time. We measure the inflation rate as the percentage increase in the CPI from one year to the next. For our simple example, the inflation rate in 2016 would be the percentage change in the CPI from 2015 to 2016: 122  120  100  1.7% 120

Because the CPI is designed to measure the cost of living, we can also say that the cost of living in our simple example increased by 1.7 per cent during 2016.

Is the CPI accurate? The CPI is the most widely used measure of inflation. Policy-makers use the CPI to track the state of the economy. Businesses use it to help set the prices of their products and the wages and salaries of their employees. The federal government increases unemployment benefits by a percentage equal to the increase in the CPI during the previous year. In setting child support payments in divorce cases, judges will often order that the payments increase each year by the inflation rate as measured by the CPI. It is important that the CPI be as accurate as possible, but there are four biases that cause changes in the CPI to overstate the true inflation rate. 1 Substitution bias. In constructing the CPI the ABS assumes that each month consumers purchase the same amount of each product in the market basket. In fact, consumers are likely to buy fewer of those products that increase most in price and more of those products that increase least in price (or fall the most in price). For instance, when horrific floods (which led to loss of life and housing) destroyed fruit and vegetable crops

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in Queensland in January 2011 the prices of some fruits, including melons, mangoes, bananas, and some vegetables rose rapidly. Around the same time floods destroyed similar crops of fruit and vegetables in Carnarvon, Western Australia. In response to the price rise, consumers significantly reduced the quantity of fruits such as melons and bananas they purchased and increased their purchases of other fruit. However, the CPI continued to be calculated on the basis that consumers continued to purchase the same quantities of all consumer goods and services, including melons and bananas, thereby overstating the rate of inflation. Therefore, due to consumer substitution between products, the prices of the market basket consumers actually buy will rise less than the prices of the market basket the ABS uses to calculate the CPI. 2 Increase in quality bias. Over time, most products included in the CPI improve in quality: cars become more durable and side air bags become standard equipment, computers become faster and have more memory, dishwashers use less water while getting dishes cleaner and so on. Increases in the prices of these products partly reflect their improved quality and partly are pure inflation. The ABS attempts to make adjustments so that only the pure inflation part of price increases is included in the CPI. These adjustments are difficult to make, so the recorded price increases overstate the pure inflation in some products. 3 New product bias. The ABS updates the market basket of goods used in calculating the CPI only approximately every five to six years. This means that new products introduced between updates are not included in the market basket. The prices of many products, such as mobile phones, Blu-ray players and 3D televisions, decrease in the years immediately after they are introduced. Unless the market basket is updated frequently, these price decreases will not be included in the CPI. 4 Outlet bias. During the mid-1990s many consumers began to increase their purchases from discount stores. By the late 1990s the Internet began to account for a significant fraction of sales of some products. If the ABS continued to collect price statistics from traditional full-price retail stores, the CPI would not reflect the prices some consumers actually paid. The acquisition of goods by mail order or over the phone or Internet from outlets within and outside the capital city of residence is considered by the ABS to be relatively small. However, where transactions made by such methods are known to be significant (as is the case with airline tickets and holiday accommodation purchased on the Internet) prices are collected from these sources.

Don’t confuse the price level and the inflation rate Do you agree with the following statement: ‘The consumer price index (CPI) is a widely used measure of the inflation rate.’ The statement may sound plausible but it is incorrect. The CPI is a measure of the price level, not of the inflation rate. We can measure the inflation rate as the percentage change in the CPI from one year to the next. In macroeconomics it is important not to confuse the level of a variable with the change in the variable. To give another example, real GDP does not measure economic growth. Economic growth is measured by the percentage change in real GDP from one year to the next.

DON’T LET THIS HAPPEN TO YOU

[ YOUR TURN Q

Test your understanding by doing related problem 1.6 on page 218 at the end of this chapter.

The producer price index In addition to the GDP deflator and the CPI, the ABS also calculates the producer price index (PPI). Like the CPI, the PPI tracks the prices of a market basket of goods. But, whereas the CPI tracks the prices of goods and services purchased by the typical household, the PPI tracks the prices firms receive for goods and services at all stages of production. The PPI includes the prices of intermediate goods, such as flour, cotton, steel and timber, and raw materials, such

Producer price index (PPI)   An average of the prices received by producers of goods and services at all stages of the production process.

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as raw wool, coal and crude oil. If the prices of these goods rise, the cost to firms of producing final goods and services will rise, which may lead firms to increase the prices of goods and services purchased by consumers. Changes in the PPI therefore can give an early warning of future movements in the CPI.

8.2 Use price indexes to adjust for the effects of inflation. LEARNING OBJECTIVE

USING PRICE INDEXES TO ADJUST FOR THE EFFECTS OF INFLATION The typical university graduate today is likely to receive a much higher salary than the student’s parents did 25 or more years ago, but prices 25 years ago were, on average, much lower than prices today. Put another way, the purchasing power of a dollar was much higher 25 years ago because the prices of most goods and services were much lower. Price indexes, such as the CPI, give us a way of adjusting for the effects of inflation so that we can compare dollar values from different years. For example, suppose your mother received a salary of $20 000 in 1980. By using the CPI we can calculate what $20 000 in 1980 was equivalent to in 2013. If the consumer price index was 26 in 1980 and 103 in 2013, then because 103/26 = 3.96, we know that, on average, prices were almost four times as high in 2013 as in 1980. We can use this result to inflate a salary of $20 000 received in 1980 to its value in terms of purchasing power in 2013: Value in 2013 dollars  value in 1980 dollars

 $20 000 

CPI in 2013 CPI in 1980

103  $79 231 26

Our calculation shows that if you were paid a salary of $79 231 in 2013, you would be able to purchase roughly the same amount of goods and services that your mother could have purchased with a salary of $20 000 in 1980. Economic variables that are calculated in the prices of the current year are referred to as nominal variables. The calculation we have just made used a price index to adjust a nominal variable—your mother’s salary—for the effects of inflation in order to create a real variable. For some purposes, we are interested in tracking changes in an economic variable over time, rather than in seeing what its value would be in today’s dollars. In that case, to correct for the effects of inflation we can divide the nominal variable by a price index and multiply by 100 to obtain a real variable.

SOLVED PROBLEM 8.1 CALCULATING REAL AVERAGE WEEKLY EARNINGS In addition to data on employment the ABS gathers data from enterprises on average weekly earnings of workers. Average weekly earnings are the wages or salaries earned by these workers per week. Economists closely follow average weekly earnings (for a standard working week) because they are a broad measure of the typical worker’s income. Nominal average weekly earnings are often referred to as the nominal wage, and real average weekly earnings are often referred to as the real wage. Use the information in the following table to calculate real average weekly earnings for each year. What was the percentage change in real average weekly earnings between 2012 and 2013? YEAR

NOMINAL WEEKLY EARNINGS ($)

CPI (2011–2012 = 100)

2011

1304.70

99.2

2012

1349.20

100.3

2013

1420.90

102.5

SOURCE: Australian Bureau of Statistics (2013), Average Weekly Earnings Australia, Table 3, Cat. No. 6302.0, Times Series Workbook, at , viewed 19 December 2013; Australian Bureau of Statistics (2013), Consumer Price Index, Australia, Tables 1 and 2, Cat. No. 6401.0, Times Series Workbook, at , viewed 19 December 2013.

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Solving the problem STEP 1: Review the chapter material. This problem is about using price indexes to correct for inflation, so you may want to review the

section ‘Using price indexes to adjust for the effects of inflation’, which begins on page 208. STEP 2: Calculate real average weekly earnings for each year. To calculate real average weekly earnings for each year, divide

nominal average weekly earnings by the CPI, and multiply by 100. For example, real average weekly earnings for 2011 are equal to: $1304.70 × $1315.22 99.2 The results for all the years are: YEAR

NOMINAL WEEKLY EARNINGS ($)

CPI (2011–2012 = 100)

REAL AVERAGE WEEKLY EARNINGS ($)

2011

1304.70

99.2

1315.22

2012

1349.20

100.3

1345.16

2013

1420.90

102.5

1386.24

STEP 3: Calculate the percentage change in real average earnings from 2012 to 2013. This percentage change is equal to:

100 ×

$1386.24 – $1345.16 = 3.05% 1345.16

We can conclude that although nominal average weekly earnings increased by 5.3 per cent [($1420.90 – $1349.20) / $1349.20] × 100, real average weekly earnings increased by only 3.05 per cent.

[ YOUR TURN Q

For more practice do related problems 2.3 and 2.5 on page 219 at the end of this chapter.

REAL VERSUS NOMINAL INTEREST RATES The difference between nominal and real values is also important when money is being borrowed and lent. The interest rate is the cost of borrowing funds, expressed as a percentage of the amount borrowed. If you lend someone $1000 for one year and charge an interest rate of 6 per cent, the borrower will pay back $1060, or 6 per cent more than the amount you lent. But is $1060 that you won’t receive for one year really 6 per cent more than $1000 today? Because prices will have gone up during the year, you will not be able to buy as much with $1060 one year from now as you could with that amount today. To calculate your true return from lending the $1000, we need to take into account the effects of inflation. The stated interest rate on a loan is the nominal interest rate. The real interest rate corrects the nominal interest rate for the effect of inflation and is equal to the nominal interest rate minus the inflation rate. As a simple example, suppose that the only goods you purchase are DVDs, and at the beginning of the year the price of DVDs is $20.00. With $1000 you can purchase 50  DVDs. If you lend the $1000 out for one year at an interest rate of 6 per cent you will receive $1060 at the end of the year. Suppose the inflation rate during the year is 2 per cent, so that the price of DVDs has risen to $20.40 by the end of the year. How has your purchasing power increased as a result of making the loan? At the beginning of the year your $1000 could purchase 50 DVDs. At the end of the year your $1060 can purchase $1060/$20.40 = 52 DVDs. In other words, you can purchase almost 4 per cent more DVDs. So in this case the real interest rate you received from lending was a little less than 4 per cent (actually, 3.92 per cent). For low rates of inflation, a convenient approximation for the real interest rate is:

8.3 Distinguish between the nominal interest rate and the real interest rate. LEARNING OBJECTIVE

Nominal interest rate   The stated interest rate on a loan. Real interest rate   The nominal interest rate minus the inflation rate.

Real interest rate = nominal interest rate − inflation rate

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In our example, we can calculate the real interest rate by using this formula as 6 per cent – 2 per cent = 4 per cent. If the inflation rate during the year was 4 per cent the real interest rate would be only 2 per cent. Holding the nominal interest rate constant, the higher the inflation rate the lower the real interest rate. Notice that if the inflation rate turns out to be higher than expected, borrowers pay and lenders receive a lower real interest rate than either of them expected. For example, if both you and the person to whom you lent the $1000 expected the inflation rate to be 2 per cent, you both expected the real interest rate on the loan to be 4 per cent. If inflation actually turns out to be 4 per cent, the real interest rate on the loan will be 2 per cent. That’s bad news for you but good news for your borrower. For the economy as a whole, we can measure the nominal interest rate by the RBA’s cash rate (see Chapter 12) and we use the inflation rate (as measured by the percentage change in the CPI) to calculate the real interest rate. Figure 8.3 shows the nominal and real interest rates for the years 1990 to 2013. When the inflation rate is high, as it was in the early 1990s (around 8 per cent for the first half of 1990, as seen in Figure 8.1), the gap between nominal and real interest rates becomes large. This also occurred in 2000/01, when the introduction of the GST caused inflation temporarily to rise to a higher rate. Inflation rose to a rate of 6 per cent, while the nominal interest rate was 5.5 per cent, therefore the real interest rate was minus 0.5 per cent, as seen in Figure  8.3. A negative real interest rate also occurred in early 2014, when nominal interest rates were at historic lows. Figure 8.3 shows that it is impossible to know whether a particular nominal interest rate is ‘high’ or ‘low’. It all depends on the inflation rate. The real interest rate provides a better measure of the true cost of borrowing and the true return to lending than does the nominal interest rate. When a firm is deciding whether to borrow the funds to buy an investment good, such as a new factory, it will look at the real interest rate, because the real interest rate measures the true cost to the firm of borrowing. It is possible for the nominal interest rate to be less than the real interest rate, which occurs when the inflation rate is negative. A negative inflation rate is referred to as deflation and occurs on the relatively rare occasions when the general price level in the economy falls. FIGURE 8.3

Nominal and real interest rates, Australia, 1990–2014 When the inflation rate is high the gap between nominal and real interest rates becomes large. This occurred in 1990 and 2000/01. This figure also shows that it is impossible to know whether a particular nominal interest rate is ‘high’ or ‘low’. It all depends on the inflation rate 18 16 14

Nominal Real

Per cent

12 10 8 6 4 2 0 –2 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

SOURCE: Created from Reserve Bank of Australia (2014), Statistics, ‘Monetary policy changes’, Table A2, at , viewed 1 May 2014; Reserve Bank of Australia (2014), Statistics, ‘Measures of consumer price inflation’, Table G01, at , viewed 1 May 2014.

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From Figure 8.3 we can see a short period during the second half of 1997 and into early 1998 when the inflation rate was negative, which caused the real rate of interest to exceed the nominal rate of interest. We will discuss deflation further later in this chapter.

DOES INFLATION IMPOSE COSTS ON THE ECONOMY? Imagine waking up tomorrow morning and finding that every price in the economy has doubled. The prices of food, petrol, televisions and houses have all doubled. But suppose that all wages and salaries have also doubled. Will this doubling of prices and wages matter? Think about walking into a steakhouse expecting to buy a steak and chips meal for $25. Instead, you find it selling for $50. Will you turn around and walk out? Probably not, because your salary has also increased overnight from $45 000 per year to $90 000 per year. So the purchasing power of your salary has remained the same, and you are just as likely to buy your meal today as you were yesterday. This hypothetical situation makes an important point: nominal incomes generally increase with inflation. Recall from Chapter 4 that we can think of the $25 price of a meal at PJ O’Reilly’s pub representing either the value of the product or the value of all the income generated in producing the product. The two amounts are the same whether the meal sells for $25 or $50. When the price of the meal rises from $25 to $50, that extra $25 ends up as income that goes to the food suppliers, the staff at PJ O’Reilly’s pub or the owners of the PJ O’Reilly’s chain, just as the first $25 did. It’s tempting to think that the problem with inflation is that, as prices rise, consumers can no longer afford to buy as many goods and services, but our example shows that this is a fallacy. An expected inflation rate of 10 per cent will raise the average price of goods and services by 10 per cent, but it will also raise average incomes by 10 per cent. Goods and services will be as affordable to the average consumer as they were before the inflation.

8.4 Discuss the problems that inflation causes. LEARNING OBJECTIVE

Inflation affects the distribution of income Why, then, do people dislike inflation? One reason is that the argument in the previous section applies to the average person, but not to every person. Some people will find their incomes rising faster than the rate of inflation and so their purchasing power will rise. Other people will find their incomes rising more slowly than the rate of inflation—or not at all—and their purchasing power will fall. People on fixed incomes are particularly likely to be hurt by inflation. If a retired worker receives a pension fixed at $2000 per month, over time inflation will reduce the purchasing power of that payment. In that way, inflation can change the distribution of income in a way that strikes many people as being unfair. The extent to which inflation redistributes income depends in part on whether the inflation is anticipated—in which case consumers, workers, firms and governments can accurately predict it and can prepare for it—or unanticipated—in which case they do not fully predict it and do not prepare for it.

The problem with anticipated inflation Like many of life’s problems, inflation is easier to manage if you see it coming and predict it accurately. Suppose that everyone knows that the inflation rate for the next 10 years will be 5 per cent per year. Workers know that unless their wages go up by at least 5 per cent per year the real purchasing power of their wages will fall. Businesses will be willing to increase workers’ wages enough to compensate for inflation because they know that the prices of the products they sell will increase. Lenders will realise that the loans they make will be paid back with dollars that are losing 5 per cent of their value each year, so they will charge a higher nominal interest rate to compensate them for this. Borrowers will be willing to pay these higher interest rates because they also know they are paying back these loans with dollars that are losing value. So far, there do not seem to be costs of anticipated inflation. Even when inflation is perfectly anticipated, however, some individuals will experience a cost. Inevitably, there will be a redistribution of income, as some people’s incomes fall behind

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Menu costs   The costs to firms of changing prices.

even an anticipated level of inflation. In addition, firms and consumers have to hold some money in notes and bank accounts paying little or no interest, for use in ATMs and EFTPOS, to facilitate their buying and selling. Anyone holding paper money will find its purchasing power decreasing each year by the rate of inflation. To avoid this cost, workers and firms will try to hold as little money as possible, but they will have to hold some. In addition, firms that print catalogues listing the prices of their products will have to reprint them more frequently. Supermarkets and other stores that mark prices on packages or on store shelves will have to devote more time and labour to changing the marked prices. The costs to firms of changing prices are called menu costs. At moderate levels of anticipated inflation menu costs are relatively small, but at very high levels of inflation, such as those experienced in some developing countries, menu costs and the costs from paper money losing value can become substantial. Finally, even anticipated inflation acts to raise the taxes paid by those holding incomegenerating assets such as bonds, shares and deposits, and raises the cost of capital for business investment. These effects arise because asset holders are taxed on the nominal payments they receive, rather than on the real payments. Similarly, anticipated inflation can lead to a higher proportion of personal income being paid in taxation. This is known as ‘bracket creep’, whereby increases in nominal income (to keep pace with inflation) push people into higher income tax brackets. They then must pay a higher marginal income tax rate than they did before they received their income rise.

The problem with unanticipated inflation In any high-income economy—such as Australia—households, workers and firms routinely enter into contracts that commit them to make or receive certain payments in the future— sometimes for years. Firms often sign two- or three-year wage contracts with their unions or employees. Once signed, this contract commits firms to paying a specified wage for the duration of the contract. When people buy homes they usually borrow most of the amount they need from a bank. These loans, called mortgage loans, are for long periods, commonly as much as 30 years, and sometimes longer. To make these long-term commitments households, workers and firms must forecast the rate of inflation. If a firm believes the inflation rate over the next three years will be 6 per cent per year, signing a three-year contract with a union that calls for wage increases of 8 per cent per year may seem reasonable because the firm may be able to raise its prices by at least the rate of inflation each year. If the firm believes that the inflation rate will be only 2 per cent over the next three years, paying wage increases of 8 per cent may significantly reduce its profits or even force it out of business. When people take out a mortgage they have to make a choice between a rate of interest fixed for a period of time or a variable rate of interest. If inflation is higher than expected those on fixed-rate contracts will find that in real terms the interest on their loan has fallen. When the actual inflation rate turns out to be very different from the expected inflation rate, some people gain and other people lose. This outcome seems unfair to most people because they are either winning or losing only because something unanticipated has happened. This apparently unfair redistribution is a key reason why people dislike unanticipated inflation.

Hyperinflation Hyperinflation   Extremely rapid increases in the general price level.

Although not common, there have been, and continue to be, a number of instances where countries have experienced extremely rapid increases in the general price level, a situation termed hyperinflation. In such instances the rate of inflation can exceed a thousand percentage points per year. Hyperinflation is caused by central banks increasing financial liquidity in the economy at a rate far in excess of the economic growth rate. This occurred in some European countries after World War I and World War II. For example, after World War I Germany experienced an inflation rate of 3.25 million per cent per month, and at the end of World War II Hungary’s rate of inflation was 41.9 quadrillion per cent per month! In more recent times, between 1 October 1993 and 24 January 1994, Yugoslavia’s inflation rate was 5 quadrillion per cent. It is not just a historical occurrence, since it still occurs. In 2008 Zimbabwe experienced crippling hyperinflation, with an annual inflation rate of an estimated 15 billion per cent.

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WHY A LOWER INFLATION RATE IS LIKE A TAX CUT FOR WESFARMERS BOND HOLDERS Borrowers and lenders are interested in the real interest rate rather than the nominal interest rate. Therefore, if expected inflation increases, the nominal interest rate will rise, and if expected inflation decreases, the nominal interest rate will fall. Suppose that Wesfarmers, the owners of Coles, Bunnings and many other businesses, sells bonds to investors to raise funds to purchase investment goods. Suppose also that Wesfarmers is willing to pay, and investors are willing to receive, a real interest rate of 4 per cent. If the inflation rate is expected to be 2 per cent the nominal interest rate on the bonds must be 6 per cent for the real interest rate to be 4 per cent. If the inflation rate is expected to be 6 per cent the nominal rate on the bond must rise to 10 per cent for the real interest rate to be 4 per cent. The following table summarises this information, assuming that the bond has a principal, or face value, of $1000. PRINCIPAL

REAL INTEREST RATE

INFLATION RATE

NOMINAL INTEREST RATE

$1000

4%

6%

10%

$1000

4%

2%

6%

M

C

A K I N G THE

ONNECTION

8.1

A lower inflation rate is like a tax cut for asset holders

With a nominal interest rate of 6 per cent the interest payment on newly issued bonds is $60. When the nominal interest rate rises to 10 per cent the interest payment on newly issued bonds is $100. Unfortunately for investors the government taxes the nominal payment on bonds with no adjustment for inflation. So, even though in this case the increase in the interest payment from $60 to $100 represents only compensation for inflation, the whole $100 is subject to the income tax. The following table shows the effect of inflation on an investor’s real after-tax interest payment assuming a tax rate of 25 per cent. INFLATION RATE

NOMINAL INTEREST PAYMENT

TAX PAYMENT

AFTER-TAX INTEREST PAYMENT

ADJUSTMENT FOR INFLATION

REAL AFTERTAX INTEREST PAYMENT

6%

$100

–$25

=$75

–$60

=$15

2%

$60

–$15

=$45

–$20

=$25

The table shows that reducing the inflation rate from 6 per cent to 2 per cent will increase the real after-tax payment received by investors who purchase a $1000 Wesfarmers bond from $15 to $25. By raising the after-tax reward to investors, lower inflation rates will increase the incentive for investors to lend funds to firms. The greater the flow of funds to firms, the greater the amount of investment spending that will occur.

A high rate of inflation causes money to lose its value so rapidly that households and firms avoid holding it. Wages are sometimes paid twice a day so that people can spend their money before it becomes worthless. Economies suffering from hyperinflation usually also suffer from severe recession. Given the dire consequences that follow from hyperinflation, why do governments and central banks allow it to happen by expanding financial liquidity so rapidly? You may have noticed that the countries mentioned above experienced hyperinflation during times of political unrest or war, which are times when governments often want to spend more than they are able to raise through taxes. The governments will then force their central banks to expand the supply of money in the economy or, in the case of Germany after World War I, simply print money to pay war reparations.

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Deflation Deflation   A decline in the general price level in the economy.

As we saw earlier, a negative inflation rate is referred to as deflation. This occurs when the general price level in the economy falls, which does not occur very often. Historically, a sustained period of deflation has occurred in Australia twice—once in the late nineteenth century and again early in the twentieth century. For borrowers of money deflation is not good news. While inflation can reduce the real value of debt, deflation increases the debt burden, because the value of the dollar that must be paid back is greater than the value when the money was borrowed. Lower nominal wages usually also accompany deflation, which means that while deflation reduces the cost of living due to a fall in the price of goods and services, the benefits of this may be negated if wages fall. Further, as we saw earlier, deflation causes the real interest rate to rise above the nominal interest rate, and higher real interest rates discourage borrowing by businesses and households. This can reduce the effectiveness of central bank policy of lowering nominal interest rates to stimulate investment and consumption. In 2009 concerns arose in many countries that a sustained period of deflation might occur as a result of the GFC. In 2009 the general price levels on an annualised basis had fallen by 0.8 per cent in Thailand, 0.34 per cent in the United States, 1.7 per cent in Japan and a massive fall of 4.5 per cent in Ireland (with deflation continuing in Japan and Ireland until late 2010). The price level in a number of other countries in Europe and Asia also fell for some months during 2009, including Belgium, France, Germany, Spain, Switzerland, China and Malaysia. Most countries affected by deflation saw price levels recovering by 2010. If the period of deflation is short, significant economic problems from deflation may not arise. However, as demonstrated in Japan and Hong Kong in the 1990s, long-term deflation causes large falls in the value of assets and can severely erode economic growth.

WHAT CAUSES INFLATION? 8.5 Understand the difference between demand-pull and cost-push inflation. LEARNING OBJECTIVE

Demand-pull inflation  Inflation that is caused by an increase in the aggregate demand for goods and services and production levels are unable to meet this demand immediately. Aggregate demand The quantity of goods and services demanded by households, firms and government, plus net exports. Cost-push inflation  Inflation that arises as a result of a negative supply shock—that is, anything that causes a decrease in the aggregate supply of goods and services. Aggregate supply The quantity of goods and services supplied by all firms.

Inflation is usually categorised as demand-pull or cost-push. Demand-pull inflation is a rise in the general price level in the economy that is caused by an increase in the aggregate demand for goods and services, and production levels are unable to meet this demand immediately. Aggregate demand (which we will learn about in detail in Chapter 10) is the quantity of goods and services demanded by households, firms and government, plus net exports. Cost-push inflation is a rise in the general price level in the economy that arises as a result of a negative supply shock—that is, anything that causes a decrease in the aggregate supply of goods and services. Aggregate supply (discussed in Chapter 10) is the quantity of goods and services supplied by firms. Demand-pull inflation occurs when aggregate demand increases and, if the economy is at full employment, creates excess demand for goods and services which also creates excess demand for labour. The increase in aggregate demand beyond potential GDP puts upward pressure on prices and nominal wages, which in turn puts further upward pressure on prices. This is often referred to as a price–wage spiral. If the increase in aggregate demand is only a one-off increase, the inflation will be a temporary phenomenon. This is because the rise in the price level will eliminate the excess demand. Continuing inflation requires continuing increases in aggregate demand. As we will see in Chapter 12, this can occur only if there are continuing increases in financial liquidity and low interest rates. A negative supply shock occurs when there is an increase in costs of production not resulting from an increase in aggregate demand. Possible sources of supply shocks include increases in import prices, increases in wages at rates that are higher than productivity growth rates, increases in rates of indirect taxation, increases in the degree of monopoly power in product markets and natural disasters such as droughts or floods. Any of these factors will lead to a rise in the price level, accompanied by a fall in real output and a rise in unemployment. For example, around 70 per cent of the goods and services that Australia imports are equipment, machinery and intermediate goods. If the prices of these increase this will increase production costs in Australia, which will decrease aggregate supply. Similarly, if wage rates rise faster than the rate of increase in productivity this will increase production costs and, if sustained, will lead to cost-push inflation.

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It is important to remember that the inflation that results from a negative supply shock will be a temporary phenomenon if the shock is a one-off event. Repeated supply shocks are necessary for ongoing cost-push inflation, and each of them (other things being equal) will further reduce output and further increase unemployment. Cost-push inflation can continue indefinitely only if it is ‘accommodated’ by continuing expansion in financial liquidity in the economy (see Chapter 12). Otherwise the rises in costs of production will reduce output and employment, which puts downward pressure on prices and wages. Most economists agree that although cost-push and demand-pull factors can initiate inflation it can only be maintained or accelerated through expansionary monetary policy. Hence anti-inflationary policy focuses almost entirely on contractionary monetary policy which in Australia means controlling interest rates, as we will discuss in later chapters.

HOW DOES INFLATION AFFECT YOU? At the beginning of this chapter we asked two questions. What should you consider regarding inflation when deciding to buy your new car? What would be the consequences if inflation turned out to be greater than anticipated? If inflation continues to be 2 per cent per year over the next three years, then given your annual pay increase of 3 per cent, your real income will increase every year also, which will make it more affordable to buy more goods and services, including a car. If inflation rises above 3 per cent, then you will be worse off as your real income is falling, and you might regret your decision to commit to a car loan. However, if you were willing to take out a loan of 7 per cent then this implies you are willing to pay a real interest rate of 5 per cent. If inflation is greater than 2 per cent then you will be paying a real rate less than 5 per cent. You will therefore be paying less in real terms for your loan and the car may still be affordable.

ECONOMICS IN YOUR LIFE (continued from page 203)

CONCLUSION Inflation is a key macroeconomic policy issue. It was a problem in Australia from the mid-1970s to 1990. Inflation again became the focus of macroeconomic policy, particularly monetary policy in the 2000s, as the unemployment rate fell and shortages of labour and other capacity constraints became apparent. As we have seen in this chapter, inflation can lead to significant costs to individuals and the economy. The RBA sees its most important role as curbing inflation. As we will see in later chapters, the main way that the RBA seeks to reduce high rates of inflation is through increases in interest rates. These rises are generally electorally very unpopular and impose high costs on many Australians. Read ‘An inside look’ to learn why economists and governments prefer a little inflation to no inflation at all.

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AN INSIDE LOOK THE BRISBANE

2013 TIMES 27 APRIL

e h t t o n s i n o i Why inflat e b o t t h g u o h t monster it’s

by the n as measured tio fla in ro ze g were evin ey so tight you the then achi on on m d g ar in he ep e ke w e n CPI would involv Wednesday whe would be quite es down, which x had risen by I was in a taxi on ic de pr in g e in ic rc pr fo er ly tual ent. consum smack in the ac y and employm radio that the year to March— g to the econom e in th ag er m lpful because, ov da he e nt w as ce n r do t of inflatio ‘But why just 2.5 pe bi . a et rd rg ta ga re ’s ts nk ra Ba cessary to Econoc serve may judge it ne d me. ‘When I ke ey middle of the Re th as n, er io iv dr ss b ce ca re interest deep n?’ the t just by cutting ke for 8¢—the in a no have any inflatio ca y ck om ro a on y ec bu e d e in real I coul stimulate th far they’re negativ came to Australia so em th ’ ng 0. tti .5 cu ally lower but by anted $3 fortunately, the rates until they’re actu other day they w Un em n. th tio ng es tti qu cu , le US is nsib right now in the derstand is terms—that It was a simple, se e first thing to un rate (as they are n Th e. tio pl fla m in si l e e al th th at — than answer isn’t etary authorities choice. The mon ate and Britain). er od m ers are actually a ve lie that it’s a policy e negative, lend ar rnment—be s ve te go ra e al th d re nt n an Whe fter you allow 2 per ce central bank w from them (a eaning between m rro e bo at er to od le op (m g. n od thin ld be highly paying pe rate of inflatio , on balance, a go n), so this shou is tio e) fla ag in er of av ct on at , fe ple, t negative for the ef and 3 per cent ability—in princi u can’t bring abou e yo th , rly ve ea ha cl t, es iti e Bu in an ntrol th stimulatory. If the author u’d only ever do terest rates to co yo in of ng l hi ro et nt m co so r , ei le n rate. stab interest rates— least—to use th t a positive inflatio ep it completely ke go ve ey u’ th t yo n’ ss do le ey emergency—un is price level, why e Reserve Bank e CPI? Why do th main reasons th ro increase in th e , ze th ar a e g nt ye ar in a ce e w r lo nt os pe al ce th 3 r So thus 2 to le of pe n rate averaging averaging a coup do)? d with an inflatio ey fie th permit inflation tis s ty. sa (a ili y’ ab ilit st e ab al pric ctical price st t and defines this as practic ou ab to and call this ‘pra re ca ey e th s all very well hell, it’s becaus y taxi driver. It’ ts on m as nu to re a in ck st gs In ba fir in t e th Bu r Th A tion. B pay fo as well as infla I less you had to t h CP en uc e m m th , oy w et pl ns rg ho r fo tio em t be ita n’ un ould al lim remem eated, but you sh at, due to practic is th ch Th f el lie fe h? d be d Hu r an l. ol ei e ve th ys th le is price was in the old da e the rise in the t higher than it e at lo th st a er in so ov ts al to uc t is s bi od e a nd pr m te grow g new your inco es and pensions delay in includin e it ag th e w of us le e ca op us be pe ca t ’s so be os al ne is , and days. For m , almost everyo ods and services are rising. That is used by an es ic ca pr CPI basket of go ly al an tu th ac er st es fa the years. n price ris in real terms over e basket. For en th treats as inflatio ris in ists s s ha od e go m of co in reason econom the quality of the new e growth is the e m ic improvement in co pr on in e g al th in r re rry fo is ca Th pollies the reason by punters and price of the d se e instance, part of th e es pr ‘th an im ith th un w er g up are so being high ’re having keepin tter under ey be th r— model Holden le ca r ub tte tro e be th about is that it’s a previous model s. ie or ss ce st of living’. ac r tte e inflation, co at st er the bonnet or be ov to s nd the CPI te If you accept that

by Ross Gittins

ES

THE BRISBANE TIM

SOURCE: Ross Gittins (2013), ‘Why inflation is not the monster it’s thought to be’, The Brisbane Times, 27 April, at , viewed 11 December 2013.

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Key points in the article The article illustrates many of the points raised in this chapter regarding the measurement of inflation. It discusses some of the reasons why the CPI tends to lead to an overestimate in inflation. It also emphasises how important it is to distinguish between nominal changes and real changes when looking at price rises.

Analysing the news A The article raises some important points that were covered in this chapter, including that the change in the CPI can overstate inflation because new and better quality goods are continuously entering the market. The article uses as an example the fact that each successive new car model has more and better features than its predecessor. So the price of a car might go up because it is a much better car or the price might stay the same but the consumer is getting ‘more car’. Simply comparing price change over time does not account for these changes.

B The article points out that generally wages grow at a greater rate than inflation so real incomes increase over time. Figure 1 shows the price of a base model Ford Falcon expressed in terms of the number of weeks of paid work

the average Australian would need to work in order to buy the car. It is clear to see that in 2012 it took less than half the work time needed than it did in 1960 to buy the car. In addition most social security payments are adjusted to rise with inflation, and most government welfare pensions are adjusted to median weekly earnings. Therefore, as long as inflation is anticipated and incorporated in factor payments, real incomes are not affected by inflation. The article speculates that many people are more aware of price rises than compensating income rises.

Thinking critically 1 Suppose the rate of inflation is greater than the nominal rate of interest so that the real rate of interest is negative. If a bank lends money at a nominal interest rate that turns out to be less than the actual inflation rate, will this increase investor spending? Briefly explain. 2 Do you think an increase in fresh food prices would have had a bigger or smaller impact on the CPI in Australia in 1965 or in 2015?

FIGURE 1 WAGES HAVE RISEN FASTER THAN THE PRICE OF NEW CARS

Number of weeks paid at average wage to afford a base model Ford Falcon

80

65

50

35

20

0

1960

1971

1986

1995

2002

2010

2012

SOURCE: Derived from Australian Bureau of Statistics (ABS) Australian Social Trends (1996), ‘Special Features: Registered Cars’, 4102.0.

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CHAPTER SUMMARY AND PROBLEMS KEY TERMS aggregate demand aggregate supply consumer price index (CPI) cost-push inflation deflation

214 214 205 214 214

demand-pull inflation hyperinflation inflation inflation rate menu costs

214 212 204 204 212

nominal interest rate price level producer price index (PPI) real interest rate

209 204 207 209

MEASURING INFLATION, PAGES 204–208 LEARNING OBJECTIVE 8.1

Define price level and inflation rate, and understand how they are calculated.

SUMMARY The price level measures the average prices of goods and services. The inflation rate is equal to the percentage change in the price level from one year to the next. The Australian Bureau of Statistics compiles statistics on three different measures of the price level: the consumer price index (CPI), the GDP deflator and the producer price index (PPI). The consumer price index is an average of the prices of goods and services purchased by the typical urban family. Changes in the CPI are the best measure of changes in the cost of living as experienced by the typical household. Biases in the construction of the CPI cause changes in it to overstate the true inflation rate. The producer price index (PPI) is an average of prices received by producers of goods and services at all stages of production.

1.7

1.8

REVIEW QUESTIONS 1.1 1.2

1.3

1.4

1.5

Briefly describe the major measures of the price level. Which measure is used most frequently in Australia to measure changes in the cost of living? Explain the difference and the link between the price level and the rate of inflation. What potential biases exist in calculating the consumer price index? What steps has the Australian Bureau of Statistics taken to reduce the size of the biases? What is the difference between the consumer price index and the producer price index?

PROBLEMS AND APPLICATIONS 1.6

[Related to Don’t let this happen to you] Briefly explain whether you agree or disagree with the following statement: ‘I don’t believe the government price statistics. The CPI for 2014 was 106, but I know that the inflation rate couldn’t have been as high as 6 per cent in 2014.’

1.9

At times, Apple has introduced a new version of its iPhone, with new and improved features, but sold it at the same or similar price as the previous model. How does the introduction of a new, improved iPhone sold at a similar price as an earlier model affect the consumer price index? In each of the following explain whether you think the CPI would overestimate, underestimate or accurately estimate the general price level, assuming all else remains constant. a A severe drought reduces the production of tropical fruit, causing the price of tropical fruit to rise significantly. b Consumers switch to buying front-loading clothes washing machines instead of the less water-efficient top-loading washing machines, even though frontloading washing machines are more expensive. c New technology significantly decreases the price of 3D televisions. Consider a simple economy that produces only three products. Use the information in the following table to calculate the inflation rate for 2015 as measured by the consumer price index. BASE YEAR 2012

PRODUCT

Haircuts Hamburgers DVDs 1.10

2014

2015

QUANTITY

PRICE

PRICE

PRICE

2

$20.00

$22.00

$25.00

10

4.00

4.20

4.50

6

15.00

15.00

14.00

When would you choose to use the consumer price index or the producer price index as a measure of the price level?

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USING PRICE INDEXES TO ADJUST FOR THE EFFECTS OF INFLATION, PAGES 208–209 LEARNING OBJECTIVE 8.2

Use price indexes to adjust for the effects of inflation.

SUMMARY

2.4

Price indexes are designed to measure changes in the price level over time, not the absolute level of prices. To correct for the effects of inflation we can divide a nominal variable by a price index and multiply by 100 to obtain a real variable. The real variable will be measured in dollars of the base year for the price index.

REVIEW QUESTIONS 2.1

2.2

What is the difference between a nominal variable and a real variable? Briefly explain how you can use data on nominal wages for 2005 to 2015 and data on the consumer price index for the same years to calculate the real wage for these years.

2.5

PROBLEMS AND APPLICATIONS 2.3

[Related to Solved problem 8.1] In 1924, the famous US novelist F. Scott Fitzgerald wrote an article for the widely read US weekly magazine The Saturday Evening Post titled ‘How to live on $36,000 a year’,1 in which he wondered how he and his wife had managed to spend all of that very high income without saving any of it. The CPI in the United States in 1924 was 17, and the CPI in 2013 was 233. What income would a person have needed in 2013 to have had the same purchasing power that Fitzgerald’s $36 000 had in 1924? Be sure to show your calculation.

The table at the foot of the page shows the world’s top 10 films of all time up to 2013,2 as measured by box office receipts worldwide, as well as several other films further down the list. The annual average CPI in the United States was 233 in 2013. Use this information and the data in the table to calculate the box office receipts for each film in 2013 dollars. Assume that each film generated all of its box office receipts during the year it was released. Use your results to prepare a new list of the top 10 films based on their earnings in 2013 dollars. [Related to Solved problem 8.1] The following table4 shows the average percentage rises in full-time adult ordinary time earnings during the years 2011–2012 and 2012–2013, and also the CPI for these years (as at June). Use these data to discuss what happened to wages negotiations and wages growth over the period 2011–2012 to 2012–2013. ANNUAL WAGE RISE, %

2012–2013

All sectors

3.41%

5.3%

Private sector

3.46%

5.65%

Public sector

3.51%

4.46%

CPI 2.6

2011–2012

100.4

102.8

Suppose that James and Frank both retire this year. For his retirement income James will rely on his superannuation,

TOTAL BOX OFFICE RECEIPTS RANKING

FILM

($US)

YEAR RELEASED

CPI3

1

Avatar

$2 783 918 982

2009

214.5

2

Titanic

$2 185 672 302

1997

160.5

3

Marvel’s The Avengers

$1 514 279 547

2012

229.6

4

Harry Potter and the Deathly Hallows: Part II

$1 328 111 219

2011

224.9

5

Iron Man 3

$1 211 992 272

2013

233.0

6

Lord of the Rings: Return of the King

$1 141 408 667

2003

184.0

7

Transformers: Dark of the Moon

$1 123 794 076

2011

224.9

8

Skyfall

$1 108 694 081

2012

229.6

9

The Dark Knight Rises

$1 079 343 943

2012

229.6

10

Toy Story 3

$1 063 759 456

2010

218.1

21

The Lion King

$952 880 140

1994

148.2

43

ET: The Extra-Terrestrial

$792 965 326

1982

96.5

122

Shrek

$491 812 794

2001

177.1

171

Rain Man

$412 800 000

1988

118.3

187

Raiders of the Lost Ark

$389 925 971

1981

90.9

250

Close Encounters of the Third Kind

$337 700 000

1977

60.6

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PART 4 UNEMPLOYMENT AND INFLATION

which will pay him a fixed amount of $2500 per month for as long as he lives. James doesn’t have any other savings for his retirement. Frank has no superannuation, but has saved a considerable amount, which he has invested in certificates of deposit at his bank. Currently Frank earns $2300 per month in interest on his bank savings. a Ten years from now, is James or Frank likely to have a higher real income? In your answer, make sure you define real income.

b Now suppose that instead of being a fixed amount, James’ superannuation payment increases each year by the same percentage as the CPI. For example, if the CPI increases by 5 per cent in the first year after James retires, then the amount he receives in the second year equals $2500 + ($2500 × 0.05) = $2625. In this case, 10 years from now is James or Frank likely to have a higher real income?

REAL VERSUS NOMINAL INTEREST RATES, PAGES 209–211 LEARNING OBJECTIVE 8.3

Distinguish between the nominal interest rate and the real interest rate.

SUMMARY

PROBLEMS AND APPLICATIONS

The stated interest rate on a loan is the nominal interest rate. The real interest rate is the nominal interest rate minus the inflation rate. Because it is corrected for the effects of inflation, the real interest rate provides a better measure of the true cost of borrowing and the true return to lending than does the nominal interest rate.

3.4

3.5

REVIEW QUESTIONS 3.1

3.2

3.3

What is the difference between the nominal interest rate and the real interest rate? If inflation is expected to increase, what is likely to happen to the nominal interest rate? The chapter explains that it is impossible to know whether a particular nominal interest rate is ‘high’ or ‘low’. Briefly explain why.

Suppose you were borrowing money to buy a car. Which of these situations would you prefer: the interest rate on your car loan is 20 per cent and the inflation rate is 19 per cent or the interest rate on your car loan is 5 per cent and the inflation rate is 2 per cent? Briefly explain. [Related to Making the connection 8.1] Describing the situation in England in 1920 the historian Robert Skidelsky wrote the following: Who would not borrow at 4 per cent a year, with prices going up 4 per cent a month?5

3.6

What was the real interest rate paid by borrowers in this situation? Suppose that the only good you purchase is hamburgers and that at the beginning of the year the price of a hamburger is $4.00. Suppose you lend $1000 for one year at an interest rate of 5 per cent. At the end of the year a hamburger costs $4.20. What is the real rate of interest you earned on your loan?

DOES INFLATION IMPOSE COSTS ON THE ECONOMY? PAGES 211–214 LEARNING OBJECTIVE 8.4

Discuss the problems that inflation causes.

SUMMARY

REVIEW QUESTIONS

Inflation does not reduce the affordability of goods and services to the average consumer, but it does impose costs on the economy. When inflation is anticipated, its main costs are that paper money loses some of its value and firms incur menu costs. Menu costs include the costs of changing prices on products and printing new catalogues. When inflation is unanticipated, the actual inflation rate can turn out to be different from the expected inflation rate. As a result, income is redistributed as some people gain and some people lose. Hyperinflation refers to extremely rapid increases in the general price level, which has economically and socially devastating effects. In some cases, deflation may occur, which refers to the decline in the general price level in the economy (the inflation rate is negative.)

4.1

4.2 4.3

4.4

4.5

4.6

Why do nominal incomes generally increase with inflation? If nominal incomes increase with inflation, does inflation reduce the purchasing power of the average consumer? Briefly explain. How can inflation affect the distribution of income? Discuss the impact of inflation on the purchasing power of consumers. Which is a greater problem: anticipated inflation or unanticipated inflation? Briefly explain. What problems does hyperinflation cause? What problems does deflation cause? If the economy is experiencing deflation, will the nominal interest rate be higher or lower than the real interest rate?

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CHAPTER 8 INFLATION

PROBLEMS AND APPLICATIONS 4.7 4.8

4.9 4.10

Explain why the rate of inflation is of concern to businesses. Explain what is meant by ‘menu costs’ of inflation. For which industries do you think these would be most important? What effect has the Internet had on the size of menu costs? Assume that people buy bonds from a firm and both the firm and the bond holders expect a 2 per cent inflation rate for the year. Given this expectation, suppose the nominal interest rate on the bonds is 6 per cent and the real interest rate is 4 per cent. Suppose that a year after the bond holders buy the bonds the inflation rate turns out to be 6 per cent, rather than the 2 per cent that had been expected. Who gains and who loses from the unexpectedly high inflation rate?

4.11

4.12

4.13

4.14

221

Suppose that the inflation rate turns out to be much higher than most people expected. In that case, would you rather have been a borrower or a lender? Briefly explain. Explain why the costs to individuals of inflation are less if the inflation is anticipated. During the late nineteenth century in Australia—between 1870 and 1914, and again between World War I and World War II—Australia experienced many years of deflation, whereby the general price level declined. Explain why some people were burdened by deflation. During the 1990s, Japan experienced periods of deflation and low nominal interest rates that approached zero per cent. Why would lenders of funds agree to a nominal interest rate of almost zero per cent? (Hint: Were real interest rates in Japan also low during this period?)

WHAT CAUSES INFLATION? PAGES 214–215 LEARNING OBJECTIVE 8.5

Understand the difference between demand-pull and cost-push inflation.

SUMMARY

PROBLEMS AND APPLICATIONS

Demand-pull inflation arises from anything that causes an increase in aggregate demand for goods and services, and production levels are unable to meet this demand immediately. Aggregate demand is the quantity of goods and services demanded by households, firms and government, plus net exports. Cost-push inflation arises as a result of a negative supply shock—that is, anything that causes a decrease in the aggregate supply of goods and services. Aggregate supply is the quantity of goods and services supplied by all firms. Most economists agree that although cost-push and demandpull factors can initiate inflation, it can only be maintained or accelerated through expansionary monetary policy. Hence antiinflationary policy focuses almost entirely on monetary policy which in Australia means controlling interest rates.

5.3

5.4

5.5

If consumer spending in Australia continued to increase even though the Australian economy was close to or at full employment, what type of inflation might occur? Briefly explain. If the price of electricity rises because of a carbon tax, why might this lead to inflation? What type of inflation would this be? At various times, much of Australia’s fruit crops in Queensland have been destroyed due to cyclones and associated floods. The scale of destruction has been sufficient to cause increases in the rate of inflation. Explain what type of inflation this would be classified as. Do you think the inflation rates at such times are entirely accurate? Briefly explain.

REVIEW QUESTIONS 5.1

5.2

Distinguish between demand-pull inflation and cost-push inflation, and give an example of a factor that might cause each to occur. What is a supply shock? Provide some examples.

ENDNOTES 1 2

3

4

F. Scott Fitzgerald (1924), ‘How to live on $36,000 a year’, The Saturday Evening Post, 5 April. The Numbers (2013), All Time Highest Grossing Movies Worldwide, at , viewed 19 December 2013. US Department of Labor (2013), Consumer Price Index, Annual Average, Bureau of Labor Statistics, at , viewed 19 December 2013. Australian Bureau of Statistics (2013), Average Weekly Earning’s,

5

Australia, Cat. No. 6302.0, Tables 3, 6 and 9, Times Series Workbook, at , viewed 19 December 2013; and Australian Bureau of Statistics (2013), Consumer Price Index, Australia, Cat. No. 6401.0, Time Series Workbook, at , viewed 19 December 2013. Robert Skidelsky (1992), John Maynard Keynes, Volume 2: The Economist as Saviour, 1920–1937, The Penguin Press, New York, p. 39.

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PA RT

5

SH ORT-RUN F LUCTUATIO NS

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CHAPTER

9

AGGREGATE EXPENDITURE AND OUTPUT IN THE SHORT RUN LEARNING OBJECTIVES After studying this chapter you should be able to: 9.1 Understand how macroeconomic equilibrium is determined in the aggregate expenditure model. 9.2 Discuss the determinants of the four components of aggregate expenditure and define the marginal propensity to consume and the marginal propensity to save. 9.3 Use a 45° line diagram to illustrate macroeconomic equilibrium. 9.4 Describe the multiplier effect and use the multiplier formula to calculate changes in equilibrium GDP. 9.5 Understand the relationship between the aggregate demand curve and aggregate expenditure.

HOW ECONOMIC UPS AND DOWNS AFFECT MYER MYER IS ONE of Australia’s oldest and largest retailers, opening its first store in Bendigo, Victoria, in 1900. It was started by two brothers, Sidney and Elcon Myer, who had migrated from Russia. Today Myer sells a wide variety of household goods. One of the major features of the demand for household goods is that it is very responsive to changes in income. Therefore when consumers’ disposable income rises demand is very strong, but in times when consumers need to tighten their belts they tend to reduce or delay buying household goods. The economic contraction of the Australian economy in 2008–2009 was the result of the global financial crisis (GFC), where collapses in financial markets—mostly in the United States and Europe—spread to the rest of the world, causing falls in output and employment in many countries. The effect on the Australian economy was less dramatic than in many other countries; however, it still led to many Australian firms laying off existing workers and not hiring new workers, and a number of firms going out of business altogether. Wellknown Australian businesses including Crazy Clarks, EzyDVD, Midas, Kleins, Kleenmaid and Toy Kingdom were among those that shut down due to the GFC. Other workers, fearing that their household might also be threatened by unemployment, delayed purchases of household goods and luxury items until the economy began to recover. The subsequent economic recovery was slower than hoped for, with economic growth still below trend by early 2014.

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The overall impact on sales of household goods by Myer and most other retailers can be seen in Figure 1, which shows total sales of household goods for the whole of Australia for the period 2000–2013. The growth up to the GFC is clearly evident, as is the subsequent decline and failure to return to pre-GFC growth. FIGURE 1 SALE OF HOUSEHOLD GOODS, AUSTRALIA (MILLIONS OF DOLLARS) 50 000 45 000

Economic contraction

Millions of dollars

40 000 35 000

© Richard Milnes/Demotix/Corbis

Strong economic growth

30 000 25 000 20 000 15 000

2000

2002

2004

2006

2008

2010

9

2012

SOURCE: Created from Australian Bureau of Statistics (2013), Retail Trade, Australia, Cat. No. 8501.0, Table 7, Time Series Workbook, at , viewed 9 January 2014.

The economic recovery from the second half of 2009 onwards was associated with rising consumer spending on household goods and increased employment in retail stores. However, growth in sales failed to return to pre-GFC levels, with Myer CEO Mr Bernie Brooks stating in 2012: What we are seeing in retail is really a tale of woe, we are seeing the most difficult time I have encountered in nearly 36 years that I have been involved in retail. I have not seen it as difficult, as consistently difficult, than what it is today. Myer and its main competitor, David Jones, began to reduce staff; however, a hostile reaction by consumers to falling customer service, together with improving sales led to a reversal of this policy. By 2013 Myer was once again hiring staff. This reflected similar experiences across the retailing sector, which was good news for the growing number of students in tertiary education and for married women with children since many work in part-time retail jobs. Increased sales also leads to increased numbers of full-time jobs in the economy as a whole as greater employment feeds through to higher incomes and expenditure.

ECONOMICS IN YOUR LIFE

WHEN CONSUMER CONFIDENCE FALLS, IS YOUR JOB AT RISK? Suppose that while attending university, you work part-time, waiting on tables at a restaurant. One morning, you read in the news that consumer confidence in the economy has fallen and, consequently, many households expect their future income to be dramatically less than their current income. Should you be concerned about losing your job? What factors should you consider in deciding how likely your manager is to lay you off? As you read the chapter, see if you can answer these questions. You can check your answers against those we provide on 255 at the end of this chapter.

SOURCE: Quotation from E. Greenblat (2012), ‘Myer chief retails “tale of woe”’, The Sydney Morning Herald, 15 June, at , viewed 9 January 2014.

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PART 5 SHORT-RUN FLUCTUATIONS

IN CHAPTER 6 we analysed the determinants of long-run growth in the economy, and in Chapter 5 saw that in the short run the economy also experiences business cycles around the long-run upward trend in real GDP. In this chapter we begin exploring the causes of the business cycle by examining the effect of fluctuations in total spending on real GDP. Aggregate expenditure (AE) The total amount of spending in the economy: the sum of consumption, planned investment, government purchases and net exports.

During some years, total spending in the economy, or aggregate expenditure (AE), increases about as much as does the production of goods and services. If this happens most firms will sell about what they expected to sell and they probably will not increase or decrease production or the number of workers hired. During other years, for example during a period of rapid economic growth, total spending in the economy increases more than the production of goods and services. In these years firms will increase production and hire more workers. In other years total spending does not increase as much as total production, such as the time of the economic contraction described in the opening case of this chapter. As a result firms cut back on production and lay off workers. In this chapter we explore why fluctuations in total spending play such an important role in the economy.

THE AGGREGATE EXPENDITURE MODEL 9.1 Understand how macroeconomic equilibrium is determined in the aggregate expenditure model. LEARNING OBJECTIVE

Aggregate expenditure model A macroeconomic model that focuses on the shortrun relationship between total spending and real GDP, assuming that the price level is constant.

The business cycle involves the interaction of many economic variables. A simple model called the aggregate expenditure model can help us begin to understand the relationships between some of these variables. The aggregate expenditure model focuses on the short-run relationship between total spending and real GDP. An important assumption of the model is that the price level is constant. In Chapter 10 we develop a more complete model of the business cycle that relaxes the assumption of constant prices. The key idea of the aggregate expenditure model is that, in any particular year, the level of GDP is determined mainly by the level of aggregate expenditure. To understand the  relationship between aggregate expenditure and real GDP we need to look more closely at the components of aggregate expenditure.

Aggregate expenditure Economists first began to study the relationship between fluctuations in aggregate expenditure and fluctuations in GDP during the Great Depression of the 1930s. Australia, the United States, the United Kingdom and other industrialised countries suffered declines in real GDP ranging from 10 per cent to 25 per cent or more during the early 1930s. In 1936 the English economist John Maynard Keynes published a book, The General Theory of Employment, Interest, and Money, that systematically analysed the relationship between fluctuations in aggregate expenditure and fluctuations in GDP. Keynes identified four components of aggregate expenditure that together equal GDP (these are the same four components we discussed in Chapter 4): 1 Consumption (C). Spending by households on goods and services, such as groceries, cars and restaurant meals. 2 Planned investment (I). Planned spending by firms on capital goods, such as factories, office buildings and machinery, and by households on new homes. 3 Government purchases (G). Spending by local, state and federal governments on goods and services, such as roads, bridges and the salaries of employees, such as teachers and nurses. 4 Net exports (NX). Spending by foreign firms and households on goods and services produced in Australia minus spending by Australian firms and households on goods and services produced in other countries.

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227

So, we can write: Aggregate expenditure = consumption + planned investment + government purchases + net exports or, AE = C + I + G + NX Governments around the world gather statistics on aggregate expenditure on the basis of these four components. Economists and business analysts usually explain fluctuations in GDP in terms of fluctuations in these four components of spending.

The difference between planned investment and actual investment Before considering further the relationship between aggregate expenditure and GDP we need to consider an important distinction. Note that it is planned investment spending, rather than actual investment spending, that is a component of aggregate expenditure. You might wonder how the amount that businesses plan to spend on investment can be different from the amount they actually spend. We can begin resolving this puzzle by remembering that goods that have been produced, but not yet sold, are referred to as inventories. Changes in inventories are included as part of investment spending along with spending on machinery, equipment, office buildings and factories. We assume that businesses always spend the amount they planned on machinery and office buildings, but the amount businesses plan to spend on inventories may be different from the amount they actually spend. For example, Random House Australia may print 20 000 copies of the latest John Grisham novel expecting to sell them all. If Random House Australia does sell all 20 000 its inventories will be unchanged, but if it sells only 15 000 it will have an unplanned increase in inventories of 5000 books. In other words, changes in inventories depend on sales of goods, which firms cannot always forecast with perfect accuracy. For the economy as a whole, we can say that actual investment spending will be greater than planned investment spending when there is an unplanned increase in inventories. Actual investment spending will be less than planned investment spending when there is an unplanned decrease in inventories. Therefore, actual investment will equal planned investment only when there is no unplanned change in inventories.

Inventories Goods that have been produced but not yet sold.

Macroeconomic equilibrium Macroeconomic equilibrium is similar to microeconomic equilibrium. In microeconomics, equilibrium in the apple market, for example, occurs at the point at which the demand for apples equals the supply of apples. When we have equilibrium in the apple market the quantity of apples produced and sold will not change unless the demand for apples or the supply of apples changes. For the economy as a whole, macroeconomic equilibrium occurs where total spending, or aggregate expenditure, equals total production, or GDP: Aggregate expenditure = GDP As we saw in Chapter 6, over the long run real GDP in Australia grows and the standard of living rises. In this chapter we are interested in understanding why GDP fluctuates in the short run. To simplify the analysis of macroeconomic equilibrium we assume that the productive capacity of the economy is not growing. In the next chapter we discuss the more realistic case of macroeconomic equilibrium in an economy that is growing and increasing its level of real GDP. If we assume that the economy is not growing, then equilibrium GDP will not change unless aggregate expenditure changes.

Adjustments to macroeconomic equilibrium The apple market isn’t always in equilibrium because sometimes the quantity of apples demanded is greater than the quantity supplied, and sometimes the quantity supplied is greater than the quantity demanded. The same outcome holds for the economy as a whole.

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Sometimes the economy is in macroeconomic equilibrium and sometimes it isn’t. When aggregate expenditure is greater than GDP the total amount of spending in the economy is greater than the total amount of production. In this situation many businesses will sell more goods and services than they had expected. For example, the manager of a Harvey Norman store might like to keep 50 refrigerators in stock to give customers the opportunity to see a variety of different sizes and models. If sales are unexpectedly high the store may end up with only 20 refrigerators. In that case the store will have an unplanned decrease in inventories: its inventory of refrigerators has declined by 30. How will the store manager react when more refrigerators are sold than expected? The manager is likely to order more refrigerators. If other stores selling refrigerators are experiencing similar sales increases and are also increasing their orders, then Westinghouse, LG and other refrigerator manufacturers will significantly increase their production. These manufacturers may also increase the number of workers they hire. If the increase in sales is affecting not just refrigerators but also other appliances, furniture, computers, restaurant meals and other goods and services, then GDP and total employment will begin to increase. In summary: when aggregate expenditure is greater than GDP, inventories will decline and GDP and total employment will increase. Now suppose that aggregate expenditure is less than GDP. In this situation many businesses will sell fewer goods and services than they had expected, so their inventories will increase. For example, the manager of the Harvey Norman store who wants 50 refrigerators in stock may find that because of slow sales the store has 75 refrigerators, so the store manager will cut back on orders for new refrigerators. If other stores also cut back on their orders Westinghouse and LG will reduce production and lay off workers. If the decrease in sales is affecting not just refrigerators but also many other goods and services, GDP and total employment will begin to decrease. These events were experienced by many firms during the economic contraction of 2008 in Australia that resulted from the 2007–2008 global financial crisis (GFC). In summary: when aggregate expenditure is less than GDP, inventories will increase and GDP and total employment will decrease. Only when aggregate expenditure equals GDP will firms sell what they expected to sell. In that case their inventories will be unchanged and they will not have an incentive to increase or decrease production. The economy will be in macroeconomic equilibrium. Table 9.1 summarises the relationship between aggregate expenditure and GDP. Increases and decreases in aggregate expenditure cause the year-to-year fluctuations in GDP. Economists devote considerable time and energy to forecasting what will happen to each component of aggregate expenditure. If economists forecast that aggregate expenditure will decline in the future, that is equivalent to forecasting that GDP will decline and that the economy will enter a contraction or recession. Individuals and firms closely watch these forecasts because fluctuations in GDP can have dramatic consequences. When GDP is increasing, so are wages, profits and job opportunities. Declining GDP can lead to declining wages (or slower wage growth) and will cause profits to fall and unemployment to rise. When economists forecast that aggregate expenditure is likely to decline and that the economy is headed for a contraction or recession, the federal government and the Reserve Bank of Australia may implement macroeconomic policies in an attempt to head off the decrease in expenditure and keep the economy from falling into a contraction or recession. We discuss these macroeconomic policies in Chapters 12 and 13.

TABLE 9.1

The relationship between aggregate expenditure and GDP

IF . . .

THEN . . .

AND . . .

Aggregate expenditure is equal to GDP

inventories are unchanged

the economy is in macroeconomic equilibrium.

Aggregate expenditure is less than GDP

inventories rise

GDP and employment decrease.

Aggregate expenditure is greater than GDP

inventories fall

GDP and employment increase.

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CHAPTER 9 AGGREGATE EXPENDITURE AND OUTPUT IN THE SHORT RUN

DETERMINING THE LEVEL OF AGGREGATE EXPENDITURE IN THE ECONOMY To understand better how macroeconomic equilibrium is determined in the aggregate expenditure model, we look more closely at the components of aggregate expenditure. Table 9.2 lists the four components of aggregate expenditure for the financial year 2012/13 in Australia. Consumption is clearly the largest component of aggregate expenditure. This is followed by investment, and then government purchases. Investment typically fluctuates from year to year, sometimes quite significantly, making it the most volatile component of aggregate expenditure. Government purchases are usually within the range of 20 to 25 per cent of aggregate expenditure. Net exports were negative in 2013, as they were throughout most of the 2000s, reflecting the fact that Australia imported more goods and services than it exported. Next, we consider the variables that determine each of the four components of aggregate expenditure.

229

9.2 Discuss the determinants of the four components of aggregate expenditure and define the marginal propensity to consume and the marginal propensity to save. LEARNING OBJECTIVE

Consumption Figure 9.1 shows movements in real consumption for Australia for the years 1986 to 2013. Note that consumption usually follows a smooth, upward trend. Only during periods of economic contraction or recession, such as the recession in 1990 and the contraction of 2008, does the growth in consumption slow. The following are the five most important variables that determine the level of consumption: 1 Current disposable income 2 Household wealth 3 Expected future income 4 The price level 5 The interest rate We can discuss how changes in each of these variables affect consumption.

Current disposable income The most important determinant of consumption is the current disposable income of households. Disposable income is the income households have after they have paid personal income tax and received government transfer payments, such as social security payments. For most households, the higher their disposable income the more they spend, and the lower their income the less they spend. Macroeconomic consumption is the total of all the consumption of Australian households. So we would expect consumption to increase when the current disposable income of households increases and to decrease when the current disposable income of households decreases. Total income in Australia expands during most years. Only during recessions, which happen infrequently, does total income decline. The main reason for the general upward trend in consumption shown in Figure 9.1 is that disposable income has followed a similar upward trend. TABLE 9.2

Components of aggregate expenditure

EXPENDITURE CATEGORY

EXPENDITURE ($ BILLIONS) FOR YEAR 2012/13

PERCENTAGE (%) OF AGGREGATE EXPENDITURE

Consumption

834.43

54.8

Investment

357.12

23.4

Government

342.22

22.5

Net exports

–10.73

–0.7

1523.04

100.0

Total

SOURCE: Australian Bureau of Statistics (2013), Australian National Accounts: National Income, Expenditure and Product, Cat. No. 5206.0, Table 9, at , viewed 7 January 2013.

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FIGURE 9.1

850

Real consumption, Australia, 1986–2013

SOURCE: Created from Australian Bureau of Statistics (2013), Australian National Accounts: National Income, Expenditure And Product, Cat. No. 5206.0, Table 8, Time Series Workbook, at , viewed 6 January 2014.

GFC downturn

750 700 Billions of dollars

Consumption usually follows a smooth, upward trend. Only during periods of economic contraction or recession does the growth in consumption slow

800

650 600 550 500 450 400

Recession

350 300 250 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012

Household wealth Consumption also depends in part on the wealth of households. A household’s wealth is the value of its assets minus the value of its liabilities. An asset is anything of value owned by a person or a firm, and a liability is anything owed by a person or a firm. A household’s assets include its home, shares, bond holdings and bank accounts, which are largely a result of past income streams. A household’s liabilities include any loans that it owes. A household with $1 million in wealth is likely to spend more than a household with $10 000 in wealth, even if both households have the same disposable income. Therefore, when the wealth of households increases consumption should increase, and when the wealth of households decreases consumption should decrease. Shares are an important category of household wealth mainly because every employee in Australia has a superannuation account, and shares make up a high proportion of these accounts. When share prices increase household wealth will increase, and so should consumption. For example, a family whose shareholdings increase in value from $50 000 to $100 000 may be willing to spend a larger fraction of its income because it is less concerned with adding to its savings. A decline in share prices should lead to a decline in consumption. Economists who have studied the determinants of consumption have concluded that permanent increases in wealth have a larger impact than temporary increases.

Expected future income Consumption depends in part on expected future income. Most people prefer to keep their consumption fairly stable from year to year, even if their income fluctuates significantly. Real estate agents, for example, earn most of their income from commissions (a percentage of the sale price) on houses they sell. Real estate agents might have very high incomes some years and much lower incomes in other years. Most agents will keep their consumption steady and not increase it significantly during good years and then drastically cut back during the slower years. If we just looked at an agent’s current income we might have difficulty estimating the agent’s current consumption. Instead, we need to take into account the agent’s expected future income. We can conclude that current income explains current consumption well, but only when current income is not unusually high or unusually low compared with expected future income.

The price level As we learned in the previous chapter, the price level measures the average prices of goods and services in the economy. Consumption is affected by changes in the price level. It is tempting to think that an increase in prices will reduce consumption by making goods and services less

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affordable. In fact, the effect of an increase in the price of one product on the quantity demanded of that product is different from the effect of an increase in the price level on total spending by households on goods and services. Changes in the price level affect consumption mainly through their effect on household wealth. An increase in the price level will result in a decrease in the real value of household wealth. For example, if you have $2000 in a bank account, the higher the price level the fewer goods and services you can buy with your money. If the price level falls, the real value of your $2000 increases. Therefore, as the price level rises, the real value of your wealth declines and so will your consumption, at least a little. Conversely, if the price level falls (which is a rare occurrence in Australian history) your consumption will increase.

The interest rate Finally, consumption also depends on the interest rate. The nominal interest rate is the stated interest rate on a loan or a financial security such as a bond. The real interest rate corrects the nominal interest rate for the impact of inflation and is equal to the nominal interest rate minus the inflation rate. Because households are concerned with the payments they will make or receive after the effects of inflation are taken into account, consumption spending depends on the real interest rate. When the real interest rate is high, the reward for saving is increased and households are likely to save more and spend less. However, many households are net lenders and therefore as the real interest rate rises their wealth increases, which may lead to increased consumer spending. Another reason why spending is likely to decrease when interest rates are high is because spending on durable goods is affected by changes in the interest rate. A high real interest rate increases the cost of spending financed by borrowing. For example, the monthly payment on a four-year car loan will be higher if the real interest rate on the loan is 7 per cent than if the real interest rate is 5 per cent.

The consumption function Figure 9.2(a) illustrates the relationship between real consumption and real disposable income for the years 1986–2013. In Figure 9.2(b) we draw a straight line through the points representing consumption and disposable income. The fact that most of the points lie almost on the line shows the close relationship between consumption and disposable income. Because changes in consumption depend on changes in disposable income, we can say that consumption is a function of disposable income. The relationship between consumption and disposable income illustrated in Figure 9.2(b) is called the consumption function. The slope of the consumption function, which is the change in consumption divided by the change in disposable income, is referred to as the marginal propensity to consume or MPC. Using the Greek letter delta D to represent ‘change in’, C to represent consumption and YD to represent disposable income, we can write the expression for the MPC as follows: MPC =

change in consumption ∆C = change in disposable income ∆YD

If, for example, between two years, consumption increased by $20 billion, while disposable income increased by $22 billion, the MPC would have been:

Consumption function The relationship between consumption and disposable income. Marginal propensity to consume (MPC) The slope of the consumption function: the change in consumption divided by the change in disposable income.

C $20   0.9 YD $22

The value for the MPC tells us that households spent 90 per cent of the increase in their disposable income. We can also use the MPC to tell us how much consumption will change as income changes. To see this relationship, rewrite the expression for the MPC: MPC =

change in consumption change in disposable income

to, Change in consumption = change in disposable income × MPC

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FIGURE 9.2

SOURCE: Created from Australian Bureau of Statistics (2013), Australian National Accounts: National Income, Expenditure and Product, Cat. No. 5206.0, Table 1 and Table 8, Time Series Workbooks, at , viewed 7 January 2014.

800 Real consumption (billions of dollars)

Panel (a) shows the relationship between consumption and income. The points represent combinations of real consumption and real disposable income for the years between 1986 and 2013. In panel (b) we draw a straight line through the points from panel (a). The line, which represents the relationship between consumption and disposable income, is called the consumption function. The slope of the consumption function is the marginal propensity to consume

$900

700 600 500 400 300 200 $400

500

600

700

800

900

1000

Real disposable income (billions of dollars)

1100

1200

1300

1100

1200

1300

(a) The relationship between consumption and income, 1986–2013 $900 800 Real consumption (billions of dollars)

The relationship between consumption and income, 1986–2013

700 600 500 400 300 200 $400

500

600

700

800

900

1000

Real disposable income (billions of dollars) (b) The consumption function

For example, with an MPC of 0.9, a $10 billion increase in disposable income will increase consumption by $10 billion × 0.9, or $9 billion.

The relationship between consumption and national income We have seen that consumption by households depends on disposable income. We now shift our focus slightly to the similar relationship that exists between consumption and GDP. We make this shift because we are interested in using the aggregate expenditure model to explain fluctuations in real GDP, rather than fluctuations in disposable income. The first step in examining the relationship between consumption and GDP is to recall from Chapter 4 that the differences between GDP and national income are small and can be ignored without affecting our analysis. In fact, in this and the following chapters we will use the terms GDP and national income interchangeably. Also note that disposable income is equal to national income plus government transfer payments minus taxes. Taxes minus government transfer payments are referred to as net taxes. So we can write the following: Disposable income = national income – net taxes We can rearrange the equation like this: National income = GDP = disposable income + net taxes

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The table in Figure 9.3 shows hypothetical values for national income (or GDP), net taxes, disposable income and consumption spending. Notice that national income and disposable income differ by a constant amount, which is equal to net taxes of $1000 billion. In fact, net taxes are not a constant amount because they are affected by changes in income. As income rises, net taxes rise because some taxes, such as personal income tax, increase and some government transfer payments, such as government payments to unemployed workers, fall. Nothing important is affected in our analysis, however, by our simplifying assumption that net taxes are constant. The graph in Figure 9.3 shows a line representing the relationship between consumption and national income. The line is very similar to the consumption function shown in Figure 9.2(b). We defined the MPC as the change in consumption that results from a change in disposable income, which is the slope of the consumption function. In fact, notice that if we calculate the slope of the line in Figure 9.3 between points A and B, we get a result that will not change whether we use the values for national income or the values for disposable income. Using the values for national income: C $5250 billion  $3750 billion   0.75 Y $7000 billion  $5000 billion

Using the corresponding values for disposable income from the table: C $5250 billion  $3750 billion   0.75 YD $6000 billion  $4000 billion

National income or GDP (billions of dollars)

Net taxes (billions of dollars)

$1 000

$1000

$0

$750

–

–

3 000

1000

2 000

2250

2000

2000

5 000

1000

4 000

3750

2000

2000

7 000

1000

6 000

5250

2000

2000

9 000

1000

8 000

6750

2000

2000

11 000

1000

10 000

8250

2000

2000

13 000

1000

12 000

9750

2000

2000

Disposable income Consumption (billions of (billions of dollars) dollars)

Change in national income (billions of dollars)

Real consumption spending (billions of dollars)

Change in disposable income (billions of dollars)

Consumption

B

$5250

Change in consumption = $1500 3750

A Change in national income = $2000

0

$5000

MPC =

7000

FIGURE 9.3

The relationship between consumption and national income Because national income differs from disposable income only by net taxes—which, for simplicity, we assume are constant—we can graph the consumption function using national income rather than disposable income. We can also calculate the MPC, which is the slope of the consumption function, using either the change in national income or the change in disposable income and always get the same value. The slope of the consumption function between point A and point B is equal to the change in consumption—$1500 billion— divided by the change in national income—$2000 billion—or 0.75

$1500 = 0.75 $2000

Real national income or real GDP (billions of dollars)

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It should not be surprising that we get the same result in either case. National income and disposable income differ by a constant amount, so changes in the two numbers always give us the same value, as is shown in the last two columns of the table in Figure 9.3. Therefore, we can graph the consumption function using national income, rather than using disposable income. We can also calculate the MPC using either the change in national income or the change in disposable income and always get the same value.

Income, consumption and saving To complete our discussion of consumption we can look briefly at the relationships between income, consumption and saving. Households either spend their income, save it or use it to pay taxes. For the economy as a whole, we can write the following: National income = consumption + saving + net taxes When national income increases there must be some combination of an increase in consumption, an increase in saving or an increase in net taxes: Change in national income = change in consumption + change in saving + change in net taxes Using symbols, where Y represents national income (and GDP), C represents consumption, S represents saving and T represents net taxes, we can write the following: Y=C+S+T and, DY = DC + DS + DT To simplify, we can assume that net taxes are always a constant amount, in which case DT = 0, so the following is also true: DY = DC + DS Marginal propensity to save (MPS) The change in saving divided by the change in disposable income.

We have already seen that the marginal propensity to consume equals the change in consumption divided by the change in income. We can define and measure the marginal propensity to save (MPS) as the change in saving divided by the change in disposable income. In calculating the MPS, as in calculating the MPC, we can safely ignore the difference between national income and disposable income. If we divide the last equation above by the change in income, DY, we get an equation that shows the relationship between the MPC and the MPS: Y S C   Y Y Y

or, 1 = MPC + MPS This last equation tells us that when net taxes are constant the MPC and the MPS must always equal 1. They must add up to 1 because part of any increase in income is consumed, and whatever remains must be saved.

Planned investment Figure 9.4 shows movements in real investment spending for the years 1960–2013. Notice that, unlike consumption, investment does not follow a smooth, upward trend. Investment declined significantly during the recessions of 1982–1983 and 1990, and again during the economic contraction of 2008. Following the recovery from the 1982–1983 recession real investment increased only slowly, but following the 1990 recession real investment increased rapidly, led by increases in spending on computers and other information technology, partly as a result of the growth of the Internet. The most rapid increase in investment over the period clearly occurred in the early to mid-2000s, largely driven by the minerals and energy boom

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in Australia. This continued until the GFC adversely affected investment in 2009–2010, after which investment recovered due to continuing investment in the mining sector. The four most important variables that determine the level of investment are: 1 Expectations of future profitability 2 The interest rate 3 Taxes 4 Cash flow

Expectations of future profitability Investment goods, such as factories, office buildings and machinery and equipment, are long lived. A firm is unlikely to build a new factory unless it is optimistic that the demand for its product will remain strong for a period of at least several years. When the economy moves into a period of economic contraction, or into a recession, many firms will postpone buying investment goods even if the demand for their own product is strong because they are afraid that the contraction or recession may become worse. For example, from 2009–2010 real investment declined continually, as firms reduced their investment spending due to the uncertainty created by the effects of the GFC. The reverse is likely to be true during an expansion. In the early 2000s many firms increased their investment spending in the expectation that capital goods would prove very profitable. The key point is this: the optimism or pessimism of firms is an important determinant of investment spending.

FIGURE 9.4

Real investment, Australia, 1960–2013 Investment is subject to more fluctuations than is consumption. Investment declined significantly during the recessions of 1982–1983 and 1990. Following the recovery from the 1982–1983 recession real investment increased only slowly, but following the 1990 recession real investment increased rapidly, led by increases in spending on computers and other information technology, partly as a result of the growth of the Internet. The most rapid increase in investment over the period occurred in the early to mid-2000s, largely driven by the minerals and energy boom in Australia. This continued until the GFC adversely affected investment in 2009–2010, after which investment recovered due to continuing investment in the mining sector

Real investment (billions of dollars)

400 350 300 250 200 150 100 50 0 1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

2010

SOURCE: Created from Australian Bureau of Statistics (2013), Australian National Accounts: National Income, Expenditure and Product, Cat. No. 5206.0, Table 2, Time Series Workbook, at , viewed 7 January 2014.

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The interest rate A significant fraction of business investment is financed by borrowing, which takes the form of issuing corporate bonds or borrowing from banks or other financial institutions. Even firms which use part of their profits (retained earnings) for investment projects face an increased opportunity cost of using retained earnings if interest rates rise. Households also borrow to finance most of their spending on new homes. The higher the interest rate, the more expensive it is for firms and households to borrow. Because households and firms are interested in the cost of borrowing after taking into account the effects of inflation, investment spending will depend on the real interest rate. Therefore, holding constant the other factors that affect investment spending, there is an inverse relationship between the real interest rate and investment spending: a higher real interest rate results in less investment spending, and a lower real interest rate results in more investment spending.

Taxes The level of investment spending is also affected by taxes. Firms focus on the profits that remain after they have paid taxes. The federal government imposes a company income tax on the profits companies earn, including profits from new buildings, equipment and other investment goods they purchase. A reduction in the company income tax rate would increase the aftertax profitability of investment spending. An increase in the company income tax rate would decrease the after-tax profitability of investment spending. Investment tax incentives also increase investment spending. An investment tax incentive allows firms to deduct a portion of their expenditure on new investment goods from their annual profit, thereby lowering the amount of profit subject to taxation.

Cash flow Cash flow The difference between the cash revenues received by the firm and the cash spending by the firm.

Many firms do not borrow to finance spending on new factories, machinery and equipment. Instead, they use their own funds. Cash flow is the difference between the cash revenues received by the firm and the cash spending by the firm. The largest contributor to cash flow is profit. The more profitable a firm is, the greater its cash flow and the greater its ability to finance investment. During periods of contraction or recession many firms experience reduced profits, which in turn reduces their ability to finance spending on new factories or machinery and equipment.

Government purchases Total government purchases include all spending by federal, local and state governments on goods and services. This includes purchases of consumption as well as investment goods such as infrastructure development, for example roads and railways. Government purchases do not include transfer payments, such as social security payments or pension payments by the federal government, because the government does not receive a good or service in return. The main source of revenue to finance government purchases is taxation receipts. The choice of government purchases depends on the priorities and policies of the political parties currently governing. Figure 9.5 shows levels of real government purchases during the years 1960–2013. Government purchases generally have grown for most of this period.

Net exports Net exports equals exports minus imports. We can calculate net exports by taking the value of spending by foreign firms and households on goods and services produced in Australia and subtracting the value of spending by Australian firms and households on goods and services produced in other countries. Figure 9.6 illustrates movements in net exports during the years 1960–2013. Australia’s exports and imports were about the same value from 1960 to 1980, which meant that net exports were approximately zero. Since 1980 net exports have largely been negative, although there have been a few years when they were positive. In the early to mid-2000s net exports plummeted, driven largely by increases in imports as a result of greater household incomes and borrowings, greater investment spending which required imported machinery and equipment, plus falls in exports due to significant droughts reducing agricultural exports. The temporary increase in net exports in late 2008 and early 2009 was

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FIGURE 9.5

Real government purchases, Australia, 1960–2013 Government purchases have generally grown for most of the 1960–2013 period

Real government purchases (billions of dollars)

300

250

200

150

100

50

0 1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

2010

SOURCE: Created from Australian Bureau of Statistics (2013), Australian National Accounts: National Income, Expenditure and Product, Cat. No. 5206.0, Table 2, Time Series Workbook, at , viewed 8 January 2014.

due to a significant fall in imports (particularly intermediate goods and consumer goods), which outweighed the fall in exports, while the increase in 2011 was in large part due to a rise in the value of mining exports. We will explore further the behaviour of net exports in Chapter 14. The three most important variables that determine the level of net exports are: 1 The price level in Australia relative to the price levels in other countries. 2 The economic growth rate in Australia relative to the economic growth rates in other countries. 3 The exchange rate between the dollar and other currencies.

The price level in Australia relative to the price levels in other countries If the inflation rate in Australia is lower than the inflation rate in other countries, then prices of Australian products increase more slowly than the prices of products of other countries. This difference in price levels increases the demand for Australian products relative to the demand for foreign products. So, Australian exports increase and Australian imports decrease, which increases net exports. The reverse will happen during periods when the inflation rate in Australia is higher than the inflation rates in other countries: Australian exports decrease and Australian imports increase, which decreases net exports.

The economic growth rate in Australia relative to the economic growth rates in other countries As GDP increases in Australia the incomes of households rise, leading them to increase their purchases of goods and services. Some of the additional goods and services purchased with

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FIGURE 9.6

Net exports, Australia, 1960–2013 Australia’s exports and imports were about the same value from 1960 to 1980, which meant that net exports were approximately zero. Since 1980 net exports have largely been negative, although there have been a few years when they were positive. The temporary increase in net exports in late 2008 and early 2009 was due to a significant fall in imports

15 000 10 000

Net exports (millions of dollars)

5 000 0 –5 000 –10 000 –15 000 –20 000 –25 000 –30 000 –35 000 1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

2010

SOURCE: Created from Australian Bureau of Statistics (2013), Australian National Accounts: National Income, Expenditure and Product, Cat. No. 5206.0, Table 13, Time Series Workbook, at , viewed 8 January 2014.

rising incomes will be produced in Australia, but a proportion will also be imported. When incomes rise faster in Australia than in other countries Australian purchases of foreign goods and services increase faster than foreign purchases of Australian goods and services. As a result, net exports fall. When incomes in other countries rise Australia’s net exports rise. This is largely because Australia is a large exporter of primary commodities, and demand for these is closely related to world economic growth. As growth and incomes rise in the rest of the world, so does the demand for Australian commodities.

The exchange rate between the dollar and other currencies Exchange rate The value of one country’s currency in terms of another country’s currency.

The exchange rate is the value of one country’s currency in terms of another country’s currency. It influences the demand for imports and exports between countries. As the value of the Australian dollar rises, the foreign currency price of many Australian products sold in other countries, such as hotel rooms, university places and manufactured goods, rises, and the dollar price of foreign products sold in Australia falls. For example, suppose that the exchange rate between the Japanese yen and the Australian dollar is ¥100 = $1. Leaving aside transportation costs, an Australian product that sells for $1 in Australia will sell for ¥100 in Japan, and a Japanese product that sells for ¥100 in Japan will sell for $1 in Australia. If the exchange rate rises to ¥150 = $1, then the Australian product that still sells for $1 in Australia will now sell for ¥150 in Japan, reducing the quantity demanded by Japanese consumers. The Japanese product that still sells for ¥100 in Japan will now sell for only $0.67 in Australia, increasing the quantity demanded by Australian consumers. For many primary commodities like coal and wheat, the prices are quoted in US dollars, and Australian producers receive whatever that price is converted into Australian dollars. When the value of the Australian

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dollar rises, prices received for primary products fall and export income falls. An increase in the value of the dollar will reduce export income and increase imports, so net exports will fall. A decrease in the value of the dollar will increase export income and reduce imports, so net exports will rise. The amount by which there is a change in demand for exports and imports will depend on the degree of responsiveness of the quantity demanded and the quantity supplied to price changes (known as the price elasticities of demand and supply for the goods and services). This responsiveness largely depends on the availability of substitutes produced in other countries.

GRAPHING MACROECONOMIC EQUILIBRIUM Having examined the components of aggregate expenditure we can now look more closely at macroeconomic equilibrium. We saw earlier in the chapter that macroeconomic equilibrium occurs when GDP is equal to aggregate expenditure. We can use a graph called the 45° line diagram to illustrate macroeconomic equilibrium. (The 45° line diagram is also sometimes referred to as the Keynesian cross diagram because it is based on the analysis of John Maynard Keynes.) To become familiar with this diagram, consider Figure 9.7, which is a 45° line diagram that shows the relationship between the quantity of Pepsi sold (on the vertical axis) and the quantity of Pepsi produced (on the horizontal axis). The line on the diagram forms an angle of 45° with the horizontal axis. The line represents all the points that are equal distances from both axes. So points such as A and B, where the number of bottles of Pepsi produced equals the number of bottles sold, are on the 45° line. Points such as C, where the quantity sold is greater than the quantity produced, lie above the line. Points such as D, where the quantity sold is less than the quantity produced, lie below the line. Figure 9.8 is very similar to Figure 9.7, except that it measures real national income or real GDP (Y ) on the horizontal axis and planned real aggregate expenditure (AE) on the vertical axis. Because macroeconomic equilibrium occurs where planned aggregate expenditure equals GDP, we know that all points of macroeconomic equilibrium must lie along the 45° line. For all points above the 45° line, planned aggregate expenditure will be greater than GDP. For all points below the 45° line, planned aggregate expenditure will be less than GDP.

9.3 Use a 45° line diagram to illustrate macroeconomic equilibrium. LEARNING OBJECTIVE

FIGURE 9.7

Quantity of Pepsi sold (bottles)

An example of a 45º line diagram

12

The 45º line shows all the points that are equal distances from both axes. Points such as A and B, at which the quantity produced equals the quantity sold, are on the 45º line. Points such as C, at which the quantity sold is greater than the quantity produced, lie above the line. Points such as D, at which the quantity sold is less than the quantity produced, lie below the line

C

10

B

8

6

A

4

D

2 45˚ 0

2

4

6

8

10

12

Quantity of Pepsi produced (bottles)

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FIGURE 9.8

The relationship between planned aggregate expenditure and GDP on a 45º line diagram Every point of macroeconomic equilibrium is on the 45º line, where planned expenditure equals GDP. At points above the line, planned aggregate expenditure is greater than GDP. At points below the line, planned aggregate expenditure is less than GDP

Real aggregate expenditure, AE (billions of dollars) $1200 Y = AE

1000

Planned aggregate expenditure is greater than GDP for points above the 45˚ line.

800

600

All points of macroeconomic equilibrium must lie on the 45˚ line.

Planned aggregate expenditure is less than GDP for points below the 45˚ line.

400

200 45˚ 0

$200

400

600

800

1000

1200

Real national income or real GDP, Y (billions of dollars)

Autonomous consumption Consumption that is independent of income. Induced consumption Consumption that is determined by the level of income.

The 45° line shows many potential points of macroeconomic equilibrium. During any particular year only one of these points will represent the actual level of equilibrium real GDP, given the actual level of planned real expenditure. To determine this point we need to draw a line on the graph to show the aggregate expenditure function. The aggregate expenditure function shows us the amount of planned aggregate expenditure that will occur at every level of national income or GDP. Changes in GDP have a much greater impact on consumption than on planned investment, government purchases or net exports. We assume for simplicity that the variables that determine planned investment, government purchases and net exports all remain constant, as do the variables other than GDP that affect consumption. For example, we will assume that a firm’s level of planned investment at the beginning of the year will not change during the year, even if the level of GDP changes. Figure 9.9 shows the aggregate expenditure function on the 45° line diagram. The lowest upward-sloping line, C, represents the consumption function, just as shown earlier in Figure  9.2. Notice that the consumption function does not begin at zero but is positive, at $200 billion, even when income is zero. This is because a certain amount of consumption occurs that is independent of income, which is called autonomous consumption. Consumption actually has both an autonomous component, which does not depend on the level of income, and a non-autonomous component, or induced consumption, that does depend on income. For example, there would still be spending on necessities—autonomous consumption—even if incomes were zero. Further, if households decide to spend more of their incomes—and save less—at every level of income there will be an autonomous increase in consumption spending. If, however, incomes increase and households increase their consumption spending as indicated by the consumption function, the increase in consumption spending is induced consumption. The quantities of planned investment, government purchases and net exports are constant because we assumed that the variables they depend on are constant. So the level of planned aggregate expenditure at any level of GDP is the amount of consumption spending at that level of GDP plus the sum of the constant amounts of planned investment, government

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FIGURE 9.9

Real aggregate expenditure, AE (billions of dollars)

Macroeconomic equilibrium on the 45º line diagram

$1400 Point of macroeconomic equilibrium

1200

Y = AE C + I + G + NX = AE

Net exports

1000

Aggregate expenditure function

C+I+G

Government purchases

C+I

800 C

Planned investment

600

400 Consumption

200 45˚ 0

241

$200

400

600

800

1000

1200

1400

Real GDP, Y (billions of dollars)

Macroeconomic equilibrium occurs where the aggregate expenditure line (AE) crosses the 45º line. The lowest upward-sloping line, C, represents the consumption function. The quantities of planned investment, government purchases and net exports are constant because we assumed that the variables they depend on are constant. So the total of planned aggregate expenditure at any level of GDP is just the amount of consumption at that level of GDP plus the sum of the constant amounts of planned investment, government purchases and net exports. We successively add each component of spending to the consumption function line to arrive at the line representing aggregate expenditure

purchases and net exports. In Figure 9.9 we add each component of spending successively to the consumption function line to arrive at the line representing planned aggregate expenditure (AE). The C + I line is higher than the C line by the constant amount of planned investment; the C + I + G line is higher than the C + I line by the constant amount of government purchases; and the C + I + G + NX line is higher than the C + I + G line by the constant amount of net exports. Note that in the years when NX is negative this would cause the C + I + G + NX line to be below the C + I + G line. The C + I + G + NX line shows all four components of expenditure and is the aggregate expenditure (AE ) function. At the point where the AE line crosses the 45° line, planned aggregate expenditure is equal to GDP and the economy is in macroeconomic equilibrium. Figure 9.10 makes the relationship between planned aggregate expenditure and GDP clearer by showing only the 45° line and the AE line. The figure shows that the AE line intersects the 45° line at a level of real GDP of $1000 billion. Therefore, $1000 billion represents the equilibrium level of real GDP. To see why this is true consider the situation if real GDP were only $800 billion. By moving vertically from $800 billion on the horizontal axis up to the AE line, we can see that planned aggregate expenditure will be greater than $800  billion at this level of real GDP. Whenever total spending is greater than total production firms’ inventories will fall. The fall in inventories is equal to the vertical distance between the AE line, which shows the level of total spending, and the 45° line, which shows the $800 billion of total production. Unplanned declines in inventories lead firms to increase their production. As real GDP increases from $800 billion, so will total income and therefore consumption. The economy will move up the AE line as consumption increases. The gap between total spending and total production will fall, but as long as the AE line is above the 45° line inventories will continue to decline and firms will continue to expand production. When real GDP rises to $1000 billion inventories stop falling and the economy will be in macroeconomic equilibrium.

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FIGURE 9.10

Macroeconomic equilibrium Macroeconomic equilibrium occurs where the AE line crosses the 45º line. In this case, that occurs at a GDP of $1000 billion. If GDP is less than $1000 billion, the corresponding point on the AE line is above the 45º line, planned aggregate expenditure is greater than total production, firms will experience an unplanned decrease in inventories and GDP will increase. If GDP is greater than $1000 billion, the corresponding point on the AE line is below the 45º line, planned aggregate expenditure is less than total production, firms will experience an unplanned increase in inventories and GDP will decrease

Real aggregate expenditure, AE (billions of dollars) $1400 Y = AE

1200 AE 1. An unplanned decrease in inventories . . .

1000

3. An unplanned increase in inventories . . .

800

600

400

2. . . . results in increasing production.

200

4. . . . results in decreasing production.

45˚ 0

$200

400

600

800

1000

1200

1400

Real GDP, Y (billions of dollars)

As Figure 9.10 shows, if GDP is initially $1200 billion planned aggregate expenditure will be less than GDP and firms will experience an unplanned increase in inventories. Rising inventories lead firms to decrease production. As GDP falls from $1200 billion consumption will also fall, which causes the economy to move down the AE line. The gap between planned aggregate expenditure and GDP will fall, but as long as the AE line is below the 45° line, inventories will continue to rise and firms will continue to cut production. When GDP falls to $1000 billion inventories will stop rising and the economy will be in macroeconomic equilibrium.

Showing a contraction or recession on the 45° line diagram Notice that macroeconomic equilibrium can occur at any point on the 45° line. Ideally, we would like equilibrium to occur at potential GDP. At potential GDP firms will be operating at their normal level of capacity and the economy will be at the natural rate of unemployment. As we learned in Chapter 7, the natural rate of unemployment is when the economy is at full employment: everyone in the labour force who wants a job will have one, except the structurally and frictionally unemployed. However, for equilibrium to occur at the level of potential GDP, planned aggregate expenditure must be high enough. As Figure 9.11 shows, if there is insufficient total spending, equilibrium will occur at a lower level of real GDP. Many firms will be operating below their normal capacity, and the unemployment rate will be above the natural rate of unemployment. Suppose that the level of potential GDP is $1000 billion. We can see from Figure 9.11 that when GDP is $1000 billion, planned aggregate expenditure is below $1000 billion, perhaps because business firms have become pessimistic about their future profitability and have reduced their investment spending. The shortfall in planned aggregate expenditure that leads to the contraction or recession can be measured as the vertical distance between the AE line

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243

FIGURE 9.11

Real aggregate expenditure, AE (billions of dollars)

Showing a recession on the 45º line diagram

$1040 Potential GDP

1020

Y = AE

Equilibrium GDP

1000

AE

980 Shortfall in aggregate expenditure that results in recession

960

940

920

When the aggregate expenditure line intersects the 45º line at a level of GDP below potential GDP, the economy is experiencing a contraction or a recession. The figure shows potential GDP is $1000 billion, but because planned aggregate expenditure is too low, the equilibrium level of GDP is only $980 billion, where the AE line intersects the 45º line. As a result, some firms will be operating below their normal capacity and unemployment will be above the natural rate of unemployment. We can measure the shortfall in planned aggregate expenditure as the vertical distance between the AE line and the 45º line at the level of potential GDP

900 45˚ 0

$900

920

940

960

980

1000

1020

1040

Real GDP, Y (billions of dollars)

and the 45° line at the level of potential GDP. The shortfall in planned aggregate expenditure is exactly equal to the unplanned increase in inventories that would occur if the economy were initially at a level of GDP of $1000  billion. The unplanned increase in inventories measures the amount by which current planned aggregate expenditure is too low for the current level of production to be the equilibrium level. Or, put another way, if any of the four components of  aggregate expenditure increased by this amount, the AE line would shift upwards and intersect the 45° line at GDP of $1000 billion and the economy would be in macroeconomic equilibrium at full employment. Figure 9.11 shows that macroeconomic equilibrium will occur when real GDP is $980 billion. Because this is 2 per cent below the potential level of GDP of $1000 billion, many firms will be operating below their normal capacity and the unemployment rate will be above the natural rate of unemployment. The economy will remain at this level of real GDP until there is an increase in one or more of the components of aggregate expenditure.

