ECO1000ECO1000ECONOMICSECONOMICS

Semester One, 2004Semester One, 2004

Lecture ElevenLecture Eleven

Outline or Plan of Today’s Outline or Plan of Today’s LectureLecture

• Material Covered: Module EightMaterial Covered: Module Eight

• Reading: Text Chapters 17, 18, 19Reading: Text Chapters 17, 18, 19

• Topics: Macroeconomic Policy and Topics: Macroeconomic Policy and the Associated Debatesthe Associated Debates

Purpose or Objectives of Purpose or Objectives of Today’s LectureToday’s Lecture

• After this lecture you will know After this lecture you will know about:about:– The main macroeconomic modelsThe main macroeconomic models– How to use the main macroeconomic How to use the main macroeconomic

models to show the effect of selected models to show the effect of selected macroeconomic policiesmacroeconomic policies

– Discuss the trade-off between Discuss the trade-off between employment and inflationemployment and inflation

The Use of Macroeconomic The Use of Macroeconomic PolicyPolicy

The Purpose of Macro Policy The Purpose of Macro Policy

• There are a few main reasons why a There are a few main reasons why a government may use macro policies:government may use macro policies:– Maintain long-term growthMaintain long-term growth– Stabilise the economyStabilise the economy

•Moderating the business cycleModerating the business cycle

– Maintain employment levels where Maintain employment levels where possiblepossible

– Control inflationControl inflation

Policy Options for Policy Options for RecessionsRecessions

• Do nothing Do nothing – Lower costs and wages will result in an Lower costs and wages will result in an

eventual increase in output. eventual increase in output.

• Stimulate aggregate demand with Stimulate aggregate demand with monetary policymonetary policy

• Stimulate aggregate demand with Stimulate aggregate demand with fiscal policy fiscal policy

Option #1: Do Nothing (market Option #1: Do Nothing (market correction)correction)

Quantity ofOutput

PriceLevel

0

AS1

Long-runAS

AD1

A

B

C

P1

P2

P3

Y1Y2

AD2

AS2

The Limits of Self-CorrectionThe Limits of Self-Correction

• Hardship for some householdsHardship for some households

• Adds to long-term unemploymentAdds to long-term unemployment

• Adds to consumer & producer Adds to consumer & producer pessimism pessimism

• Political unrestPolitical unrest

Policy Option #2: Policy Option #2: Monetary PolicyMonetary Policy

How Does Monetary Policy How Does Monetary Policy Affect Aggregate Demand?Affect Aggregate Demand?

• One part of the answer to this One part of the answer to this question is Keyne’s liquidity question is Keyne’s liquidity preference theory.preference theory.

• This theory suggests that the interest This theory suggests that the interest rate adjusts to equate money supply rate adjusts to equate money supply with money demand. with money demand.

• To examine this closely we need to To examine this closely we need to model the the money market. model the the money market.

The Money MarketThe Money Market

MS

MD

r

Interest Rate

Quantity of Money

If Md < Ms, the surplus of money creates downward pressure on interest rates and vice versa.

The Money Market and ADThe Money Market and AD

AD

Output

Price Level

Interest Rate

Quantity of Money

Y1Y2

P1

P2

Md2

Md1

Ms

r1

r2

Key Steps in the ProcessKey Steps in the Process

• 1. A higher price level increases Md 1. A higher price level increases Md (people need more money to buy (people need more money to buy things)things)

• 2. Higher Md increases the interest 2. Higher Md increases the interest raterate

• 3. A higher interest rate reduces the 3. A higher interest rate reduces the quantity of goods and services that quantity of goods and services that people demandpeople demand

What Happens to AD if Ms is What Happens to AD if Ms is Increased?Increased?

Quantity of money

Output

Interest rate

Price level

AD

AD1

Md

Ms Ms1

Expansionary & Expansionary & ContractionaryContractionary

• Central bank sells Central bank sells securitiessecurities

• O’night cash rate O’night cash rate increasesincreases

• Interest rates Interest rates increaseincrease

• Increase in Increase in consumption & consumption & investmentinvestment

• Increase in Increase in aggregate demandaggregate demand

• Central bank buys Central bank buys securitiessecurities

• O’night cash rate O’night cash rate decreasesdecreases

• Interest rates Interest rates decreasedecrease

• Decrease in Decrease in consumption & consumption & investmentinvestment

• Decrease in Decrease in aggregate demandaggregate demand

How Does the RBA Increase/Decrease Money Supply?

