Econ1020 - Macroeconomics Macroeconomic...

Econ1020 - Macroeconomics

pg. 1

The aggregate expenditure model: A macroeconomic model that focuses on the relationship

between total spending and real GDP, assuming the price level is constant.

Macroeconomic equilibrium: AE = GDP

Consumption expenditure – The five most important variables that determine the level of

consumption are:

1. Household wealth

2. Current Disposable Income

3. Expected future income

4. The price level

5. The interest rate

The Consumption Function

Slope = Marginal propensity to consume

Y axis = Real Consumption Spending, X axis = Real Disposable Income

MPC The amount by which consumption spending increases when disposable income increases.

MPC = ∆C / ∆Y

Consumption and National Income

Disposable Income YD = National Income – net taxes OR

National Income Y = GDP = YD + net taxes

Income, Consumption and Saving

National Income = consumption + saving + taxes

Y = C+S+T

Change in National Income = change in consumption + change in saving + change in taxes

∆Y = ∆C+∆S+∆T If ∆T = 0 ∆Y = ∆C+∆S

Marginal Propensity to Save:

The change in saving divided by the change in income.

1 = ∆Y/∆Y = ∆C/∆Y + ∆S/∆Y OR

1 = MPC + MPS, MPS = 1 – MPC

The four most important variables that determine the level of planned investment are:

1. Expectations of future profitability

2. The interest rate borrowing

3. Taxes ( a decrease will increase investment spending)

4. Cash flow profits


pg. 2

The three most important variables that determine the level of net exports are:

1. The price level in Australia relative to the price level in other countries

2. The growth rate of GDP in Australia relative to the growth rates of GDP in other countries

3. The exchange rate between the dollar and other countries

Graphing macroeconomic equilibrium

The 45 degree line:

- Shows all points equi-distant from both axes

- All points of macroeconomic equilibrium must lie along the 45 degree line

- At points above the 45 degree line, aggregate expenditures are greater than GDP

- At points below the 45 degree line “ lower

Consumption function and AE function

The consumption function intersects the vertical axis at a point above zero due to autonomous

consumption

Autonomous consumption:

- Consumption that is independent of income

Induced consumption

- Consumption that is determined by the level of income

The Multiplier Effect

Autonomous expenditure:

Expenditure that does not depend on GDP

Multiplier:

The increase in equilibrium real GDP divided by the increase in autonomous expenditure

Multiplier effect:

The process by which an increase in autonomous expenditure leads to a larger increase in

real GDP

A formula for the Multiplier

Multiplier = Change in equilibrium real GDP/ Change in autonomous expenditure

Multiplier = 1/1-MPC = 1/MPS


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The Multiplier Effect

The multiplier effect occurs both when autonomous expenditure increases and when it

decreases.

The multiplier effect makes the economy more sensitive to changes in autonomous

expenditure than it otherwise would be.

The larger the MPC, the larger the value of the multiplier

Out formula for the multiplier is very simplified, but serves to illustrate the process

Changes in the price level

An increase or decrease in aggregate expenditure will affect not only real GDP, but also the

price level

An inverse relationship exists between changes in the price level and changes in aggregate

expenditure

- Increases in the price level cause aggregate expenditure to fall

- Decreases in the price level cause aggregate expenditure to rise

Aggregate demand curve

A curve showing the relationship between the price level and the level of planned aggregate

expenditure in the economy, holding constant all other factors that affect aggregate

expenditure.

Changes in the price level shift the AE curve and move us ALONG the AD curve

Topic 5

Aggregate demand and aggregate supply model explains short-run fluctuations in real GDP and the

price level.

The Aggregate demand curve:

Downward sloping curve

Shows the relationship between the price level and the quantity of real GDP demanded by

households, firms and the government.

The aggregate demand curve slopes downwards for three reasons:

1. The wealth effect

2. The interest rate effect

3. The international-trade effect

The variables that shift the aggregate demand curve are:

1. Changes in government/central bank policies

2. Changes in expectations of households or firms

3. Changes in foreign variables


pg. 4

Aggregate supply – The long run aggregate supply curve LRAS:

Shows the relationship in the long-run between the price level and the quantity of real GDP

supplied

Vertical line at potential GDP

- Full employment GDP

- Natural rate of Unemployment

Shows that in the long-run increases in the price level do not affect the level of real GDP

Long run aggregate supply – Shifts in the LRAS curve occur because potential GDP increases over

time

Increases in GDP are due to:

1. An increase in resources

2. An increase in capital stock

3. New technology

Short-run aggregate supply

SRAS shows the relationship in the short-run between the price level and the quantity of real

GDP supplied by firms

- Is upward sloping, showing that in the short-run firms will produce more in response to

higher prices

A given aggregate supply curve holds constant the following factors:

- The supply of resources

- The state of technology

- The efficiency of production

Points to note:

The slope of the SRAS depends on how much costs increase as output increases

If an increase in output results in sharp increases in per-unit production costs, then the SRAS

curve will be quite steep

If an increase in output results in modest increases in per-unit production costs, then the SRAS

curve will be quite flat.

