Macro Summary Notes

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ECON1102 Macroeconomics Summary otes

What is Macroeconomics?
Macroeconomics is concerned either with the economy as a whole or with the basic subdivisions or aggregates that make up the economy. Microeconomics is the study of individual choices and group behaviour in individual markets, analysing how choices inform market forces and price signals. LN1 Measuring Macroeconomic Performance: Output and Prices Ch3: The main indicators of macroeconomic performance include: Rising living standards • Measured by GDP o GDP= the market value of final G&S produced in a country during a given period. o GDP is a measure of aggregate production or output. o GDP uses market prices to value the quantities of G&S produced. • GDP is measured in 3 ways: o Production method→ Y= O o Expenditure method→ GDP= Expenditure: Y= C + I + G + (X-M) o Income method→ GDP= Labour Income + Capital Income : GDP= L+K • The level of output (i.e. quantity and quality of G&S) tends to ↑ over time. Stable business cycle • Aim is for low volatility in fluctuations of actual output around its trend or potential output. Relatively stable price level • Measured by CPI o For a given period measures the cost in that period of a given basket of G&S relative to their cost in the base year. o The base yr changes every 5yrs. o H=
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o An inflation rate of 0→ implies prices are constant so no inflation o Inflation rate < 0 → implies prices are falling i.e. deflation. Inflation = Current CPI – Previous CPI Previous CPI x 100

o o CPI tends to overstate the level of inflation. • Stable price level is technically 0, BUT such a rate is highly unlikely so the objective is instead to target a low (positive) rate of inflation. The RBA currently sets inflation targeting at between 2-3%. Sustainable levels of public and national debt • Public debt→ influenced by gov. borrowing requirements→ borrowing by gov. from the private sector. Public debt went from $96bn in 1996 to net debt in 2002. • National debt→ influenced by our CAD or CAS→ borrowing requirements of domestic residents from foreign countries.

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ECON1102 PASS Notes

Disclaimer- The ASB Economics Faculty accepts no responsibility for the content of these pages. These notes were created by a past student for their personal revision purposes and as such may contain errors, typos, outdated statistics etc. Students are advised to read all material critically and for best results, to make their own notes based on official ECON lecture slides and notes and the BOF textbook.

Balance between current and future consumption • Excess consumption at present results in low levels of savings, thus ↓ levels of capital for investment→ ↓ levels of investment→ ↓ opportunities for consumption in the future. Full employment • Provision of employment for all individuals seeking work. 1. What does gross domestic product (GDP) mean? • Two of the criteria used to gauge a country’s macroeconomic performance include the measurement of: o Aggregate output o Average level of prices • Output is measured using the concept of gross domestic product (GDP). • GDP refers to the market value of the final goods and services produced in a country during a given period. • GDP= the market value of final G&S produced in a country during a given period. • Flow variable→ measured over a period of time, usually quarters, March, June, September and December. • For yearly GDP, add up the GDP over the 4 quarters. • GDP is a measure of aggregate production or output. • GDP uses market prices to value the quantities of G&S produced. • GDP is measured in 3 ways: o Production method→ Y= O o Expenditure method→ GDP= Expenditure: Y= C + I + G + (X-M) o Income method→ GDP= Labour Income + Capital Income : GDP= L+K • National income accounting identity is a mathematical relation showing how GDP is equal to the sum of expenditure on consumption, investment, government purchases and net exports. • GDP is not the best measure of economic wellbeing as it fails to account for changes in factors which significantly affect our economic wellbeing but cannot be measured in terms of their contribution to GDP. Such factors include leisure time, non-market economic activities, health and education levels, the availability of goods and services, income inequality and environmental quality. • However, GDP tends to be positively related to these omitted factors, and thus monitoring GDP does give some measure of a peoples’ general economic wellbeing. • Real GDP per person tends to be positively associated with many things people value, including a high material standard of living, better health and life expectancies, and better education. • Goods and services that are omitted from GDP include: o The value of unpaid housework and household duties such as cooking, cleaning, laundry that is performed. o The underground economy e.g. proceeds from drug sales. o Non-market economic activities e.g. volunteer fire-fighting, surf life-saving, • Given its setbacks, in failing to measure all the factors that contribute to peoples’ quality of life, GDP is a relatively good measure of economic welfare, though other measures such as the human development index provide a more comprehensive measure of economic welfare. • GDP omits those unpriced and non-market traded factors which affect economic welfare such as leisure time, non-market economic activities, environmental quality and resource depletion, quality of life, and economic inequality and poverty.

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ECON1102 PASS Notes

Disclaimer- The ASB Economics Faculty accepts no responsibility for the content of these pages. These notes were created by a past student for their personal revision purposes and as such may contain errors, typos, outdated statistics etc. Students are advised to read all material critically and for best results, to make their own notes based on official ECON lecture slides and notes and the BOF textbook.

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Increased leisure times available to workers in industrialised countries are not priced, and thus not reflected in GDP, nor are non-market activities such as unpaid housework, voluntary services or transactions in the underground economy. • GDP also omits the costs of economic activity such as resource exploitation and declining environmental quality e.g. deforestation, overfishing and increasing pollution. • GDP also conveys no information about the distribution of income and wealth across the population. While two economies may have the same GDP, income inequality may be high in one economy, with most of the wealth controlled by a small elite, but more equitable in another. • Despite these impediments, real GDP per capita tends to be positively associated with many aspects of economic welfare such as high material standards of living, since high GDPs correlate to a greater variety and quantity of G&S. • Higher GDP per capita, by increasing the incomes available to spend on health and education, can also indicate better health and life expectancies and better education in economies. • While GDP doesn’t provide the most comprehensive measure of economy welfare, it is positively related to factors that contribute to peoples’ quality of life, hence providing a relatively good measure of general economic wellbeing. 2. What are the three ways of measuring a country's GDP? Why are these three ways equivalent? • GDP refers to the market value of the final goods and services produced in a country during a given period. It can be equivalently measured by either the production, expenditure or income methods. • Output is measured using the concept of gross domestic product (GDP) which in turn has 3 equivalent means by which it can be measured: Y= O o The value of production GDP= O o The value of expenditure GDP = E Y= C+I+G+NX Y= L+K o The value of income GDP = Y • GDP measures only the final value of goods and services. To ensure that only the final value of goods and services are counted, at each stage of the production process only the value added to the inputs is counted in GDP. • For any firm, the value added is the market value of its product/service minus the cost of inputs purchased from other firms. • GDP, using the production method is a summation of the value-added (market value of products less the cost of inputs purchased from other firms) of final goods and services produced in the domestic economy within a given period. • Since any good or service that is produced will also be purchased by an economic agent, such as households, firms, government and the foreign sector, calculating GDP based on expenditure will give the same figure as the production method. The expenditure method uses the national income accounting identity to calculate GDP as Y= C+I+G+NX. • The convention of counting unsold output as inventory investment expenditure, guarantees that production equals expenditure. • As the revenue from the sale of final goods and services is paid out to the factors of production involved, labour and capital, GDP can also be valued by adding together the incomes that are earned in the economy over a particular period of time. Thus, GDP also equals labour income plus capital income.

