ECON 1002: Introductory Macroeconomics School of Economics Faculty of Arts and Social Sciences University of Sydney. All Lectures and Notes

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The Open Economy: Exchange Rates (cont.) & The BOP Fixed Exchange Rates • Last week: monetary policy more effective in an open economy with a flexible exchange rate. • When exchange rates are fix... ed, monetary policy less effective as a stabili sation tool. • Fixed exchange rates determined by government, not the market. – Fixed to what? Gold, another currency … – Devaluation vs revaluationGold Standard I • CB holds enough gold to convert money into gold at an agreed exchange rate. • Bretton Woods – CBs fixed exchange rates to $US; $US-gold exchange rate $35/ounce. • System collapsed: – France reduced holdings of $US – Vietnam War  persistent US balance of payments deficits 3Gold Standard II • Advantages: – Low inflation  MS can only grow at rate of growth in gold supply – Fixed international exchange rates  less uncertainty in international trade – Importers sell gold, exporters buy gold, MS ↓ in importing countries  more competitive – Makes “financial repression” (r < π) more difficult – can‟t inflate away debt 4Gold Standard III • Disadvantages: – Countries with large natural gold reserves have a natural advantage – Could limit economic growth  MS can only grow at rate of growth in gold supply – LR price stability but SR instability – Unstable  speculative attacks • Fiat money – Money that has value only because a government says so! Role of the IMF • When the IMF bails out a country that is under attack, it usually poses as a condition that the government cut its budget deficit and interest rates to be kept high Monetary Policy and Fixed Exchange Rates Fixed vs Flexible Exchange Rates Balance of Payments • The BOP records transactions between residents and non-residents. • BOP = current account + capital account • If have a flexible exchange rate, the current account balance and the capital account balance should be equal, but because of data gathering errors they are not. For this reason, the account shows a statistical discrepancy Economic Growth II: Savings and Investment Savings: resources withheld from current income/consumption. Used to acquire new output-generating capital National income identity: Y = C + I + G Y = C + S + T S + (T – G) = I Two proble ms with the Solow-Swan model Steady state? Importance of k? Endogenous growth model Endogenise Solow residual Human capital, knowledge Economic growth: The Stylised Facts of Growth We now turn from the determination of output in the short and medium run—where fluctuations dominate—to the determination of output in the long run—where growth dominates. Growth is the stead y increase in aggregate output over time Economic growth and the business cycle From the simple Keynesian model of output determination in the short-run to long-term economic growth Short-run economic fluctuations (business cycles) Simple Keynesian model: Short-run equilibrium output determined by level of aggregate expenditure Prices are assumed constant. Supply meets the level of demand. Role for monetary and fiscal policies when equilibrium output falls short or overshoots potential output The AS/AD model: output determination in the short and medium run Prices (inflation) influence the level of demand (role of policy reaction function) Short run aggregate supply perfectly elastic at a specific price (inflation) level Role for monetary and fiscal policies when equilibrium output falls short or overshoots potential output In the long run, economy self-adjusts and return to potential output level. Long run economic growth: needs another model In the AS/AD model, economic growth would be represented by a rightward shift in potential output over time Changes in aggregate demand do not affect potential output The Solow Swan model Economic growth: long run increase in nations’ potential output Economic growth = gradual but significant increase in living standards Higher consumption opportunities Improved health care and life expectancy Two main issues Tremendous increase in living standards in most industrialised economies and East Asia : which factors contribute to economic growth? Many countries have not shared in this strong economic growth : why do some countries fail to grow? High standard of living in the US, Europe and Australia are the result of centuries of sustained economic growth, or the steady increase in the quantity and quality of goods and services produced (aggregate output). Because population growth accounts for a large share of the increase in output, a more accurate measure of standards of living is output per capita. Economic growth and comparing standards of living Minimal progress for 1900 years. For thousands of years, economic progress was largely linear and linked to population growth. Without machines or technological innovations, one person could only produce so much with their time and resources. Significant gains were made in the 20th century, particularly in western countries From the end of the Roman Empire to roughly 1500, there was essentially no growth of output per capita in Europe. From about 1500 to 1700, growth of output per capita turned positive but small. Even during the Industrial Revolution, growth rates were not high by current standards (in England growth was on average 1.3% between 1760 and 1820). Suppose that real GDP per capita in Australia had grown at 2.41% per year as Japan did, instead of the actual 1.45% per year, from 1870 to 2016. How much larger would real GDP per person have been in Australia in 2016? 1.0145146 -1 = 7.2 1.0241146 -1 = 31.4 It would have been 4.4 times larger Real GDP per capita is determined by average labour productivity (Y/N) and the share of the population that is working (N/POP) Y/POP = Y/N * N/POP The quantity of goods and services that each person can consume in a country depends on how much each worker can produce and how many people (as a fraction of the total population) are working Real GDP per capita can grow only with increases in labour productivity and/or increases in the share of the population that is employed Alice and Tom, two baristas at the university coffee shop Alice can produce 50 coffees per hour and Tom can produce 35. Alice’s weekly labour productivity is 50*40 Hours = 2000 coffees per week Tom’s weekly labour productivity is 35*40 Hours = 1400 coffees per week As a team, their average weekly labour productivity is (1400+2000)/2=1700 coffees per week Capital Accumulation Versus Technological Progress Table 12-2 illustrates three main facts: The period of high growth of output per capita, from 1950 to 1973, was mostly due to rapid technological progress, not to unusually high capital accumulation. Apart