Consumption expenditure The five most important variables that determine the level of consumption are:

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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. 1

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 pg. 2

3 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. 3

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. 4

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 pg. 5

6 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. 6

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. 7

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. 8

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. 9

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 pg. 10

11 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. 11

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 pg. 12

13 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. 13

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. 14

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. pg. 15