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ECON1102 PASS Notes

Disclaimer- The ASB Economics Faculty accepts no responsibility for the content of these pages. These notes were created by a past student for their personal revision purposes and as such may contain errors, typos, outdated statistics etc. Students are advised to read all material critically and for best results, to make their own notes based on official ECON lecture slides and notes and the BOF textbook.

3. What is the distinction between nominal and real GDP? • Real GDP is a measure of GDP in which the quantities produced are valued at the prices in a base year rather than at current prices; real GDP measures the actual physical volume of production. • Nominal GDP is a measure of GDP in which the quantities produced are valued at current year prices; nominal GDP measures the current dollar value of production. • If we want to use GDP to compare economic activity at different points in time, we need to adjust for inflation/deflation. To do so, economists use a common set of prices to value quantities produced in different years. • The standard approach is to pick a particular year, the base year, and use the prices from that year to calculate the market value of output. When GDP is calculated using the prices from a base year, rather than the current year's prices, it is called real GDP, to indicate that it is a measure of real physical production. • Real GDP is GDP adjusted for inflation. To distinguish real GDP, in which quantities produced are valued at base-year prices, from GDP valued at current-year prices, economists refer to the latter measure as nominal GDP. • Chain volume movement→ this method addresses the problem that the further away we move from the base year, the less relevant are the base year prices. o The ABS now rebases every year and the resulting indexes are linked to arrive at the chain volume measures. • The advantage of using real GDP is that, unlike nominal GDP, it does not change if only the price of output has changed. • Changes in real GDP occur only if the actual quantity of goods and services produced in the economy changes. • With the choice of base year: o Using initial prices (e.g. 2007) is known as Laspeyeres index o Using final prices (e.g. 2008) is known as a Paasche index • Chain weighting: o For any 2 consecutive years compute the growth rates of real GDP implied by both the Laspeyres and the Paasche indexes. o Then take the average of the 2 growth rates and this is the chain weighted growth rate.→ it can be used to compute a real chain-weighted GDP. 4. What does the consumer price index (CPI) mean? How is the CPI measured? • The economy’s overall price level is measured using the consumer price index. • The CPI for any period measures the cost in that period of a standard basket of goods and services relative to the cost of the same basket of goods and services in a fixed year, called the base year. • The consumer price index is a means by which economists measure the average level of prices in the economy. • The CPI is published quarterly by the ABS. • The Household Expenditure Survey is used to determine a typical basket of G&S. • The base year changes every 5 years. JJ J IIJ J IIJ J JJ J J H= JJ J IIJ J IIJ J IJ J • • The consumer price index (CPI) is a measure of the cost of living during a particular period, as it calculates the cost in that period of a standard basket of household goods and services, relative to the cost of the same basket of goods and services in a fixed (base) year. Nithilla 4 ECON1102 PASS Notes

Disclaimer- The ASB Economics Faculty accepts no responsibility for the content of these pages. These notes were created by a past student for their personal revision purposes and as such may contain errors, typos, outdated statistics etc. Students are advised to read all material critically and for best results, to make their own notes based on official ECON lecture slides and notes and the BOF textbook.

By tracking what happens to the prices of typical goods bought by a household in subsequent time periods, and weighting those prices according to importance in the typical household's budget, a series for the CPI can be constructed that shows how the average price level in the economy has changed through time. 5. What is inflation and how is it measured? • The rate of change in the consumer price index is one way of measuring the rate of inflation in the economy. • The CPI is also commonly used to calculate the rate of inflation, which is an indication of how rapidly the general level of prices is rising in an economy. • The rate of inflation is the annual percentage rate of change in the general price level, as measured for example by the CPI: JJ J H− J J J H HJ I JJ = × 100 J J J H • The CPI is a relatively good measure of inflation. Inflation is measured by the percentage change in the CPI over a given period. • Inflation rate= (Current CPI-Previous CPI)/Previous CPI x 100. • Inflation is measured by the percentage change in the CPI over a given period: o Inflation rate=0 implies that prices are constant o Inflation rate>0 implies prices are rising o Inflation rate costs. Nithilla 12 ECON1102 PASS Notes

Disclaimer- The ASB Economics Faculty accepts no responsibility for the content of these pages. These notes were created by a past student for their personal revision purposes and as such may contain errors, typos, outdated statistics etc. Students are advised to read all material critically and for best results, to make their own notes based on official ECON lecture slides and notes and the BOF textbook.

Expected costs: • Price of new capital goods • Real interest rate – When does this become a factor? Only when one borrows to fund the investment? What about opportunity cost? Expected benefits (The value of the marginal product) depend on: • Productivity of new capital goods • Capital taxes • Relative price of output generated Noting the expected costs, investment is negatively related to the real interest rate (r). If there is no international borrowing: National saving = investment Why? Supply of savings and demand for savings (investment) are equalised through the financial markets.

What will affect investment? A change in the marginal product of capital. What will affect national saving? Greater household, business or public saving. 5. How are investment and capital formation related? • Most decisions to invest in new capital are made by firms. A firm’s decision to invest is in many respects a straightforward application of the cost–benefit principle; firms will choose to expand their capital stocks when the benefits of doing so exceed the costs. • National saving provides the resources for investment. Investment is the purchase of new capital goods. • The two important influences on a business’ investment decision will be: o Price of the capital goods o Real interest rates

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ECON1102 PASS Notes

Disclaimer- The ASB Economics Faculty accepts no responsibility for the content of these pages. These notes were created by a past student for their personal revision purposes and as such may contain errors, typos, outdated statistics etc. Students are advised to read all material critically and for best results, to make their own notes based on official ECON lecture slides and notes and the BOF textbook.

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Other things being equal, a ↓ in the real interest rate will make investment more attractive. Other things being equal, a ↓ in the price of capital goods will make investment more attractive. The benefit of an investment to a business is the value of the additional output it provides. The change in output for an increase in capital is called the marginal product of capital, MPK. A company will invest if: o Value of marginal product of capital (MPK)> Cost of capital Cost of Capital= Price of capital (begin of yr) + Interest Cost – Price of (depreciated) capital (end of year).

