ECON1002- Lecture PDF

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ECON1002 semester 1 notes
Chapters 1-10 from textbook
Lectures 1-6
Lecturer - Aarti Singh...

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ECON1002 - MACROECONOMICS WK1 – WHAT IS MACROECONOMICS  Concerned with the broad themes of - GDP - Inflation - U/e  Short run (business cycle) = 1-4years // long run = 4years+ (observed economic growth)  Business cycle shocks doesn’t impact economic growth (long run growth rate of around 2.4%AUS) GROSS DOMESTIC PRODUCT (measuring the nation’s output)  the market value of the final g&s produced in a country during a given period - Since 1945 significant growth with some minor blimps in growth (shown on GDP time-series graph) - Increasing female labour force participation boosts GDP (direct impact = supply of labour as they create g&s // indirection impact home production now accounted)  Market value - Price times quantity (P x Q) Y= A F (L,K) A = Total Factor Productivity Y = Output L = Labour K = Capital What is not accounted in GDP? - Stocks - Goods produced in other countries but consumed in your own country - Used goods (as nothing new is being created) - Home production - U/e benefits ect... Not accounted in gov. spending MEASURING GDP (1)Value-added method  Value added is what the firm adds to the value of the produced inputs it buys from other firms - Value of the firms output less value of purchases of intermediate goods (produced inputs)

(2)Expenditure method  All current production by firms must be either: - Bought by households + firms + gov. or foreigners - Left unsold as inventories bought by the firm which it makes GDP = Y = C + I + G + NX o Consumption- expenditure spending by households on g&s not including spending on new houses ( around 55% of total GDP on avg. o Investment – spending by firms on new buildings + machinery & inventories + spending by households on new houses ( around 23% of total GDP avg.) o Government expenditure – spending by federal + state + local govs. On g&s (around 22% of total GDP on avg.) o Net Exports – expenditure on exports (X) minus expenditure on imports (M) (NET 0%) (3)Income method  When a g&s is sold – the revenues from the sale are distributed to the workers & the owners of the capital involved in the production - GDP also = labour income (wages) + capital income (profits/rent/interest) from the production NOMINAL VS REAL GDP Nominal = current production at ‘current prices’ Real = measure current production at ‘base year’ pric REAL     

GDP ISNT THE SAME AS ECONOMIC WELLBEING leisure time is excluded non-market economic activities are excluded environmental quality & resource depletion are excluded quality of life is excluded poverty & economic inequality is excluded  real GDP is closely related to economic wellbeing. ASIDE PRODUCTIVITY = Total output / Total no. of hours worked

Income effect  consume more leisure (work less) Substitution effect  consume less leisure (work more) WK2 – MEASURING MACRO. PERFORMANCE: PRICES & SAVINGS + INVESTMENT & WEALTH CONSUMER PRICE INDEX (CPI)

 CPI is a measure of the weighted avg. change over time in the prices paid by households for a fixed basket of g&s  Produced by the Aus Bureau of Statistics (ABS) for each quarter  Weighted avg. of price changes through time  Impacts our purchasing power of household Y

EXAMPLE 

INFLATION RATE  Is the annual percentage rate of change in the avg. price level  deflation discourages immediate consumption

INFLATION IS DIFF. FROM RELATIVE PRICES (price of one good relative to other goods)

 If some prices rise while others remain constant – there is both a change in relative prices & a positive rate of inf.  If some prices rise while others fall, there is a change in relative prices – but the rate of inf. May be zero or pos. or neg. – depending on the relative frequency of price rises & falls  AUS income tax thresholds is not indexed to inflation

ADJUSTING FOR INFLATION: o CPI can be used to convert nominal into real inflation via a process called “deflating”

o CPI can be used to convert real into nominal vie a process called “indexing”

*The CPI overstates the actual level of inflation in the economy bc: (1)Quality adjustment bias (2)Substitution bias TOO o o o o o o

MUCH INFLATION (=bad) Menu costs –price of changing/printing menus constantly is costly Interference with long-run planning Unexpected redistribution of wealth Distortions of the tax system Noise in the price system Shoe leather costs – ppl. try to optimize on cash in their pockets bc zero return you get on the asset - Rather place that money on interest earning assets

INFLATION & INTEREST RATES (closely linked) - IR are among the most important variables in the economy - IR are managed by the central bank (in Aus) by the RBA  Real IR (r): The % increase in the real purchasing power of a financial asset (reflects the true cost of borrowing) - Is determined by saving & investment  Nominal IR (i) The % increase in the nominal or dollar, value of a financial asset FISHER EQUATION