from Australia & UK, the slowdown in growth of output per capita since 1973 has come mainly from a decrease in the rate of technological growth, not from unusually low capital accumulation. Convergence of output per capita across countries has come from higher technological progress rather than from faster capital accumulation. The Determinants of Technological Progress Technological progress in modern economies is the result of firms’ research and development (R&D) activities. The outcome of R&D is ideas. Australian firms appear to be lagging in R&D. Australia spends 1.5% of GDP on R&D (low compared to US, France, UK, Germany & Japan) 30% of about 95,000 R&D personnel are employed by firms in Australia. (In US, 75% of 1 million). Australian firms spend 11% of gross investment on R&D. (In US, 20%). Spending on R&D depends on: The fertility of the research process, or how spending on R&D translates into new ideas and new products, and The appropriability of research results, or the extent to which firms benefit from the results of their own R&D. How much labour should a firm employ? The marginal revenue product of capital 〖??〗_? is the extra output obtained from another hour of labour: 〖???〗_?= 〖??〗_?* P Labour is also characterised by diminishing marginal productivity: When all other factors of production are held constant, the marginal product of a factor decreases as the amount of that factor increases in the production process: when L↑???? 〖??〗_?↓ Given that P is constant, when L↑????〖 ???〗_?↓ The optimal labour stock is when 〖???〗_?= W When the marginal revenue product of labour is higher than the nominal wage, firms will employ more workers. Conversely, when the marginal revenue product of labour is lower than the nominal wage, the demand for labour will fall. Firms adjust their demand for labour until the nominal wage equal the marginal revenue product of labour 〖???〗_?= 〖??〗_?* P = W or 〖??〗_?=P/W The aggregate production function is a specification of the relation between aggregate output and the inputs in production. ?_?=?_?∗?(?_?,?_?) Y = aggregate output. K = capital: the sum of all the machines, plants, and office buildings in the economy. N = labour: the number of workers in the economy. The function F, tells us how much output is produced for given quantities of the primary factors of production (capital and labour). Y depends also on the various secondary factors of production (technology…) or Total Factor Productivity A. Assumptions: Diminishing marginal productivity of labour Diminishing marginal productivity of capital Therefore, The aggregate production function depends on the state of technology and other secondary factors of production or Total Factor Productivity A. The higher A, the higher the output for a given K and a given N. For now, we assume all secondary factors of production remain constant and A=1 Cobb Douglas production function and diminishing marginal productivity Decreasing marginal productivity of capital refers to the property that increases in capital, given labour, lead to smaller and smaller increases in output as the level of capital increases. Decreasing marginal productivity of labour refers to the property that increases in labour, given capital, lead to smaller and smaller increases in output as the level of labour increases. Using the previous Cobb-Douglas production function ?_?=5〖?_?^ 〗^0.2 〖?_?^ 〗^0.8, calculate output if the supply of labour and capital both increase by a factor of 3 When K=1 and L=1, Y=5 With K=3 and L=3, Y=15 Growth accounting: The Cobb Douglas function provides a framework to analyse countries’ historical growth and understand the respective role of increasing primary and secondary factors of production. Useful to provide clues for countries seeking to achieve similar growth Useful to understand whether the key to increasing productivity is increasing stock of capital or increasing Total Factor Productivity (the secondary factors of production) Increase in labour supply and effect on output Epilogue: The (historical) secrets of growth The dynamics of economic growth vary between countries and over time. From Book Table 14.1 In Australia from 1980 to 2013, growth has been largely the results of increase in TFP and labour supply. But productivity has slowed recently. Increases in capital stock were the main driver of economic growth in the Japan, Germany and the UK until WW2, while TFP was the stronger factor in that period in the US. From WW2 to the first oil shock (1973), increases in TFP were the main drivers of economic growth in Germany, the US and Japan (see also slide 45). TFP improvements have had a lesser impact on growth since 1973 (productivity slowdown), except in Germany The strong growth recorded in South East Asia since the 1960s was mostly due to strong increases in the stock of capital. Aggregate demand/Aggregate supply The AS/AD model of macroeconomic equilibrium beyond the short-run From PAE line to AD curve The factors driving changes in inflation Macroeconomic self-adjustment in the long run Role, tools and e ffectiveness of macroeconomic stabilization policies The aggregate demand curve: relationship between inflation (the rate of change in the price level) and short-run equilibrium output Equilibrium output = planned expenditure => the AD curve shows the relationship between inflation and expenditureding/output in the short run The AD curve is downward sloping=higher inflation lowers planned expenditure and short-run equilibrium output The AD curve and the PAE line We can derive the aggregate demand curve from the planned aggregate expenditure line by: Altering the price level in the aggregate expenditure model Linking together the equilibrium levels of GDP that can be derived from each aggregate expenditure line. As a result, the aggregate demand curve (AD) shows for each price level an equilibrium level of GDP where demand equals output (or where PAE = Y) Lecture 6 The economy: 2 September 2019 Monetary policy (introduction) Money, prices and the Reserve Bank The financial system: the allocation of saving to productive uses The role of banks: Financial intermediation Stand between savers and investors Asymmetric infor mation Help identify productive borrowers Pool saving of small savers; only need to evaluate each large loan request once. Provide access to credit that may otherwise be unavailable (e.g. to a small business) Easy to make payments. Bonds Bond prices and interest rates Bonds can be sold before maturity. Bond prices and interest rates are inversely related … why? Example: A 5-year bond, with a principal amount of 1000 and with a 5% coupon rate, paid annually issued and bought on Jan 1, 2010: Pays $50 on Jan 1 2011, 2012, 2013, 2014 Pays $1050 on Jan 1, 2015. Bond prices and interest rates (cont.) Say bondholder