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Where: o i = the nominal interest rate used to borrow the funds to buy the new capital OR if retained earnings were used, i= the opportunity cost. o Pk= The dollar price of the new capital. o o = the physical depreciation rate on the new capital. = Over time the price of that piece of capital may rise or fall (capital gain or loss can occur). The cost of capital is the net cost of owning that piece of capital for one year. If we let the price of capital goods rise at the general rate of inflation, pi, then the cost of capital is Pk= (i+ - Π), or since r= i-Π:

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Investment is the purchase or construction of new capital goods, including housing. Firms will invest in new capital goods if the benefits of doing so outweigh the costs. Two factors that determine the cost of investment are the price of new capital goods and the real interest rate. The higher the real interest rate, the more expensive it is to borrow, and the less likely firms are to invest. The benefit of investment is the value of the marginal product of new capital, which depends on factors such as the productivity of new capital goods, the taxes levied on the revenues they generate, and the relative price of the firm's output. When a firm has to borrow to purchase its new capital the real interest rate determines the real cost to the firm of paying back its debt. Since financing costs are a major part of the total cost of owning and operating a piece of capital—much as mortgage payments are a major part of the cost of owning a home—increases in the real interest rate make the purchase of capital goods less attractive to firms, all else being equal. Even if a firm does not need to borrow to buy new capital—say, because it has accumulated enough profits to buy the capital outright—the real interest rate remains an important determinant of the desirability of an investment. If a firm does not use its profits to acquire new capital, most likely it will use those profits to acquire financial assets such as bonds, which will earn the firm the real rate of interest. If the firm uses its profits to buy capital rather than to purchase a bond, it forgoes the opportunity to earn the real rate of interest on its funds. Thus, the real rate of interest measures the opportunity cost of a capital investment. Since an increase in the real interest rate raises the opportunity cost of investing in new capital,

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ECON1102 PASS Notes

Disclaimer- The ASB Economics Faculty accepts no responsibility for the content of these pages. These notes were created by a past student for their personal revision purposes and as such may contain errors, typos, outdated statistics etc. Students are advised to read all material critically and for best results, to make their own notes based on official ECON lecture slides and notes and the BOF textbook.

it lowers the willingness of firms to invest, even if they do not literally need to borrow to finance new machines or equipment. • On the benefit side, the key factor in determining business investment is the value of the marginal product of the new capital, which should be calculated net of both operating and maintenance expenses and taxes paid on the revenues the capital generates. • The value of the marginal product is affected by several factors. For example, a technological advance that allows a piece of capital to produce more goods and services would increase the value of its marginal product, as would lower taxes on the revenues produced by the new capital. • An increase in the relative price of the good or service that the capital is used to produce will also increase the value of the marginal product and, hence, the desirability of the investment. For example, if the going price for lawn-mowing services were to rise, then, all else being equal, investing in the mower would become more profitable for Patrick. 6. What role does the real interest rate play in determining saving and investment? • We expect the level of saving will ↑ with higher real returns to various assets.→ so ceteris paribus, we expect saving to ↑ with the real interest rate. • In an economy with no access to international capital markets, national saving must equal investment. The supply of saving by households, businesses and gov. and the demand for saving (for investment) by businesses are equalized by the financial markets→ interest rates act as the rationing mechanism. • Savings is an increasing function of the real interest rate while investment is a decreasing (downward sloping) function of the real interest rate:

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The real interest rate is the rate at which the real purchasing power of a financial asset increases over time. The real interest rate equals the market, or nominal, interest rate (i) minus the inflation rate (π). The real interest rate acts as the ‘reward’ or compensation for savings, thus higher real interest rates increase the opportunity cost of consumption, hence increasing the level of savings. While strengthening people’s willingness to save by increasing the reward for savings, higher real interest rates slightly reduce the amount people need to save in order to reach a given target, thus having an inverse effect on the level of savings contributed by target savers. For investors, the real interest rate is the cost of borrowing to fund capital investments, thus increases in the real interest rate will increase the cost of borrowing, hence decreasing the attractiveness of investment. Savings is thus generally an increasing function of the real interest rate, while investment is a decreasing function of the real interest rate. The supply of national saving depends on the saving decisions of households and businesses and the fiscal policies of the government (which determine public saving). The demand for saving is the amount business firms want to invest in new capital. The real interest rate, which is the ‘price’ of borrowed funds, changes to equate the supply of and demand for national saving.

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ECON1102 PASS Notes

Disclaimer- The ASB Economics Faculty accepts no responsibility for the content of these pages. These notes were created by a past student for their personal revision purposes and as such may contain errors, typos, outdated statistics etc. Students are advised to read all material critically and for best results, to make their own notes based on official ECON lecture slides and notes and the BOF textbook.

Factors that affect the supply of or demand for saving will change saving, investment, and the equilibrium real interest rate. • For example, an increase in the government budget deficit will reduce national saving and investment and raise the equilibrium real interest rate. The tendency of government budget deficits to reduce investment is called crowding out. 7. How is the market for saving and investment affected by technological change and the government's budget? • Effect of new technology is to decrease the price of capital goods→ makes investment more attractive→ increases demand curve for investment→ increase in real interest rate:

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Effect of the government’s budget is to alter the level of national savings by increasing/decreasing the public saving component. The effect of and ↑ in the budget deficit is to reduce public savings→ ↓ in supply of national saving→ increase in real interest rates:

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The crowding out effect refers to how an ↑ in the gov. budget deficit will reduce private investment spending. This is because: o ↑ in budget deficit leads to a ↓ in supply of savings o → results in an ↑ in the real interest rate o → higher interest rates make investment less attractive→ and causes a contraction along the I curve. Saving represent economic resources held back from current use to provide benefits in the future. Investment also comprises resources held back from current use to provide more output in the future. Without access to borrowing from other countries, saving and investment will be equal. The mechanism that brings this about involves changes in the real interest rate, which will adjust until saving and investment expenditures are equal. Factors, therefore, that shift either the supply of saving or the demand for investment schedules are likely to impact on the real interest rate.

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ECON1102 PASS Notes

Disclaimer- The ASB Economics Faculty accepts no responsibility for the content of these pages. These notes were created by a past student for their personal revision purposes and as such may contain errors, typos, outdated statistics etc. Students are advised to read all material critically and for best results, to make their own notes based on official ECON lecture slides and notes and the BOF textbook.

LN3 Unemployment and the Labour Market Ch5: 1. What have been the five major trends in the labour market in the post-war era? • All industrialised countries enjoyed substantial growth in real wages over the 20th century. • Since the early 1980s, the rate of real wage growth has slowed. • Recent decades have brought an increase in income inequality in many countries including Australia and the US. A growing gap in real wages between high skilled and low skilled workers developed over the course of the 1990s.→ plenty of good job at good wages for the well-educated and highly skilled but less and less opportunity for those without schooling or with poorly developed skills. • The number of people with jobs has grown substantially in recent decades. • Low and falling real wages for unskilled and low skilled workers in Australia. 2. What factors influence firms’ demand for labour? • The benefit to firms of hiring labour is the extra revenue earned from the output produced by an additional worker. However, the law of diminishing returns means that the benefit of increased output of additional labour declines as the amount of workers employed increases. This is because the slowness with which capital can be changed means existing equipment has to be shared in the short term. • The cost to the firm is the wage paid for the workers. As the real wage falls, firms will demand more workers since the benefits will increasingly exceed their costs. The labour demand curve is thus downward sloping; the higher the wage, the fewer workers employers will hire. • The demand for labour depends on both the productivity of the firm’s workers and the relative price of workers’ output. Any factor that changes the value of the marginal product of a firm’s workers will thus shift the labour demand curve. • The more productive the workers, or the more valuable the G&S they produce, the more valuable the marginal product of labour, hence the greater the demand for workers by employers at any wage level. • The two main factors that shift a firm’s labour demand are changes in: o The relative price of the company’s output e.g. coffee An increase in the relative price of workers’ output (↑ in price of coffee) makes workers more valuable, increasing the demand for labour→ shifting the demand curve to the right. o The productivity of the firm’s workers. An increase in productivity raises the value of a workers’ marginal product, thus increases the demand for labour at any given real wage→ shifts the demand curve right. • Diminishing returns to labour→ is the amount of capital and other inputs in use is held constant, then the grater the quantity of labour already employed, the less each additional worker adds to production. • An increase in productivity raises workers’ marginal product and, assuming no change in the price of output, the value of their marginal product. • Since a productivity increase raises the value of marginal product, employers will hire more workers at any given real wage, shifting the labour demand curve to the right. • Marginal product of labour= MPL= Change in Y/Change in L • Value of marginal product= Price x MPL