*RBA may be forced into cutting official IR on Tue. to a fresh record low of 0.5% as the economic crisis caused by the coronavirus outbreak deepens with signs it is debilitating Aus most important trading partner (China) DEFLATION  Is a sustained fall in the avg. price level  Problem: it can lead to high real IR = discourages important expenditure types such as a firms investment in equipment ect.. CAPITAL GAINS & LOSSES  Saving (current Y minus spending on current needs) is a flow, measured per unit of time  Savings is closely related to wealth (asset-liabilities) or net worth – which is a stock, measured at a point in time - Capital gains: Increases in the value of existing assets - Capital losses: Decreases in the value of existing assets

WHY DO HOUSEHOLDS SAVE?

o Life-cycle saving o Precautionary saving o Bequest saving SAVING & REAL INTEREST RATE  The real IR is the ‘reward’ for saving - The higher the IR = the more attractive saving is, as the higher the benefit received from saving

MEASUREMENT OF NATIONAL SAVING  National saving is current Y less spending on current needs GDP = Y = C + I + G + NX PRIVATE & PUBLIC COMPONENTS OF NATIONAL SAVING  If C & G is spending on current needs // NX = 0 National savings  S = Y – C – G Private Saving  S (private) = Y – T – C Public Saving  S (public) = T – G WHY NATIONAL SAVINGS ARE IMPORTANT: o Saving finances future investment - If domestic savings low = must borrow o/s (risky) - Can also provide a buffer against financial crisis - Excessive savings is also problematic * AUS = low level of national savings INVESTMENT DECISIONS:  Made based on the cost-benefit principle: - Invest  Marginal cost of investment < Marginal benefit of investment  Key determinant of the level of investment: real IR - (either as borrowing cost or opportunity cost of internal funds

SUPPLY & DEMAND FOR SAVINGS

CHANGES IN THE DEMAND FOR INVESTMENT

C

EXAMPLE  Covid-19//Coronavirus o Eco. downturn = anxiety induced reluctance to spend is the main threat to prosperity o Gov. globally prepare spending programmes to limit the eco. damage o Efforts to contain the virus are limiting activity by shutting factories & disrupting supply-chains = harder to manage than anxietyinduced frugality among firms & investors - When ppl. stop spending – growth slows & inflation falls & supply is constrained meaning prices can accelerate

WK3 PERFECTLY COMPETITIVE MODEL OF THE LABOUR MARKET  Supply & demand analysis can be used to analyze the market for labour - Demand for labour comes from employers for use in the production of G&S - Supply of labour comes from people who work for pay - The price of labour is determined by the wage rate per unit of time - ‘perfect competition’ – firms are price takers (take wages + IR + output price as given) & no monopolies DEMAND CURVE FOR LABOUR  as wage decreases firms demand more workers (graphically)  demand curve for labour is downward sloping  diminishing returns to labour – if the amount of capital & other inputs in use if constant then the greater the quantity of labour already employed, the less each additional workers adds to production  SHIFTS - Changes in relative price (Pc / P) - Change in labour productivity  right = increase SUPPLY OF LABOUR  Reservation price of working: the min. payment that you would accept to work rather than your next best alternative  Higher the wage = greater the supply of labour  SHIFTS: non-wage factors  shift left = producers cannot supply as much at each price level TRENDS IN REAL WAGE & U/E

o o o o

Great Real wages slow down in the 21st C. Rising wage inequality (sectorial shifts) Rising inequality due to globalisation Rising inequality due to technological change (ppl. in high income group are getting richer) - ‘routinization of jobs’ has resulted in job polarization (middleskilled level diminishing rather than higher and lower skilled jobs bc of automation)

MEASURING U/E  Employed (E) – worked for at least 1 hour  U/E (U) – activity looking for work  Labour Force (LF) = E + U  Working age-pop. = LF + Not in LF  U/E = U/LF  Participation rate = LF/working age pop. - Currently around 65/66% TYPES OF U/E  Frictional – ST // between jobs // job search  Structural – LT // technological change // u/e skill mismatch job vacancies  Cyclical – Result from lower eco. growth IMPEDIMENTS TO FULL EMPLOYMENT  Min wage laws  Labour unions  U/e benefits BUSINESS CYCLE o Peaks // troughs // expansions - Alternative way of determining whether there is a slowdown or recession - Recession: Typically when there is 2 or more consecutive quarters of negative economic growth OUTPUT GAP  Actual output (Y) – potential output or full-employment output (Y*)  Potential output is unobservable  %  100 x (Y – Y* / Y*)  Expansionary gap  Y – Y* > 0 // Contractionary gap  Y – Y* < 0 NATURAL RATE OF U/E  Indicator of low utilization of resources: u/e rate  In any eco – employment rate is not 0 - NAIRU (U*) = frictional + structural u/e - U – U* > 0  Positive cyclical u/e // contractionary gap

