Macroeconomics ECF1200

The role of the reserve bank of Australia

A financial system includes 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; prevent financial disturbances and crises that could threaten the smooth flow of funds. - Stability of Australia's financial system, and to manage and implement monetary policy. How the RBA manages financial liquidity and interest rates: [Overview of RBA decisions] ▪ RBA determines the monetary policy. [If IR's are to be changed, they are announced to the public] ▪ For the majority of the time, involvement in the financial system revolves around altering daily liquidity in the financial system to keep IR' unchanged - Every day there is a large volume of withdrawals from and injections into the financial system leaving banks with a shortage or a surplus of funds at the end of the day [shortage = funds purchased overnight in the short-term money market, increasing demand for overnight cash funds] According to the law of demand, this pushes up the price of overnight funds, which is the IR that financial institutions charge on loans or pay to borrow funds in the overnight money market, known as the cash rate The cash rate is the rate upon which all other interest rates are based. Without RBA intervention, daily changes in liquidity would cause IR's to fluctuate wildly and frequently

Aggregate expenditure model and macroeconomic equilibrium

Aggregate expenditure model can help us to begin to understand the relationships between the interaction of economic variables. Aggregate expenditure model: focuses on the short-run relationship between total spending and real GDP. Critical point: the model assumes a constant price level (in Ch. 10 we relax the assumption of constant prices). The key idea of the AE model is that, in any particular year, the level of GDP is determined mainly by the level of AE To understand the relationship between AE and real GDP, we need to look more closely at the components of AE. Consumption (C): Spending by households on G&S's, such as groceries, cars and restaurant meals. Planned investment (I): Planned spending by firms on capital goods, such as factories, office buildings and machinery, and by households on new dwellings. = Actual investment will equal planned investment only when there is no unplanned change in inventories. (Goods that have been produced but not yet sold) Government purchases (G): Spending by federal, state and local governments on G&S's, such as roads, bridges and the salaries of employees, such as teachers and nurses. Net exports (NX): Spending by foreign firms and households on G&S's produced in Australia minus spending by Australian firms and households on G&S's produced in other countries. AE= C + I (PLANNED INVESTMENT) +G +NX

The FX market and exchange rates

An Australia owned firm price's its products in AUD and pay suppliers, workers, interest to bond holders and dividends to shareholders in AUD. 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 The nominal exchange rate (Nom. XR): is the value of one country's currency in terms of another country's currency → How many units of a foreign currency you can purchase with one Australian dollar Currency traders, rather than exchanging paper currency, they buy and sell deposits in banks. A bank buying or selling AUD will actually be buying or selling Australian dollar bank deposits! → E.g., Crédit Agricole bank in France wishes to sell AUD and buy JPY. → It may exchange Australian dollar deposits that it owns for Japanese yen deposits owned by the Deutsche Bank in Germany The market exchange rate is the price of an Australian dollar for anyone wishing to buy it with their own currency. - The XR is therefore determined by the interaction of demand and supply, just as other prices are. There are three sources of demand for the AUD: 1. Foreign firms and consumers who want to buy goods and services produced in Australia. 2. Foreign firms and consumers who want to invest in Australia either through foreign direct investment [buying shares and bond, or building facilities in Australia- or through foreign portfolio investment. 3. Currency traders who believe that the value of the dollar in the future will be greater than its value today. There are three sources of supply of the AUD: 1. Australian firms and consumers who want to buy goods and services produced overseas. 2. Australian firms and consumers who want to invest overseas either through foreign direct investment → buying or building factories or other facilities overseas—or through foreign portfolio investment → buying shares and bonds issued by other countries. 3. Currency traders who believe that the value of the dollar in the future will be less than its value today.

Shifts in the money demand curve

Changes in variables other than the IR's cause the MD curve to shift. ▪ The two most important variables that cause the money demand curve to shift are: 1. Real GDP: → increase in real GDP means that the amount of buying and selling of G&S's 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 IR → An increase in real GDP (shift of MD to the right); and viceversa. 2. The price level: → A higher price level increases the quantity of money required for a given amount of buying and selling. E.g., In the 1960s, for a new car could be purchased for $2000 and a wage of just under $60 per week was the average. → An increase in the price level (shift of MD to the right); and vice-versa.

Contractionary fiscal policy

Contractionary FP: Decreases in government purchases or increases in taxes in order to reduce the increases in AD. A decrease in government purchases or an increase in taxes will reduce the rate of increase in AD, to reduce the price level, therefore helping fight inflation because the AD is increasing too fast [equilibrium beyond potential GDP] The RBA uses contractionary MP to slow the rate of increase of AD to less than it would have increased without policy. The use of MP by the RBA to increase IR's to reduce inflation. 1. The RBA increases the cash rate. 2. This increase typically flows through to increases in IR's through the entire economy as banks pass the higher cost to customers. 3. Higher IR's may reduce new investment growth, decrease net exports, and may reduce the growth rate of consumer spending. 4. The slower growth in AD may reduce the inflation rate. ▪ The economy begins in Eq. at point A, with real GDP=$930 billion and a price level= 100. During the year, the SRAS, LRAS and AD curves move to the right. ▪ Without monetary policy, AD will shift from AD1 to AD2 AD2(without policy) to a short-run Eq. that is greater than potential GDP of $1000 billion at LRAS2 ▪ The economy will be in short-run Eq. 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 IRs, AD 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 Eq. at point C with real GDP=$1000 billion, which is at its full-employment level at LRAS2, and at a price level=103. ▪ The price level is lower than it would have been if the RBA had not used contractionary monetary policy.

Is government debt a problem

During an economic contraction or a recession, automatic stabilisers and expansionary fiscal policy will lead to a budget deficit and therefore government debt Furthermore, if a government is embarking on major infrastructure projects to promote increased economic growth in the future, borrowing may be required. [High debt could lead to raising taxes to high levels or cut back on other types of spending to make the interest payments on the debt] Also note, 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 2017 when government net debt was almost $326 billion, net interest repayments on the debt were around $12.6 billion per year, or 0.7% 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 private sector investment spending means a lower capital stock in the long run and a reduced capacity of the economy to produce goods and services and employ people - 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! Remember: improvements in infrastructure, a better educated labour force and additional research and development can add to the productive capacity of the economy.

Four major categories of expenditures

Economists use these categories to understand why GDP fluctuates and to forecast future GDP. CONSUMPTION (Or personal consumption expenditures): → Expenditures on services, such as medical care, education and haircuts → Expenditures on non-durable goods, such as food and clothing (things don't really last that long) → Expenditures on durable goods, such as cars and furniture INVESTMENT (Or gross domestic investment) → 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 and firms on new housing → Changes in business inventories are changes in the stocks of goods that have been produced but not yet sold - can affect GDP GOVERNMENT PURCHASES (Or government consumption) → Spending by federal, state and local governments on goods and services, such as education, roads and submarines NET EXPORTS → The expenditure on exports (G&S's produced in Australia) minus the expenditure on imports (G&S's produced in foreign countries and purchased by Australian).

Macroeconomic equilibrium

Equilibrium occurs when the aggregate expenditure equals total production (or GDP). [But this equilibrium doesn't hold all the time] This is why actual investment and planned investment play a large role in macroeconomic equilibrium. - Only when AE = 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. AE= GDP, Inventories are unchanged and the economy is in macroeconomic equilibrium AE< GDP, inventories rise, GDP and employment decrease AE> GDP, inventories fall and GDP and employment increase

Expansionary fiscal policy

Expansionary FP: Increases in government purchases or decreases in taxes in order to increase AD. ▪ An increase in government purchases will increase AD directly because government purchases are a component of AD ▪ A cut in taxes has an indirect effect on AD. If the personal income tax rate is cut, household disposable income will rise and so should consumption spending. *The goal of expansionary fiscal policy is to increase AD by more than it would have increased without policy.* - I.e., to shift the AD curve further to the right than it would have shifted without policy. - It is appropriate when the economy is in equilibrium below full-employment (during an economic contraction or recession). Economic contraction or recession: use expansionary policy, actions of the government include increasing government spending or cut taxes. As a result the real GDP and the price level rise by more than they would without the policy.