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ECON1102 PASS Notes

Disclaimer- The ASB Economics Faculty accepts no responsibility for the content of these pages. These notes were created by a past student for their personal revision purposes and as such may contain errors, typos, outdated statistics etc. Students are advised to read all material critically and for best results, to make their own notes based on official ECON lecture slides and notes and the BOF textbook.

Cost to the firm of employing an additional worker is the wage= W. A firm will be willing to employ labour until PxMPL= W i.e. value of MPL equals the money wage OR • The marginal product of labour equals the real wage i.e. MPL= W/P 3. What factors influence workers’ supply of labour? • Virtually all of us supply labour during some phase of our lives. Whenever people work for pay, they are supplying labour services at a price equal to the wage they receive. • The suppliers of labour are workers and potential workers. At any given real wage, potential suppliers of labour must decide if they are willing to work. • The supply of labour is the total number of people willing to work at each real wage. • Your willingness to supply labour is greater the higher the wage. • People work for many reasons, including personal satisfaction, the opportunity to develop skills and talents and the chance to socialise with co-workers. • For most people income is the principal benefit of working, so the higher the real wage, the more willing they are to sacrifice other possible uses of their time. • The fact that people are more willing to work when the wages are higher is captured in the upward slope of the labour supply curve. • Any factor that affects the quantity of labour will shift the labour supply curve. The most important factor affecting the supply of labour is the size of the working age population • The size of the working age population is influenced by: o Domestic birth rate o Immigration and emigration rates o Ages at which people normally first enter the workforce and retire • An ↑ in the working age population ↑es the quantity of labour supplied→ thus shifts supply to the right. • Changes in the percentage of people of working age who seek employment e.g. as a result of social changes encouraging women to work outside the home, can also affect labour supply. • Workers decide how much labour they will supply by weighing up the costs and benefits. • The cost is the value of the activity that could have been performed with the time spent at work, this relates to activities such as leisure and other non-work pursuits. • The benefit is the wage that would be received in return for giving up those non-work pursuits. • Any non-wage factor that affects the supply of labour will shift the labour supply curve. • The supply of labour is the total number of people willing to work at each real wage, W/P. • Real unit labour costs= Average labour cost/ Average labour productivity. 4. How can a supply/demand framework be used to understand trends in the labour market? • The large increases in real wages since WW2 are results from the sustained growth in productivity experienced by industrialised countries. Increased productivity raises the demand for labour, increasing employment and the real wage. • Of the factors contributing to productivity growth in the industrialised countries, two of the most important were: o Technological progress o Large increases in capital stocks→ which provided workers with more and better tools with which to work.

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ECON1102 PASS Notes

Disclaimer- The ASB Economics Faculty accepts no responsibility for the content of these pages. These notes were created by a past student for their personal revision purposes and as such may contain errors, typos, outdated statistics etc. Students are advised to read all material critically and for best results, to make their own notes based on official ECON lecture slides and notes and the BOF textbook.

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Technological change increases worker productivity and is the basic source of rising living standards. However, a given technological innovation can affect different workers in different ways. Skill-based technical change: o Raises the marginal product of high-skill workers o Reduces the marginal product of low-skill workers

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The effect of globalisation on income inequality varies based on the international competitiveness of the industry involved. o Export industries such as mining where we have a high IC will benefit from globalisation. Increased demand will lead to an ↑ in the labour demand curve, leading to an increase in wages and employment o Industries with a low IC will become an importing industry as it will be cheaper for us to purchase G&S from more efficient overseas producers. This ↓ in demand for the local importing industry’s output will lead to a ↓ in the labour demand curve, resulting in an increase in wages and employment. o The majority of the world’s workers are low-skilled and live in developing countries, so when AIEs open up trade with them, the domestic industries that face the toughest competition are those with low-skilled labour. o Increased trade will likely lower the wages of those workers who are already poorly paid and increase the wages of those who are well paid. Globalisation will lead to an increase in the supply of labour as we now include immigrant workers. The increased supply of workers will result in an outward shift (↑) in the supply curve, leading to a lower equilibrium wage level. Technological change increases worker productivity and is the source of rising living standards. o A skill-biased technical change will ↑ the marginal product of high-skill workers while lowering that of low-skill workers. Demand for skilled workers will ↑ leading to a rise in wages and employment. The demand for unskilled workers will ↓, leading to a fall in wages and employment 19 ECON1102 PASS Notes

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Disclaimer- The ASB Economics Faculty accepts no responsibility for the content of these pages. These notes were created by a past student for their personal revision purposes and as such may contain errors, typos, outdated statistics etc. Students are advised to read all material critically and for best results, to make their own notes based on official ECON lecture slides and notes and the BOF textbook.

Two reasons for the increasing wage inequality are economic globalisation and skillbiased technological change. Both have increased the demand for, and hence the real wages of, relatively skilled and educated workers. • Attempting to block globalisation and technological change is counterproductive, however, since both factors are essential to economic growth and increased productivity. • To some extent, the movement of workers from lower paying to higher-paying jobs or industries (worker mobility) will counteract the trend toward wage inequality. A policy of providing transition aid and training for workers with obsolete skills is a more useful response to the problem. 5. What are the three different types of unemployment? • Each person in the household who is 15yrs or older is placed in one of three categories: o Employed→ a person is employed if they worked full-time or part-time (even for only 1hr) during the past week or is on vacation or sick leave from a regular job. o Unemployed→ a person is u/ed if they didn’t work during the preceding week but made some effort to find work (e.g. by going to a job interview, or being registered with Centrelink as a jobseeker). o Out of the labour force→ a person is considered to be out of the labour force if they didn’t work in the past week and weren’t actively seeking work. E.g. full time students, unpaid homemakers, retirees and people unable to work because of disabilities. • Labour force= total number of people available for work. • Labour force= Employed + Unemployed. J JJ J JJ J JI = HIIJ J JJI • Participation rate= Labour force/Working age population • Costs of unemployment include: o Economic cost→ output that is foregone since workforce is not fully utilised. Transfer payments that must be made to the unemployed. o Psychological costs→ long period so u/e can lead to loss of self-esteem, unhappiness and depression. o Social costs→ high u/e can lead to increased crime and associated social problems. o Discouraged workers→ people who have given up looking for work (so aren’t counted as u/ed). • Types of unemployment include: o Frictional o Structural o Cyclical • Frictional u/e is short-term unemployment that is associated with people searching for the right job. It will be characteristic of any dynamic economy and tends to be beneficial rather than costly to an economy. o Can be beneficial for the economy→ if the search process leads to a better fit between the worker and job, a period of frictional u/e will lead to higher output in the long run. • Structural unemployment→ the long term and chronic unemployment that exists when the skills or aspirations of workers are not matched to the jobs available in the economy. I.e. the skills of the unemployed do no match the skills in demand in the labour market. o Some workers may have a lack of skills or be subject to discrimination and this prevents them from finding stable long-term employment.