The Result of Expansionary The Result of Expansionary Monetary PolicyMonetary Policy

Quantity ofOutput

PriceLevel

0

AS1

Long-runAS

AD1

A

B

P1

P2

Y1 Y2

AD2

When to Use Expansionary When to Use Expansionary Monetary PolicyMonetary Policy

• Growth rate is low; andGrowth rate is low; and

• Consumer and investor sentiment is Consumer and investor sentiment is pessimistic; butpessimistic; but

• Inflation should also be lowInflation should also be low– Stimulation increases pricesStimulation increases prices

Policy Option #3Policy Option #3Fiscal PolicyFiscal Policy

Fiscal Policy…Fiscal Policy…

• Fiscal policy refers to the government’s Fiscal policy refers to the government’s choices regarding the overall level of choices regarding the overall level of government government purchasespurchases or or taxestaxes

• The Federal government’s control of The Federal government’s control of the economy is both direct and indirectthe economy is both direct and indirect– Its expenditures have a direct effect on Its expenditures have a direct effect on

aggregate demandaggregate demand– Taxes and tax policy have an indirect Taxes and tax policy have an indirect

effect on consumer spendingeffect on consumer spending

Fiscal PolicyFiscal Policy

Government Purchases and Government Purchases and Aggregate DemandAggregate Demand

Government PurchasesGovernment Purchases

• When the government decides to When the government decides to increase spending, this has a direct increase spending, this has a direct effect on aggregate demand.effect on aggregate demand.

• In short, the AD curve shifts to the right.In short, the AD curve shifts to the right.• But because the government spending But because the government spending

also stimulates further spending by also stimulates further spending by consumers and investors, the effect is consumers and investors, the effect is said to be said to be multipliedmultiplied. .

The Multiplier Effect of The Multiplier Effect of Government PurchasesGovernment Purchases

• Government purchases are said to have a Government purchases are said to have a multiplier effectmultiplier effect on aggregate demand. on aggregate demand.

• Each dollar spent by the government can Each dollar spent by the government can raise the aggregate demand for goods and raise the aggregate demand for goods and services by services by more than a dollar.more than a dollar.

• The total impact on the quantity of goods The total impact on the quantity of goods and services demanded can be much and services demanded can be much larger than the initial change in larger than the initial change in government spending.government spending.

The Multiplier Effect of The Multiplier Effect of Government PurchasesGovernment Purchases

AD1

AD2

Quantity of Output0

PriceLevel

1. An increase in government purchases of $5 billion initially increases aggregate demand by $5 billion…

AD3

2. …but the multiplier effect can amplify the shift in aggregate demand.

A Formula for the Government A Formula for the Government Purchases MultiplierPurchases Multiplier

• The formula for the multiplier is:The formula for the multiplier is:

Multiplier = 1/(1 - MPC)Multiplier = 1/(1 - MPC)• An important number in this formula is An important number in this formula is

the the marginal propensity to consumemarginal propensity to consume ((MPCMPC).).

• It is the fraction of extra income that a It is the fraction of extra income that a household consumes rather than saves.household consumes rather than saves.

• If households spend 80 cents out an If households spend 80 cents out an extra $1 they earn, then the MPC is 0.8extra $1 they earn, then the MPC is 0.8

An Example of the Multiplier An Example of the Multiplier EffectEffect• MPC = 0.9MPC = 0.9• Multiplier = 1/(1- 0.9) = 1/0.1 = 10Multiplier = 1/(1- 0.9) = 1/0.1 = 10• Government spends $200,000Government spends $200,000• Extra activity = 10 x $200,000 = Extra activity = 10 x $200,000 =

$2,000,000$2,000,000• This is the same mathematical This is the same mathematical

principle as the money multiplierprinciple as the money multiplier

Fiscal PolicyFiscal Policy

Tax Changes and Aggregate Tax Changes and Aggregate DemandDemand

Changes in TaxesChanges in Taxes

• When the government cuts taxes, it When the government cuts taxes, it increases households’ take-home pay.increases households’ take-home pay.

• Households save some of this additional Households save some of this additional income.income.

• Households also spend some of it on Households also spend some of it on consumer goods.consumer goods.