-

U – U* < 0  Eco. experiencing an expansionary output gap

OKUNS LAW  A quantitative relationship CAUSE OF SHORT-RUN FLUCTUATIONS  Potential output remains constant // actual output may mean there is a recessionary or expansionary gap  Firms adjust to SR changes in demand by simply expanding their output & keeping constant prices (fixed)  Firms change output in response to demand  Gov. can help to eliminate output gaps by influencing total spending o LR – changes in prices = bring eco. back to potential output

WK4 – SHORT-RUN MACRO: THE BASIC KEYNESIAN MODEL SPENDING & OUTPUT (S-R) o John Maynard Keynes  Use gov. policies that affect the level of spending = reduce or eliminate output gaps  S-R // prices are fixed: firms meet demand at preset prices  He emphasized gov. spending to stimulate demand in the eco.  When there is insufficient demand = gov. should intervene & not worry about deficits o Aggregate Expenditure --> total spending on final G&S AE = C + I + G + NX (assume that actual spending is same as planned) 

Hold inventories are to avoid stock-outs & to smooth production (actual investment and planned investment is rep. in inventories) * IP impacted by business conditions

o Planned Aggregate Spending (PAE) PAE = C + IP + G + NX

DIFFERENCE BETWEEN PLANNED & ACTUAL o Key component of spending, where actual differs from planned  Planned VS unplanned inventory investment I > IP // I < IP CONSUMPTION SPENDING o C = C + c (Y – T)

 (Y-T) Income – disposable income  C = exogenous (doesn’t depend on income level)  c = marginal propensity to consume (lies between 0 & 1) * At different Y levels MPC changes * ST needs have a larger impact on consumption spending S-R EQUILIBRIUM o Y = PAE o Also, when “withdrawals” = “planned injections” S + T + M = IP + G + X  Injections (planned) are all sources of exogenous expenditure in the co.  Withdrawals are part of Y not used for consumption purposes on domestically produced goods

TWO-SECTOR ECONOMY  HOUSEHOLDS & FIRMS  PAE = C + IP  G=0  NX = 0 PARADOX OF THRIFT o Implication of the Keynesian model:  An attempt by the community to increase savings (in the S-R) will fail = eco. will be worse off o Increasing the level of saving (or thriftiness) at each level of Y = shift the consumption function (& therefore PAE), down o Equilibrium GDP occurs at a lower GDP & savings at the same level as before due to lower Y KEY FEATURES OF 4-SECTOR MODEL  Household sector: consumption (C)  Firm sector: planned investment (IP)  Gov. sector: gov. spending (G)  Foreign sector: export (X)  PAE = C + IP + G + NX INCOME-EXPENDITURE MULTIPLIER  The effect of a one-unit increase in exogenous expenditure on S-R equilibrium output  c(1-t): marginal propensity of expenditure on g&s in a 2-sector eco.  c(1-t) – m: marginal propensity of expenditure on domestically produced g&s in a 4-sector economy  (Multiplier) X: change in the exogenous components of spending (-c, IP) OKUNS LAW:

100 ( y – y* / y* ) = -B ( U – U* )

WK5 – FISCAL POLICY (FP) --> CH8 o Due to corona virus – probably a global recession (forecast) o Currently cash rate in AUS – RBA lower cash rate to 0.25% (March 2020) MAIN COMPONENTS OF FP 1) Gov. expenditure (G) = direct impact on PAE (C + IP + G + NX)  Since G = exogenous component of spending – changing G by the same amount as the drop in PAE = eliminate output gap 2) Taxes ( T + tY ) & transfer payments (Q) = impact PAE indirectly (impact a component of spending first / C)  T = ( T – Q ) + tY  A cut in the tax rate “t” can eliminate a contractionary gap - PAE = C + c ( Y = T – tY ) + IP + G BALANCED BUDGET MULTIPLIER  The short-run effect on equilibrium GDP of an equal change in gov. expenditure & net taxes  Will output remain unchanged in the case of a balanced budget multiplier? - NO: Changes in G will directly impact PAE – but changes in taxes will impact PAE spending on how much is spent (will depend on MPC) QUALIFIERS TO USING FP – AS A STABILISATION TOOL  FP & the supply side - E.G. The Fiscal Stimulus package in AUS during the GFC – included spending on roads + schools – which would also affect the potential output  Presence of automatic stabilizers  automatic changes in gov. spending & revenue when output/income changes  The problem of budget deficits  FP is considered to be relatively inflexible – but is being used more often - 1930s / Japanese slump / GFC / recent pandemic - In most developed countries --> MP is constrained by the zero lower bound (ZLB) ZLB  is a macroeconomic problem that occurs when the ST nominal IR is at or near 0, causing a liquidity trap & limiting the capacity that the central bank has to stimulate eco. growth ROLES OF FP

1. Affecting income distribution 2. Responding to demographic change 3. Managing public debt MEASURING HOW UNEQUAL THE DISTRIBUTION OF INCOME IS (1) o Lorenz curve – graphical representation o Gini coefficient –summary measure of inequality 