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ECON1102 PASS Notes

Disclaimer- The ASB Economics Faculty accepts no responsibility for the content of these pages. These notes were created by a past student for their personal revision purposes and as such may contain errors, typos, outdated statistics etc. Students are advised to read all material critically and for best results, to make their own notes based on official ECON lecture slides and notes and the BOF textbook.

o Structural change may result in a loss of jobs for certain types of specialised workers. o Economic cost of retraining these workers. • Cyclical unemployment→ the extra unemployment that occurs during periods of economic contraction and especially recessions. o Associated with periods of slowdowns in economic activity (recessions) o Costly in terms of output forgone. 6. For what reasons do some countries find it difficult to achieve full employment? • Full employment is a situation where the quantity of labour demanded by employers equals the quantity of labour supplied. It is the natural rate of u/e, where cyclical u/e is zero. Expansionary policies at this level will not increase employment but instead add to inflationary pressures. • The natural rate of u/e is the part of the total u/e rate that is attributable to frictional and structural u/e; equivalently it is the u/e rate that prevails when cyclical u/e is zero, so that the economy has neither a contractionary nor an expansionary output gap. • An economy operating at full employment doesn’t imply that no one is looking for work. Hidden u/e is the unemployment of potential workers that is not reflected in official unemployment statistics such as older workers who would rather be working but have retired early because they cannot find employment. • Full employment also omits the under-employed, such as part-time workers wanting to work full-time. • Impediments to full employment include: o Minimum wage laws/award wages o Labour unions o Unemployment benefits • Minimum wage laws set the lowest hourly wage that employers may pay to workers. • From the model it is evident that if there is a minimum wage which exceeds the marketing-clearing wage, W, the number of people who want jobs NB exceeds firms’ demand for workers, NA. The excess supply of labour will cause unemployment equal to the difference of NB and NA in the economy. • Workers lucky enough to find jobs at the minimum wage will benefit, as they will earn more than they otherwise would have, since the minimum wage is higher than the equilibrium wage. • Those who lose from a minimum wage law are those workers unable to find employment because firms are demanding less labour as a result of the higher wages they must now pay. • Labour unions are organisations that negotiate with employers on behalf of workers. Among the issues that unions negotiate are the wages workers earn, rules for hiring and firing, the duties of different types of workers, working hours and conditions, and procedures for resolving disputes between workers and employers. • Unions gain negotiating power by their power to call a strike—that is, to refuse work until an agreement has been reached.

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ECON1102 PASS Notes

Disclaimer- The ASB Economics Faculty accepts no responsibility for the content of these pages. These notes were created by a past student for their personal revision purposes and as such may contain errors, typos, outdated statistics etc. Students are advised to read all material critically and for best results, to make their own notes based on official ECON lecture slides and notes and the BOF textbook.

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Through the threat of a strike, a union can usually get employers to agree to a wage that is higher than the market-clearing wage. As in the case of a minimum wage, a union wage that is higher than the market-clearing wage leads to unemployment, in the amount B A. Furthermore, a high union wage creates a trade-off similar to the one created by a minimum wage. Those workers who are lucky enough to get jobs as union members will be paid more than they would otherwise. Unfortunately, their gain comes at the expense of other workers, who are unemployed as a result of the artificially high union wage. The availability of unemployment benefits or gov. transfer payments to u/e workers allows the unemployed to search longer or less intensively for a job→ it may lengthen the average amount of time the typical unemployed worker is without a job. U/e benefits should be generous enough to provide basic support to the unemployed but not so generous as to remove the incentive to actively seek work.→ thus u/e benefits should be lower than the income a worker receives when working. Other gov. regulations, such as health and safety rules etc. which, although possibly conferring benefits, increase the costs of employing workers. The labour market ‘rigidity’ created by gov. regulations and union contracts are a problem in Western Europe.

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ECON1102 PASS Notes

Disclaimer- The ASB Economics Faculty accepts no responsibility for the content of these pages. These notes were created by a past student for their personal revision purposes and as such may contain errors, typos, outdated statistics etc. Students are advised to read all material critically and for best results, to make their own notes based on official ECON lecture slides and notes and the BOF textbook.

LN4 Short Run Economic Fluctuations Ch6: 1. How do economists decide whether the economy is in recession? • Economies tend to experience periods of expansion and contraction in the level of economic activity. • If we focus on GDP as a measure of economic activity then: o A contraction is a period during which the level of GDP falls o An expansion is a period when GDP is rising. • In moving between periods of expansion and contraction the economy will experience peaks and troughs. o A peak is the beginning of a contraction, the high point of GDP prior to a downturn. o A trough is the end of recession, the low point of economic activity prior to a recovery. • The classical cycle refers to peaks and troughs in the level of GDP. • Recessions last 18 months on average • A recession is characterised by 2 consecutive quarters of negative growth. • The business cycle refers to the fact that, through time, the economy undergoes a series of contractions–a period when the economy is performing poorly, and expansions–a period of strong economic performance. These expansions and contractions, which can be identified using statistical criteria, are not necessarily of regular length or magnitude. Generally speaking, however, contractions are of shorter duration than expansions. • Some of the key features of short-term economic fluctuations are that o 1. Their effects can spill over from one country to other countries o 2. Contractions, especially recessions, and expansions have implications for the rate of unemployment with unemployment increasing rapidly during economic downturns and decreasing relatively more slowly when the economy recovers o 3. They have systematic effects on the rate of inflation with inflation slowing in the wake of recessions. 2. What typically happens to the unemployment rate in recessions? • Following the high interest rates of the 1980s and early 1990s, unemployment increased in Australia. • Unemployment tends to react with a lag to whatever factor it was that initially caused the recession (in the 1990s this was high interest rates).→ the reason for this is labour hoarding. Firms are often very reluctant to immediately fire workers in the face of an economic downturn because: o It is expensive to rehire when economic conditions pick up (interview and advertising process) o Workers accumulate a range of firm specific skills and attributes over time and firms are reluctant to lose these skills. • Unemployment typically rises sharply during recessions and recovers during expansions.→ key indicator of short-term economic fluctuations. 3. How are output gaps and cyclical unemployment related? Potential Output and the Output Gap: • If policy-makers are to respond appropriately to contractions and expansions, knowing whether a particular fluctuation is small or big is essential. • A ‘big’ contraction/expansion is one in which output and the /e rate deviate significantly from their normal or trend levels. • The output gap measures how far output is from its normal level at a particular time. • Cyclical u/e is the deviation of u/e from its normal level.