The important role of inventories Whenever planned aggregate expenditure is less than real GDP some firms will experience unplanned increases in inventories. If firms do not cut back their production promptly when spending declines, they will accumulate inventories. If firms accumulate excess inventories, then even if spending quickly returns to its normal levels firms will have to sell their excess inventories before they can return to producing at normal levels. The possibility that firms will accumulate excess inventories explains why a brief decline in spending can result in a fairly long contraction or recession. In the early twentieth century many firms found it difficult to control and monitor their inventory levels. However, by the 1980s and beyond, many firms use improved systems of inventory control, which help to smooth out fluctuations in real GDP.

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M

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9.1

ONNECTION

BUSINESS ATTEMPTS TO CONTROL INVENTORIES, THEN … AND NOW A failure to control inventories can cause a firm to suffer losses or even drive it into bankruptcy. For example, early in the twentieth century in the United States excessive accumulation of inventories was a serious problem for the car industry. In his memoirs, Alfred Sloan, president of General Motors, described how he checked on inventories by travelling around the country by train and literally counting the number of unsold cars on dealers’ car lots. Not too surprisingly, this weak method of inventory control caused General Motors to suffer severe financial losses in 1920 and again in 1924. Eventually car firms improved their inventory control methods, although not before a number of firms had been driven into bankruptcy.

Modern computer firms can also suffer significant losses if they accumulate large inventories of computer components, because the prices of the components they buy from their suppliers can decline significantly, even from one week to the next. Bloomberg via Getty Images A firm that has large inventories of components may find that its costs of assembling Computer firms use supply chain management computers are significantly greater than the costs of competitors that hold smaller to keep inventories low inventories. If a sufficiently large number of firms in the economy experience an accumulation of inventories, this will reduce real GDP, because firms will reduce their production levels and sell their inventories. Computer firms pioneered methods of reducing costs by controlling inventories worldwide. Most leading computer firms have adopted variations of Configure to Order (CTO) systems to reduce inventory costs. Some only build final products once orders are placed and, as a result, hold no inventories of finished computers. Other manufacturers have adopted more limited CTO options but have still significantly reduced their inventory costs. CTO is made viable by the standardisation of and reduction in the number of parts needed from suppliers who can deliver components often within a few hours. This makes it possible for, say, a PC to be made in much shorter time and at lower cost. The inventory control techniques that allow low-cost production of computers also help the firm to respond quickly to sales declines without a significant build-up of inventories. As firms manage their inventory levels better, this helps to smooth out production levels and reduce fluctuations in real GDP.

A numerical example of macroeconomic equilibrium In forecasting real GDP economists rely on quantitative models of the economy. We can increase our understanding of the causes of fluctuations in real GDP by considering a simple numerical example of macroeconomic equilibrium. Although simplified, this example captures some of the key features contained in the quantitative models used by economic forecasters. Table 9.3 shows several hypothetical combinations of real GDP and planned aggregate expenditure. The first column lists real GDP. The next four columns list levels of planned aggregate expenditure that occur at the corresponding level of real GDP. We assume that planned investment, government purchases and net exports do not change as GDP changes. Because consumption depends on GDP it increases as GDP increases. In the first row, GDP of $8000 billion results in consumption of $6200 billion. Adding consumption, planned investment, government purchases and net exports across the row gives us planned aggregate expenditure of $8700 billion. Because planned aggregate expenditure is

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greater than GDP, inventories will fall by $700 billion. This unplanned decline in inventories will lead firms to increase production, and GDP will increase. GDP will continue to increase until it reaches $10 000 billion. At that level of GDP planned aggregate expenditure is also $10 000  billion, unplanned changes in inventories are zero and the economy is in macroeconomic equilibrium. In the last row of Table 9.3, GDP of $12 000 billion results in consumption of $8800 billion and planned aggregate expenditure of $11 300 billion. Because planned aggregate expenditure is less than GDP, inventories will increase by $700 billion. This unplanned increase in inventories will lead firms to decrease production, and GDP will decrease. GDP will continue to decrease until it reaches $10 000 billion, unplanned changes in inventories are zero and the economy is in macroeconomic equilibrium. Only when real GDP equals $10 000 billion will the economy be in macroeconomic equilibrium. At other levels of real GDP planned aggregate expenditure will be higher or lower than GDP and the economy will be expanding or contracting.

TABLE 9.3

REAL GDP (Y )

Macroeconomic equilibrium (billions of dollars)

CONSUMPTION (C )

PLANNED INVESTMENT (I )

GOVERNMENT PURCHASES (G )

NET EXPORTS (NX )

PLANNED AGGREGATE EXPENDITURE (AE )

UNPLANNED CHANGE IN INVENTORIES

REAL GDP WILL …

$8 000

$6200

$1500

$1500

–$500

$8 700

–$700

increase

 9 000

 6850

 1500

 1500

 –500

 9 350

–350

increase

10 000

 7500

 1500

 1500

 –500

10 000

0

be in equilibrium

11 000

 8150

 1500

 1500

 –500

10 650

+350

decrease

12 000

 8800

 1500

 1500

 –500

11 300

+700

decrease

Don’t confuse aggregate expenditure with consumption spending Macroeconomic equilibrium occurs where planned aggregate expenditure equals GDP. But remember that planned aggregate expenditure equals the sum of consumption spending, planned investment spending, government purchases and net exports, not consumption spending by itself. If GDP were equal to consumption the economy would not be in equilibrium. Planned investment plus government purchases plus net exports will always be a positive number. Therefore, if consumption were equal to GDP, aggregate expenditure would have to be greater than GDP. In that case inventories would be decreasing and GDP would be increasing; GDP would not be in equilibrium.

DON’T LET THIS HAPPEN TO YOU

[ YOUR TURN Q

Test your understanding by doing related problem 3.11 on page 261 at the end of this chapter.

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SOLVED PROBLEM 9.1 DETERMINING MACROECONOMIC EQUILIBRIUM Fill in the blanks in the following table and determine the equilibrium level of real GDP. All values are in billions of dollars.

REAL GDP (Y )

CONSUMPTION (C )

PLANNED INVESTMENT (I )

GOVERNMENT PURCHASES (G )

$8 000

$6200

$1675

$1675

–$500

9 000

6850

1675

1675

–500

10 000

7500

1675

1675

–500

11 000

8150

1675

1675

–500

12 000

8800

1675

1675

–500

PLANNED AGGREGATE EXPENDITURE (AE )

NET EXPORTS (NX )

UNPLANNED CHANGE IN INVENTORIES

Solving the problem STEP 1: Review the chapter material. This problem is about determining macroeconomic equilibrium, so you may want to review the

section ‘A numerical example of macroeconomic equilibrium’, which begins on page 244. STEP 2: Fill in the missing values in the table. We can calculate the missing values in the last two columns by using two equations:

(1) Planned aggregate expenditure (AE) = consumption (C) + planned investment (I) + government purchases (G) + net exports (NX) (2) Unplanned change in inventories = real GDP (Y) – planned aggregate expenditure (AE) For example, to fill in the first row we have AE = $6200 billion + $1675 billion + $1675 billion + (–$500 billion) = $9050 billion; and unplanned change in inventories = $8000 billion – $9050 billion = –$1050 billion.

CONSUMPTION (C )

PLANNED INVESTMENT (I )

GOVERNMENT PURCHASES (G )

NET EXPORTS (NX )

PLANNED AGGREGATE EXPENDITURE (AE )

UNPLANNED CHANGE IN INVENTORIES

$8 000

$6200

$1675

$1675

–$500

$9 050

–$1050

9 000

6850

1675

1675

–500

9 700

–700

10 000

7500

1675

1675

–500

10 350

–350

11 000

8150

1675

1675

–500

11 000

0

12 000

8800

1675

1675

–500

11 650

350

REAL GDP (Y )

STEP 3: Determine the equilibrium level of real GDP. Once you fill in the table you should see that equilibrium real GDP must be

$11 000 billion, because only at that level is real GDP equal to planned aggregate expenditure.

[ YOUR TURN Q

For more practice do related problem 3.12 on page 261 at the end of this chapter.

THE MULTIPLIER EFFECT

9.4 Describe the multiplier effect and use the multiplier formula to calculate changes in equilibrium GDP. LEARNING OBJECTIVE

Up to this point we have seen that aggregate expenditure determines real GDP in the short run, and we have seen how the economy adjusts if it is not in equilibrium. We have also seen that whenever aggregate expenditure changes there will be a new level of equilibrium real GDP. In this section we look more closely at the effects of a change in aggregate expenditure on equilibrium real GDP. We begin the discussion with Figure 9.12, which illustrates the effects

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of an increase in planned investment spending. We assume the economy starts in equilibrium at point A, at which real GDP is $960 billion. Firms then become more optimistic about their future profitability and increase spending on factories, machinery and equipment by $10 billion. This increase in investment spending shifts the AE line up by $10 billion, from the dark green line (AE1) to the light green line (AE2). The new equilibrium occurs at point B, at which real GDP is $1000 billion, which equals potential GDP. Notice that the initial $10 billion increase in planned investment spending results in a $40  billion increase in equilibrium real GDP. The increase in planned investment spending has had a multiplied effect on equilibrium real GDP. It is not only investment spending that will have this multiplied effect; any increase in autonomous expenditure will shift up the aggregate expenditure function and lead to a multiplied increase in equilibrium GDP. Autonomous expenditure does not depend on the level of GDP. In the aggregate expenditure model that we have been using, planned investment spending, government spending and net exports are all autonomous expenditures. An increase in autonomous expenditure will shift the aggregate expenditure function upwards and a decrease in autonomous expenditure will shift the aggregate expenditure function downwards. If, however, real GDP increases and aggregate spending increases, the economy will move up along the aggregate expenditure function. This increase in spending will be non-autonomous, that is, it is induced expenditure, and does depend on the level of real GDP. The ratio of the increase in equilibrium real GDP to the increase in autonomous expenditure is called the multiplier. The series of induced increases in consumption spending that results from an initial increase in autonomous expenditure is called the multiplier effect. The multiplier effect occurs because an initial increase in autonomous expenditure will set off a series of increases in real GDP. In Figure 9.12 we look more closely at the multiplier effect. Suppose the whole $10 billion increase in investment spending consists of firms buying additional factories and office buildings. Initially, this additional spending will cause the construction of factories and office buildings to increase by $10 billion, so GDP will also increase by $10 billion. Remember that increases in production result in equal increases in national income. So this increase in real GDP of $10 billion is also an increase in national income of $10 billion. In this example, the income is received as wages and salaries by the employees of the construction firms, as profits by the owners of the firms and so on. After receiving this additional income, these workers, managers and owners will increase their consumption of cars, restaurant meals and many other products. If the MPC is 0.75, we know the increase in consumption spending will be $7.5 billion. This additional $7.5 billion

Y = AE

$1030

AE2

1. A $10 billion increase in planned investment . . .

1020 1010

AE1 B

1000 990 980

Induced expenditure Expenditure that depends on the level of GDP. Multiplier The increase in equilibrium real GDP divided by the increase in autonomous expenditure. Multiplier effect The process by which an increase in autonomous expenditure leads to a larger increase in real GDP.

The multiplier effect The economy begins at point A, at which equilibrium real GDP is $960 billion. A $10 billion increase in planned investment shifts up aggregate expenditure from AE1 to AE2. The new equilibrium is at point B, where real GDP is $1000 billion, which is potential GDP. Because of the multiplier effect, a $10 billion increase in investment results in a $40 billion increase in equilibrium real GDP

Potential GDP

970 960

A

950

2. . . . results in a $40 billion increase in equilibrium GDP.

940

0

Autonomous expenditure Expenditure that does not depend on the level of GDP.

FIGURE 9.12

Real aggregate expenditure, AE (billions of dollars)

930

247

45˚ $940

960

980

1000

1020

1040

Real GDP, Y (billions of dollars)

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in spending will cause the firms making the cars, restaurant meals and other products to increase production by $7.5 billion, so GDP will rise by $7.5 billion. This increase in GDP means national income has also increased by another $7.5 billion. This increased income will be received by the owners and employees of the firms producing the cars, restaurant meals and other products. These workers, managers and owners in turn will increase their consumption spending, and the process of increasing production, income and consumption will continue. Eventually the total increase in consumption will be $30 billion (we will soon show how we know this is true). This $30 billion increase in consumption combined with the initial $10  billion increase in investment spending will result in a total change in equilibrium GDP of $40 billion. Table 9.4 summarises how changes in GDP and spending caused by the initial $10 billion increase in investment will result in equilibrium GDP rising by $40 billion. We can think of the multiplier effect occurring in rounds of spending. In round 1 there is an increase of $10 billion in autonomous expenditure—the $10 billion in planned investment spending in our example—which causes GDP to rise by $10 billion. In round 2 induced expenditure rises by $7.5 billion (which equals the $10 billion increase in real GDP in round 1 multiplied by the MPC ). The $7.5 billion in induced expenditure in round 2 causes a $7.5 billion increase in real GDP, which leads to a $5.6 billion increase in induced expenditure in round 3 and so on. The final column sums up the total increases in expenditure, which equal the total increase in GDP. In each round the additional induced expenditure becomes smaller because the MPC is less than 1. By round 10 additional induced expenditure is only $0.8 billion and the total increase in GDP is $37.7 billion. By round 19 the process is almost complete: additional induced expenditure is only $0.1 billion, and the total increase in GDP is $39.8 billion. Eventually, the process will be complete, although we cannot say precisely how many spending rounds it will take, so we simply label the last round n, rather than giving it a specific number. TABLE 9.4

The multiplier effect in action ADDITIONAL AUTONOMOUS EXPENDITURE (INVESTMENT)

ADDITIONAL INDUCED EXPENDITURE (CONSUMPTION)

TOTAL ADDITIONAL EXPENDITURE = TOTAL ADDITIONAL GDP

Round 1

$10 billion

$0

$10 billion

Round 2

0

 7.5 billion

 17.5 billion

Round 3

0

 5.6 billion

 23.1 billion

Round 4

0

 4.2 billion

 27.3 billion

Round 5

0

 3.2 billion

 30.5 billion

.

.

.

.

.

.

.

.

.

.

.

.

0

 0.8 billion

.

.

.

.

.

.

.

.

.

.

.

.

0

 0.2 billion

.

.

.

.

.

.

.

.

.

.

.

.

0

 0.1 billion

.

.

.

.

.

.

.

.

.

.

.

.

0

 0

Round 10

Round 15

Round 19

n

 37.7 billion

 39.5 billion

 39.8 billion

$40.0 billion

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249

We can calculate the value of the multiplier in our example by dividing the increase in equilibrium real GDP by the increase in autonomous expenditure: Y change in real GDP $40 billion 4   I change in investment spending $10 billion

With a multiplier of 4, each increase in autonomous expenditure of $1 will result in a change in equilibrium GDP of $4.

A formula for the multiplier It can be seen in Table 9.4 that during the multiplier process each round of increases in consumption is smaller than in the previous round, so eventually the increases will come to an end and we will have a new macroeconomic equilibrium. But how do we know that when we add all the increases in GDP the total will be $40 billion? We can show that this is true by first writing out the total change in equilibrium GDP: The total change in equilibrium real GDP equals the initial increase in planned investment spending = $10 billion Plus the first induced increase in consumption = MPC × $10 billion Plus the second induced increase in consumption = MPC × (MPC × $10 billion) = MPC 2 × $10 billion Plus the third induced increase in consumption = MPC × (MPC 2 × $10 billion) = MPC 3 × $10 billion Plus the fourth induced increase in consumption = MPC × (MPC 3 × $10 billion) = MPC 4 × $10 billion And so on … Or, The total change in GDP = $10 billion + MPC × $10 billion + MPC 2 × $10 billion + MPC 3 × $10 billion + MPC 4 × $10 billion + … where the … indicates that the expression contains an infinite number of similar terms. If we factor out the $10 billion from each expression we have: Total change in GDP = $10 billion × (1 + MPC + MPC 2 + MPC 3 + MPC 4 + …) Mathematicians have shown that an expression like the one in parentheses sums to: 1 1  MPC

In this case, the MPC is equal to 0.75. So we can now calculate that the change in equilibrium GDP = $10 billion × [1/(1 – 0.75)] = $10 billion × 4 = $40 billion. We have also derived a general formula for the multiplier: Multiplier 

1 change in equilibrium real GDP  change in autonomous expenditure 1  MPC

In this case the multiplier is 1/(1 – 0.75), or 4, which means that for each additional $1 of autonomous spending, equilibrium GDP will increase by $4. A $10 billion increase in planned investment spending results in a $40 billion increase in equilibrium GDP. Notice that the value of the multiplier depends on the value of the MPC: in particular, the larger the value of the MPC the larger the value of the multiplier. For example, if the MPC were 0.9 instead of 0.75, the value of the multiplier would increase from 4 to 1/(1 – 0.9) = 10.

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9.2

ONNECTION

THE MULTIPLIER IN REVERSE: THE GREAT DEPRESSION OF THE 1930s An increase in autonomous expenditure causes an increase in equilibrium real GDP, but the reverse is also true: a decrease in autonomous expenditure causes a decrease in real GDP. Many Australians became aware of this fact in the late 1920s and early 1930s when reductions in autonomous expenditure, such as Australian exports to overseas countries experiencing their own recessions, were magnified by the multiplier into the largest decline in real GDP in Australian history. In the mid-1920s the economy was booming, with high prices for exports, particularly wool and wheat. It was also a period when there was a strong inflow of capital from overseas, largely driven by government borrowing for capital works projects. For example, between 1922 and 1929 government expenditure in Australia increased by 27.4 per cent!

However, by the late 1920s export prices had plummeted, which was a significant shock to the economy, because it was very reliant on export earnings from the primary sector. In October 1929 the US stock market crashed, destroying millions More than 1000 unemployed men marched of dollars of wealth and increasing pessimism among households and firms. Many from the Esplanade to the Treasury Building banks in the United States failed (around 5000), and the shortage of money and in Perth, Western Australia, to see Premier credit spread to many other countries throughout the world. The consequence Sir James Mitchell. The reverse multiplier effect had contributed to the very high levels of of this for Australia was that the inflow of foreign capital (borrowings), largely unemployment during the Great Depression from London, suddenly stopped. Because Australia could no longer borrow from overseas, government spending and private investment decreased significantly. Between June 1929 and June 1930, private housing investment in Australia fell by 27.5 per cent and private capital investment fell by 32.7 per cent. Between June 1930 and June 1931 government capital expenditure fell by 29.7 per cent, then fell by 26.9 per cent in the following year. As aggregate expenditure declined, many firms experienced declining sales and began to lay off workers. Falling levels of production and income induced further declines in consumption spending, which led to further cutbacks in production and employment, leading to further declines in income and so on, in a downward spiral. Between 1928 and 1931, GDP fell by over 20 per cent; however, due to deflation (a fall in the general level of prices) of around 10 per cent, the decline in real GDP was probably closer to 10 per cent. The rate of unemployment rose from around 6 per cent in 1928 to estimates of between 20 per cent and 30 per cent by 1932. This was higher than the average unemployment rates of the United States and United Kingdom. In addition to the external shocks, the Australian economy was also beginning to experience domestic economic problems. It was burdened by an inefficient manufacturing sector—most likely due to the tariff protection reducing the competition from overseas producers. Real wages in the 1920s were also rising faster than the general price level in the economy, increasing production costs, and would have led to rising unemployment even without the external shocks. Further, the high levels of government spending in the 1920s were already showing signs of falling before the Great Depression, and it was unlikely that this could have been sustained even without the reduction of foreign capital inflows in the early 1930s. The severity of the Great Depression meant bankruptcy for many firms. Even firms that survived experienced sharp declines in sales. The high rates of unemployment forced many families into poverty and a daily struggle for survival. Recovery was slow, and real GDP did not regain its 1929 level until 1935, and the unemployment rate did not fall below 10 per cent until the late 1930s. SOURCE: D. Meredith and B. Dyster (1999), Australia in the Global Economy: Continuity and Change, Cambridge University Press; N. Dimsdale and N. Horsewood (2002), ‘The causes of unemployment in interwar Australia’, Economic Record, December, Vol. 78, No. 243, pp. 388–405; T. Valentine (1987), ‘The Depression of the 1930s’, in R. Maddock and I. McLean (eds), The Australian Economy in the Long Run, Chapter 3, Cambridge University Press.

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Summarising the multiplier effect You should note four key points about the multiplier effect: 1 The multiplier effect occurs both when autonomous expenditure increases and when it decreases. For example, with an MPC of 0.75, a decrease in planned investment of $10 billion will lead to a decrease in equilibrium income of $40 billion. 2 The multiplier effect makes the economy more sensitive to changes in autonomous expenditure than it would otherwise be. Because an initial decline in investment spending sets off a series of declines in production, income and spending, firms that are far removed from the industry where the fall in investment occurred also experience sales declines. 3 The larger the MPC the larger the value of the multiplier. With an MPC of 0.75 the multiplier is 4, but with an MPC of 0.50 the multiplier is only 2. This inverse relationship between the value of the MPC and the value of the multiplier holds true because the larger the MPC, the more additional consumption takes place after each rise in income during the multiplier process. 4 The formula for the multiplier, 1/(1 – MPC ), is oversimplified because it ignores some real-world complications, such as the effect that an increasing GDP can have on imports, inflation and interest rates. These effects combine to cause our simple formula to overstate the true value of the multiplier. The following chapters will start to take into account these real-world complications.

SOLVED PROBLEM 9.2 USING THE MULTIPLIER FORMULA Use the information in the table to answer the following questions. The numbers in the table are in billions of dollars.

1 2 3

REAL GDP (Y )

CONSUMPTION (C )

PLANNED INVESTMENT (I )

GOVERNMENT PURCHASES (G )

NET EXPORTS (NX )

$8 000

$6 900

$1000

$1000

–$500

9 000

7 700

1000

1000

–500

10 000

8 500

1000

1000

–500

11 000

9 300

1000

1000

–500

12 000

10 100

1000

1000

–500

What is the equilibrium level of real GDP? What is the MPC? Suppose government purchases increase by $200 billion. What will be the new equilibrium level of real GDP? Use the multiplier formula to determine your answer.

Solving the problem STEP 1: Review the chapter material. This problem is about the multiplier process so you may want to review the section entitled

‘The multiplier effect’, which begins on page 246. STEP 2: Determine equilibrium real GDP. Just as in Solved problem 9.1, so we can find macroeconomic equilibrium by calculating

the level of planned aggregate expenditure for each level of real GDP: REAL GDP (Y )

CONSUMPTION (C )

PLANNED INVESTMENT (I )

GOVERNMENT PURCHASES (G )

NET EXPORTS (NX )

PLANNED AGGREGATE EXPENDITURE (AE)

$8 000

$6 900

$1000

$1000

–$500

$8 400

9 000

7 700

1000

1000

–500

9 200

10 000

8 500

1000

1000

–500

10 000

11 000

9 300

1000

1000

–500

10 800

12 000

10 100

1000

1000

–500

11 600

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We can see that macroeconomic equilibrium will occur when real GDP equals $10 000 billion. STEP 3: Calculate the MPC.

MPC =

∆C ∆Y

In this case, MPC =

$800 billion = 0.8 $1000 billion

STEP 4: Use the multiplier formula to calculate the new equilibrium level of real GDP. We could find the new level of equilibrium

real GDP by constructing a new table where government purchases have increased from $1000 billion to $1200 billion. But the multiplier allows us to calculate the answer directly. In this case: Multiplier =

1 1 = =5 1 – MPC $1 – 0.8

So, Change in equilibrium real GDP = change in autonomous expenditure × 5 Or, Change in equilibrium real GDP = $200 billion × 5 = $1000 billion Therefore, The new level of equilibrium GDP = $10 000 billion + $1000 billion = $11 000 billion.

[ YOUR TURN Q

For more practice do related problem 4.4 on page 261 at the end of this chapter.

The paradox of thrift? We saw in Chapters 5 and 6 that an increase in savings can increase the rate of economic growth in the long run by providing funds for investment. But in the short run, if households save more of their income and spend less of it, aggregate expenditure and real GDP will decline, if we assume all else remains constant. In discussing the aggregate expenditure model, John Maynard Keynes argued that if many households simultaneously decide to increase their saving and reduce their spending, they may make themselves worse off by causing aggregate expenditure to fall, thereby pushing the economy into a contraction or recession. The lower incomes during the contraction or recession might mean that total saving does not increase, despite the attempts by many individuals to increase their own saving. Keynes referred to this outcome as the paradox of thrift because what appears to be something favourable to the longrun performance of the economy might be counterproductive in the short run. However, many economists are sceptical of the reasoning behind the paradox of thrift. As we saw in Chapter 6, an increase in saving, by increasing the supply of loanable funds, should lower the real interest rate and increase the level of investment spending. This increase in investment spending might offset some or all of the decline in consumption spending attributable to increased saving. As we have learned in this chapter, investment is an important component of aggregate expenditure, and vital if output and employment are to grow in both the short run and the long run. The global financial crisis of 2007–2008 provided a clear

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253

example of how a shortage of loanable funds (as credit became difficult and expensive to get) caused an enormous number of businesses, and in a few cases governments, to go bankrupt, leading to severe recessions in many countries. Economists continue to debate the short-run effects of an increase in saving.

CHANGES IN THE PRICE LEVEL When demand for a product increases firms will usually respond by increasing production, but they are also likely to increase prices. Similarly, when demand falls production falls, but often prices also fall. We would expect, then, that an increase or decrease in aggregate expenditure would affect not just real GDP but also the price level. So far, we have not taken into account the effect of changes in the price level on the components of aggregate expenditure. In fact, as we will see, increases in the price level will cause aggregate expenditure to fall and decreases in the price level will cause aggregate expenditure to rise. There are three main reasons for this inverse relationship between changes in the price level and changes in aggregate expenditure. We discussed the first two reasons earlier in this chapter when considering the factors that determine consumption and net exports. With the usual proviso that all other things remain equal then: 1 A rising price level decreases consumption by decreasing the real value of household wealth; a falling price level has the reverse effect. 2 If the price level in Australia rises relative to the price levels in other countries, Australian export income will fall in real terms making exports less attractive to produce, and foreign imports will become relatively less expensive, causing net exports to fall. A falling price level in Australia has the reverse effect. 3 When prices rise firms and households need more funds to finance buying and selling and therefore they try to increase the amount of funds they hold by withdrawing funds from banks, borrowing from banks or selling financial assets. If the central bank (the Reserve Bank in Australia) does not allow an increase in the availability of funds, the result will be an increase in interest rates. We will analyse in more detail why this happens in Chapters 11 and 12. As we discussed earlier in this chapter, at a higher interest rate the cost of borrowing rises and investment spending falls as firms borrow less to build new factories or to install new machinery and equipment, and households borrow less to buy new houses. Consumption may also fall as households borrow less to spend on durable goods such as cars. There is some offsetting effect as people with savings have their wealth increased when interest rates are higher and will increase their consumption spending. A falling price level decreases the interest rate and has the reverse effect of the above discussion. Other things being equal, interest rates will fall and investment spending will rise. We can now incorporate the effect of a change in the price level into the basic aggregate expenditure model in which equilibrium real GDP is determined by the intersection of the aggregate expenditure (AE ) line and the 45° line. Remember that we measure the price level as an index number with a value of 100 in the base year. If the price level rises from, say, 100 to 103, consumption, planned investment and net exports will all fall, causing the AE line to shift down on the 45° line diagram. The AE line shifts down because with higher prices less spending will occur in the economy at every level of GDP. Figure 9.13(a) shows that the downward shift of the AE line results in a lower level of equilibrium real GDP. If the price level falls from, say, 100 to 97, then consumption, investment and net exports will all rise. As Figure 9.13(b) shows, the AE line will shift up, which will cause equilibrium real GDP to increase. Figure 9.14 summarises the effect of changes in the price level on real GDP. The table shows the combinations of price level and real GDP from Figure 9.13. The graph plots the numbers from the table. In the graph, the price level is measured on the vertical axis and real GDP is measured on the horizontal axis. The relationship shown in Figure 9.14 between the price level and the level of planned aggregate expenditure is known as the aggregate demand (AD) curve. We analyse the AD curve in detail in the next chapter.

9.5 Understand the relationship between the aggregate demand curve and aggregate expenditure. LEARNING OBJECTIVE

Aggregate demand (AD) curve A curve that shows the relationship between the price level and the quantity of real GDP demanded by households, firms and the government.

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FIGURE 9.13

The effect of a change in the price level on real GDP In panel (a) an increase in the price level results in declining consumption, planned investment and net exports, and causes the aggregate expenditure line to shift down from AE1 to AE2. As a result, equilibrium real GDP declines from $1000 billion to $980 billion. In panel (b) a decrease in the price level results in rising consumption, planned investment and net exports, and causes the aggregate expenditure line to shift up from AE1 to AE2. As a result, equilibrium real GDP increases from $1000 billion to $1020 billion

Real aggregate expenditure, AE (billions of dollars)

Y = AE

1. An increase in the price level causes the AE line to shift down . . .

$1030 1020

Real aggregate expenditure, AE (billions of dollars) $1030

AE1 AE2

1010

990

990

980

980

970

970

960

960 950

2. . . . and equilibrium GDP to fall.

940

0

$940

2. . . . and equilibrium GDP to rise.

940 930

45˚ 960

980

1000

1020

1040

45˚

0

$940

960

980

1000

FIGURE 9.14

The aggregate demand curve The aggregate demand (AD) curve shows the relationship between the price level and the level of planned aggregate expenditure in the economy. When the price level is 97, real GDP is $1020 billion. An increase in the price level to 100 causes consumption and net exports to fall, which reduces real GDP to $1000 billion

1020

1040

Real GDP, Y (billions of dollars)

Real GDP, Y (billions of dollars) (a) The effect of a higher price level on real GDP

AE2 AE1

1010 1000

950

Y = AE

1020

1000

930

1. A decrease in the price level causes the AE line to shift up . . .

(b) The effect of a lower price level on real GDP

Price level

Equilibrium real GDP

97

$1020 billion

100

1000 billion

103

980 billion

Price level 103

100

97 Aggregate demand, AD

0

$980

1000

Real GDP, Y 1020 (billions of dollars)

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WHEN CONSUMER CONFIDENCE FALLS, IS YOUR JOB AT RISK? At the beginning of this chapter, we asked you to suppose that while studying at university, you work part-time at a restaurant. You read that consumer confidence in the economy has fallen and that many households expect their future income to be dramatically less than their current income. Should you be concerned about losing your job? We have seen in this chapter that if consumers expect their future incomes to decline, they will cut their consumption spending, and consumption spending is the biggest component of aggregate expenditure. So, if the decline in consumer confidence is correctly forecasting a decline in consumption spending, then aggregate expenditures and GDP will also be likely to decline. If the economy moves into a contraction or recession, spending by households on restaurant meals—which are not a necessity—will fall. This will most likely reduce the demand for meals at the restaurant where you work and you might lose your job. Before you panic, though, keep in mind that surveys of consumer confidence do not have a good track record in predicting recessions, so you may not have to move back in with your parents after all.

255

ECONOMICS IN YOUR LIFE (continued from page 225)

CONCLUSION In this chapter we learned a key macroeconomic idea: in the short run the level of GDP is determined mainly by the level of aggregate expenditure. When economists forecast changes in GDP they do so by forecasting changes in the four components of aggregate expenditure. We constructed an aggregate demand curve by taking into account the effect on aggregate expenditure of changes in the price level. But our story is incomplete. In the next chapter we analyse the aggregate demand curve and the aggregate supply curve. Then we will use these curves to show how equilibrium real GDP and the equilibrium price level are simultaneously determined. We also need to discuss the roles that the financial system and government policy play in determining real GDP and the price level in the short run. We will cover these important topics in the next three chapters. Before moving on, read ‘An inside look’ to learn about the effect of decreases and increases in aggregate expenditure on Singapore’s economy.

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AN INSIDE LOOK 13

R 20 A 31 DECEMBE

SI CHANNEL NEWSA

y m o n o c e ’s e Singapor , 3 1 0 2 n i % grew by 3.7 says PM Lee

irector of the n Khee Giap, co-d Ta r so es of Pr e an Yew Associat te at the Lee Ku itu st In s es en iv forecast Asia Competit xt year’s growth ne id sa y, lic Po School of Public 4 per cent range. p end of the 2– to e th in be y el will lik

, r cent this year y grew by 3.7 pe om on ge ec sa s es e’ m or Singap s New Year ly expected. In hi e better than initial n Loong said th Hs inister Lee ie M e im ar Pr ye y, xt da ne on Tues recast for Product (GDP) fo He added: now. So Gross Domestic d 4 per cent. an 2 n ee tw is really robust be t at en — w nm ck ro ‘fe tra vi a en on d al er remains countere The extern lt decision wheth at Singapore en e a really difficu ak m e th to n A He added thyear, which tested the country as ve he ha w e w grow is g two ow or we want to sl tin ic ow ed gr ill pr w to rough spots’ th e t er ey an w w on we em 13 economists n.] is favourable. Th a whole. [In 20 chnical recessio al environment te rn a te — ex th ow gr . e tiv m) somewhere ch and Strategy quarters of nega have to come (fro Treasury Resear of e ad a He , is ng th Li ow na gr Sele out infrastructur ll-year inister talked ab e 3.7 per cent fu M th e id ith im sa w , Pr y nk e et Th Ba ci . e so C at OCBC e expected d a more inclusiv e 3.8 per cent sh r growth investment, housing an rte ua -q tad lower than th th ur fo ggests that . She said: ‘This su overnment] . Manufacturing social expenditure underperformed queues for HDB [g ve er m ha , -ti ay ce st m fir pa m e, y pl tu ad he vernment momen For exam the third quarter’s to increased go m ue fro [d d y d te irl ra ne fa le te d or ce ne ment is likely de ly remai flats have sh e said the govern services probab Le d r an M . n g] io in ct us tru ho ns anges but co investment in arter.’ will implement ch d qu an th d ur ar fo rw e fo th s in e ift th robust making major sh ngapore fares in ted that how Si ch no su e s Le r or M ct fa B rnal w years, the progressively. in the next fe depend on exte at an so th ic al er id ill sa w Am d re so an futu dress other He al ropean er initiatives to ad rth ance of the Eu ia fu rm As ke r rfo ta fo pe ill ok w e t th tlo as the ou governmen ms that arise. added that while with new proble persist in al ns de io d economies. He ns an future— te s d ed an ne problems ce in Singapore’s e, en a id tiv Se si nf a in co po d Ch ns se h ai ut es rem said er the So Mr Lee expr ens in Asia’. He and disputes ov ‘untoward happ Asia. g t in as Northeast Asia, th and he no ut re So ed tu id in fu prov in the challenges well, investing Singapore’s g in on continue to pose do is sh lli e t. or bu en ap remain physical environm onomic Sing But observers ing the country’s rong external ec st rm a fo g ns tin tra ci , 14 prospects in 20 environment.

ASIA

CHANNEL NEWS

SOURCE: Adapted from Channel NewsAsia (2013), ‘Singapore’s economy grew by 3.7% in 2013, says PM Lee’, Channel NewsAsia, 31 December.

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Key points in the article Singapore experienced rapid economic growth from the 1960s onwards to become the wealthiest country in per capita terms in Southeast Asia. However, in the aftermath of the global financial crisis (GFC) the economy was subject to several contractions and even recession, mainly due to reduced exports to the countries where the GFC originated—the United States and Europe. By 2014 the performance and outlook for these economies and in China was much more positive. Singapore experienced higher than expected growth in 2013 and expected healthy growth to continue into the foreseeable future. Although some uncertainties remain, the article suggest that positive economic growth will continue due to more stable external factors and increased domestic investment.

Analysing the news A Singapore’s long period of economic growth, characterised by rising aggregate expenditure and rising employment, lasted for over three decades, but has sometimes experienced dramatic downturns and recoveries. For instance, falls in exports, investment spending and consumption spending began the reverse multiplier process during the GFC and, as pointed out in the article, this was also predicted to happen in 2013 (although it did not eventuate). The effect of such downturns is illustrated in Figure 1. The economy begins in equilibrium at point E and then aggregate expenditure falls from AE1 to AE2. Because planned aggregate expenditure is now less than Y1 (point A) unplanned inventories increase. In response, Singapore’s firms decrease production and employment until the economy reaches an aggregate expenditure equilibrium at point B.

export earnings. In the article, Singapore’s Prime Minister Mr Lee noted that Singapore’s fortunes depend on such external factors. Therefore during periods of strong world economic growth, Singapore’s economy is likely also to experience strong growth due to a high demand for their  exports. However, in times of a world economic downturn the export sector, and therefore the economy, of Singapore is hard hit.

C Singapore’s economy was rapidly recovering from the effects of the GFC by 2010 and positive growth continued, despite the forecast of a recession in 2013. This was due to high levels of government spending on construction (such as the increased building of HDB government flats referred to in the article) and a recovery of exports, which flowed through to the wholesale and retail sectors. The rise in aggregate spending that occurred began a multiplier effect, which created an unplanned decrease in inventories. This pattern is shown in Figure 2, where the economy begins at point B and aggregate expenditure rises from AE2 to AE1. This time, because planned aggregate expenditure is now greater than Y2 (point C ), unplanned inventories decrease. Firms in Singapore increase production and employment until the economy reaches an aggregate expenditure equilibrium at point E. Thinking critically

B Positive net exports normally make up a substantial proportion of Singapore’s aggregate expenditure. This makes Singapore more dependent on the incomes of other countries than countries that are less dependent on

1 Suppose the government of Singapore reduced income taxes to stimulate consumption and increase GDP. Compare and contrast the relative effectiveness of this policy if Singapore’s marginal propensity to consume (MPC) is close to 1, and if Singapore’s MPC is close to 0. 2 The Monetary Authority of Singapore lowers interest rates during recessions and economic contractions. Do you think that reductions in interest rates would be very effective in easing the effects of Singapore’s export-led recession?

FIGURE 1 A DECREASE IN AGGREGATE EXPENDITURE CAUSES A DECREASE IN GDP

FIGURE 2 AN INCREASE IN AGGREGATE EXPENDITURE CAUSES AN INCREASE IN GDP

Y = AE

Real aggregate expenditure, AE

AE1

E

Real aggregate expenditure, AE

Y = AE

Decrease in inventories

AE1

E

C AE2

AE2 A

B

Increase in inventories

B

45˚

45˚ Y2

Y1

Real GDP, Y

Y2

Y1

Real GDP, Y

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CHAPTER SUMMARY AND PROBLEMS KEY TERMS aggregate demand (AD) curve aggregate expenditure (AE) aggregate expenditure model autonomous consumption autonomous expenditure cash flow consumption function

253 226 226 240 247 236 231

exchange rate induced consumption induced expenditure inventories marginal propensity to consume (MPC)

238 240 247 227

marginal propensity to save (MPS) multiplier multiplier effect

234 247 247

231

THE AGGREGATE EXPENDITURE MODEL, PAGES 226–228 LEARNING OBJECTIVE 9.1

Understand how macroeconomic equilibrium is determined in the aggregate expenditure model.

SUMMARY

PROBLEMS AND APPLICATIONS

Aggregate expenditure (AE) is the total amount of spending in the economy. The aggregate expenditure model focuses on the relationship between total spending and real GDP in the short run, assuming the price level is constant. In any particular year the level of GDP is determined by the level of total spending, or aggregate expenditure, in the economy. The four components of aggregate expenditure are consumption (C), planned investment (I), government purchases (G) and net exports (NX). When aggregate expenditure is greater than GDP there is an unplanned decrease in inventories, which are goods that have been produced but not yet sold, and GDP and total employment will increase. When aggregate expenditure is less than GDP there is an unplanned increase in inventories, and GDP and total employment will decline. When aggregate expenditure is equal to GDP firms will sell what they expected to sell, production and employment will be unchanged, and the economy will be in macroeconomic equilibrium.

1.5

1.6

REVIEW QUESTIONS 1.1

1.2

1.3

1.4

What is the key idea in the aggregate expenditure macroeconomic model? What is the main reason for changes in GDP in the short run? What are inventories? What usually happens to inventories at the beginning of a contraction or recession? At the beginning of an expansion? Which of the following does the aggregate expenditure model seek to explain: long-run economic growth, the business cycle, inflation and cyclical unemployment?

1.7

1.8

Into which category of aggregate expenditure would each of the following transactions fall? a A family buys a new car. b A high school buys 12 new school buses. c A family builds a new house. d You order a computer for your personal use online from Dell. e An insurance company purchases 250 new computers from Dell. Suppose Apple plans to produce 20.2 million iPhones this year. The company expects to sell 20.1 million and add 100 000 to the inventories in its stores. a Suppose that at the end of the year Apple has sold 19.9 million iPhones. What was Apple’s planned investment spending? What was Apple’s actual investment spending? b Now suppose that at the end of the year Apple has sold 20.3 million iPhones. What was Apple’s planned investment spending? What was Apple’s actual investment spending? Assume that in the first quarter of the year, business inventories increased. Can we tell from this information whether aggregate expenditure was higher or lower than GDP during the first quarter of the year? If not, what other information do we need? Suppose you read that business inventories increased dramatically last month. What does this tell you about the state of the economy? Would your answer be affected by whether the increase in inventories was taking place at the end of a contraction or recession or the end of an expansion? Briefly explain.

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DETERMINING THE LEVEL OF AGGREGATE EXPENDITURE IN THE ECONOMY, PAGES 229–239 L E A R N I N G O B J E C T I V E 9 . 2 Discuss the determinants of the four components of aggregate expenditure and define the marginal propensity to consume and the marginal propensity to save.

SUMMARY

PROBLEMS AND APPLICATIONS

The four components of aggregate expenditure are: consumption spending, investment spending, government purchases and net exports. Consumption is determined by current disposable income, household wealth, expected future income, the price level and the interest rate. The consumption function is the relationship between consumption and disposable income. The marginal propensity to consume (MPC) is the change in consumption divided by the change in disposable income. The marginal propensity to save (MPS) is the change in saving divided by the change in disposable income. Planned investment is determined by expectations of future profitability, the real interest rate, taxes and cash flow, which is the difference between the cash revenues received by the firm and the cash spending by the firm. Government purchases include spending by the federal government and by local, state and territory governments for goods and services. Government purchases do not include transfer payments, such as social security payments by the federal government. The three determinants of net exports are the price level in Australia relative to the price levels in other countries, the economic growth rate in Australia relative to the growth rates in other countries, and the exchange rate between the Australian dollar and other currencies.

2.7

2.8

2.9

REVIEW QUESTIONS 2.1

2.2

2.3

2.4

2.5

2.6

In the aggregate expenditure model, why is it important to know the factors that determine consumption spending, investment spending, government purchases and net exports? Give an example of each of the four categories of aggregate expenditure. What are the five main determinants of consumption spending? Which of these is the most important? How would a rise in share prices or housing prices affect consumption spending? Compare what happened to real investment between 1960 and 2013 with what happened to real consumption during that period. What are the four main determinants of investment? How would a change in interest rates affect investment? What are the three main determinants of net exports? How would an increase in the growth rate of GDP in India and China affect Australian net exports?

2.10

2.11

How would the demand forecast for a major Australian furniture manufacturer be affected by each of the following? a A decrease in consumer spending in the economy b An increase in real interest rates c An increase in the value of the Australian dollar relative to other currencies d A decrease in planned investment spending in the economy Draw the consumption function and label each axis. Show the effect of an increase in income on consumption spending. Does the change in income cause a movement along the consumption function or a shift of the consumption function? How would an increase in expected future income or an increase in household wealth affect the consumption function? Would these increases cause a movement along the consumption function or a shift of the consumption function? Many people have difficulty borrowing as much money as they would like, even if they are confident that their incomes in the future will be high enough to pay it back easily. For example, many students studying medicine at university will earn high incomes after they graduate and become doctors. If they could, they would probably borrow now in order to live more comfortably while at university and pay the loans back out of their higher future income. Unfortunately, banks are usually reluctant to make loans to people who currently have low incomes, even if there is a good chance that their incomes will be much higher in the future. If people could always borrow as much as they would like, would you expect consumption to become more or less sensitive to current income? Why? An economics student raises the following objection: ‘The textbook said that a higher interest rate lowers investment, but this doesn’t make sense. I know that if I can get a higher interest rate I am certainly going to invest more in my savings account.’ Do you agree with this reasoning? Unemployed workers receive unemployment benefits from the government. Does the existence of unemployment benefits make it likely that consumption will fluctuate more or fluctuate less over the business cycle than it would in the absence of unemployment benefits? Briefly explain.

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Fill in the blanks in the following table. Assume for simplicity that taxes are zero. The numbers are in billions of dollars.

2.13

MARGINAL NATIONAL

PROPENSITY

MARGINAL

INCOME

TO

PROPENSITY

AND REAL

CONSUMPTION

SAVING

CONSUME

TO SAVE

GDP ( Y )

(C )

(S )

(MPC )

(MPS )

$9 000

$8 000

–

–

10 000

8 750

11 000

9 500

12 000

10 250

13 000

11 000

Soon after the global financial crisis, Intel Corporation began to build factories that produced memory chips that can be used in portable consumer electronic devices such as mobile phones, instead of depending on the sales of microprocessors for computers. This was done with the aim of reducing the risk associated with relying on sales of microprocessors. During a contraction or recession, why would spending on products like mobile phones be more stable than spending on computers?

GRAPHING MACROECONOMIC EQUILIBRIUM, PAGES 239–246 LEARNING OBJECTIVE 9.3

Use a 45º line diagram to illustrate macroeconomic equilibrium.

SUMMARY

PROBLEMS AND APPLICATIONS

The 45º line diagram shows all the points where aggregate expenditure equals real GDP. On the 45º line diagram, macroeconomic equilibrium occurs where the line representing the aggregate expenditure function crosses the 45º line. The economy is experiencing a contraction or a recession when the aggregate expenditure line intersects the 45º line at a level of GDP that is below potential GDP. Numerically, macroeconomic equilibrium occurs when: Consumption + planned investment + government purchases + net exports = GDP The consumption function does not begin at zero on the 45º line diagram, even when income is zero, due to autonomous consumption. Autonomous consumption is consumption that is independent of income. Induced consumption is determined by the level of income.

3.7

Real aggregate expenditure, AE

3.2

3.3

3.4

3.5

3.6

What is the meaning of the 45º line in the 45º line diagram? Use a 45º line diagram to illustrate macroeconomic equilibrium. Make sure that your diagram shows the aggregate expenditure function and the level of equilibrium real GDP and that your axes are properly labelled. What does the slope of the aggregate expenditure line equal? How is the slope of the aggregate expenditure line related to the slope of the consumption function? What is the difference between aggregate expenditure and consumption spending? Explain the difference between autonomous consumption and induced consumption. What is the macroeconomic consequence if firms accumulate large amounts of unplanned inventories at the beginning of a recession?

Y = AE

C B A

45˚

REVIEW QUESTIONS 3.1

At point A in the following graph, is planned aggregate expenditure greater than, equal to or less than real GDP? At point B? At point C? For points A and C, indicate the vertical distance that measures the unintended change in inventories.

Real GDP, Y

3.8

3.9

3.10

Suppose we drop the assumption that net exports do not depend on real GDP. Draw a graph with the value of net exports on the vertical axis and the value of real GDP on the horizontal axis. Now, add a line representing the relationship between net exports and real GDP. Briefly explain why you drew the graph the way you did. In a Treasury publication the following observation was made: ‘The impact of inventory increases on the business cycle depends upon whether they are planned or unplanned.’ Do you agree? Briefly explain. Is it possible for the economy to be in macroeconomic equilibrium at a level of real GDP that is greater than the potential level of GDP? Illustrate using a 45º line diagram.

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[Related to Don’t let this happen to you] Briefly explain whether you agree with the following argument: ‘The equilibrium level of GDP is determined by the level of aggregate expenditure. Therefore, GDP will decline only if households decide to spend less on goods and services.’

REAL GDP

261

[Related to Solved problem 9.1] Fill in the missing values in the following table. Assume that the value of the MPC does not change as real GDP changes. a What is the value of the MPC? b What is the value of equilibrium real GDP?

3.12

UNPLANNED

NET

PLANNED

PLANNED

GOVERNMENT

EXPORTS

AGGREGATE

CHANGE IN

EXPENDITURE (AE)

INVENTORIES

(Y)

CONSUMPTION (C)

INVESTMENT (I)

PURCHASES (G)

(NX)

$9 000

$7600

$1200

$1200

–$400

10 000

8400

1200

1200

–400

11 000

1200

1200

–400

12 000

1200

1200

–400

13 000

1200

1200

–400

THE MULTIPLIER EFFECT, PAGES 246–253 LEARNING OBJECTIVE 9.4

Describe the multiplier effect and use the multiplier formula to calculate changes in equilibrium GDP.

SUMMARY

4.4

Autonomous expenditure is expenditure that does not depend on the level of GDP. An autonomous change is a change in expenditure not caused by a change in income. Induced expenditure is expenditure that depends on the level of GDP. An induced change is a change in aggregate expenditure caused by a change in income. An autonomous change in expenditure will cause rounds of induced changes in expenditure. Therefore, an autonomous change in expenditure will have a multiplier effect on equilibrium GDP. The multiplier effect is the process by which an increase in autonomous expenditure leads to a larger increase in real GDP. The multiplier is the ratio of the change in equilibrium GDP to the change in autonomous expenditure. The formula for the multiplier is:

PLANNED REAL GDP

4.2

In Figure 9.12, the economy is initially in equilibrium at point A. Aggregate expenditure and real GDP both equal $960 billion. The increase in investment of $10 billion increases aggregate expenditure to $970 billion. If real GDP increases to $970 billion, will the economy be in equilibrium? Briefly explain. What happens to aggregate expenditure when real GDP increases to $970 billion?

NET

PURCHASES

EXPORTS

(Y )

(C )

(I )

(G )

(NX )

$8 000

$7300

$1000

$1000

–$500

9 000

7900

1000

1000

–500

10 000

8500

1000

1000

–500

11 000

9100

1000

1000

–500

12 000

9700

1000

1000

–500

c Suppose net exports increase by $400 billion. What will be the new equilibrium level of real GDP? Use the multiplier formula to determine your answer. 4.5

PROBLEMS AND APPLICATIONS 4.3

GOVERNMENT

b What is the MPC?

REVIEW QUESTIONS What is the multiplier effect? Use a 45º line diagram to illustrate the multiplier effect of a decrease in government purchases. What is the formula for the multiplier? Explain why this formula is considered to be too simple.

CONSUMPTION INVESTMENT

a What is the equilibrium level of real GDP?

1 1 – MPC

4.1

[Related to Solved problem 9.2] Use the information in the following table to answer the following questions. The numbers are in billions of dollars.

4.6

Explain whether each of the following would cause the value of the multiplier to be larger or smaller. a An increase in real GDP increases imports. b An increase in real GDP increases interest rates. c An increase in real GDP increases the marginal propensity to consume. d An increase in real GDP causes the average tax rate paid by households to decrease. e An increase in real GDP increases the price level. Explain whether you agree or disagree with the following statement: ‘Some economists claim that the Australian economic downturn of 2008–2009 was caused by a decline in investment. This can’t be true. If there had just

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4.7

4.8

4.9

been a decline in investment the only firms hurt would have been construction firms, computer firms and other firms selling investment goods. In fact, many firms experienced falling sales during that time, including car firms, furniture retailers and cinemas.’ Suppose a booming economy in Asia causes net exports to rise by $10 billion in Australia. If the MPC in Australia is 0.8 what will be the change in equilibrium GDP? Would a larger multiplier lead to longer and more severe recessions or shorter and less severe recessions? Briefly explain. Use the following graph to answer the questions.

a b c d

What is the value of equilibrium real GDP? What is the value of the MPC? What is the value of the multiplier? What is the value of unplanned changes in inventories when real GDP has each of the following values? • $1000 billion • $1200 billion • $1400 billion

Y = AE

Real aggregate expenditure, AE ($ billions)

AE

$1360

1040

45˚ 0

$1000

1200

1400 Real GDP, Y ($ billions)

CHANGES IN THE PRICE LEVEL, PAGES 253–254 LEARNING OBJECTIVE 9.5

Understand the relationship between the aggregate demand curve and aggregate expenditure.

SUMMARY Increases in the price level cause a reduction in consumption, investment and net exports. This causes the aggregate expenditure function to shift down on the 45º line diagram, leading to a lower equilibrium real GDP. A decrease in the price level leads to a higher equilibrium real GDP. The aggregate demand (AD) curve shows the relationship between the price level and the level of aggregate expenditure, holding constant all factors other than the price level that affect aggregate expenditure.

expenditure line? Does a change in the price level cause a movement along the aggregate demand curve or a shift of the aggregate demand curve?

PROBLEMS AND APPLICATIONS 5.4

5.5

REVIEW QUESTIONS 5.1

5.2

5.3

Briefly explain the difference between aggregate expenditure and aggregate demand. Briefly explain which components of aggregate expenditure are affected by a change in the price level. Does a change in the price level cause a movement along the aggregate expenditure line or a shift of the aggregate

5.6

Briefly explain why the aggregate expenditure line is upward sloping, while the aggregate demand curve is downward sloping. Briefly explain whether you agree with the following statement: ‘The reason the aggregate demand curve slopes downward is that when the price level is higher, people cannot afford to buy as many goods and services.’ Suppose that exports become more sensitive to changes in the price level in Australia. That is, when the price level in Australia rises, exports decline by more than they previously did. Will this change make the aggregate demand curve steeper or less steep? Briefly explain.

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263

APPENDIX THE ALGEBRA OF MACROECONOMIC EQUILIBRIUM In this chapter we relied primarily on graphs and tables to illustrate the aggregate expenditure model of short-run real GDP. Graphs help us understand economic change qualitatively. When we write down an economic model using equations we make it easier to make quantitative estimates. When economists forecast future movements in GDP they often rely on econometric models. An econometric model is an economic model written in the form of equations, where each equation has been statistically estimated, using methods similar to the methods used in estimating demand curves that we briefly described in Chapter 3. We can use equations to represent the aggregate expenditure model described in this chapter. The following equations are based on the example shown in Table 9.3 in this chapter. Y stands for real GDP and the numbers (with the exception of the MPC ) represent billions of dollars. 1 C = 1000 + 0.65Y Consumption function 2 I = 1500 Planned investment function 3 G = 1500 Government spending function 4 NX = –500 Net export function 5 Y = C + I + G + NX Equilibrium condition

Apply the algebra of macroeconomic equilibrium. LEARNING OBJECTIVE

The first equation is the consumption function. The MPC is 0.65 and 1000 is autonomous consumption, which is the level of consumption that does not depend on income. If we think of the consumption function as a line on the 45° line diagram, 1000 would be the intercept and 0.65 would be the slope. The ‘functions’ for the other three components of planned aggregate expenditure are very simple because we have assumed that these components are not affected by GDP and are therefore constant. Economists who use this type of model to forecast GDP would, of course, use more realistic investment, government and net export functions. The parameters of the functions—such as the value of autonomous consumption and the value of the MPC in the consumption function—would be estimated statistically using data on the values of each variable over a period of years. In this model, equilibrium GDP occurs where GDP is equal to planned aggregate expenditure. Equation 5—the equilibrium condition—shows us how to calculate equilibrium in the model. To calculate equilibrium we substitute equations 1 to 4 into equation 5. This gives us the following: Y = 1000 + 0.65Y + 1500 + 1500 – 500 We need to solve this expression for Y to find equilibrium GDP. The first step is to subtract 0.65Y from both sides of the equation: Y – 0.65Y = 1000 + 1500 + 1500 – 500 Then, we solve for Y: 0.35Y = 3500 Or, Y

3500  10 000 0.35

To make this result more general we can replace particular values with general values represented by letters: – 1 C = C + MPC(Y ) Consumption function – 2 I=I Planned investment function

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3 G=G 4 X = NX 5 Y = C + I + G + NX

Government spending function Net export function Equilibrium condition

The letters with ‘bars’ represent fixed or autonomous values. So, C represents autonomous consumption, which had a value of 1000 in our original example. Now, solving for equilibrium we get: – – – Y = C + MPC(Y) + I + G + NX or, – – – Y – MPC(Y) = C + I + G + NX or, – – – Y = (1 – MPC ) = C + I + G + NX or, Y

C I G NX 1  MPC

Remember that 1(1 – MPC ) is the multiplier, and all four variables in the numerator of the equation represent autonomous expenditure. Therefore an alternative expression for equilibrium GDP is: Equilibrium GDP = autonomous expenditure × multiplier

APPENDIX PROBLEMS THE ALGEBRA OF MACROECONOMIC EQUILIBRIUM, PAGES 263–264 LEARNING OBJECTIVE

Apply the algebra of macroeconomic equilibrium.

REVIEW QUESTIONS 9A.1

9A.2

Write a general expression for the aggregate expenditure function. If you think of the aggregate expenditure function as a line on the 45º line diagram, what would be the intercept and what would be the slope, using the general values represented by letters? Find equilibrium GDP using the following macroeconomic model (the numbers, with exception of MPC, represent billions of dollars): a C = 1500 + 0.75Y Consumption function b I = 1250 Planned investment function c G = 1250 Government spending function d NX = –500 Net export function e Y = C + I + G + NX Equilibrium condition

9A.3

9A.4

For the macroeconomic model in problem 9A.2, write the aggregate expenditure function. For GDP of $16 000 billion, what is the value of aggregate expenditure, and what is the value of unintended change in inventories? For GDP of $12 000 billion, what is the value of aggregate expenditure, and what is the value of the unintended change in inventories? Suppose that autonomous consumption is $500, government purchases are $1000, planned investment spending is $1250, net exports is –250, and the MPC is 0.8. What is equilibrium GDP? (Note: Figures are in billions of dollars.)

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CHAPTER

10

AGGREGATE DEMAND AND AGGREGATE SUPPLY ANALYSIS LEARNING OBJECTIVES After studying this chapter you should be able to: 10.1 Identify the determinants of aggregate demand, and distinguish between a movement along the aggregate demand curve and a shift of the curve. 10.2 Identify the determinants of aggregate supply, and distinguish between a movement along the short-run aggregate supply curve and a shift of the curve. 10.3 Use the aggregate demand and aggregate supply model to illustrate the difference between short-run and long-run macroeconomic equilibrium. 10.4 Use the dynamic aggregate demand and aggregate supply model to analyse macroeconomic conditions.

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HOW CANON RODE THE ECONOMIC CYCLE CANON AUSTRALIA WAS established in 1978 and is a market-leading supplier of consumer and business imaging products and services. During Australia’s extended period of economic growth, from the early 1990s until 2007, Canon, like other producers of digital devices, experienced huge growth in demand. This came partly from households which, with rising incomes, showed an almost insatiable appetite for these goods. Demand also grew from businesses because as their own output expanded they needed more capital, including computer screens, faxes and photocopiers to meet extra consumer demand and to cut production costs through the use of the latest technologies. Sales of digital devices grew much faster than sales for the retail industry sector as a whole—an average of almost nine times as fast. When the effects of the global financial crisis (GFC) hit the Australian economy in 2008, which led to an economic contraction, there were expectations that demand for digital devices would fall as uncertainty about employment reduced expected income. Flat-screen TVs and DVD recorders were thought to be luxury items and therefore it was anticipated that demand would fall as expected income fell. However, this proved not to be the case. While price falls of many electronic goods contributed to rising demand, there were other important contributing factors during the economic contraction. While households cut their expenditure on luxuries such as overseas holidays, white goods and going out, they increased expenditure on home entertainment systems, quality meals cooked at home and bottled wine. There was a perceived need to cut back on big expenditure items but households were still ‘cashed up’ enough to enjoy consuming less expensive luxuries at home. In the post-GFC period, although retail sales recovered, they did not return to their previous high rate of growth. In contrast demand for electronic goods and devices continued to grow very strongly. During this period, although investment in industries other than mining was slow to pick up, investment by businesses in computers, peripherals, electrical and electronic equipment continued to grow strongly. What this demonstrates is that economic contractions and expansions affect different industries in very different ways. While the sales of many electronic items remained firm during the 2008–2009 economic downturn, industries such as tourism, transport, restaurants and motor vehicles suffered from falling sales and significant losses, with some firms ending up in bankruptcy. The subsequent recovery was also uneven, with some firms going out of business and others significantly restructuring.

10

Another world of close

* World’s First 35x SuperZoom Compact Digital Camera as at 24th August 2010 - Canon PowerShot SX30 IS

Canon Australia Pty Ltd.

ECONOMICS IN YOUR LIFE

IS YOUR EMPLOYER LIKELY TO REDUCE YOUR PAY DURING A RECESSION? Suppose that you have worked as a barista for a local coffee house for two years. From on-the-job training and experience, you have honed your coffeemaking skills and mastered the perfect latte. Then the economy moves into a recession and sales at the coffee house decline. Is the owner of the coffee house likely to cut the prices of lattes and other drinks? Suppose the owner asks to meet with you to discuss your wages for next year. Is the owner likely to cut your pay? As you read the chapter, see if you can answer these questions. You can check your answers against those we provide on page 288 at the end of this chapter.

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WE SAW IN Chapter 5 that the Australian economy has experienced a long-run upward trend in real gross domestic product (GDP). This upward trend has resulted in the standard of living in Australia being much higher today than it was 50 years ago. In the short run, however, real GDP has fluctuated around this long-run upward trend because of the business cycle. Fluctuations in GDP lead to fluctuations in employment. These fluctuations in real GDP and employment are the most visible and dramatic part of the business cycle. During economic contractions or recessions, for example, we are more likely to see businesses close and workers lose their jobs. During expansions we are more likely to see new businesses open and new jobs created. In addition to these changes in output and employment, the business cycle causes changes in wages and prices. Some firms react to a decline in sales by cutting back on production, but they may also reduce the prices they charge and the wages they pay. Other firms respond to a contraction or recession by not increasing prices and workers’ wages by as much as they otherwise would have. In this chapter we expand our story of the business cycle by developing the aggregate demand and aggregate supply model. This model will help us analyse the effects of contractions and expansions on production, employment and prices.

AGGREGATE DEMAND 10.1 Identify the determinants of aggregate demand, and distinguish between a movement along the aggregate demand curve and a shift of the curve. LEARNING OBJECTIVE

Aggregate demand and aggregate supply model A model that explains shortrun fluctuations in real GDP and the price level. Aggregate demand (AD) curve A curve that shows the relationship between the price level and the quantity of real GDP demanded by households, firms and the government. Short-run aggregate supply (SRAS) curve A curve that shows the relationship in the short run between the price level and the quantity of real GDP supplied.

To understand what happens during the business cycle we need an explanation of why real GDP, the unemployment rate and the inflation rate fluctuate. We have already seen that fluctuations in the unemployment rate are caused mainly by fluctuations in real GDP. In this chapter we use the aggregate demand and aggregate supply model to explain fluctuations in real GDP and the price level. As Figure 10.1 shows, real GDP and the price level in this model are determined in the short run by the intersection of the aggregate demand curve and the aggregate supply curve. Fluctuations in real GDP and the price level are caused by shifts in the aggregate demand curve or in the aggregate supply curve. The aggregate demand (AD) curve shows the relationship between the price level and the quantity of real GDP demanded by households, firms and the government. The short-run aggregate supply (SRAS) curve shows the relationship in the short run between the price level and the quantity of real GDP supplied by firms. The aggregate demand and short-run aggregate supply curves in Figure 10.1 look similar to the individual market demand and supply curves we studied in Chapter 3. However, because these curves apply to the whole economy, rather than just to a single market, the aggregate demand and aggregate supply model is very different from the microeconomic model of demand and supply in individual markets. Because we are dealing with the economy as a whole, we need macroeconomic explanations of why the AD curve is downward sloping, why the SRAS curve is upward sloping, and why the curves shift. We begin by explaining why the AD curve is downward sloping.

Why is the aggregate demand curve downward sloping? We saw in Chapter 9 that GDP has four components: consumption (C ), investment (I ), government purchases (G ) and net exports (NX ). If we let Y stand for GDP, we can write the following: Y = C + I + G + NX The AD curve is downward sloping because a fall in the price level increases the quantity of real GDP demanded. To understand why this is true we need to look at how changes in the price level affect each of the components of aggregate demand. We begin with the assumption that government purchases are determined by the policy decisions of politicians and are not affected by changes in the price level. We can then consider the effect of changes

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Price level

Short-run aggregate supply, SRAS

269

FIGURE 10.1

Aggregate demand and aggregate supply In the short run, real GDP and the price level are determined by the intersection of the AD curve and the SRAS curve. In the figure, real GDP is measured on the horizontal axis and the price level is measured on the vertical axis. In this example equilibrium real GDP is $1000 billion and the equilibrium price level is 100

100

Aggregate demand, AD 0

$1000

Real GDP (billions of dollars)

in the price level on each of the other three components: consumption, investment and net exports.

The wealth effect: how a change in the price level affects consumption Current income is the most important variable determining the consumption of households. As income rises consumption will rise, and as income falls consumption will fall. But consumption also depends on household wealth. A household’s wealth is the difference between the value of its assets and the value of its debts. Consider two households, both with incomes of $80 000 per year. The first household has wealth of $500 000, whereas the second household has wealth of $50 000. The first household is likely to spend more of its income than the second household. So as total household wealth rises consumption will rise. Some household wealth is held in cash or other nominal assets that lose value as the price level rises and gain value as the price level falls. For instance, if you have $10 000 in cash, a 10 per cent increase in the price level will reduce the purchasing power of that cash by 10 per cent. When the price level rises the real value of household wealth declines, and so will consumption. When the price level falls the real value of household wealth rises, and so will consumption. This impact of the price level on consumption is called the wealth effect, and is one reason why the AD curve is downward sloping.

The interest-rate effect: how a change in the price level affects investment When prices rise, households and firms need more funds to finance buying and selling. Therefore, when the price level rises, households and firms try to increase the amount of funds they hold by withdrawing funds from banks, borrowing from banks or selling financial assets, such as bonds. These actions tend to drive up the interest rate charged on bank loans and the interest rate on bonds. (In Chapter 11 we analyse in more detail the relationship between money, credit and the interest rate.) A higher interest rate raises the cost of borrowing for firms and households. As a result, firms will borrow less to build new factories or to install new machinery and equipment, and households will borrow less to buy new houses. To a smaller extent, consumption will also fall as households borrow less to finance spending on cars, furniture and other durable goods. A lower price level decreases the interest rate and increases investment spending and—to a lesser extent—consumption. This impact of the price level on investment is known as the interest-rate effect, and is a second reason why the AD curve is downward sloping. However, there is a caveat to this explanation. Lenders to banks and other financial institutions—people with savings are the lenders—will have their wealth increased as the interest rate rises, and will increase their consumption spending.

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The international-trade effect: how a change in the price level affects net exports Net exports equal spending by foreign households and firms on goods and services produced in Australia minus spending by Australian households and firms on goods and services produced in other countries. If the price level in Australia rises relative to the price levels in other countries, Australian exports will become relatively less profitable to produce compared to those produced for the domestic market, and foreign imports will become relatively less expensive. Some consumers in foreign countries will shift from buying Australian products to buying domestic products. Some Australian firms will also shift from producing export goods to producing goods for the Australian market. Australian imports will rise and export earnings will fall, causing net exports to fall. A lower price level in Australia relative to other countries has the reverse effect, causing net exports to rise. This impact of the price level on net exports is known as the international-trade effect, and is a third reason why the AD curve is downward sloping.

DON’T LET THIS HAPPEN TO YOU

Be clear why the aggregate demand curve is downward sloping The aggregate demand curve and the demand curve for a single product are both downward sloping—but for different reasons. When we draw a demand curve for a single product, such as apples, we know that it will slope downwards because as the price of apples rises apples become more expensive relative to other products—such as oranges— and consumers will buy fewer apples and more of the other products. In other words, consumers substitute other products for apples. When the overall price level in the economy rises, the prices of many domestically produced goods and services are rising, so consumers have few or no other domestic products to which they can switch. A lower price level raises the real value of household wealth (which increases consumption), lowers interest rates (which increases investment and consumption) and increases earnings from Australian exports and decreases foreign imports as they become more expensive (which increases net exports).

[ YOUR TURN Q

Test your understanding by doing related problem 1.6 on page 292 at the end of this chapter.

Shifts of the aggregate demand curve versus movements along it An important point to remember is that the AD curve tells us the relationship between the price level and the quantity of real GDP demanded, holding everything else constant. If the price level changes, but other variables that affect the willingness of households, firms and the government to spend are unchanged, the economy will move up or down a stationary AD curve. If any variable other than the price level changes, the AD curve will shift. For example, if government purchases increase and the price level remains unchanged, the AD curve will shift to the right at every price level. Or, if firms become pessimistic about the future profitability of investment and cut back spending on factories and machinery, the AD curve will shift to the left, ceteris paribus.

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271

The variables that shift the aggregate demand curve The variables that cause the AD curve to shift fall into three categories: 1 Changes in government policies 2 Changes in the expectations of households and firms 3 Changes in foreign variables

Changes in government policies As we will discuss further in Chapters 12 and 13, the federal government uses fiscal policy and the Reserve Bank of Australia (RBA) uses monetary policy to attempt to shift the AD curve. Fiscal policy involves changes in federal government purchases and taxes that are intended to achieve macroeconomic objectives, such as high employment, price stability and healthy rates of economic growth. Because government purchases are one component of aggregate demand, an increase in government purchases shifts the AD curve to the right, and a decrease in government purchases shifts the AD curve to the left, ceteris paribus. An increase in personal income taxes reduces the amount of after-tax income available to households. Higher personal income taxes reduce consumption spending and shift the AD curve to the left. Lower personal income taxes shift the AD curve to the right. Monetary policy involves RBA actions to change interest rates. Lower interest rates lower the cost to firms and households of borrowing. Lower borrowing costs should increase consumption and investment spending, which shifts the AD curve to the right. Higher interest rates shift the AD curve to the left.

Changes in the expectations of households and firms If households become more optimistic about their future incomes they are likely to increase their current consumption. This increased consumption will shift the AD curve to the right. If households become more pessimistic about their future incomes the AD curve will shift to the left. Similarly, if firms become more optimistic about the future profitability of investment spending the AD curve will shift to the right. If firms become more pessimistic the AD curve will shift to the left.

Changes in foreign variables If firms and households in other countries buy fewer Australian goods or if firms and households in Australia buy more foreign goods, net exports will fall and the AD curve will shift to the left. As we saw in Chapter 4, when real GDP increases so does the income available for consumers to spend. If real GDP in Australia increases faster than real GDP in other countries, Australian imports will increase faster than Australian exports and net exports will fall. Net exports will also fall if the exchange rate between the dollar and foreign currencies rises, because the price in foreign currency of some Australian products, such as education services, sold in other countries will rise, and the dollar price of foreign products sold in Australia will fall. Much of Australia’s exports are primary commodities whose prices are determined in US dollars. A rise in the value of the Australian dollar does not affect these prices in US dollars, but lowers the dollar amount received by Australian producers, therefore reducing their export revenue. An increase in net exports at every price level will shift the AD curve to the right. Net exports will increase if real GDP grows more slowly in Australia than in other countries or if the value of the dollar falls against other currencies. A change in net exports that results from a change in the price level in Australia will not cause the AD curve to shift (this is a movement along the AD curve). Table 10.1 summarises the most important variables that cause the AD curve to shift. It is important to notice that the table shows the shift in the AD curve that results from an increase in each of the variables. A decrease in these variables would cause the AD curve to shift in the opposite direction.

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TABLE 10.1

Variables that shift the aggregate demand curve

AN INCREASE IN … interest rates

SHIFTS THE AGGREGATE DEMAND CURVE …

higher interest rates raise the cost to firms and households of borrowing, reducing investment and consumption spending

Price level

AD2 0

government purchases

Real GDP

government purchases are a component of aggregate demand

AD1

personal income taxes or business taxes

consumption spending falls when personal taxes rise, and investment falls when business taxes rise

AD2

consumption spending increases

AD1

investment spending increases

AD1

AD2

Real GDP

exports will fall, reducing net exports

Price level

AD2 0

the exchange rate (the value of the dollar relative to foreign currencies)

AD2

Real GDP

Price level

0

the growth rate of domestic GDP relative to the growth rate of foreign GDP

AD1

Real GDP

Price level

0

firms’ expectations of the future profitability of investment spending

AD2

Real GDP

Price level

0

households’ expectations of their future incomes

AD1

Price level

0

AD1

Real GDP

imports will rise and exports will fall, reducing net exports

Price level

AD2 0

BECAUSE …

AD1

Real GDP

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M

SHOULD GERMANY REDUCE ITS RELIANCE ON EXPORTS?

C

A K I N G THE

For decades the German economy has been a major exporter. As the figure here shows, in Germany exports are a larger fraction of GDP than in many other countries, including being more than twice as large as in Australia, and more than three times as large as in Japan and the United States.

273

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ONNECTION

In Germany the mittelstand are small and medium-sized firms, often family owned and operated. Many mittelstand produce machinery, optical equipment and other scientific and  engineering goods whose production requires a highly skilled workforce. Many mittelstand depend heavily on exports, © Alexandr Galimov | Dreamstime.com as do other large German industries, particularly chemicals and The decline in German exports during the 2008–2009 recession was bad cars, which also export a significant fraction of their production. news for German workers The deep worldwide recession of 2008–2009 caused by the global financial crisis was particularly bad news for Germany. From the first quarter of 2008 to the first quarter of 2009 German exports declined by nearly 20 per cent. Not surprisingly, real GDP fell by 7 per cent over the same period; this was the largest decline in nearly 30 years. 50 45 40 35

Per cent

30 25 20 15 10 5 0 USA

Japan

Australia

India

UK

China

Germany

German policy-makers debated whether a government response to the poor performance of exports was necessary. Chancellor Angela Merkel and her advisers believed that Germany still had a comparative advantage in products that embodied substantial engineering knowledge, and they believed exports would revive with the end of the recession. Because of the severity of the recession, however, they instituted a policy of subsidising payrolls in export industries, so that these firms would be able to retain their skilled workers. Some economists and policy-makers were sceptical of this policy. They argued that the demand for German exports, particularly cars, might be permanently lowered by higher savings rates—and lower consumption spending—in the United States and some European countries. They also argued that some developing countries— notably China—were increasing their exports of machinery and other engineering-based goods, thereby reducing Germany’s comparative advantage. By 2010, Germany’s export growth resumed a rapid growth rate, and by mid-2013 exports had reached their highest levels yet, both in absolute terms and as a percentage of GDP, confirming the importance of export-driven growth to the German economy. However the continuing contractions and recessions among countries in the euro zone was once again leading to sluggish growth in Germany’s exports by the end of 2013, with Germany’s growing domestic demand insufficient to compensate for slowing export growth. SOURCE: Created from World Bank (2014), ‘Data’, Exports of goods and services (per cent of GDP), at , viewed 20 January 2014; Marcus Walker (2009), ‘Germany can change to confront export slump—but will it?’, Wall Street Journal, 29 June.

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SOLVED PROBLEM 10.1 MOVEMENTS ALONG THE AGGREGATE DEMAND CURVE VERSUS SHIFTS OF THE AGGREGATE DEMAND CURVE Suppose the current price level is 110 and the current level of real GDP is $1120 billion. Illustrate each of the following situations on a graph: 1 2

The price level rises to 115, while all other variables remain constant. Firms become pessimistic and reduce their investment. Assume that the price level remains constant.

Solving the problem STEP 1: Review the chapter material. This problem is about understanding the difference between movements along an AD curve

and shifts of an AD curve, so you may want to review the section ‘Shifts of the AD curve versus movements along it’, which begins on page 270. STEP 2: To answer question 1 draw a graph showing a

movement along the aggregate demand curve. Because there will be a movement along the AD curve, but no shift of the AD curve, your graph should look like the one shown at right: We don’t have enough information to be certain what the new level of real GDP will be. We only know that it will be less than the initial level of $1120 billion—the graph shows the value as $1100 billion.

Price level

115

110

AD

0

STEP 3: To answer question 2 draw a graph showing a

shift of the AD curve. We know that the AD curve will shift to the left, but we don’t have enough information to know how far to the left it will shift. Let’s assume the shift is $30 billion. In that case your graph should look like the one shown at right: The graph shows a parallel shift in the AD curve, so that at every price level the quantity of real GDP demanded declines by $30 billion. For example, at a price level of 110, the quantity of real GDP demanded declines from $1120 billion to $1090 billion.

$1100

Real GDP (billions of dollars)

1120

Price level

110

AD1 AD2 0

$1090

1120

Real GDP (billions of dollars)

[ YOUR TURN Q

For more practice do related problem 1.7 on page 293 at the end of this chapter.

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AGGREGATE SUPPLY We have just discussed the AD curve, which is one component of the aggregate demand and aggregate supply model. Now we turn to aggregate supply, which shows the effect of changes in the price level on the quantity of goods and services that firms are willing and able to supply. Because the effect of changes in the price level is very different in the short run than in the long run, we use two aggregate supply curves: one for the short run and one for the long run. We start by considering the long-run aggregate supply curve.

10.2 Identify the determinants of aggregate supply, and distinguish between a movement along the shortrun aggregate supply curve and a shift of the curve. LEARNING OBJECTIVE

The long-run aggregate supply curve In Chapter 6 we saw that in the long run the level of real GDP is determined by the number of workers, the capital stock—including factories, office buildings and machinery and equipment— and the available technology. Because changes in the price level do not affect the number of workers, the capital stock or technology, in the long run changes in the price level do not affect the level of real GDP. Remember that the level of real GDP in the long run is called potential GDP or full-employment GDP. At potential GDP firms will operate at their normal level of capacity and everyone who wants a job will have one (except the structurally and frictionally unemployed; see Chapter 7). There is no reason for this normal level of capacity to change just because the price level has changed. The long-run aggregate supply (LRAS) curve is a curve showing the relationship in the long run between the price level and the quantity of real GDP supplied. As Figure 10.2 shows, the price level was 100 in year 1 and potential GDP was $1100 billion. If the price level had been 95, or if it had been 112, long-run aggregate supply would still have been a constant $1100 billion. Therefore the LRAS curve is a vertical line.

Shifts in the long-run aggregate supply curve

Long-run aggregate supply (LRAS) curve A curve that shows the relationship in the long run between the price level and the quantity of real GDP supplied.

Figure 10.2 also shows that the LRAS curve shifts to the right each year. In this figure potential GDP increased from $1100 billion in year 1 to $1140 billion in year 2 and to $1170 billion in year 3. The shift in aggregate supply over time occurs because potential GDP increases each year. As we saw in Chapter 6, this long-run economic growth can be due to: 1 An increase in resources, such as migrant workers or new mineral discoveries, in the economy. 2 An increase in the quantity of machinery and equipment used in production. 3 New technology or more productive ways of using resources. The above factors also shift the short-run aggregate supply curve, and therefore we will discuss them in more detail in the sections that follow.

Price level

LRASyear 1

LRASyear 2

LRASyear 3

FIGURE 10.2

The long-run aggregate supply curve Changes in the price level do not affect the level of aggregate supply in the long run. Therefore the long-run aggregate supply (LRAS) curve is a vertical line at the level of potential GDP. For instance, the price level was 100 in year 1 and potential GDP was $1100 billion. If the price level had been 95, or if it had been 112, LRAS would still have been a constant $1100 billion. Each year the LRAS curve shifts to the right as the number of workers in the economy increases, more machinery and equipment are accumulated and technological change occurs

112 100 95

0

$1100

1140

1170

Real GDP (billions of dollars)

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The short-run aggregate supply curve While the LRAS curve is vertical, the short-run aggregate supply (SRAS) curve is upward sloping. The SRAS curve is upward sloping because, over the short run, as the price level increases the quantity of goods and services firms are willing to supply will increase. The main reason firms are willing to supply more goods and services as the price level rises is that, as prices of final goods and services rise, prices of inputs—such as the wages of workers or the price of natural resources—rise more slowly. Profits rise when the prices of the goods and services firms sell rise more rapidly than the prices they pay for inputs. Therefore, a higher price level leads to higher profits and increases the willingness of firms to supply more goods and services. A secondary reason the SRAS curve slopes upward is that, as the price level rises or falls, some firms are slow to adjust their prices. A firm that is slow to raise its prices when the price level is increasing may find its sales increasing and therefore will increase production. A firm that is slow to reduce its prices when the price level is decreasing may find its sales falling and therefore will decrease production. Why do some firms adjust prices more slowly than others, and why might the wages of workers and the prices of other inputs change more slowly than the prices of final goods and services? Most economists believe that the explanation is that some firms and workers fail to predict accurately changes in the price level. If firms and workers could predict the future price level exactly, the SRAS curve would be the same as the LRAS curve. But how does the failure of workers and firms to predict the price level accurately result in an upward-sloping SRAS curve? Economists are not in complete agreement on this point, but we can briefly discuss the three most common explanations: 1 Contracts make some wages and prices ‘sticky’. 2 Firms are often slow to adjust wages. 3 Menu costs make some prices sticky.

Contracts make some wages and prices ‘sticky’ Prices or wages are said to be ‘sticky’ when they do not respond quickly to changes in demand or supply. Fixed contracts can make wages or prices sticky. For example, suppose that a building company negotiates a three-year contract with its workers through an enterprise bargain with the unions at a time when demand for buildings is increasing slowly. Suppose that after the contract is signed the demand for new building starts to increase rapidly and prices of new buildings rise. The company will find that producing more buildings will be profitable, because it can increase prices while the wages it pays its workers are fixed by contract. Or a steelworks company might have signed a multi-year contract to buy iron-ore (which is used in making steel) at a time when the demand for steel is stagnant. If steel demand and steel prices begin to rise rapidly, producing additional steel will be profitable because iron-ore prices will remain fixed by the contract. In both of these cases, rising prices lead to higher output. If these examples are representative of enough firms in the economy, a rising price level should lead to a greater quantity of goods and services supplied. In other words, the SRAS curve will be upward sloping. Note, though, that if the workers at the building company or the managers of the iron-ore companies had accurately predicted what would happen to prices, this prediction would have been reflected in the contracts, and the building and steelworks companies would not have earned greater profits when prices rose. In that case, rising prices would not have led to higher output.

Firms are often slow to adjust wages The wages of many workers remain fixed by contract for one year or even several years. For instance, suppose you accept a job at a management consulting firm in June at a salary of $60 000 per year. The firm will probably not adjust your salary, and those of other existing and new workers, until the following June, even if the prices it can charge for its services later in the year are higher or lower than the firm had expected them to be when you were first hired. If firms adjust wages only slowly, a rise in the price level will increase the profitability of hiring

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more workers and producing more output. A fall in the price level will decrease the profitability of hiring more workers and producing more output. Once again, we have an explanation for why the SRAS curve slopes upward. It is worth noting that firms are often slower to cut wages than to increase them. Cutting wages can have a negative effect on the morale and productivity of workers and can also cause some of the firm’s best workers to quit and look for jobs elsewhere.

Menu costs make some prices sticky Firms base their prices today partly on what they expect future prices to be. For instance, before it prints menus a restaurant has to decide the prices it will charge for meals. Many firms print catalogues that list the prices of their products. A large proportion of product prices are changed using scanners and computers, and therefore changing prices electronically also involves considerable time and expense. If demand for firms’ products is higher or lower than they had expected, firms may want to charge prices that are different from the ones printed in their catalogues, listed on product shelves and entered in their computer systems. The costs to firms of changing prices are called menu costs. To see why menu costs can lead to an upward-sloping SRAS curve consider the effect of an unexpected increase in the price level. In this case firms will want to increase the prices they charge. Some firms, however, may not be willing to increase prices because of menu costs. Because of their relatively low prices, these firms will find their sales increasing, which will cause them to increase output. Once again, we have an explanation for a higher price level leading to a larger quantity of goods and services supplied.

Menu costs The costs to firms of changing prices.

Shifts of the short-run aggregate supply curve versus movements along it It is important to remember the difference between a shift in a curve and a movement along a curve. The SRAS curve tells us the short-run relationship between the price level and the quantity of goods and services firms are willing to supply, holding constant all other variables that affect the willingness of firms to supply goods and services. If the price level changes but other variables are unchanged, the economy will move up or down a stationary aggregate supply curve. If any variable other than the price level changes, the aggregate supply curve will shift.

Variables that shift the short-run aggregate supply curve We now briefly discuss the five most important variables that cause the SRAS curve to shift. Note that the final two variables discussed also cause the LRAS curve to shift.

Expected changes in the future price level If workers and firms believe that the price level is going to increase by 3 per cent during the next year, they will try to adjust their wages and prices accordingly. For instance, if unions believe there will be 3 per cent inflation next year, they know that wages must rise by 3 per cent to preserve the purchasing power of those wages. Similar adjustments by other workers and firms will result in costs increasing throughout the economy by 3 per cent. The result, shown in Figure 10.3, is that the SRAS curve will shift to the left, from SRASyear 1 to SRASyear 2, so that any level of real GDP is now associated with a price level that is 3 per cent higher. In general, if workers and firms expect the price level to increase by a certain percentage, the SRAS curve will shift by an equivalent amount, holding constant all other variables that affect the SRAS curve.

Adjustments of workers and firms to errors in past expectations about the price level Workers and firms sometimes make incorrect predictions about the price level. As time passes they will attempt to compensate for these errors. Suppose, for example, that the unions sign a contract with a building company that contains only small wage increases because the company and the union expect only small increases in the price level. If increases in the price level turn out to be unexpectedly large, the union will take this into account when negotiating the next contract. The higher wages the workers receive under the new contract will increase the

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FIGURE 10.3

Price level

How expectations of the future price level affect the short-run aggregate supply The SRAS curve shifts to reflect workers’ and firms’ expectations of future prices. 1 If workers and firms expect the price level to rise by 3 per cent from 100 to 103, they will adjust their wages and prices by that amount. 2 Holding constant all other variables that affect aggregate supply, the SRAS curve will shift to the left. If workers and firms expect the price level to be lower in the future, the SRAS curve will shift to the right

1. If firms and workers expect the price level to be 3% higher in year 2 than in year 1 . . .

SRASyear 2 SRASyear 1

103 2. . . . the SRAS curve will shift to the left to reflect worker and firm expectations of rising costs.

100

0

$1000

Real GDP (billions of dollars)

company’s costs and result in the company needing to receive higher prices to produce the same level of output. If workers and firms across the economy are adjusting to the price level being higher than expected, the SRAS curve will shift to the left. If they are adjusting to the price level being lower than expected, the SRAS curve will shift to the right.

Unexpected changes in the price of an important natural resource

Supply shock An unexpected event that causes the short-run aggregate supply curve to shift.

Unexpected increases or decreases in the price of an important natural resource can cause firms’ costs to be different from expected costs. Oil prices can be particularly volatile. Some firms use oil in the production process. Other firms use products, such as plastics, that are made from oil. If oil prices rise unexpectedly the costs of production will rise for these firms. Some utilities also burn oil to generate electricity, so electricity prices will rise. Rising oil prices lead to rising petrol prices, which increases transportation costs for many firms. Because firms face rising costs they will only supply the same level of output at higher prices, and the SRAS curve will shift to the left. An unexpected event that causes the SRAS curve to shift is known as a supply shock. Supply shocks are often caused by unexpected increases or decreases in the prices of important natural resources. Because the Australian economy has experienced inflation in almost every year since the 1930s, workers and firms always expect next year’s price level to be higher than this year’s price level. Holding everything else constant, this will cause the SRAS curve to shift to the left. But everything else is not constant, because every year the Australian labour force and the Australian capital stock expand and changes in technology occur, which cause the SRAS curve to shift to the right. Whether in any particular year the SRAS curve shifts to the left or to the right depends on which of these variables has the largest impact during that year.

Variables that shift the short-run and long-run aggregate supply curves Increases in the labour force and in the capital stock and resources A firm will supply more output at every price if it has more workers and more physical capital. The same is true of the economy as a whole. So as the labour force and the capital stock grow, firms will supply more output at every price level, and the short-run and long-run aggregate supply curves will shift to the right. In Japan the population is ageing and the labour force is decreasing. Holding other variables constant, this decrease in the labour force causes the shortrun and long-run aggregate supply curves in Japan to shift to the left. With respect to resources, historically for Australia new discoveries of minerals and energy have also shifted the short-run and long-run aggregate supply curves to the right.

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Technological change As technological change takes place the productivity of workers and machinery increases, which means that firms can produce more goods and services with the same amount of labour and machinery. This improvement reduces the firms’ costs of production and therefore allows them to produce more output at every price level. As a result, the short-run and longrun aggregate supply curves shift to the right. In Australian agriculture extreme weather conditions, such as droughts, have also been important in reducing productivity of land, while favourable climatic conditions have improved the productivity of land in much the same way as technological change. Table 10.2 summarises the most important variables that cause the SRAS curve to shift. It is important to note that the table shows the shift in the SRAS curve which results from an increase in each of the variables. A decrease in these variables would cause the SRAS curve to shift in the opposite direction.

TABLE 10.2

Variables that shift the short-run aggregate supply curve

AN INCREASE IN … the labour force or the capital stock or resources

SHIFTS THE SHORT-RUN AGGREGATE SUPPLY CURVE … Price level

0

productivity

Price level

0

the expected future price level

Price level

0

workers and firms adjusting to having previously underestimated the price level

Price level

0

the expected price of an important natural resource

Price level

0

SRAS1

SRAS2

BECAUSE … more output can be produced at every price level

Real GDP SRAS1

SRAS2

costs of producing output fall

Real GDP SRAS2

SRAS1

costs of producing output rise

Real GDP SRAS2

SRAS1

workers and firms increase wages and prices

Real GDP SRAS2

SRAS1

costs of producing output rise

Real GDP

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10.3 Use the aggregate demand and aggregate supply model to illustrate the difference between short-run and long-run macroeconomic equilibrium. LEARNING OBJECTIVE

MACROECONOMIC EQUILIBRIUM IN THE LONG RUN AND THE SHORT RUN Now that we have discussed the components of the aggregate demand and aggregate supply model, we can use it to analyse changes in real GDP and the price level. In Figure 10.4 we bring the AD curve, the SRAS curve and the LRAS curve together in one graph, to show the long-run macroeconomic equilibrium for the economy. In the figure equilibrium occurs at real GDP of $1000 billion and a price level of 100. Notice that in long-run equilibrium the SRAS curve and the AD curve intersect at a point on the LRAS curve. Because equilibrium occurs at a point along the LRAS curve we know the economy is at potential GDP: firms will be operating at their normal level of capacity, and everyone who wants a job will have one, except the structurally and frictionally unemployed. In the following section we discuss the economic forces that can push the economy away from long-run equilibrium.

Recessions, expansions and supply shocks Because the full analysis of the aggregate demand and aggregate supply model can be complicated we begin with a simplified case, using two assumptions: 1 The economy has not been experiencing any inflation. The price level is currently 100 and workers and firms expect it to remain at 100 in the future. 2 The economy is not experiencing any long-run growth. Potential GDP is $1000 billion and will remain at that level in the future. These assumptions are simplifications because in reality the Australian economy has experienced at least some inflation every year since the 1930s, and potential GDP also increases every year. However, the assumptions allow us to understand more easily the key ideas of the aggregate demand and aggregate supply model. In this section we examine the short-run and long-run effects of expansions, supply shocks and contractions, which here we can refer to as recessions, because in this simple model output actually falls, rather than growing at a rate that is slower than the long-term trend rate (see Chapter 5).

Recession The short-run effect of a decline in aggregate demand Suppose that rising interest rates cause firms to reduce spending on buildings, factories and equipment, and cause households to reduce spending on new homes. The decline in investment that results will shift the AD curve to the left, from AD1 to AD2, as shown in Figure 10.5. The economy moves from point A to a new short-run macroeconomic equilibrium where the AD2 curve intersects the SRAS curve at point B. In the new short-run equilibrium real GDP has declined from $1000 billion to $980 billion and is below its potential level. This lower level of GDP will

FIGURE 10.4

Price level

LRAS

Long-run macroeconomic equilibrium In long-run macroeconomic equilibrium the AD and SRAS curves intersect at a point on the LRAS curve. In this case equilibrium occurs at real GDP of $1000 billion and a price level of 100

SRAS

100

AD 0

$1000

Real GDP (billions of dollars)

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Price level

FIGURE 10.5

1. A decline in investment shifts AD to the left causing a recession.

LRAS

The short-run and long-run effects of a decrease in aggregate demand

SRAS1 SRAS2

B C

96

In the short run a decrease in aggregate demand causes a recession. In the long run it causes only a decrease in the price level

2. As firms and workers adjust to the price level being lower than they had expected, costs will fall, and cause SRAS to shift to the right.