Factors that shift the LRAS

FACTORS THAT SHIFT THE LRAS: 1. An increase in resources → i.e., such as migrant workers or new mineral discoveries, in the economy 2. Machinery and equipment → An increase in the quantity of machinery and equipment used in production 3. New technology → New advances in technology or more productive ways of using resources Thus, each year the LRAS curve shifts to the right as the number and/or quality of workers in the economy increases, more machinery and equipment are accumulated and technological change occurs.

Effects of fiscal policy in the long run: supply side policies

FP actions are intended to meet short-run goals of stabilising the economy. ▪ Other FP 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 affect AS rather than AD , and are referred to as supply-side policies! → 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 FP actions that attempt to increase AS do so by changing taxes to increase the incentives to work, save, invest and start a business.

Demand and supply of money

How the RBA manages the supply of cash Recall: the RBA uses OMOs to controls the volume of cash levels by using repurchase agreements (very liquid and widely used by the RBA) ▪ But, we need to examine how the RBA changes the overnight cash volumes and affects IRs. 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: - Exchange settlement accounts (ESAs): 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 go through these accounts - It is important that occur during the day—in real time. This is known as Real-Time Gross Settlement (RTGS) - This system enables banks and financial institutions to access their ESAs during the day and overnight. - These accounts must always be in credit, and money in these accounts is called exchange settlement funds, or cash

Crowding out in the short run

If the government increases its spending without increasing taxation—as it would do 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.* 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. → Furthermore, paying off government debt in the future will require higher taxes in the future, which can depress economic growth ▪ 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 (usually occurs when the economy is close to full capacity). → 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.

Movements in the AD curve

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. AD= C+I+G+ NX (if consumption decreases then then AD will consequently decrease, therefore AD will shift to the left) Shifts in the AD curve: (non price determinants) 1. Changes in government policies ▪ An increase in G shifts the AD curve to the right, and a decrease in G shifts the AD curve to the left, ceteris paribus. ▪ An increase in individual income taxes reduces the amount of after-tax income available to households. Higher individual income taxes reduce consumption spending and shift the AD curve to the left. Lower individual income taxes shift the AD curve to the right. ▪ An increase in company income taxes reduces the profitability of investment spending and shifts the AD curve to the left. A decrease in company income taxes shifts the AD curve to the right. 2. Changes in the expectations of households and firms ▪ Optimism (pessimism) about future incomes could increase (decrease) consumption. 3. Changes in foreign variables ▪ Exchange rates: A rise in the XR (say between AUD-US becoming parity) lowers the dollar amount received by Australian producers, thus reducing their export revenue ▪ Relative income levels between countries: 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

New growth theory: Determinants for how fast economies grow

In recent years, economists believe productivity growth does not explain long-run growth in real GDP per capita! The new growth theory is meant to provide a better explanation of the sources of productivity change and 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. However, because knowledge capital is non-rival and non-excludable, firms can free ride and benefit on the research and development of other firms, therefore 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. Government policy can help increase the accumulation of knowledge capital in three ways: 1. Protecting intellectual property with patents and copyrights. This gives firms the incentive to engage in research and development by giving firms exclusive rights for a period of time. → Patent: The exclusive legal right to produce a product for a period of time from the date the product was invented. → 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. 2. Subsidising research and development Government provides subsidies for R&D to increase the quantity of R&D, or tax benefits to firms that invest in R&D. 3. Subsidising education IF the government subsidises education it can increase the number of workers with technical training to carry out research and development.

What determines long run economic growth?

Increases in real GDP per capita depends on increases in labour productivity. Labour productivity: the quantity of goods and services that can be produced by one worker or by one hour of work. If the quantity of goods and services consumed increased, the quantity of goods and services produced per hour of work must also increase. If increases in labour productivity are the key to long-run economic growth, what causes labour productivity to increase? 1. Increases in capital per hour worked through: → Physical capital: Manufactured goods that are used to produce other goods and services; (i.e., computers, factory buildings and machines). → Human capital: The accumulated knowledge and skills that workers acquire from education and training or life experiences. 2. Technological change: → Technological change is an increase in the quantity of output firms can produce using a given quantity of inputs. (maximises value) Entrepreneurs are critical for implementing technological change, because economic growth is dependent on technological change. → E.g., an accountant using Microsoft Excel is more productive than an accountant who uses only pen and paper. 3. Property rights: An additional requirement for economic growth is that government must provide secure rights to private property. A market system cannot function unless rights to private property are secure.

Cost-push inflation

Inflation can be categorised as 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 AS of G&S's. A negative supply shock occurs when there is an increase in the costs of production not resulting from an increase in AD, which include: - Increases in import prices - Increases in wages - Increases in indirect taxation - Increases in monopoly power in product markets - Natural disasters (i.e., droughts, floods and earthquakes). Any of these factors will lead to a rise in the price level, accompanied by a fall in real GDP and a rise in unemployment. Inflation that results from a negative supply shock will be a temporary phenomenon if the shock is a one-off event. Cost-push inflation can continue indefinitely only if it is 'accommodated' by continuing expansion in financial liquidity in the economy.

Variables that determine the four components of AE: Planned investment

Investment is subject to more fluctuations than is consumption The four most important variables that determine the level of investment are: 1. 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 2. The interest rate → Business investment is financed by borrowing, which takes the form of firms issuing corporate bonds or borrowing from banks or other financial institutions. → A higher IR results in less investment spending, since business investment is financed by borrowing. 3. Taxes → Lower corporate income taxes encourage investment spending. A higher company tax decreases after-tax profitability of investment spending. 4. Cash flow → Many firms do not borrow to finance spending on new factories, machinery and equipment. Instead, they use their own funds → The more profit, the greater the cash flow and the greater the ability to finance investment.

Balance of payment (BOP)

Is a record of a country's international trade, borrowing, lending, capital and investment flows with other countries (interactions with other economies) BOP contains three 'accounts': the current account, the capital account and the financial account. 1. 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 (NPI)—income received by Australian residents from investments [profits and dividends and interest repayments] in other countries minus income paid to overseas residents from investments in Australia. Net secondary income (NSI)—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. 2. The capital account: part of the BOP that records: - Migrants' asset transfers (i.e., assets people take with them when they leave or enter a country) - Debt forgiveness (i.e., overseas debt relief) - Sales and purchases of non-produced, non-financial assets (i.e., copyrights, patents, trademarks and franchises) 3. 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. - 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 in Australia. Note: the word 'capital' here applies not just to physical assets, but also to financial assets Remember: - 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 outflow or just → Net foreign investment Net foreign investment = difference between capital outflows from a country and capital inflows (also equal to net foreign direct investment plus net foreign portfolio investment).

Measuring money

Money can be defined very narrowly or very broadly. This has become increasingly difficult with all of the innovations in the financial market. Money, today, is much more than currency. ▪ Currency: Notes and coins held by the private non-bank sector (i.e., individuals and firms). It is the narrowest measure of money ▪ M1: The narrowest definition of the money supply which is comprised of currency plus the value of all demand deposits (or current deposits) with banks. - They are called demand deposits because they are available on demand, and are repayable on demand in notes and coins. Broader definitions of money include other assets that can be converted to money fairly quickly. ▪ M3: M1, plus all other deposits of the private non-bank sector (individuals and firms) with domestic and foreign-owned banks operating in Australia. - M3 also includes certificates of deposit, term deposits and deposits with banks from building societies, credit unions and other authorised deposit-taking institutions (ADIs). ▪ Broad Money: comprises M3, plus deposits with non-bank deposit-taking institutions minus holdings of currency and deposits of non-bank depository corporations - Non-bank depository corporations include finance companies, money market corporations and cash management trusts

Variables that determine the four components of AE

Net exports equals the value of exports minus the value of imports (X - M) - We can calculate NX by taking the value of spending by foreign firms and households on G&S's produced in Australia and subtracting the value of spending by Australian firms and households on G&S's produced in other countries. The three most important variables that determine the level of net exports: 1. The price level in Australia relative to the price levels in other countries → If inflation in Australia is lower than in other countries, demand for Australian G&S's increases. So Australian exports increase and Australian imports decrease, which increases net exports. → Reverse will happen if inflation in Australia is higher than in other countries. 2. The economic growth rate in Australia relative to the economic growth rates in other countries → When incomes rise faster in Australia than in other countries, Australian purchases of foreign G&S's increase faster than foreign purchases of Australian G&S's → As a result, net exports fall. → When incomes in other countries rise, Australia's net exports rise (note: Australia is a large exporter of primary commodities) and demand for these is closely related to world economic growth. 3. The exchange rate between the Australian dollar and other currencies → An increase in the value of the AUD will reduce export income and increase imports, so net exports will fall. → A decrease in the value of the AUD will increase export income and reduce imports, so net exports will rise.