sells their bond on Jan 1, 2013 (i.e. after 3 years) when the current interest rate on an alternative investment is 15% per annum. How much will buyer will be willing to pay? Existing bond will return $50 on Jan 1 2014 and $1050 on Jan 1, 2015  $1100 in total. Alternative investment returns (1.15)2 x $1000 = $1322.5. So original bond worth < $1000. Bond prices and interest rates Thus, buyer will be willing to pay: P x (1.15)2 = $1100  P = $831.76 If current interest rates are 5%: P x (1.05)2 = $1100  P = $997.73 If current interest rates are 2%: P x (1.02)2 = $1100  P = $1057.29 NB: If r > 0, P < $1100. r ↓  P ↑ Interest, bond prices and bond yields Multiply the bond's coupon rate by its par value (or face value) to determine its annual interest. In this example, multiply 5 percent, or 0.05, by $1,000 to get $50 in annual interest. Divide the bond's annual interest by its price to convert the price to a yield. In this example, divide $50 by $831 to get 0.0601 or 6.01%. This means the bond’s annual interest equals 6.01 percent of its market price. The higher the current interest rate, the lower the bond price The lower the bond price the higher the yield Bond yields reflect interest rates expectations Australian bond yields Australia yield curve Australia bond spread US yield curve – August 2019 The stock market Stock prices Stock price, interest rate and risk premium Bond and stock risks Stock risk generally > govt bond risk Dividends and expectations of future price (and, hence, current stock price) vary with specific information about a single company. Bond prices vary with interest rates, i.e. specific information about a whole economy. Thus, desired rate of return on stocks greater than for bonds – risk premium. Other things equal, extra risk will reduce stock prices. Bond and stock market: the benefits of diversification Diversification: it is a risk management strategy that mixes a wide variety of investments within a portfolio. Diversification helps investors ride out the ups and downs of financial markets by spreading their savings across different asset classes. Diversification reduces overall investment risk and reduces volatility of returns on an investment portfolio as a whole. Bond and stock markets help reduce risk by giving savers a means to diversify their financial investment. Money Money has 3 uses: Medium of exchange Unit of account Store of value How is money measured Currency: notes & coins Base Money : currency + reserves. M1: currency + current bank deposits M3: M1 + deposits of private non-banks Broad money: M3 + other AFI borrowings Money supply growth Money supply growth Money aggregates Banks and money creation (book) Money supply: currency + deposits Bank assets: currency + reserves + loans Bank liabilities: deposits Reserve-deposit ratio = Bank Reserves/Bank Deposits If reserve-deposit ratio < 1, then can lend out rest. But loans return to bank balance sheets as deposits. Money supply expands … Currency, reserves, deposits, R-D ratio and the money supply Desired R-D ratio: banks reserves/deposits Deposits: banks reserves/R-D ratio Money supply: currency held by public+ deposits Money supply: currency held by public+ bank reserves/R-D ratio Lecture 5: Fiscal Policy What is fiscal policy? To smooth out economic fluctuations and achieve a full-employment and non-inflationary level of GDP, the government manipulates aggregate demand by changing government ex penditures and taxes. Fiscal policy consists of:  Government spending  Taxes and transfer payments Keynes: G is the most effective tool  Great Depression (1930s):  The GFC ? Are G and C perfect substitutes? But what about T? Assessing the fiscal stance: structural versus cyclical Is the Government is pursuing an expansionary or contractionary fiscal policy? Or is it pursuing any active fiscal policy at all?  To assess the fiscal stance, the budget deficit (or surplus) figure is not accurate enough  The phase of the business cycle will change the size of the budget deficit (or surplus) even in the absence of any active fiscal policy Structural versus cyclical budget deficit/surplus Fiscal policy: two broad tools Automatic stabilizers:  act to dampen fluctuations in economic activity without direct intervention by policymakers.  They are structural features in government transfers and taxation that automatically smooth out fluctuations in disposable income (hence consumption, hence aggregate expenditure) over the business cycle. Discretionary fiscal policy  Change in G and/or T.  A change in t (the marginal tax rate) can also be used as discretionary fiscal policy. Structural versus cyclical budget deficit/surplus (continued) The structural budget balance is the budget balance that would arise if the economy was producing at full employment (potential output level) The cyclical budget balance Structural versus cyclical deficits Structural and cyclical budget deficit/surplus and the fiscal stance A change in those automatic stabilizers mean a change in the propensity to tax (t) and the multiplier Discretionary fiscal policy Changing government spending G to change PAE If the government injects G=$10billion of additional spending, and c is 0.8, the final change in GDP is: The multiplier effect of an increase in government expenditure Discretionary fiscal policy: examples in open economy with progressive taxes Discretionary fiscal policy Discretionary fiscal policy: effect of increasing government spending G Discretionary fiscal policy: effect of lower progressive tax rate Discretionary fiscal policy: effect of decreasing exogenous net taxes T We have seen that an increase in government spending (G) will increase GDP or Y We have also seen that an increase in net taxes (T) will reduce GDP (Y) An equal increase in government expenditures (G) and taxation (T) by $X will increase GDP by $X (with simple multiplier). This is because a change in government expenditure has a LARGER impact on the PAE than a change in taxation OF THE SAME SIZE. Why? Because ΔG =>ΔPAE directly, but ΔT =>ΔPAE indirectly through Δ(Y-T) and then ΔC The balance budget multiplier (assuming exogenous taxes, net exports and no progressive taxes) Identical changes in government spending G and net taxes T change output Y by that same amount. Remember: C = C + c (Y-T) where T (net taxes) = TA (taxes)- TR(transfer) Case 1 Assuming taxes are exogenous, net exports are exogenous and t=0) PAE = C + c (Y – T) + Ip + G + NX In equilibrium, Y = PAE so Y = C + c (Y – T) + I + G + NX or Y= [1/(1-c)] *(C + I + G + NX - cT) and ΔY = ΔT*[-c/(1-c)] The macroeconomic affect of a bonus payment Effectiveness of fiscal policy as a stabilisation tool A few qualifications  1. Fiscal policy affects also potential output Capital expenditures Tax and transfers can alter the behaviour of economic agents  