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ECON1102 PASS Notes

Disclaimer- The ASB Economics Faculty accepts no responsibility for the content of these pages. These notes were created by a past student for their personal revision purposes and as such may contain errors, typos, outdated statistics etc. Students are advised to read all material critically and for best results, to make their own notes based on official ECON lecture slides and notes and the BOF textbook.

Potential output (or full-employment output)→ the amount of output (real GDP) that an economy can produce when using its resources, such as capital and labour, at normal rates. • Actual output can differ from potential output due to changes in the utilisation rate of labour and capital, since potential output is not the same as maximum output. • Because capital and labour can be utilised at greater than normal rates, the country’s actual output can, in the short-run, be increased beyond potential output, and vice versa. This difference is referred to as the output gap. • The output gap→ difference between the economy’s potential output and its actual output at a point in time. • Recalling that y* is the symbol for potential output and that y stands for actual output (real GDP), we can express the output gap as y-y*. o A positive output gap (expansionary gap) → when actual output > potential output. Resources are being utilised at above-normal rates. o A negative output gap (contractionary gap) → when potential output > actual. Resources are not being utilised. 4. For what reasons might actual output sometimes grow quickly and sometimes grow slowly? What is the natural rate of unemployment? • A nation’s actual output sometimes expands and sometimes contracts due to: o Changes in output reflecting changes in the country’s potential output o Actual output doesn’t always equal potential output. • Potential output grows over time with growth in labour and capital inputs and with growth in technology. Hence, changes in labour growth, such as the ageing population, and growth in technology, such as the development and use of new technologies can affect the level of potential output. • An ageing population affects potential output by reducing the size of the working age population and decreasing the labour market participation rate, leading to a decrease in the supply of labour available in production. Furthermore, an ageing population may lead to decreased labour productivity due to the effects of age on overall health and performance, for example a heavy machinery operator’s output would decrease as they age, thus leading to a change in the level of potential output. • Similarly, the development and use of new technologies will increase the productivity of capital, hence extending the economy’s production possibility frontier, and thus increasing potential output. • Actual output doesn’t always equal potential output. For example, potential output may be growing normally, but the economy’s capital and labour resources may not be utilised fully, such that actual output is significantly below the level of potential output.→ if severe, this low level of output, resulting from under-utilisation of resources can be interpreted as a recession. • Industries that produce durable goods are more affected during recessions and booms, whilst industries providing services and non-durable goods like food are less sensitive to short-term fluctuations. • The natural rate of unemployment, u*→ the part of the total u/e rate that is attributable to frictional and structural u/e; equivalently, the unemployment rate that prevails when cyclical unemployment is zero, so that the economy has neither a contractionary nor an expansionary output gap. • Cyclical u/e is the difference between the total u/e rate and the natural rate, and can thus be expressed as u-u*, where u is actual u/e and u* is natural rate of u/e. • In a contraction:

•

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ECON1102 PASS Notes

Disclaimer- The ASB Economics Faculty accepts no responsibility for the content of these pages. These notes were created by a past student for their personal revision purposes and as such may contain errors, typos, outdated statistics etc. Students are advised to read all material critically and for best results, to make their own notes based on official ECON lecture slides and notes and the BOF textbook.

o U > U* • In an expansion: o U < U* • Negative cyclical u/e corresponds to a situation in which labour is being used more intensively than normal, so that actual u/e has dipped below its usual frictional and structural levels. 5. What is the significance of Okun's law? • Okun’s law is a quantitative representation of the relationship between cyclical unemployment and the output gap. According to Okun’s law, each extra percentage point of cyclical u/e is associated with about a 1.6% point (for Australia) increase in the output gap, measured in relation to potential output. − ∗ = −β{ − ∗{ J J HI : • • • • • Where: y= actual output and y*= potential output, and u= unemployment rate and u*= the natural rate of unemployment (where cyclical u/e is 0). o Cyclical unemployment= u-u*. This suggests that the economic costs of a recession, per person, can be quite significant. An additional percentage point of cyclical unemployment is associated with a β percentage point decline in the output gap. A negative output gap (y-y*0) is associated with an expansionary gap. Policy makers view both contractionary and expansionary gaps as problems since under a contractionary gap, labour and capital resources are not being fully utilised, and output and employment are below normal levels, wasting resources. Under an expansionary gap firms raise prices due to excess demand, increasing inflation. The u/e rate is a useful indicator of the utilisation of resources; a high u/e rate indicates labour isn’t being fully utilised, so that output has fallen below potential, while low u/e suggests labour is being utilised at greater than normal rates, leading to an expansionary gap. In the short run, changes in the amount that customers decide to spend will affect output. When total spending is low, output may fall below potential output and vice versa. Since, changes in economy-wide spending are the primary cause of output gaps, which can be found through Okun’s law, policymakers, in attempting to return actual output to potential, will implement policies can help to eliminate output gaps by influencing total spending. For example, they can eliminate a negative output gap by increasing government expenditure, which will in turn increase spending, thereby increasing demand for labour, and decreasing cyclical u/e, and increasing potential output. Okun’s law can be used as a forecasting tool. Policy makers are able to use Okun’s law to see how much output is needed is in order to reduce a certain amount of cyclical unemployment and vice versa. However, as economies become more integrated and complex this creates “noise in the system” and potentially erodes the effectiveness of Okun’s law. If policymakers rely solely on Okun’s law, the result of policies could have a disastrous effect. Okun’s law also describes the inverse relationship between unemployment and output, i.e if one increases, another declines. Two of the main goals for policy makers is declining unemployment and increasing output, a relationship described by Okun’s law. This allows policy makers to achieve the two goals simultaneously.

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ECON1102 PASS Notes

Disclaimer- The ASB Economics Faculty accepts no responsibility for the content of these pages. These notes were created by a past student for their personal revision purposes and as such may contain errors, typos, outdated statistics etc. Students are advised to read all material critically and for best results, to make their own notes based on official ECON lecture slides and notes and the BOF textbook.

• •

•

As policies targeting cyclical unemployment are successful, more workers are employed, and hence increasing the output of the economy as stated by Okun’s law. Okun's law describes a systematic relationship between cyclical unemployment and the output gap. For Australia, each extra percentage point of cyclical unemployment is associated with about a 1.6 percentage point increase in the output gap, measured in relation to potential output. This suggests that the economic costs of a recession, per person, can be quite significant. Short-term fluctuations occur because: o Over short periods of time, firms rarely adjust prices in response to changes in demand. Instead, production is adjusted to meet demand. So if demand falls, instead of price falling, output is reduced. This might mean laying off some workers until demand once again picks up. If this experience is repeated economy-wide, the result will be a recession. o Should demand increase, instead of prices increasing, output will be increased. This could be achieved by asking workers to increase their supply of overtime hours. If repeated economy-wide, the result will be an economic expansion. o Over longer periods of time, prices begin to adjust in the wake of changes in demand. As a result, demand would once again be brought into alignment with the economy's normal, or potential, level of output.