The role of the reserve bank of Australia: Open market operations

Open market operations (OMOs) ▪ 'The majority of RBA intervention in financial markets is carried out to offset daily liquidity changes to keep interest rates at the same level' ▪ The RBA sterilises, or offsets, the daily deficits or surpluses in liquidity in the financial system through the use of OMOs ▪ OMOs Involve the RBA purchasing or selling financial instruments such as Commonwealth Government Securities (CGS) and private bonds and securities, either by outright purchase or sale, or by the use of repurchase agreements - A repurchase agreement: 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 Thus, repurchase agreements change the available liquidity by temporarily transferring ownership of securities between banks and the RBA in exchange for same-day cash ▪ If the RBA wishes to increase or decrease IRs, it has to change liquidity levels actively in addition to its daily interventions. For example: - If the Board announced that IRs will be rising by 0.25% banks and other financial institutions know that the RBA will operate OMOs to reduce liquidity levels in - The RBA will sell financial instruments, reducing liquidity levels in the financial system because financial institutions pay the RBA for the instruments the finance - 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 To reduce IRs, 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 IRs

Movements along the SRAS curve

Over the short run, as the price level increases, the quantity of G&S's firms are willing to supply will increase. - As prices of final G&S's rise, prices of inputs—such as the wages of workers or the price of natural resources—rise more slowly. - As the price level rises or falls, some firms are slow to adjust their prices. 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. Three most common explanations for an upward-sloping SRAS curve in the short run; positively related to GDP. 1. Contracts make some wages and prices 'sticky' →Fixed contracts can make wages or prices sticky (i.e., prices or wages are said to be 'sticky' when they do not respond quickly to changes in demand or supply). 2. Firms are often slow to adjust wages →Wages of many workers remain fixed by contract for one year or even several years. 3. Menu costs make some prices sticky →Firms base their prices today partly on what they expect future prices to be. →However, firms may not be willing to increase prices because of menu costs (i.e., costs to firms of changing prices)

RBA changing the 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, therefore they avoid this by making repurchase agreements with the banks. It lends them cash, at an IR 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. [This increases the bank's reserves, which banks loan out most of these reserves, which creates new demand deposits and expands the money supply] Reducing the cash rate: [RBA makes a public announcement] The RBA would either: 1. Not sterilise a surplus of overnight funds, or 2. Offer 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. Increasing the cash rate: The RBA would either: 1. Not sterilise an overnight shortage, or 2. Use reverse re-purchase agreements or carry out the outright sale of bonds. When the RBA receives payment for the bonds, this reduces cash reserves held by financial institutions and the rate of interest will rise

Reasons for a downward sloping AD curve

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 AD 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 in the price level on the other components: C, I and NX. [Which create the AD altogether] These lead to movements along the AD curve 1. The wealth effect: how a change in the price level affects consumption As income rises, consumption will rise, and as income falls, consumption will fall. But consumption also depends on household wealth: difference between the value of its assets and the value of its debts 2. 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 they withdraw savings from banks, borrowing from banks or selling financial assets. - As a result, actions this drives up IR charged on bank loans, raising the cost of borrowing for firms and households, therefore they will borrow less. ▪ Consumption of durable goods also declines (i.e., cars, furniture) ▪ Thus, a lower price level decreases the IR and increases investment spending and—to a lesser extent— consumption. (less investment means less output, such as less investment in employment, then reduced levels of GDP) 3. The international-trade effect: how a change in the price level affects net exports ▪ 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 with those produced for the domestic market, and foreign imports will become relatively less expensive. ▪ 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 ▪ Thus, Australian imports will rise and export earnings will fall, causing net exports to fall.

Accuracy of the CPI

The CPI give us a way of adjusting for the effects of inflation so that we can compare dollar values from different years. Biases that cause changes in the CPI to overstate the true inflation rate: 1. Substitution bias ABS assumes consumers purchase same amount of each products each month. 2. Increase in quality bias Over time, products improve in quality (e.g., PC's become faster, dishwashers use less water). Increase in prices partly reflect improved quality and partly are pure inflation. 3. New product bias ABS updates the basket of goods used in calculating CPI approx. every six years. So new products introduced in between the updates are not included. 4. Outlet bias ABS collects price data from traditional full-price retail stores. (Not internationally and purchases online, however this is not changing)

The role of the reserve bank of Australia: Exchange rate movement

The RBA is also responsible for exchange rate management. ▪ The value of the Australian dollar (AUD) relative to other currencies (the exchange rate) is usually determined by international market forces ▪ Occasionally, the RBA intervenes in the market determination of the value of the AUD 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 AUD relative to other currencies (currency appreciation), it could purchase AUDs in foreign currency markets to increase the demand for AUD. → Here, the RBA is reducing its stock of foreign reserves as it uses them to buy dollars - If the RBA wanted to decrease the value of the AUD relative to other currencies (currency depreciation), it could increase the supply of dollars on foreign currency markets by selling AUDs → Here, the RBA is increasing its stock of foreign reserves as it accepts foreign currency in exchange for the sale of AUDs ▪ The RBA also manages Australia's foreign currency and bonds, and is the custodian of Australia's gold reserves

The business cycle

The business cycle refers to alternating periods of economic expansion and economic contraction relative to the long-term trend rate of economic growth. Here are the 3 different periods of the cycle; 1. The expansion phase—production, employment and ▪ income are increasing above trend growth - The end of an expansion is typically associated with rising interest rates and rising wages, and profits begin to fall. - Inflation rate usually increases. 2. The business cycle peak; inflation will be high, prices will be higher, RBA decreases consumption and investment to control for the economy overheating. [One peak higher than the previous peak allows for economic activity to rise over time= which means the economy is stable] 3. The contraction phase—production, employment and income are falling below trend growth. - A contraction often begins with decreased spending by firms on capital goods, and/or decreased spending by households on new houses and consumer durables - Inflation rate usually decreases A recession- production; known as when employment and income are decreasing and the rate of economic growth is negative. The business cycle trough: The bottom of a recession, followed by another period of expansion. Recession: Defined as 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 After the recession is over, the rate of unemployment continues to rise after a recession is over because: - Discourages workers re-enter the labour force - Firms continue to operate below capacity after the recession is over and may not re-hire workers for some time.

Monetary policy

The conduct of Monetary Policy (MP) to control for inflation which reduce the economic fluctuations due to the business cycle. ▪ Recall, the primary goal of the RBA is to: - Keep the inflation rate low, and more broadly, - To operate MP to reduce economic fluctuations due to the business cycle or economic shocks. ▪ The RBA pursues MP largely independently of the federal government ▪ Monetary policy (MP): The actions taken by the RBA to manage IRs in the pursuit of macroeconomic objectives. The goals of MP: 1. Full employment of the labour force 2. Stability of the Australian currency 3. Economic prosperity and welfare for the people of Australia ▪ RBA has focused MP primarily on achieving the stability of the currency; that is, on controlling inflation ▪ Using MP with the aim of achieving a publicly announced rate of inflation is called inflation targeting. ▪ MP in Australia aims to keep the rate of inflation between 2-3% per year, on average. On average, the inflation rate has been kept to between 2-3% since the RBA began inflation targeting in 1993. To understand how the RBA uses MP to change IRs and ultimately affect the inflation rate, we need to examine the demand for money

What can serve as money?