2.need to keep budget deficit under control Sustained budget deficit reduces national saving (and increases the public debt) and therefore investment (a key to long term growth)  3. relative inflexibility of fiscal policy Changes in government spending must go through a lengthy legislative process - lags Competing goals for allocation of government funds Effectiveness of fiscal policy as a stabilisation tool he magnitude of the impact of changes in government spending and taxes on GDP, employment and inflation depends on:  A. The extent to which a changes in G or in T will affect planned aggregate expenditure  B. The extent to which the change in PAE will affect GDP Those magnitudes are hard to forecast Gini coefficient and Lorenz curve Contemporary fiscal policy: 3 key roles in Australia International Gini Coefficients Contemporary fiscal policy: 3 key roles in Australia 3. Managing the public debt The difference between debt and deficit  Budget deficit: when government's revenues fall short of its expenses, and refers to net expenditure flows in a single financial year.  The debt is the cumulative balance of these flows over time.  Gross debt is the value of Commonwealth Government Securities, which the government issues to investors when it needs to borrow money to cover its costs.  Net debt is calculated by taking into account money owed to the government, along with selected financial assets it can sell to meet its financial obligations. Net debt = deposits held + government securities + loans and other borrowing - cash and deposits + advances paid + and investments + loans and placements  Increasing net debt means that the budget deficit is increasing faster than the increase in the value of financial assets. The government budget constraint Definition: the government budget constraint is the relation between debt, deficits , government spending and taxes Financing a budget deficit and the national debt The budget deficit equals spending (G), including interest payments on the debt that has already been accumulated, minus taxes net of transfers. To finance a budget deficit, the Government will borrow money by selling government securities (bonds) Do not confuse the words deficit and debt. Debt is a stock, what the government owes as a result of past deficits. The deficit is a flow, how much the government borrows during a given year Financing a budget deficit and the national debt (continued) The budget deficit equals the debt incurred by the Government over a year. The budget constraint simply states that the change in government debt during year t is equal to the deficit during year t. Budget deficits, debt reduction and debt stabilization Budget balance and net debt The dangers of very high debt levels Twin deficits: the budget balance and the current account Money, prices and the Reserve Bank The financial system: the allocation of saving to productive uses The role of banks: Financial intermediation  Stand between savers and investors  Asymmetric information  Help identify productive borrowers  Pool saving of small savers; only need to evaluate each large loan request once.  Provide access to credit that may otherwise be unavailable (e.g. to a small business)  Easy to make payments Bonds A legal promise to repay a debt at a specific date in future (maturation): principal + interest payments.  Issued by governments  Issued by firms The coupon rate: rate at time bond issued (ex: 5%). Coupon payment (if annual) = principal x coupon rate (ex: 5%*$1,000)=$50. Term: 24hrs – 30 years Bond prices and interest rates Interest, bond prices and bond yields A share or stock (equity) is a claim on partial ownership of a firm.  Regular income in the form of a dividend.  Capital gains if price of stock increases Stock price, interest rate and risk premium Bond and stock risks Bond and stock market: the benefits of diversification Money has 3 uses: 1. Medium of exchange 2. Unit of account 3. Store of value  How is money measured  Currency: notes & coins  Base Money : currency + reserves.  M1: currency + current bank deposits  M3: M1 + deposits of private non-banks  Broad money: M3 + other AFI borrowings Money supply growth Money aggregates Banks and money creation Currency, reserves, deposits, R-D ratio and the money supply If $100 is held by public in the form of currency and $200 is held in reserves. If also, the desired R-D ratio is 10% What is the money supply? The money supply are currency in hand of the public + deposits. Deposits = reserves/R-D ratio =$200/0.1=2000 Money supply =100+2000=2100 Money supply and inflation Velocity = value of transactions / money stock = nominal GDP/money stock => V= (P x Y) / M The ―quantity equation‖  M x V = P x Y If V and Y fixed, then ↑M  ↑P If the quantity of goods and services Y is constant, and so is V, then an increase in the supply of money leads to increasing inflation P Money supply and inflation The RBA and interest rates RBA uses open market operations to change supply of reserves: The RBA can influence the amount of excess reserves, and hence the level of the cash rate, by buying and selling government securities in open-market operations Open market operations and the money supply If the central bank buys govt bonds from commercial banks  ↑ reserves Given the desired R-D ratio, banks will be inclined to increase loans  ↑ deposits to level determined by reserves/R-D ratio. Central bank, saving and investment Addendum: Money Creation in the Modern Economy McLeay et al (2014) Bank of England Quarterly Bulletin The central bank controls the quantity of money in circulation (so that it is consistent with its goal of low and stable inflation) by setting the ―price‖ of reserves, i.  Given i, economic agents decide how much to borrow and banks decide how much to lend  Deposits created determine reserves needed90 Money creation Banks first decide how much to lend depending on the profitable lending opportunities available to them — which crucially, depend on the interest rate set by the central bank. It is these lending decisions that determine how many bank deposits are created by the banking system. The amount of bank deposits in turn influences how much central bank money banks need to hold in reserve (to meet withdrawals by the public, make payments to other banks, or meet regulatory liquidity requirements), which is then, in normal times, supplied on demand by the central ban Creating and destroying money Money/deposits created when  Banks issue new loans  Banks buy govt bonds from private non-banks  Central Bank buys assets (government bonds) (QE) Money/deposits destroyed when  Loans are repayed  Banks issue long-term debt/equity (i.e. non-deposit liabilities) International considerations … Limits to money creation Factors that constrain lending: Competition between banks