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ECON1102 PASS Notes

Disclaimer- The ASB Economics Faculty accepts no responsibility for the content of these pages. These notes were created by a past student for their personal revision purposes and as such may contain errors, typos, outdated statistics etc. Students are advised to read all material critically and for best results, to make their own notes based on official ECON lecture slides and notes and the BOF textbook.

LN5 Spending and Output in the Short Run Ch7: 1. What is the key assumption of the basic Keynesian model? For what time frame does the basic Keynesian model apply? • The key assumption of the Keynesian model is that firms don’t respond to every change in the demand for their products by changing their prices. Instead, they set a price for some period, and then meet the demand at that price. By ‘meeting the demand’, firms produce just enough to satisfy their customers at the prices that have been set. • Hence, output at each point in time in the economy is determined by the amount what people throughout the economy want to spend, referred to as planned aggregate expenditure. Thus fluctuations in spending will have powerful effects on the nation’s real GDP. • In the short run firms will accommodate a cut in demand by reducing output and employment, not by reducing prices, and the converse for a rise in demand. • If prices were fully flexible in the short-run there would never be excess production because firms could cut prices to sell it; there will never be persistent unemployment because workers will cut their wages to keep and get jobs; and fluctuations in demand will be accommodated by flexible prices and wages without changes in output and employment. 2. Outline the four components of the economy's planned aggregate expenditure. • Consumer expenditure or consumption (C) is spending by households on final G&S e.g. food, clothes, consumer durables such as cars and furniture. • Investment (I) is spending by firms on new capital goods e.g. offices, factories and equipment. Also includes spending on new houses and residential investment and increases in inventories. • Government purchase (G) is spending by governments on G&S e.g. schools, hospitals and paying for the services of gov employees e.g. police, soldiers etc. Transfer payments and interest on the gov. debt are not included as gov. purchases. Transfer payments and interest contribute to AE only at the point when they are spent by their recipients e.g. when a recipient of welfare payment uses the funds to buy food or other consumption goods. • Net exports (NX) are X minus M. It represents the net demand for domestic goods by foreigners. 3. What is the consumption function? Distinguish between exogenous and induced consumption. • 2/3rd of PAE is consumption spending, C. The most important determinant of the amount people plan to consume is their disposable (aggregate income less net taxes) income. Households with higher disposable incomes will consume more than those with lower disposable incomes. • Disposable income of the private sector can be defined as the total production of the economy, Y, less net taxes (taxes minus transfer payments), T. • The general link between consumption and the private sector’s disposable income is the consumption function • An exogenous variable is one whose value is determined from outside of the model. • In the consumption function, the exogenous term is a constant term, Ĉ, in the equation that is intended to capture factors other than disposable income that affect consumption. • Suppose, for example, that there is a boom in the share market or a sharp increase in home prices, making consumers feel wealthier and hence more inclined to spend, for a given level of current disposable income. This effect could be captured by assuming that

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ECON1102 PASS Notes

Disclaimer- The ASB Economics Faculty accepts no responsibility for the content of these pages. These notes were created by a past student for their personal revision purposes and as such may contain errors, typos, outdated statistics etc. Students are advised to read all material critically and for best results, to make their own notes based on official ECON lecture slides and notes and the BOF textbook.

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•

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C increases. Likewise, a fall in home prices or stock prices that made consumers feel poorer and less inclined to spend would be represented by a decrease in C. Induced consumption is expenditure that is induced by disposable income. o c= the marginal propensity to consumer. c is the amount by which consumption rises when disposable income rises by $1. We assume 0WD, firms will experience an unplanned decline in their inventories, and to rebuild their inventories firms will increase their level of production. This will cause GDP to increase and it will move towards its equilibrium value, where PAE cuts the 45 degree line. This process of GDP increasing will continue until PAE=Y. Short-run equilibrium output= The level of output that prevails during the period in which prices are determined. It is achieved when INJp= WD. It can also exist when Y= PAE. Injections are all sources of exogenous expenditure in the economy. o INJ= I+G+X Withdrawals are that part of income not used for consumption purposes. o WD= S+T+M Equilibrium is a situation in which planned injections of expenditure are enough to exactly offset any withdrawals.

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ECON1102 PASS Notes

Disclaimer- The ASB Economics Faculty accepts no responsibility for the content of these pages. These notes were created by a past student for their personal revision purposes and as such may contain errors, typos, outdated statistics etc. Students are advised to read all material critically and for best results, to make their own notes based on official ECON lecture slides and notes and the BOF textbook.

The components of PAE (two-sector economy).

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In the two-sector economy, PAE consists of households’ consumption expenditure and firms’ investment expenditure. The PAE schedule (two-sector economy).

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Summing the spending plans of households to the spending plans of firms gives the economy's overall level of planned aggregate expenditure (PAE). The 45-degree diagram shows: o 1. the economy's planned levels of expenditure, which increase as GDP increases because of induced consumption and o 2. all points of possible equilibrium in the economy, which are represented by the 45-degree line. Given the current level of planned aggregate expenditure, the economy's actual equilibrium point is found from where the PAE schedule cuts the 45-degree line. The economy's equilibrium.

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The economy will be in equilibrium when savings equals investment. The level of GDP associated with this equilibrium is Ye.

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ECON1102 PASS Notes

Disclaimer- The ASB Economics Faculty accepts no responsibility for the content of these pages. These notes were created by a past student for their personal revision purposes and as such may contain errors, typos, outdated statistics etc. Students are advised to read all material critically and for best results, to make their own notes based on official ECON lecture slides and notes and the BOF textbook.

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Equilibrium in the four-sector economy.

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In the four-sector model, equilibrium occurs when the spending plans of households, firms, the government and the foreign sector coincide with the economy's level of GDP. Alternatively, equilibrium is where the total level of withdrawals in the economy (savings, taxation and imports) equal total planned injections (planned investment, government spending and exports). Here in Figure 7.15, the economy's equilibrium is shown by Ye. A decline in planned spending leads to a contraction.

A decline in consumers’ willingness to spend at any current level of disposable income reduces planned exogenous expenditure and shifts the expenditure line down. The shortrun equilibrium point drops from E to F, reducing output and opening up a contractionary gap. 6. Why is the value of the multiplier greater than 1? • The multiplier refers to the effect of a one-unit increase in exogenous expenditure on short-run equilibrium output; for example, a multiplier of 5 means that a 10-unit decrease in exogenous expenditure reduced SR equilibrium output by 50 units. • A one dollar change in exogenous expenditure produces a larger change in SR output because of its effects on not just spending directly, but on the incomes of the producers of the G&S, which in turn changes their spending on G&S, and so on. • For example a change in spending e.g. G, not only reduces the sales of goods and services directly, but the incomes of workers and owners in the industries producing those goods. As their incomes fall, they will also reduce their spending, which reduces the output and incomes of other producers in the economy, which lead to still larger changes in output. • Hence the multiplier is greater than 1; that is, a one-dollar change in exogenous expenditure tends to change short-run equilibrium output by more than one dollar.