The next logical question is this: what can serve as money? That is, which assets should be used as the medium of exchange? The 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 meets these criteria! Commodity money: meets the criteria for a medium of exchange, but has the problem that its value depends on its quality. - E.g., gold is a medium of exchange but its value depends on its purity. - Another problem is new discoveries of gold reserves. - Its also inefficient to rely on gold for money supply (think about transporting it and how do you settle transactions?) Fiat money: Money, such as paper currency, that is authorised by a central bank (RBA) or government. - Its is legal tender in a country - Households and firms have confidence that if they accept dollars in exchange for G&S, the dollar will not lose much value during the time they hold them!

The 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. When analysing economic growth, we look at increases in real 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 proportion of the population working ... ▪ L = labour ▪ K = capital ▪ Real GDP per hour = Y/L ▪ Capital per hour worked = K/L

How do shifts in demand and supply curves affect the exchange rate

The three main factors cause the demand and supply curves in the FX market to shift are: 1. Changes in the overseas demand for Australian-produced G&S's and changes in Australian demand for foreign-produced G&S's . 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.

Expansionary MP

The use of MP by the RBA to decrease IRs to increase real GDP. 1. The RBA decreases the cash rate 2. Lower IR's may encourage investment, increase net exports, and may increase consumer spending. 3. Real GDP and the price level will rise. We use the dynamic AD-AS model to illustrate expansionary monetary policy ▪ Economy begins in Eq. at point A (real GDP=$1000 billion and price level=100). ▪ Without MP, AD will shift from AD1 to AD2 (without policy), which is not enough to keep the economy at full employment. LRAS has shifted from LRAS1 to LRAS2 ▪ The economy will be in short-run Eq. at point B, where AD2(without policy) intersects SRAS2, with real GDP of $1075 billion and a price level of 102. ▪ By lowering IRs , the RBA can increase investment, consumption and net exports sufficiently to shift AD 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.

Crowding out

The use of increases in government purchases to increase AD presents another potential problem! ▪ The size of the multiplier effect may be limited if the increase in government purchases causes one or more of the nongovernment, 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.

Autonomous consumption

This is because a certain amount of consumption occurs that is independent of income, which is called autonomous consumption (e.g., there still would be spending on necessities

What determines how fast economies grow?

To explain changes in economic growth over time within countries, and differences in growth rates between countries, we need to developed an economic growth model (EGM)! [Explains changes in real GDP per capita in the long run] The EGM will focus on two factors which determine labour productivity. 1. The quantity of capital per hour worked 2. The level of technology There are three main sources of technological change: 1. Better machinery and equipment: i.e., such as machines and softwares, increases in labour productivity, they ultimately increase human productivity. 2. Increases in human capital: i.e., increasing human capital through on-the-job training, experience and more education, will increases their productivity 3. Better means of organising and managing production.

The money demand curve

To understand how the RBA uses MP to change IRs and ultimately affect the inflation rate, we need to examine the demand for money The Money Demand (MD) curve is downward sloping to show the inverse relationship between the IR on financial assets and the quantity of money demanded. The IR on financial assets is the opportunity cost of holding money. - Low IR's reduce the opportunity cost of holding money. - High IR's increase the opportunity cost of holding money. ▪ The MD curve slopes downward because lower IRs cause households and firms to switch from financial assets like Australian Government bonds to money. ▪ All other things being equal, a fall in the IR from 5% to 4% will increase the quantity of money demanded from $250 billion to $300 billion. ▪ An increase in the IR will decrease the quantity of money demanded

Linking Australia to the international economy

Today, consumers, firms and investors in Australia routinely interact with consumers, firms and investors in other economies, such as a consumer in Singapore may eat beef produced in Australia. Nearly all economies are open! An Open economy is an economy that has interactions in trade or finance with other economies Balance of payments; understanding interactions between one economy and other economies.

Government purchases

Total government purchases include all spending by federal, state and local governments on G&S's. I.e., purchases of consumption as well as investment goods such as infrastructure development (roads and railways). Government purchases do not include transfer payments, such as social security payments or pension payments because the government does not receive a good or service in return.

Types of unemployment

Unemployment rate links with the business cycle ▪ Rises during economic contractions/recessions ▪ Falls during economic expansions and booms. ▪ The fall in the unemployment rate following the end of a recession often lags behind the economic recovery The five types of unemployment 1. Cyclical unemployment: Unemployment caused by a business cycle contraction. ('Demand deficient' unemployment) However, When the economy begins to recover, the unemployment rate usually continues to rise for some time because of discouraged workers Notice, though, that the unemployment rate never falls to zero. To understand why this is true we need to discuss: ▪ Frictional unemployment ▪ Structural unemployment. 2. Frictional unemployment and job search: Short-term unemployment arising from the process of matching workers with jobs. [Such as university graduates looking for their first job and people who have lost or quit their job and are looking for their new job] Some frictional unemployment [There will always be frictional unemployment] is good for the economy though, it means that workers and employers are taking the time necessary to match worker attributes with job characteristics 3. Seasonal unemployment: Unemployment due to factors such as weather, variations in tourism and other calendar-related events (i.e., Xmas) 4. Structural unemployment: Unemployment arising from a persistent mismatch between the skills and characteristics of workers and the requirements of jobs. (This can be due to new technology and changes in consumer tastes) ▪ Structural unemployment can last for longer periods because workers need time to learn new skills and some may never acquire these. 5. Full employment ▪ As the economy moves through the expansion phase of the business cycle, cyclical unemployment will eventually drop to close to zero (Never at zero because of frictional and structural unemployment). ▪ Natural rate of unemployment: the sum of frictional and structural unemployment. Occurs when the economy is operating at potential GDP; there is no cyclical unemployment.

What is money and the functions

What is money? 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, firm or government The functions of money Anything used as money must serve four key functions in the economy: 1. It must act as a Medium of exchange: sellers are willing to accept it in exchange for G&S. 2. It must serve as a Unit of account: each good has a single price quoted in terms of the medium of exchange (i.e., each good has a price in terms of dollars) 3. It must serve as a Store of value: if you do note use all your accumulated dollars to buy G&S today, you can hold the rest to use in the future (However, high rates of inflation can lead to money losing its value quite quickly). This has led to many people in countries that have experienced very high rates of inflation to hold gold as a store of value. So why do we even need to hold money then? → because it is the most liquid asset. 4. It must offer a Standard of deferred payment: it facilitates exchange over time by providing a store of value and a standard of deferred payment.

Why poorer counties have not experienced economic growth.

Why are many low income countries growing slowly? 1. Failure to enforce the rule of law ▪ Property rights: The legal 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 2. Wars and revolutions 3. Poor public education and health ▪ Many low-income countries have weak public school systems, so many workers are unable to read and write. ▪ People who are sick work less, and are less productive when they do work. 4. Slow technological development ▪ 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 ▪ In the high-income countries, government policies can aid the growth of technology by subsidising research and development 5. Low rates of saving and investment ▪ Tax incentives can lead to increased savings (i.e., superannuation) ▪ Investment tax credits (i.e., Governments increase incentives for firms to engage in investment in physical capital)

Nominal and real interest rates

[This is important when money is being lent] The interest rate is the cost of borrowing funds, expressed as a percentage of the amount borrowed To calculate your true return from lending, we need to take into account the effects of inflation! Nominal IRs (NIR): The stated IR on a loan (i.e., cost od borrowing or interest received Real IRs (RIR): the nominal interest adjusted for the effect of inflation , therefore it is a better measure of true cost of borrowing and the true return on lending than foes the NIR. Real interest rate RIR = nominal interest rate NIR − inflation rate(INF) Note, it is impossible to know if the NIR is 'high' or 'low'. It all depends on the inflation rate!