Risk management by banks Regulatory requirements Behaviour of money holders Central bank monetary policy affects loan demand (via i and impact on economic activity) Price of loans – limits borrowing Limits to money creation: the central bank’s monetary policy Another monetary policy tool: quantitative easing Central bank can buys assets from NBFIs (and bypasses commercial banks). But these institutions don‘t have reserves; use banks as intermediary. The central bank thus credits the reserve account of the NBFI‘s bank with the funds, and that bank credits the NBFI‘s account with a deposit Quantitative easing: transmission mechanisms Lecture 4: Macroeconomics in the short run: The basic Keynesian model of output determination: aggregate expenditure and output in the short run The concept of aggregate expenditure  The Keynesian view of consumption  Planned aggregate expenditure and output using simple algebra  Equilibrium in the Keynesian model of output deter mination  The output gap and the multiplier The goals of macroeconomic policy makers are (1) to increase the rate of long-term economic growth, and (2) stabilize the economy. Fluctuations in the level of consumption, investment, government spending and net exports will influence the level of aggregate expenditure. Fluctuations in planned aggregate expenditure can cause output to differ from potential output. Too much spending leads to expansionary output gap. Too little spending leads to a contractionary output gap. What ultimate impact will changes in aggregate expenditure have on GDP? Introduction of the Keynesian multiplier. GDP can be decomposed into expenditure components (consumption, investment, government spending and net exports); refer Week 1. The fluctuations in GDP can be understood by examining the fluctuations of each of the component of aggregate expenditure. It is possible to influence the level of output by influencing the level of any of its components The Keynesian model focusses on the short run Analysis of the economy in the short run (the period when prices do not adjust to changes in demand) Key assumptions: Firms do not respond to every changes in the demand for their products by changing their prices. Instead they set a price for some period and meet demand at that price.  In the short run, if demand is low at the current price level, firms will produce less (not lower their prices). They will produce more if demand for their goods is higher than expected (not raise price)  In the long run, classical economists argue that prices will adjust to the level of products demanded so that output will return to its potential level without intervention Firms produce goods and services (aggregate output or GDP) in response to planned aggregate expenditure on goods and services (PAE) and make payments, wages and profits, which become aggregate income (Y) Consumption: Spending by households on final goods and services 2. Investment Spending by firms on new capital goods. Spending on new houses and apartment buildings. Changes in inventories. 3. Government spending Spending by governments on goods and services (transfers payments are not included). 4. Net exports Exports minus imports Actual, planned investment and inventories Consumption is a function of income The mpc is the slope of the consumption function. The consumption function is upward sloping because consumption increases when disposable income increases Determinants of autonomous consumption The saving function Determinants of exports Exogenous determinants of imports Consumption, investment, government spending and net exports Equilibrium and full employment GDP Equilibrium and disequilibrium Circular flow of expenditure and income in a simplified economy Leakages and injections in a twosector economy Leakages and injections in a twosector economy The paradox of thrift Suppose a large group of people decides to save more. You might think that this would necessarily mean a rise in national savings.  However, increased saving mean lower consumption which causes less production. As a result, incomes will fall, and so will savings, other things equal. This induced fall in savings can largely or completely offset the initial rise. In the next diagram equilibrium output falls.  Which way it goes depends on what happens to investment, since savings are always equal to investment. If interest rates can fall, investment and hence savings may rise. But if interest rates can’t fall rates — say, because they’re already close to zero — investment is likely to fall, not rise, because of lower capacity utilization (lower consumption). And this means that GDP and hence incomes fall so much that when people try to save more, the nation actually ends up saving less What ultimate impact will changes in aggregate expenditure have on GDP? Introduction of the Keynesian multiplier The simple Keynesian multiplier Definition: the ratio of a change in GDP (Y) demanded to the initial change in expenditure The change in the quantity of aggregate output demanded depends on how much the aggregate expenditure line shifts upwards or downwards, not on which expenditure components increases or decreases: ΔY = x*Δ(?+Ip+G+NX) Assume the mpc is 0.8 and that Y is currently $500bn. The government wants to increase Y to $600bn. By how much does it have to increase G to achieve its goal? The extended Keynesian multiplier Week 2: Lectures 3-4: Introductory Macroeconomics. Measuring Economic Performance: The Price level Measuring Economic Performance: Savings and Wealth Measuring macroeconomic imperformance An economy is performing well if: Rising long term leaving standards The price level is under control (WEEK 2) The need for savings and investments are bala nced (WEEK 2) All individual seeking work are employed (WEEK 3) Extreme short-run macroeconomic fluctuations are avoided (WEEK 3) At the end of this lecture, you should be able to answer the following questions: How is the CPI (and inflation) calculated? What are the economic costs of inflation? Do I understand the distinction between the nominal and real rate of interest? Why do people save? What is the link between savings and wealth? What is national saving and how is it related to investment? Value of money, the price level and inflation Measuring the price level: The Consumer Price Index (CPI) The Consumer Price Index (CPI): average price of a basket of goods and services consumed by a typical family It is calculated relative to a base year which is set at a benchmark value of 100. For example: In the March quarter 2019, the Australian GDP price index was 114.1. The price level that year was 14.1% higher than in the base year (2011/12). Comparison of cost of living indices Ideal cost of living index: A: Determine the cost of the utility-maximising consumption basket in