AUS Gini coefficient = 0.34 in 2014 (World Bank) & 0.28 in 1981 (worse over time) Lower Gini coefficient is better

HOW TO REDUCE INEQUALITY  Is lower Y inequality desirable - There is a fine balance between equality-incentive  FP influences the distribution of income by: - Progressive income taxes (in AUS 2018/19) -

Transfer payments

MANAGING DEMOGRAPHIC CHAN  AUS pop. Is expected to in  Declining fertility rates & increase longevity = ppl. 65 & over are likely to go from 13% to 28% of the pop. in that time

HOW TO FINANCE GOV. SPENDING  Gov. budget constraint refers to the concept that gov. spending has to be financed either by raising taxes or by gov. borrowing (B)

 Idea of deficit & its relation with gov. Debt

 A -

desirable level of public debt? Low debt reduced crowding out Intergenerational equity Benefits of public spending – infrastructure

WK5 – MONEY + PRICES & RBA --> CH9 (A) HOW DOES THE FINANCIAL SYSTEM ALLOCATE SAVINGS TO PRODUCTIVE USES? BANKS & THEIR ROLE --> Via financial intermediation  Stand between savers & investors  Asymmetric information  Help identify productive borrowers  Pool savings 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  lots of lending & borrowing goes through the banking system BONDS  A legal promise to repay a debt: principal + interest payments - Issued by govs. & firms  The coupon rate = rate at time bond issued  Coupon payment (if annual) = principal x coupon rate BOND PRICING STRUCTURE E.G

STOCKS  Refers to a claim to partial ownership of a firm  Stockholders receive returns on their financial investment 1. A dividend (regular payment received by stockholders for each share that they own) 2. Shareholders also receive returns in the form of capital gains when the price of their stock increases in the stock market

STOCK PRICING E.G

(B) WHAT ARE THE PRICIAL USES OF MONEY & HOW DO WE MEASURE IT? MONEY & ITS USES:  Medium of exchange: an asset used in purchasing g&s - Previously “bartering” (trade)  Unit of account: measuring value  Store of value: HOW o o o

IS MONEY MEASURED Currency: notes & coins M1: currency + current bank deposits M3: M1 + deposits of private non-banks

(C) WHAT ROLE DO COMMERCIAL BANKS PLAY IN MONEY CREATION? MONEY SUPPLY & ROLE OF COMMERCIAL BANKS  Money supply consists of currency & bank deposits - Therefore the amount of money partly depends on the behaviour of commercial banks & their deposits

 Key concept: Bank Reserves --> Why do banks hold a fraction of their deposits as reserves? - To meet the demand of withdraws  1930s Bank Runs  occurs when a large no. of customers of a bank or other financial institution withdraw their deposits simultaneously over concerns of the banks solvency - as more ppl. withdraw their funds – the probability of default increases = prompting more ppl. to withdraw their deposits  Central Bank = lender of last resort BALANCE SHEET OF THE BANK  Assets (currency) + loans = liabilities (deposits)  Bank reserves not part of money supply  Desired “reserve-deposit” = ration = reserves / deposits - Deposits = reserves / RD ratio  Reserves / deposit ration falls - Deposits increase - Money supply increase - Money multiplier: 1/RD ration (D) WHAT IS THE RELATIONSHIP BETWEEN MONEY SUPPLY & THE GENERAL LEVEL OF PRICES? LONG-RUN  Close link between the amount of money circulating in the co. & the general level of prices  A rapidly growing supply of money = quickly rising prices (i.e. inflation) QUANTITY THEORY OF MONEY  The quantity equation is an identity that states that the nominal value of expenditure in the eco. must be = the stock of money multiplied by its velocity of circulation  MV = PY  Velocity --> is a measure of the amount of expenditure that can be financed from a given amount of money over a particular time period  V = PY / M - The higher the ratio = the higher the speed at which money circulates QUANTITY THEORY OF MONEY: IN THE LONG-RUN o Assumptions: - If V depends on payment technologies & is approximately constant over the period of interest - Real output, Y, is approximately constant during the period of interest:

M*V=P*Y o Money is neutral o E.G – if M were to increase by 10% = there would be a corresponding increase in P of 10% (E) WHAT ROLES DOES THE RBA PLAY & HOW DOES IT AFFECT THE IR?  RBA = Aus central bank  Two main responsibilities: 1. Maintaining stability of the currency – which is regarded as maintaining low inf. Via MP  target INF (2-3%) & cash rate 2. Oversight & regulation of financial markets  MP is now conducted by the RBA directly targeting IR  March 2020 – cash rate = 0.25% OPEN MARKET OPERATIONS:  Banks hold reserves in the exchange settlement accounts (ESA) w/ the RBA - Banks ...