The philips curve

→ when AD increases, unemployment will usually fall and inflation will rise → When AD decreases, unemployment will usually rise and inflation will fall ▪ As a result, when AD changes, there is a short-run trade-off between unemployment and inflation! ▪ Thus, higher unemployment is usually accompanied by lower inflation, and lower unemployment is usually accompanied by higher inflation ▪ As a result, when AD changes, there is a short-run trade-off between unemployment and inflation! ▪ Thus, higher unemployment is usually accompanied by lower inflation, and lower unemployment 6.2 Explaining the Philips curve with AD-AS model ▪ Recall, LRAS (and SRAS) shifts (due to increases in the stock of machinery and technological change) to the right. ▪ AD also shifts by the same amount, thus economy remains in equilibrium (at potential GDP). ▪ However, slow growth in AD leads to both higher unemployment and lower inflation ▪ This relationship explains why there is a short-run trade-off between unemployment and inflation (i.e., downwardsloping Phillips curve).

Should the RBA target inflation?

▪ Arguments in favour of inflation targeting: 1. In the long run there is no impact of monetary policy on potential GDP. 2. Having an explicit inflation target makes it easier for firms and households to form expectations of future inflation, thereby improving planning and efficiency. 3. MP is less subject to a change in emphasis, particularly when members of the Reserve Bank Board change. 4. An inflation target provides a measure of the RBA's performance. ▪ Arguments against inflation targeting: 1. The ability of the RBA to directly pursue its other goals is limited. 2. An inflation target policy assumes that the RBA can accurately forecast future inflation rates, which it does not always do. 3. Making the RBA only accountable for inflation targeting may make it less accountable for its other policy goals, such as low unemployment, economic growth or exchange rate management. SHOULD THE RBA TARGET INFLATION 7.2 Is independence of the RBA a good idea ▪ The case for RBA independence 1. Avoids inflationary spending by the government of the day, which may sell bonds to the central bank to finance excessive spending 2. Avoids the use of MP to further other political goals. E.g., lowering IRs before an election. ▪ The case against RBA independence 1. The ability of the RBA to directly pursue its other goals is limited. 2. An inflation target policy assumes that the RBA can accurately forecast future inflation rates, which it does not always do. 3. Making the RBA only accountable for inflation targeting may make it less accountable for its other policy goals, such as low unemployment, economic growth or exchange rate management.

Government purchases and tax multipliers

▪ 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 = Change in equilibrium real GDP/ Change in government purchases.

Government purchases and tax multipliers: Multiplier effect. IMPORTANT

▪ Multiplier effect: The process by which an increase in autonomous expenditure leads to a larger increase in real GDP. . For example: → The gov. decides to use discretionary FP to increase AD by spending an additional $10 billion to construct new rail systems in several states. → Assuming that the construction materials are produced locally, we know that the answer is greater than $10 billion because the initial increase in AD will lead to additional increases in income and spending. → To build the railways, the gov. 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 groceries, 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 rise, thereby increasing consumption spending and hence AD. ▪ Economists refer to the initial increase in gov. purchases as autonomous because it was the result of a decision by the gov., and does not directly depend on the level of real GDP!

Tax multiplier

▪ 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

Global trends in economic growth over time

▪ The Industrial Revolution made possible the sustained increases in real GDP per capita that have enabled some countries to attain high standards of living Without the industrial revolution, back in the years 1300, there was essentially 0% world economic growth. People living in economies with low or no economic growth suffer from starvation and disease, and lack basic facilities across healthcare and education. This economic growth is essential over time because an economy that grows too slowly fails to raise living standards.

How to counteract (large) fluctuations

▪ The increasing importance of services and the declining importance of goods ▪ The establishment of unemployment benefits and other government transfer programs that provide funds to the unemployed. ▪ Active federal government and central bank policies to stabilise the economy. ▪ The stability of the financial system in Australia and active financial regulation.

Problems with measuring the unemployment rate

▪ The number of discouraged workers increases during a recession; therefore the official unemployment rate appears lower than it would otherwise be; understatement of true degree of unemployment. ▪ People who claim to be unemployed but are not, can lead to the unemployment rate being overstated; overstatement of the true degree of unemployment.

Multiplier effect

▪ 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.

Is the monetary policy always effective and fair?

▪ Time lags may reduce the ability of MP to impact on the economy at the appropriate time. → Over the past two decades the RBA has largely been successful in anticipating inflation and understanding the lags. ▪ As banks and financial institutions are not required to pass on cash rate changes, the effectiveness of MP can be reduced. → Banks in Australia have not always passed on to customers the full amount of an interest rate reduction. ▪ MP is more effective at reducing the rate of inflation during an economic boom than it is at stimulating AD during a contraction or recession. → Businesses will be unwilling to borrow if the economic outlook is not good. → Banks may also be reluctant to make loans, as occurred in some countries following the 2007-2008 GFC. ▪ MP is a and does not affect all people or industries equally. ▪ With contractionary monetary policy: → Savers can benefit and increase their spending. →Borrowers (individuals and businesses) face higher interest repayments on loans →Low income earners are often 'marginal' borrowers, and may be at a higher risk of loan defaults With expansionary monetary policy borrowers benefit more than savers.

Nominal GDP

(Price and/ or Output) The market value of final G&S evaluated at current year prices. Nominal GDP can change over time due to changes in price and/or output, whereas Real GDP shows changes in output only.

What is the fiscal policy

What is fiscal policy (FP) ▪ Fiscal Policy (FP): [Actions from the federal governments such as cutting taxes] Changes in federal taxes and purchases that are intended to achieve macroeconomic policy objectives (i.e., employment, price stability and economic growth)

Potential GDP

Potential GDP is the level of real GDP attained when all firms are producing at normal capacity (Ideal level of GDP), where potential GDP can increase over time as there is greater labour force, new machinery adn technological change. - If all firms in the economy were operating at normal capacity, the level of total production of final G&S's would equal potential GDP A firm's capacity is measured by its production of final goods and services when operating on normal hours, using a normal workforce. Because of the business cycle or economic shocks, actual real GDP has sometimes been greater than potential GDP and sometimes less.

The producer price index

The producer price index (PPI): An average of the prices received by producers of goods and services at all stages of the production process. Like the CPI, the PPI tracks the prices of a 'market basket' of goods. The PPI includes the prices of intermediate goods (i.e., flour, cotton, steel and timber, raw materials such as raw wool, coal and crude oil). Changes in intermediate goods and hence PPI give an early warning sign of future movements in the CPI.

Using fiscal policy to influence the AD

The use of fiscal policy to stabilise the economy - Changes in government purchases and taxes lead to changes in AD, and thus affect the level of real GDP, employment and the price level. o I.e., when the economy is experiencing an economic contraction or recession, increases in government purchases or decreases in taxes will increase AD

Automatic stabilisers versus discretionary fiscal policy

▪ Automatic stabilisers: Changes in spending and taxes that happen without actions by the government - E.g., 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. ▪ Discretionary fiscal policy: the government takes actions to change spending or taxes - E.g., during the GFC, government spending was aimed at stimulating aggregate demand during an economic contraction

Causes in shifts in the demand for foreign exchange

1. Changes in income levels and economic growth rates in Australia and in other countries Consider first how the three factors above will affect the demand for AUD in exchange for JPY: i. 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 ii. Also, the demand for Japanese goods by Japanese consumers will rise, creating extra demand for Australian minerals and energy as production inputs iii. Thus, at any given exchange rate, the demand for AUD will increase and the demand curve for dollars will shift to the right. Changes in relative interest rates between countries A if IRs in Australia rise, and are higher relative to IRs 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 2. Speculators Speculators buy and sell foreign exchange in an attempt to profit from changes in exchange rates E.g., If the current XR 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. In sum: the demand curve for dollars shifts to the right when: (1) incomes rise in other countries that buy goods and services from Australia (2) interest rates in Australia rise relative to interest rates in other countries (3) speculators decide that the value of the dollar will rise relative to the value of other currencies.

Ways to measure GDP

1. The production method: → The sum of the value of all G&S produced by industries in the economy in a year minus the cost of G & S used in the production process. 2. The expenditure method: → The sum of the total expenditure on G&S 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 in the production of G&S, which includes profits, wages and other employee payments, income from rent and interest earned. We can measure GDP through calculating total value of expenditures on final G&S's or by calculating the value of total income.