the base year (say year 2010). B: Determine the minimum cost of the current year (i.e. 2019) consumption basket required to yield base year utility at current year prices. Index value = B/A Calculated based on preferences, not purchases This is how the CPI should be calculated! Inflation indexing When a price, wage, or interest rate is adjusted automatically with inflation, it is said to be indexed. An indexed payment increases with to the index number that measures inflation. A wide array of indexing arrangements is observed in private markets and government programs. Since the negative effects of inflation depend in large part on having inflation unexpectedly affect one part of the economy but not another—such as increasing the prices that consumers pay but not the wages that workers receive—indexing can take some of the sting out of inflation. No clear-cut threshold. One of the most famous episode of hyperinflation: Germany in 1923 when the rate of inflation reached 7,000,000,000,000%!!!! Many recent episodes of hyperinflation in South America and Africa. Venezuela has been experiencing hyperinflation since 2016. Hyperinflation magnifies the costs of inflation. With prices changing daily or even hourly, markets are no longer efficient and perform poorly. The economy slows down significantly. Saving is discouraged as every dollar saved quickly loses its purchasing power. Investment shrinks as future profits are too difficult to estimate. Huge redistributions of wealth takes place. Why is deflation a problem? With deflation, commodity prices, asset prices and incomes fall. But the value of debt and set repayments stays constant. So the real value of debt and repayments rises. This will lead to a collapse on consumption and even sound businesses may become bankrupt (eg. The 1930s and Japan over the last decade) However, the odd year of falling prices does not matter. The main risk is that it feeds into lasting expectations of falling prices and thus delayed spending which will feed further downward pressure on prices Inflation and interest rates What is an appropriate rate of inflation? Concept of Real interest rates Nominal Versus Real Interest Rates and Expected Inflation real interest rate ≈ nominal interest rate − inflation rate. Where: it = nominal interest rate for year t. rt = real interest rate for year t. t = actual rate of inflation This means that when the rate of inflation is zero, the real interest rate is equal to the nominal interest rate. With positive inflation, the nominal interest rate is higher than the real interest rate. Effectively, the real interest rate is the nominal interest adjusted for the rate of inflation. It allows consumers and investors to make better decisions about their loans and investments 2019: negative real interest rates Under some circumstances, it may still be convenient for people or businesses to hold financial assets or savings accounts, even with interest rates below zero, rather than converting their financial wealth into cash. July 2019 in Australia: The RBA lowered the cash rate to 1%. As inflation was reported at 1.6% in the June quarter 2019, the real cash rate is negative at -0.6%. Measuring macroeconomic performance Saving involves a trade-off: the decision to postpone consumption to provide resources for the future. The life-cycle theory (F. Modigliani) ` The life-cycle theory predicts that people save a lot when their income is high relative to their lifetime average income, and dissave when their income is low relative to their lifetime average income. The life-cycle hypothesis views individuals as planning their consumption and saving behaviour over long periods with the intention of allocating their consumption in the best possible ways over their entire lifetime Savings result mainly from individuals’ desire to provide for consumption in old age. During the working life, the individual saves, building up assets. At the end of the working life, the individuals begins to live off those assets. Rationales for the low Australian household saving rate The problem posed by low household saving in Australia is probably overstated. It is national saving, not household saving, that is a key determinant of an economy capacity of invest in new capital goods and thus ensure continued long-term economic growth Business saving in Australia is significant Private and public components of national savings An important concept: the opportunity cost The determinants of investment: Project evaluation and interest rates If the firm needs to borrow money to invest in new capital, it will have to pay to pay back its debt. The real interest rate then determines the real cost to the firm of paying back its debt. Thus increases in real interest rate make the purchase of capital goods less attractive to the firm (all else being equal) As a result, the demand for investment (i.e. the quantity of investment demanded) is negatively correlated with real interest rates (other things held constant). When the opportunity cost of investing is low, firms invest more. Patrick is currently earning $4400 each summer working as a barista. He is thinking of going into lawn care business. He can buy a $4000 ride-on mower by taking out a loan at 6% annual interest rate. With this mower he hopes to make $6000 per summer, after deducting the costs of maintenance and petrol. However, he will have to pay 20% government taxes on the expected $6000 revenues. Assume Patrick can resell the lawn mower for $4000 (ie does not lose value over time), should Patrick buy the lawn mower and start this new business? Saving and investment equilibrium The investment curve is downward sloping; the lower the real interest rate, the lower the marginal return on capital needs to be to still provide a better return than the interest rate. Ie the opportunity cost is low. So there is a lot of investment. In the example we saw earlier (patrick), if the interest rate is 2% instead of 6, the cost of running a lwan mowing business is much lower ($80) instead of $240. Threfore his expected benefits don’t need to be that high for his business to be worthwhile (profitable). Effect of new technology on the saving and investment equilibrium The impact of the government budget deficit on national saving and investment The mining boom and investment in Australia ECON 1002: Lecture 1: Introductory Macroeconomics Lecture 1 Week 1: Learning outcomes By the end of week 1, you should be able to discuss The distinctions between microeconomics and macroeconomics The main macroeconomic performance measurements The concept of GDP Nominal versus real GDP Introduction to national accounting The limits of GDP as a measure of an economy’s performance What is economics about? Microeconomics Macroeconomics Macroeconomics is a set of theories about