• Increased household spending shifts the Increased household spending shifts the aggregate-demand curve to the right.aggregate-demand curve to the right.

• The size of the resulting shift in aggregate The size of the resulting shift in aggregate demand is affected by the multiplier effect.demand is affected by the multiplier effect.

The Crowding Out EffectThe Crowding Out Effect

How the Multiplier Effect May How the Multiplier Effect May be Offsetbe Offset

The Crowding-Out EffectThe Crowding-Out Effect

• Fiscal policy may not affect the Fiscal policy may not affect the economy as strongly as predicted by economy as strongly as predicted by the multiplier.the multiplier.

• An increase in government purchases An increase in government purchases causes the interest rate to rise causes the interest rate to rise (because of increased money demand).(because of increased money demand).

• A higher interest rate reduces A higher interest rate reduces investment spending.investment spending.

• This is called ‘crowding out’This is called ‘crowding out’

The Crowding Out Effect of Fiscal The Crowding Out Effect of Fiscal StimulationStimulation

AD1

AD2

Quantity of Output0

PriceLevel

1. An increase in government purchases initially increases aggregate demand

AD3

2. …but higher interest rates lead to a decrease in investment and a decrease in aggregate demand.

Automatic StabilisersAutomatic Stabilisers

Automatic Stabilisers…Automatic Stabilisers…

• Automatic stabilisersAutomatic stabilisers are changes in are changes in fiscal policy that stimulate aggregate fiscal policy that stimulate aggregate demand when the economy goes into demand when the economy goes into a recession a recession without policymakers without policymakers having to take any deliberate actionhaving to take any deliberate action..

Examples of Automatic Examples of Automatic StabilisationStabilisation• The most important automatic stabiliser The most important automatic stabiliser

is the tax systemis the tax system– Taxes automatically decline in a recessionTaxes automatically decline in a recession– Helps maintain disposable incomeHelps maintain disposable income

• Another is government welfare paymentsAnother is government welfare payments– Welfare payments increase in total in Welfare payments increase in total in

recessionsrecessions– Maintains some level of aggregate demandMaintains some level of aggregate demand

What We Now Know About What We Now Know About the Economy in the Short the Economy in the Short

Run and the Long RunRun and the Long Run

In the Short Run…In the Short Run…

• Price level is sticky (predetermined)Price level is sticky (predetermined)

• Interest rate balances Interest rate balances supply/demand for moneysupply/demand for money

• Output responds to changes in Output responds to changes in aggregate demandaggregate demand

In the Long Run…In the Long Run…

• Output is fixed (natural rate)Output is fixed (natural rate)

• Interest rate balances Interest rate balances supply/demand for loanable fundssupply/demand for loanable funds

• Price level balances supply/demand Price level balances supply/demand for moneyfor money

The Trade-Off Between The Trade-Off Between Inflation and Inflation and

UnemploymentUnemployment

The Trade-offThe Trade-off

• Society faces a short-run trade-off Society faces a short-run trade-off between unemployment and inflation.between unemployment and inflation.

• If policymakers If policymakers expandexpand aggregate aggregate demand, they can lower demand, they can lower unemployment, but only at the cost unemployment, but only at the cost of higher inflation.of higher inflation.

• If we reduce aggregate demand, they If we reduce aggregate demand, they can lower inflation, but at the cost of can lower inflation, but at the cost of temporarily higher unemployment.temporarily higher unemployment.

The Phillips CurveThe Phillips Curve

• The The Phillips curvePhillips curve illustrates the short- illustrates the short-run relationship between inflation and run relationship between inflation and unemployment.unemployment.

• It shows the short-run combinations of It shows the short-run combinations of unemployment and inflation that arise unemployment and inflation that arise as shifts in the aggregate demand as shifts in the aggregate demand curve move the economy along the curve move the economy along the short-run aggregate supply curve.short-run aggregate supply curve.

Aggregate Demand, Aggregate Aggregate Demand, Aggregate Supply, and the Phillips CurveSupply, and the Phillips Curve

• The greater the aggregate demand for The greater the aggregate demand for goods and services, the greater is the goods and services, the greater is the economy’s output, and the higher is the economy’s output, and the higher is the overall price level.overall price level.

• A higher level of output results in a lower A higher level of output results in a lower level of unemployment.level of unemployment.