Problems that cause inflation

1. Distribution of income ▪ Some people will find their incomes rising faster than the rate of inflation and so their purchasing power will rise. ▪ Others may find their incomes rising more slowly than the rate of inflation (or not at all) so their purchasing power will fall- more likely to happen. ▪ The extent of redistribution depends, in part, on the degree to which inflation is: → Anticipated: where consumers, workers, firms and governments can accurately predict it and can prepare for it → Unanticipated: where they do not fully predict it and do not prepare for it. 2. Anticipated inflation If inflation is anticipated, then business will compensate wages for the effect of inflation since they anticipate that the price of their product they sell will go up by 1.5% - Similarly, lenders (of loans) will also make the adjustment by changing the NIR However, individuals will still experience a cost: - There will be a redistribution of income, and anyone holding paper money will find its purchasing power decreasing each year by the rate of inflation - Firms will need to change the cost of their product ("Menus costs"). - There is an increase in taxed paid by hose holding income-generating assets such as bonds, shares and deposits, which raises the cost of capital for business investment. o These effects arise because asset holders are taxed on the nominal payments they receive, rather than on the real payments. - Anticipated inflation can lead to a higher proportion of personal income being paid in taxation. 3. Unanticipated inflation ▪ There are winners and losers, depending on whether inflation is higher or lower than anticipated. For example: - Those on fixed incomes will lose if inflation is higher than anticipated. - Borrowers on fixed-term contracts may gain and lenders may lose when inflation is higher than anticipated. - People on fixed-payment contracts will lose if inflation is higher than anticipated.

The benefits of globalisation

A developing country could participate in 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. =give a low-income country access to funds and technology. ▪ From the 1940s to the 1970s, many developing countries sealed themselves off from the global economy. 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! Refers to the interaction and integration between businesses, governments and people of different countries as they become open to foreign investment and international trade. [Developing countries that were more globalised grew faster than countries that were less globalisation, because globalisation benefits developing countries through making it easier for them to get investment funds and technology]

Labour market regulation and deregulation: Efficiency wages

A higher-than-market wage paid by a firm to increase worker productivity. Studies have shown that workers are motivated to work harder if they receive higher wages. 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 But efficiency wages increase the labour supply, so may increase unemployment.

Nominal interest rate vs Real interest rate

A 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. Borrowers and lenders are interested in the real rate of interest they will receive or pay. Equilibrium in the market for loanable funds determines the real interest rate and the quantity of loanable funds exchanged.

Advantages and disadvantages of labour market regulation and deregulation

Advantages ▪ Flexible work arrangements may reduce frictional and structural unemployment. ▪ Improved performance can be rewarded with higher wages. ▪ Dispute resolution can occur in the workplace. Disadvantages ▪ Individual work contracts may reduce individual bargaining power between workers and employers. ▪ Increased labour market flexibility may cause a decline in the position of low-paid workers. - i.e., minimum wages may be used to ensure some protection for low-paid workers.

Aggregate demand

Aggregate demand (AD) can help explain short-run fluctuations in real GDP and the inflation rate. - Shows the relationship between the price level and the quantity of real GDP demanded by households, firms and the government, plus net exports. Short-run AS (SRAS) curve: shows the relationship in the short run (short term fluctuations) between the price level and the quantity of real GDP that would be supplied by firms at each price level. AD-AS model: A model that explains short-run fluctuations in real GDP and the price level. [Differs from micro as it shows supply and demand of the whole economy not just a market]

Long run aggregate supply curve

Because the effect of changes in the price level is very different in the short run than in the long run, we use two AS curves: one for the short run and one for the long run 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 that can be supplied. In the long run, the level of real GDP is determined by the stock of human capital, the capital stock and the available technology. Because changes in the price level do not affect the stock of human capital, 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). Therefore, the LRAS curve is a vertical line! Shifts in LRAS can still occur. The LRAS curve shifts because potential GDP increases over time.

Marginal propensity to consume (MPC)

Changes in consumption (C) depend on the changes in YD (disposable income), we can say that consumption is a function of disposable income. - The slope of the consumption function is the marginal propensity to consume. MPC refers to the proportion of the change in disposable income that is spent on consumption. [Formula on sheet] The value for the MPC tells us that households spent 90% of the increase in their disposable income. We can also use the MPC to tell us how much consumption will change as income changes. We solve the equation so that ∆C is on the left hand side: ∆C = ∆YD × MPC ▪ E.g., if MPC = 0.9 a $10 billion increase in YD will increase C by $10 billion × 0.9, or $9 billion HOWEVER we should look at the relationship between consumption and GDP because we are interested in the AE model to explain fluctuations in the real GDP, rather than fluctuations in the YD. GDP differs from YD, we can graph the consumption function using GDP rather than YD.

Real GDP

Changes in output only) A measure of the volume of final G&S's, holding prices constant (This is to filter out the effects of inflation) 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!

Consumer price index (CPI)

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. [can be referred to as cost of living index] - The CPI measures (quarterly) the rate of change in the prices of the goods and services in the market basket. One year is chosen as the base year, and the value of the CPI is set equal to 100 for that year.

Contractionary fiscal policy

Contractionary FP: Decreases in government purchases or increases in taxes in order to reduce the increases in AD. A decrease in government purchases or an increase in taxes will reduce the rate of increase in AD, to reduce the price level. Rising inflation rate: use the contractionary fiscal policy, leads to a decrease in government spending or raise taxes. As a result real GDP and the price level do not rise by as much as they would without the policy.

The economic costs of unemployment

Costs to the economy include; - Loss of GDP - Loss or deterioration of human capital (i.e., skills may deteriorate if not used) - Retraining costs (i.e., pre-existing skills are no longer required by the economy) Costs to the government: - Unemployment benefit payments are a net drain on the federal budget. - The opportunity cost of funds directed towards unemployment benefits. - Loss of tax revenue—personal income tax, company tax, GST and excise taxes. Costs to the individual - Loss of income, skills and self esteem - Retraining costs Social costs - Unemployment may contribute to family break-ups, health problems, mental illness, crime and political unrest.

Measuring money; credit

Credit: defined as loans, advances and bills provided to the private non-bank sector by all financial intermediaries. [divided into credit for housing, personal and business purposes] Note, Credit is not a form of money, but it is now used by the RBA as the main measure of monetary movements in Australia, to determine whether more funds are being loaned, or whether there has been a contraction in the volume of funds advanced. 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 G&S with credit cards ▪ 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 month is the transaction complete

Unemployment and the labour force participation rate

Definitions: Employed: A person must have worked only one hour of more in a week before the ABS unemployment rate survey Unemployment rate: The percentage of the labour force that is unemployed. To be classified as unemployed, a person must: - not have worked at all in the week before the survey; - must have been actively looking for work in the past four weeks; - must be ready to start work immediately. 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.

How is the total production measured in an economy?

Economists measure total production by Gross Domestic Product (GDP); which is the MARKET VALUE (done by taking the dollar value in dollar terms), NOT quantity of all final goods and services (end product of production process) that is produced in a country during a specified period of time. Not an intermediate good or service which is an input (required to make) into another good or service. We take GDP in the dollar value because the total number if meaningless, and GDP does not include second hand goods because that transaction has already been included in the GDP.

Fiscal policy and spending in Australia

Economists often measure government spending relative to the size of the economy by calculating government spending as a percentage of GDP. Remember that there is a difference between federal government purchases and federal government expenditures - E.g., when the federal government funds the building of a motorway or purchases the services of a university, it receives goods and services in return Government expenditure ▪ The largest share of government expenditure in Australia goes to social security and welfare payments, at over 35% in the 2016/2017 financial year. ▪ The second largest single share of total government expenditure is health, at almost 16%, followed by education at 7.5% Government revenue ▪ The largest proportion of government revenue comes from personal income taxation.