how the economy as a whole works It focuses on aggregate demand and aggregate supply It looks at national output, national employment, and the general level of prices Macroeconomics also examines a country’s economic relationship with the rest of the world Macroeconomics Macroeconomics Microeconomics provides a foundation for macroeconomics… And macroeconomics underpins many microeconomic decisions Macroeconomics’ main focus: the performance of a national economy Economic growth = rising living standard. When economic growth is high, the production of goods and services is rising, making possible increasing standard of living Macroeconomic theories are thus concerned with The factors that explain the increase in a country’s standard of living over time The role economic policy can play to speed up economic progress Main macroeconomics tools Measures of a country’s economic performance Macroeconomic theories to explain: The levels of certain economic variables (eg. economic growth, employment, prices, production…) The fluctuations of these variables Macroeconomic theories are also used to Forecast future levels of economic variables Understand and estimate the impact of economic policies and events Keep in mind… What is macroeconomics aiming to achieve? So why study macroeconomics today? Why study macroeconomics today? Macroeconomics is ubiquitous…and you know more macroeconomics than you think! Try and answer this: what are some of the implications for the low A$ exchange rates? For the economy? For you? Macroeconomics relevance to business (and your future employment) Some examples: Any firm: The current and future levels of interest rates are of utmost importance to businesses. Qantas: needs to be able to forecast future kerosene prices and passenger numbers. Economic growth forecast will help with forecasting both the demand for oil and the demand for travel. Rio Tinto: Needs to forecast commodity prices to decide future investment in its mining operation. Economic growth forecast in the major consumers of commodities will help to forecast the demand for commodities and ultimately commodity prices and the profitability of the mining industry. Understanding and managing major forthcoming issues Major issues with macroeconomics consequences which will shape our lives in the decades to come: Brexit, Europe, some future financial crisis Environmental challenges Global free trade … under threat? The rise of new world powers The impact of new technology Widening inequalities Population pressures … migration Macroeconomics also helps us answer questions such as: Why is Australia richer than India? Why some countries are so rich and others so poor? Why some countries are growing, or have stopped growing while others are not? Will the economy be better or worse by the time you graduate? Will the interest rate rise or fall next month? Will the Australian dollar be stronger or weaker next year? Why has wage growth been subdued for some time? Is the 2018-19 Budget good for the Australian econ? Major macroeconomic issues Economic growth and living standards: Some perspectives More than half the world’s population lives on less than US$4,000 per year. Average level of per capita income in Australia was US$55,507 in 2017. Korea had the same level of real income per capita as the Philippines in 1965; by 2010 Korea’s real income per capita was 6 times that of the Philippines In 1870, average real GDP per capita in the UK was 37% higher than that in the US. By 2010 average real GDP per capita is 32% higher in the US than in the UK Economic growth and living standards High standard of living in the US, Europe and Australia are the result of centuries of sustained economic growth, or the steady increase in the quantity and quality of goods and services produced (aggregate output). Because population growth accounts for a large share of the increase in output, a more accurate measure of standards of living is output per capita (we will look at that in more details later). Australia’s output Standard of living and Importance of Growth Rates A 1% growth rate over 40 years leads to an increase of 48% in the initial output per capita or standard of living 1.0140 - 1= 1.48 -1 = 48% “Rule of 70”: 1.0170 -1 = 1.007 = 100% Little (approximate) mental math tool: years to double=70/rate of growth So an economy growing at 2% per annum will double its output in 70/2 = 35 years. At 3% per annum, it will take 70/3=23 years. A broad look across time and space Growth of output per capita is a recent phenomenon and with it came major improvements in standard of living World population = 1 bn in 1900 7.7 bn todayLife expectancy = 40 yrs “ 72 yrs “Child mortality (<1yr old) = 25% “ 6% “% read & write = 25% “ 80% “Poverty (<US$2 per day) = almost 1 bn “ 1 bn “ Global standards of living are improving, mainly due to growth in China and India Growth (increasing standard of living) is not an economic certainty Growth (increasing standard of living) is not an economic certainty From the end of the Roman Empire to roughly 1500, there was essentially no growth of output per capita in Europe. From about 1500 to 1700, growth of output per capita turned positive but small. Even during the Industrial Revolution, growth rates were not high by current standards (in England growth was on average 1.3% between 1760 and 1820). Economic growth and living standards: major questions What caused this remarkable economic growth? Can it continue? Should it continue? Can it be replicated by other countries and how? Major macroeconomic issues 2. Labour productivity Average labour productivity (output per employed worker or per hour worked) is closely related to standard of living Average labour productivity has grown rapidly. However the rate of improvements in average labour productivity has slowed since 1997. Major questions: what causes the changes in the rate of improvements of average labour productivity? Productivity gains have slowed Major macroeconomic issues 3. Recessions and expansions Economies experience periods of particular weakness (recession) or strength (expansions or boom) Major macroeconomic issues 4. Unemployment The unemployment rate is the percentage of people who would like to work but can’t find work. It increases during recessions and generally decreases in boom time. Major questions: why does unemployment rise sharply in time of recession? Why is there always unemployed people even when the economy is booming? Why are unemployment rate so different between countries? Comparative unemployment rates Historical unemployment rates Major macroeconomic issues 5. Inflation Inflation is the rate at which prices are increasing over time. High rates of inflation imposes many costs on the economy. Major questions: why was inflation high in the 1970s and relatively