• Monetary and fiscal policy can shift the Monetary and fiscal policy can shift the aggregate demand curve, thus moving the aggregate demand curve, thus moving the economy along the Phillips curve.economy along the Phillips curve.

Phillips CurvePhillips Curve

Unemployment Rate (percent)0 4 7

Inflation Rate

(percent per year)

B

A

6

2

Phillips curve

The Employment/Growth The Employment/Growth Trade-OffTrade-Off

6

Unemployment rate (%)0

3. …Unemployment decreases but inflation increases.

(a) AD/AS Model

1. Output = $5 b & Unemployment = 8 percent

Output ($b)0

AD1

AS1

106102

2. Demand increases to output of $6b

(b) The Phillips Curve

3 8

Inflation rate

2

Price level (deflator)

*

*

**

5 6

AD2

In the Long Run…In the Long Run…

• In the long run, there is no trade-off In the long run, there is no trade-off between unemployment and inflation between unemployment and inflation (according to the Monetarist school (according to the Monetarist school of macroeconomic theory).of macroeconomic theory).

• This is because the unemployment This is because the unemployment rate eventually returns to its natural rate eventually returns to its natural rate.rate.

• This is equivalent to saying that the This is equivalent to saying that the Long Run Phillips Curve is vertical. Long Run Phillips Curve is vertical.

The Phillips Effect in The Phillips Effect in AustraliaAustralia

1960s-1990s1960s-1990s

The Phillips Curve in the The Phillips Curve in the 1960s 1960s

Include figure 18.8 here

Generally low inflation rate and low unemployment rate

The Phillips Curve in the 1970s The Phillips Curve in the 1970s and Early 1980sand Early 1980s

Include figure 18.11 here

Generally high inflation and medium to high unemployment rate

The Phillips Curve in the Late The Phillips Curve in the Late 1980s and Early 1990s1980s and Early 1990s

Insert Figure 18.12

Generally low inflation rate and medium to high unemployment rate

Policy Trends in AustraliaPolicy Trends in Australia

• Growth a priority in the 1960sGrowth a priority in the 1960s

• Wage control in the mid-1980s reduced Wage control in the mid-1980s reduced supply-side wage pressures on inflation. supply-side wage pressures on inflation.

• Restrictive monetary policy in the late Restrictive monetary policy in the late 1980s 1980s – Inflation fell but unemployment rose.Inflation fell but unemployment rose.

• Current RBA policy is generally keeping Current RBA policy is generally keeping inflationary expectations low.inflationary expectations low.– Medium unemployment rateMedium unemployment rate

MACROECONOMIC POLICY MACROECONOMIC POLICY DEBATESDEBATES

Should Policymakers Try to Should Policymakers Try to Stabilise the Economy?Stabilise the Economy?

• The economy is inherently The economy is inherently unstable.unstable.

• Monetary and fiscal policy Monetary and fiscal policy can influence aggregate can influence aggregate demand and offset this.demand and offset this.

• No reason for society to No reason for society to suffer through the booms suffer through the booms and busts of the business and busts of the business cycle.cycle.

• Stabilising aggregate Stabilising aggregate demand will boost demand will boost production and production and employment. employment.

• There are time lags There are time lags between decision & between decision & response for both response for both monetary & fiscal monetary & fiscal policypolicy

• This means This means intervention will be intervention will be largely ineffective in largely ineffective in the short run and may the short run and may be harmful by be harmful by exacerbating exacerbating downturns or upswingsdownturns or upswings

Yes VS No

Monetary PolicyMonetary Policy‘Rules’ VS ‘Discretion’‘Rules’ VS ‘Discretion’

• Discretionary policy can Discretionary policy can easily be mismanagedeasily be mismanaged

• Policy is manipulated in the Policy is manipulated in the political business cyclepolitical business cycle

• Policy makers don’t follow Policy makers don’t follow through on announcementsthrough on announcements

• Economic actors are Economic actors are sceptical about sceptical about announcements announcements

• Need moderate and steady Need moderate and steady growth of the money growth of the money supply to limit the supply to limit the problemsproblems

• The problems of The problems of discretionary discretionary policy are not policy are not provenproven

• Need flexibility Need flexibility for changing for changing circumstancescircumstances

• Leave it to the Leave it to the expertsexperts

• What rules are What rules are valid anyway?valid anyway?