A

100 98

281

AD1 AD2

0

$980

1000

3. Equilibrium moves from point B back to potential GDP at point C, with a lower price level.

Real GDP (billions of dollars)

result in declining profitability for many firms and layoffs for some workers; the economy will be in recession.

Adjustment back to potential GDP in the long run We know that the recession will eventually end because there are forces at work that push the economy back to potential GDP in the long run. Figure 10.5 shows how the economy moves from recession back to potential GDP. The shift from AD1 to AD2 initially leads to a short-run equilibrium with the price level having fallen from 100 to 98 (point B). Workers and firms will begin to adjust to the price level being lower than they had expected it to be. Workers will be willing to accept lower wages—because each dollar of wages is able to buy more goods and services—and firms will be willing to accept lower prices. In addition, the unemployment resulting from the recession will make workers more willing to accept lower wages, and the decline in demand will make firms more willing to accept lower prices. As a result, the SRAS curve will shift to the right from SRAS1 to SRAS2. At this point the economy will be back in long-run equilibrium (point C ). The shift from SRAS1 to SRAS2 will not happen instantly. It may take the economy several years to return to potential GDP. The important conclusion is that a decline in aggregate demand causes a recession in the short run, but in the long run it causes only a decline in the price level. Economists refer to the process of adjustment back to potential GDP just described as an automatic mechanism because it occurs without any actions by the government. An alternative to waiting for the automatic mechanism to end a recession is for the Reserve Bank of Australia to use monetary policy and the government to use fiscal policy to shift the AD curve to the right and try to restore actual real GDP to the potential GDP level more quickly. We will discuss monetary and fiscal policy in Chapters 12 and 13. Economists debate whether or not we should wait for the automatic mechanism to end recessions or whether it would be better to use monetary and fiscal policy.

Expansion The short-run effect of an increase in aggregate demand Suppose that many firms become more optimistic about the future profitability of new investment, as happened during the information technology and telecommunications booms of the late 1990s and early 2000s. The resulting increase in investment will shift the AD curve to the right, as shown in Figure 10.6. Equilibrium moves from point A to point B. Real GDP increases from $1000 billion to $1030 billion and the price level rises from 100 to 103. The economy will be above potential GDP: firms are operating beyond their normal level

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of capacity, some workers are employed who would ordinarily be structurally or frictionally unemployed, some who would ordinarily not be in the labour force re-enter the labour force and are employed, and some workers are working more overtime hours. This is the occurrence of demand-pull inflation which we learned of in Chapter 8. Remember that demand-pull inflation is a rise in the general price level caused by an increase in aggregate demand, where production levels are unable to meet this demand immediately.

Adjustment back to potential GDP in the long run Just as an automatic mechanism brings the economy back to potential GDP from a recession, so an automatic mechanism brings the economy back from a short-run equilibrium beyond potential GDP. Figure 10.6 illustrates this mechanism. The shift from AD1 to AD2 initially leads to a short-run equilibrium with the price level rising from 100 to 103 (point B). Workers and firms will begin to adjust to the price level being higher than they had expected. Workers will push for higher wages—because each dollar of wages is able to buy fewer goods and services— and firms will charge higher prices. In addition, the low levels of unemployment resulting from the expansion will make it easier for workers to negotiate for higher wages, and the increase in demand will make it easier for firms to receive higher prices. As a result, the SRAS curve will shift to the left from SRAS1 to SRAS2. At this point (point C ), the economy will be back in long-run equilibrium, at a higher level (106). Once again, the shift from SRAS1 to SRAS2 will not happen instantly. The process of returning to potential GDP may stretch out for more than a year.

Supply shock The short-run effect of a supply shock

Stagflation A combination of inflation and recession, usually resulting from a supply shock.

As we have learned, a supply shock occurs when there is an unexpected event that causes an increase in the costs of production, which shifts the aggregate supply curve to the left, and decreases the aggregate supply of goods and services. For example, a supply shock could be caused by an increase in import prices, a natural disaster or if wage rates rise faster than productivity growth rates. This leads to the occurrence of cost-push inflation, which as we saw in Chapter 8, is a rise in the general price level due to a supply shock. Suppose oil prices increase substantially. This supply shock will increase many firms’ costs and cause the SRAS curve to shift to the left, as is shown in Figure 10.7(a). Notice that the price level is higher in the new short-run equilibrium (104 rather than 100) but real GDP is lower ($970 billion rather than $1000 billion). This difficult and serious combination of inflation and recession is called stagflation.

FIGURE 10.6

The short-run and long-run effects of an increase in aggregate demand

Price level

1. An increase in investment shifts AD to the right, causing an inflationary expansion.

LRAS

SRAS2 SRAS1

In the short run an increase in aggregate demand causes an increase in real GDP. In the long run it causes only an increase in the price level

106

B

103 100

2. As firms and workers adjust to the price level being higher than they had expected, costs will rise, and cause SRAS to shift to the left.

C

A

AD1 0 3. Equilibrium moves from point B back to potential GDP at point C, with a higher price level.

$1000 1030

AD2 Real GDP (billions of dollars)

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FIGURE 10.7

The short-run and long-run effects of a supply shock Panel (a) shows that a supply shock, such as a large increase in oil prices, will cause a recession and a higher price level in the short run. The recession caused by the supply shock increases unemployment and reduces output. In panel (b) rising unemployment and falling output result in workers being willing to accept lower wages and firms being willing to accept lower prices. The SRAS curve shifts from SRAS2 to SRAS1. Equilibrium moves from point B back to potential GDP and the original price level at point A

1. The recession caused by the supply shock eventually leads to falling wages and prices, shifting SRAS back to its original position.

2. . . . moving short-run equilibrium to point B, with lower real GDP and a higher price level.

Price level

Price level

LRAS

LRAS SRAS2

SRAS2

SRAS1

SRAS1

B

B 104 A

100

1. An increase in oil prices shifts SRAS to the left . . .

104 A

100

AD

AD

$970 1000

0

Real GDP (billions of dollars)

(a) A recession with a rising price level—the short-run effect of a supply shock

2. Equilibrium moves from point B potential GDP at the original price level.

$970 1000

0

Real GDP (billions of dollars)

(b) Adjustment back to potential GDP—the long-run effect of a supply shock

Adjustment back to potential GDP in the long run The recession caused by the supply shock increases unemployment and reduces output. This eventually results in workers being willing to accept lower wages and firms being willing to accept lower prices. In Figure 10.7(b) the SRAS curve shifts from SRAS2 to SRAS1, moving the economy from point B back to point A. The economy is back to potential GDP at the original price level. It may take several years for this process to be completed. An alternative would be to try to use monetary and fiscal policy to shift the AD to the right. Using policy in this way would bring the economy back to potential GDP more quickly but would result in a permanently higher price level.

A DYNAMIC AGGREGATE DEMAND AND AGGREGATE SUPPLY MODEL The basic aggregate demand and aggregate supply model used so far in this chapter provides important insights into how short-run macroeconomic equilibrium is determined. Unfortunately, the model also provides some misleading results. For instance, it incorrectly predicts that a recession caused by the AD curve shifting to the left will cause the price level to fall, which has not happened in Australia and many other countries for an entire year since the 1930s. The difficulty with the basic model arises from the two assumptions we made when using it: (1) that the economy does not experience continuing inflation and (2) that the economy does not experience long-run growth. We can develop a more useful aggregate demand and aggregate supply model by dropping these assumptions. The result will be a model that takes into account the fact that the economy is not static, with an unchanging level of potential GDP and no continuing inflation, but dynamic, with potential GDP that grows over time and inflation

10.4 Use the dynamic aggregate demand and aggregate supply model to analyse macroeconomic conditions. LEARNING OBJECTIVE

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that continues every year. We can create a dynamic aggregate demand and aggregate supply model by making changes to the basic model that incorporates the following important macroeconomic facts: 1 Potential GDP increases continually, shifting the LRAS curve to the right. 2 During most years the AD curve shifts to the right. 3 Except during periods when workers and firms expect high rates of inflation, the SRAS curve shifts to the right. Figure 10.8 illustrates how incorporating these macroeconomic facts changes the basic aggregate demand and aggregate supply model. We start with SRAS1 and AD1 intersecting at point A at a price level of 100 and real GDP of $1000 billion. Because this intersection occurs at a point on LRAS1, we know the economy is in long-run equilibrium. The LRAS curve shifts to the right, from LRAS1 and LRAS2. This shift occurs because during the year potential GDP increases as the labour force and capital stock increase and technological progress occurs. The SRAS curve shifts from SRAS1 to SRAS2. This shift occurs because the same variables that cause the long-run aggregate supply to shift to the right will also increase the quantity of goods and services that firms are willing to supply in the short run. Finally, the AD curve shifts to the right, from AD1 to AD2. The AD curve shifts for several reasons. As population grows and incomes rise consumption will increase over time. As the economy grows firms will expand capacity and new firms will be formed, increasing investment. An expanding population and an expanding economy require increased government services, such as more police officers and teachers, so government purchases will increase. Therefore the positive economic growth is due to the LRAS curve shifting to the right, which is accommodated by shifts in the AD curve to the right. The new equilibrium in Figure 10.8 occurs at point B, where AD2 intersects SRAS2 on LRAS2. In the new equilibrium the price level remains at 100, while real GDP increases to $1030 billion. Notice that there has been no inflation because the price level is unchanged at 100. There has been no inflation because aggregate demand and aggregate supply shifted to the right by exactly as much as long-run aggregate supply. We would not expect this to be the typical situation for two reasons. First, the SRAS curve is also affected by workers’ and firms’ expectations of future changes in the price level and by supply shocks. These variables can partially, or completely, offset the normal tendency of the SRAS curve to shift to the right over the course of a year. Second, we know that sometimes consumers, firms and the government may cut back on expenditures. This reduced spending will result in the AD curve shifting to the right less than it normally would or, possibly, shifting to the left. In fact, as we will see shortly, changes in the price level and in real GDP in the short run are determined by the shifts in the SRAS and AD curves.

What is the usual cause of inflation? The dynamic aggregate demand and aggregate supply model provides a more accurate explanation than the basic model of the source of most inflation. If total spending in the economy grows faster than total production, prices rise. Figure 10.9 illustrates this point by showing that if the AD curve shifts to the right by more than the LRAS curve, inflation results because equilibrium occurs at a higher price level, point B. In the new equilibrium the SRAS curve has shifted to the right by less than the LRAS curve because the anticipated increase in prices offsets some of the technological change and increases in the labour force and capital stock that occur during the year. Although inflation is generally the result of total spending growing faster than total production, a shift to the left of the SRAS curve can also cause an increase in the price level, as we saw earlier in the discussion of supply shocks. As we see in Figure 10.8, if aggregate demand increased by the same amount as short-run and long-run aggregate supply, the price level will not change. In this case, the economy experiences economic growth without inflation.

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FIGURE 10.8

A dynamic aggregate demand and aggregate supply model We start with the basic aggregate demand and aggregate supply model

1. The economy begins in equilibrium at point A with SRAS1 and AD1 intersecting at a point on LRAS1.

LRAS1 Price level

SRAS1

A

100

AD1

Price level

LRAS1

Real GDP (billions of dollars)

$1000

0

FIGURE 10.9

LRAS2

Using dynamic aggregate demand and aggregate supply to understand inflation

SRAS1 SRAS2

104 100

B A

1. If AD shifts to the right more than LRAS . . .

AD2

2. . . . the price level rises.

AD1

0

$1000

1050

Real GDP (billions of dollars)

The most common cause of inflation is total spending increasing faster than total production. 1 The economy begins at point A, with real GDP of $1000 billion and a price level of 100. An increase in potential GDP from $1000 billion to $1050 billion causes LRAS to shift from LRAS1 to LRAS2. Aggregate demand shifts from AD1 to AD2. 2 Because AD shifts to the right by more than the LRAS curve, the price level in the new equilibrium rises from 100 to 104

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M

C

A K I N G THE

10.2

DOES TECHNOLOGICAL CHANGE CREATE UNEMPLOYMENT?

ONNECTION

Since the Industrial Revolution many people have feared that the introduction of new technologies will replace workers with machines and increase unemployment. As far back as 1812 the Luddites, a political movement of textile workers in Britain, protested against the introduction of mechanisation by destroying machinery which mechanised cloth production, because they thought the machines would make them redundant. Technological change has for two centuries allowed firms to replace repetitive manual tasks by machines. This has meant that the biggest impact has been on low-skilled, manual labour. Two Australian economists, Ross Kelly and Phil Lewis, have analysed the impact of the latest wave of technological change associated with information and communication technologies (ICTs) on the labour market. They found that the growth of firms’ use of ICTs has largely allowed firms to replace clerical workers and other labour associated with routine clerical competencies. This is evidenced by a downward trend in employment of advanced and elementary clerical occupations in Australia at a time when employment in general was rising.

© Fotomy | Dreamstime.com

New technology and equipment increases labour productivity

The following figure shows the net stock of selected electrical, electronic and IT equipment for Australia. It is important to recognise that the items of interest are net of depreciation. These items are written off within four years, which makes the observed net increases more significant. Between 1990 and 2013 the net ICT capital stock increased dramatically at an average annual rate of growth of around 7 per cent, far higher than the growth rate of real GDP. 60 000 55 000 50 000

Millions of dollars

45 000 40 000 35 000 30 000 25 000 20 000 15 000 10 000 5 000

19 90 19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08 20 09 20 10 20 11 20 12 20 13

0

Computers and peripherals

Electrical and electronic equipment

Computer software

SOURCE: Created from Australian Bureau of Statistics (2013), Australian System of National Accounts, Cat. No. 5204.0, Table 69, Information Technology Net Capital Stock, Selected Items by Industry, viewed 9 January 2014.

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We saw in Chapters 5 and 6 that growth in output per worker—labour productivity—is the key to rising living standards over the long run. But if firms can produce more output with the same number of workers, are they less likely to hire additional workers? When analysing the effects of productivity increases it is important to distinguish between what happens at the firm level and what happens at the economy-wide level. At the firm level the use of new technology can mean that fewer workers are needed to meet the production requirements. However, we should also note that if new technology is adopted to produce a new or more advanced product, this could lead to an increase in the demand for the firm’s product, and therefore the firm may require more workers to meet the demand. At the economy-wide level rising productivity leads to economic growth and rising incomes, which increase consumption spending and therefore increase aggregate demand. As aggregate demand increases, more workers are required and employment grows for the economy as a whole. In the dynamic aggregate demand and aggregate supply model the AD curve will shift to the right. In addition, the higher the growth in productivity per year, the further to the right the SRAS and LRAS curves will shift. Therefore, while productivity growth might reduce the demand for labour in some firms, the effect on aggregate demand and aggregate supply means that productivity growth does not reduce employment for the economy as a whole—in fact, it generally leads to employment growth. SOURCE: R. Kelly and P. Lewis (2010), ‘The change in labour skills over the business cycle’, Australian Bulletin of Labour, Vol. 36, No. 3, pp. 260–277; R. Kelly (2010), Structural Change and the Demand for Skills in the Australian Economy, PhD thesis, University of Canberra.

SOLVED PROBLEM 10.2 SHOWING THE OIL SHOCK OF 1974 ON A DYNAMIC AGGREGATE DEMAND AND AGGREGATE SUPPLY GRAPH The 1974 recession clearly illustrates how a supply shock affects the economy. Following the Arab–Israeli War of 1973 the Organization of Petroleum Exporting Countries (OPEC) increased the price of a barrel of oil from less than US$3 to more than US$10. Use this information and the statistics in the following table to draw a dynamic aggregate demand and aggregate supply graph showing macroeconomic equilibrium for 1973 and 1974. Assume that the aggregate demand curve did not shift between 1973 and 1974. Provide a brief explanation of your graph. ACTUAL REAL GDP

POTENTIAL GDP

PRICE LEVEL

1973

$342.8 billion

$344 billion

21.5

1974

$341.9 billion

$350 billion

25.0

Solving the problem STEP 1: Review the chapter material. This problem is about using the dynamic aggregate demand and aggregate supply model, so

you may want to review the section ‘A dynamic aggregate demand and aggregate supply model’, which begins on page 283. STEP 2: Use the information in the table to draw the graph. We need to draw five curves: AD, and SRAS and LRAS for both 1973 and

1974 (assume that the AD curve will be the same for both years). We know that the two LRAS curves will be vertical lines at the values given for potential GDP in the table. Because of the large supply shock we know that the SRAS curve shifted to the left. We are instructed to assume that the AD curve did not shift. Your graph should look like the following:

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Price level

LRAS1973

LRAS1974 SRAS1974 SRAS1973

AD

25.0 21.5

0

$341.9 342.8 344.0

350.0

Real GDP (billions of dollars)

STEP 3: Explain your graph. LRAS1973 and LRAS1974 are at the levels of potential GDP for each year. Macroeconomic equilibrium

for 1973 occurs where the AD curve intersects the SRAS1973 curve, with real GDP of $342.8 billion and a price level of 21.5. Macroeconomic equilibrium for 1974 occurs where the AD curve intersects the SRAS1974 curve, with real GDP of $341.9 billion and a price level of 25.0.

[ YOUR TURN Q

For more practice do related problem 4.6 on page 295 at the end of this chapter.

ECONOMICS IN YOUR LIFE (continued from page 267)

IS YOUR EMPLOYER LIKELY TO REDUCE YOUR PAY DURING A RECESSION? At the beginning of this chapter, we asked you to consider whether during a recession your employer is likely to reduce your pay and cut the prices of the products he or she sells. In this chapter, we saw that even during a recession, the price level rarely falls. In fact, in Australia, the general price level has not fallen for a sustained period since the early twentieth century. A typical firm is therefore unlikely to cut its prices during a recession. So the owner of the coffee house you work in will probably not cut the price of lattes unless sales have declined drastically. We also saw that most firms are reluctant to cut wages because this can have a negative effect on worker morale and productivity; they instead may not increase wages by as much as they otherwise would have. Given that you are a highly skilled barista, your employer is particularly unlikely to cut your wages for fear that you might quit and work for a competitor.

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CONCLUSION Chapter 3 demonstrated the power of the microeconomic model of demand and supply in explaining how the prices and quantities of individual products are determined. This chapter showed that we need a different model to explain the behaviour of the whole economy. We saw that the macroeconomic model of aggregate demand and aggregate supply explains fluctuations in real GDP and the price level. One of the great disagreements among economists and political leaders is whether the government and central banks should intervene to try to reduce fluctuations in real GDP and keep the unemployment and inflation rates low. We explore this important issue in Chapters 12 and 13. Read ‘An inside look’ to learn that JB Hi-Fi grew faster than many other firms in the retail sector during the post-GFC economic recovery.

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AN INSIDE LOOK NG SYDNEY MORNI

GUST 2013 HERALD 13 AU

s e i f e d t i f o r p m 6 1 1 $ ’s i F i H JB slump By Eli Greenblat

ts and gadgets, peline of produc pi w ne a id sa i ld continue JB Hi-F consoles, shou g in m ok ga to d at an th s m tronics momentu such as TV in the wider elec th ow sustained sales gr d e d th an an ng fy st ro de re St Hi-Fi for fiscal A to drive inte has helped JB w tipping sales as no r tm ile ris its ta Ch re st r e po te th hold af tail sector to market, with and 8 per cent on n across the re tween 6 per cent be by e ris s. general downtur ar to ye 14 20 it growth in three n, . first full-year prof to $116.4 millio nt ce a time when r the previous year pe .2 11 up it, of in pr owth comes at s gr le ed e sa e tiv bl si The rais ra po pa e m co downturn as B Th slightly by lower , ring an earnings ss ffe ne su si e bu ar g in rs was held back do ile ta and home st of ost re d a jump in the co d. The electronics lia m en ra sp st to Au k se or fu W re ir New Zealand an s r to report by Fa consumer ages bills driven e first large retaile th as w p ou gr . t lls namely higher w surprise rent bi entertainmen as well as fatter l are expected to s al nt t se ce no ea r t cr pe bu in , 8 d gs 5. ar in a aw on full-year earn rformance, built analysts’ d e upside. The full-year pe se e as rp su , on the market on th Simotas said th .308 billi $3 r, to ile s ta le re sa e analyst Michael th in nk d lift Ba de 14 ar 20 he w r sc re ut t tte De d the marke er, ent implied be expectations an 4 per cent high outlook statem e an tiv th si e po was expecting, or m es ar an the market 9.12—a th $1 s le at , sa sending its sh nt ar ce r ye pe ell recently he financial 60¢, or 3.2 k performing w oc st e before closing up th ith w nt levels. ough the price at curre ement alth in at y st el rg ok la tlo 27-month high. as ou w e is ved th ions due to od news in th Hi-Fi belie d of our expectat JB ea t ah hi ly There was also go at ht th ig s sl le e sa gin was ‘Sales wer ith a pick-up in stores, gross mar year, w al ne ci m an fro fin n for investors, w w io ne ut e said. ntrib y pushing into th e- higher co ss was higher,’ he lik ne d si an bu nt g ce in r stores in Januar do pe of 8 in line, but cost for July touching with sales growth . nt ce r 2.2 pe for-like growth up

G HERALD

SYDNEY MORNIN

SOURCE: Eli Greenblat (2013), ‘JB Hi-Fi’s $116m profit defies slump’, The Sydney Morning Herald, 13 August, at , viewed 15 January 2014.

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Key points in the article The Australian economy experienced economic recovery in the late 2000s following the GFC. Retail stores experienced growth but at a rate much slower than before the GFC, although stronger growth rates were achieved by the telecommunications, computers and other electronics retailers. As the article discusses, in particular electronics stores such as JB Hi-Fi experienced rapid growth in sales. This was partly due to the ability of JB Hi-Fi to move into new products.

Analysing the news A After the shock of the GFC, which led to an economic contraction in Australia and a short period of negative economic growth, the economy began to recover in the second half of 2009 and onwards. Economic growth was positive, with an improvement in consumer confidence leading to renewed retail spending, particularly for electronics products such as those sold by JB Hi-Fi. Investment spending also grew, in large part due to the  minerals and energy boom. As shown in Figure 1, the economic recovery shifted the AD curve to the right, from AD1 to AD2. At the same time, investment spending increased economic capacity, thereby shifting both the short-run and long-run aggregate supply curves to the right. Australian retailing firms also expanded supply by using more innovative management techniques, and taking advantage of lower wholesale prices dues to low production costs of suppliers in Asia (particularly China) and a higher value of the Australian dollar.

291

B The increased aggregate demand included the rapid growth in demand for the types of goods sold by JB Hi-Fi, including computers, mobile phones, sound systems, DVDs and video games. However, by late 2010 and into 2014, it was apparent that although the Australian economy was recovering, consumers were far more cautious with their spending than they had been during the 17-year period of continual economic growth in the lead-up to the GFC. Not all parts of the economy were benefiting from the recovery equally, and the increase in aggregate demand was not as rapid as some analysts had originally anticipated. The article points out that while retailers like JB Hi-Fi were recording large increases in profits during the second half of 2013, others were not expected to have such positive profit increases. Therefore, while the economy appeared briefly to be close to, or at, its long-run equilibrium as depicted in Figure 1 in the early stages of its GFC recovery, after 2010 the economy was once again in equilibrium below potential GDP. Thinking critically 1 Explain whether investment spending is likely to increase more rapidly in a country with a rapidly growing population than in a country with a slowly growing population. Does your answer depend on whether the country is a high-income industrial country or a low-income developing country? 2 In 2013 the Australian dollar was high compared to the historical average. Would a fall in the value of the Australian dollar be good news or bad news for companies such as JB Hi-Fi?

FIGURE 1 A RETURN TO A HEALTHIER RATE OF ECONOMIC GROWTH IN AUSTRALIA FOLLOWING THE GFC

Price level

LRAS1

LRAS2 SRAS1 SRAS2

P2

B

A

P1

AD2 AD1

0

Y1

Y2

Real GDP

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CHAPTER SUMMARY AND PROBLEMS KEY TERMS aggregate demand and aggregate supply model aggregate demand (AD) curve

268

long-run aggregate supply (LRAS) curve menu costs

275 277

268

short-run aggregate supply (SRAS) curve stagflation supply shock

268 282 278

AGGREGATE DEMAND, PAGES 268–274 Identify the determinants of aggregate demand, and distinguish between a movement along the aggregate demand curve and a shift of the curve.

LEARNING OBJECTIVE 10.1

SUMMARY The aggregate demand and aggregate supply model enables us to explain short-run fluctuations in real GDP and the price level. The aggregate demand (AD) curve shows the relationship between the price level and the quantity of real GDP demanded by households, firms and the government. The short-run aggregate supply (SRAS) curve shows the relationship in the short run between the price level and the quantity of real GDP supplied by firms. The long-run aggregate supply (LRAS) curve shows the relationship in the long run between the price level and the quantity of real GDP supplied. The four components of aggregate demand are consumption (C), investment (I), government purchases (G) and net exports (NX). The AD curve is downward sloping because a decline in the price level causes consumption, investment and net exports to increase. If the price level changes but all else remains constant, the economy will move up or down a stationary AD curve. If any variable other than the price level changes, the AD curve will shift. The variables that cause the AD curve to shift are divided into three categories: changes in government policies, changes in the expectations of households and firms, and changes in foreign variables.

REVIEW QUESTIONS 1.1

1.2

1.3

1.4

What relationship is shown by the aggregate demand curve? What relationship is shown by the aggregate supply curve? Explain the three reasons why the aggregate demand (AD) curve slopes downward. What are the differences between the AD curve and the demand curve for an individual product, such as apples? What are the variables that cause the AD curve to shift? For each variable, identify whether an increase in that variable will cause the AD curve to shift to the right or to the left.

PROBLEMS AND APPLICATIONS 1.5

Explain how each of the following events would affect the AD curve. a An increase in the price level b An increase in government purchases

1.6

c Higher income taxes d Higher interest rates e Faster income growth in other countries [Related to Don’t let this happen to you] A student was asked to draw an aggregate demand and aggregate supply graph to illustrate the effect of an increase in aggregate supply. The student drew the following graph: Price level

SRAS1 SRAS2

P1

P3 P2 AD2 AD1

0

Real GDP (billions of dollars)

The student explained the graph as follows: An increase in aggregate supply causes a shift from SRAS1 to SRAS2. Because this shift in the aggregate supply curve results in a lower price level, consumption, investment and net exports will increase. This change causes the aggregate demand curve to shift to the right, from AD1 to AD2. We know that real GDP will increase but we can’t be sure whether the price level will rise or fall because that depends on whether the aggregate supply curve or the aggregate demand curve has shifted further to the right. I assume that aggregate supply shifts out further than aggregate demand, so I show the final price level, P3, as being lower than the initial price level, P1.

Explain whether you agree or disagree with the student’s analysis. Be careful to explain exactly what—if anything— you find wrong with this analysis.

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[Related to Solved problem 10.1] Explain whether each of the following will cause a shift of the AD curve or a movement along the AD curve. a Firms become more optimistic and increase their spending on machinery and equipment. b The federal government increases taxes in an attempt to reduce a budget deficit. c The Australian economy experiences 4 per cent inflation.

1.8

293

[Related to Making the connection 10.1] According to an article in The Wall Street Journal in January 2014: ‘It appears the crisis in the euro zone put the brakes on the German economy,’ [Germany’s] statistics office’s head, Roderich Egeler, told a news conference, adding that domestic demand wasn’t able to fully compensate for slower exports.1

Why would German exporting firms be experiencing a slowing in export growth? What problems could this pose for the German economy?

AGGREGATE SUPPLY, PAGES 275–279 Identify the determinants of aggregate supply, and distinguish between a movement along the short-run aggregate supply curve and a shift of the curve. LEARNING OBJECTIVE 10.2

SUMMARY The long-run aggregate supply (LRAS) curve is a vertical line because in the long run real GDP is always at its potential level and is unaffected by the price level. The short-run aggregate supply curve slopes upwards because workers and firms fail to predict accurately the future price level. The three main explanations of why this failure results in an upward-sloping aggregate supply curve are: (1) contracts make wages and prices ‘sticky’, (2) businesses often adjust wages slowly and (3) menu costs make some prices sticky. Menu costs are the costs to firms of changing prices. If the price level changes but all else remains constant, the economy will move up or down a stationary aggregate supply curve. If any variable other than the price level changes, the aggregate supply curve will shift. The aggregate supply curve shifts as a result of increases in the labour force and the capital stock, technological change, expected increases or decreases in the future price level, adjustments of workers and firms to errors in past expectations about the price level, and unexpected increases or decreases in the prices of important raw materials. A supply shock is an unexpected event that causes the SRAS curve to shift to the left.

REVIEW QUESTIONS 2.1

2.2

2.3

2.4

Explain why the long-run aggregate supply (LRAS) curve is vertical. What variables cause the LRAS curve to shift? For each variable, identify whether an increase in that variable will cause the LRAS curve to shift to the right or to the left. Why does the short-run aggregate supply (SRAS) curve slope upwards? What variables cause the SRAS curve to shift? For each variable, identify whether an increase in that variable will cause the SRAS curve to shift to the right or to the left.

PROBLEMS AND APPLICATIONS 2.5

Explain how each of the following events would affect the LRAS curve. a A higher price level b An increase in the size of the labour force

2.6

2.7

2.8

2.9

2.10

2.11

c An increase in the quantity of capital goods d Technological change An article in The Economist magazine noted that ‘the economy’s potential to supply goods and services [is] determined by such things as the labour force and capital stock, as well as inflation expectations’.2 Do you agree with this list of the determinants of potential GDP? Briefly explain. Explain how each of the following events would affect the SRAS curve. a An increase in the price level b An expectation of a higher price level in the future c A price level that is currently higher than expected d An unexpected increase in the price of an important raw material e An increase in the size of the labour force Suppose that workers and firms could always predict next year’s price level with perfect accuracy. Briefly explain whether in these circumstances the SRAS curve still slopes upwards. Workers and firms often enter into contracts that fix prices or wages, sometimes for years at a time. If the price level turns out to be higher or lower than was expected when the contract was signed, one party to the contract will lose out. Briefly explain why, despite knowing this, workers and firms still sign long-term contracts. What are menu costs? How has the widespread use of computers and the Internet affected menu costs? If menu costs were eliminated would the SRAS curve be a vertical line? Briefly explain. Many economists believe that some wages and prices are ‘sticky downwards’, meaning that these wages and prices increase quickly when demand is increasing but decrease slowly, if at all, when demand is decreasing. Discuss the consequences of this for the automatic mechanism that brings the economy back to potential GDP after an increase in aggregate demand. Would your answer change if aggregate demand decreased rather than increased? Explain.

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MACROECONOMIC EQUILIBRIUM IN THE LONG RUN AND THE SHORT RUN, PAGES 280–283 L E A R N I N G O B J E C T I V E 1 0 . 3 Use the aggregate demand and aggregate supply model to illustrate the difference between short-run and long-run macroeconomic equilibrium.

SUMMARY In long-run macroeconomic equilibrium the AD and SRAS curves intersect at a point on the LRAS curve. In short-run macroeconomic equilibrium the aggregate demand and SRAS curves often intersect at a point off the LRAS curve. An automatic mechanism drives the economy to long-run equilibrium. If shortrun equilibrium occurs at a point below potential GDP, wages and prices will fall and the SRAS curve will shift to the right until potential GDP is restored. If short-run equilibrium occurs at a point beyond potential GDP, wages and prices will rise and the SRAS curve will shift to the left until potential GDP is restored. Real GDP can be temporarily above or below its potential level, either because of shifts in the AD curve or because supply shocks lead to shifts in the aggregate supply curve. Stagflation is a combination of inflation and recession, usually resulting from a supply shock.

3.5

3.6

REVIEW QUESTIONS 3.1

3.2

3.3

What is the relationship between the AD, SRAS and LRAS curves when the economy is in equilibrium? What is a supply shock? Why might a supply shock lead to stagflation? Why are the long-run effects of an increase in aggregate demand on price and output different from the short-run effects?

PROBLEMS AND APPLICATIONS 3.4

Draw a basic aggregate demand and aggregate supply graph (with LRAS constant) that shows the economy in long-run equilibrium. a Assume that there is a large increase in the demand for exports. Show the resulting short-run equilibrium on your graph. In this short-run equilibrium, is the unemployment rate likely to be higher or lower than it was before the increase in exports? Briefly explain. Explain how the economy adjusts back to long-run equilibrium. When the economy has adjusted back to long-run equilibrium, how have the values of each of the following changed relative to what they were before the increase in exports? i Real GDP ii The price level iii The unemployment rate b Assume that there is an unexpected increase in the price of oil. Show the resulting short-run equilibrium on your graph. Explain how the economy adjusts back to long-run equilibrium. In this short-run equilibrium, is the unemployment rate likely to be higher or lower

3.7

3.8

than it was before the increase in oil prices? Briefly explain. When the economy has adjusted back to long-run equilibrium, how have the values of each of the following changed relative to what they were before the unexpected increase in the price of oil? i Real GDP ii The price level iii The unemployment rate List four variables that would cause a decrease in real GDP (a recession). Indicate whether changes in each variable increase or decrease aggregate demand or short-run aggregate supply. Next, state four variables that would cause an increase in the price level (short-run inflation). Indicate whether changes in the variable increase or decrease aggregate demand or short-run aggregate supply. Why would spending on housing be likely to fluctuate more than spending by households on consumer durables, such as cars or furniture, or spending by firms on machinery and equipment? In the early to mid-2000s the Australian economy was experiencing rapid economic expansion, leading to an economic boom. By 2007 data indicated that actual real GDP had exceeded potential GDP, and the unemployment rate was the lowest it had been in over 30 years. Explain how it was possible for actual real GDP to be greater than potential GDP at this time. Use the following graph to answer these questions.

Price level

LRAS SRAS1

SRAS2 C D

B A

AD2 AD1 0

Real GDP (billions of dollars)

a Which of points A, B, C or D can represent a long-run equilibrium? b Suppose initially the economy is at point A. If aggregate demand increases from AD1 to AD2, which point represents the economy’s short-run equilibrium? Which

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point represents the eventual long-run equilibrium? Briefly explain how the economy adjusts from the short-run equilibrium to the long-run equilibrium.

3.9

295

Suppose the price of a barrel of oil rose from US$100 to US$150. Use a basic aggregate demand and aggregate supply diagram to show the short-run and long-run effects on the Australian economy.

A DYNAMIC AGGREGATE DEMAND AND AGGREGATE SUPPLY MODEL, PAGES 283–288 LEARNING OBJECTIVE 10.4

conditions.

Use the dynamic aggregate demand and aggregate supply model to analyse macroeconomic

SUMMARY To make the aggregate demand and aggregate supply model more realistic, we need to make it dynamic by incorporating three facts that were left out of the basic model: (1) potential GDP increases continually, shifting the LRAS curve to the right; (2) during most years aggregate demand will be shifting to the right; (3) except during periods when workers and firms expect high rates of inflation, the SRAS curve will be shifting to the right. The dynamic aggregate demand and aggregate supply model allows us to analyse macroeconomic conditions, including the recession of 1990 and the subsequent recovery, the strong economic growth in the 2000s, the effect of the global financial crisis and subsequent recovery.

4.6

4.7

REVIEW QUESTIONS 4.1

4.2

What are the key differences between the basic aggregate demand and aggregate supply model and the dynamic aggregate demand and aggregate supply model? In the dynamic aggregate demand and aggregate supply model, what is the result of aggregate demand increasing faster than potential GDP? What is the result of aggregate demand increasing slower than potential GDP?

[Related to Solved problem 10.2] Look again at Solved problem 10.2 on the supply shock of 1974. In the table the price level for 1973 is given as 21.5 and the price level for 1974 is given as 25.0. The values for the price level are well below 100. Does this indicate that inflation must have been low during these years? Briefly explain. In the following graph, suppose the economy moves from point A in year 1 to point B in year 2. Using the graph, briefly explain your answers to each of the questions. a What is the growth rate in potential GDP from year 1 to year 2? b Is the unemployment rate in year 2 higher or lower than in year 1? c What is the inflation rate in year 2? d What is the growth rate of real GDP from year 1 to year 2? Price level

LRAS2

LRAS1

SRAS1 SRAS2

114 112

A

B

PROBLEMS AND APPLICATIONS 4.3

4.4

4.5

Draw a dynamic aggregate demand and aggregate supply graph showing the economy moving from potential GDP in 2014 to potential GDP in 2015, with no inflation. Your graph should contain the AD, SRAS and LRAS curves for both 2014 and 2015 and should indicate the shortrun macroeconomic equilibrium for each year and the directions in which the curves have shifted. Identify what must happen to have growth during 2015 without inflation. [Related to Making the connection 10.2] In Making the connection 10.2 we saw that during the 1990s and 2000s firms implemented new technologies that increased productivity. Briefly discuss why firms might be likely to implement new technologies during a period when (a) demand is rising or (b) demand is falling. Draw a dynamic aggregate demand and aggregate supply graph to illustrate how it is possible to have real GDP falling below potential GDP between two time periods at the same time as the price level is rising.

AD2 AD1

0

4.8

$1120 1140

1160 Real GDP (billions of dollars)

In recent years at various times, billions of dollars have been wiped off the value of the Australian share market. Why would a decline in share prices be of concern to businesses and consumers? What were the consequences of this for the economy?

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APPENDIX MACROECONOMIC SCHOOLS OF THOUGHT Understand macroeconomic schools of thought. LEARNING OBJECTIVE

Keynesian revolution The name given to the widespread acceptance during the 1930s and 1940s of John Maynard Keynes’ macroeconomic model.

Macroeconomics became a separate field of economics in 1936 with the publication of John Maynard Keynes’s book, The General Theory of Employment, Interest, and Money. Keynes, an economist at the University of Cambridge in England, was attempting to explain the devastating Great Depression of the 1930s. Real GDP in Australia declined by more than 10 per cent between 1929 and 1932, and the unemployment rate soared to 22 per cent by 1932 and did not return to its pre-1929 level until World War II. Similar effects occurred in most industrialised countries throughout the world. Keynes developed the aggregate demand and aggregate supply model to explain these events. The widespread acceptance during the 1930s and 1940s of Keynes’ model became known as the Keynesian revolution. In fact, the aggregate demand and aggregate supply model remains the most widely accepted approach to analysing macroeconomic issues. Because the model has been modified significantly from Keynes’ day, many economists who use the model today refer to themselves as new Keynesians. The new Keynesians emphasise the importance of the stickiness of wages and prices in explaining fluctuations in real GDP. A significant number of economists, however, dispute whether using the aggregate demand and aggregate supply model, as we have discussed it in this chapter, is the best way to analyse macroeconomic issues. These alternative schools of thought use models that differ significantly from the standard aggregate demand and aggregate supply model. We can briefly consider each of the three major alternative models: 1 The monetarist model 2 The new classical model 3 The real business cycle model

The monetarist model

Monetary growth rule A plan for increasing the quantity of money at a fixed rate that does not respond to changes in economic conditions. Monetarism The macroeconomic theories of Milton Friedman and his followers, particularly the idea that the quantity of money should be increased at a constant rate.

The monetarist model—also known as the neo-Quantity Theory of Money model—was developed in the 1940s by Milton Friedman, an economist at the University of Chicago who was awarded the Nobel Prize in Economics in 1976. Friedman argued that the Keynesian approach overstates the amount of macroeconomic instability in the economy. In particular, he argued that the economy will ordinarily be at potential GDP. In a book entitled A Monetary History of the United States: 1867–1960, written with Anna Schwartz, Friedman argued that most fluctuations in real output were caused by fluctuations in the money supply, rather than by  fluctuations in consumption spending or investment spending. Friedman and Schwartz argued that the severity of the Great Depression in the United States was caused by the Federal Reserve allowing the quantity of money in the economy to fall by more than 25 per cent between 1929 and 1933. Friedman has argued that a country’s central bank should change its practices and adopt a monetary growth rule, which is a plan for increasing the quantity of money at a fixed rate. Friedman believed that adopting a monetary growth rule would reduce fluctuations in real GDP, employment and inflation. Friedman’s ideas, which are referred to as monetarism, attracted significant support during the 1970s and early 1980s, when economies experienced high rates of unemployment and inflation. The support for monetarism declined during the 1990s, when the unemployment and inflation rates were relatively low. In Chapter 11 we discuss the quantity theory of money, which underlies the monetarist model.

The new classical model The new classical model was developed in the mid-1970s by a group of economists including Robert Lucas of the University of Chicago, Thomas Sargent of Stanford University and Robert Barro of Harvard University. Lucas was awarded the Nobel Prize in Economics in 1995. Some of the views held by the new classical macroeconomists are similar to those held by economists before the Great Depression. Keynes referred to the economists before the Great Depression

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as ‘classical economists’. Like the classical economists, the new classical macroeconomists believe that the economy will normally be at potential GDP. They also believe that wages and prices adjust quickly to changes in demand and supply. Put another way, they believe that the stickiness in wages and prices emphasised by the new Keynesians is unimportant. Lucas argued that workers and firms have rational expectations, meaning that they form their expectations of the future values of economic variables, like the inflation rate, making use of all available information, including information on variables—such as changes in the quantity of money—that might affect aggregate demand. If the actual inflation rate is lower than the expected inflation rate, the actual real wage will be higher than the expected real wage. These higher real wages will lead to a contraction because they will cause some firms to hire fewer workers and cut back on production. As workers and firms adjust their expectations to the lower inflation rate, the real wage will decline and employment and production will expand, bringing about an economic expansion. The ideas of Lucas and his followers are referred to as the new classical macroeconomics. Supporters of the new classical model agree with supporters of  the monetarist model that the central bank should adopt a monetary growth rule. They argue that a monetary growth rule will make it easier for workers and firms to forecast accurately the price level, thereby reducing fluctuations in real GDP.

The real business cycle model Beginning in the 1980s some economists, including Finn Kydland of Carnegie Mellon University and Edward Prescott of Arizona State University (who shared the Nobel Prize in Economics in 2004), argued that Lucas was correct in assuming that workers and firms formed their expectations rationally and that wages and prices adjust quickly to supply and demand, but was wrong about the source of fluctuations in real GDP. They argued that fluctuations in real GDP are caused by temporary shocks to productivity. These shocks can be negative, such as a decline in the availability of oil or other raw materials, or positive, such as technological change that makes it possible to produce more output with the same quantity of inputs. According to this school of thought, shifts in the aggregate demand curve have no impact on real GDP because the short-run aggregate supply curve is vertical. Other schools of thought believe that the short-run aggregate supply curve is upward sloping and that only the long-run aggregate supply curve is vertical. Fluctuations in real GDP occur when a negative productivity shock causes the short-run aggregate supply curve to shift to the left—reducing real GDP—or a positive productivity shock causes the short-run aggregate supply curve to shift to the right— increasing real GDP. Because this model focuses on ‘real’ factors—productivity shocks—rather than changes in the quantity of money to explain fluctuations in real GDP, it is known as the real business cycle model.

Karl Marx: capitalism’s severest critic The schools of macroeconomic thought we have discussed in this appendix are considered part of mainstream economic theory because of their acceptance of the market system as the best means of raising living standards in the long run. One quite influential critic of mainstream economic theory was Karl Marx. Marx was born in Trier, Germany, in 1818. After graduating from the University of Berlin in 1841, he began a career as a political journalist and agitator. His political activities caused him to be expelled first from Germany and then from France and Belgium. In 1849 he moved to London, where he spent the remainder of his life. In 1867 Marx published the first volume of his greatest work, Das Kapital. Marx read closely the most prominent mainstream economists, including Adam Smith, David Ricardo and John Stuart Mill. But Marx believed that he understood how market systems would evolve in the long run much better than those earlier authors. Marx argued that the market system would eventually be replaced by a communist economy in which the workers would control production. He believed in the labour theory of value, which attributed all of the value of a good or service to the labour embodied in it. According to Marx, the owners of businesses—capitalists— did not earn profits by contributing anything of value to the production of goods or services. Instead, capitalists earned profits because their ‘monopoly of the means of production’—their ownership of factories and machinery—allowed them to exploit workers by paying them wages that were much lower than the value of workers’ contribution to production.

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New classical macroeconomics The macroeconomic theories of Robert Lucas and others, particularly the idea that workers and firms have rational expectations.

Real business cycle model A macroeconomic model that focuses on real, rather than monetary, causes of the business cycle.

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Marx argued that wages of workers would be driven to levels that allowed only bare survival. He also argued that small firms would be driven out of business by larger firms, forcing owners of small firms into the working class. Control of production would be concentrated in the hands of a few firms, which would have difficulty selling the goods they produced to the impoverished masses. A final economic crisis would lead the working classes to rise up, seize control of the economy and establish communism. Marx died in 1883 without having provided a detailed explanation of how the communist economy would operate. Marx had relatively little influence on mainstream thinking in the United States, United Kingdom and Australia, but several political parties in Europe were guided by his ideas. In 1917 the Bolshevik party seized control of Russia and established the Soviet Union, the first communist state. Although the Soviet Union was a vicious dictatorship under Vladimir Lenin and his successor, Joseph Stalin, its prestige rose when it avoided the macroeconomic difficulties that plagued the market economies during the 1930s. By the late 1940s communist parties also came to power in China and the countries of Eastern Europe. Eventually, poor economic performance led to the collapse of the Soviet Union and its replacement by a market system. Although the Communist Party remains in power in China, the economy is evolving towards a market system. Today only North Korea and Cuba have economies that claim to be based on the ideas of Karl Marx.

KEY TERMS Keynesian revolution monetarism

296 296

monetary growth rule 296 new classical macroeconomics 297

real business cycle model

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ENDNOTES 1

2

Nina Adam (2014), ‘German economic growth fails to gain impetus’, The Wall Street Journal, 15 January, at , viewed 20 January 2014. The Economist (2009), ‘Money’s muddled message’, The Economist, 19 March, at , viewed 20 January 2014.

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PA RT

6

MONE TARY AND FI SC AL PO LIC Y

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11

MONEY, BANKS AND THE RESERVE BANK OF AUSTRALIA LEARNING OBJECTIVES After studying this chapter you should be able to: 11.1 Define money and discuss its functions. 11.2 Discuss the definitions of the money supply used in Australia today. 11.3 Explain how financial institutions create money. 11.4 Discuss the role of the Reserve Bank of Australia. 11.5 Explain the quantity theory of money and use it to explain how high rates of inflation can occur.

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BURMA’S PEOPLE TURN TO GOLD FOR SAVINGS BURMA, CALLED THE Union of Myanmar by the military regime which rules the country, is the second largest country in Southeast Asia. It is also the poorest country in terms of GDP per capita in the Association of Southeast Asian Nations (ASEAN), the group of countries which also includes Brunei Darussalam, Cambodia, Indonesia, Laos, Malaysia, Philippines, Singapore, Thailand and Vietnam. Burma is a resource-rich country, with an abundance of natural gas, gold, oil, timber and arable land. However, Burma suffers from economic mismanagement, corruption and poverty. The Asian Development Bank has reported that around 26 per cent of the population live below the poverty line, with the highest concentration of poverty located in rural areas. Burma is a source country for the trafficking of women and children, and is the second largest producer of illicit opium in the world. While most of the population live in poverty, military leaders and corrupt business owners exploit the country’s natural resources. The economy’s serious macroeconomics problems include fiscal deficits, defaults on international debt repayments, high rates of inflation and a lack of reliable statistics on basic economic variables. Between 2005 and 2010 the average annual rate of inflation in Burma averaged around 20 per cent. Much of the inflation was due to the Burmese government printing money to finance building projects and the pay rises of public servants. The rapid inflation led to many Burmese people turning to other means of payment rather than the local currency, the kyat. The favourite alternative was gold, and gold traders were, in many respects, the alternative bankers. Gold was much more reliable as a store of value than money, so people kept gold rather than put their money in a bank. When inflation is high the value of savings kept in bank deposits falls rapidly. As a store of value gold is more reliable. High inflation rates also led to the rise of bartering in Burma. For the average Burma citizen there is no economic stability or decent alternative to gold in which to store their savings. It is regarded as an insurance against government policy. In fact gold has fulfilled this role for much of history where there is no reliable form of money. In 2011, the government initiated measures to reform and open up the economy and eased restrictions on the financial sector, which gave Burma greater access to international aid. However, it is generally thought that much more reform needs to be carried out. Even though by 2014 the inflation rate had fallen to 6 per cent, many businesses preferred to carry out transactions in US dollars because of lack of faith in the local currency. SOURCE: Central Intelligence Agency (CIA) (2014), The World Factbook, at , viewed 16 May 2014; Asian Development Bank (2012), Myanmar Fact Sheet, 31 December, at , viewed 21 January 2014; Rob Bryan (2010), ‘Citizens bank on gold in Burma’s troubled economy’, Bangkok Post, 29 October, at , viewed 21 January 2014. (Article in the Bangkok Post sourced from AFP News agency.)

11

Angelo Giampiccolo / Shutterstock.com

ECONOMICS IN YOUR LIFE

WHAT IF MONEY BECAME INCREASINGLY VALUABLE? Most people are used to the fact that as prices rise each year, the purchasing power of money falls. You will be able to buy fewer goods and services with $1000 one year from now than you can buy today, and you will be able to buy even fewer goods and services the year after that. In fact, with an inflation rate of just 3 per cent, in 25 years $1000 will buy only what $475 can buy today. Suppose, though, that you could live in an economy where the purchasing power of money rose each year? What would be the advantages and disadvantages of living in such an economy? As you read the chapter, see if you can answer these questions. You can check your answers against those we provide on page 321 at the end of this chapter.

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IN THIS CHAPTER we explore the role of money in the economy and we see how the banking system creates money. We also learn how the Reserve Bank of Australia— Australia’s central bank—controls the availability of funds in the financial system, thereby affecting interest rates. At the end of the chapter we explore the link between changes in the quantity of money and changes in the price level. What you learn in this chapter will serve as an important foundation to understanding monetary policy and fiscal policy, which we study in the chapters that follow.

WHAT IS MONEY AND WHY DO WE NEED IT? 11.1 Define money and discuss its functions. LEARNING OBJECTIVE

Money Assets that people are generally willing to accept in exchange for goods and services or for payment of debts. Asset Anything of value owned by a person or a firm.

Commodity money A good used as money that also has value independent of its use as money.

Could an economy function without money? We know the answer to this is ‘yes’, because there are many historical examples of economies in which people traded goods for other goods rather than using money. For example, a family operating a farm prior to a country having an accepted currency might trade a cow for a plough. Most economies, though, use money. What is money? The economic definition of money is any asset that people are generally willing to accept in exchange for goods and services or for payment of debts. An asset is anything of value owned by a person or a firm. There are many possible kinds of money: in West Africa at one time shells served as money. During World War II prisoners of war used cigarettes as money.

Barter and the invention of money To understand the importance of money let’s consider further the situation in economies that do not use money. These economies, where goods and services are traded directly for other goods and services, are called barter economies. Barter economies have a major shortcoming. To illustrate this shortcoming consider our farmer in early days before money. Suppose the farmer needs another cow and proposes to trade a spare plough to a neighbour for one of the neighbour’s cows. If the neighbour does not want the plough the trade will not happen. For a barter trade to take place between two people each person must want what the other one has. Economists refer to this requirement as a double coincidence of wants. The farmer who wants the cow might eventually be able to obtain one if he first trades with some other neighbour for something the neighbour with the cow wants. However, it may take several trades before the farmer is ultimately able to trade for what the neighbour with the cow wants. Locating several trading partners and making several intermediate trades can take considerable time and energy. The problems with barter provide an incentive to identify a product that most people will accept in exchange for what they have to trade. For example, in 1808 in Australia the ‘legal tender’ was not coins of the realm, for there was a shortage of those, but the only commodity plentiful enough to fill the void—rum! Successive Governors of New South Wales (NSW) tried to break down the position of economic privilege attained by the officers of the NSW Corps, including attempts to prevent them from illegal trading in rum, in which the officers, merchants and large landowners held a monopoly. A good used as money that also has value independent of its use as money is called a commodity money. Historically, once a good became widely accepted as money people who did not have an immediate use for it would be willing to accept it. For hundreds of years the cowrie shell, found on the shores of the Indian and Pacific Oceans, was widely used as money throughout Africa, Asia and the islands of the South Pacific. The symbol representing the cowrie was adopted as the word for money in ancient China. Cowries continued to be used as money in remote areas of Asia and Africa until the midtwentieth century. Trading goods and services is much easier once money becomes available. People only need to sell what they have for money and then use the money to buy what they want. If the farming family could find someone to buy their plough, they could use the money to buy the cow they wanted. The family with the cow would accept the money because they know they could use

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it to buy what they wanted. When money is available families will be less likely to produce everything or nearly everything they need themselves and are more likely to specialise. Most people in modern economies are highly specialised. They do only one thing—work as a nurse, an accountant or an engineer—and use the money they earn to buy everything else they need. As we discussed in Chapter 2, people become much more productive by specialising because they can pursue their comparative advantage. The high income levels in modern economies are based on the specialisation that money makes possible. We can now answer the question ‘Why do we need money?’. By making exchange easier, money allows for specialisation and higher productivity.

MONEY IN A WORLD WAR II PRISONER OF WAR CAMP

M

R.A. Radford has described his experiences as a captured British soldier in a German prisoner of war camp during World War II. At first, the prisoners traded the goods they received in packages from the Red Cross or from relatives at home on a barter basis, but the usual inefficiencies of barter led the prisoners to begin using cigarettes as money. Cigarettes were included in the Red Cross packages. According to Radford, ‘Everyone, including non-smokers, was willing to sell for cigarettes, using them to buy at another time and place. Cigarettes became the normal currency.’ Even a labour market developed: ‘Laundrymen advertised at two cigarettes a garment. Battle-dress [uniform] was scrubbed and pressed and a pair of trousers lent for the interim period for twelve…Odd tailoring and other jobs similarly had their prices.’ Prisoners set up small businesses in the camp, using cigarettes for money: ‘There was a coffee stall owner who sold tea, coffee or cocoa at two cigarettes a cup, buying his raw materials at market prices and hiring labour to gather fuel and to stoke; he actually enjoyed the services of a chartered accountant at one stage.’ Even a restaurant was organised ‘where food and hot drinks were sold while a band…performed.’

C

A K I N G THE

11.1

ONNECTION

Reg Speller / Stringer / Getty Images

In January 1945, near the end of the war, the Red Cross ration of cigarettes was During World War II cigarettes were used as money in some prisoner of war camps eliminated. Given that some of the prisoners were heavy smokers, most of the rest of the cigarette money disappeared from circulation—a disadvantage of this particular commodity money—and the camp went back to barter trading until it was liberated by the US 30th Infantry Division in April 1945. SOURCE: R.A. Radford (1945), ‘The economic organization of a P.O.W. camp’, Economica, Vol. 12, No. 48, pp. 189–201.

The functions of money Anything used as money—whether rum, a seashell or a $10 dollar note—should fulfil the following four functions: 1 Medium of exchange 2 Unit of account 3 Store of value 4 Standard of deferred payment

Medium of exchange Money serves as a medium of exchange when sellers are willing to accept it in exchange for goods or services. When the local supermarket accepts your $10 note in exchange for bread

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and milk, the $10 note is serving as a medium of exchange. To go back to our earlier example, with a medium of exchange the farmer with the extra plough does not have to want a cow, and the farmer with the extra cow does not have to want a plough. Both can exchange their products for money and use the money to buy what they want. An economy is more efficient when a single good is recognised as a medium of exchange.

Unit of account In a barter system each good has many prices. A cow may be worth two ploughs, four tonnes of wheat or eight axes. Using a good as a medium of exchange confers another benefit: it reduces the need to quote many different prices in trade. Instead of having to quote the price of a single good in terms of many other goods, each good has a single price quoted in terms of the medium of exchange. This function of money gives buyers and sellers a unit of account, a way of measuring value in the economy in terms of money. Because the Australian economy uses dollars as money, each good has a price in terms of dollars.

Store of value Money allows value to be stored easily: if you do not use all your accumulated dollars to buy goods and services today, you can hold the rest to use in the future. In fact, a fisherman and a farmer would be better off holding money rather than inventories of their perishable goods. The acceptability of money in future transactions depends on its not losing value over time. As we learned in the opening case, high rates of inflation can lead to money losing its value quite quickly. This has led to many people in Burma choosing to hold gold as a store of value. Money is not the only store of value. Any asset—Telstra shares, government bonds, real estate or Renoir paintings, for example—represents a store of value. Financial assets offer an important benefit relative to holding money because they generally pay a higher rate of interest or offer the prospect of gains in value. Other assets also have advantages relative to money because they provide services. A house, for example, offers you a place to live. Why, then, would you bother to hold any money? The answer has to do with liquidity, or the ease with which a given asset can be converted into the medium of exchange. When money is the medium of exchange it is the most liquid asset. You incur costs when you exchange other assets for money. When you sell bonds or shares to buy a car, for example, you pay a commission to your broker. If you have to sell your investment house on short notice to finance an unexpected major medical expense, you pay a commission to a real estate agent and probably have to accept a lower price to exchange the house for money quickly. To avoid such costs people are willing to hold some of their wealth in the form of money, even though other assets offer a greater return as a store of value.

Standard of deferred payment Money is useful because it can serve as a standard of deferred payment in borrowing and lending. Money can facilitate exchange at a given point in time by providing a medium of exchange and unit of account. It can facilitate exchange over time by providing a store of value and a standard of deferred payment. For example, a furniture maker may be willing to supply chairs to a large retailer, like Harvey Norman, in exchange for money in the future, usually within 30 days from the date of supply. Most employees do not get paid for their work by employers until a fortnight later. How important is it that money be a reliable store of value and standard of deferred payment? People care about how much food, clothing and other goods and services their dollars will buy. The value of money depends on its purchasing power, which refers to its ability to buy goods and services. As we saw in the situation of Burma in the opening case, inflation causes a decline in purchasing power because rising prices cause a given amount of money to purchase fewer goods and services. With deflation, the value of money increases because prices are falling.

What can serve as money? Having a medium of exchange helps to make transactions easier, allowing the economy to work more smoothly. The next logical question is this: what can serve as money? That is, which assets

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should be used as the medium of exchange? We saw earlier that an asset must, at a minimum, be generally accepted as payment to serve as money. In practical terms, however, it must be even more. Five criteria make a good suitable for use as a medium of exchange: 1 The good must be acceptable to (i.e. usable by) most people. 2 It should be of standardised quality so that any two units are identical. 3 It should be durable so that value is not lost by spoilage. 4 It should be valuable relative to its weight so that amounts large enough to be useful in trade can be easily transported. 5 The medium of exchange should be divisible because different goods are valued differently. Notes and coins meet all these criteria. What determines the acceptability of $20 notes as a medium of exchange? Basically, it is through self-fulfilling expectations: you value something as money only if you believe that others will accept it from you as payment. A society’s willingness to use dollars in various denominations as money makes them an acceptable medium of exchange. This property of acceptability is not unique to money. Your personal computer has the same keyboard organisation of letters as other computer keyboards because manufacturers agreed on a standard layout. You learned to speak English or some other language because it is probably the language that most people around you speak.

Commodity money Commodity money has value independent of its use as money. Gold, for example, was a common form of money in the nineteenth century because it was a medium of exchange, a unit of account, a store of value and a standard of deferred payment. But commodity money has a significant problem: its value depends on its purity. Therefore, someone who wanted to cheat could mix impure metals with a precious metal. Unless traders trusted each other completely they needed to check the weight and purity of the metal at each trade. Another problem with using gold as money was that the supply of money in an economy was difficult to control because it depended partly on unpredictable discoveries of new gold fields.

Fiat money It can be inefficient for an economy to rely only on gold or other precious metals for its money supply. What if you had to transport bars of gold to settle your transactions? Not only would doing so be difficult and costly, but you would also run the risk of being robbed. To get around this problem private institutions or governments began to store gold and issue paper certificates that could be redeemed for gold. In modern economies paper (or plastic in Australia) currency is generally issued by a central bank, which is an agency of the government. Today no government in the world issues paper currency that can be redeemed for gold. Paper currency has no value unless it is used as money and is therefore not commodity money. Instead, paper currency is a fiat money, which has no value except as money. If paper currency has no value except as money why do consumers and firms use it? If you look at the top of an Australian $20 note you will see that it is issued by the Reserve Bank of Australia (RBA), which is the central bank in Australia. It has the signatures of the Secretary to the Treasury and the Governor of the Reserve Bank. Because Australian dollars are fiat money, the RBA is not required to give you gold or silver for your dollar notes. The currency is legal tender in Australia, which means that the federal government requires that it be accepted in payment of debts and requires that cash or cheques denominated in dollars be used in payment of taxes. Despite being legal tender, dollar notes would not be a good medium of exchange and could not serve as money if they weren’t widely accepted by people. The key to this acceptance is that households and firms have confidence that if they accept dollars in exchange for goods and services, the dollars will not lose much value during the time they hold them. Without this confidence dollar notes would not serve as a medium of exchange.

Fiat money Money, such as paper currency, that is authorised by a central bank or government body and that does not have to be exchanged by the central bank for gold or some other commodity money. Reserve Bank of Australia The central bank of Australia.

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M

C

A K I N G THE

11.2

ONNECTION

COCA-COLA DRIES UP AS THE ZIMBABWE CURRENCY NO LONGER SERVES AS MONEY People in Africa buy more than 36 billion bottles of Coca-Cola a year. In 2008, Zimbabwe, a country in southern Africa, ran out of locally produced Coke for the first time in at least 40 years. Because they could not obtain US dollars, local Coke bottlers were not able to import from the United States the concentrated syrup used to make the soft drink. A meagre amount of Coke was imported from South Africa, but a single bottle sold for around 15 billion Zimbabwean dollars! Zimbabwe was suffering the effects of hyperinflation. Zimbabwe’s hyperinflation was of epic proportions. When it was first introduced in 1980, 1 Zimbabwean dollar was worth 1.47 US dollars. By the end of 2008, the exchange rate was 1 US dollar to 2 billion Zimbabwean dollars, and prices for some large transactions in Zimbabwe were calculated in quadrillions (15 zeros) and quintillions (18 zeros).

Marco Di Lauro/Getty Images

Local businesses struggled to supply Coke when supplying countries were unwilling to accept Zimbabwean dollars as payment

In addition to the Coke shortage, Zimbabweans were suffering shortages of fuel, food and other basic goods. As the value of the Zimbabwean currency fell against other currencies, it was difficult for local businesses such as the Coke bottlers to find anyone willing to exchange US dollars for Zimbabwean dollars. What made Zimbabwe’s currency almost worthless? The government of Zimbabwe had decided to pay for all of its expenses by printing more and more money. The faster the government printed money, the faster prices rose. Eventually, both foreigners and local residents refused to accept the Zimbabwean dollar in exchange for goods and services, and the country’s economy plunged into a devastating recession, with real GDP falling more than 12 per cent during 2008. In early 2009, the government issued 100 trillion dollar bills, not enough for a bus ticket in Harare, Zimbabwe’s capital city. Eventually, in 2009, a new Zimbabwean government took the drastic step of abandoning its own currency and making the US dollar the country’s official currency.

SOURCE: Angus Shaw (2009), ‘Coca Cola dries up in Zimbabwe’, Newzimbabwe.com, 11 December, at , viewed 21 January 2014; The Economist (2008), ‘Index of happiness? A bottle of coke tracks change in Africa’, 3 July, at , viewed 21 January 2014; Patrick McGroarty and Farai Mutsaka (2011), ‘How to turn 100 trillion dollars into five and feel good about it’, The Wall Street Journal, 11 May, at , viewed 21 January 2014; Marcus Walker and Andrew Higgins (2008), ‘Zimbabwe can’t paper over its million-percent inflation anymore,’ The Wall Street Journal, 2 July, at , viewed 21 January 2014.

HOW DO WE MEASURE MONEY TODAY? 11.2 Discuss the definitions of the money supply used in Australia today. LEARNING OBJECTIVE

Currency Notes and coins held by the private non-bank sector.

A narrow definition of money would include only those assets that obviously function as a medium of exchange: currency and accessible bank account deposits. These assets can be easily used to buy goods and services, and thus act as a medium of exchange. This strict interpretation is too narrow, however, as a measure of the money supply in the real world. Many other assets can be used as a medium of exchange, although they are not as liquid as currency or a deposit in a bank demand account. For example, you can purchase goods and services at most stores by electronic funds transfer at point of sale (EFTPOS). You can convert your savings account or term deposit at a bank into cash. Although these assets have restrictions on their use and there may be costs to converting them into cash, they can be considered part of the medium of exchange. Economists have developed several different definitions of the money supply. Each definition includes a different group of assets. The definitions range from narrow to broad and are based on how liquid the assets are. The narrowest measure of money is currency, which is made up of notes and coins held by the private non-bank sector (individuals and firms). Broader measures include other assets that can be easily converted to cash, such as your savings

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account or cheque account. The job of defining the money supply has become more difficult during the past two decades as innovation in financial markets and institutions has created new substitutes for the traditional measures of the medium of exchange. For example, currency has become far less important as a means of exchange with the increased use of EFTPOS, debit cards and credit cards. We will now look more closely at the definitions of the money supply.

M1: the narrowest definition of the money supply Figure 11.1 illustrates the definitions of the money supply. The narrowest definition of the money supply is called M1, which is composed of currency plus the value of all demand deposits with banks. Demand deposits (also called current deposits) are deposits in financial institutions that are transferable by cheque, by debit cards at EFTPOS terminals and through electronic transfer between accounts. They are called demand deposits because they are available on demand, and are repayable on demand in notes and coins. Such instruments are true transactions money, and this is reinforced by the fact that banks pay little or no interest on demand deposits. This is the essential ‘transactions core’ of any monetary aggregate.

Broader definitions of money Broader measures of money include other assets which can be converted to money fairly quickly. M2 is no longer used in Australia so will not be discussed here.

The M3 measure of money supply M3 remains an important measure of the money supply, although, as we will see below, the definition of the money supply continues to broaden over time. M3 comprises M1, plus all other deposits of the private non-bank sector with domestic and foreign-owned banks operating in Australia. Specifically, in addition to M1, M3 also includes certificates of deposit, term deposits and deposits with banks from building societies, credit unions and other authorised deposit-taking institutions (ADIs). Certificates of deposit are large savings deposits written in certificate form that also pay high interest and behave like commercial bills. Currency accounts for less than 4 per cent of M3 in total and current deposits a further

M1 The narrowest definition of the money supply which is composed of currency plus the value of all demand deposits with banks. Demand deposits Also called current deposits, these are deposits in financial institutions that are transferable by cheque, by debit cards at EFTPOS terminals and through electronic transfer between accounts. They are called demand deposits because they are available on demand, and are repayable on demand in notes and coins. M3 M1, plus all other deposits of the private non-bank sector with domestic and foreignowned banks operating in Australia.

FIGURE 11.1

Measuring the money supply, Australia, March 2014 The Reserve Bank of Australia uses several different measures of the money supply. In the pyramid each measure includes the assets of the measure above it, as well as additional assets

What’s measured? Narrow medium of exchange

Currency M1

$292.6 billion

M3

Broader medium of exchange

$57.2 billion

$1629.2 billion $1636.3 billion

Broader medium of exchange and store of value

Broad money

What’s included? Currency Notes and coins in circulation

M1 Currency + the value of all demand deposits with banks

M3 M1+ all other deposits of the private non-bank sector with domestic and foreign-owned banks operating in Australia

Broad Money M3+ deposits in other non-bank deposit-taking financial institutions, minus holdings of currency and deposits of non-bank depository corporations

SOURCE: Created from Reserve Bank of Australia (2014), Monetary Aggregates, Table D03, at , viewed 16 May 2014.

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14 per cent. The largest item is term deposits, far less ‘monetary’ in their characteristics, which are fixed-term higher-earning accounts with banks at terms of up to five years. They are also included as ‘money’ despite being relatively awkward to access at short notice for transactions purposes. Notice that M3 does not include deposits with some non-bank institutions such as finance companies. It includes only deposits with ADIs, which historically have been banks, and since 1999 also includes credit unions, building societies and a number of other institutions including PayPal Australia. ADIs are subject to the Banking Act 1959 and prudential supervision by the federal Australian Prudential Regulation Authority (APRA), whereas other non-bank institutions are not bound by APRA regulations.

Broad money Broad money M3, plus deposits with non-bank deposit-taking institutions minus holdings of currency and deposits of non-bank depository corporations.

Credit Loans, advances and bills provided to the private non-bank sector (individuals and firms) by all financial intermediaries.

DON’T LET THIS HAPPEN TO YOU

Broad money is a wider measure of Australia’s money supply. It comprises M3, plus deposits with non-bank deposit-taking institutions minus holdings of currency and deposits of nonbank depository corporations. Non-bank depository corporations include finance companies, money market corporations and cash management trusts. Non-bank depository corporations are registered with APRA but are not subject to the same prudential requirements.

Credit Credit is not a form of money, but it is now used by the RBA as the main measure of monetary movements in Australia. Credit is defined as loans, advances and bills provided to the private non-bank sector (individuals and firms) by all financial intermediaries—not just ADIs. The measure of credit enables the RBA to determine in general whether more funds are being loaned, or whether there has been a contraction in the volume of funds advanced. In Australia the level of credit totalled $2237.9 billion in March 2014, of which $905 billion was for owner-occupier housing loans, $445.1 billion was for housing loans for investment purposes, $141.8 billion for other personal loans (of which credit cards accounted for $49.8 billion) and $746 billion for business loans. The question may be asked why credit is not considered to be part of the money supply. If we use the example of credit cards we know that many people buy goods and services with credit cards. The reason that credit cards are not considered to be part of the money supply is that when you buy something with a credit card you are in effect taking out a loan from the bank that issued the credit card. Only when you pay your credit card bill at the end of the

Don’t confuse money with income or wealth Gina Rinehart’s wealth of an estimated $20 billion made her the richest person in Australia and the fifth richest woman in the world in 2014. She also has a very large income, but how much money does she have? A person’s wealth is equal to the value of their assets minus the value of any debts they have. A person’s income is equal to their earnings during the year. Gina Rinehart’s earnings as an iron-ore magnate and from her investments are very large. But her money is just equal to what she has in currency and in bank accounts. Only a small proportion of Rinehart’s $20 billion in wealth is likely to be in currency or bank accounts. Most of her wealth is invested in shares and bonds and other financial assets that are not included in the definition of money. In everyday conversation, we often describe someone who is wealthy or who has a high income as ‘having a lot of money’. However, it is important to be clear about the differences between wealth, income and money. Just as money and income are not the same for a person, so they are not the same for the whole economy. National income in Australia in 2013 was approximately $1.53 trillion for the year. By the end of 2013 the money supply, as measured by broad money, was very similar, at just over $1.6 trillion. However, there is no reason national income in a country should be equal to the country’s money supply, nor will an increase in a country’s money supply necessarily increase the country’s national income.

[ YOUR TURN Q

Test your understanding by doing related problems 2.7 and 2.8 on page 325 at the end of this chapter.

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month—usually at an ATM or via the Internet or telephone from your bank account—is the transaction complete. However, as discussed above, the RBA uses credit as its main measure of monetary activity, given its importance in the financial sector and the economy.

HOW DO FINANCIAL INSTITUTIONS CREATE MONEY? To understand the role money plays in the economy we need to look more closely at how banks and other financial institutions, such as building societies and credit unions, operate. They are profit-making private businesses, just like bookshops and supermarkets. The key role that banks and other financial institutions play in the economy is to accept deposits and make loans. By doing this they create demand deposit accounts, from which money can easily be withdrawn ‘on demand’.

11.3 Explain how financial institutions create money. LEARNING OBJECTIVE

Bank balance sheets To understand how financial institutions create money we will briefly examine a typical bank balance sheet. On a balance sheet, a firm’s assets are listed on the left and its liabilities and shareholders’ equity are listed on the right. Assets are the value of anything owned by the firm, liabilities are the value of anything the firm owes, and shareholders’ equity is the difference between the total value of assets and the total value of liabilities. Shareholders’ equity represents the value of the firm if it had to be closed, all of its assets were sold and all of its liabilities were paid off. A corporation’s shareholders’ equity is also referred to as its net worth. Figure 11.2 shows the balance sheet of Save-IT Bank. The key assets on a bank’s balance sheet are its reserves, loans and holdings of securities, such as Commonwealth government bonds. Reserves are deposits that a bank has retained, rather than loaned out or invested by, for instance, buying a government bond. Banks keep reserves either physically within the bank, as vault cash, or on deposit with the RBA, to provide a cushion against loan losses, adverse economic trends and excessive withdrawals by depositors which could cause the bank to become insolvent. Most countries have a legal requirement that banks keep reserves; however, the requirements differ between countries, and are commonly between 7 per cent and

Reserves Deposits that a bank keeps as cash in its vault or on deposit with the Reserve Bank of Australia.

FIGURE 11.2

Balance sheet for Save-IT Bank The items on a bank’s balance sheet of greatest economic importance are its reserves, loans and deposits. Notice that the difference between the value of Save-IT’s total assets and its total liabilities is equal to its shareholders’ equity. As a consequence, the left side of the balance sheet always equals the right side Note: Some entries have been combined to simplify the balance sheet.

ASSETS ($ MILLIONS) Reserves Loans Deposits with other banks Securities Buildings and equipment

LIABILITIES AND SHAREHOLDERS’ EQUITY ($ MILLIONS) 50 000 240 000 5 000

Deposits

300 000

Short-term borrowing

60 000

Long-term debt

50 000

100 000

Other liabilities

40 000

5 000

Total liabilities

450 000

Other assets

110 000

Shareholders’ equity

Total assets

510 000

Total liabilities and shareholders’ equity

60 000 510 000

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10 per cent. Legal reserve requirements in Australia were largely abolished in 1988; however, as part of a post-global financial crisis international agreement, legal limits were again introduced, and by 2016 will stand at 8 per cent in Australia. The balance sheet in Figure 11.2 shows that loans are Save-IT’s largest asset, which is true of most banks. Banks make consumer loans to households and commercial loans to businesses. A loan is an asset to a bank because it represents a promise by the person taking out the loan to make certain specified payments to the bank. A bank’s reserves and its holdings of securities are also assets because they are things of value owned by the bank. As with most banks, Save-IT’s largest liability is its deposits. Deposits include savings accounts, cheque accounts and certificates of deposits. Deposits are liabilities to banks because they are owed to the households or firms that have deposited the funds. If you deposit $100 in your savings account, the bank owes you the $100 and you can ask for it back at any time. So your savings account is an asset to you and it is a liability to the bank.

Using T-accounts to show how a bank can create money It is easier to show how banks create money by using a T-account rather than by using a balance sheet. A T-account is a stripped-down version of a balance sheet that shows only how a transaction changes a bank’s balance sheet. Individual accounts are often represented as a ‘T’ shape. This makes it easy to identify the debit entries (they are always on the left) and credit entries (they are always on the right). For example, suppose you deposit $1000 in currency into a demand account, such as a savings account, at Save-IT Bank. This transaction raises the total deposits at Save-IT by $1000 and also raises Save-IT’s reserves by $1000. We can show this on the following T-account: Assets Reserves +$1000

Liabilities Deposits +$1000

Your deposit of $1000 into your savings account increases Save-IT’s assets and liabilities by the same amount.

The total value of all the entries on the right side of a balance sheet must always be equal to the total value of all the entries on the left side of a balance sheet, therefore any transaction that increases (or decreases) one side of the balance sheet must also increase (or decrease) the other side of the balance sheet. In this case, the T-account shows that we increased both sides of the balance sheet by $1000. Initially, this transaction does not increase the money supply. The currency component of the money supply declines by $1000 because the $1000 you deposited is no longer in circulation and therefore is not counted in the money supply. But the decrease in currency is offset by a $1000 increase in the savings account deposit component of the money supply. This initial change is not the end of the story, however. Suppose banks usually keep 10 per cent of deposits as reserves. Because banks do not earn interest on reserves they have an incentive to loan out or buy securities with the other 90 per cent. In this case, Save-IT can keep $100 as reserves and loan out the other $900, which represents excess reserves. Suppose Save-IT loans out the $900 to someone to buy a used motorcycle. Save-IT could give the $900 to the borrower in currency, but usually banks make loans by increasing the borrower’s savings account. We can show this with another T-account: Assets Reserves Loans

Liabilities

+$1000 Deposits +$900 Deposits

1. By loaning out $900 in excess reserves . . .

+$1000 +$900

2. . . . Save-IT has increased the money supply by $900.

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A key point to recognise is that by making this $900 loan, Save-IT has increased the money supply by $900. The initial $1000 in currency you deposited into your savings account has been turned into $1900 in savings account deposits—a net increase in the money supply of $900. But the story does not end here. The person who took out the $900 loan did so to buy a used motorcycle. To keep things simple, let’s suppose he buys the motorcycle for exactly $900 and pays by writing a cheque on his bank account at Save-IT. The person who sold the used motorcycle will now deposit the cheque into her savings account at her bank. That bank may also be a branch of Save-IT, but in most cities there are many banks so let’s assume that the seller of the motorcycle has her account at a branch of Thrifty Bank. Once she deposits the cheque, Thrifty will send it to Save-IT Bank to be cleared and collect the $900. We can show the result using T-accounts: Save-IT Assets Reserves Loans

Liabilities +$100 +$900

1. When the $900 cheque that was deposited in a Thrifty Bank account arrives to be cleared, the increase in Save-IT’s reserves (shown in the previous T-account) falls by $900 to $100 . . .

Deposits

+$1000

2. . . . and the increase in Save-IT’s deposits falls by $900 to $1000.

Once the motorcycle buyer’s cheque has cleared, Save-IT has lost $900 in deposits—the amount loaned to the motorcycle buyer—and $900 in reserves—the amount it had to pay Thrifty when Thrifty sent it the motorcycle buyer’s cheque. Thrifty has an increase in account deposits of $900—the deposit of the cheque for $900 by the motorcycle seller—and an increase in reserves of $900—the amount it received from Save-IT. Thrifty Bank Assets Reserves

Liabilities +$900

Deposits

+$900

After the cheque drawn on the account at Save-IT clears, Thrifty Bank’s reserves and deposits both increase by $900.

Thrifty has 100 per cent reserves against this new $900 deposit, when it only needs 10 per cent reserves. It has an incentive to keep $90 as reserves and to loan out the other $810, which are excess reserves. If Thrifty does this we can show the change in its balance sheet using another T-account. In loaning out the $810 in excess reserves, Thrifty creates a new deposit in a bank account of $810. The initial deposit of $1000 in currency into Save-IT Bank has now resulted in the creation of $1000 + $900 + $810 = $2710 in bank account deposits. The money supply has increased by $2710 – $1000 = $1710. The process is still not finished! The person who borrows the $810 will spend it. Whoever receives the $810 will deposit it in their bank. That bank will have an incentive to loan out 90  per cent of these reserves—keeping 10 per cent as reserves—and the process will go on. At each stage, the additional loans being made and the additional deposits being created are shrinking by 10 per cent, as we assumed that each bank kept that amount as reserves. We can show the total increase in demand account deposits set off by your initial deposit of $1000:

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INCREASE IN DEMAND ACCOUNT DEPOSITS

Save-IT

$1000

Thrifty

900

(= 0.9 × $1000)

Third Bank

810

(= 0.9 × $900)

Fourth Bank

729

(= 0.9 × $810)

•

•

•

•

•

•

Total change in demand account deposits

$10 000

The simple deposit multiplier Simple deposit multiplier The ratio of the amount of deposits created by banks to the amount of new reserves.

Your initial deposit of $1000 increased the reserves of the banking system by $1000 and led to a total increase in demand account deposits of $10 000. The ratio of the amount of deposits created by banks to the amount of new reserves is called the simple deposit multiplier. In this case, the simple deposit multiplier is equal to $10 000/$1000 = 10. Why 10? How do we know that your initial $1000 deposit ultimately leads to a total increase in deposits of $10 000? There are two ways to answer this question. First, each bank in the process is keeping reserves equal to 10 per cent of its deposits. For the banking system as a whole, the total increase in reserves is $1000—the amount of your original currency deposit. Therefore, the system as a whole will end up with $10 000 in deposits, because $1000 is 10 per cent of $10 000. A second way to answer the question is by deriving an expression for the simple deposit multiplier using the method we used with the expenditure multiplier in Chapter 9. The total increase in deposits equals: $1000 + 0.9 × $1000 + (0.9 × 0.9) × $1000 + (0.9 × 0.9 × 0.9) × $1000 + … Or $1000 + 0.9 × $1000 + 0.92 × $1000 + 0.93 × $1000 + … Or $1000 × (1 + 0.9 + 0.92 + 0.93 + …) An expression like the one in parentheses sums to: 1 1  0.9

Simplifying further we have: 1  10 0.10

So, The total increase in deposits = $1000 × 10 = $10 000 Note that 10 is equal to 1 divided by the banks’ reserve ratio, RR, which in this case is 10 per cent, or 0.10. This gives us another way of expressing the simple deposit multiplier: Simple deposit multiplier 

1 RR

This formula makes it clear that the higher the reserve ratio the smaller the simple deposit multiplier. With a reserve ratio of 10 per cent, the simple deposit multiplier is 10. If the reserve ratio were 20 per cent, the simple deposit multiplier would fall to 1/0.20, or 5. We can use this

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formula to calculate the total increase in demand account deposits from an increase in bank reserves due to, for instance, currency being deposited in a bank: Change in demand account deposits = change in bank reserves ×

1 RR

For example, if $100 000 in currency is deposited in a bank and the reserve ratio is 10 per cent, then: Change in demand account deposits = $100 000 ×

1 = $100 000 × 10 = $1 000 000 0.10

SOLVED PROBLEM 11.1 SHOWING HOW BANKS CREATE MONEY Suppose you deposit $5000 in currency into your savings account at a branch of Thrifty Bank, which we will assume has no excess reserves at the time you make your deposit. Also assume that their reserve ratio is 0.10. 1

Use a T-account to show the initial effect of this transaction on Thrifty’s balance sheet.

2

Suppose that Thrifty makes the maximum loan it can from the funds you deposited. Use a T-account to show the initial effect on Thrifty’s balance sheet from granting the loan. Also include in this T-account the transaction from question 1.

3

Now suppose that whoever took out the loan in question 2 writes a cheque for this amount and that the person receiving the cheque deposits it in Save-IT Bank. Show the effect of these transactions on the balance sheets of Thrifty Bank and Save-IT Bank, after the cheque has been cleared. On the T-account for Thrifty Bank, include the transactions from questions 1 and 2.

4

What is the maximum increase in savings account deposits that can result from your $5000 deposit? What is the maximum increase in the money supply? Explain.

Solving the problem STEP 1: Review the chapter material. This problem is about how banks create demand account deposits, so you may want to review

the section ‘Using T-accounts to show how a bank can create money’, which begins on page 310. STEP 2: Answer question 1 by using a T-account to show the impact of the deposit. Keeping in mind that T-accounts show only

the changes in a balance sheet that result from the relevant transaction and that assets are on the left side of the account and liabilities are on the right side, we have: Thrifty Bank Assets Reserves

Liabilities

+$5000

Deposits

+$5000

Because the bank now has your $5000 in currency in its vault, its reserves (and therefore its assets) have risen by $5000. But this transaction also increases your savings account balance by $5000. Because the bank owes you this money, the bank’s liabilities have also risen by $5000. STEP 3: Answer question 2 by using a T-account to show the effect of the loan. The problem tells you to assume that Thrifty Bank

currently has no excess reserves and that its reserve ratio is 10 per cent. This ratio means that if the bank’s savings account deposits go up by $5000, they keep $500 as reserves and can loan out the remaining $4500. Remembering that new loans usually take the form of setting up, or increasing, a savings account for the borrower, we have: Thrifty Bank Assets Reserves Loans

+$5000 +$4500

Liabilities Deposits Deposits

+$5000 +$4500

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The first line of the T-account shows the transaction from question 1. The second line shows that Thrifty has loaned out $4500 by increasing the savings account of the borrower by $4500. The loan is an asset to Thrifty because it represents a promise by the borrower to make certain payments as specified in the loan agreement. STEP 4: Answer question 3 by using T-accounts for Thrifty and Save-IT to show the impact of the cheque clearing. We now show

the effect of the borrower using their loan of $4500 from Thrifty to pay a contractor with a cheque. The person who received the $4500 deposits it in her savings account at Save-IT. We need two T-accounts to show this: Thrifty Bank Assets Reserves Loans

Liabilities

+$500 Deposits +$4500

+$5000

Save-IT Bank Assets Reserves

Liabilities

+$4500 Deposits

+$4500

Look first at the T-account for Thrifty. Once Save-IT sends the cheque written by the borrower to Thrifty, Thrifty loses $4500 in reserves and Save-IT gains $4500 in reserves. The $4500 is also deducted from the account of the borrower. Thrifty is now satisfied with the result. It received a $5000 deposit in currency from you. When that money was sitting in the bank vault it wasn’t earning any interest for Thrifty. Now $4500 of the $5000 has been loaned out and is earning interest. These interest payments allow Thrifty to cover its costs and earn a profit, which it has to do to remain in business. Save-IT now has an increase in deposits of $4500, resulting from the cheque being deposited, and an increase in reserves of $4500. Save-IT is in the same situation as Thrifty was in question 1: it has excess reserves as a result of this transaction and a strong incentive to lend them out in order to earn some interest. STEP 5: Answer question 4 by using the simple deposit multiplier formula to calculate the maximum increase in savings account

deposits and the maximum increase in the money supply. The simple deposit multiplier expression is (remember that RR is the reserve ratio): Change in demand account deposits = change in bank reserves ×

1 RR

In this case, bank reserves rose by $5000 as a result of your initial deposit and the reserve ratio is 0.10, so Change in demand account deposits = $5000 ×

1 = $5000 × 10 = $50 000 0.10

Because savings account deposits are part of the money supply, it is tempting to say that the money supply has also increased by $50 000. Remember, though, that your $5000 in currency was counted as part of the money supply while you had it, but it is not included when it is sitting in a bank vault. Therefore, Increase in demand account deposits – decline in currency in circulation = change in the money supply Or $50 000 – $5000 = $45 000

[ YOUR TURN Q

For more practice do related problem 3.10 on page 326 at the end of the chapter.

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The simple deposit multiplier versus the real-world deposit multiplier The story we have told about the way an increase in reserves in the banking system leads to the creation of new deposits and therefore an increase in the money supply has been simplified in two ways. First, we assumed that banks only hold reserves of 10 per cent. That is, we assumed that when you deposited $1000 in currency into your savings account at Save-IT Bank, Save-IT loaned out $900, keeping only the $100 in reserves. In fact, banks may keep extra reserves to guard against the possibility that many depositors may simultaneously make withdrawals from their accounts. The more reserves banks keep, the smaller the deposit multiplier. Imagine an extreme case where Save-IT keeps your entire $1000 as reserves. If Save-IT does not loan out any of your deposit, the process described earlier of loans leading to the creation of new deposits, leading to the making of additional loans and so on will not take place. The $1000 increase in reserves will lead to a total increase of $1000 in deposits, and the deposit multiplier will be only 1, not 10. Second, we assumed that the whole amount of every transaction is deposited in a bank; no one takes any of it out as currency. In reality, households and firms keep roughly constant the amount of currency they hold relative to the value of their savings account balances. So, we would expect to see people increasing the amount of currency they hold as the balances in their savings accounts rise. Once again, think of the extreme case. Suppose that when SaveIT makes the initial $900 loan to the borrower who wants to buy a used motorcycle, the seller of the motorcycle cashes the cheque and spends the money, instead of depositing it in her bank account. In that case Thrifty Bank does not receive any new reserves and does not make any new loans. Once again, the $1000 increase in your savings account at Save-IT is the only increase in deposits, and the deposit multiplier is 1. Although for simplicity we have considered only savings accounts, in practice in Australia we should consider not just savings but all the other components of demand deposits such as debit cards at point-of-sales terminals and electronic transfers between accounts. Although the story of the deposit multiplier can be complicated, the key point to bear in mind is that the most important part of the money supply is the demand account balance component. When banks and other financial institutions make loans they increase demand account balances, and the money supply expands. Banks make new loans whenever they gain reserves. The whole process can also work in reverse. If banks lose reserves, they reduce their outstanding loans and deposits, and the money supply contracts. We can summarise these important conclusions: 1 Whenever banks gain reserves they make new loans and the money supply expands. 2 Whenever banks lose reserves they reduce their loans and the money supply contracts.

THE RESERVE BANK OF AUSTRALIA We discussed in Chapter 5 that a well-functioning financial system is essential to enable economic growth to occur. No country without a well-developed financial system has been able to sustain high levels of economic growth. We noted that a country’s financial system comprises financial markets and financial intermediaries—banks and non-bank financial institutions—that act as go-betweens for borrowers and lenders. At the centre of a country’s financial system is its central bank—in Australia, the Reserve Bank of Australia (RBA). The RBA has two main essential roles: to maintain the financial integrity and stability of Australia’s financial system; and to manage and implement monetary policy. A stable financial system is one in which financial intermediaries facilitate the smooth flow of funds between borrowers and lenders, and thereby enable economic activity to occur. The RBA involves itself in the prevention of financial disturbances and crises that could threaten the smooth flow of funds. For example, the RBA monitors and, if necessary, controls the rate of credit growth, which if rapid and accompanied by high inflation can destabilise financial markets. The RBA is also responsible for the production, issue, reissue or cancellation of coins and notes in the economy. Notes are printed by Note Printing Australia in Victoria—a separately incorporated

11.4 Discuss the role of the Reserve Bank of Australia. LEARNING OBJECTIVE

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Monetary policy The actions taken by the Reserve Bank of Australia to manage interest rates in the pursuit of macroeconomic goals.

subsidiary of the RBA. Coins are produced by the Royal Australian Mint in Canberra. The RBA must also ensure that money in circulation remains free of counterfeit notes. Monetary policy refers to the actions taken by the RBA to manage interest rates in the pursuit of macroeconomic goals. In Australia the primary goal of the RBA is to keep the inflation rate low. The RBA pursues monetary policy largely independently of the federal government. This frees it from the possible constraints of the political process. Independence of the central bank from the government varies from country to country, and certainly does not apply to all countries. Since 1993 the RBA has determined that the maintenance of low inflation is the best role it can play in helping Australia achieve economic growth and prosperity. A low rate of inflation provides increased certainty for business and for consumers, and contributes to the international competitiveness of Australia’s goods and services, both of which will enable the achievement of economic growth, and therefore employment and economic prosperity. Monetary policy in Australia aims to keep the rate of inflation between 2 per cent and 3 per cent per year on a medium-term average. This inflation target is the central focus of monetary policy in Australia. The RBA can also use monetary policy during economic contractions or recessions, as it did in response to the 2007–2008 global financial crisis (GFC), to avoid or lessen the effects of recession. We will examine monetary policy in more detail in the next chapter.

How the RBA manages financial liquidity and interest rates

Cash rate The interest rate that financial institutions charge on loans or pay to borrow funds in the overnight money market.

Open market operations The RBA purchasing or selling financial instruments such as Commonwealth Government Securities and private bonds and securities, either by outright purchase or sale, or by the use of repurchase agreements.

Decisions about monetary policy are made by the Reserve Bank Board, which comprises the Governor of the RBA, the Deputy Governor, the secretary to the Federal Government Treasury and six external members from business and academia. Members of the board usually meet 11 times a year on the first Tuesday of each month (except January) to decide whether current interest rates are sufficient to control inflation and meet the objectives of the RBA Act. If interest rates are to be changed, this is usually announced to the public following the board meeting. For the majority of the time involvement in the financial system revolves around altering daily liquidity in the financial system to keep interest rates unchanged. Every day there is a large volume of withdrawals from, and injections into, the financial system. This leads banks and other financial institutions to experience a shortage or a surplus of funds at the end of the day. If banks and other financial institutions experience a shortage of funds at the end of  the day, this has to be purchased overnight on the short-term money market. This increases the demand for overnight funds—known as cash. According to the law of demand, this pushes up the price of overnight funds, which is the interest rate that financial institutions charge on loans or pay to borrow funds in the overnight money market, known as the cash rate. Similarly, a surplus of funds at the end of a day would increase the supply of funds (a cash surplus) on the overnight money market, and put downward pressure on the cash rate. The cash rate is the rate upon which all other interest rates are based. Without RBA intervention, these daily changes in liquidity would cause interest rates to fluctuate wildly and frequently. For example, consider what happens to banks’ monetary reserves on the day each fortnight that the federal government pays its public sector wages and makes its social security payments. On these ‘pay days’, there is an increase in demand by the public for money which can cause banks to be in deficit at the end of the day. Without RBA intervention the overnight cash rate would rise. As the cash rate underpins all other interest rates, a rise in the cash rate would soon lead to increases in other interest rates such as deposit rates, and lending rates including personal loans, mortgages and credit cards. Similarly, on the days when the federal government transfers Goods and Services Tax (GST) receipts to state and territory governments, surpluses of funds occurs in the financial system and without RBA intervention the rate of interest would fall.