Explanations of the SRAS curve

Economists disagree over the shape of the SRAS curve, however, we can generally say that as

output increases , the pressure on resources causes the SRAS curve to get steeper and steeper

- Sticky nominal wages

- Sticky prices

- Menu costs (costs of changing prices)


pg. 5

Variables that shift the SRAS curve:

1. Expected changes in the future price level

2. Adjustments of workers and firms to errors in past expectations about the price level

3. Unexpected changes in the price of an important natural resource such as oil.

Variables that shift the SRAS and LRAS curves:

1. Increases in the labour force and/or in the capital stock, and/or in resources

2. Technological change

A dynamic AD/AS model

Three changes to the basic model:

1. Potential real GDP increases continually, shifting the long-run aggregate supply curve to the

right.

2. During most years the aggregate demand curve will be shifting to the right.

3. Except during periods when workers and firms expect high rates of inflation, the short run

aggregate supply curve will be shifting to the right.

Macroeconomics schools of thought

Keynesian revolution:

- The name given to the widespread acceptance during the 1930s and 40s of John

Maynard Keynes’s macroeconomic model.

Alternative models to Keynes:

1. The monetarist model

2. The new classical model

3. The real business cycle model

The Monetarist model

Monetary growth rule:

- A plan for increasing the quantity of money at a fixed rate that does not respond to

changes in economic conditions.

Monetarism:

- The macroeconomic theories of Milton Friedman and his followers; particularly the idea

that the quantity of money should be increased at a constant rate.

The New classical model

New classical economics:

- The macroeconomic theories of Robert Lucas and others

- The idea that workers and firms have rational expectations

- Will anticipate effects of any stabilisation policy


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The real business cycle model

Real business cycle model:

- Focuses on real, rather than monetary, causes of the business cycle

- Business cycle fluctuations are an efficient response to productivity changes

- Source of fluctuations found in the supply side of the economy

Notes on fiscal policy – topic 10

Fiscal policy involves changes in taxes and government purchases to achieve important

macroeconomic policy goals.

The government can affect the levels of both aggregate demand and aggregate supply

through fiscal policy.

Learning objectives

Define Fiscal Policy: Changes in federal taxes, transfer payments and purchases that are

intended to achieve macroeconomic policy objectives, such as full employment, price

stability, and sustainable economic growth.

Explain how fiscal policy affects aggregate demand:

An increase in government purchases will increase aggregate demand (AD) directly.

An increase in transfer payments or a reduction in taxes has an indirect effect on

AD through the effect on disposable income – this is appropriate when the economy

is in equilibrium below full-employment, e.g. a recession.

Contractionary Fiscal Policy

CFP involves decreasing government purchases and/or increasing taxes

A decrease in government purchases/increase in taxes will reduce the rate of

increase in aggregate demand, to reduce the inflation – this is appropriate when

the economy is above full-employment equilibrium and the inflation rate is high.

An initial increase in autonomous (i.e. discretionary) government spending, such as

building new railway lines, may increase AD by an amount that is more than the

initial amount of new spending.


pg. 7

Explain how the multiplier process works with respect to fiscal policy:

Government purchase multiplier

Change in equilibrium real GDP/ change in government purchases

Discuss the limitations of fiscal policy:

There are two main problems associated with the effectiveness of using fiscal policy to

stabilize the economy:

Time lags: The time lag of fiscal policy typically is longer than monetary policy

Recognition lag: the time it takes policy makers to ascertain there is a problem to be

addressed.

Legislative lag: the time it takes to have policy approved by both Houses of Federal

Parliament.

Implementation lag: the time it takes to implement the policy, and for the policy to

take effects.

Crowding out: A decline in private expenditures as a result of an increase in government

purchases. An increase in government purchases diverts financial and real resources

away from the private sector.