• Rational Rational ExpectationsExpectations

The Central Bank Should Aim for Zero The Central Bank Should Aim for Zero InflationInflation

• No benefits but many No benefits but many costs to inflationcosts to inflation– eg shoeleather, menu, etceg shoeleather, menu, etc

• Reducing inflation is a Reducing inflation is a policy with temporary policy with temporary costs and permanent costs and permanent benefits.benefits.– Once the disinflationary Once the disinflationary

recession is over, the recession is over, the benefits of zero inflation benefits of zero inflation would persist.would persist.

• Zero inflation is probably Zero inflation is probably unattainable and output unattainable and output and unemployment and unemployment costs from policy are too costs from policy are too high.high.

• Instead aim for a Instead aim for a low low inflation.inflation.

• Policymakers can reduce Policymakers can reduce many of the costs of many of the costs of inflation without actually inflation without actually reducing inflation.reducing inflation.

Yes VS No

The Government Should Balance the The Government Should Balance the BudgetBudget

• Deficits are a Deficits are a burden on future burden on future generationsgenerations– Need more taxes Need more taxes

or less spending or less spending

• Deficits reduce Deficits reduce savings & therefore savings & therefore investment in investment in capital & therefore capital & therefore lower growthlower growth

• The problem of deficits is The problem of deficits is often exaggerated.often exaggerated.

• Current govt spending may Current govt spending may produce benefits well into produce benefits well into the future.the future.

• Need flexibility in spending Need flexibility in spending for emergencies etcfor emergencies etc

• Govt debt can increase Govt debt can increase because population growth because population growth and technological progress and technological progress increase the nation’s ability increase the nation’s ability to pay the interest on the to pay the interest on the debt.debt.

Yes VS No

Tax Laws Should be Reformed to Tax Laws Should be Reformed to Encourage SavingEncourage Saving

• A nation’s productive capability is determined A nation’s productive capability is determined largely by how much it saves and invests for the largely by how much it saves and invests for the future.future.

• A nation’s saving rate is a key determinant of its A nation’s saving rate is a key determinant of its long-run economic prosperity. long-run economic prosperity.

• When the saving rate is higher, more resources are When the saving rate is higher, more resources are available for investment in new plant and available for investment in new plant and equipment.equipment.

• We heavily tax the income from capital and reduce We heavily tax the income from capital and reduce benefits for those who have accumulated wealth.benefits for those who have accumulated wealth.

• This reduces saving, capital accumulation, labour This reduces saving, capital accumulation, labour productivity and economic growth.productivity and economic growth.

YES

Tax Laws Should be Reformed to Tax Laws Should be Reformed to Encourage SavingEncourage Saving

• Such changes in tax laws would primarily benefit Such changes in tax laws would primarily benefit the wealthy.the wealthy.

• High-income households save a higher fraction of High-income households save a higher fraction of their income than low-income households.their income than low-income households.

• Any tax change that favours people who save will Any tax change that favours people who save will also tend to favour people with high incomes.also tend to favour people with high incomes.

• Reducing the tax burden on the wealthy would Reducing the tax burden on the wealthy would lead to a less egalitarian society.lead to a less egalitarian society.

• Raising public saving by eliminating the Raising public saving by eliminating the government’s budget deficit would provide a more government’s budget deficit would provide a more direct and equitable way to increase national direct and equitable way to increase national saving.saving.

NO

ConclusionConclusion

• Choosing among alternative policies is not Choosing among alternative policies is not easy. easy.

• No policies come with benefits but no costs No policies come with benefits but no costs (remember, everyone faces trade-offs). (remember, everyone faces trade-offs).

• The study of economics should make you a The study of economics should make you a better participant in our national debates.better participant in our national debates.

• You should be able to objectively list the You should be able to objectively list the pros and cons of policies and make a pros and cons of policies and make a rational decision based on the facts.rational decision based on the facts.

In Light of the Objectives of the In Light of the Objectives of the Lecture…Lecture…

• We now know about:We now know about:– The main macroeconomic modelsThe main macroeconomic models– How to use the models to show the How to use the models to show the

impact of policyimpact of policy– The pros and cons of the various policies The pros and cons of the various policies

that the government or its agencies may that the government or its agencies may deploy to manage economic deploy to manage economic fluctuations.fluctuations.

Next WeekNext Week

REVISIONREVISION

THE ENDTHE END