Causes of shifts in the supply of foreign exchange

Factors affecting the supply curve for AUD are similar to those affecting the demand curve for dollars. E.g., 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. An increase in IRs in Japan relative to IRs in Australia will make financial investments in Japan more attractive to Australian investors. Thus, higher Japanese IRs will cause the supply of dollars to shift to the right, as Australian investors exchange dollars for yen

Shifts in the SRAS curve

Factors that shift the SRAS curve (i.e., non-price determinants) 1. Expected changes in the future price level ▪ If workers and firms expect the price level to increase by a certain percentage, the SRAS curve will shift by an equivalent amount 2. Adjustments of workers and firms to errors in past expectations about the price level ▪ 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 (and vice-versa) ▪ E.g., incorrect predictions about the price level requires an adjustment of wages. However, higher wages results in increasing costs to the firm resulting in the company needing to receive higher prices to produce the same level of output. 3. Unexpected changes in the price of an important natural resource ▪ Unexpected increases or decreases in the price of an important natural resource can cause firms' costs to be different from expected costs. ▪ E.g., oil in the production process. If oil prices rise unexpectedly, the costs of production will rise for these 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 to the left is known as a supply shock [These two factors will also shift the LRAS] 4. Increases in the labour force and in the capital stock and resources ▪ As the labour force and the capital stock grow, firms will supply more output at every price level, and the SRAS and LRAS curves will shift to the right ▪ With respect to resources (historically for Australia), new discoveries of minerals and energy have shifted the the SRAS and LRAS curves to the right. 5. Technological change ▪ As technological change takes place, the productivity of workers and machinery increases, which means that firms can produce more G&S's 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. ▪ Thus, the SRAS and LRAS curves will shift to the right.

Is GDP a good measure of economic wellbeing?

GDP does not include: 1. Household production: G&S's people produce for themselves that are not bought or sold in markets (e.g., cleaning, childcare, gardening, home maintenance). Such as if a carpenter makes a bookcase for personal use, it will not be counted in the GDP. 2. The underground economy: Buying and selling of G&S's that is concealed from the government to avoid taxes (want to avoid taxes on the income they earn) or regulations or because the G&S's are illegal. → Estimates of the underground economy in Australia is approx. 1.5% of GDP (around $26 billion) 8% of GDP in the United States and 13% of GDP in Western Europe It is said that people in countries with higher levels of GDP are better off because they have increased wellbeing. However GDP is not an accurate measure of wellbeing because it fails to consider other factors that may affect wellbeing. Shortcomings of GDP as a measure of wellbeing include: 1. The distribution of GDP is not captured in GDP measures (i.e., loss of taxation, social welfare payments) Income generated might be only going to a small portion of the population. Economic wellbeing may be unchanged or become relatively worse for other sections of the population, despite GDP increasing in the economy as a whole. This raises issue of equity in the distribution of income, an issue that taxation and social welfare payments can seek to address. 2. The value of leisure is not included in GDP. GDP might be higher if people work more, however the wellbeing of a person might be lower because less time would be available for leisure. 3. The level, quality, and access to health care and education is not measured in GDP. Such as education; the production GDP levels might be high but the availability may be limited or too expensive. (Provision) Any measure of wellbeing must include measures of access and affordability of essential goods and services. 4. GDP is not adjusted for pollution or other negative effects of production. Increased production leads to increased GDP, but this is not adjusted to compensate for the costs of pollution. 5. 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 and security guards etc.

Fiscal policy in an open economy

Fiscal policy has a smaller impact on aggregate demand in an open economy than in a closed economy As we discussed in the previously, expansionary fiscal policy may result in higher IRs. In a closed economy, the main effect of higher IRs is to reduce domestic investment spending and purchases of consumer durables. In an open economy, higher IRs 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 IRs, but the inflow of foreign capital will cause the demand for the AUD 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 AD. 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. Also, the government may try to fight inflation by using a contractionary fiscal policy to slow the rate of economic growth Contractionary fiscal policy lowers IRs which 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 AUD. This will reduce the foreign exchange value of the dollar and increase net exports. Therefore, a contractionary fiscal policy in an open economy will have a smaller impact on AD 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

Monetary policy and economic activity: how interest rates affect aggregate demand

How interest rates affect the three components in aggregate demand (apart form G) 1. Consumption: ▪ An increase in IRs increases the returns from lending and the costs of borrowing ▪ Thus, households to cut back on consumption spending and thus save more in order to increase lending or reduce borrowing. ▪ Changes in IRs also affects Households wealth since they place savings in interest-bearing deposits, real estate or shares. 2. Investment: ▪ The higher the IR, the more expensive it is for firms to borrow (and vice-versa) ▪ Spending by households on new houses and apartments is also part of investment. When IRs on mortgage loans fall, the cost of borrowing to buy new homes falls and more new homes will be purchased (and vice-versa). 3. Net exports: ▪ When the value of the AUD falls (rises), net exports rise (fall). ▪ If IRS in Australia rise relative to IRs 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 AUD. ▪ Thus, as the value of the dollar increases, net exports will fall

Current account balance equals net foreign investment

If a country imports more than it exports and/or if its income outflows exceed its income inflows= bad. Therefore, we can write that the current account balance (CAB) is equal to the sum of net exports (NX) and net primary income (NPY). (Since net secondary income is so small, for simplicity we ignore it here) 𝑪𝑨𝑩 = 𝑵𝑿 + 𝑵𝑷𝒀 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. [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). As a prologue, consider what happens when imports are greater than exports, as frequently occurs in Australia. Australian exports in 1960 were a little over 12% of GDP and imports were 15% of GDP. Meaning that net exports have been negative more years than they have been positive, therefore net primary income is negative. So, net exports and net income are negative and therefore there will be a net inflow in the financial account. 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).

Demand-Pull inflation

Inflation can be categorised as demand pull which is a rise in general price level in the economy that is caused by an increase in the aggregate demand (AD) for G&S's, and production levels are unable to meet this demand immediately Occurs when AD increases which, if the economy is close to or at full employment, creates excess demand for G&S's and also creates excess demand for labour The increase in AD beyond potential GDP puts upward pressure on prices and nominal wages which creates a price-wage spiral. - If the increase in AD 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 AD (as we will see in Ch.12) this can occur only if there are continuing increases in financial liquidity and low IRs.

Is economic growth good or bad?

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 There are criticisms though: ▪ Globalisation that has accompanied economic growth has undermined the distinctive cultures of many countries (imports of food, clothing, movies and other goods displace domestically produced goods) ▪ Economic growth contributes to global warming, deforestation and other environmental problems. [Globalisation has lead to increase pollution and depletion of natural resources]

The market for loanable funds

Loanable funds is the money that households save and lend to business. Market for loanable funds: The interaction of borrowers and lenders that determines the market interest rate and the quantity of loanable funds exchanged. Demand for loanable funds: Determined by the willingness of firms to borrow funds to engage in new investment projects. - When deciding whether to borrow funds, firms compare the expected rate of return on their investment with the interest rate (the cost of borrowing). The demand for loanable funds is downward sloping because the lower the interest rate, the more investment projects firms can profitable undertake and the greater the quantity of loanable funds they will demand. Supply of loanable funds: Determined by the willingness of households to save, and by the extent of government saving or dissaving. - The willingness of households to save rather than consume will depend in part on the interest rate they receive. - The higher the interest rate, the greater the reward for saving and the larger the amount of funds households will save. The supply curve for loanable funds is upward sloping to reflect the fact that the higher the interest rate, the greater the quantity of saving supplied.

Monetary policy in an open economy

Monetary policy has a greater impact on AD in an open economy than in a closed economy. - If the RBA engages in an expansionary monetary policy, it will lower IRs in an attempt to stimulate AD. - In a closed economy, the main effect of lower IRs is once again on domestic investment spending and purchases of consumer durables - In an open economy, lower IRs will also affect the exchange rate between the dollar and foreign currencies - Lower IRs 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

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. What is the long-run effect of a permanent increase in government spending? ▪ To understand why: → Recall 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% of GDP. → In that case, private expenditure—the sum of consumption, investment and net exports—will make up the other 75% of GDP → If government purchases are increased permanently to 30% of GDP, in the long run private expenditure must fall to 70 % 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.

Net foreign debt

Net foreign debt: The difference between the amount Australia lends to other countries and the amount that Australia borrows from overseas → Has risen significantly as a proportion of GDP over time - Australia does not have sufficient domestic saving levels to fund investment - Australia debt repayments as a proportion of GDP are very low compared to many other countries. - For some developing countries, debt servicing burdens are so high (much of which is government debt) that at times borrowing occurs just to make the interest repayments on borrowing. → In 2010 and 2011 the governments of Greece, Ireland and Portugal became bankrupt; the European Union (EU) and the International Monetary Fund 'bailed them out'.