Open market operations The RBA sterilises, or offsets, the daily deficits or surpluses in liquidity in the financial system through the use of open market operations —also referred to as domestic market operations. This will be examined in greater detail in the next chapter. Open market operations (OMOs) involve the RBA purchasing or selling financial instruments such as Commonwealth

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Government Securities (CGS) and private bonds and securities, either by outright purchase or sale, or by the use of repurchase agreements. A repurchase agreement is when the RBA offers to buy (or sell) CGS and other eligible financial instruments, from banks or other authorised financial dealers, provided the same banks or dealers are prepared to repurchase (or resell) them in the immediate future, often in a few days’ time, at a price agreed at the outset. Therefore repurchase agreements change the available liquidity by temporarily transferring ownership of securities between banks and the RBA in exchange for same-day cash. The use of repurchase agreements, instead of the outright purchase of bonds and securities, became the dominant means of altering liquidity in the financial system in the late 1990s to the mid-2000s. This was in part because the federal government operated with budget surpluses during this time, and therefore did not need to supply as many CGS to raise funds to finance budget deficits. However, in 2009 the effects of the GFC together with large government spending programs moved the budget into a substantial deficit position. To fund this, once again the government began selling large quantities of securities. However, repurchase agreements continue to be used in the financial system since they are very liquid assets. As we have discussed, the majority of RBA intervention in financial markets is carried out to offset daily liquidity changes to keep interest rates at the same level. However, if the RBA wishes to increase or decrease interest rates as part of its monetary policy objectives, it has to change liquidity levels actively in addition to its daily interventions. Or the RBA may deliberately not offset overnight cash surpluses or deficits, leading to the cash rate making a quantum move. Therefore, because the RBA controls the supply of scarce same-day funds, essential for banks to balance their books, it possesses the leverage it needs to make interest rates adjust. As we will discuss in the following chapter, if the rate of inflation is considered to be too high monetary policy will be enacted to increase interest rates in the financial sector. Any decision to change interest rates receives regular exposure in the media, as periodic adjustments to the official cash rate are widely speculated on. For example, if the Reserve Bank Board announced that interest rates will be rising by 0.25 per cent, banks and other financial institutions know that the RBA will operate OMOs to reduce liquidity levels in the financial system. The RBA will sell financial instruments, reducing liquidity levels in the financial system because financial institutions pay the RBA for the instruments. Or, the RBA may be able to change interest rates by simply not supplying the necessary liquidity in the case of an overnight cash deficit. This shortage of cash on  the overnight money market would cause the cash rate to rise, after which other interest rates, such as mortgage rates and credit card rates, will also rise. According to the RBA, the expectation held by banks and dealers that the RBA will act in a manner that will move the cash rate to its new target is sufficient to make the interest rates offered by banks change quickly. To reduce interest rates, the RBA will not sterilise a surplus of cash on the overnight money market, or if there is not a cash surplus or it is insufficient to change interest rates by the required amount, the RBA will buy bonds and securities from banks and dealers. This will increase reserves held by financial institutions and subsequently, as they supply additional cash on the overnight money market, the cash rate will fall, followed by a fall in other interest rates. We will discuss details of the relationship between the price of bonds and securities and the interest rate on these securities in the following chapter. Obviously, in order to entice banks to buy or sell bonds and securities the RBA has to alter the returns on them.

317

Repurchase agreement An RBA offer to buy (or sell) Commonwealth Government Securities and other eligible financial instruments, from banks or other authorised financial dealers, provided the same banks or dealers are prepared to repurchase (or resell) them at a future date, often in a few days’ time, at a price agreed at the outset.

Exchange rate management The RBA is also responsible for exchange rate management. The value of the Australian dollar relative to other currencies (the exchange rate) is usually determined by international market forces—that is, the demand for and supply of Australian dollars worldwide (see Chapter 14). However, occasionally the RBA intervenes in the market determination of the value of the Australian dollar, in an attempt either to increase or decrease its value on international markets. For example, if the RBA wanted to increase the value of the Australian dollar relative to other currencies (known as a currency appreciation) it would purchase Australian dollars in foreign currency markets to increase the demand for Australian dollars. Or, if the RBA wanted to decrease the value of the Australian dollar relative to other currencies (known as a currency

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depreciation) it could increase the supply of dollars on foreign currency markets by selling Australian dollars. In the first case the RBA is reducing its stock of foreign reserves as it uses them to buy dollars, and in the second case the RBA is increasing its stock of foreign reserves as it accepts foreign currency in exchange for the sale of Australian dollars. These sorts of interventions do not occur very often, and may not be very successful if there are strong market forces operating to move the value of the currency in the opposite direction. Changes in domestic interest rates also affect exchange rates (as we will see in Chapter 14). The RBA also has the role of investing its stock of foreign reserves—such as foreign currency and bonds—and is also the custodian of Australia’s gold reserves.

THE QUANTITY THEORY OF MONEY 11.5 Explain the quantity theory of money and use it to explain how high rates of inflation can occur. LEARNING OBJECTIVE

Quantity theory of money A theory of the connection between money and prices that assumes that the velocity of money is constant.

People have been aware of the connection between increases in the money supply and inflation for centuries. In the sixteenth century the Spanish conquered Mexico and Peru and shipped large quantities of gold and silver back to Spain. The gold and silver were minted into coins and spent across Europe to further the political ambitions of the Spanish kings. Prices in Europe rose steadily during these years, and many observers discussed the relationship between this inflation and the flow of gold and silver into Europe from the Americas. The quantity theory of money refers to the proposition that there is a positive relationship between the quantity of money in the economy and the general price level. According to the theory, in the long run, if the quantity of money increases the price level will also rise.

Connecting money and prices: the equation of exchange From as early as the seventeenth century, classical economists wrote of the direct relationship between the quantity of money and the price level. In the early twentieth century the economist Irving Fisher formalised the connection between money and prices by using the  following equation of exchange: M×V=P×Y

Velocity of money The average number of times each dollar in the money supply is used to purchase goods and services which are included in GDP.

The equation states that the money supply (M ) multiplied by the velocity of money (V ) equals the price level (P) multiplied by real GDP (Y ). Fisher defined the velocity of money, often referred to simply as ‘velocity’, as the average number of times each dollar of the money supply is used to purchase goods and services which are included in GDP. Rewriting the original equation by dividing both sides by M, we have the equation for velocity: V=

P×Y M

Because velocity is defined to be equal to (P × Y )/M, we know that the equation of exchange must always hold true: the left side must be equal to the right side. A theory is a statement about the world that might possibly be false. Therefore, the equation of exchange is not a theory. Irving Fisher turned this equation into the quantity theory of money by asserting that velocity was constant. He argued that the average number of times a dollar is spent depends on how often people get paid, how often they do their grocery shopping, how often businesses mail bills and other factors that do not change very often. Because this assertion may be true or false, the quantity theory of money is, in fact, a theory.

The quantity theory explanation of inflation The equation of exchange gives us a way of showing the relationship between changes in the money supply and changes in the price level, or inflation. To see this relationship more clearly, we can use a handy mathematical rule that states that an equation where variables are multiplied together is equal to an equation where the growth rates of these variables are added together. So, we can transform the equation of exchange from: M×V=P×Y to:

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Growth rate of the money supply + growth rate of velocity = growth rate of the price level (or inflation rate) + growth rate of real GDP (or economic growth rate) This way of writing the equation of exchange is more useful for investigating the effect of changes in the money supply on the inflation rate. Remember that the growth rate for any variable is the percentage change in the variable from one year to the next. The growth rate of the general price level is the inflation rate, so we can rewrite the equation of exchange to help us understand the factors that determine the inflation rate: Inflation rate = growth rate of the money supply + growth rate of velocity – economic growth rate If Irving Fisher was correct in thinking that velocity is constant, then the growth rate of velocity will be zero. That is, if velocity is, say, always 8.6, then its percentage change from one year to the next will always be zero. This assumption allows us to rewrite the equation one last time: Inflation rate = growth rate of the money supply – economic growth rate This equation leads to the following predictions: 1 If the money supply grows at a faster rate than economic growth there will be inflation. 2 If the money supply grows at a slower rate than economic growth there will be deflation. (Recall that deflation is a decline in the price level.) 3 If the money supply grows at the same rate as economic growth the price level will be stable, and there will be neither inflation nor deflation. It turns out that Irving Fisher was wrong in asserting that the velocity of money is constant. From year to year there can be significant fluctuations in velocity. As a result, the predictions of the quantity theory of money do not hold every year, but most economists agree that the quantity theory provides a useful insight into the long-run relationship between the money supply and inflation: in the long run, inflation results from the money supply growing at a faster rate than the economic growth rate. In Australia there have been periods of a clearly observed direct correlation between the quantity of money and the price level. For example, during the inflationary period of the mid-1970s, when the annual rate of inflation reached almost 18 per cent, the growth rate of the quantity of money, as measured by the M3 measure of the money supply, also increased. A slower growth rate in M3 accompanied the significant decrease in the rate of inflation in the aftermath of the 1990 recession. However, during the period of strong economic growth in the early to mid-2000s, rising growth rates of the quantity of money occurred at times when the rate of inflation was increasing and when it was decreasing. In the latter half of 2009, following the GFC, there was a period of slow growth in M3 and relatively low inflation. Therefore, we can conclude that there is not always a clear correlation between the growth rate of the quantity of money and the rate of inflation. Short-run variations are observed. Further, it should be remembered that correlation does not imply causation. For example, it can also be argued that inflation and economic growth causes the money supply to increase— the opposite causation than what is suggested by the quantity theory of money. In fact, as we will see in the next chapter, current RBA monetary policy targets the rate of interest, and not the money supply, to control inflation.

High rates of inflation Why do some governments and central banks allow high rates of inflation? The quantity theory can help us to understand the reasons for high rates of inflation. As we saw in Chapter 8, very high rates of inflation—in excess of hundreds or thousands of percentage points per year—are known as hyperinflation. Hyperinflation is caused by central banks increasing the money supply at a rate far in excess of the economic growth rate. A high rate of inflation causes money to lose its value so rapidly that households and firms avoid holding it. As we saw in the opening case of this chapter, if inflation becomes severe enough people stop using paper currency, so

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it no longer serves the important functions of money. Economies suffering from high inflation usually also suffer from very slow economic growth, if not severe recession. Given the dire consequences that follow from high inflation, why do governments and central banks allow it by expanding the money supply so rapidly? The main reason is that governments often want to spend more than they are able to raise through taxes. Developed countries, such as Australia, can usually bridge gaps between spending and taxes by borrowing through selling government bonds to the public. Developing countries often have difficulty selling bonds because the public is sceptical of their ability to pay back the money. If they are unable to sell bonds to the public, governments in developing countries will force their central banks to purchase them. As we discussed previously, when a central bank buys bonds the money supply will increase, which can be inflationary.

M

C

A K I N G THE

11.3

ONNECTION

THE GERMAN HYPERINFLATION OF THE EARLY 1920s When Germany lost World War I a revolution broke out that overthrew Kaiser Wilhelm II and a new government known as the Weimar Republic was installed. In the peace treaty of 1919, the Allies, dominated by the ‘Big Four’—the United States, Great Britain, France and Italy—imposed payments called reparations on the new German government. The reparations were meant as compensation to  the Allies for the damage Germany had caused during the war. It was very difficult for the German government to use tax revenue to cover both its normal spending and the reparations. The German government decided to pay for the difference between its spending and its tax revenues by selling bonds to the central bank, the Reichsbank. After a few years the German government fell far behind in its reparations payment. In January 1923 the French government sent troops into the German industrial area known as the Ruhr to try to collect the payments directly. German workers in the Ruhr went on strike, and the German government decided to support them by paying their salaries. Raising the funds to do so was financed by an inflationary monetary policy—the German government sold bonds to the Reichsbank, thereby increasing the money supply.

The inflationary increase in the money supply was very large: the total number of marks—the German currency—in circulation rose from 115 million in © Bettmann/CORBIS January 1922 to 1.3 billion in January 1923 and then to 497 billion billion, or During the hyperinflation of the 1920s people 497 000 000 000 000 000 000, in December 1923. Just as the quantity theory predicts, in Germany used paper currency to light their the result was a staggeringly high rate of inflation. The German price index that stoves stood at 100 in 1914 and 1440 in January 1922 had risen to 126 160 000 000 000 in December 1923. The German mark became worthless. The German government ended the hyperinflation by (1) negotiating a new agreement with the Allies that reduced its reparations payments, (2) reducing other government expenditures and raising taxes to balance its budget, and (3) replacing the existing mark with a new mark. Each new mark was worth one trillion old marks. The German central bank was also limited to issuing a total of 3.2 billion new marks. These steps were enough to bring the hyperinflation to an end—but not before the savings of anyone holding the old marks had been wiped out. Most middle-income Germans were extremely resentful of this outcome. Many historians believe that the hyperinflation greatly reduced the allegiance of many Germans to the Weimar Republic and may have helped pave the way for Adolf Hitler and the Nazis to seize power 10 years later. SOURCE: Adapted from Thomas Sargent (1986), ‘The end of four big hyperinflations’, in Rational Expectations and Inflation, pp. 79–94, © 1985, 1993 by Pearson Education, Inc. Reproduced by permission of Pearson Education, Inc. All rights reserved.

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WHAT IF MONEY BECAME INCREASINGLY VALUABLE? At the beginning of the chapter, we asked you to consider whether you would like to live in an economy in which the purchasing power of money rises every year. The first thing to consider when thinking about the advantages and disadvantages of this situation is that the only way for the purchasing power of money to increase is for the price level to fall; in other words, deflation must occur. Because the price level in Australia hasn’t fallen for an entire year since the 1930s, most people alive today have experienced only rising price levels—and declining purchasing power of money. Would replacing rising prices with falling prices necessarily be a good thing? It might be tempting to say ‘yes’, because if you have a job, your salary will buy more goods and services each year. But, in fact, just as a rising price level results in most wages and salaries rising each year, a falling price level is likely to mean falling wages and salaries each year. So, it is likely that, on average, people would not see the purchasing power of their incomes increase, even if the purchasing power of any currency they hold would increase. There can also be a significant downside to deflation, particularly if the transition from inflation to deflation happens suddenly. In Chapter 8, we defined the real interest rate as being equal to the nominal interest rate minus the inflation rate. If an economy experiences deflation, then the real interest rate will be greater than the nominal interest rate. A rising real interest rate can be bad news for anyone who has borrowed, including home owners who may have substantial mortgage loans. So, you are probably better off living in an economy experiencing mild inflation than one experiencing deflation.

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ECONOMICS IN YOUR LIFE (continued from page 301)

CONCLUSION Money plays a key role in the functioning of an economy by facilitating trade in goods and services and by making specialisation possible. Without specialisation, no advanced economy can prosper. Households and firms, banks and the central bank are participants in the process of creating the money supply. In the next chapter we will explore how the RBA uses monetary policy to promote its economic objectives. Read ‘An inside look’ to examine the proposition which occasionally surfaces that, given the close economic links between Australia and New Zealand, they should adopt the same currency.

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AN INSIDE LOOK ARY 2014 STUFF 20 JANU

? y c n e r r u c n a i An Australas by Maria Slade

nt tools which are importa y, lit bi xi fle te ra if and exchange This meant that d bring business ic stabilisation’. ul om co t y on no nc t ec ro rre bu ac cu try m for coun lasian ic shock in one hhooks. A common Austra fis om of on e ec g ar in sh an us its as e w ad e es with ld need to be m ts frustrated ther benefits, but com , Greg Martin, ge adjustments wou r ps he Ap ot ta e ec th d til an In al A CEO of ralian/New Ze d employment. typically s of the Aust es prices, wages an do ly nt rre ese channels is cu r with the vagarie th lle h se ug p ro ap th t ss es and e busine ‘Adjustmen ore volatile pric . Its costs and m exchange rate. Th lia in ra lt st su Au re in n ss d ca etary busine its results slower an ances where mon so st 25 per cent of its s, in ie w nc fe e rre ar cu e er e in both . Things output.’ And ‘th t some degree of revenue base ar e exchange rate fectively withou th ef of d e ke at or st w e s th ha an union are affected by single Australasi e report said. if there was a er si ea nts Australian, be political union’, th ld ou w kiwi was at 75 ce e th n he w . o ys d ag a common ed an A year currency, he sa been calling for stralian, has liv ve Au ha t is n’ ld ife w ou w se ie says. utives businesses Martin, who ist Cameron Bagr ys Intilecta exec sa om d on an ec f try ie ch un Z ’ currency, AN worked in the co ke and eat it too. g to have your ca r time there. tin ei d th an of w an of t t is lo y it os nt a m ig of t d re ith lo ‘A sove spen es w e concept com the currency with th e ]. is us ’s m nf tu ity lia co al ra en e re st pl om e Au eo ‘P Th 11 ts [m r example, in 20 hy] it never ge Fo [w . ys y e el sa us e at ca in he tim , ag Be ul ks g. im you that’s tal thin fishhoo 75 per cent. ‘Can ore of a sentimen 4. m ly as w ’ ab e. et ob if m rg pr sa s Ta en e it’ te be ve I think feels th Cash Ra onomy would ha and business, it ec ily d m an fa al an id Ze br be w hy to Ne a I have unlikely where the r Martin, there’s te at 4.75?’ Unfortunately fo realms of d had our cash ra e’ w . on so e not out of the im yt is an y y ity nc nc tiv rre uc rre cu cu od nment Anzac and Pr A common much closer alig n and New Zeal ire lia qu ra re st ic ld Au om t ou on in w jo The ns-Tasman ec s and labour possibility, but it rengthening tra e two tax system issed th sm as di t ch bu su l Commissions’ St al s , or ar of dynamics of fact released last ye we get those sorts nefits. ‘If . be ys e sa th ie gh gr relations report, ei Ba tw , ou looks more of markets the costs would permit onomic level it d ec ro an ic k m ris the idea saying a te at ra ace ove exchange ng in pl Yes it would rem ntially increasi te po .’ er s, go on a ris mpa easier price co trade. etary union investment and ‘in forming a mon : id sa rt po re e etary policy B But th nomy over mon to au s er nd rre a country su STUFF

SOURCE: Maria Slade (2014), ‘An Australasian currency?’, Stuff, 20 January, at , viewed 22 January 2014.

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Key points in the article Australia and New Zealand have much in common including their colonial heritage and to a large extent the two countries have a common market, since goods, services, capital and labour can virtually move freely between them. They do, however, have separate currencies and central banks. The article points out that there could be considerable advantages of having a single currency— money common to both countries—but opponents point to the lack of sovereignty, particularly the ability to control domestic monetary policy and therefore interest rates and inflation.

Analysing the news A Fiat money, that is, currency, is useful as long as all businesses and households accept it in exchange for goods and services. The Australian and New Zealand dollars are fairly freely exchangeable but, as pointed out in the article, a single currency would be much less costly as a means of exchange between Australian and New Zealand citizens. However, the article also points out that there would be much resistance by people to giving up their currency. Despite their many common cultural and political similarities the two economies are quite different in terms of industry structure and trade patterns. The exchange rate—the price of the domestic currency in terms of other countries’ currencies—would largely be determined by the prices of mining and energy, Australia’s main exports. This would impact on New Zealand exports, mainly agricultural goods.

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B If there was a common currency for Australia and New Zealand then interest rates would have to be the same in both countries. Since Australia is such a large economy compared to New Zealand, New Zealand would lose its ability to set monetary policy and would be dominated by economic activity in Australia. This is the main potential problem with a common currency that is discussed in the article. Thinking critically 1 Suppose that Australia and New Zealand moved to the same currency, the Australian dollar. Now suppose Australia’s economy enters a boom and, in response, the central bank raised interest rates in an attempt to control inflation. What would be the effect on New Zealand’s economy, assuming that it had not entered an economic boom? 2 Many member countries of the European Union trading bloc moved to a single currency, the euro, in 2002, believing there to be economic advantages of operating on the same currency. However, not all member countries have adopted the euro, preferring to keep their own currency. What would be the advantages and disadvantages to New Zealand of adopting the Australian dollar?

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CHAPTER SUMMARY AND PROBLEMS KEY TERMS asset broad money cash rate commodity money credit currency demand deposits

302 308 316 302 308 306 307

fiat money M1 M3 monetary policy money open market operations quantity theory of money

305 307 307 316 302 316 318

repurchase agreement Reserve Bank of Australia reserves simple deposit multiplier velocity of money

317 305 309 312 318

WHAT IS MONEY AND WHY DO WE NEED IT? PAGES 302–306 LEARNING OBJECTIVE 11.1

Define money and discuss its functions.

SUMMARY A barter economy is an economy that does not use money and in which people trade goods and services directly for other goods and services. Barter trade occurs only if there is a double coincidence of wants, where both parties to the trade want what the other one has. Because barter is inefficient, there is strong incentive to use money, which is any asset that people are generally willing to accept in exchange for goods or services or in payment of debts. An asset is anything of value owned by a person or a firm. A commodity money is a good used as money that also has value independent of its use as money. Money has four functions: a medium of exchange, a unit of account, a store of value and a standard of deferred payment. Paper currency is fiat money, which has no value except as money.

4000 francs. According to Jevons, ‘as Mademoiselle could not consume any considerable portion of the receipts herself, it became necessary in the meantime to feed the pigs and poultry with the fruit’. Did the goods Mademoiselle Zélie receive as payment fulfil the four functions of money described in the chapter? Why or why not? 1.6

People lined up on the veranda of the American mission hospital here from miles around to barter for doctor visits and medicines, clutching scrawny chickens, squirming goats and buckets of maize. But mostly they arrived with sacks of peanuts on their heads.2

Why wouldn’t the people buying medical services at this hospital use money to pay for the medical services they are buying?

REVIEW QUESTIONS 1.1

1.2

1.3

1.4

In a pure barter economy, if a farmer with a surplus of wheat required a car he would need to find not simply a car dealer but a dealer who wanted to purchase wheat. What do economists call this problem? What is the difference between commodity money and fiat money? What are the functions of money? Can something be considered money if it does not fulfil all the functions? Why do businesses accept paper (plastic) currency when they know that, unlike a gold coin, the paper the currency is printed on is worth very little?

1.7

In the late 1940s the Communists under Mao Zedong were defeating the government of China in a civil war. The paper currency issued by the Chinese government was losing much of its value and most businesses refused to accept it. At the same time, there was a paper shortage in Japan. During these years Japan was still under military occupation by the United States, following its defeat in World War II. Some of the US troops in Japan realised that they could use dollars to buy up vast amounts of paper currency in China, ship it to Japan to be recycled into paper and make a substantial profit. Under these circumstances, was the Chinese paper currency a commodity money or a fiat money? Briefly explain.

1.8

According to Peter Heather, a historian at the University of Oxford, during the Roman Empire the German tribes east of the Rhine River produced no coins of their own but used Roman coins instead:

PROBLEMS AND APPLICATIONS 1.5

The English economist William Stanley Jevons1 described a world tour during the 1880s by a French singer, Mademoiselle Zélie. One stop on the tour was a theatre in the Society Islands, part of French Polynesia in the South Pacific. She performed for her usual fee, which was one-third of the receipts. This turned out to be three pigs, 23 turkeys, 44 chickens, 5000 coconuts and ‘considerable quantities of bananas, lemons, and oranges’. She estimated that all of this would have had a value in France of

[Related to Making the connection 11.2] An article in The New York Times provides the following description of a hospital in Zimbabwe:

Although no coinage was produced in Germania, Roman coins were in plentiful circulation and could easily have provided a medium of exchange (already in the first century, Tacitus tells us, Germani of the Rhine region were using good-quality Roman silver coins for this purpose).3

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a What is a medium of exchange? b What does the author mean when he writes that Roman coins could have provided the German tribes with a medium of exchange? c Why would any member of a German tribe have been willing to accept a Roman coin from another member of the tribe in exchange for goods or services when the

1.9

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tribes were not part of the Roman Empire and were not governed by Roman law? In the 1970s Pol Pot, the dictator of Cambodia, proclaimed that he intended to do away with money in his country because money represented the decadence of the West (Western Europe and the United States). Historically, did money exist only in the West? What effect would the elimination of money have had on the economy?

HOW DO WE MEASURE MONEY TODAY? PAGES 306–309 LEARNING OBJECTIVE 11.2

Discuss the definitions of the money supply used in Australia today.

SUMMARY The narrowest definition of the money supply in Australia today is M1, which includes currency plus the value of all demand account deposits with banks. There are broader definitions of money, including M3 and broad money, which include a range of different account balances with not just banks but also non-bank financial institutions. Credit is not money, but is now used by the Reserve Bank of Australia (RBA) as the main measure of monetary movement in Australia. Credit includes loans, advances and bills provided to the private non-bank sector (individuals and firms) by all financial intermediaries.

2.5

2.6

REVIEW QUESTIONS 2.1

2.2

2.3

What is the main difference between the M1 and broader definitions of the money supply? Why does the RBA use more than one definition of the money supply? Distinguish between money, income and wealth.

PROBLEMS AND APPLICATIONS 2.4

2.7

2.8

Briefly explain whether each of the following is counted in M1.

a The coins in your pocket b The funds in your cheque account c The funds in your savings account d Your MasterCard credit card limit Assume that you have $2000 in currency in a shoebox in your cupboard. One day you decide to deposit the money in a demand deposit account. Briefly explain how this will affect M1. Suppose you decide to withdraw $100 in currency from your bank demand deposit account. What is the effect on M1? Ignore any actions the bank may take as a result of your having withdrawn the $100. [Related to Don’t let this happen to you] Briefly explain whether you agree with the following statement: ‘I recently read that more than half of the money issued by the government is actually held by people in foreign countries. If that’s true, then Australia is less than half as wealthy as government statistics indicate.’ [Related to Don’t let this happen to you] Is measuring income a way of measuring wealth?

HOW DO FINANCIAL INSTITUTIONS CREATE MONEY? PAGES 309–315 LEARNING OBJECTIVE 11.3

Explain how financial institutions create money.

SUMMARY

REVIEW QUESTIONS

On a bank’s balance sheet, reserves and loans are assets and deposits are liabilities. Reserves are deposits that the bank has retained, rather than loaned out or invested, which are kept by banks as part of prudential bank management. When a bank accepts a deposit it keeps only a fraction of the funds as reserves and loans out the remainder. In making a loan banks increase the bank account balance of the borrower. When the borrower buys something with the funds the bank has loaned, the seller will deposit the payment in a bank. The seller’s bank will keep part of the deposit as reserves and loan out the remainder. This process will continue until no banks have excess reserves. In this way, the process of banks making new loans increases the volume of demand deposit account balances and the money supply. The simple deposit multiplier is the ratio of the amount of deposits created by banks to the amount of new reserves. An expression for the simple deposit multiplier is 1/reserve ratio.

3.1

3.2

3.3 3.4

3.5

What is the largest asset and the largest liability of a typical bank? Suppose you decide to withdraw $100 in cash from your bank deposit account. Draw a T-account showing the effect of this transaction on your bank’s balance sheet. What does it mean to say that banks ‘create money’? Give the formula for the simple deposit multiplier. If the reserve ratio is 20 per cent, what is the maximum increase in demand account deposits that will result from an increase in bank reserves of $20 000? What causes the real-world money multiplier to be smaller than the simple deposit multiplier?

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PROBLEMS AND APPLICATIONS 3.6

3.7

3.8

3.9

3.10

The manager of a local bank describes demand deposits as ‘fuel’ which the bank uses to go out and make loans and mortgages. Briefly explain what she means. ‘Banks don’t really create money, do they?’ was the challenge that a retired professor of economics was known to have used in his Australian economic history course to ascertain what his students remembered from their introductory economics course about the creation of money. He reported that few students were confident enough or remembered enough to reply correctly to his question. How would you reply? ‘Most of the money supply of Australia is created by banks making loans.’ Briefly explain whether you agree with this statement. Would a series of bank runs in a country (people rapidly withdrawing large volumes of money from financial institutions) decrease the total quantity of M3? Wouldn’t a bank run simply move funds in demand deposit accounts to currency in circulation? [Related to Solved problem 11.1] Suppose you deposit $2000 in currency into your cheque account at a branch of the Commonwealth Bank, which we will assume has no excess reserves at the time you make your deposit. Also assume that the bank maintains a reserve ratio of 0.2, or 20 per cent. a Use a T-account to show the initial impact of this transaction on the Commonwealth Bank’s balance sheet. b Suppose that the Commonwealth Bank makes the maximum loan they can from the funds you deposited. Using a T-account, show the initial impact of granting the

3.11

loan on the bank’s balance sheet. Also include on this T-account the transaction from (a). c Now suppose that whoever took out the loan in (b) writes a cheque for this amount and that the person receiving the cheque deposits it in a branch of the Westpac bank. Show the effect of these transactions on the balance sheets of the Commonwealth Bank and Westpac bank, after the cheque has been cleared. (On the T-account for the Commonwealth Bank, include the transactions from (a) and (b).) d What is the maximum increase in cheque account deposits that can result from your $2000 deposit? What is the maximum increase in the money supply? Explain. Consider the following simplified balance sheet for a bank: Assets Reserves Loans

3.12

Liabilities

$10 000 Deposits $70 000 $66 000 Shareholders’ equity $6 000

a If the bank holds a reserve ratio of 10 per cent, how much in excess of the required reserves is the bank holding? b What is the maximum amount by which the bank can expand its loans? c If the bank makes the loans in (b), show the immediate impact on the bank’s balance sheet. Briefly explain whether you agree with the following statement: ‘Assets are things of value that people own. Liabilities are debts. Therefore, a bank will always consider a demand account deposit to be an asset, and a car loan to be a liability.’

THE RESERVE BANK OF AUSTRALIA, PAGES 315–318 LEARNING OBJECTIVE 11.4

Discuss the role of the Reserve Bank of Australia.

SUMMARY

REVIEW QUESTIONS

The Reserve Bank of Australia (RBA) is the central bank of Australia. It has two central main roles: to ensure that Australia’s financial system is stable and functioning well, and to implement monetary policy. It is also responsible for exchange rate management. Monetary policy refers to the actions the RBA takes to manage interest rates to achieve macroeconomic objectives. The RBA’s basic monetary policy tool is to use open market operations to control the cash rate, which will then affect all other interest rates. Open market operations are the buying and selling by the RBA of Commonwealth Government Securities and private bonds and securities, either by outright purchase or sale, or by the use of repurchase agreements. The cash rate is the interest rate that financial institutions charge on loans or pay to borrow funds in the overnight money market. A repurchase agreement is an offer by the RBA to buy (or sell) Commonwealth Government Securities and other eligible financial instruments, from banks or other authorised financial dealers, provided the same banks or dealers are prepared to repurchase (or resell) them at a future date, often in a few days’ time, at a price agreed at the outset.

4.1

4.2

4.3

What are the main roles of the Reserve Bank of Australia (RBA)? How does the RBA control liquidity in the overnight money market? Why does an open market purchase of government securities by the RBA increase bank reserves? Why does an open market sale of government securities by the RBA decrease bank reserves?

PROBLEMS AND APPLICATIONS 4.4

4.5

What features would you say characterise a stable financial system? The Reserve Bank of Australia (RBA) has stated that: The principal medium-term objective of monetary policy is to control inflation, so an inflation target is thus the centrepiece of the monetary policy framework.4

4.6

Explain why the RBA is targeting inflation in Australia. Explain the most frequent reason why the RBA uses open market operations in Australia.

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In the aftermath of the global financial crisis, the Australia government gave cash hand-outs of up to $900 to most tax payers, as part of a policy aimed to stimulate economic

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growth. What impact would this have had on the cash rate if there were no intervention on the overnight money market by the RBA? Briefly explain.

THE QUANTITY THEORY OF MONEY, PAGES 318–320 LEARNING OBJECTIVE 11.5

Explain the quantity theory of money and use it to explain how high rates of inflation can occur.

SUMMARY The equation of exchange relates the money supply to the price level: M × V = P × Y, where M is the money supply, V is the velocity of money, P is the price level and Y is real GDP. The velocity of money is the average number of times each dollar in the money supply is spent during the year. Economist Irving Fisher formalised the quantity theory of money, which assumes that the velocity of money is constant. If the quantity theory of money is correct, the inflation rate should equal the rate of growth of the money supply minus the rate of growth of real GDP (economic growth rate). Although the quantity theory of money is not literally correct because the velocity of money is not constant, it is true that in the long run inflation results from the money supply growing faster than real GDP. When governments attempt to raise revenue by selling large quantities of bonds to the central bank, the money supply will increase rapidly, resulting in a high rate of inflation. However, in the short run, the correlation between inflation and growth in the money supply is not always strong. Some economists also argue the opposite causation effect to the quantity theory of money, that is, that inflation causes an increase in the growth rate of the money supply.

5.5

5.6

Hyperinflation in 2007 and 2008 made Zimbabwe’s currency virtually worthless despite the introduction of bigger and bigger notes, including a 10 trillion dollar bill.5

REVIEW QUESTIONS 5.1

5.2

5.3

What is the quantity theory of money? How does the quantity theory explain why inflation occurs? Is the quantity theory of money better able to explain the inflation rate in the long run or in the short run? Briefly explain. What is hyperinflation? Why do governments sometimes allow it to occur?

PROBLEMS AND APPLICATIONS 5.4

increasing at 1 per cent per year instead of remaining constant, what will the inflation rate be? Suppose that during one period the velocity of money is constant and during another period it undergoes large fluctuations. During which period will the quantity theory of money be more useful in explaining changes in the inflation rate? Briefly explain. [Related to Making the connection 11.2] In April 2009, the African nation of Zimbabwe suspended the use of its own currency, the Zimbabwean dollar. According to a news article at that time:

5.7

In the same article, Zimbabwe’s Economic Planning Minister, Elton Mangoma, was quoted as saying the Zimbabwean dollar ‘will be out for at least a year’, and in January 2009 the government of Zimbabwe made the US dollar the country’s official currency. Why would hyperinflation make a currency ‘virtually worthless’? How might using the US dollar as its currency help to stabilise Zimbabwe’s economy? [Related to Making the connection 11.2] An article on Zimbabwe describes conditions in summer 2008 as follows: Official inflation soared to 2.2 million percent in Zimbabwe— by far the highest in the world…[and] unemployment has reached 80 percent.6

5.8

According to the quantity theory of money, if the money supply is growing at a rate of 6 per cent per year, the economic growth rate is 3 per cent per year and velocity is constant, what will the inflation rate be? If velocity is

Is there a connection between the very high inflation rate and the very high rate of unemployment? Briefly explain. [Related to Making the connection 11.3] During the German hyperinflation of the 1920s, many households and firms in Germany were hurt economically. Do you think any groups in Germany benefited from the hyperinflation? Briefly explain.

ENDNOTES 1 2

3 4

W. Stanley Jevons (1889), Money and the Mechanism of Exchange, New York, D Appleton and Company, pp. 1–2. Celia W. Dugger (2010), ‘Zimbabwe health care, paid with peanuts’, The New York Times, 18 December, at , viewed 22 January 2014. Peter Heather (2006), The Fall of the Roman Empire: A New History of Rome and the Barbarians, Oxford University Press, New York, p. 89. Reserve Bank of Australia (2014) ‘About monetary policy: The monetary policy framework’, at , viewed 22 January 2014.

5

6

Voice of America (2009), ‘Zimbabwe suspends use of own currency’, News, 11 November, at , viewed 22 January 2014. The New York Times (2008), ‘Inflation soars to 2 million percent in Zimbabwe’, The New York Times, 17 July, at , viewed 22 January 2014.

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CHAPTER

12

MONETARY POLICY

LEARNING OBJECTIVES After studying this chapter you should be able to: 12.1 Define monetary policy and describe the main goals of monetary policy in Australia. 12.2 Describe how the Reserve Bank of Australia affects interest rates. 12.3 Use the dynamic aggregate demand and aggregate supply model to show the effects of monetary policy on real GDP and the price level. 12.4 Discuss the Reserve Bank of Australia’s use of monetary policy to target inflation. 12.5 Assess the arguments for and against the independence of the Reserve Bank of Australia.

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INTEREST RATES AFFECT HOUSE PRICES THE RATE OF interest charged by banks and other financial institutions on home mortgage loans can significantly affect the housing market. As interest rates rise the demand for new houses falls and the prices of existing homes also fall. For instance, the effect of the six interest rate rises over two  years in the mid-2000s saw house prices in some suburban areas in Australia fall by more than 5 per cent, with the rate rises adding over $150 per month to average mortgage repayments. By 2008, the global financial crisis (GFC) had hit and the Reserve Bank of Australia (RBA) began to lower interest rates rapidly as part of its expansionary monetary policy. Interest rates were decreased in a series of six rate reductions in a period of just over one year. The RBA again began increasing interest rates in late 2009 and periodically throughout 2010 to combat expected inflation. By the end of 2011 with inflation not increasing and unemployment increasing, the RBA again began cutting interest rates and by early 2014 the interest rate (cash rate) remained at a historical low of 2.5 per cent. The lower interest rates had significant positive effects on the ability of heavily mortgaged households to make repayments, and left more of their income available for purchasing other goods and services. It also allowed more households to afford mortgages. However, with new mortgages increasing by a huge 25 per cent between November 2012 and November 2013, the reduction in required interest payments was counterbalanced by reduced affordability of housing. This is because the increase in demand for houses grew at a greater rate than supply, pushing house prices up by an average of almost 10 per cent in 2013 in Australia’s capital cities, and over 14 per cent in Sydney. This is an example of the complications involved with implementing monetary policy. Low interest rates contributed to large increases in housing prices, but rates needed to be low due to rising unemployment and economic growth rates that were below trend. Higher interest rates have the opposite effects of the rates experienced during periods of interest rate cuts. They make it less affordable to pay back a mortgage, reduce the number of people who can afford to enter the housing market and, for investors in housing for rental properties, they increase the opportunity cost of investment compared to alternatives such as bank deposits, and house prices tend to fall or stagnate. SOURCE: House price data taken from RP Data (2014), ‘RP Data—Rismark Home Value Index Release’, Press Releases, RP Data, 2 January, at , viewed 24 January 2014.

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ECONOMICS IN YOUR LIFE

SHOULD YOU BUY A HOUSE DURING AN ECONOMIC CONTRACTION? If you are like most university students, buying a house is one of the farthest things from your mind. But suppose you think forward some years to when you might be married and maybe even (gasp!) have children. You are considering buying a house, leaving behind years of renting. However, you’ve read in the news that a majority of economists are predicting that an economic contraction is likely to begin soon. What should you do? Would this be a good time or a bad time to buy a house? As you read the chapter, see if you can answer these questions. You can check your answers against those we provide on page 352 at the end of this chapter.

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IN CHAPTER 11 we saw that banks play an important role in providing credit to households and firms, and in creating the money supply. We also saw that the Reserve Bank of Australia (RBA), as Australia’s central bank, has the responsibility of implementing monetary policy and of ensuring the stability and integrity of Australia’s financial system. In this chapter we explore monetary policy, including how the RBA decides which monetary policy actions to take and how it implements monetary policy.

WHAT IS MONETARY POLICY? 12.1 Define monetary policy and describe the main goals of monetary policy in Australia. LEARNING OBJECTIVE

Monetary policy The actions taken by the Reserve Bank of Australia to manage interest rates to pursue macroeconomic objectives.

Inflation targeting Conducting monetary policy so as to commit the central bank to achieving a publicly announced level of inflation.

The Reserve Bank of Australia (RBA) was established by the Reserve Bank Act 1959 and is responsible for implementing monetary policy in Australia. Monetary policy in Australia refers to the actions taken by the RBA to manage interest rates in the pursuit of macroeconomic objectives. As we proceed through this chapter you will learn how monetary policy works and the mechanism by which changes in interest rates affect the economy.

The goals of monetary policy According to the Reserve Bank Act 1959, section 10(2),1 the goals or economic objectives of monetary policy are: 1 Full employment of the labour force 2 Stability of the Australian currency 3 Economic prosperity and welfare for the people of Australia Since 1993 the RBA has focused monetary policy primarily on achieving the stability of the currency, that is, on controlling inflation. Using monetary policy with the aim of achieving a publicly announced rate of inflation is called inflation targeting. In addition to controlling inflation, the RBA also uses monetary policy to lessen the effects of an economic contraction or recession. This was demonstrated by the low interest rate policy used by the RBA during the 2007–2008 global financial crisis (GFC). As we have seen in previous chapters, rising prices erode the value of money as a medium of exchange and a store of value. After inflation rose dramatically and unexpectedly during the 1970s, peaking at almost 18 per cent in 1974 due to a combination of very high world oil prices and rapid growth in wages in Australia, policy-makers in Australia and many industrial countries began to move to price stability as a specific policy goal. During the recession of 1982–1983 the rate of inflation fell to just over 2 per cent, but then rose to between 6 per cent and 8 per cent until Australia’s severe recession of 1990 (which was caused by very high interest rates). Since 1991 the inflation rate has generally been below 4 per cent (with the exception of the one-off spike in 2000 caused by the introduction of the Goods and Services Tax in Australia). In the view of most economists, inflationary pressures have been well contained since the 1990s. By focusing on price stability—that is, maintaining a low and stable rate of inflation—the RBA believes that it can assist in establishing a sound basis for economic growth in the long run. A low and stable rate of inflation can help to provide an economic environment that is supportive of economic growth, and therefore low rates of unemployment and economic wellbeing and prosperity. Many economists support the RBA’s focus on price stability, although there are those who disagree. We will examine these different points of view later in the chapter. It is important to note here that, by aiming to achieve price stability in order to achieve economic growth in the long run, monetary policy may, in the short run, have the effect of slowing down the rate of economic growth. For example, as we will discuss later in this chapter, the RBA can raise interest rates to reduce the inflation rate. But, as we saw in Chapter 5, higher interest rates typically reduce household and firm spending, which may result in slower growth. However, the short-run slowdown caused by higher interest rates would be carried out with the intent of preserving price stability and a healthy economy over time.

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In Australia the RBA and the federal government have a joint understanding that the RBA will target an inflation rate of between 2 per cent and 3 per cent per annum on average over the business cycle. That is, the government relies on the RBA to achieve price stability. This agreement was formalised in 1996, and restated numerous times, most recently in the 2013 Statement on the Conduct of Monetary Policy. Here it was stated that: Both the Reserve Bank and the Government agree on the importance of low inflation. Low inflation assists business and households in making sound investment decisions. Moreover, low inflation underpins the creation of jobs, protects the savings of Australians and preserves the value of the currency. In pursuing the goal of medium-term price stability, both the Reserve Bank and the Government agree on the objective of keeping consumer price inflation between 2 and 3 per cent, on average, over the cycle. This formulation allows for the natural shortrun variation in inflation over the business cycle while preserving a clearly identifiable performance benchmark over time.2 Figure 12.1 shows the rate of inflation in Australia from 1993 to 2013, with a trend line added. We can see that, on average, the inflation rate has been kept to between 2 per cent and 3 per cent since the RBA began inflation targeting in 1993. This demonstrates a remarkable level of price stability for a sustained period of time, indicating that the RBA has been very successful in targeting the inflation rate.

FIGURE 12.1

The rate of inflation, Australia (actual and trend) 1993–2014 The trend line shows that, on average, the inflation rate has been kept to between 2 per cent and 3 per cent since the RBA began inflation targeting in 1993

7 6 5

Per cent

4 3 2 1 0 –1 1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

2014

Note: The inflation rate is an annualised rate, measured as the percentage increase in the consumer price index (CPI) from the same quarter in the previous year. SOURCE: Reserve Bank of Australia, Statistics (2014), ‘Measure of consumer price inflation’, Table G01, at , viewed 18 May 2014.

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THE DEMAND FOR AND SUPPLY OF MONEY 12.2 Describe how the Reserve Bank of Australia affects interest rates. LEARNING OBJECTIVE

The demand for money In order to understand how the RBA can use monetary policy to change interest rates and ultimately affect the rate of inflation, we need to examine the demand for money. Figure 12.2 shows the demand curve for money. The interest rate is on the vertical axis and the quantity of money is on the horizontal axis. For simplicity here we are using the M1 definition of money, which equals currency in circulation plus the value of all demand deposits with banks. Notice that the demand curve for money is downward sloping. To understand why the demand curve for money is downward sloping, consider that households and firms have a choice between holding money or other financial assets, such as Commonwealth Government Securities (CGS). Money has one very desirable characteristic: it is liquid and you can easily use it to buy goods, services or financial assets. Money also has one undesirable characteristic: it earns either no interest or a very low rate of interest. The currency in your wallet earns no interest, and the money in your deposit account earns either no interest or very little interest. Alternatives to money, such as CGS, pay interest but have to be sold if you want to use the funds to buy something. When interest rates rise on financial assets such as CGS the amount of interest that households and firms lose by holding money increases. When interest rates fall the amount of interest households and firms lose by holding money decreases. Remember that opportunity cost is what you have to forgo to engage in an activity. The interest rate is the opportunity cost of holding money. We now have an explanation for why the demand curve for money slopes downward: when interest rates on CGS and other financial assets are low, the opportunity cost of holding money is low, so the quantity of money demanded by households and firms will be high; when interest rates are high, the opportunity cost of holding money will be high, so the quantity of money demanded will be low. In Figure 12.2, assuming all other things remain constant, a decrease in interest rates from 7 per cent to 6 per cent causes the quantity of money demanded by households and firms to rise from $250 billion to $300 billion.

Shifts in the money demand curve We saw in Chapter 3 that the demand curve for a good is drawn holding constant all variables, other than the price, that affect the willingness of consumers to buy the good. Changes in variables other than the price cause the demand curve to shift. Similarly, the demand curve for money is drawn holding constant all variables, other than the interest rate, that affect the willingness of households and firms to hold money. Changes in variables other than the interest rate cause the demand curve to shift. The two most important variables that cause the money demand curve to shift are real GDP and the price level. In addition, financial innovation such

FIGURE 12.2

The demand for money The money demand curve slopes downward because lower interest rates cause households and firms to switch from financial assets like Australian Commonwealth Government Securities to money. All other things being equal, a fall in the interest rate from 7 per cent to 6 per cent will increase the quantity of money demanded from $250 billion to $300 billion. An increase in the interest rate will decrease the quantity of money demanded

Interest rate, i

1. A decrease in the interest rate . . .

7%

6

2. . . . causes an increase in the quantity of money demanded.

0

Money demand, MD

$250

300

Quantity of money, M (billions of dollars)

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as automatic teller machines (ATMs), electronic funds transfer at point of sale (EFTPOS) and Internet banking have also affected the demand for money. An increase in real GDP means that the amount of buying and selling of goods and services will increase. This additional buying and selling increases the demand for money as a medium of exchange, therefore the quantity of money households and firms want to hold increases at each interest rate. An increase in real GDP will cause the money demand curve to shift to the right. A decrease in real GDP decreases the quantity of money demanded at each interest rate, shifting the money demand curve to the left. A higher price level increases the quantity of money required for a given amount of buying and selling. In the 1960s, for example, when a new car could be purchased for $2000 and a wage of just under $60 per week was the average, the quantity of money demanded by households and firms was much lower than today, even adjusting for the effect of the lower real GDP and the smaller population in the 1960s. An increase in the price level increases the quantity of money demanded at each interest rate, shifting the money demand curve to the right. A decrease in the price level decreases the quantity of money demanded at each interest rate, shifting the money demand curve to the left. Figure 12.3 illustrates shifts in the money demand curve.

How the RBA manages the supply of cash Having discussed money demand we now turn to the supply of cash in the short-term money market. In Chapter 11 we discussed how the RBA controls the volume of cash on the overnight money market. We learned that every day the RBA manages the supply of cash on the overnight money market, neutralising cash deficits or cash surpluses, to prevent interest rates from changing. Without RBA involvement the large volumes of withdrawals from, and injections into, the financial system would create shortages or surpluses of cash, which would then lead to changes in interest rates. The RBA sterilises, or offsets, the daily deficits or surpluses in liquidity in the financial system through the use of open market operations. Recall from Chapter 11 that open market operations involve the RBA purchasing or selling financial instruments such as CGS and private bonds and securities, either by outright purchase or sale or, as is mainly the case, by the use of repurchase agreements. It is interesting to note that in the 1970s and 1980s open market operations largely involved the outright purchase and sale of government bonds and securities. However, since the late 1990s, the RBA affects overnight cash levels mainly by using repurchase agreements of private and public financial instruments. Repurchase agreements have an advantage over the outright sale of bonds and securities because the repurchase agreement market is very liquid. We will now examine in more detail the process by which the RBA changes the overnight cash volumes and affects interest rates. Every month (except January) the Reserve Bank Board meets and decides whether to increase or decrease interest rates. As we saw in Chapter 11, to

Open market operations The RBA purchasing or selling financial instruments such as Commonwealth Government Securities and private bonds and securities, either by outright purchase or sale, or by the use of repurchase agreements.

FIGURE 12.3

Interest rate, i

An increase in real GDP or an increase in the price level will shift money demand to the right.

A decrease in real GDP or a decrease in the price level will shift money demand to the left.

0

MD3

MD1

Shifts in the money demand curve Changes in real GDP or the price level cause the money demand curve to shift. An increase in real GDP or an increase in the price level will cause the money demand curve to shift from MD1 to MD2. A decrease in real GDP or a decrease in the price level will cause the money demand curve to shift from MD1 to MD3

MD2

Quantity of money, M (billions of dollars)

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Cash rate The interest rate that financial institutions charge on loans or pay to borrow funds in the overnight money market.

Exchange settlement accounts Accounts held with the RBA by banks and other financial institutions to enable the overnight transfer of funds (cash) between financial institutions, and between the RBA and financial institutions.

do this the RBA controls a single interest rate, on which all the other short-term and variable interest rates are based, the overnight cash rate. Figure 12.4 clearly shows how other short-term interest rates, such as those on 90-day and 180-day bills, closely track the cash rate. You will also notice the significant changes in the cash rate over the time period shown, for example the very high interest rates in 1986 and again in 1989, and the low rates in 2009 and in 2012 and 2013, which we will discuss later in this chapter. The cash rate is determined on the overnight money market, as a result of the demand for and supply of funds, which depends on whether banks and financial institutions require additional funds or wish to lend surplus funds. Banks each maintain a special account with the RBA, known as an exchange settlement account, which is used by banks and a number of other financial institutions to settle the obligations between each other and with the RBA. All the payments passing between the banks and the RBA or the federal government go through these accounts. It is important to note that most settlements (over 90 per cent) between banks and financial institutions occur between each other during the day—in real time. This is known as Real-Time Gross Settlement (RTGS), and was introduced in Australia in 1998. RTGS uses the RBA’s Reserve Bank Information and Transfer System (RITS), which is a system that enables banks and financial institutions to access their exchange settlement accounts during the day and overnight. Although most inter-bank payments are settled during the day, at the end of each day any unsettled transactions must be settled via the exchange settlement accounts. These accounts must always be in credit, and money in these accounts is called exchange settlement funds, or cash. The RBA pays interest on overnight balances, but as the rate of interest earned on these funds is 0.25 per cent below the cash rate banks usually try to minimise overnight balances and lend out any surpluses they may have. Banks with surplus funds in their accounts are willing to lend it overnight to other banks that are short of funds, as financial institutions are not allowed to go into overdraft. The interest rate charged on these loans is set at 0.25 per cent above the overnight cash rate. Suppose the demand for funds exceeded the supply of funds, resulting in a shortage of funds on the overnight money market. If the RBA did nothing the cash rate would rise. The RBA avoids a rise in the cash rate by making repurchase agreements with the banks. It lends them cash, at an interest rate equal to the cash rate, for an agreed period of between one and 90  days, using Commonwealth, state or certain other financial instruments as security. The banks deposit the funds they receive from the RBA, which increases the banks’ reserves.

FIGURE 12.4

20

Short-term interest rates, Australia, 1985–2013

SOURCE: Reserve Bank of Australia (2014), About Monetary Policy, Graph 2 at , viewed 24 January 2014. © Reserve Bank of Australia, 2001–2010. All rights reserved.

18 16

Interest rates (per cent)

Short-term interest rates, such as those on 90-day and 180-day bills, closely track the cash rate. There have been significant changes in the cash rate over the time period shown, for example the very high interest rates in 1986 and again in 1989. You can also see the low interest rates during and after the 1990 recession, and again during the 2008 economic contraction, and in most of the subsequent years of slow recovery

Cash rate 90-day bills 180-day bills

14 12 10 8 6 4 2 0 1985

1989

1993

1997

2001

2005

2009

2013

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The banks loan out most of these reserves, which creates new demand deposits and expands the money supply (as we discussed in Chapter 11). If the RBA decides to change the cash rate it will publicly announce its intention to do so, after which bids and/or offers for financial securities such as repurchase agreements and bonds are then quickly made. This transparency has meant that banks and other financial institutions know that the RBA will change liquidity levels in the financial system. It is this certainty and understanding between banks and other financial institutions and the RBA that moves the cash rate to its new target and makes the short-term interest rates offered by banks change quickly. To reduce the cash rate the RBA would not sterilise a surplus of overnight funds, or it would supply more settlement funds than banks and other financial institutions require by offering to buy back repurchase agreements or make outright purchases of bonds. As the RBA pays for these financial instruments, this increases cash reserves held by financial institutions and subsequently, as the level of liquidity rises, the rate of interest falls. If the RBA decides to raise the cash rate it will borrow cash from the banks through what are called reverse repurchase agreements, or it could engage in the outright sale of bonds and securities. This will reduce financial reserves held by banks and other financial institutions and subsequently increase interest rates. Or, the RBA may be able to raise interest rates by simply not supplying the necessary liquidity in the case of an overnight shortage of exchange settlement funds.

Equilibrium in the money market As we have just learned, the RBA uses monetary policy to target interest rates in the economy. The RBA will adjust the availability of overnight funds to whatever level is required to keep interest rates at their targeted level. This means that if we draw a curve to represent the money supply in the economy it is horizontal at the current interest rate. Figure 12.5A illustrates equilibrium in the money market with the RBA’s monetary policy of controlling the cash rate to affect interest rates in the financial system. It shows that by adjusting liquidity in the financial system the money supply will be adjusted to whatever level is necessary to keep the rate of interest at a particular rate. In Figure 12.5A this rate is illustrated at 7 per cent. This means that the money supply is determined endogenously. That is, it is determined by the availability of funds and credit, and the demand for money, and is not set or explicitly controlled by the RBA. Therefore the money supply (MS ) curve is horizontal at the targeted rate of interest. This is a very different approach to monetary policy that was used in the 1970s and 1980s, when the RBA targeted the money supply, as measured by M3 (known as the money base, or base money). Using monetary policy to target the money supply is known as monetary targeting. An increase in the money supply would make more funds available, and therefore reduce the rate of interest, while a decrease in the money supply would put upward pressure on interest FIGURE 12.5A

Interest rate, i

Interest rate targeting

7%

MS

MD

0

Monetary targeting Conducting monetary policy to control the size and rate of growth of the money supply.

$1800

Quantity of money (billions of dollars)

The money supply has become increasingly difficult to target in Australia and many other countries, with financial innovation, the huge growth of credit and the growth of the private sector’s ability to affect the money supply via private bonds, securities and loans. Therefore, monetary targeting was abandoned in Australia in the 1990s and interest rate targeting is now used. The figure shows that the money supply will be adjusted to whatever level is necessary to keep the rate of interest at the rate targeted by the RBA. In this figure the target rate of interest is 7 per cent

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FIGURE 12.5B

Interest rate, i

Monetary targeting In the 1970s and 1980s the RBA targeted the money supply—referred to as monetary targeting—and would change the money supply, thereby affecting interest rates. An increase in the money supply would make more funds available and reduce the rate of interest, while a decrease in the money supply would put upward pressure on interest rates. In the figure, if the RBA increased the money supply from $1800 billion to $1900 billion, this would lead to a fall in the rate of interest, from 7 per cent to 6 per cent

2. . . . the equilibrium interest rate falls.

Money supply, MS1

MS2

1. When the RBA increases the money supply from MS1 to MS2 . . .

7%

6

MD

0

$1800

1900

Quantity of money, M (billions of dollars)

rates. Under a policy of monetary targeting, the money supply curve was illustrated as vertical (perfectly inelastic) to represent the RBA’s control over it. Figure 12.5B includes both the money demand and money supply curve, showing how equilibrium is achieved in the money market if monetary targeting is used. Just as with other markets, equilibrium in the money market occurs when the money demand curve intersects the money supply curve. Figure 12.5B shows that an increase in the money supply from $1800 billion to $1900 billion leads to a fall in the rate of interest, from 7 per cent to 6 per cent. The reverse would occur if the money supply was reduced. As we will see later in this chapter, some countries still use monetary targeting as their main form of monetary policy. However, over time, the money supply has become increasingly difficult to target in Australia and many other countries. This is due to financial innovation, the huge growth of credit and the growth of the private sector’s ability to affect the money supply via private bonds, securities and loans. In fact, as we saw in Chapter 11, the RBA now states that it uses credit, not the money supply, as its main measure of monetary movements in Australia. Therefore, monetary targeting in Australia was abandoned in the 1990s and interest rate targeting is now used.

A tale of two interest rates In Chapter 5 we discussed the loanable funds model of the interest rate. In that model the equilibrium interest rate was determined by the supply and demand for loanable funds. Why do we need two models of the interest rate? The answer is that the loanable funds model is concerned with the long-term real rate of interest and the money market model is concerned with the short-term nominal rate of interest. Here it is important to consider again the distinction between the nominal interest rate and the real interest rate. Recall that we calculate the real interest rate by subtracting the inflation rate from the nominal interest rate. The long-term real rate of interest is the interest rate that is most relevant when savers consider purchasing a long-term financial investment such as a corporate bond. It is also the rate of interest that is most relevant to firms which are borrowing to finance long-term investment projects such as new factories or office buildings, or to households who are taking out a mortgage loan to buy a new home. When conducting monetary policy, however, the short-term nominal interest rate is the most relevant interest rate because it is the interest rate most affected by increases and decreases in liquidity. Often—but not always—there is a close connection between movements in the short-term nominal interest rate and movements in the long-term real interest rate. So when the RBA takes action to increase the short-term nominal interest rate, usually the longterm real interest rate will also increase. In other words, as we will discuss in the next section, when the interest rate on short-dated securities rises, the real interest rate on mortgage loans will also usually rise.

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MONETARY POLICY AND ECONOMIC ACTIVITY We have just learned that the RBA uses the cash rate as its monetary policy target because it has good control of the cash rate and because it believes that changes in the cash rate will ultimately affect economic variables that are related to its monetary policy objectives. The cash rate is not directly relevant for households and firms. No households or firms—only banks and certain other financial institutions—can have exchange settlement accounts with the RBA and borrow or lend in the overnight cash market. However, as we saw in Figure 12.4, changes in the cash rate result in changes in interest rates on other short-term financial assets. This usually flows through to interest rates on long-term financial assets, such as corporate bonds and mortgages. The effect of a change in the cash rate on long-term interest rates is usually smaller than it is on short-term interest rates and the effect may occur after a lag in time. Ultimately, the ability of the RBA to use monetary policy to affect economic variables such as real GDP depends upon its ability to affect real interest rates, such as the real interest rates on mortgages and corporate bonds. Because the cash rate is a short-term nominal interest rate, the RBA sometimes has difficulty affecting long-term real interest rates. Nevertheless, for purposes of the following discussion we will assume that the RBA is able to affect long-term real interest rates.

12.3 Use the dynamic aggregate demand and aggregate supply model to show the effects of monetary policy on real GDP and the price level. LEARNING OBJECTIVE

How interest rates affect aggregate demand Changes in interest rates affect aggregate demand, which is the total level of spending in the economy. Recall from Chapter 10 that aggregate demand has four components: consumption, investment, government purchases and net exports. Changes in interest rates will not affect government purchases, but they will affect the other three components of aggregate demand in the following ways: 1 Consumption. An increase in interest rates increases the returns from lending and the costs of borrowing. It is commonly suggested that the effect is to induce households to cut back on consumption spending and thus save more in order to increase lending or reduce borrowing. In fact, the issue is more complicated than this. Households do not have to put their savings in interest-bearing deposits but can also use savings to buy other assets such as real estate or shares, or to contribute to superannuation funds. Hence a change in interest rates may have more of an effect on the composition of households’ existing wealth rather than on the proportions of income that are consumed and saved. A rise in interest rates will create an incentive to cut back on current consumption because it increases the amount of additional future consumption that can be obtained by giving up a unit of current consumption. For households that are net borrowers, this so-called substitution effect will be reinforced by a negative income effect. Higher interest rates will mean lower future incomes net of interest payments, thereby discouraging both future and current consumption. Hence, these households will reduce their current consumption. On the other hand, for households that are net lenders the outcome of an increase in interest rates is uncertain. The substitution effect will work as before to discourage current consumption, but in this case there will be a positive income effect. Higher interest rates, by increasing future incomes, will encourage not only future but also current consumption, since wealth has increased. If the substitution effect is stronger than the income effect, current consumption will still fall and saving will increase. If, however, the income effect is stronger, there will be a rise in current consumption and a fall in saving. 2 Investment. Firms finance most of their spending on machinery, equipment and factories out of their profits (retained earnings) or by borrowing. Firms borrow either from the financial markets by issuing corporate bonds, or from banks and other financial institutions. The higher the interest rate, the more expensive it is for firms to borrow. Because firms are interested in the cost of borrowing after taking into account the effects of inflation, investment spending will depend on the real interest rate. Therefore, holding

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constant the other factors that affect investment spending, there is an inverse relationship between the real interest rate and investment spending: a higher real interest rate results in less investment spending, and a lower real interest rate results in more investment spending. Even when firms use part of their profits for investment projects they face an increased opportunity cost of using profits if interest rates rise. Finally, spending by households on new homes is also part of investment. As we saw in the opening case, when interest rates on mortgage loans fall the cost of borrowing to buy new homes falls and more new homes will be purchased. When interest rates on mortgage loans rise, fewer new homes will be purchased. 3 Net exports. Recall that net exports are equal to spending by foreign households and firms on goods and services produced in Australia minus spending by Australian households and firms on goods and services produced in other countries. The value of net exports depends partly on the exchange rate between the dollar and foreign currencies. When the value of the Australian dollar rises, because Australian commodity export prices are largely traded in US dollars, Australian firms receive less export income. In other industries, such as education, the rise in the Australian dollar increases the prices foreigners have to pay for Australian goods and services whose prices are determined in Australia, so foreign demand for Australian goods and services will fall. Australian households and firms, however, will pay less for goods and services produced in other countries, so demand for imported goods and services will rise. As a result, Australia will receive less export income and import more, so net exports fall. When the value of the Australian dollar falls net exports rise. If interest rates in Australia rise relative to interest rates in other countries, investing in Australian financial assets becomes more desirable, causing foreign investors to increase their demand for dollars, which increases the value of the Australian dollar. As the value of the dollar increases, net exports will fall. If interest rates in Australia decline relative to interest rates in other countries, the value of the dollar will fall and net exports will rise.

The effects of monetary policy on real GDP and the price level In Chapter 10 we developed a dynamic aggregate demand and aggregate supply model that takes into account two important facts about the economy: (1) the economy experiences continuing inflation, with the price level rising every year, and (2) the economy experiences long-run growth, with the long-run aggregate supply (LRAS ) curve shifting to the right every year. Recall from Chapter 6 that over time the Australian labour force and Australian capital stock will increase. Technological progress will also occur. The result will be an increase in potential GDP, which we show by the LRAS curve shifting to the right. These factors will also result in firms supplying more goods and services at any given price level in the short run, which we show by the short-run aggregate supply (SRAS ) curve shifting to the right. During most years the aggregate demand (AD) curve will also shift to the right, indicating that aggregate expenditure will be higher at every price level. There are several reasons why aggregate expenditure usually increases. As the population grows and incomes rise, consumption will increase over time. Also, as the economy grows firms expand capacity and new firms are established, increasing investment spending. Finally, an expanding population and an expanding economy require increased government services, such as more teachers and police officers, so government purchases will expand. During certain periods, however, aggregate demand does not increase enough during the year to keep the economy at potential GDP. This slow growth in aggregate demand may be due to households and firms becoming pessimistic about the future state of the economy, leading them to cut back their spending on consumer durables, houses and factories. Other possibilities exist, as well: the federal government might decide to cut back its purchases, or recessions in other countries might cause a decline in Australian exports. Many of these factors contributed to the slowdown in the growth rate of aggregate demand and the rise in the unemployment rate in Australia in 2008 and 2009, as Australia began to experience the effects of the GFC. These effects continued for a number of subsequent

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Price level

Expansionary monetary policy causes the AD curve to shift further to the right.

FIGURE 12.6

Expansionary monetary policy LRAS1

LRAS2

SRAS1

SRAS2

C

103

B

102 100

A

AD2(with policy)

AD2(without policy) AD1

0

339

$1000

1075 1100

Real GDP (billions of dollars)

The economy begins in equilibrium at point A, with real GDP of $1000 billion and a price level of 100. Without monetary policy, aggregate demand will shift from AD1 to AD2(without policy), which is not enough to keep the economy at full employment because long-run aggregate supply has shifted from LRAS1 to LRAS2. The economy will be in short-run equilibrium at point B, where AD2(without policy) intersects SRAS2, with real GDP of $1075 billion and a price level of 102. By lowering interest rates the RBA increases investment, consumption and net exports sufficiently to shift aggregate demand to AD2(with policy). The economy will be in equilibrium at point C with real GDP of $1100 billion, which is its full-employment level at LRAS2, and a price level of 103. The price level is higher than it would have been if the RBA had not acted to increase spending in the economy

years. In Figure  12.6, in the first year the economy is in equilibrium at potential GDP of $1000 billion and a price level of 100 on LRAS1 (point A). In the second year LRAS increases to $1100 billion, from LRAS1 to LRAS2, but aggregate demand increases only from AD1 to AD2(without policy), which is not enough to keep the economy in macroeconomic equilibrium at potential GDP. Without the RBA intervening, the short-run equilibrium will occur at $1075  billion (point B) where AD2(without policy) intersects SRAS2. The $25 billion gap between this level of real GDP and potential GDP at LRAS2 means that some firms are operating at less than their normal capacity. Incomes and profits will fall, firms will begin to lay off workers and the unemployment rate will rise. Economists at the RBA closely monitor the economy and continually update forecasts of future levels of real GDP and prices. If RBA economists anticipate that the growth in aggregate demand is slowing, as it did following the GFC, they would present their findings to the Reserve Bank Board, which decides whether circumstances require a change in monetary policy. For example, suppose that the Reserve Bank Board meets and considers a forecast indicating that a gap of $25 billion will open between equilibrium real GDP and potential GDP. In other words, the situation shown in Figure 12.6 will occur. The Reserve Bank Board may then decide to take action to lower interest rates to stimulate aggregate demand. The figure shows the results of a successful attempt to do this: the AD curve has shifted further to the right, to AD2(with policy) and equilibrium occurs at LRAS2 (point C ). When a central bank decreases interest rates to increase real GDP it is engaging in expansionary monetary policy. An expansionary monetary policy is also sometimes known as a loose monetary policy. Notice that in Figure 12.6 the expansionary monetary policy caused the inflation rate to be higher than it would have otherwise been. Without the expansionary policy, the price level would have risen from 100 to 102, so the inflation rate for the year would have been 2 per cent. By shifting the AD curve further the expansionary policy caused the price level to increase from 102 to 103, raising the inflation rate to 3 per cent instead of 2 per cent.

Expansionary monetary policy The use of monetary policy by the Reserve Bank of Australia to decrease interest rates to increase real GDP.

Can the RBA eliminate contractions and recessions? Figure 12.6 shows an expansionary monetary policy that performs so well that no contraction actually takes place. The RBA manages to shift AD to keep the economy continually at potential GDP. In fact, however, this ideal is very difficult for the RBA to achieve. Keeping a

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contraction or a recession shorter and milder than it would otherwise be is usually the best the RBA can do. This action occurred in 2008 and 2009 when, in response to the GFC and the resulting contraction of the Australian economy, the RBA progressively lowered the cash rate from 7.25 per cent in March 2008 to 3 per cent by April 2009, and to a historic low level of 2.5 per cent by August 2013. It is likely that this initial action in 2008 and 2009 helped to prevent the rate of unemployment from rising further than it did and helped prevent the economic growth rate falling by more than it actually did. The subsequent lowering of interest rates between late 2011 and 2013 (following increases in late 2009 and 2010 during the recovery) was aimed at boosting the persistent below-trend rate of economic growth. Further, as we will see in the next chapter, it is the role of the federal government to try to smooth economic fluctuations in business cycles and prevent contractions or recessions. If the RBA is to be successful in offsetting the effects of the business cycle it needs to be able to recognise quickly the need for a change in monetary policy. If the RBA is late in recognising that a contraction is beginning or that the inflation rate is increasing, it may not be able to implement a new policy soon enough to do much good. In fact, if policy is implemented too late it may actually destabilise the economy. The RBA constantly monitors a range of economic indicators; however, it may still take months for data to be gathered and to be analysed. There is therefore a recognition lag, or delay, before the RBA may know that a contraction or recession is imminent. Once the appropriate monetary policy has been decided upon, the RBA can change the cash rate immediately, so there is no time lag in implementing policy (unlike fiscal policy, as we will see in the next chapter). The longest time lag, however, is the time it takes for interest rate changes to affect real GDP—sometimes referred to as the impact lag. As we have learned, interest rate changes impact strongly on investment, but investment by its nature cannot be changed quickly—most investment projects are already committed to or are ongoing, and it is only proposed projects that may be altered. Therefore the full impact of a monetary policy change may take up to two years, or sometimes longer. Given the time lags involved, it is possible that by the time expansionary monetary policy has its full impact on the economy, the economy may have recovered from an economic contraction. The increase in aggregate demand caused by the RBA’s lowering of interest rates may expand aggregate demand by more than is required to reach potential GDP and could therefore cause an acceleration in inflation.

Using monetary policy to fight inflation

Contractionary monetary policy The use of monetary policy by the Reserve Bank of Australia to increase interest rates to reduce inflation.

In addition to using expansionary monetary policy to reduce the severity of economic contractions or recessions, the RBA can use monetary policy to keep aggregate demand from expanding so rapidly that the inflation rate begins to increase. When the RBA acts to increase interest rates to reduce inflation it is engaging in contractionary monetary policy. A contractionary policy is also sometimes known as a tight monetary policy. The RBA used contractionary monetary policy to address anticipated inflationary periods in 2006 and 2007, and again from late 2009 to late 2010. In the 2006–2007 instance, there were fears expressed that the economy was at equilibrium at potential GDP or even beyond potential GDP. There were numerous data showing that the economy was close to or at full capacity, including severe labour shortages and capacity bottlenecks. The Reserve Bank Governor and other members of the Reserve Bank Board were worried that aggregate demand was increasing so rapidly that the inflation rate would begin to accelerate. Estimates of inflation in 2007 had been running at an annualised rate of around 3 per cent, and the RBA believed that the underlying rate of inflation, which abstracts from temporary influences, was even higher. In the recovery period after the economic contraction of 2008–2009, when Australia was recovering from the effects of the GFC, the RBA again became concerned about inflationary pressures building in the economy. This time the RBA was concerned not that the economy was at or beyond potential GDP, as it clearly wasn’t, but that the expansionary monetary policy that it had been utilising was no longer appropriate during the recovery. The RBA argued that the interest rate rises between 2009 and 2010, from 3 per cent to 4.75 per cent, were heading off any potential increases in the rate of inflation beyond its 2 per cent to 3 per cent target,

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TOO LOW FOR ZERO: A CASH RATE OF ALMOST ZERO IN THE UNITED STATES

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In December 2008 the central bank of the United States, the Federal Reserve (the Fed), pushed the cash rate (known as the federal funds rate in the US) to almost zero and kept it there throughout mid-2009. The severity of the 2008–2009 recession meant, though, that even such a very low rate of interest was doing little to stimulate the economy. To lower the cash rate the Fed buys Treasury bills through open market purchases, which increases bank reserves. Banks then lend out these reserves. The following figure shows this dramatic decrease in the cash rate, which was lowered from over 5 per cent in 2007 to almost 0 per cent by 2009, where it remained for years.

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7 6 © Paul Cowan | Dreamstime.com

The Federal Reserve in the United States pushed interest rates almost to zero during and after the GFC

Per cent

5 4 3 2 1 0

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

SOURCE: Created from Federal Reserve (2014), ‘Selected interest rates’, Table H.15, Federal Reserve Statistical Release, at , viewed 23 January 2014.

However, in late 2008 and 2009, many banks piled up excess reserves rather than lending the funds out. Total bank reserves had been less than US$50 billion in August 2008, but with the deepening of the financial crisis they had soared to more than US$900 billion by May 2009. Primarily, the increase in reserves reflected the reluctance of banks to make loans at low interest rates to households and firms whose financial positions had been damaged by the recession. Some economists believed the Fed was facing a situation known as a liquidity trap, in which short-term interest rates are pushed to zero, leaving the central bank unable to lower them further. Liquidity traps were thought to have occurred in the US during the 1930s and in Japan during the 1990s. Not being able to push interest rates below zero was a problem for the Fed. Because the cash rate cannot be negative the Fed turned to other policies. In particular, the Fed decided to embark on a policy of quantitative easing, which involves buying securities beyond the short-term Treasury securities that are usually involved in open market operations. The Fed began purchasing 10-year Treasury notes to keep interest rates from rising. Interest rates on home mortgage loans typically move closely with interest rates on 10-year Treasury notes. The Fed also purchased certain mortgage-backed securities. The Fed’s objectives in keeping interest rates on 10-year Treasury notes low and in purchasing mortgage-backed securities was to keep interest rates on mortgages low and to keep funds flowing into the mortgage market in order to help stimulate demand for housing. SOURCE: Glenn Rudebusch (2009), ‘The Fed’s monetary policy response to the current crisis,’ FRBSF Economic Letter, 22 May, Federal Reserve Bank of San Francisco, at , viewed 4 February 2011.

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FIGURE 12.7

Contractionary monetary policy The economy begins in equilibrium at point A, with real GDP of $930 billion and a price level of 100. During the year, the SRAS, LRAS and AD curves move to the right. Without monetary policy, aggregate demand will shift from AD1 to AD2(without policy) to a short-run equilibrium that is greater than potential GDP of $1000 billion at LRAS2. The economy will be in short-run equilibrium at point B, where AD2(without policy) intersects SRAS2, with real GDP of $1030 billion and a price level of 104. When the RBA increases interest rates, aggregate demand does not increase by as much as it would have without policy, and the AD curve will shift to the right to AD2(with policy). The economy will be in equilibrium at point C with real GDP of $1000 billion, which is at its full-employment level at LRAS2, and at a price level of 103. The price level is lower than it would have been if the RBA had not used contractionary monetary policy

Price level Contractionary monetary policy causes the AD curve to shift to the right by less than it would have without policy.

LRAS1

LRAS2 SRAS1 SRAS2

104

B

103 A

100

C

AD2(without policy) AD2(with policy)

AD1 0

930

1000 1030

Real GDP (billions of dollars)

although it subsequently revised this forecast and began lowering interest rates again from late 2011 through to 2013. During the recovery period following the economic contraction due to the GFC, the RBA raised the cash rate seven times, from its low of 3 per cent in April 2009 to 4.75  per  cent in November 2010. Australia was one of the very few countries to increase interest rates at this time. Figure 12.7 uses the dynamic aggregate demand and aggregate supply model to illustrate the effects of contractionary monetary policy. In the figure the economy is in equilibrium in year 1 at point A, with a price level of 100 and real GDP of $930 billion. From year 1 to year 2, the SRAS, LRAS and AD curves move to the right. The figure shows that without RBA policy action to increase rates aggregate demand would shift from AD1 to AD2(without policy) to a short-run equilibrium that is greater than potential GDP of $1000 billion at LRAS2. The economy would be in short-run equilibrium at point  B, where AD2(without policy) intersects SRAS2, with real GDP of $1030 billion and a price level of 104. When the RBA increases interest rates, aggregate demand does not increase by as much as it would have without policy, and the AD curve shifts to the right to AD2(with policy). In Figure 12.7 monetary policy is successful; the economy is in equilibrium at point C with real GDP of $1000 billion, which is at its full-employment level at LRAS2, and at a price level of 103. The inflation rate is lower than it would have been if the RBA had not used contractionary monetary policy. To summarise, Figure 12.8 provides a useful overview of the steps involved in expansionary and contractionary monetary policies.

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FIGURE 12.8

Expansionary and contractionary monetary policy

Reserve Bank Board decreases the cash rate

Other interest rates fall

Investment, consumption and net exports increase

The AD curve shifts to the right by more than it otherwise would have

Real GDP and the price level rise by more than they would have without policy

Other interest rates rise

Investment, consumption and net exports decrease

The AD curve shifts to the right by less than it otherwise would have

Real GDP and the price level rise by less than they would have without policy

(a) An expansionary policy

Reserve Bank Board increases the cash rate (b) A contractionary policy

SOLVED PROBLEM 12.1 THE EFFECTS OF MONETARY POLICY The hypothetical information in the table shows what the values for real GDP and the price level will be in 2016 if the RBA does not use monetary policy. YEAR

POTENTIAL GDP

REAL GDP

PRICE LEVEL

2015

$1700 billion

$1700 billion

110

2016

$1760 billion

$1745 billion

111.5

1

If the RBA wants to keep real GDP at its potential level in 2016, should it use an expansionary or contractionary monetary policy? Should it increase or decrease the cash rate?

2

Suppose the RBA’s policy is successful in keeping real GDP at its potential level in 2016. State whether each of the following will be higher or lower than if the RBA had taken no action. a Real GDP b Potential GDP c The inflation rate d The unemployment rate

3

Use a dynamic aggregate demand and aggregate supply model to illustrate your answer. Make sure that your graph includes LRAS curves for 2015 and 2016; SRAS curves for 2015 and 2016; AD curves for 2015 and for 2016, with and without monetary policy action; and equilibrium real GDP and the price level in 2016, with and without policy.

Solving the problem STEP 1: Review the chapter material. This problem is about the effects of monetary policy on real GDP and the price level, so you

may want to review the section ‘The effects of monetary policy on real GDP and the price level’, which begins on page 338. STEP 2: Answer question 1 by explaining how the RBA can keep real GDP at its potential level. The information in the table tells us

that without monetary policy the economy will be below potential GDP in 2016. To keep real GDP at its potential level, the RBA must undertake an expansionary monetary policy. To implement an expansionary policy the cash rate should be reduced. STEP 3: Answer question 2 by explaining the effect of the RBA’s policy. If the policy is successful, real GDP in 2016 will increase

from the level of $1700 billion, as given in the table, to its potential level of $1760 billion. Potential GDP is not affected by monetary policy, so its value will not change from the expansionary policy. Because the level of real GDP will be higher, the unemployment rate will be lower than it would have been without policy. The expansionary monetary policy shifts the AD curve to the right, so short-run equilibrium will move up the SRAS curve and the price level will be higher.

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STEP 4: Answer question 3 by drawing the graph. Your graph should look similar to the following.

Price level

RBA policy causes the AD curve to shift further to the right than it would have without policy.

LRAS2015

LRAS2016 SRAS2015 SRAS2016

113

C

111.5 110

B AD2016(with policy)

A

AD2016(without policy)

AD2015 0

$1700

1745 1760

Real GDP (billions of dollars)

The economy starts in equilibrium in 2015 at point A, with the AD and SRAS curves intersecting the LRAS curve. Real GDP is at its potential level of $1700 billion and the price level is 110. Without monetary policy the AD curve shifts to AD2016(without policy) and the economy is in short-run equilibrium at point B. Because potential GDP has increased from $1700 billion to $1760 billion, short-run equilibrium real GDP of $1745 billion is below the potential level. The price level has increased from 110 to 111.5. With policy the AD curve shifts to AD2016(with policy) and the economy is in equilibrium at point C. Real GDP is at its potential level of $1760 billion. We don’t have enough information to be sure of the new equilibrium price level. We do know that it will be higher than 111.5. The graph shows the price level rising to 113. Therefore, without policy the inflation rate in 2016 would have been about 1.4 per cent. With policy it will be about 2.7 per cent. EXTRA CREDIT: It’s important to bear in mind that in reality the RBA is unable to use monetary policy to keep real GDP exactly at its

potential level, as this problem suggests.

[ YOUR TURN Q

For more practice do related problems 3.8 and 3.9 on page 354 at the end of this chapter.

Is monetary policy always effective and fair? There are a few qualifications and considerations that we need to add to our discussion on monetary policy. These additional points can impact on the effectiveness of monetary policy, and also involve equity considerations. The first point to consider is to remember that monetary policy is subject to time lags. As we saw earlier in this chapter time lags mean that by the time monetary policy has its full impact on the economy the economic circumstances may have changed, and the policy chosen may no longer be appropriate. However, as we will see later in this chapter, over the past two decades the RBA has largely been successful in anticipating inflation and understanding these lags, and has effectively used monetary policy for inflation targeting. Second, monetary policy is usually more effective at slowing down the rate of economic growth than it is in increasing it. High rates of interest will effectively reduce most components of aggregate demand—new investment will fall, some consumer spending will decline and earnings from exports will fall due to the higher exchange rate that accompanies higher interest rates. For example, the extremely high interest rates in Australia in 1988 and 1989 (prior to the RBA gaining independence from the government) plunged the Australian

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economy into a severe recession. However, in a time of recession monetary policy is often less effective than during an economic boom. During a recession business confidence is at a very low level. Businesses will be unwilling to borrow money for investment when they are uncertain of their own viability, and are uncertain about the ability to generate sufficient profits to repay loans. Households, given uncertainty and fearing low wages or even unemployment, may wish to increase their savings or reduce debt by reducing consumption. In a number of countries experiencing severe recessions after the 2007–2008 GFC, nominal interest rates were zero, or almost zero, but this wasn’t sufficient to restore borrowing or economic growth. There are other important issues relating to monetary policy. While monetary policy is effective at slowing down the rate of economic growth and containing inflation, it affects some sectors and groups of people more than others. For example, higher interest rates relative to other countries will lead to an exchange rate appreciation, which, ceteris paribus, will reduce the export earnings for many firms in the agriculture, manufacturing and service sectors, as they face much competition in international markets. However, the minerals and energy sector has been less affected by periods of higher exchange rates over the past decade, as demand for its products remained strong from China, India and the Republic of Korea, even in the face of higher prices. Further, while interest rate rises can control inflation and therefore contribute to maintaining a healthy economic growth rate, the burden of monetary policy falls on some people and not others. For instance, under contractionary monetary policy, people with savings benefit and can increase their spending. However, marginal borrowers and lower income earners who generally have little savings do not benefit, and face higher interest repayments on loans, which can often impose severe hardship. It is for this reason that monetary policy has often been referred to as a ‘blunt instrument’. While it can be very effective in achieving its policy goal, the impacts on people are unequal. Finally, it is also important to remember that financial institutions in Australia are not required to alter their interest rates only when the RBA changes monetary policy. For example, in 2007, when the very large level of defaults of mortgage loans in the United States led to the GFC and a worldwide shortage of funds, most central banks around the world increased liquidity levels to prevent interest rates from rising. However, by the end of 2007 most of the

WHY DOES THE SHARE MARKET CARE ABOUT MONETARY POLICY? You have probably seen newspaper headlines similar to these: ‘RBA rate cut fuels share market gains’ or ‘Share prices fall in anticipation of RBA rate increase’.

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Why do changes in the cash rate affect the share market? There are two main explanations. In thinking about both explanations, remember that changes in the cash rate usually cause changes in other interest rates. The first reason that share prices react to the RBA raising or lowering interest rates is because changes in interest rates affect the economy. As we have seen, lower interest rates usually result in increases in real GDP. Fundamentally, the value of a share depends on the profitability of the firm that issued the shares. When real GDP is increasing, the profitability of many firms will also be increasing. Share prices tend to rise when financial markets expect the RBA to lower interest rates to stimulate the economy. When financial markets expect the RBA to raise interest rates to slow down an economy at risk of rising inflation share prices tend to fall. The second reason that share prices react to changes in interest rates is that changes in interest rates make it more or less attractive for people to put their wealth in shares rather than in other financial assets. Wealth holders look for the highest return possible on their assets, holding constant the riskiness of the investments. If the interest rates on CGS, bank certificates of deposit and corporate bonds are all low, holding wealth in shares will be more attractive. When interest rates are high, holding wealth in shares will be less attractive.

Apples Eyes Studio. Shutterstock. Pearson Education Ltd.

The share market reacts when the RBA either raises or lowers interest rates

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major banks in Australia indicated that there was still a shortage of funds. Consequently, from early 2008 and continuing through to the end of 2010 all of the major banks in Australia increased their interest rates independently of the RBA numerous times—moving outside the RBA’s target range. Such moves cause the RBA to lose some of its ability to implement monetary policy effectively, although its overall ability to manage interest rates remains strong.

DON’T LET THIS HAPPEN TO YOU

Remember that with monetary policy it’s the interest rate— not the money—that counts It is tempting to think of monetary policy working like this: if the RBA wants more spending in the economy it increases the money supply and people spend more because they now have more money. If the RBA wants less spending in the economy it decreases the money supply and people spend less because they now have less money. In fact, that is not how monetary policy works. For example, when the RBA reduces the availability of overnight liquidity—cash—by selling repurchase agreements, bonds and securities, the buyers (banks and other financial institutions) of these have just exchanged their funds for other assets—securities and bonds—from the RBA. They have not decreased their income, and no one’s income has decreased, so no one’s spending should be affected. It is only when this decrease in cash held by financial institutions results in higher interest rates that spending is affected. When interest rates are higher, households are less likely to buy new homes and cars, and businesses are less likely to buy new factories and computers. Higher interest rates can also lead to a higher value of the dollar, which can reduce export earnings and increase the demand for imports, thereby decreasing net exports. It isn’t the increase in liquidity that has brought about this reduction in spending; it’s the higher interest rates.

[ YOUR TURN Q

Test your understanding by doing related problem 3.14 on page 355 at the end of this chapter.

SHOULD THE RBA TARGET INFLATION? 12.4 Discuss the Reserve Bank of Australia’s use of monetary policy to target inflation. LEARNING OBJECTIVE

Over the past two decades or so, many central banks, including the RBA, have adopted inflation targeting as a framework for carrying out monetary policy. With inflation targeting, the central bank commits to conducting policy to achieve a publicly announced inflation target of, for example, 2 per cent to 3 per cent in Australia. Inflation targeting need not impose an inflexible rule on the central bank. The central bank would still be free, for example, to take action in the case of an economic contraction or recession, as many central banks did throughout the contractions and recessions that arose during the aftermath of the GFC. Nevertheless, monetary policy goals and operations focus on inflation and inflation forecasts. Inflation targeting has been adopted by the central banks of New Zealand (1988), Canada (1991), the United Kingdom (1992) and Sweden (1993), as well as Australia (unofficially in 1993 and officially in 1996), with the United States, while unofficially targeting inflation during the 2000s, announced their first official inflation target in 2012. Inflation targeting has also been used in other countries including Chile, the Republic of Korea, Mexico and South Africa, as well as in some transition economies in Eastern Europe, such as the Czech Republic, Hungary and Poland. Experience with inflation targeting has varied, but typically the move to inflation targeting has been accompanied by lower inflation (sometimes at the cost of higher unemployment). Countries that do not use inflationary targeting largely include the countries in the European Union monetary system. Should the RBA use an inflation target? Arguments in favour of inflation targeting focus on four points. First, as we have already discussed, in the long run real GDP returns to its potential level and potential GDP is not affected by monetary policy. Therefore, in the long run the RBA can have an impact on inflation but not on real GDP. Having an explicit inflation target

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would draw the public’s attention to this fact. Second, by announcing an inflation target, the RBA makes it easier for households and firms to form accurate expectations of future inflation, improving their planning and the efficiency of the economy. Third, an announced inflation target helps institutionalise good monetary policy. It is less likely that abrupt changes in policy would occur as members join and leave the Reserve Bank Board. Finally, an inflation target promotes accountability for the RBA by providing a yardstick against which its performance can be measured. Inflation targeting also has opponents, who typically raise three points. First, a numerical target for inflation reduces the flexibility of monetary policy to address other policy goals, such as unemployment, economic growth or exchange rate management. Second, inflation targeting assumes that the RBA can accurately forecast future inflation rates, which is not always the case. And, finally, holding the RBA accountable only for an inflation goal may make it less likely that the RBA will achieve other important policy goals. As we learned earlier, it is also important to remember that financial institutions in Australia are not required to alter their interest rates only when the RBA changes monetary policy. Independent moves on interest rates by banks can impede the ability of the RBA to implement monetary policy effectively. The RBA’s performance from the early 1990s onwards has generally received high marks from economists, as distinct from the significant criticism of the severe recessionary effect of the interest rate rises in 1988 and 1989. This, however, occurred prior to the RBA gaining independence from the federal government. The 1990s and 2000s, for example, saw low inflation and a substantial economic expansion. In addition, in recent years the RBA has acted to head off the threat of future inflation before it has become established. The RBA has been successful at building public support for the idea that low inflation is important to the efficient performance of the economy. The RBA’s early action on threatening inflation is likely to be more successful than waiting to act until inflation is actually rising. The RBA’s strategy is not without risk, however. The RBA’s prestige during the past two decades has been dependent on public trust in the effectiveness of RBA leadership in containing inflation, while maintaining economic growth.

HOW DOES THE RBA MEASURE INFLATION? To attain its goal of price stability, the RBA has to consider carefully the best way to measure the inflation rate. As we saw in Chapter 8, the consumer price index (CPI) is the most widely used measure of inflation. This is sometimes referred to as the headline rate of inflation. The CPI is useful in estimating the actual price rises paid by consumers; however, a measure of the underlying rate of inflation usually provides a better indicator of the trend in inflation in the economy. The underlying rate of inflation is a measure of the inflation rate that excludes items subject to volatile price changes and the effects of one-off inflationary events, shocks or policies (such as the introduction of the Goods and Services Tax (GST) in 2000). We also learned in Chapter 8 that the CPI suffers from biases that cause it to overstate the rate of inflation. An alternative measure of changes in consumer prices can be constructed from the data gathered to calculate GDP. We saw in Chapters 4 and 8 that the GDP deflator is a broad measure of the price level that includes the price of every good or service that is in GDP. However, changes in the GDP deflator are not a good measure of inflation experienced by the typical consumer, worker or firm, because the deflator includes prices of goods, such as industrial equipment, that are not widely purchased.

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lightpoet. Shutterstock

An alternative measure of the rate of inflation excludes food and automotive fuel prices

It is very important for the RBA to have an accurate understanding of the current underlying rate of inflation when it is implementing monetary policy. Therefore in addition to looking at the CPI, the RBA also uses other measures of consumer inflation.

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The first of these involves what are known as exclusion-based measures, where items in the CPI basket which experience volatility in prices are removed when calculating the inflation rate. The items that are usually excluded are automotive fuel and fruit and vegetables. For example, in Queensland in 2006, Cyclone Larry destroyed much of the banana plantations, causing the price of bananas in Australia to increase by around 400 per cent. The RBA estimated that the increase in the price of bananas added around three-quarters of a per cent to the annual rate of inflation as measured by the CPI, when in reality most people were no longer buying bananas. However, in some cases it might be appropriate to include so-called ‘volatile’ items. For example, if fuel prices have permanently trended upwards over many years and fuel is not included, the inflation rate may be underestimated. The other main measure of the inflation rate is the trimmed-mean measure. This method calculates a seasonally adjusted CPI and then orders the components from lowest to highest. It then ‘trims’ off a certain percentage of the components at the lowest and highest ends of the distribution of the price changes, and then calculates an average rate of inflation from what is left. The RBA normally uses two methods of trimming—a 15 per cent trim of the items at either end of the price change distribution, and a weighted median method. The main benefit of using a trimmed mean measure is that instead of simply excluding some items such as fuel or fruit regardless of whether or not their prices have been volatile, the trimmed mean aims to exclude items experiencing very large price changes that are unrepresentative of the general movement in prices. The following graph shows the annual rate of inflation from 1990 to 2013 as measured by the CPI, the CPI minus volatile items (fruit, vegetables and fuel) and one example of a trimmed-mean measure (the highest and lowest end 15 per cent trim). You can easily see that the CPI measure is the most volatile, with much greater ups and downs. The example of the ‘banana-induced’ inflation in 2006 can be seen in the CPI with an estimated inflation rate of 4 per cent, but not in the CPI minus volatile items or trimmed-mean measures. The impact of the GST in 2000–2001 appears in both the CPI and the CPI minus volatile items, whereas the trimmed-mean estimate of underlying inflation removes this one-off effect, along with some other temporary volatility over the time period. 10 9 8

CPI CPI minus volatile items Trimmed mean

7 6 5 4 3 2 1 0

19

9 19 0 9 19 1 9 19 2 9 19 3 9 19 4 9 19 5 9 19 6 9 19 7 9 19 8 9 20 9 0 20 0 0 20 1 0 20 2 0 20 3 0 20 4 0 20 5 0 20 6 0 20 7 0 20 8 0 20 9 1 20 0 1 20 1 1 20 2 13

–1

SOURCE: Created from Reserve Bank of Australia (2014), ‘Measures of consumer price inflation’, Statistics, Table G1, at , viewed 25 January 2014.

Each method of estimating the rate of inflation has its advantages and disadvantages, therefore by looking at a range of estimates the RBA aims to gain a more accurate understanding of the trend in prices when formulating monetary policy to target an inflation rate of between 2 per cent and 3 per cent in the medium term. SOURCE: Tony Richard and Tom Rosewall (2010), ‘Measures of underlying inflation’, The Bulletin, March Quarter, Reserve Bank of Australia, at , viewed 28 January 2014.