low now? Why is inflation still so high in some countries such as Venezuela, Brazil and Zimbabwe? Is high inflation the price to pay for low unemployment? Global inflation rate Comparative inflation rates Week 1 – Week 4Macroeconomics Building Blocks Measuring macro performance Output Prices and Inflation Savings, wealth and investment Unemployment Short-run macro: Economic fluctuations The Keynesian model of output determination in the short run Week 5- Week 12 Policy responses: Fiscal policy Monetary policy & the RBA Aggregate demand and supply Economic growth The role of saving Exchange rates & the balance of payments Measuring the performance of an economy:1. OUTPUT Gross Domestic Product (GDP): a basic measure of living standard Australia’s recent economic performance Measuring GDP 3 ways to measure GDP Product approach Expenditure approach Income approach Product approach to measuring GDP The product method measures GDP as the sums of the value added at each stage of the production process (i.e wages+gross profit) Example of Product Approach Another example of Product Approach Farmer Chin produces 100L of milk. She sells 40 litres at 1$ per litre and feed the rest to her pigs which she sells for 120$. Her contribution to GDP is: 40+120=160 Now assume that she pays a farmhand 10$ to produce those 100L of milk. Her contribution of GDP is: 10 (wages) + gross profits (40+120-10) = 160 Now assume farmer Chin purchases 100L of milk at 0.50cents per liter. She sells 40 litres at 1$ per liter, feed the remaining to the pigs which she sells for $120. Her contribution to GDP is: 160-50=110 GDP: Expenditure measure Calculates GDP by adding up the aggregate expenditure on all final goods and services produced during the year in a country. It includes Personal consumption expenditures (purchases of services, non-durable goods and durable goods expected to last at least 3 years). Investment: New physical capital, new residential construction and changes in inventories . Government consumption and investment Net exports of goods and services GDP: Expenditure measure Australia’s recent economic performance GDP: Income measure The income approach to GDP sums the incomes to all those involved in the production process GDP(I) = W + Π +MI+ (IT - Sb) where: W = wages, salaries, employers’ social contributions and supplements (rents, dividends, interest…) Π = gross operating surplus (profits) MI= gross mixed income (income from unincorporated businesses) IT = indirect taxes Sb = subsidies W + Π = domestic factor income W + Π + MI = GDP at factor cost (ie cost of factors of production) Direct taxes, indirect taxes, subsidies and the Income Account A comparison Example Let’s go back to the example of the production of bread. And let’s suppose an economy where only bread is produced, sold and consumed. Product approach to GDP (sum of value added at each stage of the production process): GDP=120+120+140=380 Income approach to GDP (sum of wages,profits) GDP=80+40+50+70+40+100=380 Expenditure approach to GDP GDP=380 (ie price of bread at the end) The circular flow of income in a two-sector model Limitations of national accounting methods GDP underestimates the size of the economy Household production and non-market economic activities are not included in GDP Because non-market economic activities are not counted in official statistics, GDP data substantially underestimate the size of the economy and par extension the standards of living of the country. It is particularly true in developing countries which may substantially underestimate the true amount of economic activity in the poorest country. The underground economy Only about 3% of GDP in Australia Underground economy in Greece is about one quarter of GDP, according to University of Macedonia Professor Vassilis Vlachos. Underground economy estimated at up to 40% in Brazil Value of household production relative to GDP Limitations of national accounting methods There are 3 key GDP concepts Nominal versus real GDP Nominal GDP: Value of output at the prices prevailing in the period during which the output is produced. It is useful for comparisons across countries. Real GDP: Output produced in any one period at the prices of some base year. The growth rate of the economy is the rate at which real GDP is increasing. It produces a more accurate view of changes in a country’s total production over time as it strips the impact of rising/decreasing prices. Example: concept check 2.5 Levels of GDP versus growth of GDP Economic growth rate: percentage increase in output over a 12-month period (Real GDP2018/Real GDP2017)*100-100 GDP versus GDP per capita GDP per capita is a most important indicator of an economy’s relative long-run performance. With more people a country can produce more, therefore larger countries will have higher GDP than smaller countries Given rising population, current GDP data overstates the increase in GDP overtime As a result, to look at a more accurate picture of the growth in GDP overtime and across countries, we need to look at GDP per capita or GDP divided by the total population of a country Real GDP per capita is the most accurate indicator of standard of living across space and time. What is so important about the standard of living? Real GDP is not the same as economic well-being Growth, standard of living and happiness Growth, standard of living and happiness The Easterlin Paradox: Rich people are happier than poorer people on average, and richer countries are happier than poorer countries. yet growing national income is not always accompanied by growing national happiness. This suggests: Once basic needs are satisfied, higher income does not increase happiness What matters is relative income Income distribution matters more than level of income. Still, a recent study points to a strong relation across countries between average income and average happiness Food for thoughts… Rich nations should change their goal from one of economic growth to that of "increased happiness in a situation of stable income and declining population". In our developed economies, "people buy things they don't need, with money they don't have, to impress people they don't like". Charles Sturt University Professor of Public Ethics Clive Hamilton The Australian Bureau of Statistics (ABS) has been leading the world in developing new measures of progress and wellbeing. ABS Deputy Australian Statistician Peter Harper is overseeing Measures of Australia's Progress (MAP), which moves away from using GDP as a key measure of a nation's progress and instead considers progress to be "multi-dimensional covering a range of economic, social, environmental and, more recently, governance concerns". Australia’s recent economic performance [Show More]

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