Measuring Inflation

Price level: A measure of the average prices of goods and services in the economy (a statistic to measure the cost of living). Inflation: Is the sustained increase in the general level of prices in the economy, which impacts a typical household. Inflation rate: The percentage increase in the general price level in the economy from one year to the next.

The long-run effects of tax policy

Reducing each of the following taxes can increase AS: 1. Personal income tax: reducing the marginal tax rates on individual income increases the quantity of labour supplied 2. Company income tax: cutting the company income tax rate would encourage investment spending 3. Taxes on capital gains ('double taxation' problem): Individuals pay taxes on capital gains. 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. → 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. 4. Tax simplification: may improve the efficiency of firm and household decision making ▪ With tax reductions and simplifications: → 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

Technological change

Technological change helps economies avoid diminishing returns to capital and is the key to sustaining economic growth. ▪Helps avoid diminishing returns to capital: Technological change shifts the production function and allows more output per hour worked with the same amount of capital per hour worked Technological change includes: ▪ The replacement of existing capital with more productive capital ▪ Reorganising how production takes place.

Job creation and job destruction

The Australian economy creates and destroys hundreds of thousands of jobs every year; such as new firms begin and existing firms expand, while some firms contract; some firms go out of business. ▪ Job creation and destruction is a normal part of an economy and is due to changes in: - Consumer tastes - Technological change - Entrepreneurial success and failure

Relationship between aggregate demand curve and aggregate expenditure

The aggregate demand curve - Increases or decreases in expenditure would affect not just real GDP but also the price level. Increases in the price level will cause AE to fall and decreases in the price level will cause AE to rise. There are three main reasons for this inverse relationship between changes in the price level and changes in AE. 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 making exports less attractive to produce, and foreign imports will become relatively less expensive, causing net exports to fall. 3. Higher RIR's increases the cost of borrowing and reduces investment spending. Consumption may also fall as households borrow less to spend on durable goods. - People with savings have their wealth increased when IR's are higher and will increase their consumption spending A falling price level has the reverse effect: other things being equal, interest rates will fall, and investment spending will rise

The effects of the Monetary policy on real GDP and price level.

The effects of MP on real GDP and the price level, the economy experiences continuing inflation and continuing long-run growth, thus keeping the economy at potential GDP. However, during certain periods AD may not increase enough during the year to keep the economy at potential GDP. - This may be due to the fact that households and firms becoming pessimistic about the future state of the economy and thus cutting back their spending on consumer durables, houses and factories. - Or, the government might decide to cut back its purchases. These factors may contribute to a slowdown in the growth rate Part of the RBA's job is to monitor these events and continually update forecasts of future levels of real GDP and prices. ▪ If RBA economists anticipate that the growth in AD is slowing, they present their findings to the Reserve Bank Board, which decides whether circumstances require a change in MP. So, the RBA has two tools in its disposal to counteract declines in growth (or rapid growth): - Contractionary monetary policy - Expansionary monetary policy ▪ The idea behind these two policy tools is to increase (decrease) AD by more (less) than it would have increased (decreased) without policy.

Deficits, surpluses and federal government debt

The federal government's budget shows the relationship between its expenditures and its tax revenue. ▪ 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. Government spending increases during economic contractions and recessions and tax revenues fall, creating or increasing the budget deficit Tax revenue falls during contractions and recessions and government spending increases ▪ If the government has a budget deficit, this has to be financed by borrowing. ▪ This borrowing contributes to the net debt of the government. ▪ Net debt is the difference between the amount of funds the government borrows and the amount it lends

Creative destruction: Determinants for how fast economies grow

The key to rising living standards is not small changes to existing products but, rather, products that meet consumer wants in qualitatively better ways. 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. Such as a car displacing the horse drawn carriage.

Labour market regulation and deregulation: minimum wages

The majority of workers in Australia are 'covered' by minimum wage laws set by Fair Work Commission. ▪ Most workers earn wages that are much higher than the minimum wage. ▪ However, he imposition of minimum wages affects only those in low-skilled, low-paid jobs ▪ Economists argue over the effect minimum wages may have on employment because wages offered by minimum wage legislation outweighs any possible small (if any) effect on employment.

Long run economic growth

The process by which rising productivity increases the average standard of living. A successful economy is capable of increasing the production of goods and services faster than the growth in population. Attaining this level of growth is the only way that the standard of living of an average person in a country can increase. [Countries with little to no economic growth tend to live in poverty] - Rising productivity; firms expanding their operations, training workers and adopt new technologies. - However to carry out these functions, the firms must acquire funds from households, either directly through financial markets (Share and bond markets) or through financial intermediaries such as the bank.

Exchange rate depreciation

The same logic (in reverse) applies when the XR depreciates Assume the XR between 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. Thus, we can conclude that a depreciation in the domestic currency will increase export income and decrease imports, thereby increasing net export income

Why is balance of payments always zero?

The sum of the current account, capital account, and financial account balances = BOP The current account balance in 2015/2016 was −$72.828 billion This value is approximately equal (with opposite sign) to the balance of the sum of the capital account and financial account, which was $75.904 billion To make the balance on the current account = the balance on the capital and financial accounts, the balance of payments includes an entry called 'Net errors and omissions'. Includes some imports/exports or some capital inflows/outflows that have not been measured accurately A current account deficit must be exactly offset by a capital and financial account surplus, leaving the balance of payments equal to zero

Labour market regulation and deregulation: Trade unions

Trade unions are organisations of workers that bargain with employers for higher wages and better working conditions for their members. In doing so, they also increase employer costs, which may reduce employment.

Determinants of aggregate expenditure in the economy: level of consumption

Variables that determine the level of consumption are: 1. Current disposable income: → Income households have after they have paid individual income tax and received government transfer payments. → The higher their disposable income the more they spend, and vice versa. 2. Household wealth → A household's wealth is the value of its assets (home, shares and bond holdings) minus the value of its liabilities (loans it owes) → When the wealth of households increases, consumption should increase (and vice-versa). 3. Expected future income → Promotions in jobs and bonuses, can increase consumption. 4. The price level → Changes in the price level affect consumption mainly through their effect on household wealth. 5. The interest rate → When the IR is high (consumption spending depends on the RIR), the reward for saving is increased and households are likely to save more and spend less. → Spending on durable goods is most likely to be affected by changes in the interest rate.

Should the federal government always be balanced?

When the economy is contracting, or in a recession, tax revenues fall and government spending rises, moving the budget into a deficit When actual GDP is above its potential level during a boom, the budget automatically moves into a surplus—tax revenues rise. These actions would increase aggregate demand, thereby pushing real GDP further beyond potential GDP and raising the risk of higher inflation To maintain a balanced budget every year could involve policies that might destabilise the economy.

Exchange rate appreciation

When the market value of the AUD increases—appreciates—the foreign currency prices of many Australian exports largely remain the same since many Australian exports are commodities that have their prices denominated in US dollars. However, for Australian commodity (the full dollar value) exporters, revenue in Australian dollars falls. When the AUD appreciates, the Australian dollar price of foreign imports falls, increasing the demand for imports E.g., suppose initially the XR between the AUD 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 XR changes 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 (and exporters loose $16.67 per bottle) Thus, we can conclude that an appreciation in the domestic currency will reduce export income and increase imports, thereby decreasing net export income

Induced consumption

incomes increase and households increase their consumption spending, the increase in consumption spending is induced consumption.

Why fiscal policy is harder than the monetary policy

→ Control over MP is concentrated in the hands of the RBA, which can change monetary policy at any of its monthly meetings → By contrast, the government and parliament have to agree on changes in fiscal policy. It must be passed by both Houses of federal parliament which can take many months. ▪ Even after a change in fiscal policy has been approved, it takes time to implement the policy. → E.g., 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

Dynamic AD-AD model

▪ We can create a dynamic AD-AS 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.