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IS THE INDEPENDENCE OF THE RESERVE BANK OF AUSTRALIA A GOOD IDEA? The RBA conducts monetary policy independently of the government although the members of the Reserve Bank Board are appointed by the government. The RBA does not, however, have absolute independence. The Australian Constitution contains no provision for a central bank. The authority of the RBA comes from legislation passed by parliament, which is free at any time to pass new legislation to reorganise the RBA or even to abolish it. So it is unlikely that the RBA would pursue a monetary policy that was strongly opposed by the government. Nevertheless, the RBA is able to formulate monetary policy without taking into account the wishes of the government.

349

12.5 Assess the arguments for and against the independence of the Reserve Bank of Australia. LEARNING OBJECTIVE

The case for RBA independence The main reason to keep the RBA—or any country’s central bank—independent of the government is to avoid inflation. Whenever a government is spending more than it is collecting in taxes, it must borrow the difference by selling bonds. The governments of many developing countries have difficulty finding anyone other than their central bank to buy their bonds. The more bonds the central bank buys the faster the money supply grows and the higher the inflation rate will be. Even in developed countries, governments that control their central banks will be tempted to sell bonds to the central bank rather than to the public. Another fear is that if the government controls the central bank it may use that control to further its political interests. It is difficult in any democratic country for a government to be re-elected at a time of high unemployment. If the government controls the central bank it may be tempted before an election to drive down interest rates to increase production and employment, even if this led in the long run to higher inflation and accompanying economic costs. During the lead-up to the November 2007 federal election in Australia the RBA increased interest rates—the first time it has ever done so during an election campaign, confirming its independence.

The case against RBA independence In democracies, elected representatives usually decide important policy matters. In Australia, however, monetary policy is not decided by elected members of parliament. Instead, it is decided by the unelected Reserve Bank Board. The members are usually academic economists or people with careers in banking, finance or other areas of business, plus two members from the government. Because the majority of those deciding monetary policy do not have to run for election they are not accountable for their actions to the ultimate authorities in a democracy: the voters. Some economists and politicians argue that the RBA should operate like other parts of the executive branch of government. Under this proposal, the members of the Reserve Bank Board would serve only as long as the government wanted them to. That way, if the government didn’t like the current monetary policy it would have the authority to dismiss the members of the Reserve Bank Board and appoint others in their place. When the government ran for re-election the voters would have an opportunity to express their approval or disapproval of the government’s actions regarding monetary policy. The RBA’s independence from the rest of the government, coupled with the RBA’s decision-making process, has concentrated power in the hands of the Governor of the RBA and the Reserve Bank Board. The strong tradition at the RBA is that the Governor plays a major role in setting policy.

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ECONOMICS IN YOUR LIFE (continued from page 329)

SHOULD YOU BUY A HOUSE DURING AN ECONOMIC CONTRACTION? At the beginning of this chapter, we asked whether buying a house during an economic contraction is a good idea. Clearly, there are many considerations to keep in mind when buying a house, which is the largest purchase you are likely to make in your lifetime. Included among these considerations are the price of the house relative to other comparable houses in the area, whether house prices in the area have been rising or falling, and the location of the house relative to shops, work and schools. Also important is the interest rate you will have to pay on the mortgage loan you would need in order to buy the house. As we have seen in this chapter, during a contraction or recession, the RBA often takes actions to lower interest rates. Because mortgage rates are typically lower during an economic contraction than at other times, you may want to take advantage of low interest rates to buy a house. But, contractions are also times of rising unemployment, and you would not want to make a commitment to borrow a lot of money for 25 or so years if you were in significant danger of losing your job. We can conclude, then, that if your job seems secure, buying a house during a contraction may be a good idea.

CONCLUSION Monetary policy is the means by which central banks can pursue goals for inflation, employment and economic growth. As we have seen, in Australia, since 1993, the primary goal of monetary policy has been to control inflation. Many journalists and politicians refer to the Governor of the RBA as second only to the Treasurer of Australia in their ability to affect the Australian economy. The government, however, also uses its power over spending and taxes to try to stabilise the economy. In the next chapter we discuss how fiscal policy—changes in government spending and taxes—affects the economy. Read ‘An inside look’ to learn how the central bank in the United Kingdom used monetary policy during the post-GFC recession and contractions.

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AN INSIDE LOOK NUARY 2014 SBS NEWS 10 JA

d r o c e r s d l o h d n a l g n E f o k n Ba low rates e of money. preserve the valu to nt ce r pe 0 2. of antitative set level d stimulus, or qu ue in nt its co ld ’s ho nk to ba l n at high The centra ) has voted s not kept inflatio ha e, of England (BoE m nt nk m ce ra r Ba e og pe pr Th A vel of 0.50 easing (QE), analysts. at a record-low le feared by some nd the en ou r be ar d ng ha pi key interest rate m as ls pu leve slowed to 2.1 pe level of stimulus th inflation rate on -m as 12 s, and maintain the ’s ar in ye ita ur Br omy. west level for fo recovering econ Policy Committee cent in November, the lo y ar et on M s . d’ glan price rises slowed at 0.5 per ‘The Bank of En ciding with its food and energy the Bank Rate n ai nt ai m to ee arch 2009, coin itt d M m in m Co ed e ch ‘Th today vote un . la ay per cent, QE was t said on Thursd ing rate to 0.50 s nd se le ha n rc ai m pu t its se t cent,’ a statemen k of as e central decision to cu aintain the stoc e. Under QE, th at nc si es rv er se ev re d oo nk also voted to m ral ba where it has st buy assets such issuance of cent that is used to d. sh ue financed by the ca in nt s te co it ea cr ),’ bank with the aim of A696 billion k Carney, corporate bonds ar d M an STG375 billion ($ or t rn en ve m go rn r ve go and, unde s from as onomic activity. The Bank of Engl lending—and ec e borrowing cost g is ra tin t os in cemented no bo ill w it rate falls t austerity, Brita t en en m m rn has stated that oy ve pl go em ite half of last C Desp least until the un ry in the second ’ policy. ve ce co an re id 0.50 per cent at th gu d ow ar gr t revival onomic nt, under a ‘forw a housing marke level of its ec w to lo r ks ea an to seven per ce -y th ur rt fo pa a tic e ment stands at ’s gross domes et year, in larg British unemploy ivate sector offs e loans. Britain pr m e ho th ter p in ar n ea qu tio ch ird ea id e th am bs cr 0.8 per cent in th 7.4 per cent as jo by ew gr d ) . an DP ng (G s— t di ar oduc e ye e spen orge Osborne pr huge cuts in stat t pace for thre Ge es r st te fa is e in an th m th — er 13 ance t is falling fast G25 billion of 20 On Monday, fin ’s unemploymen to find an extra ST s try ed un ne co in e th ita at Br Th official data. tion. warned that rding to the latest ar’s general elec co ye ac xt , ne ed meron’s r ct te pe af d ex ts inister David Ca is year an M th of painful cu e ts im cu Pr d by ne an ks many billion in pl But cutbac to bite, forcing ue in follows STG17 nt co t en m 2015. coalition govern STG20 billion in er spending. etary policy as on m e us to to rein in consum is ns sk ito ta Br n ai m ts E’ en b The Bo e to a governm nual inflation clos an ep ke to ol to a

SBS NEWS

SOURCE: SBS News (2014), ‘Bank of England holds record low rates’, SBS, 10 June, at , viewed 23 January 2014.

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Key points in the article The article discusses monetary policy used in the United Kingdom (UK) as the economy struggled to avoid another recession soon after the 2008–2009 GFC-induced recession. Slow rates of economic growth, high unemployment and a weak housing market led the central bank in the UK—the Bank of England (BoE)—to keep interest rates extremely low for years following the GFC. These economic conditions, including the downturn in most European Union economies, with some countries (for example, Greece) experiencing severe recessions, created business pessimism. Businesses were reluctant to borrow money for investment, even when interest rates were very low. With low interest rates failing to stimulate the economy, the BoE tried to increase liquidity by buying long-term bonds, a policy known as quantitative easing. (See Making the connection 12.1 for details of this policy in the United States.) By the end of 2013, the UK economy was showing signs of a recovery; however, the BoE remained reluctant to increase interest rates until economic growth was higher and unemployment rates were lower.

Analysing the news A In an attempt to stimulate aggregate demand and hence the rate of economic growth, the BoE used expansionary monetary policy. The article states that the official interest rate, the Bank Rate (equivalent to what is known as the cash rate in Australia), has been at record low levels of 0.5 per cent (since 2009 following the GFC), and remained at that level into 2014. We can see from Figure 1 that the cash rate was lowered from well over 5 per cent in 2007 to 0.5 per cent by 2009. However, the continuing need to keep interest rates so low for so many years reveals that monetary policy is not always effective or sufficient during a recession, with the

low interest rates not enough to stimulate economic growth sufficiently. It also shows that monetary policy can take time to take effect. It was only by 2013 that the low interest rates in the UK appeared to be having a significant effect.

B As this chapter showed, expansionary monetary policy has the potential to become inflationary. The article discusses the very low interest rates and the accompanying policy of the central bank buying government and corporate bonds to increase liquidity in the economy (quantitative easing), which could be inflationary under certain circumstances. However, the article indicates that high inflation rates did not occur in the UK and that a rising rate of inflation is not expected to be a problem given the current economic conditions. However, as the economy recovers further, interest rates may be increased to prevent high inflation in the future. C The Bank of England was hoping that the low interest rates would eventually boost the housing market, which would then flow through to increased demand in related industries. As pointed out in the article, by 2013 the UK housing market did revive and contributed significantly to stronger economic growth rates. Thinking critically

1 In the UK (and similarly in Australia), adjustable (variable) mortgage interest rates are common. However, in the United States, more than 80 per cent of house mortgages involve fixed interest rates rather than adjustable interest rates. How does this impact on the effectiveness of expansionary monetary policy in the US? 2 Suppose households and firms in an economy are extremely interest-rate sensitive with respect to their purchases. For example, a very small rise in the interest rate causes households and firms to dramatically reduce their FIGURE 1 THE UK CENTRAL BANK REDUCED INTEREST RATES TO CLOSE TO expenditures on consumption and ZERO DURING AND AFTER THE GFC investment; put differently, suppose the money demand curve is nearly 6 horizontal. What does this extreme interest-rate sensitivity imply about 5 the relative effectiveness of monetary policy?

Per cent

4

3

2

1

0

2006

2007

2008

2009

2010

2011

2012

2013

2014

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CHAPTER SUMMARY AND PROBLEMS KEY TERMS cash rate 334 contractionary monetary policy 340 exchange settlement accounts 334

expansionary monetary policy 339 inflation targeting 330 monetary policy 330

monetary targeting open market operations

335 333

WHAT IS MONETARY POLICY? PAGES 330–331 LEARNING OBJECTIVE 12.1

Define monetary policy and describe the main goals of monetary policy in Australia.

SUMMARY

1.2

Monetary policy in Australia refers to the actions taken by the Reserve Bank of Australia (RBA) to manage interest rates to pursue macroeconomic objectives. The RBA is Australia’s central bank. The Reserve Bank Act 1959 sets out three monetary policy goals that are intended to promote a well-functioning economy: price stability, full employment and economic prosperity. Since the early 1990s the RBA’s primary goal has been to control inflation. Inflation targeting involves conducting monetary policy in order to commit the central bank to achieving a publicly announced level of inflation.

1.1

PROBLEMS AND APPLICATIONS 1.3

1.4

1.5

REVIEW QUESTIONS

What is inflation targeting? How does inflation targeting help to achieve the main goals of monetary policy?

What are the main goals of monetary policy, as outlined in the Reserve Bank Act 1959?

Why is price stability usually the RBA’s main monetary policy goal? What problems can high inflation rates cause for the economy? If Australia’s rate of inflation rose to over 3 per cent for a few months during a year, but then returned to below 3 per cent, does this mean that the RBA’s goal of inflation targeting has failed? Explain. Do you think that the RBA has achieved its aim of price stability over the past 20 years? Explain.

THE DEMAND FOR AND SUPPLY OF MONEY, PAGES 332–336 LEARNING OBJECTIVE 12.2

Describe how the Reserve Bank of Australia affects interest rates.

SUMMARY The RBA’s monetary policy target is the cash rate, which in turn affects variables such as real GDP and the price level, that are closely related to the RBA’s policy goal of inflation targeting. The Reserve Bank Board announces a target for the cash rate after each monthly meeting. The cash rate is the interest rate financial institutions and the RBA charge each other for overnight loans. To lower the cash rate the RBA would either not sterilise an overnight cash surplus or, if required, would increase overnight liquidity. To increase the cash rate the RBA would either not sterilise an overnight cash deficit or, if required, would decrease overnight liquidity. The RBA utilises open market operations to manage the cash rate. Open market operations is the purchasing or selling of financial instruments such as Commonwealth Government Securities and private bonds and securities, either by outright purchase or sale, or by the use of repurchase agreements.

REVIEW QUESTIONS 2.1

What do economists mean by the ‘demand for money’? What is the advantage of holding money? What is the disadvantage?

2.2

2.3

2.4

Draw a demand and supply graph showing equilibrium in the money market. Suppose the RBA wants to lower the equilibrium interest rate. Show on the graph how the RBA would accomplish this objective. What is the cash rate? What role does it play in monetary policy? Explain the effect open market purchases have on the equilibrium interest rate.

PROBLEMS AND APPLICATIONS 2.5

2.6

Explain the effect that each of the following has on the demand for money curve. a A decrease in real GDP. b An increase in interest rates. c An increase in the general level of prices. If the RBA purchases $100 million worth of Commonwealth Government Securities (CGS), assuming all else remains the same (ceteris paribus), predict what will happen to interest rates. Explain your reasoning.

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If the RBA did not act to sterilise overnight liquidity changes, what would be the likely effect on nominal interest rates caused by the following? a The federal government transfers the Goods and Services Tax receipts to the governments of the Australian states and territories.

2.8

b There is a withdrawal of funds by bank customers on pay days. c A shortage of funds arises due to an increase in loan defaults. Why does the RBA no longer use monetary targeting to affect interest rates?

MONETARY POLICY AND ECONOMIC ACTIVITY, PAGES 337–346 Use the dynamic aggregate demand and aggregate supply model to show the effects of monetary policy on real GDP and the price level. LEARNING OBJECTIVE 12.3

SUMMARY An expansionary monetary policy lowers interest rates to increase consumption, investment and net exports. This increased spending causes the aggregate demand (AD) curve to shift out (rightwards) more than it otherwise would, raising the level of real GDP and the price level. A contractionary monetary policy raises interest rates to decrease consumption, investment and net exports. This decreased spending causes the AD curve to shift out (rightwards) less than it otherwise would, reducing both the level of real GDP and the inflation rate below what they would be in the absence of policy.

3.7

3.8

Price level

3.2

3.3

3.5

3.6

ADyear 2(without policy)

109.5 107.0

How does an increase in interest rates affect aggregate demand? Briefly discuss how each component of aggregate demand is affected. If the RBA believes the economy is about to fall into a recession what actions could it take? If the RBA believes that the inflation rate is about to increase above its target rate, what actions could it take? Should it always take this action whenever the inflation rate exceeds its target rate?

[Related to the chapter opening case] In Australia in 2013, the housing market was very strong; however, at the same time, the rate of unemployment rose and the economic growth rate remained below trend. How might RBA activity help explain these seemingly contradictory economic occurrences? In explaining why monetary policy did not pull Japan out of a recession in the early 2000s, an official at the Bank of Japan was quoted as saying that despite ‘major increases in the money supply’, the money ‘stay[ed] in banks’.3 Explain what the official meant by saying that the money stayed in banks. Why would that be a problem? Where does the money go if an expansionary monetary policy is successful? Suppose a newspaper headline read ‘Companies invest as interest rates reach a 20 year low’. Explain the connection between this headline and the monetary policy pursued by the RBA during that time.

LRASyear 2

110.5

ADyear 2(with policy)

ADyear 1 0

PROBLEMS AND APPLICATIONS 3.4

LRASyear 1

SRASyear 1 SRASyear 2

REVIEW QUESTIONS 3.1

How might firms’ expectations that the rates of return on new investments are too low make monetary policy less effective in ending a recession? [Related to Solved problem 12.1] Use the following graph to answer these questions.

3.9

$1200

1240 1260

Real GDP (billions of dollars)

a If the RBA does not take any policy action what will be the level of real GDP and the price level in year 2? b If the RBA wants to keep real GDP at its potential level in year 2, should it use an expansionary policy or a contractionary policy? Should the RBA be buying financial securities or selling them? c If the RBA takes no policy action what will be the inflation rate in year 2? If the RBA uses monetary policy to keep real GDP at its full-employment level, what will be the inflation rate in year 2? [Related to Solved problem 12.1] The hypothetical information in the following table shows what the situation will be in 2016 if the RBA does not use monetary policy. POTENTIAL YEAR

GDP

REAL GDP

PRICE LEVEL

2015

$1700 billion

$1700 billion

110

2016

$1760 billion

$1780 billion

114

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3.10

3.11

a If the RBA wants to keep real GDP at its potential level in 2016, should it use an expansionary policy or a contractionary policy? Should the RBA be buying financial securities or selling them? b If the RBA’s policy is successful in keeping real GDP at its potential level in 2016, state whether each of the following will be higher, lower or the same as it would have been if the RBA had taken no action. i Real GDP ii Potential GDP iii The inflation rate iv The unemployment rate c Draw a dynamic aggregate demand and aggregate supply graph to illustrate your answer. Make sure that your graph contains LRAS curves for 2015 and 2016; SRAS curves for 2015 and 2016; AD curves for 2015 and for 2016, with and without monetary policy action; and equilibrium real GDP and the price level in 2016, with and without policy. In 2010 the RBA increased the cash rate four times. This was done even though the annual rate of inflation, as measured by the CPI, averaged only 2.8 per cent. Why do you think the RBA increased the cash rate? Between 2005 and early 2008 oil prices and house prices in Australia rose significantly, increasing the cost of living for Australians. During the same period the RBA increased interest rates eight times. Do you think that the RBA was aiming to make Australians worse off by raising interest rates at a time when other expenses were also increasing?

3.12

3.13

3.14

3.15

3.16

355

According to an article about monetary policy in Japan: In February…[Japan’s] gauge of core consumer prices slipped from 0.1% from a year earlier… The Bank of Japan [BOJ] said last year it would regard prices as stable if they rose from zero to 2% a year…The Bank of Japan’s target for short-term interest rates is just 0.5%…‘It will be very difficult for the BOJ to raise interest rates when the prices are below the rate it defines as stable’ says Teizo Taya, special counselor for the Daiwa Institute of Research and a former BOJ policy board member.4 a What is the term for a falling price level? b Why would the Bank of Japan, the Japanese central bank, be reluctant to raise its target for short-term interest rates if the price level is falling? c Why would a country’s central bank consider a falling price level to be undesirable? Some business people believe that active monetary policy makes the economy less stable rather than more stable. Briefly explain why they think that. [Related to Don’t let this happen to you] Briefly explain whether you agree with the following statement: ‘The RBA has an easy job. If it wants to increase real GDP by $20 billion, all that it has to do is reduce interest rates.’ Most of the countries of the European Union use a common currency, the euro, and have a common monetary policy determined by the European Central Bank. What are the implications for any member country wishing to control its own rate of inflation? [Related to Making the connection 12.1] Keynes is reported to have remarked that using an expansionary monetary policy to pull an economy out of a deep recession can be like ‘pushing on a string’. Briefly explain what you think Keynes is likely to have meant.

SHOULD THE RBA TARGET INFLATION? PAGES 346–348 LEARNING OBJECTIVE 12.4

Discuss the Reserve Bank of Australia’s use of monetary policy to target inflation.

SUMMARY

REVIEW QUESTIONS

In the 1970s and 1980s the RBA used the money supply as its monetary target, rather than an interest rate. However, during the 1980s the relationship between movements in the money supply and movements in real GDP and the price level weakened, and it became increasingly difficult to control the money supply. Many economists and central bankers have supported using inflation targeting. Under inflation targeting, monetary policy is conducted to commit the central bank to achieving a publicly announced inflation target. A number of foreign central banks have adopted inflation targeting, as has the RBA. The RBA’s performance since the early 1990s has generally received high marks from economists.

4.1

4.2

For many years now the RBA has used the cash rate as its monetary policy target. Why doesn’t it target the money supply at the same time? What are the main arguments used to support inflation targeting? What are the main arguments against inflation targeting?

PROBLEMS AND APPLICATIONS 4.3

Do you think that inflationary targeting has introduced an economic environment that is more conducive or less conducive to investment and economic growth? Explain your answer.

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4.5

At various times in recent years, the major banks in Australia pursued their own interest rate policy and increased their interest rates by more than the amount by which the RBA increased the cash rate. Would such actions mean that monetary policy has become ineffective? [Related to Making the connection 12.3] If measures of consumer inflation such as those which remove volatile

items, or the RBA’s trimmed-mean measures, are better measures of the inflation rate than is the CPI, why is the CPI more widely used? In particular, can you think of reasons why the federal government uses the CPI when deciding how much to increase unemployment payments to keep the purchasing power of the payments from declining?

IS THE INDEPENDENCE OF THE RESERVE BANK OF AUSTRALIA A GOOD IDEA? PAGE 349 LEARNING OBJECTIVE 12.5

Assess the arguments for and against the independence of the Reserve Bank of Australia.

SUMMARY The RBA conducts monetary policy without formal input from the government. However, the RBA’s independence is not absolute because parliament can pass legislation at any time to reorganise or even abolish it. Advocates of RBA independence argue that isolating it from political pressure allows it to choose policies in the best interests of the economy. Internationally, countries with independent central banks tend to have lower inflation rates. Opponents of RBA independence argue that concentrating so much power in the hands of unelected officials is inconsistent with democratic principles.

5.2

PROBLEMS AND APPLICATIONS 5.3

5.4

REVIEW QUESTIONS 5.1

What arguments do economists make in support of the independence of the RBA and what arguments are used against the independence of the RBA?

Do you think that the RBA is truly independent of the government in its determination of monetary policy? Provide evidence for your answer. Suppose a corrupt government of a country wants to vastly increase expenditure on arms. Why would the independence of the country’s central bank have any relevance in this situation?

In what ways is the RBA more independent of the federal government than other institutions like, for instance, the Federal Treasury?

ENDNOTES 1

2

ComLaw, at , viewed 9 February 2011. All legislative material herein is reproduced by permission but does not purport to be the official or authorised versions. It is subject to Commonwealth of Australia copyright. Reserve Bank of Australia (2013), Statement on the Conduct of Monetary Policy, 24 October, at , viewed 26 January 2014.

3 4

James Brooke (2002), ‘Critics say Koizumi’s economic medicine is a weak tea’, The New York Times, 27 February. Yuka Hayashi (2007), ‘Japan’s consumer prices may threaten economy,’ The Wall Street Journal, 25 April, at , viewed 28 January 2014.

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13

FISCAL POLICY

LEARNING OBJECTIVES After studying this chapter you should be able to: 13.1 Define fiscal policy. 13.2 Explain how fiscal policy affects aggregate demand and how the government can use fiscal policy to stabilise the economy. 13.3 Explain how the multiplier process works with respect to fiscal policy. 13.4 Discuss the difficulties that can arise in implementing fiscal policy. 13.5 Define federal budget deficit and federal government debt and explain how the federal budget can serve as an automatic stabiliser. 13.6 Discuss the long-run effects of fiscal policy.

DID THE FISCAL STIMULUS BOOST SALES AT RETAIL STORES LIKE HARVEY NORMAN? WHEN IT WAS feared that the global financial crisis (GFC) might send Australia into recession in 2008 the government introduced a range of economic stimulus measures, beginning in December 2008. These included cash payments to families with children and to pensioners, and the First Home Buyer’s grant was increased substantially. In this first round of government spending $10.4 billion was spent. This was then soon followed by another round of cash payments in early 2009, with direct payments of up to $900 per person made to the majority of taxpayers. Another aspect of the fiscal stimulus package was a range of infrastructure building projects costing $42 billion. It would have been expected that retailers, such as the giant furniture and electronics retailer Harvey Norman Holdings Ltd, would have been big beneficiaries of the fiscal stimulus, particularly the cash handout to households. The injections of cash did impact on retail spending, which strengthened during the first half of 2009. However, the boost to retail sales was short lived. Following the sluggish sales in 2009, Harvey Norman Holdings announced plans to close up to 10 stores in 2010. The chairman, Mr Gerry Harvey, stated in January 2009:

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Now that I’ve looked at my first couple of weeks, or three weeks nearly, of sales in January, they’re not good. My view is if there’d been no fiscal stimulus I don’t think it’d have been much different. He stated that the government may have been better off keeping the stimulus money. In retrospect now you say to yourself: ‘was that a real good idea, that was 10.4 billion, that’s a lot of money’. Did it have just a temporary effect for December and then disappear? Gee—let’s maybe learn a lesson from that and not do that again. A number of economists, probably the majority, argue that the cash payments did play an important role in preventing a recession in Australia, along with other factors, including the stable and well-regulated financial system in Australia, the Reserve Bank of Australia’s expansionary monetary policy and the continued strong demand for minerals and energy by China and India. Some economists, however, question the effectiveness of the cash payments, arguing that a significant proportion was spent on imported goods and was also saved or used to repay debts, reducing the stimulus effect on the economy. The subsequent budget deficits also meant that the government has had to borrow very large amounts of funds, leading to Australia’s highest ever net government debt—estimated at over $200 billion in 2014 and expected to reach $260 billion by 2016. Government budget deficits and borrowing during a recession is generally accepted by economists as the appropriate course of action; however, the magnitude of the spending during and immediately after the GFC has been the focus of debate and criticism, as has the inability to balance the budget ever since. The problem arising from government debt is that it has to be paid back, with interest, and this places a burden on current and future taxpayers, and may ultimately reduce economic growth rates in the future. The interest repayments alone represent a current drain on the budget, with annual net interest payments expected to reach over $12 billion by 2016. Despite these deficits, the unemployment rate had risen to 6 per cent in early 2014 and the labour force participation rate had fallen as some people gave up looking for work. Five years after the stimulus package, retail sales data had only just begun to show signs of moving up towards longrun average growth rates.

AAP Image/Dean Lewins

13

ECONOMICS IN YOUR LIFE

WHAT WOULD YOU DO WITH $500? Suppose that the federal government announces that it will immediately send you, and everyone else in the economy, a $500 tax rebate. How will you respond to this increase in your disposable income? What effect will this tax rebate be likely to have on equilibrium real GDP in the short run? As you read the chapter, see if you can answer these questions. You can check your answers against those we provide on page 382 at the end of this chapter.

SOURCE: Source of quotes from Gerry Harvey: ABC News (2009), ‘It’s like the stimulus package never happened: Harvey Norman’, ABC News, 20  January, Australian Broadcasting Commission, at , viewed 12 February 2014. Sources of quotes from Malcolm Turnbull: ABC News (2009), ‘Turnbull won’t support another stimulus “spendathon”’, ABC News, 2 April, Australian Broadcasting Commission, at , viewed 8 February 2011; Herald Sun (2009), ‘Malcolm Turnbull says stimulus only giving “modest returns”’, Herald Sun, 6 May, at , viewed 8 February 2011.

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IN CHAPTER 12 we discussed how the Reserve Bank of Australia (RBA) uses monetary policy to pursue macroeconomic goals and, primarily, price stability. In this chapter we explore how the government uses fiscal policy, which involves changes in taxes and government purchases, to try to achieve important macroeconomic policy goals. As we saw in Chapter 8, the price level and the levels of real GDP and total employment in the economy depend in the short run on aggregate demand and short-run aggregate supply. The government can affect the levels of both aggregate demand and aggregate supply through fiscal policy. We explore how the government decides which fiscal policy actions to take to achieve its goals. We also discuss the disagreements between economists and policy-makers over the effectiveness of fiscal policy.

WHAT IS FISCAL POLICY? 13.1 Define fiscal policy. LEARNING OBJECTIVE

Fiscal policy Changes in federal taxes and purchases that are intended to achieve macroeconomic policy objectives, such as high employment, price stability and healthy rates of economic growth.

As we saw in Chapter 12, the RBA closely monitors the economy and the Reserve Bank Board meets each month to decide whether to change monetary policy. Less frequently, the federal government also makes changes in taxes and government purchases to achieve its macroeconomic policy objectives, which include low unemployment, price stability and healthy rates of economic growth. Changes in federal taxes and spending that are intended to achieve macroeconomic policy objectives are called fiscal policy.

What fiscal policy is and what it isn’t In Australia the federal, state and local governments all have responsibility for taxing and spending. Economists typically use the term fiscal policy to refer only to the actions of the federal government. State and local governments will sometimes change their taxing and spending policies to aid their local economies, but these are not fiscal policy actions because they are not intended to affect the national economy. The federal government makes many decisions about taxes and spending, but not all of these decisions are fiscal policy actions because they are not intended to achieve macroeconomic policy goals. For example, a decision to cut the taxes of people who take out private health insurance is a health policy action, not a fiscal policy action. Similarly, the increases in defence spending that occurred in the years after 2001 to fund counter-terrorism and the wars in Iraq and Afghanistan were part of defence policy, not fiscal policy.

Automatic stabilisers versus discretionary fiscal policy Automatic stabilisers Transfer payments and taxes that automatically increase or decrease along with the business cycle.

Discretionary fiscal policy When the government is taking actions to change spending or taxes to achieve its economic objectives (fiscal policy).

There is an important distinction between automatic stabilisers and discretionary fiscal policy. Some government taxes and transfer payments automatically increase and decrease along with the business cycle, and are referred to as automatic stabilisers. The word automatic refers to the fact that changes in these types of spending and taxes happen without actions by the government. For example, when the economy is expanding and employment is increasing, government transfers for unemployment benefit payments to workers who were previously unemployed will automatically decrease. During an economic contraction or a recession, as unemployment rises unemployment benefit payments will automatically increase. Similarly, when the economy is expanding or experiencing an economic boom and incomes are rising, the amount the government collects in taxes will increase as people pay additional taxes on their higher incomes. When the economy is contracting or in a recession, the amount the government collects in taxes will fall. With discretionary fiscal policy the government takes actions to change spending or taxes. The tax cuts passed by parliament each year from 2006 to 2008 are examples of discretionary fiscal policy actions. The increase in government spending in 2008–2009 that we read about in the opening case, which was aimed at stimulating aggregate demand during an economic contraction, is also discretionary fiscal policy.

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An overview of government spending and taxes Economists often measure government spending relative to the size of the economy by calculating government spending as a percentage of gross domestic product (GDP). Remember that there is a difference between federal government purchases and federal government expenditures. When the federal government purchases a military aircraft or the services of school teachers it receives a good or service in return. Federal government expenditures include purchases plus all other federal government spending. Figure 13.1 shows that total federal government expenditure as a proportion of GDP increased by a large amount during the early to mid-1970s and trended downwards during the 1990s and into the 2000s—a result of the microeconomic reform policies of governments during this time which saw the sale of many government business enterprises to the private sector, and a transfer of the provision of some goods and services to the private sector. Between 2008 and 2010 government expenditure as a proportion of GDP rose, peaking at around 26.2 per cent of GDP in 2010, due in large part to the spending programs designed to expand the economy following a short period of negative economic growth in 2008 which resulted from the global financial crisis (GFC). Subsequent below-trend economic growth saw government expenditure as a proportion of GDP generally remain higher than it was during the 2000s. Government expenditure goes to many different areas throughout the economy. These include transfer payments such as social security and welfare, transfers to states and territories, spending on health, education, defence and other government services. Figure 13.2 shows FIGURE 13.1

Total government expenditure as a percentage of GDP, 1970–2015 Government expenditure as a proportion of GDP increased by a large amount during the early to mid-1970s and trended downwards during the 1990s and into the 2000s—a result of the microeconomic reform policies of governments during this time. By 2007 government expenditure as a proportion of GDP was 23.8 per cent. From 2008 to 2010 government expenditure as a proportion of GDP rose, peaking at around 26.2 per cent of GDP in 2010. Although it fluctuated, after 2010 government expenditure as a proportion of GDP generally remained higher than it had been during the 2000s

30 29 28 27 26 25 Per cent

24 23 22 21 20 19 18 17 16 15 1970

1975

1980

1985

1990

1995

2000

2005

2010

2015

Note: Data for 2015 are Treasury estimates. SOURCE: Created from Commonwealth Government (2013), ‘Historical Australian Government Data’, Mid-Year Economic and Fiscal Outlook, 2013–14, Appendix D, Table D1, at , viewed 10 February 2014.

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FIGURE 13.2

Government expenditure by function, 2013/14 The largest share of government expenditure in Australia goes to social security and welfare payments, at 33.6 per cent in the 2013/14 financial year. The second largest single share of total government expenditure is health, at 15.7 per cent SOURCE: Created from Australian Government (2013), Mid-Year Economic and Fiscal Statement 2013–14, December, Table 3.21, at , viewed 10 February 2014.

Health 15.7%

Other economic affairs 2.9%

Social security and welfare 33.6%

General purpose inter-government transactions 12.7% Public debt interest 3.3% Defence 5.5%

Education 7.3%

General public services 8.1%

Housing and community amenities Other 2.1% purposes 8.8%

total government expenditure by function for the 2013/14 financial year. We can see from Figure 13.2 that the largest share of government expenditure in Australia goes to social security and welfare payments, at 33.6 per cent. (Although not shown in the figure, the largest share of current social security and welfare payments—around 40 per cent—is spent on the age pension and services to the aged. This is followed by payments to families with children (25 per cent) and disability pensions and expenditures (18 per cent)). Figure 13.2 also shows us that the second largest single share of total government expenditure is health at 15.7 per cent. Figure 13.3 shows the means by which the government receives its revenue. Clearly, the largest proportion of government revenue comes from personal income taxation. For the 2013/14 financial year, almost 45 per cent of federal government revenue came from personal income taxation. The second largest source of revenue was from company income taxation and petroleum and minerals resource taxation, at 19.5 per cent of total revenue.

FIGURE 13.3

Government revenue by source, 2013/14 The largest proportion of government revenue comes from personal income taxation. For the 2013/14 financial year, almost 45 per cent of federal government revenue came from personal income taxation. The second largest source of revenue is from company income taxation and petroleum and minerals resource taxation, at 19.5 per cent of total revenue SOURCE: Created from Australian Government (2013), Mid-Year Economic and Fiscal Statement 2013–14, December, Table 3.5, at , viewed 10 February 2014.

Other taxation 0.9% Sales tax (incl. GST) 14.1% Carbon pricing 2.0% Customs duty and other excise tax 4.6% Fuel excise tax 5.1% Fringe benefits tax 1.1% Superannuation tax 1.9%

Non-taxation revenue 5.9%

Personal income tax 44.9%

Company income tax and petroleum and minerals resource tax 19.5%

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USING FISCAL POLICY TO INFLUENCE AGGREGATE DEMAND

363

13.2

The federal government may use fiscal policy to try to offset the effects of the business cycle on the economy. Because changes in government purchases and taxes lead to changes in aggregate demand, they can affect the level of real GDP, employment and the price level. When the economy is experiencing an economic contraction or recession, increases in government purchases or decreases in taxes will increase aggregate demand. As we have seen in Chapter 10, the inflation rate may increase when aggregate demand is increasing faster than aggregate supply. Decreasing government purchases or raising taxes can slow the growth of aggregate demand and reduce the inflation rate.

Explain how fiscal policy affects aggregate demand and how the government can use fiscal policy to stabilise the economy. LEARNING OBJECTIVE

Expansionary fiscal policy Expansionary fiscal policy involves increasing government purchases or decreasing taxes. An increase in government purchases will increase aggregate demand directly because government purchases are a component of aggregate demand. As we read in the opening case to this chapter, expansionary fiscal policy was used from 2008–2009 (with some programs running until 2012) to increase aggregate demand during the economic contraction during and after the GFC. A cut in taxes has an indirect effect on aggregate demand. The income that households have available to spend after they have paid their taxes is called disposable income. If the personal income tax rate is cut, household disposable income will rise and so should consumption spending. Tax cuts on business income can increase aggregate demand by increasing business investment. We use the dynamic aggregate demand and aggregate supply model to show the effects of fiscal policy. To review this model briefly, recall that over time potential GDP increases, which we show by the long-run aggregate supply (LRAS) curve shifting to the right. The factors that cause the LRAS curve to shift also cause firms to supply more goods and services at any given price level in the short run, which we show by the short-run aggregate supply (SRAS) curve shifting to the right. Finally, during most years the aggregate demand (AD) curve also shifts to the right, indicating that aggregate expenditure is higher at every price level. Figure 13.4 shows the results of expansionary fiscal policy. The goal of expansionary fiscal policy is to increase aggregate demand relative to what it would have been without policy. In the hypothetical situation shown in Figure 13.4 the economy begins in equilibrium at potential GDP of $1200 billion and a price level of 100 (point A). In the second year, LRAS increases to $1400 billion but AD1 increases only to AD2(without policy), which is not enough to keep the economy in macroeconomic equilibrium at potential GDP. Assuming that all else remains constant

Price level

LRAS1

LRAS2

Expansionary fiscal policy causes the AD curve to shift further to the right

SRAS1 C 103 102

A

100

SRAS2

B

AD2 (with policy) AD2 (without policy)

AD1

$1200

0

1350 1400

Real GDP (billions of dollars)

Expansionary fiscal policy Increases in government purchases or decreases in taxes in order to increase aggregate demand.

FIGURE 13.4

Expansionary fiscal policy The economy begins in equilibrium at point A, at potential GDP of $1200 billion and a price level of 100. In the second year, LRAS increases to $1400 billion, but AD1 increases only to AD2(without policy), which is not enough to keep the economy in macroeconomic equilibrium at potential GDP. The economy will be in short-run equilibrium at point B, with real GDP of $1350 billion and a price level of 102. Increasing government purchases or cutting taxes will shift aggregate demand to AD2(with policy). The economy will be in equilibrium at point C with real GDP of $1400 billion, which is its potential level, and a price level of 103. The price level is higher than it would have been if expansionary fiscal policy had not been used

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(including the simplification that there is no monetary policy action), without expansionary fiscal policy of spending increases or tax reductions the short-run equilibrium will occur at $1350 billion (point B) with the price level rising to 102. The $50 billion gap between this level of real GDP and the potential level means that some firms are operating at less than their full capacity. Incomes and profits will be falling, some firms will begin to lay off workers and the unemployment rate will rise. Increasing government purchases or cutting taxes can shift aggregate demand to AD2(with policy). The economy will be in equilibrium at point C with real GDP of $1400 billion, which is its potential level, and a price level of 103. The price level and therefore the inflation rate is higher than it would have been if expansionary fiscal policy had not been used.

Contractionary fiscal policy Contractionary fiscal policy Decreases in government purchases or increases in taxes in order to reduce the increases in aggregate demand.

Contractionary fiscal policy involves decreasing government purchases or increasing taxes. Policy-makers use contractionary fiscal policy to reduce increases in aggregate demand that seem likely to lead to an increase in the rate of inflation. In Figure 13.5 the economy again begins at potential GDP of $1200 billion and a price level of 100 (point A). Once again, LRAS increases to $1400 billion in the second year. In this scenario the shift in aggregate demand to AD2(without policy) results in a short-run macroeconomic equilibrium beyond potential GDP of $1450 billion (point B). Assuming once again that all else remains constant (and that there is no monetary policy action taken), the economy will experience a rise in the price level, from 100 to 104. Decreasing government purchases or increasing taxes will shift AD1 to AD2(with policy) and keep real GDP from moving beyond its potential level. The result, shown in Figure 13.5, is that at the new equilibrium at point C, the inflation rate is 3 per cent rather than 4 per cent, and real GDP is at its potential level of $1400 billion. Table 13.1 summarises how fiscal policy affects aggregate demand.

FIGURE 13.5

Contractionary fiscal policy The economy begins in equilibrium at point A, at potential GDP of $1200 billion and a price level of 100. LRAS increases to $1400 billion in the second year. The shift in aggregate demand from AD1 to AD2(without policy) results in a short-run macroeconomic equilibrium beyond potential GDP of $1450 billion (point B). The economy will experience a rising inflation rate, with the price level rising from 100 to 104. Decreasing government purchases or increasing taxes will shift AD1 to AD2(with policy) and keep real GDP from moving beyond its potential level. The inflation rate is 3 per cent rather than 4 per cent, and real GDP is at its potential level of $1400 billion

Price level Contractionary fiscal policy causes the AD curve to shift to the right by less than it would have without policy.

LRAS1

LRAS2 SRAS1 SRAS2

B

104 103 100

C A AD2(without policy)

AD2 (with policy) AD1 0

$1200

1400 1450

Real GDP (billions of dollars)

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365

Countercyclical fiscal policy

PROBLEM

TYPE OF POLICY

ACTIONS BY THE GOVERNMENT

RESULT

Economic contraction or recession

Expansionary

Increase government spending or cut taxes

Real GDP and the price level rise by more than they would have without policy

Rising inflation rate

Contractionary

Decrease government spending or raise taxes

Real GDP and the price level do not rise by as much as they would have without policy

DON’T LET THIS HAPPEN TO YOU

Don’t confuse fiscal policy and monetary policy If you keep in mind the definitions of money, income and spending, the difference between monetary policy and fiscal policy will be clearer. A common mistake is to think of monetary policy as the RBA fighting economic contractions by increasing financial liquidity so people will have more money to spend, and to think of fiscal policy as the government fighting economic contractions by spending more money. In this view, the only difference between fiscal policy and monetary policy would be the source of the money. To understand what’s wrong with the descriptions of fiscal policy and monetary policy just given, first remember that the problem during a contraction is not that there is too little money but too little spending. There may be too little spending for a number of reasons. For example, households may cut back on their spending on cars and houses because they are pessimistic about the future. Firms may cut back their investment spending because they have lowered their estimates of the future profitability of new machinery and factories. Or the major trading partners of Australia—such as Japan, China, the European Union and the United States—may be suffering from recessions, which cause households and firms in those countries to cut back their spending on Australian products. The purpose of expansionary monetary policy is to lower interest rates, which in turn increases aggregate demand. When interest rates fall, households and firms are willing to borrow more to buy cars, houses and factories. The purpose of expansionary fiscal policy is to increase aggregate demand by having the government either directly increase its own purchases or cut taxes to increase household disposable income and therefore increase consumption spending. Just as increasing or decreasing the money supply does not have a direct effect on government spending or taxes, increasing or decreasing government spending or taxes does not have a direct effect on the money supply. Fiscal policy and monetary policy have the same goals, but they have different effects on the economy.

[ YOUR TURN Q

Test your understanding by doing related problem 2.6 on page 386 at the end of this chapter.

GOVERNMENT PURCHASES AND TAX MULTIPLIERS Suppose that during a recession the government decides to use discretionary fiscal policy to increase aggregate demand by spending an additional $10 billion to construct new rail systems in several cities. How much will equilibrium real GDP increase as a result of this increase in government purchases? Assuming that the construction materials are purchased locally and not imported, we know that the answer is greater than $10 billion because we know the initial increase in aggregate demand will lead to additional increases in income and spending. To build the railways the government hires private construction firms. These firms will hire more workers to carry out the new construction projects. Newly hired workers will increase their spending on cars, furniture, restaurant meals and other products. Sellers of these products will increase their production and hire more workers. At each step, real GDP and income will

13.3 Explain how the multiplier process works with respect to fiscal policy. LEARNING OBJECTIVE

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rise, thereby increasing consumption spending and aggregate demand. Economists refer to the initial increase in government purchases as autonomous because it was the result of a decision by the government, and does not directly depend on the level of real GDP. The increases in consumption spending are induced by the initial increase in autonomous spending. As we learned in Chapter 9, economists refer to the series of induced increases in consumption spending that result from an initial increase in autonomous expenditure as the multiplier effect. Figure 13.6 illustrates how an increase in government purchases affects the aggregate demand curve. The initial increase in government purchases causes the aggregate demand curve to shift to the right An initial increase in autonomous government spending, such as building new railway lines, will increase aggregate demand by an amount that is more than the because total spending in the economy is now higher initial amount of new spending at every price level. The shift to the right from AD1 to AD2 represents the impact of the initial increase of $10 Multiplier effect billion in government purchases. Because this initial The process by which an increase in government purchases raises incomes and leads to further increases in consumption increase in autonomous expenditure leads to a larger spending, the aggregate demand curve will ultimately shift further to the right, to AD3. increase in real GDP. To understand the multiplier effect better, let’s start with a simplified analysis in which we assume that the price level is constant. In other words, initially we will ignore the effect of an upward-sloping SRAS curve. Figure 13.7 shows how spending and real GDP increase over a number of periods beginning with the initial increase in government purchases in the first period, holding the price level constant. The initial spending in the first period raises real GDP and total income in the economy by $10 billion. How much additional consumption spending will result from $10 billion in additional income? Recall that the marginal propensity to consume (MPC) tells us the proportion of extra income that consumers will spend. In addition to increasing their consumption spending on domestically produced goods, we know that households will save some of the increase in income, use some to pay income taxes and use some to purchase imported goods, which will have no direct effect on spending and production in the Australian economy. In Figure 13.7 we assume that in the second period households increase their consumption spending by one-half of the increase in income from the first period—or by $5 billion. This second period spending will, in turn, increase real GDP and

FIGURE 13.6

The multiplier effect and aggregate demand An initial increase in government purchases of $10 billion causes the aggregate demand curve to shift to the right, from AD1 to AD2, and represents the impact of the initial increase of $10 billion in government purchases. Because this initial increase raises incomes and leads to further increases in consumption spending, the aggregate demand curve will shift further to the right, to AD3

Price level

2. . . . and the multiplier effect results in a further shift.

100 1. An initial $10 billion increase in government purchases shifts the aggregate demand to the right by $10 billion . . .

0

AD1

AD2

AD3

Real GDP (billions of dollars)

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FIGURE 13.7

The multiplier effect of an increase in government purchases Following an initial increase in government purchases, spending and real GDP increase over a number of periods due to the multiplier effect. The new spending and increased real GDP in each period is shown in green and the level of spending from the previous period is shown in orange, so the sum of the orange and green areas represents the cumulative increase in spending and real GDP. In total, equilibrium real GDP will increase by $20 billion as a result of an initial increase of $10 billion in government purchases

Period

Additional spending this period

Cumulative increase in spending and real GDP

1

$10 billion in government purchases

$10 billion

2

$5 billion in consumption spending

$15 billion

3

$2.5 billion in consumption spending

$17.5 billion

4

$1.25 billion in consumption spending

$18.75 billion

5

$0.625 billion in consumption spending

$19.375 billion

6 . . .

$0.3125 billion in consumption spending . . .

$19.6875 billion . . .

n

0

$20 billion

Real GDP (billions of dollars) $20 19.6875 19.375 18.75 17.5

15

10

0

1

2

Initial increase in government purchases

3

4

5

6

...

Induced increases in consumption spending

n Time period

income by an additional $5 billion. In the third period, consumption spending will increase by $2.5 billion, or one-half of the $5 billion increase in income from the second period. The multiplier effect will continue over a number of periods, with the additional consumption spending in each period being half of the income increase from the previous period. Eventually, the process will be complete, although we cannot say precisely how many periods it will take, so we simply label the final period n, rather than giving it a specific number. In the graph in Figure 13.7 the new spending and increased real GDP in each period is shown in green and the level of spending from the previous period is shown in orange. The sum of the orange and green areas represents the cumulative increase in spending and real GDP. How large will the total increase in equilibrium real GDP be as a result of the initial increase of $10 billion in government purchases? The ratio of the change in equilibrium real GDP to the initial change in government purchases is known as the government purchases multiplier: Government purchases multiplier 

change in equilibrium real GDP change in government purchases

If, for example, the government purchases multiplier has a value of 2, an increase in government purchases of $10 billion should increase equilibrium real GDP by 2 × $10 billion = $20 billion. We show this in Figure 13.7 by having the cumulative increase in real GDP equal

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$20 billion. This assumes that the whole of the initial $10 billion is spent by the government on Australian-produced goods and services. It is likely that some of this expenditure will be used for the purchase of goods produced overseas, which would make the multiplier effect smaller; however, for simplification we have ignored this in this example. Tax cuts also have a multiplier effect. Cutting personal income taxes increases the disposable income of households. When household disposable income rises, so will consumption spending, depending on the size of the MPC. These increases in consumption spending will set off further increases in real GDP and income, just as increases in government purchases do. Suppose we consider a change in taxes of a specific amount—say, a tax cut of $10 billion—with the tax rate remaining unchanged. The expression for this tax multiplier is: Tax multiplier 

change in equilibrium real GDP change in taxes

The tax multiplier is a negative number because changes in taxes and changes in real GDP move in opposite directions: an increase in taxes reduces disposable income, consumption and real GDP, and a decrease in taxes raises disposable income, consumption and real GDP. For example, if the tax multiplier is –1.6, a $10 billion cut in taxes will increase real GDP by –1.6 × –10 billion = $16 billion. We would expect the tax multiplier to be smaller in absolute value than the government purchases multiplier. To see why, think about the difference between a $10 billion increase in government purchases and a $10 billion decrease in taxes. Earlier, we assumed that the whole of the $10 billion in government purchases results in an increase in aggregate demand. However, we know that some portion of a $10 billion decrease in taxes will be saved by households and not spent, and some portion will be spent on imported goods. The fraction of the tax cut that is saved or spent on imports will not increase aggregate demand. Therefore, the first period of the multiplier process will lead to a smaller increase in aggregate demand than occurs when there is an increase in government purchases, and the total increase in equilibrium real GDP will be smaller.

The effect of changes in tax rates A change in tax rates has a more complicated effect on equilibrium real GDP than does a tax cut of a fixed amount. To begin with, the value of the tax rate affects the size of the multiplier effect. The higher the tax rate, the smaller the multiplier effect. To see why, think about the size of the additional spending increases that take place in each period following an increase in government purchases. The higher the tax rate, the smaller the amount of any increase in income that households have available to spend, which reduces the size of the multiplier effect. So, a cut in tax rates affects equilibrium real GDP through two channels: (1) a cut in tax rates increases the disposable income of households, which leads them to increase their consumption spending, and (2) a cut in tax rates increases the size of the multiplier effect.

Taking into account the effects of aggregate supply To this point, we have discussed the multiplier effect assuming that the price level was constant. We know, though, that when the SRAS curve is upward sloping, as the AD curve shifts to the right the price level will rise. As a result of the rise in the price level, equilibrium real GDP will not increase by the full amount that the multiplier effect indicates. Figure 13.8 illustrates how an upward-sloping SRAS curve affects the size of the multiplier. To keep the graph relatively simple, assume that the SRAS and LRAS curves do not shift. The economy starts at point A, with real GDP below its potential level. An increase in government purchases shifts the aggregate demand curve from AD1 to AD2. Just as in Figure 13.6, the multiplier effect causes a further shift in aggregate demand to AD3. If the price level remained constant real GDP would increase from $1100 billion at point A to $1122 billion at point B. However, because the SRAS curve is upward sloping the price level rises from 100 to 103, reducing the increase in the total quantity of goods and services demanded in the economy. The new equilibrium occurs at point C with real GDP having risen to $1120 billion, or by $2 billion less than if the price level had remained unchanged. We can conclude that the actual change in real GDP resulting from an increase

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Price level

1. An initial increase in government purchases combined with the multiplier effect shifts the aggregate demand to the right.

FIGURE 13.8

Multiplier effect and aggregate supply

LRAS

SRAS C

103 A

100

2. Because the SRAS curve is upward sloping, real GDP and the price level are both higher in the new equilibrium.

B

AD3 AD2 AD1 $1100

0

369

1120 1122

The economy is initially at point A. An increase in government purchases causes the aggregate demand curve to shift to the right, from AD1 to AD2. The multiplier effect results in the aggregate demand curve shifting further to the right, to AD3 (point B). Because of the upward-sloping supply curve the shift in aggregate demand results in a higher price level. In the new equilibrium at point C, both real GDP and the price level have increased. The increase in real GDP is less than indicated by the multiplier effect with a constant price level

Real GDP (billions of dollars)

in government purchases or a cut in taxes will be less than indicated by the simple multiplier effect with a constant price level.

The multipliers work in both directions Increases in government purchases and cuts in taxes have a positive multiplier effect on equilibrium real GDP. Decreases in government purchases and increases in taxes also have a multiplier effect on equilibrium real GDP, but in this case the effect is negative. For example, an increase in taxes will reduce household disposable income and consumption spending. As households buy fewer cars, furniture, cinema tickets and other products, the firms that sell these products will cut back on production and begin laying off workers. Falling incomes will lead to further reductions in consumption spending. A reduction in government spending on roads would set off a similar process of decreases in real GDP and income. The cutback would be felt first by construction contractors selling goods and services directly to the government, and then it would spread to other firms. We look more closely at the government purchases multiplier and the tax multiplier in Appendix 2 at the end of this chapter.

SOLVED PROBLEM 13.1 FISCAL POLICY MULTIPLIERS Briefly explain whether you agree or disagree with the following statement: ‘Real GDP is currently $1200 billion, and potential GDP is $1250 billion. If the government increased government purchases by $50 billion or cut taxes by $50 billion, the economy could be brought to equilibrium at potential GDP.’

Solving the problem STEP 1: Review the chapter material. This problem is about the multiplier process, so you may want to review the section

‘Government purchases and tax multipliers’, which begins on page 365. STEP 2: Explain how the necessary increase in purchases or cut in taxes is less than $50 billion because of the multiplier effect.

The statement is incorrect because it does not consider the multiplier effect. Because of the multiplier effect, an increase in government purchases or a decrease in taxes of less than $50 billion is necessary to increase equilibrium real GDP by $50 billion. For instance, assume that the government purchases multiplier is 2 and the tax multiplier is –1.6. We can then calculate the necessary increase in government purchases as follows:

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Government purchases multiplier =

change in equilibrium real GDP change in government purchases

2=

$50 billion change in government purchases

Change in government purchases =

$50 billion = $25 billion 2

And the necessary change in taxes: Tax multiplier = –1.6 = Change in taxes =

change in equilibrium real GDP change in taxes $50 billion change in taxes $50 billion = –$31.25 billion –1.6

[ YOUR TURN Q

For more practice do related problems 3.5 and 3.6 on page 387 at the end of this chapter.

13.4 Discuss the difficulties that can arise in implementing fiscal policy. LEARNING OBJECTIVE

THE LIMITS OF USING FISCAL POLICY TO STABILISE THE ECONOMY Poorly timed fiscal policy, like poorly timed monetary policy, can do more harm than good. As we discussed in Chapter 12, it takes time for policy-makers to collect statistics and identify changes in the economy. It can also take a substantial amount of time for the government to formulate policy and get it passed through parliament. If the government decides to increase spending or cut taxes to fight an economic contraction that is about to end, the effect may be to increase the inflation rate. Similarly, cutting spending or raising taxes to slow down an economy that has actually already moved into an economic contraction or recession can make the contraction or recession longer and deeper. Getting the timing right can be more difficult with fiscal policy than with monetary policy for two main reasons. Control over monetary policy is concentrated in the hands of the Reserve Bank Board, which can change monetary policy at any of its monthly meetings or at any other time by calling a special meeting. By contrast, the government and parliament have to agree on changes in fiscal policy. Usually, the Treasurer initiates a change in fiscal policy through the budget in May each year. This must be passed by both Houses of federal parliament—the Lower House (Legislative Assembly) and the Upper House (the Senate), which can take many months. Even after a change in fiscal policy has been approved, it takes time to implement the policy. Suppose parliament agrees to increase aggregate demand by spending $10 billion to construct additional railway lines. It will probably take at least several months to prepare detailed plans for the construction. State or territory governments will then ask for bids from private construction companies. Once the winning bidders have been selected, they will usually need several months to begin the project. Only then will significant amounts of spending actually take place. This delay may push the spending beyond the end of the contraction that the spending was intended to fight.

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Does government spending reduce private spending? In addition to the timing problem, the use of increases in government purchases to increase aggregate demand presents another potential problem. We have been assuming that when the federal government increases its purchases by $10 billion the multiplier effect will cause the increase in aggregate demand to be greater than $10 billion. However, the size of the multiplier effect may be limited if the increase in government purchases causes one or more of the non-government, or private, components of aggregate expenditures—consumption, investment or net exports—to fall. A decline in private expenditure as a result of an increase in government purchases is called crowding out.

Crowding out in the short run Consider the case of a temporary increase in government purchases. Suppose the government decides to fight a contraction by spending $10 billion more this year on railway construction. Once the $10 billion has been spent, the program will end and government spending will drop back to its previous level. If the government increases its spending without increasing taxation—as it would do so during a contraction—then it will probably be operating with a budget deficit. The government would therefore be borrowing money through the sale of bonds and securities. If the borrowing comes from the domestic market, this will increase the demand for loanable funds, which will increase the real rate of interest on bonds and securities. (See Chapter 5 to revisit the loanable funds model.) If government borrowing occurs on global financial markets, as is usually the case when the Australian government sells bonds and securities, then there may be little or no effect on domestic interest rates. This is the view held by the Governor of the RBA, Glenn Stevens, who in 2009 told a government Senate Committee that the government borrowing to fund its stimulus spending would have no material impact on interest rates.1 Higher interest rates could also occur if government borrowing for spending programs increases aggregate demand by an amount that puts upward pressure on inflation. Some economists argued that this is what occurred in Australia in 2010, when the Australian government was borrowing around $1 million each day to fund stimulus infrastructure programs that were continuing even though the rate of economic growth was returning to a healthier level. It was argued that this contributed to the inflationary pressures that led the RBA to increase interest rates four times during 2010. Higher interest rates will result in a decline in each component of private expenditures. This is known as financial crowding out. Consumption spending and investment spending will decline because households will borrow less to buy cars, furniture, new houses and services, and firms will borrow less to finance factories, computers and machinery. Net exports may also decline as higher interest rates will attract foreign investors, putting upward pressure on the exchange rate, leading to an increase in imports and a decline in export earnings. The greater the sensitivity of consumption, investment and net exports to changes in interest rates, the more crowding out will occur. In a deep recession, many firms may be so pessimistic about the future and have so much excess capacity that investment spending falls to very low levels and is unlikely to fall much further even if interest rates rise. In this case, crowding out is unlikely to be a problem. If the economy is close to potential GDP, however, then an increase in interest rates may result in a significant decline in investment spending. Further, paying off government debt in the future will require higher taxes in the future, which can depress economic growth. Another potential source of financial crowding out arises if government borrowing to fund a deficit leads to a risk premium—a higher interest rate—being applied to funds loaned to the government. This is most likely to apply to countries where government debt represents a relatively large proportion of GDP, such as Greece and Spain. There is also the possibility of resource crowding out. This would occur if the government was competing with the private sector for resources such as labour and raw materials. If increases in government spending occurred at a time when the economy was near or at full capacity, the government would be taking resources that would otherwise be used by the private sector. The competition for the resources would put upward pressure on the prices of raw materials

Crowding out A decline in private expenditure as a result of an increase in government purchases.

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and wages. In fact, in the 2007/08 Commonwealth budget, along with the 2007/08 Western Australian state budget, resource crowding out was sighted as a reason why the governments were delaying public works projects, or introducing them slowly over a number of years. The economy was operating at or near full capacity during this time. In the recovery period following the 2008–2009 economic contraction, some economists and private businesses were concerned about resource crowding out. Government expansionary fiscal policy included building programs which continued until 2012, which during a time of economic recovery could have increased the prices of construction materials and labour paid by both the government and the private sector. However, resource crowding out would be far less of a problem in a time of economic contraction or recession, which is the time when a government would be more likely to increase purchases and operate a budget deficit.

Crowding out in the long run Most economists agree that in the short run an increase in government spending results in partial, but not complete, crowding out, although economists disagree on the extent of crowding out in the short run. What is the long-run effect of a permanent increase in government spending? In this case, most economists agree that the result is complete crowding out. In the long run, the decline in investment, consumption and net exports exactly offsets the increase in government purchases, and aggregate demand remains unchanged. To understand crowding out in the long run, recall from Chapter 10 that in the long run the economy returns to potential GDP. Suppose that the economy is currently at potential GDP and that government purchases are 25 per cent of GDP. In that case private expenditure—the sum of consumption, investment and net exports—will make up the other 75 per cent of GDP. If government purchases are increased permanently to 30 per cent of GDP, in the long run private expenditure must fall to 70 per cent of GDP. There has been complete crowding out: private expenditure has fallen by the same amount that government purchases have increased. If government spending is taking a larger share of GDP, then private spending must take a smaller share. An expansionary fiscal policy does not have to cause complete crowding out in the short run. If the economy is below potential GDP it is possible for both government purchases and private expenditure to increase. But in the long run any permanent increase in government purchases must come at the expense of private expenditure.

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ONNECTION

AAP Image/Dean Lewins

The financial crisis made the US recession of 2007–2009 more severe and long-lasting than many other US recessions

WHY WAS THE UNITED STATES RECESSION OF 2007–2009 SO SEVERE? The fall-out from the global financial crisis was far less severe in Australia than in many other countries. Many countries throughout the European Union and Asia, and also the United States, suffered severe recessions. According to estimates by the United States’ budget office, the effects of the US government’s stimulus package indicate that even the $825 billion in increased government spending and tax cuts left the US economy with real GDP far from potential GDP and the unemployment rate above 9 per cent. Why was the US recession of 2007–2009 so severe? The US economy had not experienced a significant financial crisis since the Great Depression of the 1930s. Both the Great Depression and the recession of 2007–2009 were severe. Was their severity the result of the accompanying financial crises? More generally, do recessions accompanied by financial crises tend to be more severe than recessions that do not involve bank crises?

US economists Carmen Reinhart and Kenneth Rogoff have gathered data on recessions and financial crises in a number of countries, in an attempt to answer this question. The following table shows the average change in key economic variables during the period following a financial crisis for a number of countries, including the United States during the Great Depression and European and Asian countries in the post–World War II era. The table shows that for these countries, on average, the recessions following financial crises were quite severe. Unemployment rates increased by 7 percentage points—for example, from 5 per cent to

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12 per cent—and continued increasing for nearly five years after a crisis had begun. Real GDP per capita also declined sharply, and the average length of a recession following a financial crisis has been nearly two years. Adjusted for inflation, share prices dropped by more than half, and housing prices dropped by more than one-third. Government debt soared by 86 per cent. The increased government debt was partly the result of increased government spending, including spending to bail out failed financial institutions. But most of the increased debt was the result of government budget deficits resulting from sharp declines in tax revenues as incomes and profits fell as a result of the recession. (Note that the table doesn’t include data for the United States during the 2007–2009 recession because that recession was still under way when this research was being carried out.) ECONOMIC VARIABLE

AVERAGE CHANGE

AVERAGE DURATION OF CHANGE

NUMBER OF COUNTRIES

Unemployment rate

+ 7 percentage points

4.8 years

14

Real GDP per capita

–9.3%

1.9 years

14

Real share prices

–55.9%

3.4 years

22

Real house prices

–35.5%

6 years

21

Real government debt

+86%

3 years

13

The next table shows some key indicators for the 2007–2009 US recession compared with other US recessions of the post–World War II period: DURATION

DECLINE IN REAL GDP

PEAK UNEMPLOYMENT RATE

Average for postwar recessions

10.4 months

–1.7%

7.6%

Recession of 2007–2009

18 months

–4.1%

10.1%

Consistent with Reinhart and Rogoff’s findings that recessions following financial panics tend to be unusually severe, the 2007–2009 recession was the worst in the United States since the Great Depression of the 1930s. The recession lasted nearly twice as long as the average of earlier post-war recessions, GDP declined by more than twice the average, and the peak unemployment rate was about one-third higher than the average. Because most people did not see the financial crisis coming, they also failed to anticipate the severity of the 2007–2009 recession. Note: In the second table, the duration of recessions is based on US National Bureau of Economic Research business cycle dates, the decline in real GDP is measured as the simple percentage change from the quarter of the cyclical peak to the quarter of the cyclical trough, and the peak unemployment rate is the highest unemployment rate in any month following the cyclical peak. SOURCE: Data from Carmen M. Reinhart and Kenneth S. Rogoff, (2009), This Time Is Different: Eight Centuries of Financial Folly, Princeton University Press, Figures 14.1–14.5; and the US Bureau of Economic Analysis and National Bureau of Economic Research.

DEFICITS, SURPLUSES AND FEDERAL GOVERNMENT DEBT The federal government’s budget shows the relationship between its expenditures and its tax revenue. If the federal government’s expenditures are greater than its revenue a budget deficit results. If the federal government’s expenditures are less than its tax revenue a budget surplus results. As with many macroeconomic variables, it is useful to consider the size of the surplus or deficit relative to the size of the overall economy. Government spending increases

13.5 Define federal budget deficit and federal government debt and explain how the federal budget can serve as an automatic stabiliser. LEARNING OBJECTIVE

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during economic contractions and recessions, and tax revenues fall creating or increasing the budget deficit. Figure 13.9 shows the Commonwealth government budget position from 1970/71 to 2014/15. The figure shows that the budget was generally in deficit throughout the 1970s and 1980s, was mainly in surplus from 1997/98 to 2007/08 and then moved into deficit from 2008/09 onwards. Figure 13.9 also shows large deficits occurring during recessions. Tax revenue falls during contractions and recessions and government spending increases. The deficit in 1982/83 occurred at a time of recession in Australia, and, similarly, the severe recession of 1990 (caused by a monetary policy of extremely high interest rates) is associated with a fall in the surplus in the 1990/91 budget, which then moved into deficit. The large increase in government purchases and cash handouts from 2008/09 onwards, which we read about in the opening case of this chapter, can be seen with the budget moving from a surplus to a large deficit in 2008/09. If the Commonwealth government has a budget deficit, this has to be financed by borrowing. This borrowing contributes to the net debt of the Commonwealth government. Net debt is the difference between the amount of funds the government borrows and the amount it lends. Figure 13.10 shows the net debt of the Commonwealth government from 1970/71 to 2014/15. In Australia, the net debt of the Commonwealth government was generally increasing from the second half of the 1970s, accelerating in the 1980s up to 1986/87. Decreases in net debt between 1987/88 and 1990/91 were followed by substantial

Budget deficit The situation in which the government’s expenditures are greater than its tax revenue. Budget surplus The situation in which the government’s expenditures are less than its tax revenue.

FIGURE 13.9

Commonwealth government budget—surpluses and deficits, Australia, 1970/71 to 2014/15 The figure shows the Commonwealth government budget position from 1970/71 to 2014/15. It shows that the budget was generally in deficit throughout the 1970s and 1980s, was mainly in surplus from 1997/98 to 2007/08 and then moved into deficit from 2008/09 onwards

30 20 10

Billions of dollars

0 –10 –20 –30 –40 –50 –60

5

1

4/ 1 20 1

0/ 1 20 1

7

3

6/ 0 20 0

9

2/ 0 20 0

8/ 9 19 9

5

1

4/ 9 19 9

7

0/ 9 19 9

6/ 8 19 8

3 2/ 8

9 19 8

5

8/ 7 19 7

4/ 7 19 7

19 7

0/ 7

1

–70

Note: Data for 2015 are Treasury estimates. SOURCE: Australian Government (2013), Mid-Year Economic and Fiscal Statement 2013–14, December, Appendix D, Table D1, at , viewed 10 February 2014.

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FIGURE 13.10

Commonwealth government net debt, Australia, 1970/71 to 2014/15 In Australia the net debt of the Commonwealth government was generally increasing from the second half of the 1970s, accelerating in the 1980s up to 1986/87. Decreases in net debt between 1987/88 and 1990/91 were followed by substantial increases in net debt over the period 1991/92 to 1995/96, during which the net debt peaked at 18.5 per cent of GDP in 1995/96, or $96 billion. The Coalition government consistently reduced the net debt of the Commonwealth government throughout the period after 1995/96 and by 2005/06 the government had no net debt, and had become a net saver. Australia moved into a position of significant debt from 2008/09 onwards, as government borrowing was required to fund the budget deficit

240 220 200 180 160

Billions of dollars

140 120 100 80 60 40 20 0 –20 –40

5 20

14

/1

1 10

/1

7 20

06

/0

3 20

20

02

/0

9 98

/9

5 19

94

/9

1 19

90

/9

7 19

86

/8

3 19

82

/8

9 19

78

/7

5 19

/7 74 19

19

70

/7

1

–60

Note: Data for 2015 are Treasury estimates. SOURCE: Created from Australian Government (2013), Mid-Year Economic and Fiscal Statement 2013–14, December, Appendix D, Table D5, at , viewed 10 February 2014.

increases in net debt over the period 1991/92 to 1995/96, during which the net debt peaked at 18.5 per cent of GDP in 1995/96, or $96 billion. The Coalition government consistently reduced the net debt of the Commonwealth government throughout the period after 1995/96 and by 2005/06 the government had no net debt. This meant that the government had become a net saver, which made Australia one of the very few countries in the world with a government that had no net debt. As we can see from Figure 13.10, Australia moved into a position of significant debt from 2008/09 onwards, as government borrowing was required to fund the budget deficit.

How the federal budget can serve as an automatic stabiliser The federal budget deficit often increases during economic contractions and recessions because of discretionary fiscal policy actions. Discretionary increases in spending or cuts in taxes to increase aggregate demand will increase the budget deficit. Federal budget deficits also occur during contractions or recessions without the government taking any action because of the effects of the automatic stabilisers we briefly mentioned earlier in this chapter. Deficits occur automatically during economic contractions or recessions for two reasons: first, during a contraction or recession wage income and profits fall, causing government tax

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Cyclically adjusted budget deficit or surplus The deficit or surplus in the federal government’s budget if the economy were at potential GDP.

revenues to fall; second, the government automatically increases transfer payments as more people become unemployed when the economy contracts or moves into recession. This increase in transfer payments takes place without the government taking any new policy action. Because budget deficits automatically increase during economic contractions and recessions and decrease during economic expansions and booms, economists often look at the cyclically adjusted budget deficit or surplus, which can provide a more accurate measure of the effects on the economy of the government’s spending and tax policies than can the actual budget deficit or surplus. The cyclically adjusted budget deficit or surplus measures what the deficit or surplus would be if the economy were at potential GDP. In Figure 13.11 the federal budget is balanced at potential GDP, but it moves into surplus when real GDP is above its potential level and into deficit when real GDP is below its potential level. Suppose the tax receipts and levels of government expenditures are such that the federal budget is balanced when real GDP is at its potential level of $1200 billion. If real GDP is greater than $1200 billion, the increased tax revenue and the decreased transfer payments will result in a budget surplus. Higher taxes and lower transfer payments cause total spending to rise by less than it otherwise would have, which helps reduce the chance that the economy will experience higher inflation. If real GDP is less than $1200 billion, the reduced tax revenue and the increased transfer payments will result in a budget deficit. These automatic budget surpluses and deficits can help to stabilise the economy.

FIGURE 13.11

How the level of GDP affects the cyclically adjusted budget deficit Suppose the federal budget is balanced at potential GDP of $1200 billion. If real GDP is above $1200 billion there will be a budget surplus. If real GDP is below $1200 billion there will be a budget deficit

Budget surplus or deficit (billions of dollars)

LRAS

Budget line Surplus 0 Deficit

$1200 billion

Real GDP

SOLVED PROBLEM 13.2 THE EFFECT OF ECONOMIC FLUCTUATIONS ON THE BUDGET DEFICIT The federal government’s budget in Australia was in deficit by over $15 billion in 1993 and moved into a surplus of over $12 billion in 2000. Someone commented, ‘The government must have acted to raise taxes or cut spending or both’. Do you agree? Briefly explain.

Solving the problem STEP 1: Review the chapter material. This problem is about the federal budget as an automatic stabiliser, so you may want to review

the section ‘How the federal budget can serve as an automatic stabiliser’, which begins on page 375. STEP 2: Explain how changes in the budget deficit can occur without the government acting. If the government takes action to

raise taxes or cut spending, the federal budget deficit will decline. But the deficit will also decline automatically when real GDP increases, even if the government takes no action. When real GDP increases, rising household incomes and firms’ profits result in higher tax revenues. Increasing real GDP also usually means falling unemployment, which reduces government spending on

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unemployment benefits and other transfer payments. So, you should disagree with the comment. A falling deficit does not mean that the government must have acted to raise taxes or cut spending. Further, during the time period mentioned in this example, the government privatised (sold to the private sector) a number of government business enterprises, and used the proceeds to pay off government debt, which reduced annual interest repayments in the budget.

[ YOUR TURN Q

For more practice do related problem 5.6 on page 388 at the end of this chapter.

Should the federal budget always be balanced? Although many economists believe that it is a good idea for the federal government to have a balanced budget when the economy is at potential GDP, few economists believe that the federal government should attempt to balance its budget every year. To see why economists take this view, consider what the government would have to do to keep the budget balanced during a contraction or recession, when the federal budget automatically moves into deficit. To bring the budget back into balance the government would have to raise taxes or cut spending, but these actions would reduce aggregate demand, thereby making the contraction or recession worse by slowing down economic growth. Similarly, when real GDP increases above its potential level, the budget automatically moves into surplus. To eliminate this surplus the government would have to cut taxes or increase government spending. But these actions would increase aggregate demand, thereby pushing real GDP further beyond potential GDP and raising the risk of higher inflation. To balance the budget every year the government might have to take actions that would destabilise the economy.

Is government debt a problem? As we have seen, at times government debt may be necessary. During an economic contraction or a recession automatic stabilisers and expansionary fiscal policy will lead to a budget deficit and therefore government debt. Further, if a government is embarking on major infrastructure projects to promote increased economic growth in the future, such as roads, railways and improved air and sea ports, borrowing may be required. However, debt can be a problem for a government for the same reasons that debt can be a problem for a household or a business. If a family has difficulty making the monthly mortgage payment it will have to cut back spending on other things. If the family is unable to make the payments it will have to default on the loan and will probably lose its house. The federal government in Australia is in no danger of defaulting on any debts. Ultimately, the government can raise the funds it needs through taxes to make the interest payments on the debt. If the debt becomes very large relative to the economy, however, the government may have to raise taxes to high levels or cut back on other types of spending to make the interest payments on the debt. There is also an opportunity cost involved in servicing debt in terms of the interest repayments that must be made that could have been used for other expenditures. For example, in 2013/14, when government net debt was almost $200 billion, net interest repayments on the debt were around $10.7 billion per year, or 0.7 per cent of GDP. In the long run, a debt that increases in size relative to GDP can pose a problem. As we discussed previously, crowding out of private investment spending may occur. Lower investment spending means a lower capital stock in the long run and a reduced capacity of the economy to produce goods and services. This effect is somewhat offset if some of the government debt is incurred to finance improvements in infrastructure, such as bridges, highways and ports, to finance education or to finance research and development. Improvements in infrastructure, a better educated labour force and additional research and development can add to the productive capacity of the economy.

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13.2

GOVERNMENT BANKRUPTCY IN EUROPE

ONNECTION

During the 2007–2008 global financial crisis (GFC) very large budget deficits and high levels of government debt were revealed in a number of countries in the European Union (EU). In some countries additional debt was incurred as governments bailed out failing financial institutions. The extent of the debts was so large that it became probable that some governments would default on their debts. One of the first countries at risk of defaulting was Greece, which in 2008 had government debts of over 300 billion euros, or around 110 per cent of GDP. By 2010 gross government debt in Greece had risen to almost 130 per cent of its GDP— over four times in excess of the allowable limit imposed by the EU. Large annual budget deficits—11 per cent of GDP in 2010—meant that the Greek government was not in a position to reduce its debts. The severity of the situation forced the EU and the International Monetary Fund (IMF) to instigate a bailout package for Greece in May 2010 of 150 billion euros. In return Greece had to implement a series of measures to reduce its budget deficits, including freezing public sector wages and increasing Greece’s relatively low retirement age of 61 years to 63 years by 2015. Following the Greece rescue package, in May 2010 the EU established a rescue fund of 440 billion euros for struggling EU countries to access if required. In 2010 the government of Ireland requested help from the EU because it was unable to meet its repayments on debt and appeared to be in a worse situation than Greece. Without EU assistance Ireland would have defaulted on its government debts. The situation in Ireland was due to high government spending, initially enabled by a huge property boom, which yielded enormous stamp duty and capital gains revenues for the government. Between 2000 and 2008 government expenditure as a proportion of GDP rose from 28 per cent to a massive 44 per cent! With revenues high, between 2000 and 2008 the Irish government doubled state pensions, increased public sector wages by almost 60 per cent, halved the capital gains tax and lowered income tax rates. When the property boom ended in

© Stelya | Dreamstime.com

The once strong economy of Ireland faced government bankruptcy in 2010, with a number of other EU countries facing similar financial difficulties

FIGURE 1

Central government debt as a percentage of GDP, selected countries

140

120

Per cent of GDP

100

80

60

40

20

n Sp ai

er m

an y

SA G

U

nd Ire la

K U

ce Fr an

m gi u Be l

ga l tu Po r

nd el a Ic

Ita ly

G re

ec e

0

SOURCE: Created from World Bank (2013), World Development Indicators, data files, at , viewed 10 February 2014.

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Government budget deficits as a percentage of GDP, selected countries

FIGURE 2 0 –2 –4 –6 –8

Per cent of GDP

–10 –12 –14 –16 –18 –20 –22 –24 –26 –28 –30 m iu lg

m er G

Be

an y

ly Ita

n ai Sp

l

ce Fr an

d

ga tu Po r

an el Ic

SA U

K U

ec e re G

Ire

la

nd

–32

SOURCE: Created from World Bank (2013), World Development Indicators, data files, at , viewed 10 February 2014.

2009, government revenue fell dramatically. The GFC also hit Ireland hard, with large Irish banks facing collapse, and the government taking on huge debts to bail out the banks and prevent the financial system from collapsing. By 2010 gross government debt had risen to 112 per cent of GDP and the budget deficit was a massive 31 per cent of GDP. In response to a request for aid from the Irish government in November 2010 the EU approved an 85 billion euro bailout. However, by 2013, although the budget deficit was falling, net debt had risen to around 125 per cent of GDP. By May 2011, Portugal required a bailout—78 billion euros over three years—and a number of other EU countries were assessed as being at risk of government debt default, including Spain, Italy and Iceland (Iceland had previously received bailout funds in 2008). Figure 1 shows central government gross debt as a proportion of GDP for countries with large government debts in 2010—the time immediately following the GFC. It is important to note that it is not just the level of debt that determines a country’s risk of default. Factors such as the extent of a government’s budget deficit, the growth rate and size of the economy, and the type and term structure of the debt influence the ability to service debts. Figure 2 shows government budget deficits for the same countries as a percentage of GDP for 2010. The collapse of government finances in some European countries highlights the risk associated with large budget deficits and rising government debt levels. SOURCE: BBC News (2010), ‘Greece plans to ban early retirement’, BBC News, 9 February, at , viewed 12 February 2014; Alan Kohler (2010), ‘Don’t forget to save for a rainy day’, The Drum, 29 November, Australian Broadcasting Commission, at , viewed 12 February 2014.

THE EFFECTS OF FISCAL POLICY IN THE LONG RUN Some fiscal policy actions are intended to meet short-run goals of stabilising the economy. Other fiscal policy actions are intended to have long-run effects by expanding the productive capacity of the economy and increasing the rate of economic growth. These policy actions primarily

13.6 Discuss the long-run effects of fiscal policy. LEARNING OBJECTIVE

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Supply-side policies Fiscal policies that have long-run effects by expanding the productive capacity of the economy and increasing the rate of economic growth. These policy actions primarily affect aggregate supply rather than aggregate demand, shifting the longrun aggregate supply curve to the right. Tax wedge The difference between the pre-tax and post-tax return to an economic activity.

affect aggregate supply rather than aggregate demand, and are referred to as supply-side policies. We saw in Chapter 6 that supply-side policies also include increasing productivity through new technology and education, increasing the size of the labour force and microeconomic reforms to increase economic efficiency. Most fiscal policy actions that attempt to increase aggregate supply do so by changing taxes to increase the incentives to work, save, invest and start a business.

The long-run effects of tax policy The difference between the pre-tax and post-tax return to an economic activity is known as the tax wedge. The tax wedge applies to the marginal tax rate, which is the fraction of each additional dollar of income that must be paid in taxes. When discussing the model of demand and supply in Chapter 3, we saw that increasing the price of a good or service increases the quantity supplied. So we would expect that reducing the tax wedge by cutting the marginal tax rate on income would result in a larger quantity of labour supplied because the after-tax wage would be higher. Similarly, we saw in Chapter 5 that a reduction in the income tax rate would increase the after-tax return to saving, causing an increase in the supply of loanable funds, a lower equilibrium interest rate and an increase in investment spending. In general, economists believe that the smaller the tax wedge for any economic activity—such as working, saving, investing or starting a business—the more of that economic activity that will occur. We can look briefly at the effects on aggregate supply of cutting each of the following taxes: 1 Personal income tax. As we have seen, reducing the marginal tax rates on personal income will reduce the tax wedge faced by workers, thereby increasing the quantity of labour supplied. Many small businesses are sole proprietorships, whose profits are taxed at the personal income tax rates. Therefore, cutting the personal income tax rates also raises the return to entrepreneurship, encouraging the opening of new businesses. Most households are also taxed on their returns from saving at the personal income tax rates. Reducing marginal income tax rates therefore also increases the return to saving. 2 Company income tax. The federal government taxes the profits earned by corporations at the company income tax rate. Cutting the company income tax rate would encourage investment spending by increasing the return corporations receive from new investments in equipment, factories and office buildings. Because innovations are often embodied in new investment goods, cutting company income tax potentially can increase the pace of technological change. 3 Taxes on capital gains. Corporations distribute some of their profits to shareholders in the form of payments known as dividends. Shareholders may also benefit from higher corporate profits by receiving capital gains. A capital gain is the change in the price of an asset, such as a share of stock. Rising profits usually result in rising share prices and capital gains to shareholders. Individuals pay taxes on capital gains (although the tax on capital gains can be postponed if the shares are not sold). As a result, the same earnings are, in effect, taxed twice: once when corporations pay the company income tax on their profits, and again when the profits are received by individual investors in the form of capital gains. Economists debate the costs and benefits of a separate tax on corporate profits. With the company income tax remaining in place, one way to reduce the ‘double taxation’ problem is to reduce the taxes on capital gains. Lowering the tax rates on capital gains increases the supply of loanable funds from households to firms, increasing saving and investment and lowering the equilibrium real interest rate. Since the 2000s the taxation treatment of capital gains in Australia has been relatively generous.

Tax simplification In addition to the potential gains from cutting individual taxes there are also gains from tax simplification. The complexity of tax law has created a whole industry of tax preparation services. Tax law is extremely complex and is hundreds of pages long. Taxpayers spend millions of hours each year filling out their tax forms or paying an accountant to do it. The opportunity cost of this, the compliance cost, is billions of dollars each year, and represents an administrative burden of income tax. If tax law were greatly simplified, the economic resources

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currently used by the tax preparation industry would be available to produce other goods and services. In addition to wasting resources, the complexity of tax law may also distort the decisions taken by households and firms. Simplified taxation rules would increase economic efficiency by reducing the number of decisions made by households and firms solely to reduce their tax payments.

The economic effect of tax reform We can analyse the economic effects of tax reduction and simplification using the aggregate demand and aggregate supply model. Figure 13.12 shows that without tax changes the longrun aggregate supply curve will shift from LRAS1 to LRAS2. This shift reflects the increases in the labour force and the capital stock and the technological change that would occur even without tax reduction and simplification. As we know from our discussion of the AD–AS model in Chapter 10, during any year the aggregate demand curve and short-run aggregate supply curve will also shift. To focus on the impact of tax changes on aggregate supply, we will ignore the short-run aggregate supply curve and we will assume that the aggregate demand remains unchanged at AD1. In this case, equilibrium moves from point A to point B, with real GDP increasing from Y1 to Y2, and the price level decreasing from P1 to P2. If tax reduction and simplification is effective, the economy will experience increases in labour supply, saving, investment and the formation of new firms. Economic efficiency will also be improved. Together these factors will result in an increase in the quantity of real GDP supplied at every price level. We show the effects of the tax changes in Figure 13.12 by a shift in long-run aggregate supply to LRAS3. With aggregate demand remaining unchanged, the equilibrium in the economy moves from point A to point C (rather than to point B, which is the equilibrium without tax changes), with real GDP increasing from Y1 to Y3, and the price level decreasing from P1 to P3. An important point to notice is that compared with the equilibrium without tax changes (point B) the equilibrium with tax changes (point C ) occurs at a lower price level and a higher level of real GDP. We can conclude that the tax changes have benefited the economy by increasing output and employment, while at the same time reducing the price level. Clearly our analysis is unrealistic because we ignored the changes in aggregate demand and short-run aggregate supply that will actually occur. How would a more realistic analysis differ from the simplified one in Figure 13.12? The change in real GDP would be the same because in the long-run real GDP is equal to its potential level, which is represented by the long-run aggregate supply curve. The results for the price level would be different, however, because we would expect both aggregate demand and short-run aggregate supply to shift to the right. The most likely case is that the price level would end up higher in the new equilibrium than in the original equilibrium. However, because the position of the long-run aggregate supply curve is

Price level

LRAS1

LRAS2

FIGURE 13.12

LRAS3

Increase in LRAS without tax changes

Additional increase in LRAS because of tax changes

A

P1

B

P2

C

P3

The supply-side effects of a tax change The economy’s initial equilibrium is at point A. With no tax change the long-run aggregate supply curve shifts to the right, from LRAS1 to LRAS2. Equilibrium moves to point B, with the price level falling from P1 to P2 and real GDP increasing from Y1 to Y2. With tax reductions and simplifications the long-run aggregate supply curve shifts further to the right to LRAS3 and equilibrium moves to point C, with the price level falling to P3 and real GDP increasing to Y3

AD1

Y1

0

Y2

Y3

Real GDP

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further to the right as a result of the tax changes, the increase in the price level will be smaller than it would have otherwise been, although—as we will discuss in the next section—not all economists would agree with this conclusion. We can conclude that a successful policy of tax reductions and simplifications will benefit the economy by increasing output and employment and, at the same time, may result in smaller increases in the price level.

How large are supply-side effects? Most economists would agree that there are supply-side effects to reducing taxes: decreasing marginal income tax rates will increase the quantity of labour supplied, cutting the company income tax will increase investment spending and so on. The magnitude of the effects is the subject of considerable debate, however. For example, some economists argue that the increase in the quantity of labour supplied following a tax cut will be limited because many people work a number of hours set by their employers and lack the opportunity to work additional hours. Similarly, some economists believe that tax changes have only a small effect on saving and investment. In this view, saving and investment are affected much more by changes in income or changes in expectations of the future profitability of new investment due to technological change or improving macroeconomic conditions than they are by tax changes. Economists who are sceptical of the magnitude of supply-side effects believe that tax cuts have their greatest impact on aggregate demand, rather than on aggregate supply. In their view, focusing on the impact of tax cuts on aggregate demand, while ignoring any impact on aggregate supply, yields accurate forecasts of future movements in real GDP and the price level, which indicates that the supply-side effects must be small. If tax changes have only small effects on aggregate supply, it is unlikely that they will reduce the size of price increases to the extent shown in the analysis in Figure 13.12. Ultimately, the size of the supply-side effects of tax policy can be resolved only by careful studies of the effects of differences in tax rates on labour supply and saving and investment decisions. Here again, economists are not always in agreement. As in other areas of economics, over time differences between economists in their estimates of the supply-side effects of tax changes may narrow as additional studies are undertaken.

ECONOMICS IN YOUR LIFE (continued from page 359)

WHAT WOULD YOU DO WITH $500? At the beginning of the chapter, we asked how you would respond to a $500 tax rebate and what effect this tax rebate would be likely to have on equilibrium real GDP in the short run. This chapter has shown that tax cuts increase disposable income, but when this is not a permanent increase in disposable income, consumption spending will not increase significantly, and neither will GDP. As mentioned in the chapter, people who are able to borrow usually try to smooth out their spending over time and don’t increase spending much in response to a one-time increase in their income. But if you are a student struggling to get by on a low income and you are unable to borrow against the higher income you expect to earn in the future, you may well spend most of the rebate.

CONCLUSION In this chapter we have seen how the federal government uses changes in government purchases and taxes to achieve its economic policy goals. We have seen that economists debate the effectiveness of discretionary fiscal policy actions intended to stabilise the economy. The government shares responsibility for economic policy with the RBA. In the next two chapters we look more closely at the international economy, including how monetary policy and fiscal policy are affected by the linkages between economies. Read ‘An inside look’ for a discussion of the arguments for and against using infrastructure spending to increase aggregate demand and employment.

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AN INSIDE LOOK THE AUSTRALIAN

5 OCTOBER 2013

n o d y e h t , e r u t In infrastruc reason a r o f s t a h d r a h

to fund these d spending cuts an s se ea cr in x ta said he out ign, Tony Abbott ts. pa ec m oj t the lack of ca pr n tio ec r. n quibble abou te ca is in e DURING the el m on e , im se pr ur e assessments Of co infrastructur quality of the il? Another e ta th en wanted to be an d le an tit y at nc th re For example, nspa achieving itted to a tra (IA) undertakes. m lia m But what does ra co st s Au on e lli ur Bi ct stru on the part in railway? ing reluctance without a Infra n em gu se be a Adelaide to Darw k or en tw be ne s cost–benefit ere ha e broadband tails about the to another th de ad y he an fibre-to-the-hom -a e go as e le th re of IA to alysis? Giving ork? cost–benefit an undertakes. ines that don’t w ar wealth debt bm su e assessments it ad m e lly ur ct ca ru lo level of Common st of t fra en ch in es at clut pr th e k th in r, th r le even more Moreove ime Ministe int on which to pi e recently po th g Why does the Pr n tin ve ar gi st y, od lic t a go to allow private signature po spending is no omic strategy is e on ur ec ct should be his d ru re st er fra ef in pr mmodative bt. The government’s , spurred by acco a massive de id is vo e e defeated Labor er th l th fil at to th rrency and rprise the evidence ch as a falling cu at would ente su th s ts er ec bender? What is et oj m pr ra e pa ic infrastructur are economic pipeline of publ sessments and as fit ts on the go ne interest rates. be – st co structure projec ians and low fra ic in l lit ra po ve meet prudent e se m e so ar t scattered C There hat is it abou fluoro course, they are of ith w d, s an lie unfunded? So w n— er gi sw be lative net or about to Perhaps the an ctive of their re pe es irr s. , infrastructure? es tie ni at st rtu ss the to these; we and photo oppo t is committed at infra- acro th en m n rn tio vests, hard hats ve ic go nv e co are worthwhile. ep-seated benefits. Th A There is a deis a good thing; it provides immediate can only hope that most of themt a good thing or a ng pacity of the ng in itself is no structure spendi structure spendi the productive ca s fra In ild bu d ly an si t ea en n employm the costs ca g. It depends. is that the possibility that litical bad thin has to confront po tt e bo th in Ab at economy. The ed th ok e lo —20 per A final issu fits is simply over e is far too high ur ct ru st fra exceed the bene in g buildin garded as hat would be re d Max cost of w an e ov irn ab ba nt argument. ee ce Fr r e union 30 pe onomists, John esent projects ar . Their cent to pr l ly al nt ly ce al Two eminent ec re rtu te vi ba de le. As tractors eighed into this ent reasonab petitive subcon m m rn co ve e go or e m th Corden, have w r ch fo hi e has to m w it is a suitable tim the government tive sites, fro g, uc tin od pr pa ci ly al rti ci argument is that pa so on n be are barred from before there ca crease spending to use debt to in of the equation de ure si ct ru is st th fra up in ts. ing more t is fix nd en fu m to gu n ar ve r gi ei public investmen n th any consideratio esian rationale, B Using a Keyn ining investment is likely to leave projects. as a in m for competent PM t d that op an ld th ou w I ow gr e, that the fall-off ic In the meantim drivers of econom ructure PM. rnally validated a gap in terms of te ex nd fu label than infrast r to tte bt be de of le e ru judicious us nsidered. They ts should be co public investmen

by Judith Sloan

THE AUSTRALIAN

SOURCE: J. Sloan (2013), ‘In infrastructure, they don hard hats for a reason’, The Australian, 5 October, at , viewed 3 February 2014.

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Key points in the article Proponents of spending on infrastructure as a means of stimulating the economy argue that for each dollar spent, infrastructure spending is effective at creating jobs. They also estimate that the multiplier effect for increases in government spending is larger than the multiplier effect for tax cuts. Those opposed to using infrastructure spending as a way to increase employment argue that there are considerably fewer jobs created than predicted. An important factor in determining job creation through infrastructure spending is the time needed for the spending to occur and to have its full effect on the economy.

Analysing the news A As you read in this chapter, expansionary fiscal policy

C The article points out that infrastructure projects will only be effective if they are worthwhile in terms of the costs and benefits. If they are worthwhile they will improve productive capacity and shift the short-run and longrun aggregate supply curves to the right. Infrastructure spending also takes time to affect the economy, which can make a large difference in the overall effectiveness of the spending. If the spending only starts after a relatively long period of time, the economy may have already begun to recover by the time the additional spending can have an effect. In this case, the expansionary fiscal policy could expand aggregate demand by too great an amount, leading to an increase in inflation. Thinking critically

involves increasing government purchases or decreasing taxes to increase aggregate demand. After the GFC, a stimulus package designed to combat the expected recession was embarked on by the then Labor government. A portion of this stimulus package was designated for infrastructure spending, and the government believed that it would have a greater economic effect than the tax rebates also implemented by the government in 2008. In 2013, the incoming Coalition government also committed itself to new infrastructure projects with Prime Minister Abbott announcing that he wanted to be known as the ‘infrastructure PM’. Infrastructure spending has an effect on jobs growth, but infrastructure spending is subject to potentially significant time delays because the government needs to approve the spending, infrastructure projects need to be identified and planned, and workers need to be hired. The amount of time it takes to actually implement these projects can delay or even weaken their economic effect.