Financial crowing out: To finance a budget deficit, the government may need to sell more bonds and

securities, pushing up interest rates. Higher interest rates will reduce private investment spending

and consumption spending. Higher interest rates may also cause the Aus dollar to appreciate and

thus net exports to decline.

Resource crowding out: The government competes with the private sector for labour and other real

resources (e.g. land & intermediate goods), putting upward pressure on wages and prices. Higher

wages and prices reduce private investment and consumption.


pg. 8

- Most economists agree that there is partial crowding out in the short run.

- The extent of crowding out is larger if the economy is close to running at its full

capacity.

- Most economists agree that there is complete crowding out in the long run.

When the price level is not constant, AD (and thus equilibrium real GDP) will not

increase as much as when the price level is constant, i.e. the multiplier will be smaller –

the crowding out effect.

Explain how the federal budget can serve as an automatic stabiliser:

Federal government deficits decrease or surpluses increase automatically during expansions

because…

- Tax revenues increase

- Unemployment benefit payments decrease

Discuss the supply-side effects of fiscal policy:

Supply-side policies are Fiscal policies that have long-run effects by expanding the productive

capacity of the economy and increasing the rate of economic growth.

These policy actions primarily affect long run aggregate supply rather than aggregate demand.

The long-run effects of fiscal policy

Lowering personal income tax taxes can increase the incentive to work, and thus the labour supply.

Lowering company income tax and capital gain tax can encourage investment. Depending on the

type of investment (e.g. transport infrastructure or R&D instead of residential property), it may also

increase the production capacity in the long run.


pg. 9

Macro-economics in an open economy – Topic 11

Explain the main components of the balance of payments:

BOP: The record of a country’s international trade, borrowing, lending, capital and investment flows

with other countries.

It consists of four components:

Current account balance = net exports + net primary income + net secondary income.

(CAB) Net exports (NX) or balance of trade in goods and services : The value of the goods and

services Australia exports minus the value of the goods and services Australia imports

(CAB) Net primary income: (also known as net factor income): Income received by Australian

residents from investments in other countries, e.g. profits, dividends and interest repayments on

loans, plus income sent home by Australians working overseas, minus income paid overseas on

investments in Australia by residents of other countries, and minus income sent home by expatriates

working in Australia.

Financial account balance = purchases of physical and financial assets Australia has made abroad

minus foreign purchases of physical and financial assets in Aus.

(FAB) contains direct investment, portfolio investment, financial derivatives, other investments and

reserve assets.

The FA balance is a measure of net inbound foreign investment (FI).

FA balance (FAB) = inbound FI – outbound FI = net inbound FI

Inbound FI: Investment in Aus by foreign countries

Outbound FI: Investment in foreign countries in Aus


pg. 10

Capital account balance = net capital inflows due to migrants’ asset transfers, debt forgiveness and

sales and purchases of non-produced, non-financial assets.

Discuss the twin deficits hypothesis & concerns of current account deficit

Twin deficits hypothesis

If a government runs a budget deficit, it typically needs to raise an amount equal to the deficit by

selling bonds and securities

To attract investors, the interest rates offered must be higher than the current level, causing other

interest rates to rise

Higher interest rates can lead to crowding out of private investment and consumption

Higher interest rates will attract capital inflows and thus lead to an exchange rate appreciation,

reducing net exports

A budget deficit is likely to concurrent with a current account deficit – known as the twin deficits

hypothesis

In practice, “BOP imbalance” typically means CA deficit

CA deficits, if not self-corrected through exchange rate realignment, have to be financed either by

selling assets to foreign investors or by borrowing from overseas.

Assets that can be sold include: company ownership (i.e. equity), land & property titles, foreign

currency holdings, gold.

Australia’s current account has been in deficit since 1960


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As a country with abundant resources but a small population and a low saving rate, Australia does

not have sufficient domestic savings to maintain the high levels of domestic investment required for

economic growth.

It has to rely on foreign capital to fill the saving gap.

Explain how exchange rates are determined and how their movements affect net exports

If the home currency appreciates against other currencies (provided that prices are fixed):

- Exports become more expensive to foreign buyers

- Imports become cheaper to Australian buyers

- Net exports fall, reducing the rate of increase of aggregate demand and real GDP.

Examine the effectiveness of monetary and fiscal policy in an open economy

Monetary Policy

Monetary policy has a greater impact on AD in an open economy with a flexible exchange rate

regime than in a closed economy.

Expansionary monetary policy:

In an open economy, lower interest rates also lead to an exchange rate depreciaton, which increases

net exports.