1 Government economists calculate the effects of an economic stimulus package using estimates of the government spending multiplier. Some economists, though, argue that these economists have overestimated the sizes of the government purchases and tax multipliers. Other economists have argued that the sizes of these multipliers were underestimated. Why do economists have difficulty in reaching agreement on the sizes of these multipliers? 2 The Labor government’s stimulus spending resulted in a large increase in the federal budget deficit. Some (most) economists, however, were relatively unconcerned that crowding out would significantly reduce the effect of the stimulus spending on real GDP. Briefly explain the two types of crowding out, and explain why the government was relatively unconcerned about it arising from its stimulus package.

B An increase in infrastructure spending is subject to the multiplier effect, where every dollar spent will increase GDP by more than one dollar. Figure 1 shows aggregate demand increasing from AD1 to AD2 when infrastructure spending is first increased. The amount of the increase is equal to the initial increase in government spending. Due to the multiplier effect, aggregate demand continues to increase, from AD2 to AD3. The increase in spending therefore results in a larger increase in real GDP.

FIGURE 1 THE EFFECT ON AGGREGATE DEMAND OF INFRASTRUCTURE SPENDING Price level

P

AD1 0

Y1

Y2

Y3

AD2

AD3

Real GDP

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CHAPTER SUMMARY AND PROBLEMS KEY TERMS automatic stabilisers budget deficit budget surplus contractionary fiscal policy crowding out

360 374 374 364 371

cyclically adjusted budget deficit or surplus discretionary fiscal policy expansionary fiscal policy fiscal policy

376 360 363 360

multiplier effect supply-side policies tax wedge

366 380 380

WHAT IS FISCAL POLICY? PAGES 360–362 LEARNING OBJECTIVE 13.1

Define fiscal policy.

SUMMARY Fiscal policy involves changes in federal taxes and purchases that are intended to achieve macroeconomic policy objectives. Automatic stabilisers refers to the automatic increase or decrease in transfer payments and taxes throughout the business cycle. Discretionary fiscal policy is when the government is taking actions to change spending or taxes to achieve its economic objectives (fiscal policy). The largest component of federal expenditures is transfer payments. The largest source of federal government revenue is income taxes.

1.5

1.6

REVIEW QUESTIONS 1.1 1.2

1.3

What is fiscal policy? Who is responsible for fiscal policy? What is the difference between fiscal policy and monetary policy? What is the difference between federal purchases and federal expenditures? Are federal expenditures higher today than they were in 1970?

1.7

if they traded in a pre-1995 car and purchased a fuelefficient car. The scheme was scrapped before it took effect. If the scheme had gone ahead, would the subsequent government spending been an example of fiscal policy? Does it depend on what goals the government had in mind for the policy to achieve? If the government does not change fiscal policy during the business cycle, will there be any forces that will help smooth out the economic fluctuations? Explain. In Australia, what are the major sources of federal government revenue, and what are the major sources of federal government expenditure? According to government forecasts, the ‘baby boomers’ will start becoming eligible for the age pension in increasing numbers. As a result, the annual growth rate of social security and welfare spending is expected to increase significantly. Who are the ‘baby boomers’? Why should their retirement cause such a large increase in the growth rate of spending by the federal government on social security?

PROBLEMS AND APPLICATIONS 1.4

In 2010, the government announced the ill-fated ‘cash for clunkers’ scheme that proposed to pay people $2000

USING FISCAL POLICY TO INFLUENCE AGGREGATE DEMAND, PAGES 363–365 LEARNING OBJECTIVE 13.2

to stabilise the economy.

Explain how fiscal policy affects aggregate demand and how the government can use fiscal policy

SUMMARY We can use the dynamic aggregate demand and aggregate supply model to look more closely at expansionary and contractionary fiscal policies. The dynamic aggregate demand and aggregate supply model takes into account that (1) the economy experiences continuing inflation, with the price level rising every year, and (2) the economy experiences long-run growth, with the LRAS curve shifting to the right every year. To fight economic contractions and recessions the government can increase government purchases or cut taxes. This expansionary policy causes the aggregate demand (AD) curve to shift to the right by more than it otherwise would, raising the level of real GDP and the price level. To fight rising

inflation the government can decrease government purchases or raise taxes. This contractionary policy causes the aggregate demand curve to shift to the right by less than it otherwise would, reducing the increase in real GDP and the price level.

REVIEW QUESTIONS 2.1

2.2

What is expansionary fiscal policy? What is contractionary fiscal policy? If the government decides that expansionary fiscal policy is necessary, what changes should it make in government spending or taxes? What changes should it make if it decides that contractionary fiscal policy is necessary?

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PROBLEMS AND APPLICATIONS 2.3

2.4

2.5

2.6

2.7

Briefly explain whether you agree with the following statements: ‘An expansionary fiscal policy involves an increase in government purchases or an increase in taxes. A contractionary fiscal policy involves a decrease in government purchases or a decrease in taxes.’ Identify each of the following as (i) part of an expansionary fiscal policy, (ii) part of a contractionary fiscal policy or (iii) not part of fiscal policy. a The company income tax rate is increased. b Defence spending is increased. c Families are allowed to deduct all their expenses for child care from their taxable income. d The personal income tax rate is decreased. e The state of New South Wales builds a new highway in an attempt to expand employment in the state. Assume that the economy is in equilibrium at potential GDP and then the demand for housing sharply declines. What actions could the government take to move the economy back to potential GDP? [Related to Don’t let this happen to you] Is it possible for the government to carry out an expansionary fiscal policy if the Reserve Bank of Australia does not simultaneously increase financial liquidity in the economy? Briefly explain. Use the following graph to answer these questions. Price level

LRAS2016

2.8

LRAS2017 SRAS2016

SRAS2017 117.0 114.2 AD2017

(with policy)

110.0 AD2017

(without policy)

2.9

a If the government does not take any policy actions, what will be the values of real GDP and the price level in 2017? b What actions can the government take to bring real GDP to its potential level in 2017? c If the government takes no policy actions, what will be the inflation rate in 2017? If the government uses fiscal policy to keep real GDP at its potential level, what will be the inflation rate in 2017? The hypothetical information in the following table shows what the situation will be in 2017 if the government does not use fiscal policy: Year

Potential GDP

Real GDP

Price level

2016

$1.4 trillion

$1.4 trillion

110.0

2017

$1.6 trillion

$1.4 trillion

111.5

a If the government wants to move real GDP to its potential level in 2017, should it use expansionary policy or contractionary policy? In your answer make sure you explain whether the government should be increasing or decreasing government purchases and taxes. b If the government is successful in moving real GDP to its potential level in 2017, state whether each of the following will be higher, lower or the same as it would have been if they had taken no action: i Real GDP ii Potential GDP iii The inflation rate iv The unemployment rate. c Draw a dynamic aggregate demand and aggregate supply graph to illustrate your answer. Make sure that your graph contains LRAS curves for 2016 and 2017; SRAS curves for 2016 and 2017; AD curves for 2016 and 2017, with and without fiscal policy action; and equilibrium real GDP and the price level in 2017, with and without fiscal policy. If the Reserve Bank of Australia increased the overnight cash rate, what accompanying fiscal policy do you think would be appropriate?

AD2016 $1400

0

1600 1650

Real GDP (billions of dollars)

GOVERNMENT PURCHASES AND TAX MULTIPLIERS, PAGES 365–370 LEARNING OBJECTIVE 13.3

Explain how the multiplier process works with respect to fiscal policy.

SUMMARY Because of the multiplier effect, an increase in government purchases or a cut in taxes will have a multiplied effect on equilibrium real GDP. The government purchases multiplier is equal to the change in equilibrium real GDP divided by the change in government purchases. The tax multiplier is equal

to the change in equilibrium real GDP divided by the change in taxes. Increases in government purchases and cuts in taxes have a positive multiplier effect on equilibrium real GDP. Decreases in government purchases and increases in taxes have a negative multiplier effect on equilibrium real GDP.

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REVIEW QUESTIONS 3.1

3.2

Why does a $1 increase in government purchases lead to more than a $1 increase in income and spending? Define the government purchases multiplier and the tax multiplier. 3.5

PROBLEMS AND APPLICATIONS 3.3

In The General Theory of Employment, Interest and Money, John Maynard Keynes wrote: If the Treasury were to fill old bottles with bank notes, bury them at suitable depths in disused coal mines which are then filled up to the surface with town rubbish, and leave it to private enterprise…to dig the notes up again…there need be no more unemployment and, with the help of the repercussions, the real income of the community…would probably become a good deal greater than it is.2

3.4

Which important macroeconomic effect is Keynes discussing here? What does he mean by ‘repercussions’? Why does he appear unconcerned about whether government spending is wasteful? Suppose that real GDP for an economy is currently $13.1 trillion, potential GDP is $13.5 trillion, the government purchases multiplier is 2 and the tax multiplier is –1.6. a Holding other factors constant, by how much will government purchases need to be increased to bring the economy to equilibrium at potential GDP? b Holding other factors constant, by how much will taxes

3.6

3.7

3.8

387

have to be cut to bring the economy to equilibrium at potential GDP? c Construct an example of a combination of increased government spending and tax cuts that will bring the economy to equilibrium at potential GDP. [Related to Solved problem 13.1] Briefly explain whether you agree or disagree with the following statement: ‘Real GDP is currently $1800 billion and potential GDP is $1650 billion. If the government decreased its purchases by $150 billion or increased taxes by $150 billion, the economy could be brought to equilibrium at potential GDP.’ [Related to Solved problem 13.1] Briefly explain whether you agree with the following remark: ‘Real GDP is $250 billion below its full-employment level. With a multiplier of 2, if the government increases government purchases by $125 billion or the RBA increases the cash in financial markets by $125 billion, real GDP can be brought back to its full-employment level.’ Some research shows that the tax multiplier might increase from one year to the next. Briefly explain why the tax multiplier might have a larger value after two years than after one year. If the short-run aggregate supply (SRAS) curve were a horizontal line at the current price level, what would be the effect on the size of the government purchases and tax multipliers?

THE LIMITS TO USING FISCAL POLICY TO STABILISE THE ECONOMY, PAGES 370–373 LEARNING OBJECTIVE 13.4

Discuss the difficulties that can arise in implementing fiscal policy.

SUMMARY

PROBLEMS AND APPLICATIONS

Poorly timed fiscal policy can do more harm than good. Getting the timing right with fiscal policy can be difficult because passing legislation for a new fiscal policy can be a very long process. Because an increase in government purchases may lead to a higher interest rate, it may result in a decline in consumption, investment and net exports. A decline in private expenditure as a result of an increase in government purchases is called crowding out. Crowding out may cause an expansionary fiscal policy to fail to meet its goal of keeping the economy at potential GDP.

4.4

REVIEW QUESTIONS

4.5

4.1

4.2

4.3

Which can be changed more quickly: monetary policy or fiscal policy? Briefly explain. What is meant by crowding out? What is the difference between financial crowding out and resource crowding out? Explain the difference between crowding out in the short run and in the long run.

According to an article in The New York Times written in December 2008, the severe recession in the United States began in December 2007, but many policy-makers and economists did not recognise that the country was in a recession until September 2008.3 Does the idea that few economists believed the economy was in a recession until nine months after the recession began tell us anything about the difficulty governments may face in implementing a fiscal policy that stabilises rather than destabilises the economy? Some economists argue that because increases in government spending crowd out private spending, increased government spending will reduce the long-run growth rate of real GDP. a Is this most likely to happen if the private spending being crowded out is consumption spending, investment spending or net exports? Briefly explain.

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4.6

b In terms of its effect on the long-run growth rate of real GDP, would it matter if the additional government spending involves (i) increased spending on highways and bridges, or (ii) increased spending on national parks? Briefly explain. Suppose that at the same time the government pursues an expansionary fiscal policy, the Reserve Bank of Australia

4.7

pursues an expansionary monetary policy. How might an expansionary monetary policy affect the extent of crowding out in the short run? [Related to the Making the connection 13.1] Why would recessions accompanied by a financial crisis be more severe than recessions that do not involve bank crises?

DEFICITS, SURPLUSES AND FEDERAL GOVERNMENT DEBT, PAGES 373–379 LEARNING OBJECTIVE 13.5

serve as an automatic stabiliser.

Define federal budget deficit and federal government debt and explain how the federal budget can

SUMMARY A budget deficit occurs when the federal government’s expenditures are greater than its tax revenues. A budget surplus occurs when the federal government’s expenditures are less than its tax revenues. A budget deficit automatically increases during economic contractions and recessions and decreases during economic expansions and booms. Government net debt is the difference between the amount of funds the government borrows and the amount it lends. The automatic movements in the federal budget help to stabilise the economy by cushioning the fall in spending during contractions and recessions, and restraining the increase in spending during expansions and booms. The cyclically adjusted budget deficit or surplus measures what the deficit or surplus would be if the economy were at potential GDP.

5.6

5.7

REVIEW QUESTIONS 5.1

5.2

5.3

5.4

In what ways does the federal budget serve as an automatic stabiliser for the economy? What is the difference between the federal budget deficit and federal government debt? Why do few economists argue that it would be a good idea to balance the federal budget every year? What is the cyclically adjusted budget deficit or surplus? Suppose that the economy is currently at potential GDP and the federal budget is balanced. If the economy moves into a recession, what will happen to the federal budget?

5.8

PROBLEMS AND APPLICATIONS 5.5

In a column in the Financial Times,4 the prime minister and the finance minister of the Netherlands argue that the European Union, an organisation of 28 countries in Europe, should appoint ‘a commissioner for budgetary discipline’. They believe that ‘The new commissioner should be given clear powers to set requirements for the budgetary policy of countries that run excessive deficits.’ What is an ‘excessive’ budget deficit? Does judging whether a deficit is excessive depend in part on whether the country is in a recession? How can budgetary policies be used to reduce a budget deficit?

5.9

5.10

[Related to Solved problem 13.2] The federal government’s budget was in surplus by almost $20 billion in 2007/08 and in deficit by over $54 billion in 2009/10. What does this information tell us about fiscal policy actions taken by the government during these years? The federal government calculates its budget on a fiscal year that begins each year on 1 July and ends the following year on 30 June, and releases its budget estimates for the coming year in May. Just prior to the beginning of the 2013 fiscal year, the government forecast that the federal budget deficit would be $18 billion. Within three months (and a change of party leader), the government revised this figure to a deficit of over $30 billion. By December 2013, a mid-year economic statement (and a new government) estimated that federal revenue was going to be lower than forecast and expenditure higher, and the budget deficit would be almost $47 billion. a Is it likely that the economy was growing faster or more slowly than the initial 2013 May budget had forecast? Explain your reasoning. b Suppose that the government was committed to balancing the budget each year. Does what happened during 2013 provide any insight into difficulties they might run into in trying to balance the budget every year? During the mid-2000s the Australian federal government operated successive budget surpluses that were approximately 1 per cent of GDP. Does this mean that it was operating contractionary fiscal policy during this time? Discuss. What variables would a forecast of a future federal budget deficit or surplus depend on? What is it about these variables that make future budget balances difficult to predict? Discuss whether you think government debt is a good or bad thing.

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THE EFFECTS OF FISCAL POLICY IN THE LONG RUN, PAGES 379–382 LEARNING OBJECTIVE 13.6

Discuss the long-run effects of fiscal policy.

SUMMARY Some fiscal policy actions are intended to have long-run effects by expanding the productive capacity of the economy and increasing the rate of economic growth. Because these policy actions primarily affect aggregate supply rather than aggregate demand, they are sometimes referred to as supply-side policies. The difference between the pre-tax and post-tax return to an economic activity is known as the tax wedge. Economists believe that the smaller the tax wedge for any economic activity—such as working, saving, investing or starting a business—the more of that economic activity will occur. Economists debate the size of the supply-side effects of tax changes.

REVIEW QUESTIONS 6.1 6.2

6.4

6.5

What is meant by supply-side economics? What is the ‘tax wedge’?

PROBLEMS AND APPLICATIONS 6.3

Explain the effect that each of the following fiscal policy measures could have on aggregate supply. a The reduction of taxes on capital gains b Reducing the higher marginal income tax rates to the same level as the company income tax rate

6.6

6.7

c Increasing the marginal income tax rates paid by individuals Some economists and policy-makers have argued in favour of a ‘flat tax’. A flat tax would replace the current individual income tax system, with its many tax brackets, exemptions and deductions, with a new system containing a single tax rate and few, or perhaps no, deductions and exemptions. Suppose a political candidate hired you to develop two arguments in favour of a flat tax. What two arguments would you advance? Alternatively, if you were hired to develop two arguments against a flat tax, what two arguments would you put forward? Suppose that an increase in marginal tax rates on individual income affects both aggregate demand and aggregate supply. Briefly describe the effect of the tax increase on equilibrium real GDP and the equilibrium price level. Will the changes in equilibrium real GDP and the price level be larger or smaller than they would be if the tax increase affected only aggregate demand? Briefly explain. Is it possible for cuts in marginal tax rates to result in an increase in total taxes collected? When the economy is at its potential GDP level, do you think there is a role for fiscal policy? Why or why not?

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APPENDIX 1 Explain the short-run Phillips curve and the long-run Phillips curve. LEARNING OBJECTIVE

Phillips curve A curve showing the shortrun relationship between the unemployment rate and the inflation rate.

IS THERE A SHORT-RUN TRADE-OFF BETWEEN UNEMPLOYMENT AND INFLATION? The Phillips curve Unemployment and inflation are the two great macroeconomic problems the government and the Reserve Bank of Australia (RBA) must deal with in the short run. As we have learned, when aggregate demand increases unemployment will usually fall and inflation will rise. When aggregate demand decreases unemployment will usually rise and inflation will fall. As a result, when aggregate demand changes there is a short-run trade-off between unemployment and inflation: higher unemployment is usually accompanied by lower inflation, and lower unemployment is usually accompanied by higher inflation. As we will see later in this appendix, this trade-off may exist in the short run but not in the long run. Although today the short-run trade-off between unemployment and inflation plays a role in the RBA’s monetary policy decisions, this trade-off was not widely recognised until the late 1950s. In 1957 New Zealand economist A.W. Phillips plotted data on the unemployment rate and the inflation rate in Great Britain and drew a curve showing their average relationship. Since that time, a graph showing the short-run relationship between the unemployment rate and the inflation rate has been called a Phillips curve. (Phillips actually measured inflation by the percentage change in wages, rather than by the percentage change in prices. Because wages and prices usually move together, this difference is not important to our discussion.) Figure 13A1.1 shows a graph similar to the one Phillips prepared. Each point on the Phillips curve represents a possible combination of the unemployment rate and the inflation rate that might be observed in a given year. Point A represents a year in which the inflation rate is 4 per cent and the unemployment rate is 5 per cent, and point B represents a different year in which the inflation rate is 2 per cent and the unemployment rate is 6 per cent. Phillips documented that there is usually an inverse relationship between unemployment and inflation. During years when the unemployment rate is low the inflation rate tends to be high, and during years when the unemployment rate is high the inflation rate tends to be low. FIGURE 13A1.1 THE PHILLIPS CURVE Phillips was the first economist to show that there is often an inverse relationship between unemployment and inflation. Here we can see this relationship at work. In the year represented by point A the inflation rate is 4 per cent and the unemployment rate is 5 per cent. In the year represented by point B the inflation rate is 2 per cent and the unemployment rate is 6 per cent Inflation rate (per cent per year)

4%

A

B

2

0

5%

6

Unemployment rate (per cent)

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Explaining the Phillips curve with aggregate demand and aggregate supply curves The inverse relationship between unemployment and inflation that Phillips discovered is consistent with the aggregate demand and aggregate supply analysis. Figure 13A1.2 shows the factors that cause this inverse relationship. Panel (a) shows a dynamic aggregate demand and aggregate supply (AD–AS ) model and panel (b) shows the Phillips curve. Remember that because of growth in the labour force, increases in the stock of machinery and equipment and technological change, the long-run aggregate supply (LRAS ) and the short-run aggregate supply (SRAS ) curves usually shift to the right each year. If aggregate demand (AD) shifts to the right by the same amount, the economy can remain in macroeconomic equilibrium at potential GDP. The inflation rate is determined by the increase in the price level from one year to the next. If aggregate demand does not increase by as much as LRAS, short-run macroeconomic equilibrium will occur at a level of real GDP below the potential level. The unemployment rate will rise, but the price level will rise by less than it would have, meaning that the inflation rate will fall. Looking at Figure 13A1.2, suppose that initially, in year 1, the economy is in short-run macroeconomic equilibrium at potential real GDP of $1400 billion. Assume the unemployment rate is 5 per cent and the inflation rate is 4 per cent. In panel (a) we show this equilibrium as point A at the intersection of ADyear 1, SRASyear 1 and LRASyear 1 on the aggregate demand and aggregate supply graph. In panel (b) we show the same equilibrium as the corresponding point A on the Phillips curve, with an unemployment rate of 5 per cent and an inflation rate of 4 per cent. In year 2, if the AD curve shifts to the right by the same amount as the LRAS curve, then macroeconomic equilibrium occurs at real GDP of $1450 billion, which is the new higher level of potential GDP (point B). The price level rises from 100 to 104, so the inflation rate remains at 4 per cent. Point B on the Phillips curve is the same as point A because the inflation and unemployment rates haven’t changed. FIGURE 13A1.2 USING AGGREGATE DEMAND AND AGGREGATE SUPPLY ANALYSIS TO EXPLAIN THE PHILLIPS CURVE The economy in year 1 is in macroeconomic equilibrium at potential real GDP of $1400 billion. The unemployment rate for the year is 5 per cent and the inflation rate is 4 per cent. In panel (a), the intersection in year 1 of the AD, SRAS and LRAS curves at point A marks this initial equilibrium. In panel (b) the corresponding point A shows the same equilibrium. Suppose that in year 2 the AD curve shifts right by the same amount as the LRAS curve. In panel (a) macroeconomic equilibrium occurs at real GDP of $1450 billion, which is the new higher level of full-employment real GDP (point B). The price level rises from 100 to 104, so the inflation rate remains at 4 per cent. Point B on the Phillips curve is the same as point A because the inflation and unemployment rates have not changed. If growth in aggregate demand is weak, however, macroeconomic equilibrium in panel (a) occurs at $1430 billion, point C, which is below the year 2 level of potential GDP. The unemployment rate rises from 5 per cent to 6 per cent. At the same time the price level only rises from 100 to 102, so the inflation rate has fallen from 4 per cent in the previous year to 2 per cent. The short-run equilibrium has moved down the Phillips curve from point A, with an unemployment rate of 5 per cent and an inflation rate of 4 per cent, to point C, with an unemployment rate of 6 per cent and an inflation rate of 2 per cent

Price level

2. If AD shifts to here, the unemployment rate

LRASyear 1

LRASyear 2 remains 5% and the

inflation rate remains 4% . . .

SRASyear 1

Inflation rate (per cent per year)

SRASyear 2

104 102

A

100

C

B

ADyear 2 (strong

increase in demand)

ADyear 2 (weak

increase in demand)

1. The economy starts at equilibrium with an unemployment rate of 5% and an inflation rate of 4%.

$1400

0

ADyear 1

3. . . . but if AD shifts only to here, the unemployment rate rises to 6% and the inflation rate is only 2%.

The economy in year 1 and in year 2, if there is strong growth in AD.

A, B

4%

The economy in year 2, if there is slow growth in AD.

C

2

Phillips curve 1430

1450

Real GDP (billions of dollars)

(a) The aggregate demand and aggregate supply (AD–AS ) model

0

5%

6

Unemployment rate (per cent)

(b) The Phillips curve

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If growth in aggregate demand is weak—perhaps because firms reduce their spending on plant and equipment or consumers reduce their spending on goods and services following a drop in share prices—macroeconomic equilibrium occurs at $1430  billion (point C ), which is below the year 2 level of potential GDP. We know that when real GDP drops below its potential level firms begin to lay off workers and the unemployment rate rises. In this case the unemployment rate rises from 5 per cent to 6 per cent. At the same time the price level only rises from 100 to 102 (rather than 104), so the inflation rate has fallen from 4 per cent during the previous year to 2 per cent. In panel (b) the short-run equilibrium has moved down the Phillips curve from point A, with 5 per cent unemployment and 4 per cent inflation, to point C, with 6 per cent unemployment and 2 per cent inflation. To summarise, the AD–AS model indicates that slow growth in aggregate demand leads to both higher unemployment and lower inflation. This relationship explains why there is a shortrun trade-off between unemployment and inflation, as shown by the downward-sloping Phillips curve. The AD–AS model and the Phillips curve are different ways of illustrating the same macroeconomic events. The Phillips curve has an advantage over the AD–AS model, however, when we want to analyse explicitly changes in the inflation and unemployment rates.

Is the Phillips curve a policy menu? Structural relationship A relationship that depends on the basic behaviour of consumers and firms and remains unchanged over long periods of time.

During the 1960s some economists argued that the Phillips curve represented a structural relationship in the economy. A structural relationship depends on the basic behaviour of consumers and firms and remains unchanged over long periods. Structural relationships are useful in formulating economic policy because policy-makers can anticipate that these relationships are constant—that is, the relationships will not change as a result of changes in policy. If the Phillips curve were a structural relationship, it would present policy-makers with a reliable menu of combinations of unemployment and inflation. Potentially, policy-makers could use expansionary monetary and fiscal policies to choose a point on the curve that had lower unemployment and higher inflation. They could also use contractionary monetary and fiscal policies to choose a point that had lower inflation and higher unemployment. Because many economists and policy-makers in the 1960s viewed the Phillips curve as a structural relationship, they believed it represented a permanent trade-off between unemployment and inflation. As long as policy-makers were willing to accept a permanently higher inflation rate, they would be able to keep the unemployment rate permanently lower. Similarly, a permanently lower inflation rate could be attained at the cost of a permanently higher unemployment rate. As we discuss in the next section, however, economists came to realise that the Phillips curve did not, in fact, represent a permanent trade-off between unemployment and inflation.

Is the short-run Phillips curve stable? During the 1960s the basic Phillips curve relationship seemed to hold because a stable trade-off appeared to exist between unemployment and inflation. In the early 1960s the inflation rate in many industrialised countries was low, while the unemployment rate was high. In the late 1960s the unemployment rate had declined, while the inflation rate had increased. Then in 1968, in his presidential address to the American Economic Association, US economist Milton Friedman (who went on to win the Nobel Prize in Economics in 1976) argued that the Phillips curve did not represent a permanent trade-off between unemployment and inflation. At almost the same time, US economist Edmund Phelps published an academic paper making a similar argument. Phelps was awarded the Nobel Prize in Economics in 2006. Friedman and Phelps noted that economists had come to agree that the LRAS curve was vertical (a point we discussed in Chapter 10). If this observation were true, the Phillips curve could not be downward sloping in the long run. A critical inconsistency existed between a vertical LRAS curve and a long-run Phillips curve that is downward sloping. Friedman and Phelps argued, in essence, that there is no trade-off between unemployment and inflation in the long run.

The long-run Phillips curve To understand the argument that there is no permanent trade-off between unemployment and inflation, recall, first, that the level of real GDP in the long run is also referred to as

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potential GDP. At potential GDP firms will operate at their normal level of capacity and everyone who wants a job will have one, except the structurally and frictionally unemployed. Friedman defined the natural rate of unemployment as the unemployment rate that exists when the economy is operating at potential GDP. The actual unemployment rate will fluctuate in the short run but will always come back to the natural rate in the long run. In the same way, the actual level of real GDP will fluctuate in the short run but will always come back to its potential level in the long run. In the long run, a higher or lower price level has no effect on real GDP because real GDP is always at its potential level in the long run. In the same way, in the long run a higher or lower inflation rate will have no effect on the unemployment rate because the unemployment rate is always equal to the natural rate in the long run. Figure 13A1.3 illustrates Friedman’s conclusion that the LRAS curve is a vertical line at potential GDP, and the long-run Phillips curve is a vertical line at the natural rate of unemployment.

393

Natural rate of unemployment The unemployment rate that exists when the economy is operating at potential GDP.

FIGURE 13A1.3 A VERTICAL LONG-RUN AGGREGATE SUPPLY CURVE MEANS A VERTICAL LONG-RUN PHILLIPS CURVE Milton Friedman and Edmund Phelps argued that there is no trade-off between unemployment and inflation in the long run. If real GDP automatically returns to its potential level in the long run, the unemployment rate must return to the natural rate of unemployment in the long run. In this figure we assume potential GDP is $1400 billion and the natural rate of unemployment is 5 per cent Price level

Long-run aggregate supply curve

Inflation rate (per cent per year)

Long-run Phillips curve

Potential GDP 0

$1400 billion Real GDP (billions of dollars)

Natural rate of unemployment 0

5%

Unemployment rate (per cent)

The role of expectations of future inflation If the long-run Phillips curve is a vertical line, then no trade-off exists between unemployment and inflation in the long run. This conclusion seemed to contradict the experience of the 1950s and 1960s, which showed a stable trade-off between unemployment and inflation. Friedman argued that the statistics from those years actually showed only a short-run trade-off between inflation and unemployment. The short-run trade-off existed, but only because workers and firms sometimes expected the inflation rate to be either higher or lower than it turned out to be. Differences between the expected inflation rate and the actual inflation rate could lead the unemployment rate to rise above or dip below the natural rate. To see why, consider a simple case of a company negotiating a wage contract with unions. Remember that both the company and the unions are interested in the real wage, which is the nominal wage corrected for inflation. Suppose, for example, that the company’s managers and the unions agree on a wage of $31.50 per hour to be paid during 2015. Both the company and the unions expect that the price level will increase from 100 in 2014 to 105 in 2015, so the inflation rate will be 5 per cent. We can calculate the real wage the company expects to pay and its workers expect to receive as follows:

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Real wage 

$31.50 nominal wage  100   100  $30 105 price level

But suppose that the actual inflation rate turns out to be higher or lower than the expected inflation rate of 5 per cent. Table 13A1.1 shows the effect on the actual real wage. If the price level rises only to 102 during 2015, the inflation rate will be 2 per cent, and the actual real wage will be $30.88, which is higher than the company and the unions had expected. With a higher real wage, the company will hire fewer workers than it had planned to at the expected real wage of $30. If the inflation rate is 8 per cent, the actual real wage will be $29.17, and the company will hire more workers than it had planned. If the company and the unions expected a higher or lower inflation rate than actually occurred, other firms and workers probably made the same mistake. If actual inflation is higher than expected inflation, actual real wages in the economy will be lower than expected real wages and many firms will hire more workers than they had planned. Therefore, the unemployment rate will fall. If actual inflation is lower than expected inflation, actual real wages will be higher than expected and many firms will hire fewer workers than they had planned, and the unemployment rate will rise. Table 13A1.2 summarises this argument. Friedman and Phelps concluded that an increase in the inflation rate increases employment (and decreases unemployment) only if the increase in the inflation rate is unexpected. TABLE 13A1.1 THE IMPACT OF UNEXPECTED PRICE LEVEL CHANGES ON THE REAL WAGE NOMINAL WAGE

$31.50

EXPECTED REAL WAGE

ACTUAL REAL WAGE

Expected P2015 = 105

Actual P2015 = 102

Actual P2015 = 108

Expected inflation = 5% $31.50 × 100 = $30 105

Actual inflation = 2% $31.50 × 100 = $30.88 102

Actual inflation = 8% $31.50 × 100 = $29.17 108

TABLE 13A1.2 THE BASIS FOR THE SHORT-RUN PHILLIPS CURVE IF …

THEN …

AND …

actual inflation is greater than expected inflation,

the actual real wage is less than the expected real wage,

the unemployment rate falls.

the actual real wage is greater than the

the unemployment rate rises.

actual inflation is less than expected inflation,

expected real wage,

Do workers understand inflation? A higher inflation rate can lead to lower unemployment if both workers and firms mistakenly expect the inflation rate to be lower than it turns out to be. But this same result might be due to firms forecasting inflation more accurately than workers do, or to firms understanding better the effects of inflation. Some large firms employ economists to help them gather and analyse information that is useful in forecasting inflation. Many firms also have human resources departments that gather data on wages paid at competing firms and analyse trends in wages. Workers generally rely on much less systematic information about wages and prices. Workers also often fail to realise that expected inflation increases the value of total production and the value of total income by the same amount. Therefore, although not all wages will rise as prices rise, inflation will increase the average wage in the economy at the same time that it increases the average price. If workers fail to understand that rising inflation leads over time to comparable increases in wages, then, when inflation increases, in the short run firms can increase wages by less than inflation without needing to worry about workers quitting or their morale falling. Once again, we have a higher inflation rate leading in the short run to lower real wages and lower unemployment. In other words, we have another explanation for a downward-sloping short-run Phillips curve.

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APPENDIX QUESTIONS AND PROBLEMS KEY TERMS natural rate of unemployment 393

Phillips curve

390

structural relationship

392

REVIEW QUESTIONS 13A1.1

13A1.2

13A1.3

What is the Phillips curve? Draw a graph of a short-run Phillips curve. Why did economists during the early 1960s think of the Phillips curve as a ‘policy menu’? Were they correct to think of it in this way? Briefly explain. Why did Milton Friedman argue that the Phillips curve did not represent a permanent trade-off between unemployment and inflation? In your answer make sure you explain what Friedman meant by the ‘natural rate of unemployment’.

PROBLEMS AND APPLICATIONS 13A1.4

Use the following two graphs to answer the following questions. Assume that the natural rate of unemployment is 5 per cent and that the inflation rate in the first year is 2 per cent.

Price level

LRAS1 LRAS2 AS1

AS2

C

104 102

A

100

B AD3

AD2 AD1

$1450

0

Real GDP 1500 1520 (billions of dollars)

Inflation rate (per cent per year)

4%

D

E

2

Phillips curve 0

4.8%

5.0

Unemployment rate (per cent)

a Briefly explain which point on the Phillips curve graph represents the same economic situation as point B on the aggregate demand and aggregate supply graph. b Briefly explain which point on the Phillips curve graph represents the same economic situation as point C on the aggregate demand and aggregate supply graph. 13A1.5 Given that the Phillips curve is derived from the aggregate demand and aggregate supply model, why use the Phillips curve analysis? What benefits does the Phillips curve analysis offer compared to the AD–AS model? 13A1.6 Briefly explain whether you agree with the following statement: ‘Any economic relationship that changes as economic policy changes is not a structural relationship.’ 13A1.7 In macroeconomics in the 1960s and early 1970s it was often taught that an economy could have higher unemployment in order to achieve lower inflation, or that higher inflation may be the result of policies aimed at achieving lower unemployment. Why might such views of the trade-off between inflation and unemployment have existed in the 1960s? Why are such views rare today?

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APPENDIX 2 A CLOSER LOOK AT THE MULTIPLIER Apply the multiplier formula. LEARNING OBJECTIVE

In this chapter we saw that changes in government purchases and changes in taxes have a multiplied effect on equilibrium real GDP. In this appendix we will build a simple economic model of the multiplier effect.

An expression for equilibrium real GDP We can write a set of equations that includes the key macroeconomic relationships we have studied in this and previous chapters. It is important to note that in this model we will be assuming that the price level is constant. We know that this is unrealistic because an upwardsloping SRAS curve means that when the AD curve shifts the price level will change. Nevertheless, our model will be approximately correct when changes in the price level are small. It also serves as an introduction to more complicated models that take into account changes in the price level. For simplicity, we also start out by assuming that taxes, T, do not depend on the level of real GDP, Y. We also assume that there are no government transfer payments to households. Finally, we assume that we have a closed economy, with no imports or exports. The numbers (with the exception of the MPC ) represent billions of dollars. 1 C = 1000 + 0.75(Y – T ) Consumption function 2 I = 1500 Planned investment function 3 G = 1500 Government purchases function 4 T = 1000 Tax function 5 Y=C+I+G Equilibrium condition The first equation is the consumption function. The marginal propensity to consume, or MPC, is 0.75, and 1000 is the level of autonomous consumption, which is the level of consumption that does not depend on income. We assume that consumption depends on disposable income, which is Y – T. The functions for planned investment spending, government spending and taxes are very simple because we have assumed that these variables are not affected by GDP and therefore are constant. Economists who use this type of model to forecast GDP would, of course, use more realistic planned investment, government purchases and tax functions. Equation 5—the equilibrium condition—states that equilibrium GDP equals the sum of consumption spending, planned investment spending and government purchases. To calculate a value for equilibrium real GDP we need to substitute Equations 1 to 4 into Equation 5. This substitution gives us the following: Y = 1000 + 0.75(Y – 1000) + 1500 + 1500 = 1000 + 0.75Y – 750 + 1500 + 1500 We need to solve this equation for Y to find equilibrium GDP. The first step is to subtract 0.75Y from both sides of the equation: Y – 0.75Y = 1000 – 750 + 1500 + 1500 Then, we solve for Y: 0.25Y = 3250 or, Y

3250  13 000 0.25

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1 2 3 4 5

– C = C + MPC(Y – T ) – I=I – G=G – T=T Y=C+I+G

397

Consumption function Planned investment function Government purchases function Tax function Equilibrium condition

The letters with ‘bars’ represent fixed or autonomous values that do not depend on the values – of other variables. So, C represents autonomous consumption, which had a value of 1000 in our original example. Now, solving for equilibrium we get: Y  C  MPC(Y  T )  I  G

or, Y – MPC(Y) 5 C – (MPC 3 T ) 1 I 1 G

or, Y(1  M P C ) C  (MPC  T )  I  G

or, Y

C  (MPC  T )  I  G 1  MPC

A formula for the government purchases multiplier To find a formula for the government purchases multiplier we need to rewrite the last equation for changes in each variable, rather than levels. Letting ∆ stand for the change in a variable, we have: Y 

C  (MPC  T )  I  G 1  MPC

If we hold constant changes in autonomous consumption spending, planned investment spending and taxes, we can find a formula for the government purchases multiplier, which is the ratio of the change in equilibrium real GDP to the change in government purchases: Y 

G 1  MPC

or, Government purchases multiplier =

∆Y 1 = 1 – MPC ∆G

For an MPC of 0.75, the government purchases multiplier will be: 1 4 1  0.75

A government purchases multiplier of 4 means that an increase in government purchases of $10 billion will increase equilibrium real GDP by 4 × $10 billion = $40 billion.

A formula for the tax multiplier We can also find a formula for the tax multiplier. We start again with this equation: Y 

C  (MPC  T )  I  G 1  MPC

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Now we hold constant the values of autonomous consumption spending, planned investment spending and government purchases, but we allow the value of taxes to change: Y 

MPC  T 1  MPC

or, the Tax multiplier 

Y MPC  T 1  MPC

For an MPC of 0.75, the tax multiplier will be: 0.75  3 1  0.75

The tax multiplier is a negative number because an increase in taxes causes a decrease in equilibrium real GDP and a decrease in taxes causes an increase in equilibrium real GDP. A tax multiplier of –3 means that a decrease in taxes of $10 billion will increase equilibrium real GDP by –3 × –$10 billion = $30 billion. In this chapter we discussed the economic reasons for the tax multiplier being smaller than the government spending multiplier.

The ‘balanced budget’ multiplier What will be the effect of equal increases (or decreases) in government purchases and taxes on equilibrium real GDP? At first, it might appear that the tax increase would exactly offset the government purchases increase, leaving real GDP unchanged. But we have just seen that the  government purchases multiplier is larger (in absolute value) than the tax multiplier. We can use our formulae for the government purchases multiplier and the tax multiplier to calculate the net effect of increasing government purchases by $10 billion at the same time that taxes are increased by $10 billion: Increase in real GDP from the increase in government purchases  $10 billion 

1 1  MPC

Decrease in real GDP from the increase in taxes  $10 billion 

MPC 1  MPC

So, the combined effect equals: $10 billion 

MPC 1  1  MPC 1  MPC

or, $10 billion 

1 MPC  $10 billion 1  MPC

The balanced budget multiplier is therefore equal to (1 – MPC )/(1 – MPC ), or 1. Equal dollar increases and decreases in government purchases and in taxes lead to the same dollar increase in real GDP in the short run.

The effects of changes in tax rates on the multiplier We now consider the effect of a change in the tax rate, as opposed to a change in a fixed amount of taxes. Changing the tax rate actually changes the value of the multiplier. To see this, suppose the tax rate is 20 per cent, or 0.2. In that case an increase in household income of $10 billion will increase disposable income by only $8 billion (or, $10 billion × (1 – 0.2)). In general, an increase in income can be multiplied by (1 – t) to find the increase in disposable income, where t is the tax rate. So, we can rewrite the consumption function as: C  C  MPC(1  t)Y

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We can use this expression for the consumption function to find an expression for the government purchases multiplier using the same method as we did previously: Government purchases multiplier 

Y 1  G 1  MPC(1  t)

We can see the effect of changing the tax rate on the size of the multiplier by trying some values. First, assume that the MPC = 0.75 and t = 0.2. Then, Government purchases multiplier 

1 1 Y    2.5 1  0.75(1  0.2) 1  0.6 G

This value is smaller than the multiplier of 4 that we calculated by assuming that there was only a fixed amount of taxes (which is the same as assuming the marginal tax rate was zero). This multiplier is smaller because spending in each period is now reduced by the amount of taxes households must pay on any additional income they earn. We can calculate the multiplier for an MPC of 0.75 and a lower tax rate of 0.1: Government purchases multiplier 

1 1 Y    3.1 1  0.75(1  0.1) 1  0.675 G

Cutting the tax rate from 20 per cent to 10 per cent increased the value of the multiplier from 2.5 to 3.1.

The multiplier in an open economy Up to now we have assumed that the economy is closed, with no imports or exports. We can consider the case of an open economy by including net exports in our analysis. Recall that net exports equals the value of exports minus the value of imports. Exports are determined primarily by factors such as the exchange value of the dollar and the levels of real GDP in other countries that we do not include in our model. So we will assume that exports are fixed, or autonomous: Exports  Exports

Imports will increase as real GDP increases because households will spend some portion of an increase in income on imports. We can define the marginal propensity to import (MPI ) as the fraction of an increase in income that is spent on imports. So our expression for imports is: Imports  MPI  Y

We can substitute our expressions for exports and imports into the expression we derived earlier for equilibrium real GDP: Y  C  MPC( 1 t)Y  I  G  (Exports  MP I  Y )

where the expression Exports – MPI × Y represents net exports. We can now find an expression for the government purchases multiplier using the same method as we did previously: Government purchases multiplier 

1 Y  1  [MPC(1  t) MPI] G

We can see the effect of changing the value of the marginal propensity to import on the size of the multiplier by trying some values of key variables. First, assume MPC = 0.75, t = 0.2 and MPI = 0.1. Then, Government purchases multiplier 

1 1 Y   2 1  (0.75(1  0.2)  0.1) 1  0.5 G

This value is smaller than the multiplier of 2.5 that we calculated by assuming that there were no exports or imports (which is the same as assuming the marginal propensity to import

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was zero). This multiplier is smaller because spending in each period is now reduced by the amount of imports households buy with any additional income they earn. We can calculate the multiplier with MPC = 0.75, t = 0.20 and a higher MPI of 0.2: Government purchases multiplier 

1 1 Y    1.7 1  (0.75(1  0.2)  0.2) 1  0.4 G

Increasing the marginal propensity to import from 0.1 to 0.2 decreased the value of the multiplier from 2 to 1.7. We can conclude that countries with a higher marginal propensity to import will have smaller multipliers than countries with a lower marginal propensity to import. It is always important to bear in mind that the multiplier is a short-run effect that assumes that the economy is below the level of potential GDP. In the long run the economy is at potential GDP, so an increase in government purchases causes a decline in the non-government components of real GDP, but it leaves the level of real GDP unchanged. The analysis in this appendix is simplified compared to what would be carried out by an economist forecasting the effects of changes in government purchases or changes in taxes on equilibrium real GDP in the short run. In particular, our assumption that the price level is constant is unrealistic. However, looking more closely at the determinants of the multiplier has helped us see more clearly some important macroeconomic relationships.

APPENDIX PROBLEMS PROBLEMS AND APPLICATIONS 13A2.1

13A2.2

13A2.3

Assuming a fixed amount of taxes and a closed economy, calculate the value of the government purchases multiplier, the tax multiplier and the balanced budget multiplier if the marginal propensity to consume equals 0.6. Calculate the value of the government purchases multiplier if the marginal propensity to consume equals 0.8, the tax rate equals 0.25 and the marginal propensity to import equals 0.2. Use a graph to show the change in the aggregate

13A2.4

demand curve resulting from an increase in government purchases if the government purchases multiplier equals 2. Now, on the same graph, show the change in the aggregate demand curve resulting from an increase in government purchases if the government purchases multiplier equals 4. Using your understanding of the multiplier process, explain why an increase in the tax rate would decrease the size of the government purchases multiplier. Similarly, explain why a decrease in the marginal propensity to import would increase the size of the government purchases multiplier.

ENDNOTES 1 2 3

Parliament of Australia, Senate (2009), Government’s Economic Stimulus Initiatives, October, Commonwealth of Australia. J.M. Keynes (1936), The General Theory of Employment, Interest, and Money, London, Macmillan. Floyd Norris (2008), ‘It’s a recession’, The New York Times, 1 December, at , viewed 18 February 2011.

4

Mark Rutte and Jan Kees de Jager (2011), ‘Expulsion from the eurozone has to be the final penalty,’ Financial Times, 7 September , at , viewed 12 February 2014.

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7

THE I N TE RNATIO NAL E CO NO MY

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14

MACROECONOMICS IN AN OPEN ECONOMY LEARNING OBJECTIVES After studying this chapter you should be able to: 14.1 Explain the main components of the balance of payments and understand how it is calculated. 14.2 Explain how exchange rates are determined and how changes in exchange rates affect the prices of imports and exports. 14.3 Explain the saving and investment equation. 14.4 Explain the effect of a government budget deficit or surplus on investment in an open economy. 14.5 Discuss the difference between the effectiveness of monetary policy and fiscal policy in an open economy and in a closed economy.

AUSTRALIAN UNIVERSITIES EXPERIENCE CRUNCH FROM HIGH DOLLAR IN THE MID-1980s there was virtually no such industry as the ‘export of education and training services’ in Australia. Prior to that point Australia had a small number of international students in Australia—mainly in the universities—who were all either AusAid (fully Australian government funded) or private students paying subsidised fees. John Dawkins became federal Minister for Education in 1987 and rapidly moved education and training from an ‘aid’ towards a ‘trade’ mentality. Between 1986 and 2010 Australia’s total international student enrolments in higher education grew from 14 000 to over 242 000, but then declined to around 231 000 in 2013. Export earnings from education and training grew from nothing to become Australia’s largest service export industry. According to Commonwealth government estimates, the export of education services is worth around $15 billion annually, of which a little more than two-thirds is generated by the tertiary education sector. The cost to a student of studying in Australia includes university fees, the cost of books and other learning materials, plus accommodation and living expenses, which must be paid for in Australian dollars. These costs then have to be converted to the

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local currency of the country in which the student lives in order to arrive at the cost to the overseas student or their family. The weakness of the Australian dollar during the 1980s and 1990s compared to the currencies of its major sources of overseas students, such as Singapore and Malaysia, contributed to maintaining Australia’s competitiveness relative to its major competitors, the United States and the United Kingdom, against whose currencies the Australian dollar also depreciated. In the 2000s the emerging mega-markets of India and China provided huge opportunities for Australian educational institutions. In 2013, China and India were the largest and second largest, respectively, source countries for earnings from overseas students in Australia, followed by Vietnam, South Korea and Malaysia. However, students from all over the world, including the United States and Europe, study in Australia. Between January 2010 and February 2012 the monthly average value of the Australian dollar rose significantly. This effectively meant that the cost of studying for students from Australia’s main source countries had generally risen by a very large amount, and relative to Australia’s main competitors, the United States and the United Kingdom. Despite some fall in the value of the Australia dollar between 2012 and the end of 2013, it remained still well above its pre-2010 average. The figure here shows that the effect on student numbers was marked, with significant falls in the number of overseas students participating in higher education in Australia. This clearly shows the importance of exchange rate movements to the export of education.

14

© Marc Dietrich | Dreamstime.com

ECONOMICS IN YOUR LIFE

250 000

THE AUSTRALIAN DOLLAR AND YOUR NEW CAR PRICE

200 000

150 000

100 000

50 000

0

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

SOURCE: P. Lewis (2007), ‘Exports of educational services from Australia’, Proceedings of the 6th Global Conference on Business and Economics, Rome, 13–14 October; Australian Government (2013), ‘Export income to Australia from international education activity in 2012–13, Research Snapshot, Australian Education International, November, at , viewed 17 February 2014; Australian Government (2013), International Student Data 2013, Australian Education International, Basic Pivot Table 2002 onwards, at , viewed 17 February 2014.

2013

Suppose that you are shopping for a car, and you are planning to buy a new small Mazda. One morning, as you head out the door to visit a car dealership, you hear the following news on the radio (yes, you are listening to a news channel): ‘Overseas investors are starting to sell significant holdings of Australian dollars.’ What effect might this decision to sell Australian currency have on the price you pay for your Mazda car? As you read this chapter, see if you can answer this question. You can check your answer against the one we provide on page 425 at the end of this chapter.

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IN THIS CHAPTER we look closely at the linkages between countries at the macroeconomic level. Countries are linked by trade in goods and services and by flows of financial investment. We will see how policy-makers take these linkages into account when conducting monetary and fiscal policy.

14.1 Explain the main components of the balance of payments and understand how it is calculated. LEARNING OBJECTIVE

Open economy An economy that has interactions in trade or finance with other economies. Closed economy An economy that has no interactions in trade or finance with other economies. Balance of payments The record of a country’s international trade, borrowing, lending, capital and investment flows with other countries. Current account Records current, or shortterm, flows of funds into and out of a country.

THE BALANCE OF PAYMENTS: LINKING AUSTRALIA TO THE INTERNATIONAL ECONOMY Today, consumers, firms and investors in Australia routinely interact with consumers, firms and investors in other economies. A consumer in Singapore may eat beef produced in Australia, listen to music on an iPhone made in China and wear a shirt made in Italy. A firm in Australia may sell its products in dozens of countries around the world. An investor in London may sell an Australian government bond to an investor in Mexico City. Nearly all economies are open economies to varying degrees and have extensive interactions in trade or finance with other countries. Open economies interact by trading goods and services and by making investments in each other’s economies. A closed economy has no interactions in trade or finance with other countries. No economy today is completely closed, although a few countries, such as North Korea, have very limited economic interactions with other countries. A useful way to understand the interactions between one economy and other economies is through the balance of payments. The balance of payments is a record of a country’s international trade, borrowing, lending, capital and investment flows with other countries. Table 14.1 shows the balance of payments for Australia in 2012/13. Notice that the balance of payments contains three ‘accounts’: the current account, the capital account and the financial account.

The current account The current account records current, or short-term, flows of funds into and out of a country. The current account includes: • Net exports—income received for exports minus the amount paid for imports of goods and services. • Net primary income—income received by Australian residents from investments in other countries including profits, dividends, rental income and interest repayments on foreign borrowing from Australia, minus income paid to overseas residents from investments in Australia. • Net secondary income—the difference between transfers made to Australian residents from other countries, minus transfers made to residents of other countries including overseas food aid, pensions and migrants’ funds. Any payments received by Australian residents are positive numbers in the current account, and any payments made by Australian residents are negative numbers in the current account. We will examine the net exports and net primary income components of the current account in the following sections. Net secondary income is a relatively small part of the current  account therefore we will not examine it further.

Net exports

Balance of trade in goods and services The difference between the value of the goods and services a country exports, and the value of the goods and services a country imports.

The net exports component of the current account comprises the net exports of goods— known as the balance on merchandise trade, and the net exports of services—known as net services. Together, net goods and net services make up the balance on goods and services—sometimes also called the balance of trade in goods and services. The balance of trade in goods and services is a topic that the media and politicians often discuss. If a country exports more than it imports it has a trade surplus. If it exports less than it imports it has a trade deficit. Table 14.1 shows that in 2012/13 Australia had a trade deficit for goods and services of $17.851 billion. Figure 14.1 shows Australia’s balance on goods, and the balance on goods and services (total net exports) from 1960 to 2013. Between 1960 and 1980 earnings from total exports and

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405

Balance of payments, Australia, 2012/13 CURRENT ACCOUNT

Net exports Exports of goods Imports of goods Balance of merchandise (goods) trade Exports of services Imports of services Net services Balance on goods and services Net primary income Income into Australia (credits) Income going overseas (debits) Total net primary income Net secondary income Transfers into Australia (credits) Transfers overseas (debits) Total net secondary income CURRENT ACCOUNT BALANCE

$ BILLIONS 249.088 –255.391

–6.303 52.411 –63.959 –11.548 –17.851 48.323 –83.253 –34.930 7.305 –9.423 –2.118 –54.899

CAPITAL ACCOUNT BALANCE FINANCIAL ACCOUNT Net direct investment Direct investment abroad (assets) Direct foreign investment in Australia (liabilities) Total net direct investment Net portfolio investment Portfolio investment abroad (assets) Foreign portfolio investment in Australia (liabilities) Total net portfolio investment Financial derivatives Other investment Reserve assets FINANCIAL ACCOUNT BALANCE CAPITAL AND FINANCIAL ACCOUNT BALANCE Net errors and omissions

$ BILLIONS

–0.453

–6.382 55.616 49.234 –30.899 66.521 35.622 –8.602 –18.675 –0.811 56.768 56.315 –1.416

SOURCE: Created from Australian Bureau of Statistics (2013), ‘Balance of payments, summary’, Table 1, Balance of Payments and International Investment Position, Australia, September Quarter, Cat. No. 5302.0, at , viewed 19 February 2014.

expenditure on total imports were approximately the same. From 1980 to the mid-1990s the goods trade balance fluctuated between positive and negative, while the balance on total goods and services was more often in deficit than surplus. Of particular note is the huge trade deficit experienced between 2003 and 2008. During this time a nation-wide drought caused a significant fall in agricultural export earnings, and imports rose by a large amount, as strong economic growth and a booming minerals sector led to increased importation of machinery and equipment. In 2009 and again in 2011 the balance on goods and services moved into surplus, before again moving into a deficit in 2012 and 2013. The surplus was due to a recovery of agricultural exports as droughts ended and also due to a large increase in export earnings from minerals and energy. By 2013, export earnings from goods had fallen in part due to falls in some commodity prices.

Net primary income The net primary income component on Australia’s current account has been consistently negative, or in deficit. This can be clearly seen in Figure 14.2, which shows the net primary income component of Australia’s current account from 1960 to 2013. Remember that net

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FIGURE 14.1

Balance on goods and services, Australia, 1960–2013 From 1980 to the mid-1990s the goods trade balance fluctuated between positive and negative, while the balance on total goods and services was more often in deficit than surplus. Of particular note is the huge trade deficit experienced between 2004 and 2008. In 2009 and again in 2011 the balance on goods and services moved into surplus, before again moving into a deficit in 2012 and 2013 30 25 20 15

Billions of dollars

10 5 0 –5 –10 –15 –20 Balance on goods and services Balance on goods

–25 –30 –35 1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

2010

2015

SOURCE: Created from Australian Bureau of Statistics (2013), Balance of Payments and International Investment Position, Australia, Cat. No. 5302.0, Time Series Workbook, Table 51, at , viewed 14 February 2014.

primary income includes profits, dividends, rental income and interest repayments on loans. Domestic saving in Australia is low, meaning that there is insufficient saving to provide funds available to be borrowed for investment. Therefore Australian businesses and governments borrow from overseas to finance investment and spending. This means that a large component of net primary income is composed of interest repayments on overseas loans. Australia is also a net recipient of foreign investment. Foreign financial institutions, corporations and individuals buy bonds, securities and shares in Australia, and also own many businesses in Australia. The outflow of profits and dividends usually exceeds the inflow that Australian residents receive from overseas investments, which also contributes to the deficit in net primary income. Figure 14.2 also shows that the deficit in net primary income began to grow during the second half of the 1980s, with the deficit accelerating in the 2000s. As we will discuss later in this chapter, the value of the Australian dollar fell after the currency was ‘floated’ in 1983, which meant that loans denominated in foreign currencies required more Australian dollars to repay them after this time. From the early 1990s to 2007 the continual period of strong economic growth led to increased levels of domestic borrowing, largely for investment, together with increased foreign investment. This can be seen particularly during the minerals boom of the 2000s. During this time both interest repayments on borrowings and the repatriation of profits and dividends overseas increased. The economic contraction of 2008–2009 resulting from the global financial crisis (GFC) and the generally subsequent below-trend economic growth rates, saw a decrease in the deficit on net primary income, as the sum of the returns on shares and interest earnings flowing out to overseas investors fell.

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407

FIGURE 14.2

Net primary income, Australia, 1960–2013 The net primary income component on Australia’s current account has been consistently negative or in deficit. A large component of net primary income is composed of interest repayments on overseas loans. The net outflow of profits and dividends exceeds the inflow that Australian residents receive from overseas investments, which also contributes to the deficit in net primary income

0 –5 –10

Billions of dollars

–15 –20 –25 –30 –35 –40 –45 –50 –55 1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

2010

2015

SOURCE: Created from Australian Bureau of Statistics (2013), Balance of Payments and International Investment Position, Australia, Cat. No. 5302.0, Time Series Workbook, Table 51, at , viewed 14 February 2014.

As Table 14.1 shows, for the 2012/13 financial year primary income outflows to overseas countries exceeded inflows into Australia by $34.93 billion—a decline from the previous few years. Later in this chapter we examine whether or not the current account deficit is a problem for Australia.

The capital account A less important part of the balance of payments is called the capital account. The capital account records relatively minor transactions, such as migrants’ asset transfers—which consist of assets people take with them when they leave or enter a country, debt forgiveness and sales and purchases of non-produced, non-financial assets. Non-produced, non-financial assets include copyrights, patents, trademarks and franchises, as well as sales or purchases of Australian embassy land. The balance on the capital account is the sum of net capital transfers and net acquisition/disposal of non-produced, non-financial assets. The capital account is usually (but not always) in surplus in Australia, with more capital being transferred into Australia than out of Australia, largely due to positive net migration. From Table 14.1 we can see that in 2012/13 the balance on the capital account was relatively small and in deficit by $0.453 billion.

The financial account The financial account records purchases of physical assets and financial assets that a country has made abroad and foreign purchases of physical and financial assets in the  country. The financial account records long-term flows of funds into and out of a country. There is a capital outflow from Australia when an investor in Australia buys a bond issued by a foreign company or government, or when an Australian firm builds or buys a physical asset, such as a factory, in

Capital account The part of the balance of payments that records migrants’ asset transfers, debt forgiveness and sales and purchases of nonproduced, non-financial assets.

Financial account The part of the balance of payments that records purchases of physical and financial assets a country has made abroad and foreign purchases of physical and financial assets in the country.

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Net foreign investment The difference between capital outflows from a country and capital inflows, also equal to net foreign direct investment plus net foreign portfolio investment.

another country. There is a capital inflow into Australia when a foreign investor buys a bond or security issued by an Australian firm or by the government, or when a foreign firm builds or buys a physical asset, such as a factory, in Australia. Notice that we are using the word ‘capital’ here to apply not just to physical assets, such as factories, but also to financial assets, such as shares and bonds. When firms build or buy facilities in foreign countries, they are engaging in foreign direct investment. When investors buy shares, bonds or securities issued in another country, they are engaging in foreign portfolio investment. Another way of thinking of the balance on the financial account is as a measure of net capital flows, or the difference between capital inflows and capital outflows. (Here we are omitting a few transactions included in the capital account, as discussed in the next section.) A closely related concept to net capital flows is net foreign investment, which is equal to capital outflows minus capital inflows. Net capital flows and net foreign investment are always equal but have opposite signs: when net capital flows are positive net foreign investment is negative, and when net capital flows are negative net foreign investment is positive. That is, when more foreign investment is flowing into Australia than is being invested by Australians abroad, Australia’s net foreign investment is negative. If more is being invested by Australians abroad than the amount of foreign investment flowing into Australia, Australia’s net foreign investment is positive. Net foreign investment is also equal to net foreign direct investment plus net foreign portfolio investment. Later in this chapter we will use the relationship between the balance on the financial account and net foreign investment to understand an important aspect of the international economic system. Table 14.1 also shows direct investment, portfolio investment and a number of other categories of investment flows into and out of Australia. The amount of Australian direct investment abroad was significantly less than the amount of foreign direct investment in Australia in 2012/13, leaving a total net direct investment figure of $49.234 billion. This means that more direct investment was made by other countries in Australia than was invested by Australians in other countries. Historically there is usually more direct investment coming into Australia from other countries than the amount that Australians invest overseas. In 2012/13 there was more than double the amount of portfolio investment coming into Australia than was made by Australians in other countries, with $30.899 billion leaving Australia and $66.521 invested in Australia. Table 14.1 shows a net inflow of portfolio investment of $35.622 billion. This is due to good returns on Australian shares, together with the higher interest rates on bonds and securities sold in Australia, relative to the very low rates in many other countries. There are other less significant investment components in the financial account which we do not need to focus on here, except to note that the reserve assets component refers to changes in financial assets such as foreign currency reserves held by the Reserve Bank of Australia (RBA). In 2012/13 the RBA purchased $0.811 billion of foreign financial assets, which largely comprised the purchase of foreign currency. This appears as a negative item in the financial account, because there was an outflow of Australian financial assets in exchange for the foreign assets.

Why is the balance of payments always zero? The sum of the current account balance, the capital account balance and the financial account balance equals the balance of payments. Table 14.1 shows that the balance of payments for Australia in 2012/13 was zero. It’s not just by chance that this balance was zero; the balance of payments is always zero. Notice that the current account balance in 2012/13 was –$54.899 billion. This value is approximately equal (with opposite sign) to the balance of the sum of the capital account and financial account, which was $56.315 billion. To make the balance on the current account equal the balance on the capital and financial accounts, the balance of payments includes an entry called ‘Net errors and omissions’. This includes some imports or exports of goods and services or some capital inflows or capital outflows that have not been measured accurately. To understand better why the balance of payments must equal zero every year, consider the following. In 2012/13 Australia spent nearly $55 billion more on goods, services, interest repayments and other items in the current account than it received. What happened to that $55 billion? We know that every dollar of that $55 billion was used by foreign individuals or firms to invest in Australia, or was added to foreign holdings of Australian dollars. We know this because logically there is nowhere else for the dollars to go. If the dollars weren’t spent on Australian goods, services and interest repayments—and we know they weren’t because in that case they would have shown up in the current account—they must have been spent on

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investments in Australia or not spent at all. In the latter case, they would have been added to foreign holdings of dollars. Changes in foreign holdings of dollars are known as official reserve transactions. Foreign investment in Australia or additions to foreign holdings of dollars both show up as positive entries in the Australian financial account. Therefore, a current account deficit must be exactly offset by a capital and financial account surplus, leaving the balance of payments equal to zero. Similarly, a country that runs a current account surplus, such as China or Japan, must run a capital and financial account deficit of exactly the same size. If a country’s current account surplus is not exactly equal to its capital and financial account deficit, or if a country’s current account deficit is not exactly equal to its capital and financial account surplus, some transactions must not have been accounted for.

Don’t confuse the balance of trade, the current account balance and the balance of payments The terminology of international economics can be tricky. The current account balance includes the balance of trade in goods and services, net primary income and net secondary income. In many countries the net income components are much smaller than the balance of trade in goods and services. However, Australia is the recipient of huge amounts of foreign investment and therefore net primary income is negative and large relative to the trade balance. In 2012/13 the balance on goods and services was –$17.851 billion, compared to the net primary income balance of –$34.93 billion. Even though the balance of payments is equal to the sum of the current account balance and the capital and financial account balances—and must equal zero—you may sometimes see references to a balance of payments ‘surplus’ or ‘deficit’. The most likely explanation for these references is that the person making the reference has confused the balance of payments with either the balance of trade on goods and services or the current account balance. This is a very common mistake.

DON’T LET THIS HAPPEN TO YOU

[ YOUR TURN Q

Test your understanding by doing related problem 1.6 on page 428 at the end of this chapter.

SOLVED PROBLEM 14.1 UNDERSTANDING THE ARITHMETIC OF OPEN ECONOMIES Test your understanding of the relationship between the current account and the financial account by evaluating the following assertion by a political commentator: ‘The industrial countries are committing economic suicide. Every year they invest more and more in developing countries. Every year more Japanese and US manufacturing firms move their factories to developing countries. With extensive new factories and low wages, developing countries now export far more to the industrial countries than they import.’

Solving the problem STEP 1: Review the chapter material. This problem is about the relationship between the current account and the financial account,

so you may want to review the section ‘Why is the balance of payments always zero?’ on page 408. STEP 2: Explain the errors in the commentator’s argument. The argument sounds plausible. It would not be difficult to find almost

identical statements to this one in books and articles published during the past few years by well-known political commentators. But the argument contains an important error. The commentator has failed to understand the relationship between the current account and the financial account. The commentator asserts that developing countries are receiving large capital inflows from industrial countries. In other words, developing countries are running financial account surpluses. The commentator also asserts that developing countries are exporting more than they are importing. In other words, they are running current account surpluses. As we have seen in this section, it is impossible to run a current account surplus and a financial account surplus simultaneously. A country that runs a current account surplus must run a financial account deficit, and vice versa. The point here is not obvious—if it were, it wouldn’t confuse so many intelligent politicians, journalists and political commentators. Unless you understand the relationship between the current account and the financial account you won’t be able to understand a key aspect of the international economy.

[ YOUR TURN Q

For more practice do related problems 1.7, 1.8 and 1.9 on page 428 at the end of this chapter.

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14.2 Explain how exchange rates are determined and how changes in exchange rates affect the prices of imports and exports. LEARNING OBJECTIVE

Nominal exchange rate The value of one country’s currency in terms of another country’s currency.

THE FOREIGN EXCHANGE MARKET AND EXCHANGE RATES A firm that operates entirely within Australia will price its products in Australian dollars and will use Australian dollars to pay suppliers, workers, interest to bond holders and dividends to shareholders. A multinational corporation, in contrast, may sell its product in many different countries and receive payment in many different currencies. Its suppliers and workers may also be spread around the world and may have to be paid in local currencies. Corporations may also use the international financial system to borrow in a foreign currency. During the 1990s, for example, many large firms located in East Asian countries, such as Thailand and South Korea, received US dollar loans from foreign banks. When firms make extensive use of foreign currencies they must deal with fluctuations in the exchange rate. The nominal exchange rate is the value of one country’s currency in terms of another country’s currency. Economists also calculate the real exchange rate, which corrects the nominal exchange rate for changes in prices of goods and services. We discuss the real exchange rate later in this chapter. The nominal exchange rate determines how many units of a foreign currency you can purchase with one Australian dollar. Using a hypothetical example, the exchange rate between the Australian dollar and the Japanese yen can be expressed as ¥100 = $1. (This exchange rate can also be expressed as how many Australian dollars are required to buy one Japanese yen: $0.01 = ¥1.) The market for foreign exchange is very active. Every day the equivalent of more than US$5 trillion worth of currency is traded in the foreign exchange market. The exchange rates that result from this trading are reported each day on websites, the electronic boards of foreign exchange dealers and in the business or financial sections of most newspapers. Banks and other financial institutions around the world employ currency traders, who are linked together by computers. Rather than exchanging large amounts of paper currency, they buy and sell deposits in banks. A bank buying or selling Australian dollars will actually be buying or selling Australian dollar bank deposits. Dollar bank deposits exist not just in banks in Australia but also in banks around the world. Suppose that the Crédit Agricole bank in France wishes to sell Australian dollars and buy Japanese yen. It may exchange Australian dollar deposits that it owns for Japanese yen deposits owned by the Deutsche Bank in Germany. Businesses and individuals usually obtain foreign currency from banks and other foreign exchange dealers in their own country. The market exchange rate is the price of an Australian dollar for anyone wishing to buy it with their own currency. The exchange rate is therefore determined by the interaction of demand and supply, just as other prices are. Let’s consider the demand for Australian dollars in exchange for Japanese yen. There are three sources of foreign currency demand for the Australian dollar: 1 Foreign firms and consumers that want to buy goods and services produced in Australia. 2 Foreign firms and consumers that want to invest in Australia either through foreign direct investment—buying or building factories or other facilities in Australia—or through foreign portfolio investment—buying shares and bonds issued in Australia. 3 Currency traders who believe that the value of the dollar in the future will be greater than its value today.

Equilibrium in the market for foreign exchange Figure 14.3 shows the demand and supply of Australian dollars for Japanese yen. Notice that as we move up the vertical axis in Figure 14.3 the value of the dollar increases relative to the value of the yen. When the exchange rate is ¥120 = $1 the dollar is worth 1.2 times as much relative to the yen as when the exchange rate is ¥100 = $1. Consider, first, the demand curve for Australian dollars in exchange for yen. The demand curve has the normal downward slope. When the value of the dollar is high the quantity of dollars demanded will be low. A Japanese investor will be more likely to buy a $1000 bond

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issued by the Australian Treasury when the exchange rate is ¥80 = $1 and the investor pays only ¥80 000 to buy $1000 than when the exchange rate is ¥120 = $1 and the investor must pay ¥120 000. Similarly, a Japanese firm is more likely to buy $100 000 worth of beef from Australia when the exchange rate is ¥80 = $1 and the beef can be purchased for ¥8 million than when the exchange rate is ¥120 = $1 and the beef will cost ¥12 million. Consider, now, the supply curve of Australian dollars in exchange for yen. The supply curve has the normal upward slope. When the value of the dollar is high the quantity of Australian dollars supplied in exchange for yen will be high. An Australian investor will be more likely to buy a ¥100 000 bond issued by the Japanese government when the exchange rate is ¥120 = $1 and she needs to pay only $833 to buy ¥100 000 than when the exchange rate is ¥80 = $1 and she must pay $1250. The owner of an Australian electronics store is more likely to buy ¥20 million worth of televisions from Sony Corporation when the exchange rate is ¥120 = $1 and he only needs to pay $166 667 to purchase the televisions than when the exchange rate is ¥80 = $1 and he must pay $250 000. As in any other market, equilibrium occurs in the foreign exchange market where the quantity supplied equals the quantity demanded. In Figure 14.3, ¥100 = $1 is the equilibrium exchange rate. At exchange rates above ¥100 = $1 there will be a surplus of dollars and downward pressure on the exchange rate. The surplus and the downward pressure will not be eliminated until the exchange rate falls to ¥100 = $1. If the exchange rate is below ¥100 = $1 there will be a shortage of dollars and upward pressure on the exchange rate. The shortage and the upward pressure will not be eliminated until the exchange rate rises to ¥100 = $1. Surpluses and shortages in the foreign exchange market are eliminated very quickly because the volume of trading in major currencies such as the dollar and the yen is large and currency traders are linked together via computers. Currency appreciation occurs when the market value of a country’s currency rises relative to the value of another country’s currency. Currency depreciation occurs when the market value of a country’s currency declines relative to the value of another country’s currency.

Currency appreciation Occurs when the market value of a currency rises relative to another currency. Currency depreciation Occurs when the market value of a currency falls relative to another currency.

FIGURE 14.3

Exchange rate (¥/$)

Supply Surplus of dollars

¥120

Supply of dollars in exchange for yen

100

80 Shortage of dollars

Demand for dollars in exchange for yen

Equilibrium in the foreign exchange market When the exchange rate is ¥120 to the dollar it is above its equilibrium level and there will be a surplus of dollars. When the exchange rate is ¥80 to the dollar it is below its equilibrium level and there will be a shortage of dollars. At an exchange rate of ¥100 to the dollar, the foreign exchange market is in equilibrium

Demand

0

Quantity of dollars traded

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M

C

A K I N G THE

14.1

ONNECTION

EXCHANGE RATES LISTINGS Many online sites, as well as the financial pages of most newspapers, list the exchange rate between the dollar and other important currencies. The rates in the following table are for 18 February 2014. Note that the euro is the official currency used by 18 European countries, including France, Germany and Italy, and is also used by another five European countries. UNITS OF FOREIGN CURRENCY PER AUSTRALIAN DOLLAR

AUSTRALIAN DOLLAR PER UNITS OF FOREIGN CURRENCY

0.90

1.11

92.75

0.01

Euro

0.66

1.52

British pound

0.54

1.85

Chinese yuan

5.49

0.18

Indian rupee

56.18

0.018

US dollar Japanese yen

© Edyta Pawlowska | Dreamstime.com

Many online sites and the financial pages of most newspapers provide information on exchange rates

Adapted from: XE Currency Converter–Live Rates, at , viewed 17 February 2014.

Notice that the expression for the exchange rate stated as units of foreign currency per Australian dollar is the reciprocal of the exchange rate stated as Australian dollars per unit of foreign currency. So the exchange rate between the Australian dollar and the US dollar can be stated as either 0.90 US dollars per Australian dollar or 1/0.90 = 1.11 Australian dollars per US dollar. Banks are the most active participants in the market for foreign exchange. Typically, banks buy currency for slightly less than the amount for which they sell it. This spread between the buying and selling prices allows banks to cover their expenses from currency trading and to make a profit. Therefore, when most businesses and individuals buy foreign currency from a bank they receive fewer units of foreign currency per dollar than would be indicated by the exchange rate shown online or printed in a newspaper.

DON’T LET THIS HAPPEN TO YOU

Don’t confuse what happens when a currency appreciates with what happens when it depreciates One of the more confusing aspects of exchange rates is that they can be expressed in two ways. We can express the exchange rate between the Australian dollar and the yen either as how many yen can be purchased with one dollar or as how many dollars can be purchased with one yen. That is, we can express the exchange rate as ¥100 = $1 or as $0.01 = ¥1. When a currency appreciates, it increases in value relative to another currency. When it depreciates, it decreases in value relative to another currency. If the exchange rate changes from ¥100 = $1 to ¥120 = $1, the dollar has appreciated and the yen has depreciated because it now takes more yen to buy one dollar. If the exchange rate changes from $0.01 = ¥1 to $0.015 = ¥1, however, the dollar has depreciated and the yen has appreciated because it now takes more dollars to buy one yen. This situation can appear confusing because the exchange rate seems to have ‘increased’ in both cases. To determine which currency has appreciated and which has depreciated, remember that an appreciation of the domestic currency means that it now takes more units of the foreign currency to buy one unit of the domestic currency. A depreciation of the domestic currency means it takes fewer units of the foreign currency to buy one unit of the domestic currency. This observation holds no matter which way we express the exchange rate.

[ YOUR TURN Q

Test your understanding by doing related problem 2.5 on page 429 at the end of the chapter.

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How do shifts in demand and supply affect the exchange rate? Shifts in the demand and supply curves cause the equilibrium exchange rate to change. Three main factors cause the demand and supply curves in the foreign exchange market to shift: 1 Changes in the overseas demand for Australian-produced goods and services and changes in Australian demand for foreign-produced goods and services. 2 Changes in the desire to invest in Australia and changes in the desire of Australian firms and individuals to invest in foreign countries. 3 Changes in the expectations of currency traders about the likely future value of the dollar and the likely future value of foreign currencies.

Shifts in the demand for foreign exchange Consider first how the three factors listed above will affect the demand for Australian dollars in exchange for Japanese yen. During an economic expansion in Japan the incomes of Japanese households will rise and the demand by Japanese consumers and firms for Australian goods and services will increase. Also, the demand for Japanese goods by Japanese consumers will rise, creating extra demand for Australian minerals and energy as production inputs. At any given exchange rate, the demand for Australian dollars will increase and the demand curve for dollars will shift to the right. Similarly, if interest rates in Australia rise, and are higher relative to interest rates in other countries, the desirability of investing in Australian financial assets will increase, and the demand curve for dollars will also shift to the right. This occurred in Australia in 2009 and 2010 because the RBA was increasing interest rates at the same time as the US Federal Reserve, the Bank of England and the central banks of many other countries had reduced their interest rates to zero, or close to zero. Some buyers and sellers in the foreign exchange market are speculators. Speculators buy and sell foreign exchange in an attempt to profit from changes in exchange rates. If a speculator becomes convinced that the value of the Australian dollar is going to rise relative to the value of the yen, the speculator will sell yen and buy dollars. If the current exchange rate is ¥120 = $1 and the speculator is convinced that it will soon rise to ¥140 = $1, the speculator could sell ¥600 million and receive $5 million (¥600 million/¥120) in return. If the speculator is correct and the value of the dollar rises against the yen to ¥140 = $1, the speculator will be able to exchange $5 million for ¥700 million ($5 million × ¥140), for a profit of ¥100 million. To summarise, the demand curve for dollars shifts to the right when incomes rise in other countries which buy goods and services from Australia, when interest rates in Australia rise relative to interest rates in other countries or when speculators decide that the value of the dollar will rise relative to the value of other currencies. During economic contractions or recessions in other countries, overseas income will fall, reducing the demand for Australian-produced goods and services and shifting the demand curve for Australian dollars to the left. Similarly, if interest rates in Australia fall relative to interest rates in other countries, the desirability of investing in Australian financial assets will decrease and the demand curve for dollars will shift to the left. Finally, if speculators become convinced that the future value of the Australian dollar will be lower than its current value, the demand for dollars will fall and the demand curve will shift to the left.

Speculators Currency traders who buy and sell foreign exchange in an attempt to profit from changes in exchange rates.

Shifts in the supply of foreign exchange The factors affecting the supply curve for Australian dollars are similar to those affecting the demand curve for dollars. An economic expansion in Australia increases the incomes of Australians and increases their demand for goods and services, including goods and services made in other countries. For example, as Australian consumers and firms increase their spending on Japanese products they must supply Australian dollars in exchange for yen, which causes the supply curve for Australian dollars to shift to the right. Similarly, an increase in interest rates in Japan relative to interest rates in Australia will make financial investments in Japan more attractive to Australian investors. These higher Japanese interest rates will cause the supply of dollars to shift to the right, as Australian investors exchange dollars for yen. Finally, if speculators become convinced that the future value of the yen will be higher relative to the

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dollar than it is today, the supply curve of dollars will shift to the right as traders attempt to exchange dollars for yen. A contraction or recession in Australia will reduce incomes in Australia, decreasing the demand for overseas products and causing the supply curve for Australian dollars to shift to the  left. Similarly, a decrease in interest rates in other countries relative to interest rates in Australia will make financial investments offshore less attractive and cause the supply curve of dollars to shift to the left. If traders become convinced that the future value of another currency will be lower relative to the dollar, the supply curve will also shift to the left.

Adjustment to a new equilibrium The factors that affect the supply and demand for currencies are constantly changing. Whether the exchange rate increases or decreases depends on the direction and size of the shifts in the demand curve and supply curve. For example, as Figure 14.4 shows, if the demand curve for dollars in exchange for Japanese yen shifts to the right by more than the supply curve shifts, the equilibrium exchange rate will increase.

Some exchange rates are not determined by the market To this point, we have assumed that exchange rates are determined in the market. This assumption is a good one for many currencies, including the Australian dollar, the euro, the Japanese yen, the US dollar and the British pound, although at times the central banks do intervene to affect the market-determined rate, as we will learn of in the next chapter. The Australian dollar is one of the world currencies with the least central bank intervention. Some currencies, however, have fixed exchange rates that do not change over long periods. For example, for more than 10 years the value of the Chinese yuan (renminbi) was fixed against the US dollar at a rate of 8.28 yuan to the US dollar. In 2010 China announced that it was moving to allow more flexibility in its exchange rate, but although some depreciation has been allowed to occur since then, its value remains largely fixed to a group of currencies, and it is only allowed to move within a fairly narrow band. As we will discuss in more detail in Chapter 15, a country’s central bank has to intervene in the foreign exchange market to buy and sell its currency to keep the exchange rate fixed. This often imposes severe restrictions on their ability to conduct domestic monetary policy.

How movements in the exchange rate affect exports and imports Exchange rate appreciation When the market value of the Australian dollar increases—appreciates—the foreign currency prices of many Australian exports largely remain the same since many Australian exports are commodities which have their prices denominated in US dollars. For Australian commodity

FIGURE 14.4

Shifts in the demand and supply curves resulting in a higher exchange rate An increase in the supply of Australian dollars will decrease the equilibrium exchange rate. An increase in the demand for dollars will increase the equilibrium exchange rate, holding other factors constant. In the case shown in this figure, the demand curve and the supply curve have both shifted to the right. Because the demand curve has shifted to the right by more than the supply curve, the equilibrium exchange rate has increased from ¥120 to the dollar at point A to ¥130 to the dollar at point B

Exchange rate (¥/$)

2. . . . while the demand curve for dollars shifts further to the right . . .

S1 S2

3. . . . causing the equilibrium exchange rate to rise.

B

¥130 120

1. The supply curve of dollars shifts to the right . . .

A D2 D1

0

Quantity of dollars traded

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exporters, revenue in Australian dollars falls. For those exporters where prices are determined in Australia, such as university education, prices for overseas customers rise and demand for Australian goods and services falls, as we read in the opening case to this chapter. For instance, fewer students would choose to study in Australia when the Australian exchange rate rises relative to other currencies. When the Australian dollar appreciates, the Australian dollar price of foreign imports falls, increasing the demand for imports. For example, suppose initially that the market exchange rate between the Australian dollar and the euro is $1 = €0.5. A bottle of French champagne that has a price of €50 in France will have a price of $100 in Australia. An appreciation of the dollar would decrease the dollar price of the French champagne. If the market exchange rate between the Australian dollar and the euro changed to $1 = €0.6, the price of the French champagne in Australia will fall to $83.33 (€50/0.6). Australian consumers will buy more French champagne at the lower price. To generalise, we can conclude that an appreciation in the domestic currency will reduce export income and increase imports, thereby decreasing net export income.

Exchange rate depreciation When the market value of the Australian dollar decreases—depreciates—the foreign currency prices of many Australian exports largely remain the same since many Australian exports are commodities which have their prices denominated in US dollars. However, for Australian commodity exporters, revenue in Australian dollars rises. For those exporters where prices are determined in Australia, such as our earlier example of a university education, prices for overseas customers fall and demand for Australian goods and services rises. For instance, more students would choose to study in Australia when the Australian exchange rate falls relative to other currencies. When the Australian dollar depreciates the Australian dollar price of foreign imports rises. Using our earlier example, assume that the market exchange rate between the Australian dollar and the euro changed from $1 = €0.5 to $1 = €0.4. The dollar price of the French champagne would rise from $100 to $125 (€50/0.4). As a result, we would expect less French champagne to be sold in Australia. To generalise, we can conclude that a depreciation in the domestic currency will increase export income and decrease imports, thereby increasing net export income. As we saw in previous chapters, net exports is a component of aggregate demand. If the economy is currently operating below potential GDP, then, holding all other factors constant, a depreciation in the domestic currency should increase net exports, aggregate demand and real GDP. An appreciation in the domestic currency should have the opposite effect: export income should fall and imports should rise, which will reduce net exports, aggregate demand and real GDP.

SOLVED PROBLEM 14.2 THE EFFECT OF CHANGING EXCHANGE RATES ON THE PRICES OF IMPORTS In June 2004 the average price of goods and services imported into Australia from the United States rose considerably from the average price of goods and services only four months earlier, in February. Further, over the decade from January 2004 to January 2014, the exchange rate between the Australian dollar and the US dollar changed from an average of approximately A$1.00 = US$0.77 to A$1.00 = US$0.88 (with a lot of fluctuations during this time, as we would expect). 1

Is it likely that the value of the Australian dollar appreciated or depreciated relative to the US dollar between February and June 2004?

2

Were the Australian prices of goods and services of imports from the United States cheaper or more expensive in 2014 than in 2004, assuming ceteris paribus?

Solving the problem STEP 1: Review the chapter material. This problem is about changes in the value of a currency, so you may want to review the

section ‘How movements in the exchange rate affect exports and imports’, on page 414.

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STEP 2: Explain whether the value of the Australian dollar appreciated or depreciated against the US dollar. We know that if the

Australian dollar depreciates against the US dollar it will take fewer US dollars to purchase one Australian dollar, and, equivalently, more Australian dollars will be required to purchase one US dollar. A US consumer or business will need to pay fewer US dollars to buy products imported from Australia: a good or service that had been selling for US$100 will now sell for less than US$100. An Australian consumer or business will have to pay more Australian dollars to buy products imported from the United States: a good or service that had been selling for A$100 will now sell for more than A$100. We can conclude that if the price of goods imported into Australia from the United States rose, the value of the Australian dollar must have depreciated relative to the US dollar. STEP 3: Explain whether the Australian prices of goods and services of imports from the United States are cheaper or more

expensive in 2014 than in 2004 (ceteris paribus). The change in the exchange rate between the Australian dollar and the US dollar in 2004 and 2014 was substantial. In 2014 one Australian dollar was worth around 15 per cent more US dollars than in 2004. Therefore goods and services imported into Australia from the United States were cheaper in Australian dollars in 2014 than in 2004, assuming all other factors remained the same.

[ YOUR TURN Q

For more practice do related problem 2.10 on page 430 at the end of this chapter.

The real exchange rate

Real exchange rate The price of domestic goods and services in terms of foreign goods and services.

We have seen that an important factor in determining the amount of exports and imports between countries is the relative prices of each country’s goods. The relative prices of two countries’ goods are determined by two factors: the relative price levels in the two countries and the nominal exchange rate between the two countries’ currencies. Economists combine these two factors in the real exchange rate. The real exchange rate is the price of domestic goods and services in terms of foreign goods and services. Recall that the price level is a measure of the average prices of goods and services in an economy. We can calculate the real exchange rate between two currencies as: Real exchange rate  nominal exchange rate 

domestic price level foreign price level

Notice that changes in the real exchange rate reflect both changes in the nominal exchange rate and changes in the relative price levels. For example, suppose that the exchange rate between the Australian dollar and the British pound is $1 = £0.5, the price level in Australia is 100 and the price level in the UK is also 100. Then the real exchange rate between the dollar and the pound is: Real exchange rate  0.5 pound/dollar 

100  0.5 100

This means that one Australian dollar will purchase £0.5 (or 50 pence). Now suppose the nominal exchange rate increases to $1 = £0.6, while the price level in Australia rises to 105 and the price level in the UK remains 100. The real exchange rate will be: Real exchange rate 5 0.6 pound/dollar 3

105 5 0.63 100

The increase in the real exchange rate from 0.5 to 0.63 tells us that the prices of Australian goods and services are now 26 per cent higher than they were relative to British goods and services. Real exchange rates are reported as index numbers with one year chosen as the base year. Like the consumer price index, the real exchange rate’s main value is in tracking changes over

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time—in this case changes in the relative prices of domestic goods in terms of foreign goods. When it comes to trade between countries, it is the real exchange rate which is important, rather than nominal exchange rate.

THE INTERNATIONAL SECTOR AND NATIONAL SAVING AND INVESTMENT

14.3

Having studied what determines the exchange rate we are now ready to explore further the linkages between the Australian economy and foreign economies. We have seen that open economies such as Australia interact with other countries by trading goods and services, and through financial flows of capital and investment. Australian exports in 1960 were a little over 12 per cent of GDP and imports were 15 per cent of GDP. As Figure 14.5 shows, by 2013 exports and imports were both a little over 20 per cent of GDP. The figure also shows that, more often than not, imports exceeded exports as a proportion of GDP, meaning that net exports have been negative more years than they have been positive. As we saw earlier in this chapter, the current account balance has been negative by a much greater amount than the net exports component because of the large net primary income deficit, resulting from interest repayments to foreigners on borrowings, and dividend payments and profit repatriation on foreign investment in Australia. If you look again at the net income movements in Figure 14.2 you can see that the difference between primary income inflows into Australia and primary income outflows from Australia to other countries has increased significantly over time. By 2013 the deficit in net primary income was almost $35 billion, which is around 65 per cent of the current account deficit.

Explain the saving and investment equation. LEARNING OBJECTIVE

Current account balance equals net foreign investment If your spending is greater than your income what can you do? You can sell some assets—maybe those 800 Telstra shares your grandparents gave you—or you can borrow money. A firm can be in the same situation: if a firm’s costs are greater than its revenues it has to make up the difference by selling assets or by borrowing. A country is in the same situation if it imports more than it exports and/or if its income outflows exceed its income inflows. Therefore, we can write that the current account balance (CAB ) is equal to the sum of net exports (NX ) and net primary income (NPI ). (Since net secondary income is so small, for simplicity we ignore it here). Therefore: CAB = NX + NPI FIGURE 14.5

26

Exports and imports as a percentage of GDP, Australia, 1960–2013

Exports Imports

24

Billions of dollars

22

In 1960 exports were a little over 12 per cent of GDP and imports were 15 per cent of GDP. By 2013 exports and imports were both a little over 20 per cent of GDP

20 18 16 14 12 10 1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

2010

2015

SOURCE: Created from Reserve Bank of Australia, Statistics (2014), ‘Gross domestic product, expenditure components’, Table G11, at , viewed 18 February 2014.

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If the current account balance is negative (a deficit), then the country must finance the difference by selling assets—such as land, office buildings or factories—or by borrowing. In other words, for any country, a current account deficit must be exactly offset by a capital and financial account surplus. As the capital account is relatively insignificant, we will group the capital account and the financial account together as net foreign investment (NFI ) in the following discussion. When a country sells more assets to foreigners than it buys assets from foreigners, or borrows more from foreigners than it lends to foreigners—as it must if it is running a current account deficit—the country experiences a net capital inflow and a financial account surplus. Remember that the financial account balance is roughly equal to net capital inflows, which in turn are equal to net foreign investment, but with the opposite sign. That is, a net capital inflow means that more foreign investment is coming into Australia from other countries than the amount of Australian investment going abroad, so Australia’s net foreign investment must be negative. Consider what happens when imports are greater than exports, as frequently occurs in Australia as we saw in Figure 14.5, and when net primary income is negative, as we saw in Figure 14.2. Net exports and net income are negative and therefore there will be a net inflow in the financial account, as people sell assets (physical and financial) and borrow to pay for the current account deficit. Therefore net capital flows will be equal to the current account deficit (but with the opposite sign) and net foreign investment will be equal to the amount of the current account deficit (with the same sign). We can summarise this discussion with the following equations: Current account balance + financial account balance = 0 or, Current account balance = – financial account balance or, Net exports + net primary income = net foreign investment Countries such as Australia that have a current account deficit and need substantial foreign investment must borrow more from abroad than they lend abroad. If the current account is in deficit, net foreign investment must be negative by the same amount—that is, foreign investment into Australia must exceed Australian investment abroad by the amount of the current account deficit. As we saw earlier in Table 14.1, the current account deficit of close to $55 billion was matched by a net capital inflow in the financial account of approximately the same amount. Countries such as Japan, Singapore, Malaysia, China and Saudi Arabia that have current account surpluses must lend abroad more than they borrow from abroad: if the current account balance is positive, net foreign investment will also be positive by the same amount—that is, more investment will be flowing out of the country than into it—and the financial account will be in deficit (a net capital outflow).

Domestic saving, domestic investment and net foreign investment As we saw in Chapter 5, the total saving in any economy is equal to saving by the private sector plus saving by the government sector, which we called public saving. Private saving is equal to what households have left of their income after spending on consumption goods and paying taxes (for simplicity we assume here that transfer payments are zero): Private saving = national income – consumption – taxes or, Sprivate = Y – C – T Public saving is equal to the difference between government spending and taxes: Government saving = taxes – government spending or,

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Spublic = T – G When the government runs a budget surplus by spending less than it receives in taxes it is saving. When the government runs a budget deficit, public saving is negative. Negative saving is also known as dissaving. We can write the following expression for the level of saving in the economy: National saving = private saving + public saving or, S = Sprivate + Spublic Next, remember the basic macroeconomic equation for GDP: GDP = C + I + G + NX In an open economy we need to add to this equation additional sources of income—other than exports—that come from overseas. As we saw in Table 14.1 Australia also receives incomes from dividends, profits and interest earned on overseas investments, but also pays income overseas, the balance of which is net primary income, or NPI. Therefore we can now extend the GDP equation to show total national income, which the Australian Bureau of Statistics (ABS) classifies as gross national income (GNI ) (formerly gross national product). We can express gross national income as: GNI = C + I + G + NX + NPI or, GNI = GDP + NPI Remember that national saving is what remains after C and G have been paid for. Therefore we can express national saving (S ) as:

Gross national income Is equal to GDP (C + I + G + NX) plus net income receivable from nonresidents. It measures the total income that a country has for expenditure and saving.

S = GNI – C – G = GDP + NPI – C – G = (C + I + G + NX ) + NPI – C – G As the consumption and government expenditure parts of the above equation cancel each other out, this leaves us with: S = I + NX + NPI Remembering that NX + NPI equals the current account balance (CAB ), we get: S = I + CAB We can use this equation, our definitions of private and public saving and the fact that the current account deficit equals net foreign investment to arrive at an important relationship, known as the saving and investment equation. National saving = domestic investment + net foreign investment or, S = I + NFI

Saving and investment equation An equation showing that national saving is equal to domestic investment plus net foreign investment.

This equation is an identity because it must always be true, given the definitions we have used. That is, national saving must be equal to domestic investment plus net foreign investment. The saving and investment equation tells us that a country’s saving will be invested either domestically or overseas. If you save $1000 and use the funds to buy a bond issued by BHP Billiton, BHP Billiton may use the $1000 to renovate a factory in Australia (I ) or to build a factory in China (NFI ) as a joint venture with a Chinese firm. A country such as Australia that has negative net foreign investment must be saving less than it is investing domestically. To see this, rewrite the saving and investment equation by moving domestic investment to the left side: S – I = NFI

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If net foreign investment is negative—as it is for Australia every year—domestic investment must be greater than national saving. The level of saving in Japan has been well above domestic investment. The result has been high levels of Japanese net foreign investment. For example, Japanese conglomerate Sumitomo Corporation owns Emerald Grain (bulk grain handler) in Australia. Japanese company Sony owns the Columbia Pictures film studio in the United States. Japanese investors hold billions of US dollars worth of Treasury bonds in the United States. Japan needs a high level of net exports to help offset a low level of domestic investment. When exports of a product begin to decline and imports begin to increase, governments are very tempted to impose tariffs or quotas to reduce imports. In fact, many Japanese firms have been urging the Japanese government to impose trade restrictions on imports from China.

14.4 Explain the effect of a government budget deficit or surplus on investment in an open economy. LEARNING OBJECTIVE

THE EFFECT OF A GOVERNMENT BUDGET DEFICIT ON INVESTMENT Why does an increase in the government budget deficit cause a fall in domestic investment or net foreign investment? To understand the answer to this question, first remember that if the federal government runs a budget deficit the Australian Treasury must raise an amount equal to the deficit by selling government bonds and securities. Some of these securities will be purchased by Australians but the majority will be sold on international financial markets. Investors in the United Kingdom, the United States, China or Japan will have to buy Australian dollars to be able to purchase bonds in Australia. This greater demand for dollars will increase their value relative to foreign currencies. As the value of the dollar rises, export earnings by Australia will fall and imports to Australia will rise. Net exports and therefore net foreign investment will fall. When a government budget deficit leads to a decline in net exports, the result is sometimes referred to as the twin deficits hypothesis, which refers to the possibility that a government budget deficit will also lead to a current account deficit. The twin deficits idea became widely discussed in Australia from the mid1970s and throughout the 1980s, when the federal government ran large budget deficits that resulted in high interest rates, a high exchange value of the dollar and large current account deficits. However, the link between a government budget deficit and a current account deficit assumes that other factors affecting the current account remain the same, which they do not. For example, from the late 1990s to 2007, the government operated budget surpluses and the current account deficit increased even more. The saving and investment equation shows that an increase in the government budget deficit will not lead to an increase in the current account deficit provided either private saving increases or domestic investment declines. According to the twin deficits idea, when the federal government ran budget surpluses in the late 1990s and 2000s, the current account should also have been in surplus, or at least the current account deficit should have been small. In fact, the increase in national saving due to the budget surpluses was more than offset by a sharp decline in private saving, and Australia ran very large current account deficits.

Is Australia’s current account deficit a problem? Large current account deficits have resulted in foreign investors purchasing large amounts of Australian assets

Do persistent current account deficits represent a problem for Australia? Current account deficits result largely from Australian net foreign investment being negative. This means

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that Australia has either borrowed from the rest of the world or foreigners have purchased Australian assets. In most years foreign investors have accumulated more Australian physical and financial assets than Australian investors have accumulated foreign physical and financial assets. By the financial year ending June 2013, foreign investors owned $812 billion more of Australian assets than Australian investors owned of foreign assets. By 2013 total foreign investment in Australia was $2345.3 billion, while Australian investment abroad totalled $1533.3 billion. The amount by which overseas investment into Australia exceeds Australian investment overseas ($812 billion) is referred to as Australia’s total net foreign liability. Total net foreign liability is the sum of net foreign debt liabilities and net foreign equity liabilities. Net foreign debt is the difference between the amount Australia lends to other countries and the amount Australia borrows from overseas. Net foreign equity liability refers to the foreign ownership of Australian assets such as shares in a company minus Australian ownership of foreign assets. Figure 14.6 shows Australia’s net foreign debt and total net foreign liabilities as a percentage of GDP. Clearly net foreign liabilities have been rising significantly over time, with a significant jump in the mid-1980s, due to the government relaxing capital controls on private sector borrowing and foreign purchases of Australian assets, together with the effect of the floating of the dollar (as discussed earlier in this chapter). We can see that by 2013 net foreign debt comprised around 98 per cent of total net foreign liabilities, and has risen significantly over time as a proportion of GDP. From Figure 14.6 we can see that Australia’s net foreign debt as a proportion of GDP has risen from very low levels in the mid-1970s—less

421

Net foreign debt The difference between the amount Australia lends to other countries and the amount that Australia borrows from overseas.

FIGURE 14.6

Net foreign debt and total net foreign liabilities as a percentage of GDP, Australia, 1975/76–2012/13 Net debt and total net foreign liabilities as a proportion of GDP rose significantly over time

70

60

Net foreign debt Net foreign liabilities

Per cent of GDP

50

40

30

20

10

19 75 / 19 197 77 6 / 19 197 79 8 / 19 198 81 0 / 19 198 83 2 / 19 198 85 4 / 19 198 87 6 / 19 198 89 8 / 19 199 91 0 / 19 199 93 2 / 19 199 95 4 / 19 199 97 6 / 19 199 99 8 / 20 200 01 0 / 20 200 03 2 / 20 200 05 4 / 20 200 07 6 / 20 200 09 8 / 20 201 11 0 / 20 201 13 2 /2 01 4

0

SOURCE: Australian Bureau of Statistics (2013 and earlier), Balance of Payments and International Investment Position, Australia, Cat. No. 5302.0, Table 39, Time Series Workbook, at , viewed 14 February 2014; Reserve Bank of Australia (2014), Statistics, Gross Domestic Product, Expenditure Components, Table G11, , viewed 14 February 2014.

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than 5 per cent of GDP—to a level that has settled between 49 per cent and 52 per cent of GDP from 2006 to 2013. Total net foreign liabilities have risen from 10 per cent in the mid-1970s to a high of 58 per cent in 2010, before declining somewhat to 53 per cent by 2013. Australia is clearly a debtor country. As we have seen, net debt and net foreign liabilities means that the net primary income component of the current account contains the outflows of interest repayments on borrowings, and profits and dividends on direct and portfolio investment in Australia. So the question remains, is the current account deficit, which is largely composed of the deficit in net primary income, a problem for Australia? Australia’s saving rate is too low (around 11 per cent of net disposable income in 2013) to support the investment necessary for the economy. With low saving rates in Australia, only the continued flow of funds from foreign investors has made it possible for Australia to maintain the high levels of domestic investment required for economic growth. Australia has always been a resource-rich country, with a relatively small population and low savings, and does not have sufficient domestic saving or investment to develop the economy and maintain or increase economic growth and living standards. The issue becomes whether Australia can service its debt and make its repayments on borrowings. For example, if you borrowed $400 000 to buy a house while your annual income was $100 000, your debt to annual income ratio would be 400 per cent! However, this will not worry the bank from which you borrowed the money, as it knows that you have a valuable asset—the house—and your annual income gives you the means by which you can make the interest repayments and eventually pay off the loan. A similar analysis can be used for national debt. Therefore, whether the national debt is 50 per cent of GDP or higher is not the main issue. The important point is whether Australia can service its debt, and what proportion of national income is required to service the debt. The largest proportion of net foreign debt in Australia is private debt, although since 2008 federal government debt has been increasing, representing around 26 per cent of net foreign debt by 2013. Less government debt reduces the burden on taxpayers in the future. If the private sector is borrowing for investment purposes, then it is expanding Australia’s capital stock, thereby generating a means (future profits) by which borrowings can be repaid. The proportion of GDP needed to pay the net interest and dividends on foreign borrowings and investment averaged between 2 per cent and 4 per cent of GDP between 1960 and today. In 2013 debt repayments as a proportion of GDP were 1.4 per cent, with a total net income deficit of 2.4 per cent of GDP. When we include the deficit in net exports and net secondary income, the total current account deficit in 2013 was 3.6 per cent of GDP. Therefore, the data indicate that Australia’s net foreign debt is not a problem for the economy. As a proportion of GDP, net debt and net liabilities have fluctuated over time but have not shown signs of persistently rising or of increasing to unmanageable levels. The continued willingness of foreign investors to lend to Australia and buy Australian shares and bonds, and foreign companies to build factories in Australia, can be seen as a vote of confidence in the strength of the Australian economy and the buying power of Australian consumers. However, debt servicing does require that a country uses some of its national income to make interest repayments, so it is not an issue to be dismissed. For some countries, particularly poor developing countries, debt service burdens are so high (much of which is government debt) that it places a huge burden on national income. Borrowing then occurs simply to make the interest repayments, with no additional means of making repayments being generated, causing these countries to spiral into ever rising debt. The debt forgiveness initiative by wealthier countries, which began as a joint initiative in the mid-1990s, is seen as an important step in addressing the enormous debts and crippling poverty of developing countries. Further, as we learned in Chapter 13, even developed countries, such as Ireland, Portugal and Greece, defaulted on government debt in 2010 and 2011, and had to be bailed out by funds from the European Union (EU) and the International Monetary Fund. By 2013 Spain and Cyprus had also received EU bailouts. Clearly excessive government borrowing and debt servicing difficulties are no longer confined only to developing countries.

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INTERNATIONAL DEBT RELIEF FOR POOR COUNTRIES There are many countries throughout the world, a high concentration of which are in sub-Saharan Africa, which are ravaged by poverty and often characterised by a lack of functioning governance, economic and justice systems, and mired in crime, corruption and, in some cases, civil war. The external debts of these countries have risen so high that the debts will never be repaid, with the debt servicing placing a huge burden on the meagre GDP generated, and with some countries spending more on servicing debt than on health and education.

M

C

A K I N G THE

14.2

ONNECTION

In the 1990s and 2000s the international community commenced a number of initiatives aimed at reducing world poverty. The United Nations founded the Millennium Development Goals in 2000, an initiative which called on governments of developed countries to increase their foreign aid from an average of 0.3 per cent of GDP to 0.7 per cent of GDP by 2015—which did not occur. This was agreed to in principle by all the world’s countries and leading development institutions, with the aim of reducing world poverty by half by the year 2015, and improving child, maternal and general health, reducing the spread of HIV/AIDS and providing universal primary school education. In addition to the Millennium Development Goals, many countries agreed to address the problem of external debt faced by the world’s poorest countries. While poor countries remain burdened with debt, they cannot fund the economic and social infrastructure necessary for development and economic growth. Therefore a combination of initiatives was required to address world poverty. In 1996 the World Lucian Coman / Shutterstock Bank and the International Monetary Fund (IMF) launched the Heavily Indebted Debt reduction and forgiveness programs Poor Countries Initiative (HIPC), which was the first international response to provide are currently operating in a large number of debt relief and forgiveness for the world’s poorest and most heavily indebted countries in Africa countries. Since 2005 the Multilateral Debt Relief Initiative (MDRI) has also been operating under the umbrella of the HIPC. The MDRI is a debt forgiveness program formed by the G8 major industrial countries to cancel 100 per cent of debts owed to them by certain countries, and managed by the IMF, the World Bank and the International Development Association (IDA).

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Debt reduction programs are in operation for 36 countries (although three more countries were due to be extended debt relief in 2013), 30 of which are in Africa. In 2012, total debt relief had amounted to around US$114 billion (in net present value terms). Poor countries are not automatically eligible for the HIPC initiative, as debt forgiveness does not resolve the problems that originally caused the high debt levels. To be eligible for debt relief countries must be facing debt that cannot be managed by usual debt relief measures, must agree to implement economic reform policies of the IMF and the IDA and have developed a Poverty Reduction Strategy Paper (PRSP). PRSPs are jointly prepared by the debtor country and the external development partners, including the IMF, the World Bank and countries owed debt repayments. A PRSP formulates the economic, structural and social policies that a country commits to pursue to achieve economic growth and poverty reduction. SOURCES: International Monetary Fund (2013), Debt Relief Under the Heavily Indebted Poor Countries (HIPC) Initiative: Factsheet, 1 October, at , viewed 18 February 2014; International Monetary Fund (2013), The Multilateral Debt Relief Initiative: Factsheet, 1 October , at , viewed 19 February 2014; The World Bank (2013), Heavily Indebted Poor Countries (HIPC) Initiative and Multilateral Debt Relief Initiative (MDRI)—Statistical Update, 19 December, at , viewed 19 February 2014.

14.5 Discuss the difference between the effectiveness of monetary and fiscal policy in an open economy and in a closed economy. LEARNING OBJECTIVE

MONETARY POLICY AND FISCAL POLICY IN AN OPEN ECONOMY When we discussed monetary and fiscal policy in Chapters 12 and 13 we did not emphasise that Australia is an open economy. Now that we have explored some of the links between economies, we can look at the difference between how monetary and fiscal policy work in an open economy as opposed to a closed economy. Economists refer to the ways in which monetary and fiscal policy affect the economy as policy channels. An open economy has more policy channels than does a closed economy.

Monetary policy in an open economy When the RBA wants to reduce the rate of inflation it engages in contractionary monetary policy. The RBA increases interest rates to reduce the growth rate of aggregate demand. In a closed economy the main effect is on domestic investment spending and purchases of consumer durables. In an open economy higher interest rates will lead to a higher foreign exchange value of the dollar. Export revenue will fall and the prices of imported products in Australia will fall. As a result, net exports will fall. The contractionary policy will have a larger impact on aggregate demand, and therefore it will be more effective in slowing down the growth in economic activity. If the RBA engages in an expansionary monetary policy it will lower interest rates in an attempt to stimulate aggregate demand. In a closed economy the main effect of lower interest rates is once again on domestic investment spending and purchases of consumer durables. In an open economy, lower interest rates will also affect the exchange rate between the dollar and foreign currencies. Lower interest rates will cause some investors in Australia and abroad to switch from investing in Australian financial assets to investing in foreign financial assets. This switch will lower the demand for the dollar relative to foreign currencies and cause its value to decline. A lower exchange rate will increase export revenue from foreign markets and increase the price of imported products in Australia. As a result, net exports will increase. This additional policy channel will increase the ability of an expansionary monetary policy to affect aggregate demand. To summarise: monetary policy has a greater impact on aggregate demand in an open economy than in a closed economy.

Fiscal policy in an open economy To engage in an expansionary fiscal policy the federal government increases its purchases or cuts taxes. Increases in government purchases directly increases aggregate demand. Tax cuts increase aggregate demand by increasing household disposable income and business income,

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which results in increased consumption spending and investment spending. As we discussed in the previous chapter, expansionary fiscal policy (a government budget deficit) may result in higher interest rates. In a closed economy the main effect of higher interest rates is to reduce domestic investment spending and purchases of consumer durables. In an open economy higher interest rates will also lead to an increase in the foreign exchange value of the dollar and a decrease in net exports. However, if the government finances its deficits by borrowing on international financial markets, there is not likely to be any effect on interest rates, but the inflow of foreign capital will cause the demand for the Australian dollar to rise, leading to an appreciation of the dollar, reducing net exports. Therefore, in an open economy an expansionary fiscal policy may be less effective since the decrease in net exports will reduce the rate of increase of aggregate demand. In a closed economy only consumption and investment are crowded out by an expansionary fiscal policy. In an open economy net exports may also be crowded out. The government can fight inflation by using a contractionary fiscal policy to slow the rate of economic growth. A contractionary fiscal policy cuts government purchases or raises taxes to reduce household disposable income and consumption spending. It also reduces the federal budget deficit, or increases the budget surplus, which may lower interest rates. Lower interest rates will increase domestic investment and purchases of consumer durables, thereby offsetting some of the reduction in government spending and increase in taxes. In an open economy, if the government reduces its deficits there will be a reduced need for borrowing from overseas, and therefore less demand for the Australian dollar. This will reduce the foreign exchange value of the dollar and increase net exports. Therefore, in an open economy a contractionary fiscal policy will have a smaller impact on aggregate demand and thus will be less effective in slowing down an economy. In summary: fiscal policy has a smaller impact on aggregate demand in an open economy than in a closed economy.

THE AUSTRALIAN DOLLAR AND YOUR NEW CAR PRICE At the beginning of the chapter, we posed this question: What effect might the decision by overseas investors to sell significant holdings of Australian currency have on the price you pay for your new Mazda car? We learned in this chapter that if there is an increase in the supply of Australian dollars on the international currency market, the dollar will depreciate. Therefore the sale of Australian dollars by overseas investors will increase the supply of Australian dollars and lead to a depreciation. Since your Mazda car is built overseas, you will now need more Australian dollars to pay for your new car. Unfortunately for you, the behaviour of overseas investors has made your new car more expensive to purchase. The basic point is important—economies are interdependent and economic activities and financial transactions carried out in other countries affects economic activity in Australia.

ECONOMICS IN YOUR LIFE (continued from page 403)

CONCLUSION At one time Australian policy-makers—and economics textbooks—ignored the linkages between Australia and other economies. In the modern world these linkages have become increasingly important, and economists and policy-makers must take them into account when analysing the economy. In the next chapter we study more about how the international financial system operates. Read ‘An inside look’ for a debate about which factors are likely to affect the value of the Australian dollar the most.

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AN INSIDE LOOK 13

R 20 TOR 1 NOVEMBE

TA BUSINESS SPEC

r a l l o d y k r u m Stevens’ s n o i t i n o m e r p oulas by Stephen Kouk

rrent account t judges the cu ke ar m e th es ssie dollar. Sometim Stevens the level of the Au r n fo en nt Gl rta or po rn im ve ,…terms of ficit to be of Australia go rate differentials this week, de st er re rli te Reserve Bank Ea in ll. is fa it ld , it is the times lian dollar shou owth. Other times rate are Other gr ge or an s ch es says the Austra in ex e th th or w ewhere credit ‘these levels of licy settings som sts and trade, po co d of an ls ce Stevens said that ve an le e rm tiv economic perfo Australia’s rela , for example. not supported by —China or the US ld or w lia and e th in se ll, not el between Austra fa ls ia to y nt el re lik productivity’. ffe e di ar te e terms of trade B Interest ra of the world will remain wide and A ‘Moreover, th it seems quite likely that at some r parts rve Bank moves So erially many othe at m be ill w rise, from here. r rther as the Rese fu lla do en n ue id w lia ra en st ev Au d the to coul is should contin point in the future . That is hard cle in 2014. Th er w cy lo ’ de ng ki lly tra hi ia of er te s at ra ]. ‘M to a a term lower,’ [he said oning the Aussie and might offset ck r re lla is do it s e ed en th cr t ev A or St esupp tripl ems t a good 10 to to quantify but it se time, Australia’s bu e s, m nt sa e ce e tiv w th si fe At po a d the ll not decline. dollar should fa dget position an . bu so ct or fe s y, er nt -p ad ce ar re ne s 80 US A governor, rating, will see investor 15 cents towards this generates t to verbal the RB t an w en t im d with them no nt at ld se th ou s w While I stralian assets, an her factor ot Au y of bu e to ng le ra ab a d layed orld in a less ing an d his call on an will the rest of the w Stevens underp se ith ba W r. he lla as do r n lla lia exacerbates lian do . the Austra ralia, this only drive the Austra e terms of trade st th Au r fo an st th ca n re tio fo posi his rrency. The ctors influence robust ards the local cu expected drop on fa w r to he t ot en at im th nt s se sitive is likely to y know stance in the US tle odd that his the po Stevens obviousl y lit lic a it po y es ar ak et m on asy m e Aussie ts which by definition, th lmed the other super-e currency marke d, he an w k er ea ov w r de lla tra do rms of ortive of an keep the US focus on the te likely to be supp e ar . ch ng a lot. If hi ro w st r of de y lla tra do dollar could fall terms of e e factors, man th th if — ht en rig ev n be tio apprecia Stevens might ost to Australia’s make the Australian dollar ill be a mighty bo be reasonable to w ld e ou er w th it , , ht ds rig es or ic w is he inevitably move ity pr fall. In other and inflation will dollar if commod n ie tio si ss po Au e er iv w tit lo es pe a com ems more likely ly variabl forecast for wrong—and it se and were the on is ll s fa en de ev tra St If of . s r to track above higher and the term t set for the dolla the currency. ge of — e be lu ill va w e th he s t ed or in the side of e fact than no that determin erge as a thorn derstanding of th em un to ng is ro th r st a fo is d r. e dolla parity an Indeed, ther lue of the Aussie influence the va at do e bl ly al ria tu policy settings. va ac r la at th a particu g in nt oi np pi ith g ghtin The problem w portance or wei e is that the im tim r la cu e. rti tim pa a s over terminant change given to each de REVIEW WEEKLY

SOURCE: S. Koukoulas (2013), ‘Stevens’ murky dollar premonitions’, Business Spectator, 1 November, at , viewed 13 February 2014.

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Key points in the article During 2010 and 2011, the Australian dollar rose significantly against many currencies but particularly against the US dollar. It is likely that the exchange rate appreciation was to some extent related to trade, with an increase in the demand for the Australian dollar arising from the strong demand for minerals and energy from countries such as China and India. But large inflows into Australia of both direct and portfolio investment would also have put upward pressure on the exchange rate. The article discusses the view of the RBA governor that falling terms of trade after the mining boom should result in a depreciation of the Australian dollar. However, the article points out that other factors also determine the value of the currency, particularly foreign investment, which would prevent a depreciation.

Analysing the news A This chapter has explained international trade and

investment flows between open economies. We have learned how the demand for and supply of imports and exports, together with direct and portfolio investment flows, impact on the currency exchange rate between countries. The article discusses the RBA governor’s view that Australia’s terms of trade (prices of exports relative to the prices of imports) may decline, leading to some depreciation of the Australian dollar. However, the rise in the dollar in 2010 and 2011 was higher than should have been the case given the increase in the terms of trade at that time. It seems likely that investment flows may be the key to explaining the strength in the value of the Australian dollar, both then and during 2013.

B Australia is usually the net recipient of foreign investment. As this article discusses, this has particularly been the case in recent years because of the high returns on FIGURE 1 FOREIGN DIRECT INVESTMENT IN AUSTRALIA INCREASED SIGNIFICANTLY DURING THE 2000s, EXCEEDING AUSTRALIAN DIRECT INVESTMENT ABROAD

investment in Australian assets, particularly the relative prosperity of the economy compared with other countries and Australia’s higher interest rates relative to other countries. Figure 1 shows the annual direct investment flows into and out of Australia. We can see from Figure 1 that during the 2000s there was a very large increase in direct investment in Australia, which briefly dropped a little during the GFC, and then once again grew strongly, reaching almost $640 billion by 2013. In addition to rises in direct investment, Figure 2 shows the substantial foreign portfolio investment coming into Australia, which has been on a strong upward trajectory since the early 2000s, reaching $1290 billion by 2013. Foreign portfolio investment is measured as a positive inflow into Australia. The large increases in foreign investment would have pushed the Australian dollar higher and since investment flows are likely to continue they will keep the currency relatively high. The Australian dollar is likely to continue to be high due to both portfolio and direct investment flows into Australia. The article therefore puts forward an opposing view to the one expressed by the RBA governor, arguing that the Australian dollar is not likely to depreciate due to strong direct and portfolio investment flows into Australia.

Thinking critically 1 Suppose the RBA wished to pursue a contractionary monetary policy to reduce inflation. What would you expect to happen to the value of the Australian dollar, the current account and the flows of investment to and from Australia? 2 How might the RBA intervention in question 1 alter the relative effectiveness of an Australian expansionary fiscal policy? FIGURE 2 FOREIGN PORTFOLIO INVESTMENT IN AUSTRALIA HAS INCREASED SIGNIFICANTLY DURING THE 2000s, ACCELERATING FROM 2005, AND EXCEEDING AUSTRALIAN PORTFOLIO INVESTMENT ABROAD

700

1400

Foreign direct investment in Australia Australian direct investment abroad

600 500

1000

SOURCE: Created from Australian Bureau of Statistics (2013), Balance of Payments and International Investment Position, Australia, Cat. No. 5302.0, Time Series Workbook, Table 76 and Table 77, at , viewed 19 February 2014.

13

11

20

09

20

07

20

05

20

03

20

01

20

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20

19

89

19

13

11

20

09

20

07

20

05

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03

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01

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97

19

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–600

93

–400

–500

91

–200

–400

89

–300

97

0

95

–200

200

19

–100

400

93

0

600

19

100

800

19

200

91

Billions of dollars

300

19

400 Billions of dollars

Foreign portfolio investment in Australia Australian portfolio investment abroad

1200

SOURCE: Created from Australian Bureau of Statistics (2013), Balance of Payments and International Investment Position, Australia, Cat. No. 5302.0, Time Series Workbook, Table 76 and Table 77, at , viewed 19 February 2014.

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CHAPTER SUMMARY AND PROBLEMS KEY TERMS balance of payments balance of trade in goods and services capital account closed economy currency appreciation

404 405 407 404 411

currency depreciation current account financial account gross national income net foreign debt net foreign investment

411 404 407 419 421 408

nominal exchange rate open economy real exchange rate saving and investment equation speculators

410 404 416 419 413

THE BALANCE OF PAYMENTS: LINKING AUSTRALIA TO THE INTERNATIONAL ECONOMY, PAGES 404–409 LEARNING OBJECTIVE 14.1

Explain the main components of the balance of payments and understand how it is calculated.

SUMMARY Nearly all economies are open economies that trade with and invest in other economies. A closed economy has no transactions in trade or finance with other economies. The balance of payments is a record of a country’s international trade, borrowing, lending, capital and investment flows with other countries. The current account records current, or short-term, flows of funds into and out of a country. The balance of trade in goods and services is the difference between the value of the goods and services a country exports and the value of the goods and services a country imports. The capital account records migrants’ transfers, debt forgiveness and sales and purchases of non-produced, non-financial assets. The financial account shows investments a country has made abroad and foreign investments received by the country. Net foreign investment is the difference between capital outflows from a country and capital inflows. Apart from measurement errors, the sum of the current account, the capital account and the financial account must equal zero. Therefore, the balance of payments must also equal zero.

Increase in foreign holdings of assets Exports of goods Imports of services Net errors and omissions

REVIEW QUESTIONS 1.1

1.2

1.3

What is the relationship between the current account, the capital account, the financial account and the balance of payments? What is the difference between net exports and the current account balance? Explain whether you agree or disagree with the following statement: ‘Australia has run a balance of payments deficit every year since 1974.’

1.7

1.8

PROBLEMS AND APPLICATIONS 1.4

1.5

In 2012 France had a financial account deficit of close to 74.2 billion euros. Did France experience a net capital outflow or a net capital inflow in 2012? Briefly explain. Use the information in the following table to prepare a balance of payments account like the one shown in Table 14.1. Assume the balance on the capital account is zero. All values are in billions of dollars.

1.9

1.10

856 –256 ?

Overseas food aid

–60

Exports of services

325

Income received on investments

392

Imports of goods

–1108

Increase in holdings of assets in foreign countries

–1040

Income payments on investments 1.6

$1181

–315

[Related to Don’t let this happen to you, on page 409] In 2010 Germany had a surplus in the balance of trade in goods and services of 154 billion euros. Which was larger in that year: Germany’s exports of goods and services or its imports of goods and services? In 2010 Germany had a current account surplus of 128.8 billion euros. Explain how it was possible for Germany’s current account surplus to be smaller than its balance of trade surplus. In 2010, would the balance on Germany’s capital and financial accounts have been –128.8 billion euros? Briefly explain. [Related to Solved problem 14.1] Is it possible for a country to run a trade deficit and a financial account deficit simultaneously? Briefly explain. [Related to Solved problem 14.1] Suppose we know that a country has been receiving large inflows of foreign investment. What can we say about its current account balance? [Related to Solved problem 14.1] Australia runs a current account deficit every year. What must be true about Australia’s financial account balance? According to this chapter, the Australian trade deficit is almost always smaller than the Australian current account deficit. Why is this true?

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An article in The New York Times observed that, ‘China is quickly shifting from being a country known for exports to one capable of making huge investments in global financial markets, analysts say.’1 Is there a connection between

429

China’s exports and its financial investments in other countries? Your answer should mention China’s current account and its financial account.

THE FOREIGN EXCHANGE MARKET AND EXCHANGE RATES, PAGES 410–417 LEARNING OBJECTIVE 14.2

of imports and exports.

Explain how exchange rates are determined and how changes in exchange rates affect the prices

SUMMARY

PROBLEMS AND APPLICATIONS

The nominal exchange rate is the value of one country’s currency in terms of another country’s currency. Australia’s exchange rate is determined in the foreign exchange market by the demand for and supply of the dollar. Changes in the exchange rate are caused by shifts in demand or supply. The three main sets of factors that cause the supply and demand curves in the foreign exchange market to shift are changes in the demand for Australianproduced goods and services and changes in the demand for foreign-produced goods and services; changes in the desire to invest in Australia and changes in the desire to invest in foreign countries; and changes in the expectations of currency traders— particularly speculators—concerning the likely future values of the dollar and the likely future values of foreign currencies. Currency appreciation occurs when a currency’s market value rises relative to another currency. Currency depreciation occurs when a currency’s market value falls relative to another currency. The real exchange rate is the price of domestic goods in terms of foreign goods. The real exchange rate is calculated by multiplying the nominal exchange rate by the ratio of the domestic price level to the foreign price level.

2.5

2.6

REVIEW QUESTIONS 2.1

2.2

2.3

2.4

If the exchange rate between the Japanese yen and the Australian dollar expressed in terms of yen per dollar is ¥110 = $1, what is the exchange rate when expressed in terms of dollars per yen? Suppose that the current exchange rate between the Australian dollar and the euro is 0.6 euros per dollar. If the exchange rate changes to 0.8 euros per dollar, did the euro appreciate or depreciate against the dollar? Why do foreign households and foreign firms demand Australian dollars in exchange for foreign currency? Why do Australian households and firms supply Australian dollars in exchange for foreign currency? What are the three main sets of factors that cause the supply and demand curves in the foreign exchange market to shift?

2.7

2.8

[Related to Don’t let this happen to you, on page 412] If we know the exchange rate between country A’s currency and country B’s currency, and we know the exchange rate between country B’s currency and country C’s currency, then we can calculate the exchange rate between country A’s currency and country C’s currency. a Suppose the exchange rate between the Japanese yen and the Australian dollar is currently ¥120 = $1 and the exchange rate between the British pound and the Australian dollar is £0.60 = $1. What is the exchange rate between the yen and the pound? b Suppose the exchange rate between the yen and dollar changes to ¥130 = $1 and the exchange rate between the pound and dollar changes to £0.50 = $1. Has the dollar appreciated or depreciated against the yen? Has the dollar appreciated or depreciated against the pound? Has the yen appreciated or depreciated against the pound? Graph the demand for and supply of Australian dollars for euros and label each axis. Show graphically and explain the effect of an increase in interest rates in Europe by the European Central Bank (ECB) on the demand for and supply of dollars and the resulting change in the exchange rate of euros for Australian dollars. Assume that interest rates in Australia have not changed. Graph the demand for and supply of Australian dollars for euros and label each axis. Show graphically and explain the effect of an increase in Australian government budget deficits that increase Australian interest rates on the demand for and supply of dollars and the resulting change in the exchange rate of euros for Australian dollars. Why might the change in the exchange rate lead to a current account deficit? Some exporting firms have argued that the Chinese government has been keeping the value of the Chinese yuan artificially low against other currencies, which gives Chinese exporters an advantage when selling their products overseas. Why would a low value of the yuan in exchange for other currencies help Chinese exporting firms?

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Use the graph to answer the following questions.

2.10

Exchange rate (¥/$) S

2.11 ¥105

95

D2 D1 0

Quantity of dollars traded

a Briefly explain whether the dollar appreciated or depreciated against the yen. b Which of the following events could have caused the shift in demand shown in the graph? i Interest rates in Australia declined relative to those in other countries ii Income rose in Japan iii Speculators began to believe that the value of the dollar will be higher in the future.

2.12

[Related to Solved problem 14.2] When a country’s currency appreciates, is this generally good news or bad news for the country’s consumers? Is it generally good news or bad news for the country’s businesses? Explain your reasoning. In 2010, when the Australian dollar hit US$1.00, and exceeded this in 2011 and 2012, manufacturers, farmers, tourist operators and educational institutions expressed the view that if the exchange rate did not improve it would be difficult for their businesses to compete with overseas producers. When people in these Australian industries were talking about an ‘improvement’ in the exchange rate between the Australian dollar and the US dollar, did they want the Australian dollar to exchange for more US dollars or for fewer US dollars? Why was the exchange rate of the Australian dollar to the US dollar particularly high between 2010 and 2012? [Related to the chapter opening case] A news article recently had the headline: ‘Export demand for education may rise on falling dollar’. a What does the headline mean when it refers to a ‘falling dollar’? b Why would the dollar’s drop increase the demand for the export of Australian education?

THE INTERNATIONAL SECTOR AND NATIONAL SAVING AND INVESTMENT, PAGES 417–420 LEARNING OBJECTIVE 14.3

Explain the saving and investment equation.

SUMMARY A current account deficit must be exactly offset by a capital and financial account surplus. We can therefore conclude that the current account deficit will equal net foreign investment. National saving is equal to private saving plus government saving. Private saving is equal to national income minus consumption and minus taxes. Government saving is the difference between taxes and government spending. As we saw in previous chapters, GDP is equal to the sum of investment, consumption, government spending and net exports. We can extend GDP to include income generated in other countries. This means that national income becomes GDP plus net primary income (termed gross national income). We can use this fact, our definitions of private and government saving and the fact that the current account balance equals net foreign investment to arrive at an important relationship known as the saving and investment equation: S = I + NFI.

REVIEW QUESTIONS 3.1

3.2

Explain the relationship between the current account deficit and net foreign investment. What is the saving and investment equation? If national saving declines, what will happen to domestic investment and net foreign investment?

3.3

If a country saves more than it invests domestically, what must be true of its net foreign investment?

PROBLEMS AND APPLICATIONS 3.4

3.5

3.6

3.7

In 2013, domestic investment in Australia was 23.4 per cent of GDP, and Australian net foreign investment was 3.3 per cent of GDP. What percentage of GDP was Australian national saving? In 2012, France’s net foreign investment was negative. Which was larger in France in 2012: national saving or domestic investment? Briefly explain. Briefly explain whether you agree with the following statement: ‘Because in 2012 national saving was a smaller percentage of GDP in the United Kingdom than in Australia, domestic investment must also have been a smaller percentage of GDP in the United Kingdom than in Australia.’ Look again at how we arrived at the equation S = I + NX + NPI. Suppose that we define national income as being equal to Y + TR, where TR equals government transfer payments, and we define government spending as being equal to G + TR. Show that after making these adjustments we end up with the same saving and investment equation.

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3.9

431

succeed in reducing Australia’s current account deficit to zero, what would be the likely effect on domestic investment spending within Australia? Assume that no other federal government economic policy is changed. (Hint: Use the saving and investment equation to answer this question.)

Use the saving and investment equation to explain why Australia experienced large current account deficits in the mid-2000s. Suppose a politician proposes that tariffs be imposed on imports from countries with which Australia has a trade deficit. If this proposal were enacted and if it were to

THE EFFECT OF A GOVERNMENT BUDGET DEFICIT ON INVESTMENT, PAGES 420–424 LEARNING OBJECTIVE 14.4

Explain the effect of a government budget deficit or surplus on investment in an open economy.

SUMMARY When the government runs a budget deficit, national saving will decline unless private saving increases by the full amount of the budget deficit, which is unlikely. As the saving and investment equation (S = I + NFI) shows, the result of a decline in national saving must be a decline in either domestic investment or net foreign investment.

4.6

REVIEW QUESTIONS 4.1

4.2 4.3

Economists at China International Capital Corp., or CICC, say the companies that will suffer the most from a stronger yuan are textile and apparel makers and office equipment producers.…That could mean a sting for [overseas] clothing retailers… that buy a lot from China.3

What happens to national saving when the government runs a budget surplus? What is the twin deficits hypothesis? What factors should be considered when determining whether or not foreign debt is a problem for a country? Do you think Australia’s foreign liabilities are a problem?

PROBLEMS AND APPLICATIONS 4.4

4.5

If investment spending in Australia has been strong, why would this reduce apprehension about the size of the current account deficit? What does the current account deficit have to do with investment spending? An economist at the European bank ING, Tim Condon, was quoted in The Wall Street Journal in 2011 as predicting that ‘China’s current account or saving-investment surplus [will be in] the 1–2% of GDP range…’.2 Is he correct in

referring to China’s current account as being the same as its saving-investment surplus? Briefly explain. If the Chinese government runs a large budget deficit, what will be the likely effect on its current account? In 2010 China introduced some flexibility into its exchange rate determination and allowed the value of the yuan to appreciate somewhat. According to a news article at the time:

4.7

a Does a ‘stronger yuan’ mean that the yuan will exchange for more or fewer dollars? b How can both Chinese companies, such as apparel makers, and Australia clothing retailers such as Kmart, Target and Big W be hurt by a stronger yuan? c What effect will a stronger yuan be likely to have on the Chinese current account? What effect is it likely to have on the Australian current account? Australia’s net external liabilities have been rising as a proportion of GDP over time. What are the potential advantages and disadvantages of rising external liabilities for Australia? Would your analysis of external debt for Australia apply to very poor developing countries?

MONETARY POLICY AND FISCAL POLICY IN AN OPEN ECONOMY, PAGES 424–425 L E A R N I N G O B J E C T I V E 1 4 . 5 Discuss the difference between the effectiveness of monetary policy and fiscal policy in an open economy and in a closed economy.

SUMMARY When the RBA implements contractionary monetary policy it increases interest rates to reduce the growth rate of aggregate demand. In a closed economy the main effect is on domestic investment and purchases of consumer durables. In an open economy higher interest rates will also reduce net exports. If the RBA implements expansionary monetary policy it lowers interest rates, which increases aggregate demand. In a closed economy the main effect of lower interest rates is on domestic investment spending and purchases of consumer durables. In an open economy lower interest rates will also cause an increase in net exports. We can conclude that monetary policy has a greater

impact on aggregate demand in an open economy than in a closed economy. To engage in expansionary fiscal policy the government increases government spending or cuts taxes. Expansionary fiscal policy can lead to higher interest rates and crowding out. In a closed economy the main effect of higher interest rates is on domestic investment spending and spending on consumer durables. In an open economy higher interest rates will also reduce net exports. Contractionary fiscal policy will reduce the budget deficit (or may increase the surplus) and may lower interest rates. In a closed economy lower interest rates increase domestic investment and spending on consumer durables. In an

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open economy lower interest rates also increase net exports. We can conclude that fiscal policy has a smaller impact on aggregate demand in an open economy than in a closed economy.

5.5

REVIEW QUESTIONS 5.1 5.2

5.3

What is meant by a ‘policy channel’? Why does monetary policy have a greater effect on aggregate demand in an open economy than in a closed economy? Why does fiscal policy have a smaller impact in an open economy than in a closed economy?

5.6

PROBLEMS AND APPLICATIONS 5.4

An article in The Economist magazine described Ireland as ‘an extraordinarily open economy’.4 Is fiscal policy in Ireland likely to be more or less effective than it would be in a less open economy? Briefly explain.

Suppose that interest rates in Australia rise relative to those in other countries. a How will this policy affect real GDP in the short run if Australia is a closed economy? b How will this policy affect real GDP in the short run if Australia is an open economy? c How will your answer to part b change if interest rates also rise in the countries that are the major trading partners of Australia? Suppose the federal government increases spending without also increasing taxes. In the short run, how will this action affect real GDP and the price level in a closed economy? How will the effects of this action differ in an open economy?

ENDNOTES 1

2

David Barboza (2011), ‘China’s growing overseas portfolio’, New York Times, 9 May, at , viewed 19 February 2014. Josh Chin (2011), ‘Economists react: Chinese imports way up in August’, The Wall Street Journal, 12 September, at , viewed 19 February 2014.

3

4

Jason Dean, Norihiko Shirouzu, Clare Ansberry and Kersten Zhang, (2010), ‘Yuan impact: General manufacturing’, The Wall Street Journal, 21 June, at , viewed 19 February 2014. The Economist (2011), ‘Celtic Cross’, 26 May, at , viewed 19 February 2014.

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15

THE INTERNATIONAL FINANCIAL SYSTEM LEARNING OBJECTIVES After studying this chapter you should be able to: 15.1 Understand how different exchange rate systems operate. 15.2 Discuss the three key aspects of the current exchange rate system. 15.3 Discuss the growth of international capital markets.

WHO LOSES AND WHO BENEFITS FROM A STRONG AUSTRALIAN DOLLAR? BETWEEN 2010 AND 2012 the Australian dollar rose against many major currencies and at times exceeded parity with the US dollar. By early 2014 the Australian dollar had fallen relative to the US dollar to just below $US0.90, but this was still close to 40 per cent higher than in early 2009. The effects on Australian businesses were quite disparate with significant gainers and losers. Among those hardest hit by the currency appreciation were Australian manufacturers who compete against cheaper imports. Other manufacturers with a large proportion of their earnings received from exports of their goods and services, such as building materials manufacturer James Hardie and transport group Brambles, were also adversely affected. This is because their earnings overseas were reduced when converted to Australian dollars. Similarly, Australian farmers exporting products including grains, wool, dairy, beef and fruit suffer from reduced export earnings when the Australian dollar appreciates. Among the industries also badly affected was the tourism sector. Following an already flat year for Australian tourism in 2010, during 2011 visitor numbers fell by 0.2 per cent in total, and by 5.9 per cent from the United Kingdom and 3.4 per cent from the United States. The loss in visitor numbers was compounded by record

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numbers of Australians taking advantage of the strong Australian dollar to holiday overseas. The AOT Group is one of Australia’s leading wholesale and inbound travel distribution businesses. Via their retail partners in Australia and their wholesale partners around the world, the AOT Group sells travel to over 700 000 passengers per year. AOT founder and chief executive, Andrew Burnes, commented that: ‘Eventually it gets to the point where the [exchange rate] is really starting to bite’. He said that tourism operators who rely on overseas visitors were ‘feeling the pinch’. Despite all of this, he also stated that tourism operators were optimistic that increased numbers of tourists from Asia would help fill the void created by fewer visitors from Europe. By December 2013, with the Australian dollar off its peak, tourism numbers had recovered somewhat, growing by 5.5 per cent during 2013, including 6.8 per cent from the United Kingdom and 6.2 per cent from the United States. The biggest percentage increase came from China, at 14.2 per cent, where the rapidly growing middle class has greatly increased the demand for overseas travel. Not all parts of the tourism industry are affected in the same way. For instance, transport companies such as Qantas Airways should benefit from a rising Australian dollar via lower US-dollar-denominated fuel costs. Qantas would lose overseas passengers not coming to Australia but gain from Australians travelling overseas. The impacts on commodity producers are somewhat more complex since a strong Australian dollar reduces overseas earnings, but the increase in the value of the Australian dollar is, in part, due to high commodity prices, which were particularly strong in the latter half of the 2000s in the coal, iron-ore and gas industries. Retailers of electrical goods, white goods and furniture (which are mostly imported), such as Harvey Norman and David Jones, mainly benefit from a high Australian dollar because a large proportion of their products are imported. The lower costs of production in China and India, coupled with a strong Australian dollar, reduced the wholesale prices of imports, increasing demand and profits. Consumers of these, and other imported products, benefit through lower product prices. Increased profits and lower consumer prices may also occur in those firms whose production inputs comprise a large proportion of imports, because the higher Australian dollar reduces the prices paid for inputs imported into Australia. SOURCE: Tourism Australia (2013), Arrivals Data Archive, at , viewed 17 February 2014; The AOT Group (2014), ‘About the AOT Group’, at , viewed 26 January 2014; Matt O’Sullivan (2011), ‘Tourism operator fears as Aussie dollar climbs’, The Sydney Morning Herald, 3 January, at , viewed 26 February 2014.

15 © Stephen Gibson | Dreamstime.com

ECONOMICS IN YOUR LIFE

EXCHANGE RATE RISK IN YOUR LIFE Suppose that you decide to take a job in South Korea. You plan to work there for the next five years, build up some savings and then return to Australia. As you prepare for your move, you read that economists expect the average productivity of Korean firms to grow faster than the average productivity of Australian firms over the next five years. If economists are correct, assuming all else remains equal, will the savings that you accumulate (in Korean won) be worth more or less in Australian dollars than it would have been worth without the relative gains in Korean productivity? As you read this chapter, see if you can answer this question. You can check your answer against the one we provide on page 448 at the end of this chapter.

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A KEY FACT about the international economy is that the exchange rates between the major currencies fluctuate. These fluctuations have important consequences for firms, consumers and governments. We read of examples of these consequences in the opening case to this chapter. In Chapter 14 we discussed the basics of how exchange rates are determined. We also looked at the relationship between a country’s imports and exports, and at capital flows into and out of a country. In this chapter we look further at the international financial system and at the role central banks play in the system.

EXCHANGE RATE SYSTEMS 15.1 Understand how different exchange rate systems operate. LEARNING OBJECTIVE

Floating currency A currency whose exchange rate is determined by the demand for and supply of the currency in the foreign exchange market. Exchange rate system An agreement between countries on how exchange rates should be determined. Managed float exchange rate system An exchange rate system under which the value of the currency is determined by demand and supply, with occasional central bank or government intervention. Fixed exchange rate system A system under which countries agree to keep the exchange rates between their currencies fixed.

A country’s exchange rate can be determined in several ways. Some countries simply allow the exchange rate to be determined by the demand for and supply of their currency, in the way that the prices of goods and services are determined. A country that allows demand and supply to determine the value of its currency is said to have a floating currency. Some countries attempt to keep their exchange rate constant relative to another major currency, such as the US dollar. For example, China kept the exchange rate constant between its currency, the yuan (also known as the yuan renminbi), and the US dollar until 2005, when it announced it would begin to pursue increased exchange rate flexibility. When countries can agree on how exchange rates should be determined economists say that there is an exchange rate system. Currently, many countries, including Australia, allow their currencies to float most of the time, although governments or central banks will occasionally intervene to buy and sell their currency or other currencies to affect exchange rates. In other words, many countries sometimes attempt to manage the float of their currencies, which means that their exchange rate system is a managed float exchange rate system. The current Australian exchange rate system, which was floated in December 1983, is a managed float exchange rate system, although the Australian currency is one of the world’s currencies with the least amount of central bank intervention. Historically, the two most important alternatives to the managed float exchange rate system were the gold standard and the Bretton Woods System. These were both fixed exchange rate systems where exchange rates remained constant for long periods. Under the gold standard a country’s currency consisted of gold coins and paper currency that the government was committed to redeem for gold. When countries agree to keep the value of their currencies constant, there is a fixed exchange rate system. The gold standard was a fixed exchange rate system that lasted from the nineteenth century until the 1930s. Under the gold standard, exchange rates were determined by the relative amounts of gold in each country’s currency, and the size of a country’s money supply was determined by the amount of gold available. To expand its money supply rapidly during a war or an economic depression, a country would need to abandon the gold standard. Because of the Great Depression of 1929–1933, by the mid-1930s most countries, including the United States and Britain, on whose currency Australia’s was based, had abandoned the gold standard. Although during the following decades there were occasional discussions about restoring the gold standard no serious attempt to do so occurred. A conference held in Bretton Woods, New Hampshire, in the United States in 1944 set up an exchange rate system in which the United States pledged to buy or sell gold at a fixed price of US$35 per ounce. The central banks of all other member countries of the new Bretton Woods System pledged to buy and sell their currencies at a fixed rate against the US dollar. By fixing their exchange rates against the US dollar these countries were fixing the exchange rates between their currencies as well. Unlike under the gold standard, neither the United States nor any other country was willing to redeem its paper currency for gold domestically. The United States would redeem US dollars for gold only if they were presented by a foreign central bank. Fixed exchange rate regimes can run into difficulties because exchange rates are not free to adjust quickly to changes in demand and supply for currencies. As we will see in the next section, central banks will often encounter difficulties if they are required to keep an exchange

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rate fixed over a period of years. By the early 1970s the difficulties of keeping exchange rates fixed led to the end of the Bretton Woods System. The appendix to this chapter contains additional discussion of the gold standard and the Bretton Woods System.

DON’T LET THIS HAPPEN TO YOU

Remember that modern currencies are fiat money Although countries have not been on the gold standard since 1933 many people still believe that somehow gold continues to ‘back’ currency. In January 2014 the Reserve Bank of Australia (RBA) held $3.665 billion in gold reserves, which amounts to 6.9 per cent of its total reserve assets. Holdings of foreign exchange comprise the largest part of the RBA’s total reserve assets, at 77.7 per cent. The gold reserves owned by the RBA clearly are a relatively minor portion of total reserves, and have no connection to the amount of paper money issued. In the United States the Department of Treasury still owns billions of US dollars worth of gold bars, most of which are stored at the Fort Knox Bullion Depository in Kentucky. (Even more gold is stored in a basement of the Federal Reserve Bank of New York, which holds about one-quarter of the world’s gold supply—almost 10 per cent of all the gold ever mined. This gold, however, is entirely owned by foreign governments and international agencies.) As we saw in Chapter 11, US currency—like the currencies of Australia and other countries—is fiat money, which means that it has no value except as money. The link between gold and money that existed for centuries has been broken in the modern economy.

[ YOUR TURN Q

Test your understanding by doing related problem 1.3 on page 451 at the end of this chapter.

THE CURRENT EXCHANGE RATE SYSTEM The current exchange rate system has three important aspects: 1 Australia, like Britain and the United States, allows its currency to float against other major currencies. 2 Most countries in Western Europe have adopted a single currency, the euro. 3 Some developing countries have attempted to keep their currencies’ exchange rates fixed against the US dollar or another major currency. We begin by looking at the changing value of the Australian dollar over time. In discussing the value of the Australian dollar we can look further at what determines exchanges rates in the short run and in the long run.

15.2 Discuss the three key aspects of the current exchange rate system. LEARNING OBJECTIVE

Euro The common currency of many European countries which are members of the European Union.

The floating dollar Since 1983 the value of the Australian dollar has fluctuated widely against other major currencies. Figure 15.1 shows the exchange rate between the Australian dollar and a tradeweighted index (TWI) of other currencies from 1970 to 2014. The TWI attempts to measure the value of the Australian dollar against a basket of currencies of its major trading partners. If Australia carries out most of its trade in Japanese yen, then the index will give a higher weight to the exchange rate against the yen than against the currency of a country with which Australia trades less, such as Thailand. Until 1983 the value of the Australian dollar was pegged against various currencies by the RBA. For most of Australia’s history the Australian dollar had a fixed rate of exchange with the British pound. However, with successive devaluations of the pound the Australian dollar was fixed at a higher rate. Eventually the decision was made to fix the value of the Australian dollar to the US dollar. The spikes in Figure 15.1 show the devaluations in the Australian dollar which took place in the 1970s. In December 1983 the government decided to float the Australian dollar, letting its value be determined by market forces. The Australian dollar depreciated substantially over the next five years, then fluctuated around a fairly steady level during the 1990s. It began

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FIGURE 15.1

Trade-weighted index of the Australian dollar, 1970–2014 The Australian dollar used to be pegged against the British pound, then the US dollar, then a basket of currencies of countries Australia traded with. In December 1983 the Australian dollar was floated and allowed to find its own value against other currencies

130 120 110 Australian dollar floated

Index (1970 = 100)

100 90 80 70 60 50 40 1970

1975

1980

1985

1990

1995

2000

2005

2010

2015

SOURCE: Reserve Bank of Australia (2014), ‘Exchange rates’, Statistics, Table F11, at , viewed 26 February 2014.

to appreciate in the early 2000s (dropping briefly during the global financial crisis), and by 2011 had reached its highest level in more than 28 years, largely due to the depreciation of the US dollar against many major currencies and the strong foreign demand for Australia’s minerals and energy. Figure 15.1 also shows the decline in the exchange rate in 2013 and early 2014.

What determines exchange rates in the long run? Over the period after 1983, why did the value of the Australian dollar fall against the major currencies and why did it trend upwards during most of the 2000s? In the short run, the two most important causes of exchange rate movements are changes in interest rates—which cause investors to change their views of which countries’ financial investments will yield the highest returns—and changes in investors’ expectations about the future values of currencies. Over the long run, other factors are also important in explaining movements in exchange rates.

The theory of purchasing power parity

Purchasing power parity The theory that in the long run exchange rates move to equalise the purchasing power of different currencies.

It seems reasonable that, in the long run, exchange rates should be at a level that makes it possible to buy the same amount of goods and services with the equivalent amount of any country’s currency. In other words, the purchasing power of every country’s currency should be the same. The idea that in the long run exchange rates move to equalise the purchasing power of different currencies is referred to as the theory of purchasing power parity. To make the theory of purchasing power parity clearer, consider a simple example. Suppose that a Cadbury’s chocolate bar has a price of $1 in Australia and £1 in the United Kingdom and that the exchange rate is one Australian dollar per British pound. (Note that this does not reflect the actual exchange rate; we have kept it simple for our example.) In that case, at least with respect to chocolate bars, the Australian dollar and the pound have equivalent purchasing power. If the price of a Cadbury’s chocolate bar increases to $2 in Australia but stays at £1 in

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the UK, the exchange rate will have to change to two Australian dollars per pound in order for the Australian dollar to maintain its relative purchasing power. As long as this happens it will be possible to buy a Cadbury’s chocolate bar for £1 in the UK or to exchange £1 for $2 and buy the chocolate bar in Australia. If exchange rates are not at the values indicated by purchasing power parity, it appears that there are opportunities to make profits. For example, suppose a Cadbury’s chocolate bar sells for £2 in the UK and $1 in Australia, and the exchange rate between the Australian dollar and the pound is $1 = £1. In this case it would be possible to exchange one million pounds for one million Australian dollars and use the dollars to buy one million chocolate bars in Australia. The Cadbury’s chocolate bars could then be shipped to the UK where they could be sold for two million pounds. The result of these transactions would be a profit of one million pounds (ignoring shipping costs for simplification). In fact, if the Australian dollar–pound exchange rate does not reflect the purchasing power for many products—not just Cadbury’s chocolate bars—this process could be repeated until extremely large profits were made. In practice, though, as people attempted to make these profits by exchanging pounds for Australian dollars they would bid up the value of the Australian dollar until it reached the purchasing power exchange rate of $1 = £1. Once the exchange rate reflected the purchasing power of the two currencies there would be no further opportunities for profit. This mechanism appears to guarantee that exchange rates will be at the levels determined by purchasing power parity. Three real-world complications keep purchasing power parity from being a complete explanation of exchange rates, even in the long run: 1 Not all products can be traded internationally. Where goods are traded internationally profits can be made whenever exchange rates do not reflect their purchasing power parity values. However, more than half of all goods and services produced in Australia and most other countries are not traded internationally. In fact, Australia exports on average only around 20 per cent of its GDP. When goods are not traded internationally their prices will not be the same in every country. For instance, suppose that the exchange rate is £1 = $1 but the price for having a tooth filled by a dentist is twice as high in Australia as it is in the UK. In this case there is no way to buy up the low-priced British service and resell it in Australia. Because many goods and services are not traded internationally, exchange rates will not reflect exactly the relative purchasing powers of currencies. 2 Products and consumer preferences are different across countries. We expect the same product to sell for the same price around the world, but if a product is similar but not identical to another product their prices might be different. For example, a 100 gram Nestlé chocolate bar may sell for a different price compared with a 100 gram Cadbury’s chocolate bar. Prices of the same product may also differ across countries if consumer preferences differ. If consumers in Britain like chocolate bars more than consumers in Australia do, a Cadbury’s chocolate bar may sell for more in Britain than in Australia. 3 Countries impose barriers to trade. Most countries impose tariffs and quotas on imported goods. A tariff is a tax placed on imported goods which makes them more expensive (and less competitive) on the domestic market. A quota is a limit on the quantity of a good that can be imported. For example, the United States has a quota on imports of sugar. As a result, the price of sugar in the United States is much higher than the price of sugar in other countries. Because of the quota, there is no legal way to buy up the cheap foreign sugar and resell it in the United States.

The four determinants of exchange rates in the long run We can take into account the shortcomings of the theory of purchasing power parity to develop a more complete explanation of how exchange rates are determined in the long run. There are four main determinants of exchange rates in the long run: 1 Relative price levels. The purchasing power parity theory is correct in arguing that in the long run the most important determinant of exchange rates between two countries’ currencies is their relative price levels. If prices of goods and services rise faster in Australia than in the United States, the value of the Australian dollar has to decline to maintain demand for Australian products.

439

Tariff A tax imposed by a government on imported goods which makes them more expensive on the domestic market. Quota A numerical limit imposed by the government on the quantity of a good that can be imported into the country.

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M

C

A K I N G THE

15.1

ONNECTION

© 2011 McDonald’s. The Golden Arches Logo is a trademark of McDonald’s Corporation and its affiliates

Is the price of a Big Mac in China or Australia the same as the price of a Big Mac in the United States?

THE BIG MAC THEORY OF EXCHANGE RATES In a light-hearted attempt to test the accuracy of the theory of purchasing power parity, The Economist magazine regularly compares the prices of Big Macs in different countries. If purchasing power parity holds you should be able to take the US dollars required to buy a Big Mac in the United States and exchange them for exactly the amount of foreign currency needed to buy a Big Mac in any other country. The following table is for January 2014, when Big Macs were selling for an average of US$4.62 in the United States. The implied exchange rate shows what the exchange rate would be if purchasing power parity held for Big Macs. For example, in January 2014 a Big Mac sold for A$5.05 in Australia and US$4.62 in the United States, so for purchasing power parity to hold the exchange rate should have been A$5.05/US$4.62, or A$1.09 = US$1. The actual exchange rate in January 2014 was A$1.14 = US$1. So, on Big Mac purchasing power parity grounds, the Australian dollar was undervalued against the US dollar by 4.4 per cent ((A$1.09 – A$1.14)/A$1.14) × 100 = 4.4 per cent). That is, if Big Mac purchasing power parity held, it would have taken 4.4 per cent fewer Australian dollars to buy a US dollar than it actually did. THE BIG MAC INDEX

COUNTRY

IN LOCAL CURRENCY

PRICES OF BIG MAC

IMPLIED PPP OF THE US DOLLAR

ACTUAL US DOLLAR EXCHANGE RATE 21 JULY 2010

UNDER (–)/OVER (+) VALUATION AGAINST US DOLLAR (%)

United States

US$4.62

Australia

A$5.05

1.09

1.14

–4.4

Britain

£2.79

0.60

0.60

0

China

Yuan 16.60

3.59

6.05

–40.7

Euro area

€3.66

0.79

0.74

+6.8

Japan

¥310

67.10

104.25

–35.6

New Zealand

NZ$5.50

1.19

1.20

–0.8

Singapore

S$4.60

1.00

1.28

–21.9

SOURCE: The Economist (2014), ‘The Big Mac Index, 23 January, at , viewed 25 February 2014.

Could you take advantage of this difference between the purchasing power parity exchange rate and the actual exchange rate to become fabulously wealthy by buying up low-priced Big Macs in New York and reselling them at a higher price in Australia? Unfortunately, the low-priced US Big Macs would be a soggy mess by the time they reached Australia. The fact that Big Mac prices are not the same around the world illustrates one reason why purchasing power parity does not hold exactly. Many goods and services are not traded internationally.

2 Relative rates of productivity growth. When the productivity of a firm increases the firm is able to produce more goods and services using fewer workers, machines or other inputs. The firm’s costs of production fall and usually so will the price of its product. If the average productivity of Japanese firms increases faster than the average productivity of Australian firms, Japanese products will have relatively lower prices than Australian products, which increases the quantity demanded of Japanese products relative to Australian products. As a result, the value of the yen should rise against the Australian dollar. For most of the period from the early 1970s to the mid-1990s, Japanese productivity increased faster

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than Australian productivity, which contributed to the fall in the value of the Australian dollar against the yen. However, between the mid-1990s and 2013, Australian productivity increased faster than Japanese productivity, and the value of the Australian dollar generally rose against the yen. 3 Preferences for domestic and foreign goods. If consumers in Australia increase their preferences for Japanese products, the demand for yen will increase relative to the demand for Australian dollars, and the yen will increase in value relative to the Australian dollar. During the 1970s and 1980s many Australian consumers increased their preferences for Japanese products, particularly cars and consumer electronics. This greater preference for Japanese products helped to increase the value of the yen relative to the Australian dollar. 4 Tariffs and quotas. For many years until the mid-1980s Australia had quotas and very high tariffs on imported manufactured goods. The quotas and tariffs reduced the demand for imports and hence the demand for foreign currencies, which resulted in a higher exchange rate than would have been the case without quotas and tariffs. The reduction in the use of tariffs and quotas in Australia in the 1980s and 1990s was a significant factor in explaining the fall in the trade-weighted exchange rate of the Australian dollar during this time. Because these four factors change over time, one country’s currency can increase or decrease by substantial amounts in the long run. These changes in exchange rates can create problems for firms. A decline in the value of a country’s currency (depreciation) lowers the foreign currency prices of the country’s exports or if, as is the case with most of Australia’s exports, their prices are determined in US dollars, the prices received by Australian producers in Australian dollars rise. A depreciation of the Australian dollar increases the prices of imports. An increase in the value of a country’s currency (appreciation) has the reverse effect. However, the effect of exchange rate fluctuations on a firm can be complex. For example, firms often import production inputs from overseas, such as farm machinery, and export outputs overseas, such as wheat. For these firms a depreciation of the Australian dollar increases costs of production but also increases revenue, so determining the impact on profitability is not so straightforward.

The euro A second key aspect of the current exchange rate system is that most Western European countries have adopted a single currency, the euro. After World War II many of the countries of Western Europe wanted to integrate their economies more closely. In 1957 Belgium, France, West Germany, Italy, Luxembourg and the Netherlands signed the Treaty of Rome, which established the European Economic Community, often referred to as the European Common Market. Tariffs and quotas on products being shipped within the Common Market were greatly reduced, while tariffs and quotas were erected against non-member countries, including Australia. Over the years, Britain, Sweden, Denmark, Finland, Austria, Greece, Ireland, Spain and Portugal joined the European Economic Community, which was renamed the European Union (EU) in 1991. By 2014, 28 countries were members of the EU. EU members decided to move to a common currency by 1999. Three of the 15 countries that were then members of the EU—the UK, Denmark and Sweden—decided to retain their domestic currencies. The move to a common currency took place in several stages. On 1  January 1999 the exchange rates of the 12 participating countries (which had risen to 18 by 2014) were permanently fixed against each other and against the common currency, the euro. At first the euro was a pure unit of account. Although firms began quoting prices in both domestic currency and euros, no euro currency was actually in circulation. On 1 January 2002 euro coins and paper currency were introduced and on 1 June 2002 the old domestic currencies were withdrawn from circulation. The EU countries who have adopted the euro are sometimes referred to as the ‘eurozone’. A new European Central Bank (ECB) was also established. Although the central banks of the member countries continue to exist, the ECB has assumed responsibility for monetary policy and for issuing currency. The ECB is run by a governing council that consists of a sixmember executive board—appointed by the participating governments—and the governors of

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the central banks of the member countries that have adopted the euro. The ECB represents a unique experiment in allowing a multinational organisation to control the domestic monetary policies of independent countries. Economists are divided over whether the creation of the euro helps growth in the EU countries. Having a common currency makes it easier for consumers and firms to buy and sell across borders. It is no longer necessary for someone in France to exchange francs for marks in order to do business in Germany. This change should reduce costs and increase competition. However, the participating countries are no longer able to run independent monetary policies. In addition, with fixed exchange rates the value of one country’s currency cannot fall during an economic contraction or a recession, which would normally expand net exports to help revive aggregate demand. This was a major problem for a number of EU member countries during the recessions which followed the global financial crisis (GFC) of 2007–2008. We look more closely at this in Making the connection 15.2.

M

C

A K I N G THE

15.2

ONNECTION

CAN THE EURO SURVIVE THE RECESSIONS? The euro was first introduced as currency at the beginning of 2002. The period from then until the recessions that occurred during and following the GFC was one of relative economic stability in most of Europe. With low interest rates, low inflation rates and expanding employment and production the advantages of the euro seemed obvious. The countries using the euro no longer had to deal with problems caused by fluctuating exchange rates. Having a common currency also makes it easier for consumers and firms to buy and sell across borders. Some of the lower-income European countries seemed particularly to prosper under the euro. The Spanish economy grew at an average annual rate of 3.9 per cent between 1999 and 2007. The unemployment rate in Spain had been nearly 20 per cent in the mid-1990s but had dropped to 7.9 per cent by 2007. Ireland and Greece had also experienced rapid growth during these years.

By 2008, with recessions throughout many parts of Europe gathering force, some economists and policy-makers were starting to question whether the euro was Has the euro slowed Europe’s recovery from making the economic crisis worse. The countries using the euro can no longer the GFC-induced recessions? pursue independent monetary policies, which are instead determined by the European Central Bank (ECB), which has its headquarters in Frankfurt, Germany. Countries that were particularly hard hit by recessions—for example Spain, where the unemployment rate had more than doubled to 18.1 per cent by 2009, reaching 26 per cent by 2014—were unable to pursue a more expansionary policy than the ECB was willing to implement for the eurozone as a whole. Similarly, countries could not attempt to revive their exports by allowing their exchange rates to depreciate, both because most of their exports were to other eurozone countries, and because the value of the euro was determined by factors affecting the eurozone as a whole. © Antoni Vicens | Dreamstime.com

Problems in the eurozone were made worse by a sovereign debt crisis that developed in 2010. Sovereign debt refers to bonds issued by a government. The recessions of 2007–2009 caused large increases in government spending and reductions in tax revenues in a number of European countries, particularly Greece, Ireland, Spain, Portugal and Italy. The resulting government budget deficits were paid for by issuing government bonds. By the spring of 2010, many investors had come to doubt the ability of Greece, in particular, to make the interest payments on the bonds. If Greece defaulted and stopped making interest payments on its bonds, investors would be likely to stop buying bonds issued by several other European governments, and the continuation of the euro would be called into question. The ECB helped Greece avoid a default by directly buying its bonds. The bank extended similar help to Spain, Ireland and Italy. The International Monetary Fund and the European Union put together aid packages meant to keep Greece and other countries from defaulting. In exchange for the aid, these countries were required to cut government spending and raise taxes even though doing so resulted in significant protests from unions, students and other groups.

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During the years of the gold standard, countries had similarly been unable to run expansionary monetary policies and were unable to have their exchange rates depreciate. During the Great Depression of the 1930s these drawbacks to remaining on the gold standard led one country after another to abandon it and by the mid-1930s the gold standard had collapsed. Following the GFC, a similar abandonment of the euro appeared unlikely. Because many eurozone countries export a significant portion of their GDP to other eurozone countries, exchange rate stability has been important to their economic stability. In addition, some of the European countries hit hardest by the recessions, particularly Spain and Ireland, were suffering from the bursting of housing bubbles. More expansionary monetary policies or depreciating exchange rates were unlikely to result in economic recovery until the effects of the collapse in residential construction had run its course. So, it was unclear that the constraints imposed by the euro were holding back recovery in Europe. Finally, because so many contracts and agreements among households, firms and governments in Europe were written in euros, abandoning the euro was likely to be disruptive to the financial system and to trade. The ultimate fate of the euro will help to answer the question of whether independent countries with diverse economies can successfully maintain a joint monetary policy and a single currency. SOURCE: Eurostat (2014), ‘Unemployment statistics’, Statistics, European Commission, at , viewed 25 February 2014; The Economist (2009), ‘One size fits none’, The Economist, 11 June, at , viewed 25 February 2014.

Pegging against the US dollar A final key aspect of the current exchange rate system is that some developing countries have attempted to keep their exchange rates fixed against the US dollar or another major currency. Having a fixed exchange rate can provide important advantages for a country that has extensive trade with another country. When the exchange rate is fixed, business planning becomes much easier. For instance, if the South Korean won increases in value relative to the Australian dollar, Hyundai, the Korean car manufacturer, may have to raise the Australian dollar price of the cars it exports to Australia, thereby reducing sales. If the exchange rate between the Korean won and the Australian dollar is fixed, Hyundai’s planning is much easier. In the 1980s and 1990s an additional reason developed for having fixed exchange rates. During those decades the flow of foreign investment funds to developing countries, particularly those in East Asia, increased substantially. It became possible for firms in countries such as South Korea, Thailand, Malaysia and Indonesia to borrow US dollars directly from foreign investors or indirectly from foreign banks. For example, a Thai firm might borrow US dollars from a New York bank. If the Thai firm wants to build a new factory in Thailand with the borrowed US  dollars, it has to exchange the US dollars for the equivalent amount of Thai currency, the baht. Once the factory opens and production begins, the Thai firm will be earning the additional baht it needs to exchange for US dollars to make the interest payments on the loan. A problem arises if the value of the baht falls against the US dollar. Suppose that the exchange rate is 25 baht per US dollar when the loan is taken out. A Thai firm making an interest payment of US$100 000 dollars per month on a US dollar loan could buy the necessary US dollars for 2.5 million baht. But if the value of the baht declines to 50 baht to the US dollar, it would take five million baht to buy the US dollars necessary to make the interest payment. These increased payments might be a crushing burden for the Thai firm. The government of Thailand would have a strong incentive to avoid this problem by keeping the exchange rate between the baht and the US dollar fixed. Finally, in the 1980s and 1990s some countries feared the inflationary consequences of a floating exchange rate. When the value of a currency falls, the prices of imports rise. If imports are a significant fraction of the goods consumers buy, or are a significant proportion of inputs used by producers, a fall in the value of the currency may significantly increase the inflation rate. During the 1990s an important part of Brazil’s and Argentina’s anti-inflation policies was a fixed exchange rate against the US dollar. As we will see, though, there are difficulties with following a fixed exchange rate policy, and, ultimately, both Brazil and Argentina abandoned fixed exchange rates.

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The east Asian exchange rate crisis of the late 1990s Pegging The decision by a country to keep the exchange rate fixed between its currency and another currency.

When a country keeps its currency’s exchange rate fixed against another country’s currency, it is pegging its currency. It is not necessary for both countries involved in a peg to agree to it. When a developing country has pegged the value of its currency against the US dollar, the responsibility for maintaining the peg has been entirely with the developing country. Countries attempting to maintain a peg can run into problems, however. When the government fixes the price of a good or service the result can be persistent surpluses or shortages. Figure 15.2 shows the exchange rate between the US dollar and the Thai baht. The figure is drawn from the Thai point of view, so we measure the exchange rate on the vertical axis as US dollars per baht. The figure represents the situation in the 1990s when the government of Thailand pegged the exchange rate between the US dollar and the baht above the equilibrium exchange rate as determined by demand and supply. A currency pegged at a value above the market equilibrium exchange rate is said to be overvalued. A currency pegged at a value below the market equilibrium exchange rate is said to be undervalued. Pegging made it easier for Thai firms to export products to the United States and protected Thai firms that had taken out US dollar loans. The pegged exchange rate was 25.19 baht to the US dollar, or about US$0.04 to the baht. By 1997 this exchange rate was well above the market equilibrium exchange rate of 35 baht to the US dollar, or about US$0.03 to the baht. The result was a surplus of baht on the foreign exchange market. To keep the exchange rate at the pegged level the Thai central bank, the Bank of Thailand, had to buy these baht with US dollars. In buying baht with US dollars the Bank of Thailand gradually used up its US  dollar reserves. To continue supporting the pegged exchange rate, the Bank of Thailand borrowed additional US dollar reserves from the International Monetary Fund (IMF). It also raised interest rates to attract more foreign investors to investments in Thailand, thereby increasing the demand for the baht. Although higher domestic interest rates helped attract foreign investors, they made it more difficult for Thai firms and households to borrow the funds they needed to finance their spending. As a consequence, domestic investment and consumption declined, pushing the Thai economy into recession. International investors realised that there were limits to how high the Bank of Thailand would be willing to push interest rates and how many US dollar loans the IMF would be willing to extend to Thailand. These investors began to speculate against the baht by exchanging baht for US dollars at the official, pegged exchange rate. If, as they expected, Thailand was forced to abandon the peg, they would be able to buy back the baht at a much lower exchange rate, making a substantial profit. Because these actions by investors make it more difficult to maintain a fixed exchange rate, they are referred to as destabilising speculation. Figure 15.3 shows the results of this destabilising speculation. The decreased demand for baht

FIGURE 15.2

By 1997 the Thai baht was overvalued against the US dollar The government of Thailand pegged the value of the baht against the US dollar to make it easier for Thai firms to export to the United States and to protect Thai firms that had taken out US dollar loans. The pegged exchange rate of US$0.04 per baht was well above the equilibrium exchange rate of US$0.03 per baht. In the example in this figure, the overvalued exchange rate created a surplus of 70 million baht, which had to be purchased with US dollars by the Thai central bank

Exchange rate (US$/baht)

Surplus of baht that must be purchased with dollars to maintain the peg

S

Pegged exchange rate

$0.04

0.03 Equilibrium exchange rate

D

0

130

160

200

Quantity of baht traded per day (millions)

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Exchange rate (US$/baht)

FIGURE 15.3

2. . . . which increases the surplus of baht . . .

Pegged exchange rate

S

$0.04 1. Investors become convinced the value of the baht will fall, causing the demand curve to shift to the left . . .

0.03

0.02 D1

3. . . . and lowers the equilibrium exchange rate.

D2

0

60

130

445

200

Quantity of baht traded per day (millions)

Destabilising speculation against the Thai baht In 1997 the pegged exchange rate of US$0.04 = 1 baht was above the equilibrium exchange rate of US$0.03 = 1 baht. As investors became convinced that Thailand would have to abandon its pegged exchange against the US dollar and allow the value of the baht to fall, they decreased their demand for baht from D1 to D2. The new equilibrium exchange rate became US$0.02 = 1 baht. This increased the quantity of baht the Bank of Thailand had to purchase in exchange for US dollars from 70 million per day to 140 million to defend the pegged exchange rate. The destabilising speculation by investors caused Thailand to abandon its pegged exchange rate in July 1997

shifted the demand curve for baht from D1 to D2, increasing the quantity of baht the Bank of Thailand needed to buy in exchange for US dollars. Foreign investors also began to sell off their investments in Thailand and exchange the baht they received for US dollars. This capital flight forced the Bank of Thailand to run through its US dollar reserves quickly. Dollar loans from the IMF temporarily allowed Thailand to defend the pegged exchange rate. Finally, on 2 July 1997, Thailand abandoned its pegged exchange rate against the US dollar and allowed the baht to float. Thai firms that had borrowed US dollars were now faced with interest payments that were much higher than they had planned. Many firms were forced into bankruptcy and the Thai economy plunged into a deep recession. Many currency traders became convinced that other East Asian countries, such as South Korea, Indonesia and Malaysia, would have to follow Thailand and abandon their pegged exchange rates. The result was a wave of speculative selling of these countries’ currencies. These waves of selling—sometimes referred to as speculative attacks—were difficult for countries to fight off. Even if a country’s currency was not initially overvalued at the pegged exchange rate, the speculative attacks would cause a large reduction in the demand for the country’s currency. The demand curve for the currency would shift to the left, which would force the country’s central bank to run through its US dollar reserves quickly. Within the space of a few months, South Korea, Indonesia, the Philippines and Malaysia abandoned their pegged currencies. All these countries also plunged into recession.

The decline in pegging Following the disastrous events experienced by the East Asian countries the number of countries with pegged exchange rates declined sharply. Most countries that continue to use pegged exchange rates are small and trade primarily with a single, much larger country. So, for instance, several Caribbean countries continue to peg against the US dollar, and several former French colonies in Africa that formerly pegged against the French franc now peg against the euro. Overall, the trend has been towards replacing pegged exchange rates with managed floating exchange rates.

The Chinese experience with pegging In 1978 China began to move away from central planning and towards a market system. The result was a sharp acceleration in economic growth. Real GDP per capita grew at a rate of over 6.5 per cent per year between 1979 and 1995, and at the very rapid rate of over 9 per cent per year between 1996 and 2010, slowing to close to 7.5 per cent by 2014. An important

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part of Chinese economic policy was the decision in 1994 to peg the value of the Chinese currency, the yuan, to the US dollar at a fixed rate of 8.28 yuan to the US dollar. Pegging against the US dollar ensured that Chinese exporters would face stable US dollar prices for the goods they sold to the United States. By the early 2000s many economists argued that the yuan was undervalued against the US dollar, possibly significantly so. It was argued by many other countries that the undervaluation of the yuan gave Chinese firms an unfair competitive advantage on international markets. To support the undervalued exchange rate, the Chinese central bank had to buy large amounts of US dollars with yuan. By 2005 the Chinese government had accumulated more than US$700 billion, most of which it had used to buy US Treasury bonds. In addition, China was coming under pressure from its trading partners to allow the yuan to increase in value. Chinese exports of textile products were driving some textile producers out of business in Japan, the United States, Australia and Europe. China also began to export more sophisticated products, including televisions, personal computers and mobile phones. Politicians in other countries were anxious to protect their domestic industries from Chinese competition, even if the result was higher prices for domestic consumers. The Chinese government was reluctant to revalue the yuan, however, because it believed high levels of exports were needed to maintain rapid economic growth. The Chinese economy needs to create as many as 20 million new nonagricultural jobs per year to keep up with population growth and the shift of workers from rural areas to cities. Because of China’s large holdings of US dollars, it would also incur significant losses if the yuan increases in value. By July 2005 the pressure on China to revalue the yuan had become too great. The government announced that it would switch from pegging the yuan against the US dollar to linking the value of the yuan to the average value of a basket of currencies—the dominant currencies were the US dollar, the Japanese yen, the euro and the Korean won, while several other currencies were also considered, including the Australian dollar. The immediate effect was a fairly small increase in the value of the yuan, from US$1 = 8.28 yuan to US$1 = 8.11 yuan. The Chinese central bank declared that it had switched from a peg to a managed floating exchange rate. Some economists and policy-makers were sceptical, however, that much had actually changed because the initial increase in the value of the yuan had been small and because the Chinese central bank did not explain the details of how the yuan would be linked to the basket of other currencies. Five years later, many economists still believed that the yuan was undervalued. In 2010 China announced a renewed commitment to moving towards a more flexible exchange rate system and the value of the yuan slowly increased and by 2014 had reached above US$1 = 6 yuan. Despite this some economists and policy-makers still believe the yuan is undervalued and urged the Chinese government to allow its currency to become more responsive to changes in demand and supply in the foreign exchange market. In 2014, China’s holdings of US$ exceeded US$3.5 trillion.

SOLVED PROBLEM 15.1 COPING WITH FLUCTUATIONS IN THE VALUE OF THE AUSTRALIAN DOLLAR Analyse the following statement: Some economists say that if the flow of foreign capital into Australia fell significantly, the Australian dollar could fall sharply in value, reigniting the threat of inflation and putting pressure on the RBA to raise interest rates. Use a foreign exchange market graph in your analysis and make sure you explain what the value of the Australian dollar has to do with the Australian inflation rate, as well as why a falling value of the Australian dollar puts pressure on the RBA to raise interest rates.

Solving the problem STEP 1: Review the chapter material. This problem is about the determinants of exchange rates, so you may want to review the

section ‘The current exchange rate system’, which begins on page 437. STEP 2: Draw the graph. Begin by drawing a diagram to show the effect of a decline in the flow of capital into Australia. ‘Flow of

capital into Australia’ refers to foreign investors engaging in portfolio investment—buying Australian shares and bonds—or direct investment—such as building factories or mines in Australia. To invest in Australia, foreign investors must exchange their currencies for Australian dollars. If they decide to cut back on investing in Australia, their demand for Australian dollars will fall. This

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reduction is shown in the following figure, which shows the exchange rate of the Australian dollar relative to the US dollar, by the shift from D1 to D2. The equilibrium exchange falls from A$1 = US$0.90 to A$1 = US$0.70. Exchange rate (US$ per A$1)

S

US$0.90

US$0.70 D1

D2 0

Quantity of dollars traded per day

STEP 3: Explain why a falling value of the Australian dollar puts pressure on the RBA to raise interest rates. If the value of the

Australian dollar falls the prices of imports will rise. Rising import prices may lead to an increase in the inflation rate. If the RBA wants to keep inflation down then it will pursue a contractionary monetary policy which means increasing interest rates. Higher interest rates make Australian financial investments more attractive to foreign investors. In the graph, this would result in shifting the demand for Australian dollars back to the right.

[ YOUR TURN Q

For more practice do related problem 2.20 on page 453 at the end of this chapter.

INTERNATIONAL CAPITAL MARKETS One important reason exchange rates fluctuate is that investors seek out the best investments they can find anywhere in the world. For instance, if Chinese investors increase their demand for Australian securities, the demand for Australian dollars will increase and the value of the Australian dollar will rise. But if interest rates in Australia decline, foreign investors may sell Australian securities and the value of the Australian dollar will fall. Shares in companies and long-term debt, including corporate and government bonds and bank loans, are bought and sold on capital markets. In the 1980s and 1990s European governments removed many restrictions on foreign investments in financial markets. It became possible for foreign investors to invest freely in Europe and for European investors to invest freely in foreign markets. In the 1980s Australia—which previously had one of the most regulated financial sectors in the world—opened up its capital markets to the free flow of capital into and out of Australia. Improvements in communications and computer technology made it possible for investors in Australia to receive better and more timely information about foreign firms and for foreign investors to receive better information about Australian firms. The growth in economies around the world also made more savings available to be invested. Although at one time the US capital market was larger than all other capital markets combined, today this is no longer true. Today there are large capital markets in Europe and Japan, and smaller markets in Australia, Latin America and East Asia. The three most important international financial centres today are New York, London and Tokyo. Each day the Australian media displays not just the Australian Securities Exchange (ASX) shares index but also the

15.3 Discuss the growth of international capital markets. LEARNING OBJECTIVE

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Dow Jones Industrial Average and the Standard and Poor’s 500 stock indexes of US shares, the Nikkei 225 average of Japanese stocks, the Financial Times Stock Exchange (FTSE) index of shares on the London Stock Exchange and the DJ STOXX 50 index of European shares. By 2014 corporations, banks and governments worldwide had raised more than $1.5 trillion in funds on global financial markets. The globalisation of financial markets has helped increase growth and efficiency in the world economy. Now it is possible for the savings of households around the world to be channelled to the best investments available. It is also possible for firms in nearly every country to tap the savings of foreign households to gain the funds needed for expansion. No longer are firms forced to rely only on the savings of domestic households to finance investment. But the globalisation of financial markets also has a downside, as the events of the GFC and subsequent economic contractions and recessions showed. Because financial securities issued in one country are held by investors and firms in many other countries, if those securities decline in value the financial pain will be widely distributed. So the sharp decline in the value of mortgage-backed securities issued in the United States hurt not only US investors and financial institutions but investors and financial institutions in many other countries as well.

ECONOMICS IN YOUR LIFE (continued from page 435)

EXCHANGE RATE RISK IN YOUR LIFE At the beginning of the chapter, we posed this question: If the average rate of productivity growth in South Korea is greater than in Australia over the next five years, then, all else being equal, will the savings that you accumulate (in Korean won) be worth more or less in Australian dollars than it would have been worth without the relative gains in Korean productivity? To answer this question, we saw in this chapter that when the average productivity of firms in one country increases faster than the average productivity of firms in another country, the value of the faster-growing country’s currency should—all else being equal—rise against the slower-growing country’s currency. Therefore, the savings that you accumulate in won while you are in South Korea are likely to be worth more in Australian dollars than they would have been worth without the gains in Korean productivity. It is important to note that this assumes ceteris paribus, because, as we learned in this chapter, there are other factors that can have a significant effect on exchange rates.

CONCLUSION Fluctuations in exchange rates continue to cause difficulties for firms and governments. From the gold standard to the Bretton Woods System to currency pegging, governments have attempted to find a workable system of fixed exchange rates. Fixing exchange rates runs into the same problems as fixing any price: as demand and supply shift, surpluses and shortages will occur unless the price adjusts. Eighteen countries in Europe are attempting to avoid this problem by using a single currency. Economists are looking closely at the results of that experiment. Read ‘An inside look’ for a current-day assessment of the effects that the floating of the Australian dollar has had on the economy.

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AN INSIDE LOOK 13

BER 20 TION 12 DECEM

? e v a h o t d a h a i l a r t s u A t a o l f e Th

THE CONVERSA

the Australian lped to expand he so al g tin oa By 83. l flows and C Fl ed this day in 19 cilitating capita at fa flo by as , w r em lla st . do sy t through and sink financial The Australian develop a marke water, list badly, to on s ke nk ta ba to n ge lia ed . 1985, it seem helping Austra . The real exchan Australian dollars ly was the idea y from abroad in in el n fre tio w fla e rro in th r bo r fo fo And that actual to k which justed y the groundwor e dollar rate, ad too high, on In this way the float helped la en rate—roughly, th be d ha s— er s and the 2000s. trade partn de—the price s of the late 1980 tra Australia and its om me of bo s g rm in te nk e ba th mism didn’t co s. A fall in bility and dyna rts—in 1985 xi po and off, for year fle im at to of th in e l ic al er pr t ov Bu n tip d by the te flexibility ca ll in incomes ra fa of exports divide e ge th an g in ch e th Ex ad re d r free. e. An down, sp hard to manag ng Australian fo ni d sent the dollar io fin sh s cu m d fir an at , eated ht imports volatility th with the float cr ed to all who boug . nd de pa tra ex to at d th se or ere expo omy might do ed rates, banking sect producers that w Australian econ happen with fix e th d : di m d le an ob d te pr ul ra ge g to a lower a new A That co e lower—leadin on the exchan er s w s on te si ra ci st de re in y te t arke housing better if in through polic n. With a free m might create a tio is fla th in t tic bu es — er m te th or through do exchange ra ges were smoo ncy, these chan ter af s ar ye 20 e Australian curre in th bubble. a lower dollar, would welcome ings turned out, e ird m th so a le t hi ou w l, ab al and faster. As th the RBA eraged So over change rate av ention (such as rv te in r fo k ea s. w the float, the ex e 1970 se is big fall erage value of th d the ca ign currency). A re ha fo g in of at s ie flo tit an hy lower than its av w buying large qu ppens—would another reason if and when it ha ugh the dying But there was — ro de Th . tra 83 of s 19 rm te the te intervention le by la e balance of in does not mean th at become irresistib g th in t ag Bu r. an m lla do a, rate er t of the reduce the days of the fixed nds into and ou fu of now. w flo e th licymakers can and more of is needed e payments— or m g in are things that po e rb er so th ab s, es en el be rth d Neve ed sector, and country—ha red trade-expos ue n. ag io le nt be te e e at th th s’ include], tween do to help policymaker vered the link be s anyway. [These se ea r id lla od do go , e e is th ar t g or most of them B Floatin ary policy (tha financial sect ents and monet ce…tougher s). en te ud ra pr st d re y an te ar in ity et balance of paym or uctiv budg pply settings for prod ce the money su fit y w lic sa po it d as an y lic n… policy to influen s. re ary po regulatio ease cost pressu RBA to set monet that would help It permitted the t… en helped m . s st ut ju ha tp r ad e dolla n and ou the floating of th r the economic , to manage inflatio fo on s ay ar w e ye ating th y flo d irt a ve Th so pa y. But The 1983 float al exchange rate an open econom e as Th h s. is 90 ur flo 19 d lia depends on 80s an Austra inued prosperity ickly spreading reforms of the 19 nt qu Co t, a. cu ce e na er w pa no tariffs h policy choices. by reducing rate is could adjust as ng to make toug And tariff cuts, ui t. in nt en co m st lia s ju ra m ad st Au the costs of ed Australian fir er of trade-expos ur bo la d an t uc the market pow prod lped to free up and unions, he markets.

by Jim Minifie

N

THE CONVERSATIO

SOURCE: Jim Minifie (2013), ‘The float Australia had to have?’, The Conversation, 12 December, at , viewed 17 February 2014.

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Key points in the article Until 1983 Australia had a highly regulated economy. The article discusses problems that were seen to be caused by the Australian exchange rate being pegged to the US  dollar. In 1983 the government began a series of reforms to the economy which significantly increased the degree of competition in Australia with the aim of stemming the tide of economic decline in Australia. These reforms included the floating of the Australian dollar and an end to restrictions on the flow of capital into and out of Australia. The article examines the impact of the floating of the Australian dollar on various areas within the Australian economy, and on the ability of the RBA to conduct monetary policy.

Analysing the news A The article points out that under a fixed exchange rate regime changes could be made to the exchange rate, which would then flow through to economic effects within the economy. But with a floating exchange rate, exchange rate adjustments, and therefore economic adjustments, to external trade and investment conditions, occur much more quickly. The floating of the Australian dollar allowed the supply of and demand for the dollar in international markets to decide on the appropriate value of the dollar rather than politicians, and freed monetary policy to focus on domestic issues. Figure 1 shows the depreciation of the Australian dollar relative to the US dollar that occurred after the December 1983 float.

B The floating of the Australian dollar means that the RBA can set its own monetary policy since it can set whatever interest rate it chooses without regard to having to fix the exchange rate. Therefore while the RBA no doubt considers the effects of its interest rate policy on the exchange rate, as raised in the article, it is able to pursue an independent monetary policy to target inflation which would not be possible under a fixed rate system. C The floating of the Australian dollar and the other economic reforms initiated by the Labor government and successive Liberal–National Coalition governments have been the major reason why Australia is now a strong, competitive modern economy. The article points out that Australia has benefited greatly from opening up its product and capital markets to the world. However, a floating currency is not without problems, as it can lead to widely fluctuating returns for exporters, changing prices for importers and currency speculation. Thinking critically 1 Do you think it is better for markets to determine the value of currencies rather than governments or central banks? 2 Why wouldn’t it be possible for the RBA to pursue independent monetary policy if it also needed to maintain a fixed exchange rate?

FIGURE 1 THE AUSTRALIAN–US EXCHANGE RATE, 1984–2014 1.20 1.10

$US per one $A

1.00 0.90 0.80 0.70 0.60 0.50 0.40 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

SOURCE: Reserve Bank of Australia (2014), ‘Exchange rates’, Statistics, Table F11, at , viewed 27 February 2014.

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451

CHAPTER SUMMARY AND PROBLEMS KEY TERMS euro exchange rate system fixed exchange rate system floating currency

437 436 436 436

managed float exchange rate system 436 pegging 444 purchasing power parity 438

quota tariff

439 439

EXCHANGE RATE SYSTEMS, PAGES 436–437 LEARNING OBJECTIVE 15.1

Understand how different exchange rate systems operate.

SUMMARY When countries agree on how exchange rates should be determined, economists say that there is an exchange rate system. A floating currency is the outcome of a country allowing its currency’s exchange rate to be determined by demand and supply. The current exchange rate system is a managed float exchange rate system under which the value of most currencies is determined by demand and supply, with occasional central bank intervention. A fixed exchange rate system is a system under which countries agree to keep the exchange rates between their currencies fixed. Under the gold standard, the exchange rate between two currencies was automatically determined by the quantity of gold in each currency. By the end of the Great Depression of the 1930s, every country had abandoned the gold standard. Under the Bretton Woods System, which was in place between 1944 and the early 1970s, the United States agreed to exchange dollars for gold at a price of $35 per ounce. The central banks of all other members of the system pledged to buy and sell their currencies at a fixed rate against the dollar.

standard? How did the Bretton Woods System differ from the gold standard?

PROBLEMS AND APPLICATIONS 1.3

[Related to Don’t let this happen to you] Briefly explain whether you agree with the following statement: ‘The RBA is limited in its ability to issue paper currency by the amount of gold reserves it holds. To issue more paper currency, the RBA first has to buy more gold.’

1.4

Australia and most other countries abandoned the gold standard during the 1930s. Why would the 1930s have been a particularly difficult time for countries to have remained on the gold standard? (Hint: Think about the macroeconomic events of the 1930s and about the possible problems with carrying out an expansionary monetary policy while remaining on the gold standard.)

1.5

If a country is using the gold standard, what is likely to happen to the country’s money supply if new gold deposits are discovered in the country? Is this change in the money supply desirable? Briefly explain.

1.6

After World War II, why might countries have preferred the Bretton Woods System to re-establishing the gold standard? In your answer, be sure to note the important ways in which the Bretton Woods System differed from the gold standard.

REVIEW QUESTIONS 1.1

1.2

What is an exchange rate system? What is the difference between a fixed exchange rate system and a managed float exchange rate system? How were exchange rates determined under the gold

CURRENT EXCHANGE RATE SYSTEM, PAGES 437–447 LEARNING OBJECTIVE 15.2

Discuss the three key aspects of the current exchange rate system.

SUMMARY The current exchange rate system has three key aspects: (1) the Australian dollar floats against other major currencies; (2) most countries in Western Europe have adopted a common currency; and (3) some developing countries have fixed their currencies’ exchange rates against the US dollar or against another major currency. Since 1983 the value of the Australian dollar has fluctuated widely against other major currencies. The theory of purchasing power parity states that in the long run exchange rates move to equalise the purchasing power of different currencies. This theory helps to explain some of the long-run movements in the value of the Australian dollar relative

to other currencies. Purchasing power parity does not provide a complete explanation of movements in exchange rates for several reasons, including the existence of tariffs and quotas. A tariff is a tax imposed by a government on imports. A quota is a government-imposed limit on the quantity of a good that can be imported. Currently, 18 European Union member countries use a common currency, known as the euro. The experience of the countries using the euro will provide economists with information on the costs and benefits to countries of using the same currency. When a country keeps its currency’s exchange rate fixed against another country’s currency, it is pegging its currency. Pegging can result in problems similar to the problems countries

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encountered with fixed exchange rates under the Bretton Woods System. If investors become convinced that a country pegging its exchange rate will eventually allow the exchange rate to decline to a lower level, the demand curve for the currency will shift to the left. This illustrates the difficulty of maintaining a fixed exchange rate in the face of destabilising speculation.