Fiscal Policy

Fiscal policy has a smaller impact on AD in an open economy with a flexible exchange rate regime

than in a closed economy

Expansionary fiscal policy: increases in government purchases and/or tax cuts.

- Selling more government bonds will push up interest rates.

- Higher interest rates lead to an exchange rate appreciation, reducing net exports.


pg. 12

Topic 12 – International Financial System

Understand how different exchange rate systems operate

There are three main types of exchange rate systems

Floating exchange rate:

The exchange rates are determined by the demand for and the supply of currencies in the

foreign exchange (FX) market.

There is no “pure” floating exchange rate regime. The IMF uses the term “independently

floating regime.” Examples: Australia, Mexico, Israel, the UK, the US and Japan.

Managed floating exchange rate:

The value of most currencies is determined by demand and supply, with occasional central

bank or government intervention. Examples: Argentina, Czech Republic, Papua New Guinea,

Singapore.

Fixed exchange rate:

A system under which countries agree to keep the exchange rates between their currencies

fixed. Historical examples: the gold standard, the Bretton Woods system.

Explain trade weighted index and real exchange rate

Trade weighted index:

The TWI measures the value of a currency against a basket of the currencies of the country’s

main trading partners.

Even if a country pegs its currency against another currency (i.e. the anchor currency), its

TWI may still fluctuate if its trading partners do not peg their currencies against the same

anchor currency.

Real exchange rate:

The price of domestic goods and services (G&S) in terms of foreign G&S.

Real exchange rate = nominal exchange rate x (domestic price level/foreign price level)

Nominal exchange rate = Units of foreign currency/ 1 unit of home currency


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Real exchange rate appreciation: Domestic G&S become more expensive in terms of foreign

G&S reduce the home country’s trade competitiveness.

Real exchange rate depreciation: Domestic G&S become cheaper in terms of foreign G&S

improve the home country’s trade competitiveness.

Real trade weighted index: Bilateral real exchange rate has the same limitation as bilateral

nominal exchange rate in that it only measures the export competitiveness against a single

country. So a better measure is trade weighted real exchange rate or, in equivalent, real

trade weighted index.

Discuss the three key aspects of the current exchange rate system

1) Most developed countries like Australia, the UK, the US and Japan allow their currencies to

float against other currencies, with occasional central bank intervention.

2) Some developing countries have attempted to keep their currencies fixed against the US

dollar or other major currencies

3) Many nations in the European Union have adopted the single currency, the Euro.

Discuss the US-China exchange rate dispute

China started to pegged the yuan to the US$ in 1994

Officially, since 2005 the yuan has been pegged to a basket of currencies. But it is widely

believed the basket is dominated by the US$.

The US argued that the “artificially low value” of the yuan gave China producers “unfair

advantages” over the US producers, causing a large trade deficit of the US against China.

Explain the Big Mac Index, purchasing power parity and long run determinants of exchange rates

Big Mac index

The Economist magazine regularly publishes the Big Mac index, showing the US$ price of a

Big Mac in different countries and the implied over or under valuation of their currencies

against the US$.


pg. 14

In July 2011, a Big Mac cost Yuan14.7 in China, equal to $2.27 at the market exchange rate of

0.155$/yuan

If a Big Mac was priced the same as in the US ($4.07), then the yuan was undervalued by

about 44%

Purchasing Power parity

When the LOP (The law of one price – at the absence of transportation costs and trade

barriers, a product should be sold at the same price everywhere when expressed in the

same currency) is applied to all G&S, it becomes the purchasing power parity (PPP)

PPP – the long run exchange rates move to equalise the purchasing power of different

currencies

Long run determinants of exchange rates

If PPP holds, then the equilibrium (or long run) nominal exchange rate between two

currencies is given by:

Long run nominal exchange rate = (foreign price level/domestic price level)

Nominal exchange rate = Units of foreign currency/1 unit of home currency

Factors that affect the relative price level affect the relative price levels affect the long run

nominal exchange rate:

- Relative money supply growth

- Relative productivity (and thus real output) growth

Why PPP does not hold in reality? – Some G&S are not traded internationally by nature (e.g.

houses) or due to high transportation costs (e.g. car repairing services)

Product and consumer preferences are different across countries, so the baskets of G&S are

not identical

Countries impose barriers, e.g. tariffs and quotas, to trade.


pg. 15

Since these factors cause nominal exchange rates to deviate from the long run values

implied by PPP, they can also be considered as long term determinants of nominal exchange

rate.

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