REVIEW QUESTIONS 2.1

2.2

2.3

2.4

2.5

What is the theory of purchasing power parity? Does it give a complete explanation for movements in exchange rates in the long run? Briefly explain. Briefly describe the four determinants of exchange rates in the long run. Why did many European countries agree to replace their previous currency with the euro? What does it mean when one currency is ‘pegged’ against another currency? Why do countries peg their currencies? What problems can result when a country pegs its exchange rate? Briefly describe the Chinese experience with pegging the yuan.

explain which currency is overvalued in terms of Big Mac purchasing power parity. IMPLIED BIG MAC

EXCHANGE

ACTUAL

COUNTRY

PRICE

RATE

EXCHANGE RATE

Chile

Pesos 1850

463 pesos per US$

Israel

Shekels 15.9

3.40 shekels per US$

Russia

Rubles 75.0

27.8 rubles per US$

New Zealand

NZ $5.10

1.16 NZ$ per US$

2.12

2.13

PROBLEMS AND APPLICATIONS 2.6

2.7

2.8

2.9

2.10

2.11

Consider the following: An Australian manufacturing representative said that weak currencies overseas, particularly in Europe and Asia, had dragged down its sales 2 per cent worldwide, ultimately costing it $35 million in net income. What is meant by a ‘weak currency’? Why would weak currencies overseas hurt Australian manufacturers’ sales? Following the floating of the Australian dollar in 1983, the trade-weighted index of the Australian dollar fell substantially. Does this indicate that the Australian dollar was overvalued or undervalued? Explain your answer. Consider this statement: ‘It usually takes around 100 yen to buy one Australian dollar and more than two Australian dollars to buy one British pound. These values show that Australia must be a much wealthier country than Japan and that the UK must be wealthier than Australia.’ Do you agree with this reasoning? Briefly explain. [Related to the opening case] Between 2010 and early 2012 the Australian dollar appreciated significantly against the US dollar and some other currencies, and remained relatively strong for some years after. Discuss which consumers and industries benefited, and which ones were disadvantaged by the appreciation. According to the theory of purchasing power parity, if the inflation rate in Australia is higher than the inflation rate in New Zealand, what should happen to the exchange rate between the Australian dollar and the New Zealand dollar? Briefly explain. [Related to Making the connection 15.1] Assume that the Big Mac is selling for $4.07 in the United States. Calculate the implied exchange rate between each of the currencies in the following table relative to the US dollar, and

2.14

2.15

2.16

2.17

2.18

Britain decided not to join other European Union countries in using the euro as its currency. Opponents of adopting the euro argued that it is not possible to manage the entire economy of Europe with just one interest rate policy. For instance, how do you alleviate a recession in Italy and curb inflation in Germany? What interest rate policy would be used to alleviate a recession in Italy? What interest rate policy would be used to curb inflation in Germany? What does adopting the euro have to do with interest rate policy? In January 2013 the exchange rate for the Australian dollar against the euro was A$0.77 per euro. In January 2014 the exchange rate was A$0.65 per euro. Was this change in the euro–Australian dollar exchange rate good news or bad news for Australian firms exporting goods and services to Europe? Briefly explain. [Related to Making the connection 15.2] Jordi Galí, an economist in Spain, notes that the Spanish economy was in recession during the early 1990s, but that ‘in 1992 and 1993 a series of [exchange rate] devaluations got us out of trouble.’1 Was Spain able to use exchange rate devaluations to deal with the recession of 2007–2009? Briefly explain. Construct a numerical example showing how an investor could have made a profit by selling Thai baht for US dollars in 1997. When Airbus, a subsidiary of a company located in France, sold A380 super-jumbo jetliners to Air France, the transaction was made in US dollars rather than euros. What advantages are there to aerospace firms in different countries in agreeing to carry out all transactions in a single currency? What disadvantages are there? What does it mean to say that a government is taking action to ‘support’ its currency? Do you agree with the conclusion that these actions are not effective in the long run if they run counter to the judgment of financial markets? Briefly explain. Use the following graph to answer the following questions. a According to the graph, is there a surplus or a shortage of baht in exchange for US dollars? Briefly explain. b To maintain the pegged exchange rate, will the Thai central bank need to buy baht in exchange for US dollars or sell baht in exchange for US dollars? How many baht will the Thai central bank need to buy or sell?

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S

$0.03

0.02 Pegged exchange rate

D

0

70

100

Quantity of baht traded per day (millions)

120

For many years Argentina suffered from high rates of inflation. As part of its program to fight inflation, in the 1990s the Argentine government pegged the value of the Argentine peso to the US dollar at a rate of one peso per US dollar. In January 2002 the government decided to abandon the peg and allow the peso to float. Just before the peg was abandoned, firms in Buenos Aires posted signs urging customers to come in and shop and take advantage of the ‘Last 72 Hours of One to One’.2 What was likely to happen to the exchange rate between the US dollar and the peso once Argentina abandoned the peg? Why would customers find it better to shop before the peg ended than after? 2.20 [Related to Solved problem 15.1] A financial commentator discussing the effects of an increase in the value of the Australian dollar made the following two observations: a ‘The stronger dollar will also mean lower inflation in this country.’ 2.19

453

b ‘The biggest danger in coming months is that a rising Australian dollar will make foreigners less willing to invest in Australia.’ Explain whether you agree with these two observations. 2.21 Suppose a developing country pegs the value of its currency against the US dollar. Suppose that the exchange rate between the US dollar and the yen and between the US dollar and the euro increases. What will be the impact on the ability of the developing country to export goods and services to Japan and Europe? Briefly explain. 2.22 An article in The Economist magazine observed the following: ‘In Argentina, many loans were taken out in US dollars: this had catastrophic consequences for borrowers once the peg collapsed…’3 What does it mean that Argentina’s ‘peg collapsed’? Why was this catastrophic for borrowers in Argentina who had taken out US dollar loans? 2.23 Graph the demand and supply of Chinese yuan for US dollars and label each axis. To maintain its pegged exchange rate the Chinese central bank bought large quantities of US dollars with yuan. Indicate whether the pegged exchange rate was above or below the market equilibrium exchange rate and show on the graph the quantity of yuan the Chinese central bank would have to supply each trading period. 2.24 The following is from an article in The Wall Street Journal on changes in the South Korean economy: The biggest is a change in where Korean companies are finding growth. It is no longer just the US and Europe, markets where Samsung, Hyundai and other big exporters have long focused on. Instead, it is in places like China, central Asia and the Middle East … The broader trend is that global economic growth is less tied to the US, a phenomenon that has been called decoupling.4

If the trend identified in this article is correct, what are the implications for the policy of the South Korean government with respect to the US dollar–won exchange rate?

INTERNATIONAL CAPITAL MARKETS, PAGES 447–448 LEARNING OBJECTIVE 15.3

Discuss the growth of international capital markets.

SUMMARY

PROBLEMS AND APPLICATIONS

A key reason that exchange rates fluctuate is that investors seek out the best investments they can find anywhere in the world. Since the 1980s the markets for shares and bonds have become global. As a result, firms around the world are no longer forced to rely only on the savings of domestic households for funds.

3.3

3.4

REVIEW QUESTIONS 3.1

3.2

Briefly explain whether Australia’s financial market is highly regulated or highly deregulated according to world standards. What were the main factors behind the globalisation of capital markets in the 1980s and 1990s?

3.5

This chapter states that ‘the globalisation of financial markets has helped increase growth and efficiency in the world economy’. Briefly explain which aspects of globalisation help to increase growth in the world economy. Briefly explain how globalised financial markets led to the spread of the problems experienced in the United States when the value of their mortgage-backed financial securities fell significantly. The global financial crisis of 2007–2008 led some economists and policy-makers to suggest the reinstitution of capital controls—or limits on the flow of foreign financial exchange and financial investments across countries— which existed in many European countries prior to the 1960s. Why would a financial crisis lead to a desire to use capital controls? What problems might result from capital controls?

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APPENDIX Explain the gold standard and the Bretton Woods System. LEARNING OBJECTIVE

THE GOLD STANDARD AND THE BRETTON WOODS SYSTEM It is easier to understand the current exchange rate system by further considering two earlier systems, the gold standard and the Bretton Woods System, which together lasted from the early nineteenth century to the early 1970s.

The gold standard As we saw in this chapter, under the gold standard the currency of a country consisted of gold coins and paper currency that could be redeemed for gold. Great Britain adopted the gold standard in 1816, but as late as 1870 only a few nations had followed. In the late nineteenth century, however, Great Britain’s share of world trade increased as did its overseas investments. The dominant position of Great Britain in the world economy motivated other countries to adopt the gold standard. By 1913 every country in Europe, except Spain and Bulgaria, and most countries in the Western hemisphere had adopted the gold standard. Under the gold standard the exchange rate between two currencies was automatically determined by the quantity of gold in each currency. If there was one-fifth of an ounce of gold in a US dollar and one ounce of gold in a British pound, the price of gold in the United States would be US$5 per ounce and the price of gold in Britain would be £1 per ounce. (An ounce is equivalent to approximately 28 grams.) The exchange rate would therefore be US$5 = £1.

The end of the gold standard From a modern point of view, the greatest drawback to the gold standard was that the central bank lacked control of the money supply. The size of a country’s money supply depended on its gold supply, which could be greatly affected by chance discoveries of gold or by technological change in gold mining. Because the central bank cannot determine how much gold will be discovered, it lacks the control of the money supply necessary to pursue an active monetary policy. During wartime, countries usually went off the gold standard to allow their central banks to expand the money supply as rapidly as was necessary to pay for the war. Britain and Australia abandoned the gold standard at the beginning of World War I in 1914 and did not resume redeeming its paper currency for gold until 1925. When the Great Depression began in 1929 governments came under pressure to abandon the gold standard to allow their central banks to pursue active monetary policies. In 1931 Great Britain became the first major country to abandon the gold standard. A number of other countries, including Australia, also went off the gold standard that year. The United States remained on the gold standard until 1933, and a few countries, including France, Italy and Belgium, stayed on it even longer. By the late 1930s the gold standard had collapsed. The earlier a country abandoned the gold standard, the easier time it had fighting the Depression with expansionary monetary policies. The countries that abandoned the gold standard by 1932 suffered an average decline in production of only 3 per cent between 1929 and 1934. The countries that stayed on the gold standard until 1933 or later suffered an average decline of more than 30 per cent. The devastating economic performance of the countries that stayed on the gold standard the longest during the 1930s is the key reason no attempt was made to bring back the gold standard in later years.

The Bretton Woods system In addition to the collapse of the gold standard, the global economy had suffered during the 1930s from tariff wars. The United States had started the tariff wars in June 1930 by enacting the Smoot-Hawley Tariff, which raised the average US tariff rate to more than 50 per cent. Many other countries raised tariffs during the next few years, leading to a collapse in world trade. As World War II was coming to an end, economists and government officials in the United States and Europe concluded that they needed to restore the international economic system to

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avoid another depression. In 1947 the United States and most other major countries, including Australia, apart from the Soviet Union, began participating in the General Agreement on Tariffs and Trade (GATT), under which they worked to reduce trade barriers. The GATT was very successful in sponsoring rounds of negotiations between countries, which led to sharp declines in tariffs. US tariffs dropped from an average rate of more than 50 per cent in the early 1930s to an average rate of less than 2 per cent today. However, in the 1970s tariffs, quotas and other trade barriers in the United States, European Union, Japan and many other countries began to rise significantly again, particularly on agricultural products. In 1995 the GATT was replaced by the World Trade Organization (WTO), which today continues to work towards reducing tariffs and other restrictions to free trade, to date with limited success. The effort to develop a new exchange rate system to replace the gold standard was more complicated than establishing the GATT. A conference held in Bretton Woods, New Hampshire, in 1944 set up a system in which the United States pledged to buy or sell gold at a fixed price of $35 per ounce. The central banks of all other members of the new Bretton Woods System pledged to buy and sell their currencies at a fixed rate against the US dollar. By fixing their exchange rates against the US dollar, these countries were fixing the exchange rates between their currencies as well. Unlike under the gold standard, no country was willing to redeem its paper currency for gold domestically. Under the Bretton Woods System central banks were committed to selling US dollars in exchange for their own currencies. This commitment required them to hold US dollar reserves. If a central bank ran out of US dollar reserves it could borrow them from the newly created International Monetary Fund (IMF). In addition to providing loans to central banks that were short of US dollar reserves, the IMF would oversee the operation of the system and approve adjustments to the agreed-on fixed exchange rates. Under the Bretton Woods System, a fixed exchange rate was known as a par exchange rate. If the par exchange rate was not the same as the exchange rate that would have been determined in the market, the result would be a surplus or a shortage. For example, Figure 15A.1 shows the exchange rate between the US dollar and the British pound. The figure is drawn from the British point of view, so we measure the exchange rate on the vertical axis as US dollars per pound. In this case, the par exchange rate between the US dollar and the pound is above the equilibrium exchange rate as determined by supply and demand.

455

Bretton Woods System An exchange rate system that lasted from 1944 to 1971, under which countries pledged to buy and sell their currencies at a fixed rate against the US dollar.

International Monetary Fund (IMF) An international organisation that provides foreign currency loans to central banks and oversees the operation of the international monetary system.

FIGURE 15A.1 A FIXED EXCHANGE RATE ABOVE EQUILIBRIUM RESULTS IN A SURPLUS OF POUNDS Under the Bretton Woods System central banks were obligated to defend par exchange rates by buying and selling their countries’ currencies at fixed rates against the US dollar. If the par exchange rate was above equilibrium, the result would be a surplus of domestic currency in the foreign exchange market. If the par exchange rate was below equilibrium, the result would be a shortage of domestic currency. In the figure, the par exchange rate between the pound and the US dollar was US$4 = £1, whereas the equilibrium exchange rate was US$2.80 = £1. This gap forced the Bank of England to buy £1 million per day in exchange for US dollars Exchange rate (US$/£)

Surplus of pounds = the quantity the Bank of England had to purchase with dollars

S

Par exchange rate

$4.00

2.80 Equilibrium exchange rate

D 0

1

1.4

2 Quantity of pounds traded per day (millions)

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Devaluation A reduction in a fixed exchange rate. Revaluation An increase in a fixed exchange rate.

In this example, at the par exchange rate of US$4 per pound, the quantity of pounds demanded by people wanting to buy British goods and services or wanting to invest in British assets is smaller than the quantity of pounds supplied by people who would like to exchange them for US dollars. As a result, the Bank of England must use US dollars to buy the surplus of £1 million per day. Only at an exchange rate of US$2.80 per pound would the surplus be eliminated. If the par exchange rate were below the equilibrium exchange rate, there would be a shortage of domestic currency in the foreign exchange market. A persistent shortage or surplus of a currency under the Bretton Woods System was seen as evidence of a fundamental disequilibrium in a country’s exchange rate. After consulting with the IMF, countries in this position were allowed to adjust their exchange rates. In the early years of the Bretton Woods System many countries found that their currencies were overvalued against the US dollar, meaning that their par exchange rates were too high. A reduction of a fixed exchange rate is a devaluation. An increase in a fixed exchange rate is a revaluation. In 1949 there was a devaluation of several currencies, including the British pound, against which the Australian currency (the pound) was pegged, reflecting the fact that those currencies had been overvalued against the US dollar.

The collapse of the Bretton Woods system By the late 1960s the Bretton Woods System faced two severe problems. The first was that after 1963 the total number of US  dollars held by foreign central banks was larger than the gold reserves of the United States. In practice, most central banks—with the Bank of France being the main exception—rarely redeemed US dollars for gold. But the basis of the system was a credible promise by the United States to redeem US dollars for gold if called upon to do so. By the late 1960s, as the gap between the US dollars held by foreign central banks and the gold reserves of the United States grew larger and larger, the credibility of the US promise to redeem US dollars for gold was called into question. The second problem faced by the Bretton Woods System was that some countries with undervalued currencies, particularly West Germany, were unwilling to revalue their currencies. Governments resisted revaluation because it would have increased the prices of their countries’ exports. Many German firms, such as Volkswagen, put pressure on the government not to endanger their sales in the US market by raising the exchange rate of the deutsche mark against the US dollar. Figure 15A.2 shows the situation faced by the German government in 1971. The figure takes the German point of view, so the exchange rate is expressed in terms of US dollars per deutsche mark. FIGURE 15A.2 WEST GERMANY’S UNDERVALUED EXCHANGE RATE The Bundesbank, the German central bank, was committed under the Bretton Woods System to defending a par exchange rate of US$0.27 per deutsche mark (DM). Because this exchange rate was lower than what the equilibrium market exchange rate would have been there was a shortage of deutsche marks in the foreign exchange market. The Bundesbank had to supply deutsche marks equal to the shortage in exchange for US dollars. The shortage in the figure is equal to DM1 billion per day Exchange rate (US$/DM)

S

Equilibrium exchange rate

$0.35

0.27 Par exchange rate

D Shortage of deutsche marks = the quantity that the Bundesbank had to supply in exchange for dollars

0

1

1.4

2

Quantity of deutsche marks traded per day (billions)

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Under the Bretton Woods System, the Bundesbank, the German central bank, was required to buy and sell deutsche marks for US dollars at a rate of US$0.27 per deutsche mark. The equilibrium that would have prevailed in the foreign exchange market if the Bundesbank did not intervene was about US$0.35 per deutsche mark. Because the par exchange rate was below the equilibrium exchange rate, the quantity of deutsche marks demanded by people wanting to buy German goods and services or wanting to invest in German assets was greater than the quantity of deutsche marks supplied by people who wanted to exchange them for US dollars. To maintain the exchange rate at US$0.27 per deutsche mark the Bundesbank had to buy US  dollars and sell deutsche marks. The amount of deutsche marks supplied by the Bundesbank was equal to the shortage of deutsche marks at the par exchange rate. By selling deutsche marks and buying US dollars to defend the par exchange rate, the Bundesbank was increasing the West German money supply, risking an increase in the inflation rate. Because Germany had suffered devastating hyperinflation during the 1920s, the fear of inflation was greater in Germany than in any other industrial country. No German government could survive politically if it allowed a significant increase in inflation. Knowing this fact, many investors in Germany and elsewhere became convinced that eventually the German government would have to allow a revaluation of the mark. During the 1960s most European countries, including Germany, relaxed their capital controls. Capital controls are limits on the flow of foreign exchange and financial investment across countries. The loosening of capital controls made it easier for investors to speculate on changes in exchange rates. For instance, an investor in the United States could sell US$1 million and receive about DM3.7 million at the par exchange rate of US$0.27 per deutsche mark ($1 million/0.27). If the exchange rate rose to US$0.35 per deutsche mark, the investor could then exchange deutsche marks for US dollars, receiving approximately US$1.3  million (3.7 million × 0.35) at the new exchange rate: a return of 30 per cent on an initial US$1 million investment. The more convinced investors became that Germany would have to allow a revaluation, the more US dollars they exchanged for deutsche marks. Figure 15A.3 shows the results. The increased demand for deutsche marks by investors hoping to make a profit from the expected revaluation of the mark shifted the demand curve for marks to the right, from D1 to D2. Because of this expectation the Bundesbank had to increase the marks it supplied in exchange for US dollars, raising further the risk of inflation in Germany. As we saw in the chapter,

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Capital controls Limits on the flow of foreign exchange and financial investment across countries.

FIGURE 15A.3 DESTABILISING SPECULATION AGAINST THE DEUTSCHE MARK, 1971 In 1971 the par exchange rate of US$0.27 = DM1 was below the equilibrium exchange rate of US$0.35 = DM1. As investors became convinced that West Germany would have to revalue the deutsche mark, they increased their demand for marks from D1 to D2. The new equilibrium exchange rate became US$0.42 = DM1. This increase in demand raised the quantity of marks the Bundesbank had to supply in exchange for US dollars to defend the par exchange rate from DM1 billion to DM2 billion per day Exchange rate (US$/DM)

S

$0.42

0.35

0.27 Par exchange rate

D1

0

1

1.4

2

D2

3 Quantity of deutsche marks traded per day (billions)

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because these actions by investors make it more difficult to maintain a fixed exchange rate, they are referred to as destabilising speculation. By May 1971 the Bundesbank had to buy more than US$1 billion per day to support the fixed exchange rate against the US dollar. Finally, on 5 May the West German government decided to allow the mark to float. In August, President Richard Nixon of the United States decided to abandon the US commitment to redeem US dollars for gold. Attempts were made over the next two years to reach a compromise that would restore a fixed exchange rate system, but by 1973 the Bretton Woods System was effectively dead. In 1971 Australia moved to a pegged exchange rate against the US dollar instead of the British pound. The Australian exchange rate became more flexible throughout the 1970s (known as a crawling peg) until the floating of the Australian dollar in 1983.

APPENDIX QUESTIONS AND PROBLEMS KEY TERMS Bretton Woods System capital controls devaluation

455 457 456

International Monetary Fund (IMF) 455

revaluation

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THE GOLD STANDARD AND THE BRETTON WOODS SYSTEM, PAGES 454–458 LEARNING OBJECTIVE

Explain the gold standard and the Bretton Woods System.

REVIEW QUESTIONS 15A.1

15A.2 15A.3

15A.4 15A.5

15A.6

What determined the exchange rates between currencies under the gold standard? Why did the gold standard collapse? Briefly describe how the Bretton Woods System operated. What is the difference between a devaluation and a revaluation? What are capital controls? What role did the International Monetary Fund play in the Bretton Woods System? What is destabilising speculation? What role did it play in the collapse of the Bretton Woods System?

PROBLEMS AND APPLICATIONS 15A.7

15A.8

15A.9

Suppose that under the gold standard there was one-fifth of an ounce of gold in a US dollar and one ounce of gold in a British pound. Demonstrate that if the exchange rate between the US dollar and the pound was US$4 = £1, rather than US$5 = £1, you could make unlimited profits by buying gold in one country and selling it in the other. If the exchange rate was US$6 = £1, how would your strategy change? For simplicity, assume there was no cost to shipping gold from one country to the other. How did the gold standard make the Great Depression of the 1930s even worse? When most countries left the gold standard in the 1930s the mining industry in South Africa underwent a huge increase in profitability. Briefly explain why the end of the gold standard might be good news for the owners of gold mines.

By the mid-1960s the price of gold on the London market had increased to more than US$35 per ounce. (Remember that it was not legal during these years for investors in the United States to own gold.) Would this have happened if foreign investors had believed that the US commitment to buy and sell gold at US$35 per ounce under the Bretton Woods System would continue indefinitely? Briefly explain. 15A.11 One economist has argued that the East Asian exchange rate crisis of the late 1990s was due to ‘the simple failure of governments to remember the lessons from the breakdown of the Bretton Woods System’. What are the lessons from the breakdown of the Bretton Woods System? In what sense did the East Asian governments fail to learn these lessons? 15A.12 It was argued that following the break-up of the Bretton Woods System that had kept the deutsche mark tied to the US dollar, Germany’s Bundesbank adopted a monetary policy strategy that allowed it to stabilise prices better in the long run. Why might keeping the German mark tied to the value of the US dollar have made it difficult for the Bundesbank to pursue a policy of price stability? 15A.13 An article in The Economist magazine noted that after the end of the Bretton Woods System, ‘The Europeans did not like leaving their currencies to the whims of the markets…’5 What does it mean for a country to leave its currency to the ‘whims of the markets’? What problems might a country experience as a result? What exchange rate system did most European countries ultimately adopt? 15A.10

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ENDNOTES 1 2

3

The Economist (2009), ‘One size fits none’, The Economist, 11 June, at , viewed 25 February 2014. Larry Rohter (2002), ‘Argentina unlinks peso from dollar, bracing for devaluation’, The New York Times, 7 January, at , viewed 26 February 2014. The Economist (2002), ‘Spoilt for choice’, The Economist, 31 May, at , viewed 26 February 2014.

4

5

Evan Ramstad (2007), ‘Korean stock rally shows a different picture’, The Wall Street Journal, 19 June, at , viewed 27 February 2014. The Economist (2011), ‘Forty years on’, The Economist, 13 August, at , viewed 26 February 2014.

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glossar y A Absolute advantage The ability of an individual, firm or country to produce more of a good or service than competitors using the same amount of resources. Aggregate demand and aggregate supply model A model that explains short-run fluctuations in real GDP and the price level. Aggregate demand (AD) curve A curve that shows the relationship between the price level and the quantity of real GDP demanded by households, firms and the government. Aggregate expenditure (AE) The total amount of spending in the economy: the sum of consumption, planned investment, government purchases and net exports. Aggregate expenditure model A macroeconomic model that focuses on the short-run relationship between total spending and real GDP, assuming that the price level is constant. Aggregate supply The quantity of goods and services supplied by all firms. Allocative efficiency A state of the economy in which production reflects consumer preferences; in particular, every good or service is produced up to the point where the last unit provides a marginal benefit to consumers equal to the marginal cost of producing it. Asset Anything of value owned by a person or a firm. Automatic stabilisers Government spending and taxes that automatically increase or decrease along with the business cycle. Autonomous consumption Consumption that is independent of income. Autonomous expenditure Expenditure that does not depend on the level of GDP.

B Balance of payments The record of a country’s international trade, borrowing, lending, capital and investment flows with other countries. Balance of trade in goods and services The difference between the value of the goods and services a country exports and the value of the goods and services a country imports. Bretton Woods System An exchange rate system that lasted from 1944 to 1971, under which countries pledged to buy and sell their currencies at a fixed rate against the US dollar. Broad money M3, plus deposits into non-bank deposit-taking institutions minus holdings of currency and deposits of non-bank depository corporations. Budget deficit The situation in which the government’s expenditures are greater than its tax revenue. Budget surplus The situation in which the government’s expenditures are less than its tax revenue. Business cycle Alternating periods of economic expansion and economic contraction relative to trend growth.

C Capital Manufactured goods that are used to produce other goods and services. Capital account The part of the balance of payments that records migrants’ transfers, debt forgiveness and sales and purchases of non-produced, non-financial assets.

Capital controls Limits on the flow of foreign exchange and financial investment across countries. Cash flow The difference between the cash revenues received by the firm and the cash spending by the firm. Cash rate The interest rate on loans in the overnight money market. Catch-up The prediction that the level of GDP per capita (or income per capita) in poor countries will grow faster than in rich countries. Centrally planned economy An economy in which the government decides how economic resources will be allocated. Ceteris paribus (‘all else being equal’) The requirement that when analysing the relationship between two variables—such as price and quantity demanded—other variables must be held constant. Closed economy An economy that has no interactions in trade or finance with other economies. Commodity money A good used as money that also has value independent of its use as money. Comparative advantage The ability of an individual, firm or country to produce a good or service at a lower opportunity cost than other producers. Competitive market equilibrium A market equilibrium with many buyers and many sellers. Complements Goods and services that are used together. Consumer price index (CPI) A measure of changes in retail prices of a basket of goods and services representative of consumption expenditure by typical Australian households in capital cities. Consumer sovereignty Occurs because firms must produce goods and services that meet the wants of consumers or the firms will go out of business. Therefore it is ultimately consumers who decide what goods and services will be produced. Consumption Spending by households on goods and services, not including spending on new houses. Consumption function The relationship between consumption and disposable income. Contraction The period of a business cycle during which total production and total employment are falling below trend growth. Contractionary fiscal policy Involves decreasing government purchases or increasing taxes in order to reduce the increases in aggregate demand. Contractionary monetary policy The use of monetary policy by the Reserve Bank of Australia to increase interest rates to reduce inflation. Copyright The legal right of the creator of a book, movie, piece of music or software program to the exclusive right to use the creation during the creator’s lifetime, plus an additional period of time for their heirs. Cost-push inflation Inflation that arises as a result of a negative supply shock—that is, anything that causes a decrease in the aggregate supply of goods and services. Credit Loans, advances and bills provided to the private non-bank sector (individuals and firms) by all financial intermediaries. Crowding out A decline in private expenditures as a result of an increase in government purchases. Currency Notes and coins held by the private non-bank sector. Current account The part of the balance of payments that records a country’s net exports and net income. Currency appreciation Occurs when the market value of a currency rises relative to another currency.

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GLOSSARY Currency depreciation Occurs when the market value of a currency falls relative to another currency. Cyclical unemployment Unemployment caused by a business cycle contraction. Cyclically adjusted budget deficit or surplus The deficit or surplus in the federal government’s budget if the economy were at potential GDP.

D Deflation A decline in the general price level in the economy. Demand curve A curve that shows the relationship between the price of a product and the quantity of the product demanded. Demand deposits Also called current deposits, these are deposits in financial institutions that are transferable by cheque, by debit cards at EFTPOS terminals and through electronic transfer between accounts. They are called demand deposits because they are available on demand, and are repayable on demand in notes and coins. Demand schedule A table showing the relationship between the price of a product and the quantity of the product demanded. Demand-pull inflation Inflation that is caused by an increase in the aggregate demand for goods and services and production levels are unable to meet this demand immediately. Demographics The characteristics of a population with respect to age, race and gender. Devaluation A reduction in a fixed exchange rate. Discouraged workers People who are available for work but have not looked for a job during the previous four weeks because they believe no jobs are available for them. Discretionary fiscal policy When the government is taking actions to change spending or taxes to achieve its economic objectives (fiscal policy). Dynamic efficiency Occurs when new technologies and innovation are adopted over time.

E Economic growth The expansion of society’s productive potential. Economic growth is usually measured by the rate of growth in real GDP. Economic growth model A model that explains changes in real GDP per capita in the long run. Economic growth rate The rate of change of real GDP from one year to the next. Economic models Simplified versions of reality used to analyse real-world economic situations. Economic variable Something measurable that relates to resource use that can have different values, for example wages, prices, litres of water. Economics The study of the choices people and societies make to attain their unlimited wants, given their scarce resources. Efficiency wage A higher-than-market wage paid by a firm to increase worker productivity. Enterprise bargaining Wages and working conditions negotiations between employers and unions or employers and employees at the workplace level. Entrepreneur Someone who operates a business, bringing together the factors of production—labour, capital and natural resources—to produce goods and services. Equity The fair distribution of economic benefits between individuals and between societies. Euro The common currency of many European countries which are members of the European Union. Exchange rate The value of one country’s currency in terms of another country’s currency.

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Exchange rate system An agreement between countries on how exchange rates should be determined. Exchange settlement accounts Accounts held with the Reserve Bank of Australia (RBA) by banks and other financial institutions to enable the overnight transfer of funds (cash) between financial institutions, and between the RBA and financial institutions. Expansion The period of a business cycle during which total production and total employment are increasing above trend growth. Expansionary fiscal policy Involves increasing government purchases or decreasing taxes in order to increase aggregate demand. Expansionary monetary policy The use of monetary policy by the Reserve Bank of Australia to decrease interest rates to increase real GDP.

F Factor markets Markets for the factors of production, such as labour, capital, natural resources and entrepreneurial ability. Factors of production Labour, capital, natural resources and other inputs used to produce goods and services. Fiat money Money, such as paper currency, that is authorised by a central bank or government body and that does not have to be exchanged by the central bank for gold or some other commodity money. Final good or service A good or service which is the end product of the production process that is purchased by the final user. Financial account The part of the balance of payments that records purchases of physical and financial assets a country has made abroad and foreign purchases of physical and financial assets in the country. Financial intermediaries Firms such as banks and non-bank financial intermediaries (NBFIs) (which include credit unions, building societies, managed funds, superannuation funds and insurance companies) that borrow funds from savers and lend them to borrowers. Financial system The system of financial markets and financial intermediaries through which firms acquire funds from households. Fiscal policy Changes in federal taxes and purchases that are intended to achieve macroeconomic policy objectives, such as high employment, price stability and healthy rates of economic growth. Fixed exchange rate system A system under which countries agree to keep the exchange rates between their currencies fixed. Floating currency A currency whose exchange rate is determined by demand and supply. Foreign direct investment The ownership of, or controlling interest in, assets, such as a factories, businesses or farms, in a foreign country. Foreign portfolio investment The purchase by an individual or firm of financial securities, such as shares or bonds issued in another country. Free market A market with few government restrictions on how a good or service can be produced or sold, or on how a factor of production can be employed. Frictional unemployment Short-term unemployment arising from the process of matching workers with jobs.

G GDP deflator A measure of the price level, calculated by dividing nominal GDP by real GDP and multiplying by 100. Globalisation The process of countries becoming more open to foreign trade and investment. Government purchases Spending by federal, state and local governments on goods and services.

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GLOSSARY Gross domestic product (GDP) The market value of all final goods and services produced in a country during a period of time. Gross national income Is equal to GDP (C + I + G + NX) plus the net income transfers received from other countries, including dividends and interest earned or paid. It measures the total income that a country has for expenditure and saving.

H Human capital The accumulated knowledge and skills workers acquire from education and training or from their life experiences. Hyperinflation Extremely rapid increases in the general price level.

I Income effect The change in the quantity demanded of a good that results from the effect of a change in the good’s price on consumer purchasing power. Induced consumption Consumption that is determined by the level of income. Induced expenditure Expenditure that depends on the level of GDP. Industrial Revolution The application of mechanical power to the production of goods, beginning in Britain during the mid to late 1700s. Inferior good A good for which the demand increases as income falls and decreases as income rises. Inflation The sustained increase in the general level of prices in the economy. Inflation rate The percentage increase in the general price level in the economy from one year to the next. Inflation targeting Conducting monetary policy so as to commit the central bank to achieving a publicly announced level of inflation. Intermediate good or service A good or service that is an input into another good or service. International Monetary Fund (IMF) An international organisation that provides foreign currency loans to central banks and oversees the operation of the international monetary system. Inventories Goods that have been produced but not yet sold. Investment Spending by firms on new factories, office buildings, machinery and inventories, plus spending by households on new houses.

J Job Services Australia A national network of private and community recruitment agencies that find jobs for unemployed people and other job seekers.

K Keynesian revolution The name given to the widespread acceptance during the 1930s and 1940s of John Maynard Keynes’s macroeconomic model.

L Labour force The sum of employed and unemployed workers in the economy. Labour force participation rate The percentage of the working age population in the labour force. Labour productivity The quantity of goods and services that can be produced by one worker or by one hour of work. Law of demand Holding everything else constant, when the price of a product falls the quantity demanded of the product will increase, and when the price of a product rises the quantity demanded of the product will decrease. Law of supply Holding everything else constant, increases in price cause increases in the quantity supplied, and decreases in price cause decreases in the quantity supplied.

Long-run aggregate supply (LRAS) curve A curve that shows the relationship in the long run between the price level and the quantity of real GDP supplied. Long-run economic growth The process by which rising productivity increases the average standard of living. Long-term unemployed Those in the labour force who have been continuously unemployed for a year or longer.

M M1 The narrowest definition of the money supply which is composed of currency plus the value of all demand deposits with banks. M3 M1, plus all other deposits of the private non-bank sector with domestic and foreign-owned banks operating in Australia. Macroeconomics The study of the economy as a whole, including topics such as inflation, unemployment and economic growth. Managed float exchange rate system An exchange rate system under which the value of the currency is determined by demand and supply, with occasional central bank or government intervention. Marginal analysis Analysis that involves comparing marginal benefits and marginal costs. Marginal propensity to consume (MPC) The slope of the consumption function: the amount by which consumption changes when disposable income changes. Marginal propensity to save (MPS) The amount by which saving changes when disposable income changes. Market A group of buyers and sellers of a good or service and the institution or arrangement by which they come together to trade. Market demand The demand by all the consumers of a given good or service. Market economy An economy in which the decisions of households and firms interacting in markets allocate economic resources. Market equilibrium A situation in which quantity demanded equals quantity supplied. Market for loanable funds The interaction of borrowers and lenders that determines the market interest rate and the quantity of loanable funds exchanged. Market supply The supply by all firms of a given good or service. Menu costs The costs to firms of changing prices. Microeconomics The study of how households and firms make choices, how they interact in markets and how the government attempts to influence their choices. Mixed economy An economy in which most economic decisions result from the interaction of buyers and sellers in markets, but in which the government plays a significant role in the allocation of resources. Monetarism The macroeconomic theories of Milton Friedman and his followers, particularly the idea that the quantity of money should be increased at a constant rate. Monetary growth rule A plan for increasing the quantity of money at a fixed rate that does not respond to changes in economic conditions. Monetary policy The actions taken by the Reserve Bank of Australia to manage interest rates to pursue macroeconomic objectives. Monetary targeting Conducting monetary policy to control the size and rate of growth of the money supply. Money Assets that people are generally willing to accept in exchange for goods and services or for payment of debts. Multifactor productivity (MFP) The quantity of goods and services produced per combined input of labour and capital. Multiplier The increase in equilibrium real GDP divided by the increase in autonomous expenditure. Multiplier effect The process by which an increase in autonomous expenditure leads to a larger increase in real GDP.

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GLOSSARY

N Natural rate of unemployment The unemployment rate that exists when the economy is operating at potential GDP. Net exports The value of exports minus the value of imports. Net foreign debt The difference between the amount Australia lends to other countries and the amount that Australia borrows from overseas. Net foreign investment The difference between capital outflows from a country and capital inflows, also equal to net foreign direct investment plus net foreign portfolio investment. New classical macroeconomics The macroeconomic theories of Robert Lucas and others, particularly the idea that workers and firms have rational expectations. New growth theory A model of long-run economic growth that emphasises that technological change is influenced by economic incentives, and so is determined by the working of the market system. Nominal exchange rate The value of one country’s currency in terms of another country’s currency. Nominal GDP The market value of final goods and services evaluated at current year prices. Nominal interest rate The stated interest rate on a loan. Non-accelerating inflation rate of unemployment (NAIRU) The level of unemployment below which the rate of inflation will rise. Normal good A good for which the demand increases as income rises and decreases as income falls. Normative analysis Analysis concerned with what ought to be and involves making value judgments, which cannot be tested.

O Open economy An economy that has interactions in trade or finance with other economies. Open market operations The Reserve Bank of Australia purchasing or selling financial instruments such as Commonwealth Government Securities and private bonds and securities, either by outright purchase or sale, or by the use of repurchase agreements. Opportunity cost The highest-valued alternative that must be given up to engage in an activity.

P Patent The exclusive right to produce a product for a period of time from the date the product was invented. Pegging The decision by a country to keep the exchange rate fixed between its currency and another currency. Per-worker production function The relationship between real GDP, or output, per hour worked and capital per hour worked, holding the level of technology constant. Phillips curve A curve showing the short-run relationship between the unemployment rate and the inflation rate. Positive analysis Analysis concerned with what is and involves value-free statements that can be checked by using the facts. Potential GDP The level of GDP attained when all firms are producing at capacity. Price level A measure of the average prices of goods and services in the economy. Price mechanism The system in a free market where price changes lead to producers changing production in accordance with the level of consumer demand. Producer price index (PPI) An average of the prices received by producers of goods and services at all stages of the production process. Product markets Markets for goods—such as computers—and services—such as medical treatment.

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Production possibility frontier A curve showing the maximum attainable combinations of two products that may be produced with available resources. Productive efficiency The situation in which a good or service is produced using the least amount of resources. Productivity The output produced per unit of input. Property rights The rights individuals or businesses have to the exclusive use of their property, including the right to buy or sell it. Purchasing power parity The theory that in the long run exchange rates move to equalise the purchasing power of different currencies.

Q Quantity demanded The amount of a good or service that a consumer is willing and able to purchase at a given price. Quantity supplied The amount of a good or service that a firm is willing and able to supply at a given price. Quantity theory of money A theory of the connection between money and prices that assumes that the velocity of money is constant. Quota A numerical limit imposed by the government on the quantity of a good that can be imported into the country.

R Real business cycle model A macroeconomic model that focuses on real, rather than monetary, causes of the business cycle. Real exchange rate The price of domestic goods and services in terms of foreign goods and services. Real GDP A measure of the volume of final goods and services, holding prices constant. Real interest rate The nominal interest rate minus the inflation rate. Recession The period of a business cycle during which total production and total employment are decreasing. Repurchase agreement The Reserve Bank of Australia’s offer to buy (or sell) Commonwealth Government Securities and other eligible financial instruments, from banks or other authorised financial dealers, provided the same banks or dealers are prepared to repurchase (or resell) them at a future date, often in a few days’ time, at a price agreed at the outset. Reserve Bank of Australia The central bank of Australia. Reserves Deposits that a bank keeps as cash in its vault or on deposit with the Reserve Bank of Australia. Resources Inputs used to produce goods and services, including natural resources such as land, water and minerals, labour, capital and entrepreneurial ability. These are otherwise referred to as the factors of production. Revaluation An increase in a fixed exchange rate. Rule of law The ability of a government to enforce the laws of the country, particularly with respect to protecting private property and enforcing contracts.

S Saving and investment equation An equation showing that national saving is equal to domestic investment plus net foreign investment. Scarcity The situation in which unlimited wants exceed the limited resources available to fulfil those wants. Seasonal unemployment Unemployment due to factors such as weather, variations in tourism and other calendar-related events. Shortage A situation in which the quantity demanded is greater than the quantity supplied. Short-run aggregate supply (SRAS) curve A curve that shows the relationship in the short run between the price level and the quantity of real GDP supplied.

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GLOSSARY Simple deposit multiplier The ratio of the amount of deposits created by banks to the amount of new reserves. Speculators Currency traders who buy and sell foreign exchange in an attempt to profit from changes in exchange rates. Stagflation A combination of inflation and recession, usually resulting from a supply shock. Structural relationship A relationship that depends on the basic behaviour of consumers and firms and remains unchanged over long periods of time. Structural unemployment Unemployment arising from a persistent mismatch between the skills and characteristics of workers and the requirements of jobs. Substitutes Goods or services that can be used for the same purpose. Substitution effect The change in the quantity demanded of a good that results from a change in price, making the good more or less expensive relative to other goods that are substitutes. Supply curve A curve that shows the relationship between the price of a product and the quantity of the product supplied. Supply schedule A table that shows the relationship between the price of a product and the quantity of the product supplied. Supply shock An unexpected event that causes the short-run aggregate supply curve to shift. Supply-side policies Fiscal policies that have long-run effects by expanding the productive capacity of the economy and increasing the rate of economic growth. These policy actions primarily affect aggregate supply rather than aggregate demand, shifting the long-run aggregate supply curve to the right. Surplus A situation in which the quantity supplied is greater than the quantity demanded.

T Tariff A tax imposed by a government on imported goods which makes them more expensive on the domestic market. Tax wedge The difference between the pre-tax and post-tax return to an economic activity. Technological change The change in the ability of a firm to produce a given level of output with a given quantity of inputs. Trade The act of buying or selling a good or service in a market. Trade-off The idea that, because of scarcity, producing more of one good or service means producing less of another good or service. Transfer payments Payments by the government to individuals for which the government does not receive a good or service in return.

U Underground economy Buying and selling of goods and services that is concealed from the government to avoid taxes or regulations or because the goods and services are illegal. Unemployment rate The percentage of the labour force that is unemployed.

V Value added The market value a firm adds to a product. Velocity of money The average number of times each dollar in the money supply is used to purchase goods and services which are included in GDP. Voluntary exchange The situation that occurs in markets when both the buyer and seller of a product are made better off by the transaction.

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index Page numbers in bold indicate definition of a key term. Page numbers in italics refer to figures. 45° line diagram 239, 240, 241 showing contraction on 242–243, 243 90-day bank bills 334 180-day bank bills 334

A Abbott, Tony 383 absolute advantage 39–40 account, unit of 304, 441 accountancy graduates 72–73 Afghanistan 160 Africa 112, 147–148, 160–161, 423–424 age ageing of baby boomer generation 62 unemployment rate by 181, 182, 185, 186 aggregate demand 214, 268–271 effect of interest rates 337–338 influence of fiscal policy 363–364, 363–365 macroeconomic equilibrium 280–283, 281, 282 multiplier effect 366 aggregate demand and aggregate supply model 268, 269 dynamic 283–284, 285 Keynesian revolution 296 macroeconomic equilibrium 280–283 aggregate demand (AD) curve 253, 254, 268 downward sloping 268–270 shifts of versus movements along 270 variables that shift 271, 272, 284, 285 aggregate expenditure (AE) 226–227, 228 components 229–231, 229, 253, 254 consumption and national income 232–234 determining 229–239 macroeconomic equilibrium 227, 239–242, 241, 242 price level 230–231 role of inventories 243 aggregate expenditure function 240, 241 aggregate expenditure model 226 aggregate supply 214 determinants 275–279 long-run see long-run aggregate supply curve model see aggregate demand and aggregate supply model multiplier effect and 368–369, 369 short-run see short-run aggregate supply curve supply-side policies 194, 380 agribusiness 203

allocative efficiency 9 Angola 160 annually reweighted chain volume measures 102 anticipated inflation 211–212 AOT Group 435 Apollo spacecrafts 158 Apple iPad 57, 76 iPhone 6 iPod 44 APRA (Australian Prudential Regulation Authority) 308 areas of rectangle and triangle 27–28, 28 Argentina 146, 148, 443 ASEAN (Association of Southeast Asian Nations) 301 Asian Development Bank 301 Asian financial crisis (1996–97) 130, 444–445 assets 230, 302, 309 asset price bubble 133 assumptions in economic models 10 Atkins diet 43 Australasian currency 322 Australia balance on goods and services (1960–2013) 406 Big Mac index 440 consumption (1986–2013) 230, 232, 233 economic growth 156–159, 156 employment (2014) 177 employment growth (1978–2013) 184 exports and imports as percentage of GDP (1960–2013) 417 GDP 88 government purchases (1960–2013) 237 inflation rate (1970–2014) 204, 319 inflation targeting 346 interest rates, short-term (1985–2013) 334 investment (1960–2013) 235 life expectancy at birth 114 movements in real GDP (1980–2013) 127 net exports (1960–2013) 238 net foreign debt as percentage of GDP 421 net primary income (1960–2013) 407 nominal and real interest rates (1990–2014) 210 pegged exchange rate 458 sale of household goods (2000–13) 225

unemployment categories 189 unemployment rate (1960–2013) 187, 189 Australian Bureau of Statistics (ABS) 419 consumer price index 205–206, 205 GDP 91–98, 94, 97 labour force survey 176–178, 177, 183, 188 Measures of Australia’s Progress 100 real GDP 101–102 youth unemployment rate 195, 196 Australian Chamber of Commerce and Industry (ACCI) 13 Australian Constitution 349 Australian Copyright Council 155 Australian dollar 403, 410–415 exchange rate listings 412 floating 437–438, 438, 449 foreign demand for 410 impacts of current exchange rate 434–435 Stevens’ prediction of fall 426 US dollar versus 415 Australian Fair Pay Commission (AFPC) 191 Australian Industrial Relations Commission (AIRC) 191 Australian Industry Group 13 Australian parliament 370 Australian Securities Exchange (ASX) 120, 447–448 Australian System of National Accounts 92 Australian Treasury 100, 316, 370, 411, 420 Austria 441 authorised deposit-taking institutions (ADIs) 307–308 automatic mechanism 281, 282 automatic stabilisers 360, 375–376 autonomous consumption 240 autonomous expenditure 247–248, 248 The Avengers (movie) 46 average annual economic growth rate 115, 145 average annual percentage changes 147 average weekly earnings 208 awards 191

B baby boomers 62 balance of payments 404 Australia and international economy 404–409 capital account 407, 418 current account 404–407 current account balance equals net foreign investment 417–418

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INDEX financial account 407–408, 418 monetary policy and 449 net foreign investment 418 terminology 409 zero 408–409 balance of trade in goods and services 404, 409 balance on goods and services 404, 405, 406 balance on merchandise trade 404, 405 balance sheets 309–310, 309 balanced budget 122, 377 balanced budget multiplier 398 banana market 348 Bangladesh 163 banks see also central banks balance sheets 309–310, 309 currency traders 410, 412 exchange settlement accounts 334–335 failure in 1920s 250 interest rate independence 345–346, 347 interest rate management 317 money creation by 309–315 overview of operations 120–121 repurchase agreement 317 reserves 309–310, 334–335 T-accounts 310–312 Bank of England 351, 456 Bank of France 456 Bank of Thailand 444, 445 Banking Act 1959 308 bar graph 22, 22 Barro, Robert 296–297 barter economies 302–303 base money 335 behavioural economic models 10 Belgium 214, 378, 379, 441 Bell Laboratories 154 Better Life Index 104 Bhutan 104 Big Mac theory of exchange rates 440 Blu-ray players 74 BMW 33, 48 bonds 120, 213 Botswana, economic growth in 117–118 bracket creep 212 Brambles 434 Brazil 99, 159, 443 Bretton Woods System 436–437, 454, 455–458 Brin, Sergey 143 Britain see United Kingdom British pound versus US dollar 455–456, 455 broad money 308 budget deficit 122, 125, 317, 359, 373–374 cyclically adjusted 375–376, 376 effect on investment 420–422 effect on loanable funds market 125

government budget 374 government debt 373–377 government net debt 375 budget exhaustion 36 budget surplus 122, 125, 373–374 cyclically adjusted 375–376, 376 government budget 374 government debt 373–374 Bundesbank 456–458 Burma 301 business cycle 90, 112 basic definitions in 127–128 characteristics 128 effect on car sales 128–129, 129 effect on inflation rate 129–130, 130 effect on unemployment rate 130–131, 131 peaks and troughs 127–128 shocks and 132–133 stability in Australia 134–135 business fixed investment 95 business-process outsourcing (BPO) 3

C call centres 3 Cambodia 166 Canada 346 Canon Australia 267 capital 42, 116 human see human capital knowledge capital 154–155 Marxist theory 297–298 per hour worked 116, 150–151, 150 as technological change 151 capital account 405, 407, 418 capital controls 457 capital flight 445 capital gain 380 capital gains tax 380 capital inflow 408 capital outflow 407–408 capital stock 116, 275, 278–279, 279 car industry in Australia 110–111 effect of business cycle on sales 128–129, 129 in India 136 moving assembly line 193 sport utility vehicles (SUVs) 43 trade-offs when buying cars 33, 47 carbon tax 164 carbon trading permits 164 cash 316, 334 cash flow 236 cash rate 203, 316–317, 334, 335, 340, 341, 342 cash supply management 316–317, 333–335 catch-up 159 causal relationship 10–11, 319 Central African Republic 160

central banks 305, 309–310, 315, 319–320, 346–347, 454, 456 centrally planned economy 7–8, 143, 152 certificates of deposit 307–308 ceteris paribus (‘all else being equal’) 59 chain volume measures 101–102 changes in business inventories 95 charitable donor fatigue 36 Chile 36, 346 China 214, 317 Big Mac index 440 BMW in 33 communist economy 298 current account surplus 418 economic growth rate 143, 445 exchange rate 414 GDP 88 global financial crisis (2007–08) 133, 273 Google in 143 imports from 435 international students 403 manufacturers leaving 166 movement to mixed economy 8–9 offshoring to 3, 16 overseas travel 435 pegging 445–446 pollution 100 Chinese yuan 446 cigarette currency 303 circular-flow diagram 93–95, 94 classical macroeconomic theory 296–297 closed economy 121, 404 clothing industry 163 Club of Rome 164 Coca-Cola 154–155, 306 cold calling 190 Columbia Pictures 420 commercial loans 308, 310 commodity money 302, 305 Commonwealth Government Securities (CGS) 316–317, 332 communist economies 298 Communist Party of China 143 Communist Party of Soviet Union 152 company income tax 236, 380 comparative advantage 40, 303 competitive markets 68 competitive market equilibrium 68 complements 61, 63 compounding 145–146 Configure to Order (CTO) 244 Congo, Democratic Republic of 159, 160–161 consumer behaviour, assumption of rationality in 4–5, 43 consumer durables 128 consumer loans 308, 310 consumer non-durables 128

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INDEX consumer price index (CPI) 205 biases in 206–207 formula 206 market basket 205–206, 205, 216 measuring inflation with 347–348 consumer sovereignty 8, 58 consumer tastes 61, 63, 441 consumption 95, 97 autonomous 240 determinants 229–231 effect of interest rate increases 337 income, saving and 234 induced 240 macroeconomic equilibrium 241 national income and 232–234 price level changes 253 wealth effect 269 consumption function 231–232, 233 consumption spending 25, 26 consumption tax 126 contraction 90, 127–128, 339–340, 346–347, 374 on 45° line diagram 242–243, 243 contractionary fiscal policy 364, 364, 425 contractionary monetary policy 340–342, 342, 343, 345, 424 contracts 276 convergence 159 copyright 155 Corden, Max 383 correlation 10–11, 319 corruption 160 Costello, Peter 133 cost-of-living index 205 cost–push inflation 214–215, 282 countercyclical fiscal policy 365 cowrie shell money 302 Crazy Clarks 224–225 creative destruction 155 credit 308, 336 credit boom 136 credit cards 308 crime 100 crowding out 125, 371 in long run 372 in short-run 371–372 CSIRO (Commonwealth Scientific and Industrial Research Organisation) 161 currency 306, 308 see also exchange rate; money; specific currency appreciation 317, 345, 411, 412 Australasian 322 depreciation 317–318, 411, 412 overvalued or undervalued 444–446, 456–458 pegged see pegging price level 439 speculation 413, 444, 445, 457, 458 currency appreciation 317, 345, 411, 412 currency depreciation 317–318, 411, 412

currency traders 410, 412 current account 404, 405 in balance of payments 404–407 net exports 404–405 current account balance 405, 409, 417–418 current account deficit 409, 418, 420–422 current deposits 307 cyclical unemployment 186–187 cyclically adjusted budget deficit or surplus 376, 376 Cyclone Larry 348 Cyprus 134, 422

D ∆ (delta) 24 Daewoo Corporation 163 The Dark Knight Rises (movie) 46 Das Kapital (Marx) 297–298 David Jones 225, 435 Dawkins, John 402 debt forgiveness 422, 423–424 default 377 deflation 210–211, 214, 319 Dell 161 demand 58 ceteris paribus condition 59 change in, versus change in quantity demanded 63–64 effect of shifts in, on equilibrium 70–74, 74 for foreign exchange 413, 414 law of 59 in loanable funds market 122–123, 123, 124 market equilibrium 68–70, 69 for money 332–333, 332, 333 variables that shift 60–62, 63 demand curve 22–23, 23, 28, 58, 59 market equilibrium 68–69, 69 for money 332–333, 336, 336 movements along 60, 63–64 shifts in: effect on equilibrium 71–72, 71, 74 shifts in: effect over time 72, 72 shifts in: for money 333 shifts in: graphing 60, 60 shifts in: variables causing 60–62, 63 shifts in: versus movements along 63–64, 70 demand deposits 307 demand schedule 58, 59 demand-deficient unemployment 187 demand–pull inflation 214–215, 282 demographics 61 Deng Xiaoping 143 Denmark 441 Department of Education, Employment and Workplace Relations 195, 402 Department of Intellectual Property 154

467

deposits 310 real world deposit multiplier 315 simple deposit multiplier 312–313 depreciation 92 deregulation of labour market 191–193 Desh Garments Ltd 163 destabilising speculation 444, 445, 457, 458 Deutsche Bank 290 deutsche mark versus US dollar 456–458 devaluation 456 Devarajan, Shantayanan 117 developing countries catch-up with high-income countries 159 debt forgiveness 422, 423–424 economic growth 148, 149 factors hindering growth 159–162 fixed exchange rate systems 443 health in 161 underground economy in 99 Dickens, Charles 124 disability support pension 182–183 discouraged workers 130, 176 discretionary fiscal policy 360 disposable personal income 25, 26, 229, 398–399 dissaving 122, 419 DJ STOXX 50 448 domestic market operations 316–317, 371 double coincidence of wants 302–303 double counting 91 Dow Jones Industrial Average 448 durable goods 95, 128 DVDs (digital video discs) 74 dynamic aggregate demand and aggregate supply model 283–284, 285, 338–339 Phillips curve 391–392, 391 dynamic efficiency 9

E East Asia 443 exchange rate crisis (late 1990s) 130, 444–445 Easterly, William 117, 147–148 Eastern Europe 346 Eberhard Faber Pencil Company 43–44 econometric models 263–264 economics 4 purpose of 4 as social science 11, 12 three key ideas 4–6 economic activity 337–346 economic effect of tax reform 381–382 economic efficiency costs of inflation 211–214 costs of unemployment 184–185 effect of government intervention 9 efficiency wages 192–193 economic growth 37–38, 37, 90 in Australia 156–159, 156

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INDEX benefits 148 global see global economic growth economic growth model 144, 148–149 creative destruction 155 new growth theory 154–155 per-worker production function 150–151, 150 technological change versus capital 151, 152 economic growth rate 102 Australia versus world 237–238 calculating 115 fluctuations in 127 see also business cycle importance of small differences in 145–146 shocks and 132–133 unemployment rate and 187 economic incentives 5 economic models 4 of demand and supply 10, 58 forming and testing hypotheses 10–11 normative versus positive analysis 11 role of assumptions 10 economic stabilisation 134–135, 370–372 economic variables 10–11, 22–26, 23, 25, 26 that shift market demand 60–62, 63 that shift market supply 65–67, 67 The Economist 440 education 99, 155 in developing countries 161 tertiary education sector 402–403 unemployment and 181, 181 efficiency wages 192–193 electronic goods and services computer firms 244 computer sales 78, 286–287 retail sector 267, 286–287, 290, 435 Emerald Grain 420 emergency aid relief 36 employed 176, 177 employment Australia (2014) 177 Australia, growth in (1978–2013) 184 full 188–189 job creation and destruction 183 labour market regulation and deregulation 191–193 endogenous growth theory 154 enterprise bargaining 191–192 entrepreneur 44, 116, 155 entrepreneurial ability 42 role 44, 45 equation of exchange 318–319 equilibrium in foreign exchange market 410–411, 411 equilibrium in money market 335–336 equilibrium price 68, 69–70, 74 equilibrium quantity 68, 74 equilibrium real GDP 396–397

equity 9, 192 Ethiopia 160 euro 412, 437 in exchange rate systems 441–442 survival of 442–443 European Central Bank (ECB) 441–442 European Common Market 441 European Economic Community (EEC) 441 European Union (EU) aid packages 442 bankruptcy 378–379 Big Mac index 440 creation of 441 financial bailouts 133–134, 422 monetary system 346 trade barriers 455 exchange rate 238–239 see also currency aggregate demand and 338 appreciation 414–415 Australia/New Zealand 322 Big Mac theory 440 changes in 271, 272 depreciation 415 devaluation 456 East Asian crisis (late 1990s) 130, 444–445 effect of shifts in demand and supply on 413–414, 414 effect on exports and imports 414–415 fixed 414 fundamental disequilibrium 456 listings 412 long-run determinants 439–441 market see foreign exchange market nominal 410 not determined by market 414 par 455, 456, 457 purchasing power parity 438–439, 440 RBA management 317–318 real 410, 416–417 revaluation 456 exchange rate systems 436 Bretton Woods 436–437, 455–456 current 437–446 euro 441–442 fixed 436–437, 456 floating dollar 437–438, 438 managed float 436, 446 pegging 443–446 exchange settlement accounts 334–335 exchange settlement funds 334 excludable 154 exclusion-based measures 348 expansion 90, 127–128, 281–282 expansionary fiscal policy 363–364, 363, 424–425 expansionary monetary policy 215, 339–340, 343, 424

expectations changes in firms 271, 272, 277–278, 278 of future income 230 of future inflation 393–394, 394 of future prices 62, 63, 66–67, 67 of future profitability 235 household 271, 272 rational 297 of wages 277–278, 278, 279 expenditure 95 exports 94, 96 see also net exports of educational services 402–403 effect of exchange rate movements on 414–415 percentage of GDP, Australia 417 extended labour force underutilisation rate 178 EzyDVD 224–225

F factor markets 42 factors of production 42, 95 Fair Work Australia 11, 290 farm businesses 203 Federal Reserve Bank (US) 133, 437 fiat money 305, 437 final good or service 91 financial account 405, 407–408, 418 financial crowding out 371 financial institutions see also banks exchange settlement accounts 334–335 interest rate independence 345–346, 347 money creation by 309–315 financial intermediaries 120–121, 315 financial markets 120, 447–448 financial securities 120, 316–317 financial system 95, 112, 119 central banks in see central banks international 434–448 see also exchange rate systems macroeconomics of saving and investment 121–122 market for loanable funds 122–125, 123–125 overview 120–121 role in long-run economic growth 119–120 stability in Australia 135 Financial Times Stock Exchange (FTSE) 448 Finland 441 firms see also specific business changes in expectations 271, 272, 277–278, 278 number in market 66, 67 fiscal policy 360 aggregate demand, effect on 271, 281 aggregate demand, influence on 363–364, 363–365

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INDEX automatic stabilisers versus discretionary 360 contractionary 364, 364, 425 countercyclical 365 economic stabilisation 134–135, 370–372 expansionary 363–364, 363, 424–425 government spending and taxes 361–362 in long run 379–382 monetary policy versus 365 in open economy 424–425 parameters 360 Phillips curve as policy menu 392 fiscal stimulus in Australia 122, 358–359 Fisher, Irving 318–319 fixed exchange rate 414, 456 fixed exchange rate system 436–437 see also pegging floating currency 436, 443 focus groups 44 Ford, Henry 44 Ford Motor Company 111, 193 foreign direct investment 162, 163, 405, 408 foreign exchange market 409 equilibrium in 410–411, 411 exchange rates and 410–417 foreign investors 421 foreign portfolio investment 162, 163, 405, 408 formal versus informal sector 99 formulae areas of rectangle and triangle 27–28, 28 macroeconomic equilibrium 263–264 multiplier 249 multiplier effect 396–400 percentage change 27 summary for using 29 Fort Knox Bullion Depository 437 France 214, 441 global financial crisis (2007–08) 378, 379 invasion of Ruhr 320 life expectancy at birth 114 free market 42 gains from 42–43 free ride 154 Freebairn, John 383 frictional unemployment 187–188, 190–191 Friedman, Milton 296, 392 full employment 188–189 full-employment rate of unemployment 188–189 full-time employment 183, 184 fundamental disequilibrium in exchange rate 456

G G8 423–424 Garnett, Doug and Margaret 203

Gartner 78 Gates, Bill 57 GATT (General Agreement on Tariffs and Trade) 455 GDP deflator 102–103, 103, 204–205, 347–348 gender labour force participation rate 179–180, 180 unemployment rate 185 General Agreement on Tariffs and Trade (GATT) 455 General Motors 244 General Motors Holden (GMH) 110–111 General Theory of Employment, Interest, and Money (Keynes) 226, 296 Germany Bretton Woods System 456–458 global financial crisis (2007–08) 214, 378, 379 hyperinflation after World War I 212–213, 320, 457 reliance on exports 273 Treaty of Rome 441 Gillard Labor government immigration policy 13 global digital music trade 46 global economic growth from BC to present 144–145, 145 criticisms of 162–164 economic catch-up 159–162 global economic groups 148, 149 over time 144 rule of law and 160, 160 global financial crisis (2007–08) 13, 111, 112, 132, 133, 224–225 bankruptcy in Europe 378–379, 378, 379 budget deficit 317 deflation as result of 214 effect on aggregate demand 338–339 effect on economic growth 119–120 effect on electronic sales 267 effect on German exports 273 effect on public debt 133–134 effect on unemployment rate 131, 131, 186, 189 effect on United States cash rate 341 effect on United States: recession 372–373 fiscal stimulus in Australia 122, 358–359 market for loanable funds 252–253 RBA and interest rates 203, 329, 340 reasons for 133, 135 recession 128 survival of euro 442–443 globalisation 162 in Bangladesh 163 benefits 162–164, 163 of financial markets 447–448 gold 301

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gold standard 436, 443, 454 goods and services balance of trade in 404–405 durable and non-durable goods 95 economic questions of production 6–7 final and intermediate 91 government provision 8 increasing importance of services 134 Goods and Services Tax (GST) introduction 128–129, 204, 210, 330 transfer of receipts 316 Google in China 143 illegal downloads 46 government bonds 320 government budget as automatic stabiliser 375–376 balanced 122, 377 bankruptcy in Europe 378–379, 378, 379 costs of unemployment 185 deficits, surpluses and debt 373–377 government debt 359, 377 government expenditure 361–362 by function 362 government purchases versus 361 overview of 361–362 as percentage of GDP 361 government intervention early guild systems 42–43 effect on efficiency 9 income distribution 7 in market economies 8 government policy accumulation of knowledge capital 154–155 conduct of monetary policy 331 control of Reserve Bank 349 fiscal see fiscal policy immigration 12–13 minimum wage laws 11 government purchases 5, 8, 96, 97, 236, 237, 361–362 1922–1929 250 aggregate demand and 272 government expenditure versus 361 macroeconomic equilibrium 241 multiplier effect of increase 367, 371 multiplier formula 397 tax multipliers and 365–369 government revenue by source 362 government role in market system 45–47, 116 government spending private spending versus 371 and taxes 361–362, 361, 362 graphs 21–22, 35 bar 22, 22 demand curve 60 macroeconomic equilibrium 239–242

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INDEX market equilibrium 69 pie chart 22, 22 positive and negative relationships 25, 26 predicting changes in prices and quantities 70–74, 74 production possibility frontier 34–35 supply curve 65 time-series 22, 23 of variables: one 22 of variables: two 22–23, 23 of variables: more than two 24–25, 25 Great Depression (1930s) 8, 131, 132, 135, 226, 250, 296, 436, 443, 454 Greece 133–134, 378, 378, 379, 422, 441, 442 gross domestic product (GDP) 91 see also national income components 95–96, 97 costs of unemployment 184 equation 97 measuring total production 91–96 measuring using three methods 93–95, 94 measuring using value-added 91–92, 92 potential see potential GDP real see real gross domestic product shortcomings as measure of total production 97–98 shortcomings as measure of wellbeing 98–100, 104, 105 gross domestic product (GDP) deflator 102–103, 103, 204–205, 347–348 gross national income (GNI) 92, 419 gross private domestic investment see investment growth rate see economic growth rate

H Haitian earthquake (2010) 36 Harvey Norman 358–359, 435 headline rate of inflation 347–348 health 99, 161 Heavily Indebted Poor Countries Initiative (HIPC) 423–424 high-income countries catch-up by developing countries 159 economic growth 148, 149 Hitler, Adolf 320 HIV epidemic in Africa 117, 161 Hobbes, Thomas 144 Hong Kong 214 household expectations 271, 272 household production 97–98 household wealth 230 housing affordability 329 housing bubbles 443 housing investment 95 housing market 75–76, 329 human capital 116, 149–150, 161, 184 Human Development Index (HDI) 101, 104

Human Development Report 101 Hungary: hyperinflation after World War II 212 hurricane Sandy 36 hyperinflation 212, 457 in Germany after World War I 212–213, 320 in Hungary after World War II 212 quantity theory of money 319–320 in Zimbabwe 306 hypothesis 10–11 hysteresis 133 Hyundai 443

I I, Pencil (Read) 43–44 Iceland 134, 378, 379 IDC 78 identity 419 iiNet 46 IMF see International Monetary Fund immigration 457 visas 13 government policy 12–13 impact lag 340 imports 95, 96 from China 435 effect of exchange rate movements on 414–415 percentage of GDP, Australia 417 income 60–61, 63, 308 consumption, saving and 234 costs of unemployment 185 disposable 25, 26, 229, 398–399 expected future income 230 living standards versus 147–148 income differentials 8 income distribution 7, 98, 211 income effect 60, 337 income taxes 236, 380 increasing returns 154 index numbers 206 India 317 car industry 136 GDP 88 imports from 435 international students 403 life expectancy at birth 114 offshoring to 3, 16 technological change 161 underground economy in 99 indigenous Australian unemployment rate 185 Indonesia 88–89, 445 induced consumption 240 induced expenditure 247–248, 248 Industrial Relations Act 1993 191 industrial relations system 191–193 Industrial Revolution 144, 145, 146 inferior good 61 inflation 204 see also hyperinflation

anticipated 211–212 causes of 214–215, 284, 285 cost–push 214–215, 282 deflation 210–211, 214 demand–pull 214–215, 282 economic costs of 211–214 effect on interest rates 209–211 expectations of future inflation 393–394, 394 government policy on see monetary policy measuring 204–208 price indexes, using to adjust for effects of 208 quantity theory explanation 296, 318–319 unanticipated 212 unemployment, inverse relationship with 391 unemployment, short-run trade-offs with 390–394 worker understanding of 394 inflation rate 90, 204 Australia (1970–2014) 204 Australia (1990–2013) 348 Australia (1993–2014) 330, 331 benefits of moderate level of 216 effect of business cycle on 129–130, 130 effect on bond holders 213 formula 206 underlying 340, 347–348 unemployment rate and 188–189 inflation targeting 330–331, 331 arguments for and against 346–347 by Reserve Bank 316, 340–342 information 120–121 information and communication technologies (ICT) 158, 287–288 infrastructure 377, 383 Infrastructure Australia (IA) 383 inputs 65–66, 67 intellectual property rights 46–47 interest rates aggregate expenditure and 231 Australia (1990–2014) 210 cash rate 316–317 compounding 145–146 effect on aggregate demand 337–338 effect on house prices 329 investment and 236 management of see monetary policy movements in 123–125, 124 negative 216 nominal 123, 209–211 price level changes 253 real 123, 209–211 short-term 334, 335 interest rate targeting 317, 333–335, 335 interest-rate effect 269, 272 intermediate good or service 91 international capital markets 447–448

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INDEX international debt relief 422, 423–424 International Development Association (IDA) 423–424 international economy 404–409 International Federation of the Phonographic Industry (IFPI) 46 international financial system 434–448 International Monetary Fund (IMF) 133–134, 378, 422, 423–424, 442, 444–446, 455 international sector 417–420 international students 402–403 international-trade effect 270 the Internet: illegal downloads 46 Internet Service Providers (ISPs) 46 Intilecta Apps 322 inventory 227–228 aggregate expenditure and 243 control over 244 investment 95, 97 determinants 235–236 in developing countries 161–162 effect of budget deficit on 420–422 effect of interest rates on 337–338 interest-rate effect 269 macroeconomic equilibrium 241 macroeconomics of 121–122 movements in 123–125, 124 national saving and 417–420 planned 234–235, 235 planned versus actual 227 investment tax incentives 236 invisible hand of market 43, 44 Ireland 133–134, 214, 378–379, 378, 379, 422, 441 global financial crisis (2007–08) 442 housing bubble 443 Italy 134, 146, 378, 379, 441, 442

J James Hardie 434 Japan 166, 214, 418, 420, 440, 455 Japanese yen 410–415 JB Hi-Fi 290 job creation 183 job destruction 183 job search 187–188, 190 Job Services Australia 190 Jobs, Steve 44, 57 just-in-time system 150

K Kelly, Ross 287 Kenny, Charles 147–148 Keynes, John Maynard 226, 239, 252, 296 Keynesian cross 239 Keynesian revolution 296 Khrushchev, Nikita 152 Kleenmaid 224–225 Kleins 224–225 knowledge capital 154–155

Korean won 443 Kuznets, Simon 104 Kydland, Finn 297

L labour force 42, 176 labour force participation rate 177–178 see also unemployment rate increases in labour force 278–279, 279 labour force survey 176–178, 177, 183, 188 measuring 176–183, 184 trends in 179–180, 180 labour market regulation and deregulation 191–193 labour productivity 116, 149–150, 156–159, 156, 287 labour theory of value 297–298 law, rule of 45–47 law of demand 59 law of diminishing returns 151 law of supply 64–65 legal basis of market system 45–47 legal tender 305 leisure, value of 98–99 Lewis, Professor Phil 13, 195, 287 liabilities 230, 309 life expectancy at birth 114, 148 Limits to Growth (Club of Rome) 164 liquidity 120, 304, 335 liquidity management 316–317 liquidity trap 341 living standards 112–115 income versus 147–148 loanable funds see market for loanable funds London Stock Exchange 448 Long Boom 132, 157 long-run aggregate supply (LRAS) curve 275, 275 effect of monetary policy 338–339, 342 shifts in 275 variables that shift 278–279, 284, 285 long-run determinants of exchange rate 439–441 long-run economic growth 113 Australian federation to present 112–113, 113 calculating 115 determinants 115–116, 148–150 financial system role in 119–120 fluctuations in see business cycle global see global economic growth living standards and 112–115 short-run fluctuations 131 long-run effects of tax policy 380 long-run fiscal policy 379–382 long-run macroeconomic equilibrium 280–283, 280 long-run money supply 319 long-run Phillips curve 392–393, 393 long-term real interest rate 336

471

long-term unemployed 180–181, 181 loose monetary policy 339 Lucas, Robert 161, 296–297 Luddites 287 Luxembourg 441

M M1 307, 332 M3 307–308, 319, 335 macroeconomics 13–14, 90 in an open economy 402–426 of saving and investment 121–122 schools of thought 296–298 macroeconomic equilibrium 227 adjustments to 227–228 algebra of 263–264 graphing 239–242, 241 in long run and short run 280–283 numerical example 244–245, 245 macroeconomic policies 228 Madagascar 159 malaria 161 Malaysia 159, 214, 403, 418, 445 managed float exchange rate system 436, 446 Mao Tse Tung 143 margin, optimal decisions at 5–6 marginal analysis 6 marginal benefit (MB) 5–6 marginal cost (MC) 5–6 marginal opportunity costs 35–37, 37 marginal propensity to consume (MPC) 231–232, 233, 248, 251 marginal propensity to import (MPI) 399–400 marginal propensity to save (MPS) 234 marginal tax rate 380 marginally attached to labour force 176, 177 market 4, 42 market demand 58 market economy 7–8, 153 market equilibrium 68 demand and supply 68–70, 69 effect of demand and supply shifts 70–74, 74 market for loanable funds 112, 122, 336 demand and supply in 122–123, 123 effect of budget deficit on 125, 125 global financial crisis (2007–08) 252–253 movements in saving, investment and interest rates 123–125, 124 market income 89 market regulation 157–158 market supply 64–65 market supply curve 64–65, 65 market system 42 elimination of surpluses and shortages 68–69 gains from free markets 42

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INDEX government enforcement of contracts and property rights 47 government protection of private property 45–47, 116 market mechanism 43 market value 91–92 Marx, Karl 297–298 Measures of Australia’s Progress (MAP) 100 medium of exchange 303–305 menu costs 212, 277 merchandise exports 22, 22 Merkel, Angela 273 Mexico 346 microeconomics 13–14, 90, 194 Microsoft 161 tablet computers 57 Windows 8 78 Windows operating system 46–47 Midas 224–225 Mill, John Stuart 297 Millenium Development Goals 104, 423 Minebea Co Ltd 166 minimum wage laws 11, 192 mining sector 13 mixed economy 8–9 model 10 monetarism 296 monetarist economic model 296 monetary growth rule 296 monetary policy 316, 330, 424 see also Reserve Bank of Australia balance of payments and 449 contractionary 340–342, 342, 343, 345, 424 economic activity and 337–346 effect on aggregate demand 271, 281 effect on real GDP and price level 338–339 effectiveness 344–346 expansionary 215, 339–340, 343, 424 fairness 345 fiscal policy versus 365 goals 330–331 inflation measurement 347–348 inflation targeting 316, 330–331, 331, 340–342 inflation targeting arguments 346–347 interest rate targeting 317, 333–335, 335 monetary targeting 335–336, 336 in open economy 424 Phillips curve as policy menu 392 real and nominal interest rates 336 share market response to 345 to stabilise economy 134–135 Statement on the Conduct of Monetary Policy (2013) 331 time lags 340, 344 monetary targeting 335–336, 336 monetary union 322

money 302 see also currency; money supply barter and invention 302–303 broad 308 creation by financial institutions 309–315 credit 308 demand for 332–333, 332, 333 forms 304–305, 437 functions 303–304 income and wealth versus 308 quantity theory of 318–320 velocity of 318–319 money base 335 money market equilibrium 335–336 money supply 311, 315, 318–319 measures 306–308, 307 money supply (MS) curve 335 national income versus 308 mortgage loans 212 mortgage-backed securities 341 Mozambique 161 multifactor productivity (MFP) 159 Multilateral Debt Relief Initiative (MDRI) 423–424 multiplier 247, 249 in open economy 399–400 real world deposit 315 simple deposit 312–313, 315 multiplier effect 246, 247–249, 247, 251, 366 aggregate demand and 366 aggregate supply and 368–369, 369 directions of 369 of increase in government purchases 367, 371 simple economic model of 396–400 Myer 224

N NAIRU (non-accelerating inflation rate of unemployment) 188–189 NASA 158 National Health and Medical Research Council 155 national income see also gross domestic product (GDP) accounting for 92, 121 money supply versus 308 relationship between consumption and 232–234 National Institute of Economic and Industry Research 3 natural rate of unemployment 188–189, 393, 2421 natural resources 42, 278–279, 279 Nazism 320 neo-Quantity Theory of Money model 296 net capital flows 408 net debt 374, 375 net domestic product (NDP) 92

net errors and omissions 408 net exports 93, 96, 97, 236–237 current account 404–405 determinants 237–239 effect of interest rates on 338 international-trade effect 270 macroeconomic equilibrium 241 price level changes 253 net foreign debt 421–422, 421 net foreign equity liability 421–422, 421 net foreign investment (NFI) 408 current account balance equals 417–418 domestic saving, domestic investment and 418–420 net foreign liability 421–422, 421 net overseas migration 12–13 net primary income 404, 405–406, 405, 407 net secondary income 404, 405 net services 404, 405 net taxes 121, 232 net worth 309 the Netherlands 441 new classical macroeconomics 296–297 new economy 158 new growth theory 154–155 new Keynesians 296 new product bias 207 New South Wales Rum Corps 302 New Zealand 322, 346, 440 newly industrialising countries: economic growth 148, 149 Newstart Allowance: full-employment rate of unemployment 185 Niger 159 Nikkei 225 448 Nixon, Richard 458 nominal exchange rate 410 nominal GDP 101, 102–103, 103 versus real GDP 101–102 nominal interest rate 123, 209–211, 210, 231 short-term 336, 337 nominal variable 208 nominal wage 208 non-accelerating inflation rate of unemployment (NAIRU) 188–189 non-bank depository corporations 308 non-bank financial intermediaries (NBFIs) 120–121 non-durable goods 95, 128 non-excludable 154 non-market income 89 non-observed economy 97–98 non-rival 154 normal good 61 normative analysis 11 North, Douglass 146 not in labour force 176, 177 Note Printing Australia 315–316

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O official reserve transactions 409 offshoring 10, 14 case for 15–16 to the Philippines 3 top 25 destinations 16 oil price rises 132–133, 157, 186, 189, 287 Oliver, Damian 195 OPEC (Organization of the Petroleum Exporting Countries) 132–133, 157, 186, 189, 287 open economy 121, 399–400, 404 fiscal policy in 424–425 macroeconomics in 402–426 monetary policy in 424 open market operations (OMOs) 316–317, 333 opportunity cost 7, 35, 40 increasing marginal 35–37, 37 of job search 190–191 Organisation for Economic Cooperation and Development (OECD) 104 outlet bias 207 outsourcing 3 overvalued currency 444–446, 456–458

P Pack, Howard 117 Pactics 166 Page, Larry 143 par exchange rate 455, 456, 457 paradox of thrift 252–253 part-time employment 183, 184 patent 154 pegging 444 Chinese experience 445–446 crawling peg 458 decline in 445 East Asian exchange rate crisis (late 1990s) 130, 444–445 against US dollar 443, 444–445, 444, 445 percentage change 27 personal consumption expenditure 95 personal income tax 380 Peru 99 per-worker production function 150–151, 150 effect of technological change on 151, 152 Pharmaceutical Benefits Scheme (PBS) 5 pharmacy graduates 72–73 Phelps, Edmund 392 the Philippines 3, 16, 445 Phillips curve 390, 390 dynamic aggregate demand and aggregate supply model 391–392, 391 expectations of future inflation 393–394, 394 long run 392–393, 393

as policy menu 392 stability in short-run 392 Phnom Penh Special Economic Zone 166 physical capital 116, 150 pie chart 22 policy channels 424 pollution 100 population 61, 62, 63 Portugal 134, 378, 379, 379, 422, 441, 442 positive analysis 11 potential GDP 118 growth in 118–119, 119 macroeconomic equilibrium 242–243, 243, 281–283, 281, 283, 284, 285 poverty 89, 148, 162, 185 Poverty Reduction Strategy Paper (PRSP) 424 practical price stability 216 Prescott, Edward 297 price of inputs 65–66, 67 plotting on graph 23 of related goods 61 of substitutes in production 66 price floors in labour markets 11 price indexes 208 price level 102–103, 103, 129, 204 in aggregate expenditure 230–231, 253, 254 Australia versus world 237 changes in 253, 254, 269–270, 276–278, 278, 279 changes in, predicting 70–74, 74 of currencies 439 demand for money 332–333, 333 effect of monetary policy 338–339 equation of exchange 318–319 increase in see inflation macroeconomic equilibrium 280–283 real wage and 394 price mechanism 43 price stability 330 Prices and Incomes Accord (1983–1996) 186, 189 price–wage spiral 214 private property protection 45–47 private saving 121, 418–420 private spending 371 producer durables 128 producer price index (PPI) 207–208 products introduced by entrepreneurs 45 product markets 42 production factors 42 substitutes in 66, 67 production possibility frontier 34 economic growth 37–38, 37 graphing 34–35, 35 increasing marginal opportunity costs 35–37, 37 productive efficiency 9

473

productivity 66, 67, 279 Australia (1861–2012) 156–157, 156 Australia (since 1940) 156, 157 Australia, (slowdown, 1970s and 1980s) 157–158 Australia, (1990s to present) 158–159 Australia, multifactor productivity 159 exchange rates and 440–441 Productivity Commission 158, 322 property rights 45–47, 116, 160 public debt 133–134 public saving 121–122, 418–420 purchasing power 60, 102 purchasing power parity 438–439, 440

Q Qantas Airways 435 Quader, Noorul 163 quality bias 207 quantitative easing 213, 341, 351 quantity plotting on graph 23 predicting changes in 70–74, 74 quantity demanded 58, 63–64 quantity supplied 64, 67–68, 68 quantity theory of money 318 equation of exchange 318–319 explanation of inflation 296, 318–319 high rates of inflation 319–320 quota 439, 441

R Random House Australia 227 rational expectations 297 real business cycle model 297 real exchange rate 410, 416–417 real gross domestic product (RGDP) 27, 101, 269 Australia (1960–2013) 119 calculating 101–102 cyclically adjusted budget deficit or surplus 376, 376 demand and see aggregate demand effect of monetary policy 338–339 expenditures and see aggregate expenditure exports and imports 417 fluctuations in see business cycle GDP deflator 102–103, 103 growth in see economic growth rate macroeconomic equilibrium 280–283 net foreign debt as percentage 421 versus nominal GDP 101–102 per capita 113–114, 113 per hour worked 150–151, 150 real interest rate 123, 209–211, 210, 231, 371 long-term 336, 337 real variable 208 real wage 208, 394 real world deposit multiplier 315

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INDEX Real-Time Gross Settlement (RTGS) 334 recession 90, 127–128, 359, 372–373, 374 see also global financial crisis (2007–08) on 45° line diagram 242–243, 243 1982–83 129–131, 130, 131 1990–91 129–131, 130, 131, 133 macroeconomic equilibrium and 280–281 monetary policy 339–340, 345, 346–347 shocks and 132–133 recognition lag 340 regulation 157–158 of labour market 191–193 Reichsbank 320 Reinhart, Carmen 372–373 reparations 320 Republic of Korea (South Korea) 159, 163, 317, 346, 403, 445 repurchase agreement 317, 333, 334 research and development 155 reserves 309–310, 334–335 reserve assets 405, 408 Reserve Bank Act 1959 330 Reserve Bank Information and Transfer System (RITS) 334 Reserve Bank of Australia 122, 203, 228, 305 Board 316, 333, 339, 340, 347, 349 cash rate 203, 316–317, 334, 335, 340, 342 cash supply management 316–317, 333–335 contractions and 339–340 credit 308, 336 exchange rate management 317–318 gold reserves 437 Governor 349 independence 349 inflation measurement 347–348 liquidity management 316–317 measures of money supply 307, 308 monetary policy see monetary policy open market operations 316–317 recessions and 339–340 reserve assets 405, 408 reserves 309–310, 334–335 response to GFC 203, 329 roles of 315–318 short-run trade-offs 390–394 resource crowding out 371–372 resources 4 retail sector 224–225 retained earnings 119 retraining costs 184 revaluation 456 reverse purchase agreements 335 revolution and wars 160–161 Ricardo, David 297 Rinehart, Gina 308

risk 120 rival 154 robots 33 Rogoff, Kenneth 372–373 Romer, Paul 154, 161 Royal Australian Mint 316 rule of law 45–47, 159–160, 160 rule of 70 115

S safety net 192 Samsung Galaxy Tab 57, 76 Sargent, Thomas 296–297 Sarkozy, Nicolas 100–101 Saudi Arabia 418 saving consumption, income and 234 in developing countries 161–162 macroeconomics of 121–122 movements in 123–125, 124 national saving and investment 417–420 saving and investment equation 419 scarcity 4, 6–9, 34 Schumpeter, Jospeh 155 Schwartz, Anna 296 scientific method 11 Scrooge, Ebenezer 124 seasonal unemployment 188 seasonally adjusted unemployment rate 188 securities 120 Sen, Amartya 100–101 services see goods and services share market 345 shareholders’ equity 309 shares 120 shocks see supply shocks shortage 69, 69 short-run aggregate supply (SRAS) curve 268, 269 changes in price level 276–277 effect of monetary policy 338–339, 342 shifts in, versus movements along 277 variables that shift 277–279, 278, 279, 284, 285 short-run crowding out 371–372 short-run macroeconomic equilibrium 280–283 short-term interest rates 334, 335 short-term nominal interest rate 336 simple deposit multiplier 312–313, 315 Singapore 117, 256, 418, 440 Sloan, Alfred 244 slope of line 24–25, 24 of non-linear curves 25, 26, 27 of tangent line 27 smartphone sales 78 SMEs (small and medium-sized enterprises) 273 Smith, Adam 42–43, 297

Smoot–Hawley Tariff 454 social costs of unemployment 185 social science 11, 12 Social Security System 8, 182–183, 185, 190–191 Society of Indian Automobile Manufacturers (SIAM) 136 sole parent benefit 182–183 sole proprietorships 380 Solow, Robert 154 Sony 420 South Africa 117, 346 South Korea (Republic of Korea) 159, 163 sovereign debt 442 Soviet Union 7–8, 116 communist economy 298 economic failure 152 Spain 134, 214, 441 in the Americas 318 EU bailout 422 global financial crisis (2007–08) 378, 379, 442 housing bubble 443 specialisation and gains from trade 38–39, 39 speculation, destabilising 444, 445, 457, 458 speculative attacks 445 speculators 413, 457 stagflation 282 Standard and Poor’s 500 448 standard of deferred payment 304 standard of living see living standards Stevens, Glenn 426 sticky prices 276, 277 sticky wages 276 Stiglitz, Joseph 100–101 Stiglitz Report 101 store of value 304 structural adjustment 186 structural relationship 392 structural unemployment 188, 190–191 sub-prime mortgages 133 substitutes 61, 63 in production 66, 67 substitution bias 206–207 substitution effect 59, 337 Sumitomo Corporation 420 superannuation 162 supply 64 change in, versus change in quantity supplied 67–68 effect of shifts in, on equilibrium 70–74, 71, 74 of foreign exchange 413–414, 414 law of 64–65 in loanable funds market 122–123, 123 market equilibrium 68–70, 69 variables that shift 65–67, 67 supply curve 58, 64 market equilibrium 68–69, 69

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INDEX for money 336, 336 shifts in: effect on equilibrium 70–74, 71, 74 shifts in: effect over time 72, 72 shifts in: graphing 65 shifts in: variables causing 65–67, 67 shifts in: versus movements along 67–68, 68, 70 supply schedule 64, 65 supply shocks 278 effect on economic growth rate 132–133 macroeconomic equilibrium and 282–283, 283 oil price rises 186, 189, 287 sources 214–215 supply-side policies 194, 380, 381, 382 surplus 68, 69 Sweden 346, 441 Switzerland 214

T tablet computers 57, 78 T-accounts 310–312 TAFE (Technical and Further Education) 155 Tanzania 117 tariff 158, 439, 441, 455 tariff wars (1930s) 454 tastes 61, 63, 441 tax(es) aggregate demand and 272 on bonds 213 bracket creep 212 on capital gains 380 income taxes 236, 380 investment and 236 long-run effects of policy 380 tax rates 368 tax rates and multiplier 398–399 tax reform 381–382, 381 tax simplification 380–381 tax multipliers effect of changes in tax rates 398–399 formula 397–398 government purchases and 365–369 tax wedge 380 technical recession 128 technological change 38, 66, 149 as cause of unemployment 287–288 in developing countries 161 economic growth and 116 effects in general 151 effect on per-worker production function 151, 152 effect on supply 66, 67, 279 sources 149–150 term deposits 308 tertiary education sector 402–403 Thai baht versus US dollar 443, 444–445, 444, 445 Thailand 214 theory 10

Tiffany & Co 166 tight monetary policy 340 time lags 340 time-series graph 22, 23 total employment 183, 184 total expenditure 93–95, 94 total income 93–95, 94 total production 91–96, 94, 97–98 see also gross domestic product total revenue (TR) 28 tourism sector 434–435 Toy Kingdom 224–225 Toyoda, Sakichi 44 Toyota Motor Corporation 150 trade 34, 38 absolute advantage versus comparative advantage 39–40 comparative advantage and gains from 40 specialisation and gains from 38–39, 39 trade barriers 455 trade deficit 404 trade protection 158 trade secret 154–155 trade surplus 404 trade unions 192 trade-off 6–7 efficiency versus equity 9 emergency aid relief 36 minimum wage laws 11 production possibility frontier 34–38 short-run, between unemployment and inflation 390–394 trade-weighted index (TWI) 437, 438 transfer payments 95, 134, 185, 229 trimmed-mean measure 348 tsunami (2004) 36 twin deficits 420

U unanticipated inflation 212 underground economy 98 underlying rate of inflation 340, 347–348 undervalued currency 444–446, 456–458 unemployed 176, 177 unemployment Australian categories 189 costs 184–185 cyclical 186–187 distribution 185, 186 duration 180–181, 181, 182 frictional 187–188, 190–191 full-employment rate 188–189 inverse relationship with inflation 391 job creation and destruction 183 labour market regulation and deregulation 191–193 seasonal 188 short-run trade-offs with inflation 390–394 structural 188, 190–191

475

technological change as cause of 287–288 types 186–189 Unemployment and Sickness Benefits Act (C’wlth) 134 unemployment benefits 134, 182–183, 185, 190–191 unemployment rate 90, 176, 250 Australia (1960–2013) 187, 189 effect of business cycle on 130–131, 131, 186 hysteresis in 133 inflation and 188–189 labour force survey 176–178, 177, 183, 188 measuring 176–183, 184 measuring, problems with 178 natural 188–189 youth 195, 196 zero 189 Union of Myanmar 301 unit of account 304, 441 unit trusts 120 United Kingdom 346 Big Mac index 440 EU 441 global financial crisis (2007–08) 378, 379 Glorious Revolution (1688) 146 gold standard 454 life expectancy at birth 114 origins of Industrial Revolution in 146 United Nations see also World Bank Human Development Index 101, 104 Human Development Report 101 Millenium Development Goals 104, 423 United Nations Development Program (UNDP) 104 United States Big Mac index 440 Bretton Woods System 436–437 cash rate 341 global financial crisis (2007–08) 133, 214, 372–373, 378, 379 gold standard 454 Great Depression (1930s) 135, 250 inflation targeting 346 life expectancy at birth 114 sugar quota 439 tariff wars (1930s) 454 unemployment insurance 190–191 University of Chicago 296–297 US dollar 415, 434–435 British pound versus 455–456, 455 Chinese yuan versus 446 deutsche mark versus 456–458 pegging against 443 reserves 455 Thai baht versus 443, 444–445, 444, 445

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V value, store of 304 value added 91–92, 92 value of leisure 98–99 vault cash 309 VCRs (video cassette recorders) 74 velocity of money 318–319 Venezuela 159 Vietnam 403 volatile items 348 Volkswagen 456 voluntary exchange 9

W wages adjustments to 276–277 calculating real average weekly earnings 208–209 efficiency 192–193

inflation rate and 216, 217 minimum wage laws 11, 192 sticky 276 trade union bargaining 192 worker expectations 277–278, 278, 279 Walsh, Lucas 195 wars and revolution 160–161 wealth 230, 308 wealth effect 269 Wealth of Nations, An Inquiry into the Nature and Causes of (Smith) 42–43 Weimar Republic 320 welfare system 8, 182–183, 185, 190–191 Wellbeing Framework 100 wellbeing measures 98–101, 104, 105 Wesfarmers 213 Wilhelm II, Kaiser 320 Woolworths Ltd 175

WorkChoices 191 worker understanding of inflation 394 Workplace Relations Act 1996 191 World Bank 89, 147–148, 160, 423 World Trade Organization (WTO) 455 World War I: hyperinflation in Germany 212–213, 320, 457 World War II: prisoner of war camps 303

Y Young, Alwyn 117 youth unemployment rate 195, 196 Yugoslavia 212

Z zero balance of payments 408–409 zero unemployment rate 189 Zimbabwe 99, 212, 306

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