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ECON1102 PASS Notes

Disclaimer- The ASB Economics Faculty accepts no responsibility for the content of these pages. These notes were created by a past student for their personal revision purposes and as such may contain errors, typos, outdated statistics etc. Students are advised to read all material critically and for best results, to make their own notes based on official ECON lecture slides and notes and the BOF textbook.

•

The multiplier is measured as: H J J= 1

1 − {I − {{1 − { • The marginal tax rate is the change in taxes arising from a change in income. It affects the tax function, which subsequently affects the consumption and import parameters, c and m, in determining the size of the multiplier. • For a given value of the marginal propensity to consume, the value of the multiplier will be smaller the higher are the values of respectively, the marginal propensity to import and the tax rate. • Under a high tax rate, a change in domestic income will not flow through to expenditure on domestically produced goods and services to as great an extent as when the tax rate is low. By the converse, a lower tax rate increases the size of the multiplier. • A cut in the marginal tax rate will decrease taxes, increasing disposable incomes. A decrease in the tax rate decreases the denominator because it increases the marginal propensity to expend domestically. A smaller denominator will lead to an increase in the size of the multiplier. • Changes in exogenous expenditure will lead to changes in short-run equilibrium output. In particular, if the economy is initially at full employment, a fall in exogenous expenditure will create a contractionary gap and a rise in exogenous expenditure will create an expansionary gap. • The amount by which a one-unit increase in exogenous expenditure raises short-run equilibrium output is called the multiplier. An increase in exogenous expenditure not only raises spending directly; it also raises the incomes of producers, who in turn increase their spending, and so on. Hence the multiplier is greater than 1; that is, a one-dollar increase in exogenous expenditure tends to raise short-run equilibrium output by more than one dollar. 7. What is meant by the paradox of thrift? • The economy will be in disequilibrium when firms’ production does not match planned aggregate spending—equivalently, when planned injections differ from withdrawals. Since this situation causes firms to experience unintended changes to their inventories, production plans are adjusted according to the prevailing level of aggregate demand and the economy returns to equilibrium. • In the context of the Keynesian model: o An attempt by the community to ↑ its savings will fail o The economy will be worse off as a result of that attempt.

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ECON1102 PASS Notes

Disclaimer- The ASB Economics Faculty accepts no responsibility for the content of these pages. These notes were created by a past student for their personal revision purposes and as such may contain errors, typos, outdated statistics etc. Students are advised to read all material critically and for best results, to make their own notes based on official ECON lecture slides and notes and the BOF textbook.

The paradox of thrift.

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An exogenous increase in savings leads to a lower level of equilibrium GDP. Increased saving (or thriftiness) by the community means that people ↑ their level of savings. This leads to a downward shift in the vertical intercept of the consumption function, matched by an equivalent upward shift in the vertical intercept of the savings function (see above). The result of an upward shift in the savings function, and a downward shift in the consumption function, s to reduce the level of PAE at every level of GDP. Equilibrium, where planned aggregate spending matches aggregate production and where Ip=S, moves from Ye0 to Ye1. This is the first key result, the attempt to ↑ aggregate savings means a fall in planned expenditure and hence a lower equilibrium level of GDP for the economy. The second key result is that the attempt to ↑ savings has actually failed. Equilibrium occurs where savings matched planned investment spending. Since firms’ spending plans haven’t changes, we know that ultimately the aggregate level of savings will be equal to the unchanged level of planned investment. In reality, it is the fall in income associated with the reduction in GDP that ensures savings once again match planned investment.

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ECON1102 PASS Notes

Disclaimer- The ASB Economics Faculty accepts no responsibility for the content of these pages. These notes were created by a past student for their personal revision purposes and as such may contain errors, typos, outdated statistics etc. Students are advised to read all material critically and for best results, to make their own notes based on official ECON lecture slides and notes and the BOF textbook.

LN6 Fiscal Policy Ch8: 1. By what means can fiscal policy be used to eliminate an output gap? • The main instruments of fiscal policy are non discretionary components, the automatic stabilisers taxation and transfer payments, and the discretionary component of government purchases. • Changes in government purchases, being a component of PAE, directly affects total spending, thus an expansionary gap can be closed by decreasing the government’s purchases. The decrease in spending will reduce injections in the form of reduced government expenditure, helping to close the expansionary gap between injections and withdrawals. • Taxation and transfer payments can indirectly affect planned spending by changing the disposable income in the private sector. A decrease in government transfer payments will reduce disposable incomes, and through the consumption function, will affect a decrease in spending. • Furthermore, during periods of expansion, incomes will rise, thus more people move into higher tax brackets, increasing the level of taxation (a withdrawal) and reducing their disposable incomes, leading to lower levels of consumption (an injection), which will lead to a decrease in economic activity, thus helping close the expansionary output gap. 2. Why is there a difference between the macroeconomic effects of changes to government expenditure and changes to taxes and transfer payments? • Balanced Budget multiplier→ the short run effect of equilibrium GDP of an equal change in gov. expenditure and net taxes. • An increase in government purchases eliminates a contractionary gap.

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After a 10-unit decline in the exogenous part of consumer spending C, the economy is at point F, with a contractionary gap of 50. A 10-unit increase in government purchases raises exogenous expenditure by 10 units, shifting the expenditure line back to its original position and raising the equilibrium point from F to E. At point E, where output equals potential output (Y = Y* = 4800), the output gap has been eliminated.

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ECON1102 PASS Notes

Disclaimer- The ASB Economics Faculty accepts no responsibility for the content of these pages. These notes were created by a past student for their personal revision purposes and as such may contain errors, typos, outdated statistics etc. Students are advised to read all material critically and for best results, to make their own notes based on official ECON lecture slides and notes and the BOF textbook.

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A cut in the tax rate can eliminate a contractionary gap.

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Fiscal policy includes two general tools for affecting total spending and eliminating output gaps: o Changes in government purchases and o Changes in taxes or transfer payments. An increase in government purchases increases exogenous expenditure by an equal amount. An exogenous reduction in taxes or an increase in transfer payments increases exogenous expenditure by an amount equal to the marginal propensity to consume times the reduction in taxes or increase in transfers. The ultimate effect of a fiscal policy change on short-run equilibrium output equals the change in exogenous expenditure times the multiplier. Accordingly, if the economy is in contraction, an increase in government purchases, a cut in taxes, or an increase in transfers can be used to stimulate spending and eliminate the contractionary gap. Gov. purchases of G&S, being a component of PAE, directly affect total spending. If output gaps are caused by too much/little spending, then the gov. can guide the economy toward full employment by changing its own level of spending. Gov. purchases are part of total exogenous expenditure, and changes in gov. purchases change exogenous expenditure one-for-one. A change in consumption spending, ~C, however will change the output gap by more due to the effects of the multiplier. Unlike changes in gov. purchases, changes in taxes or transfers don’t affect planned spending directly→ they work indirectly by changing disposable income, Y-T. According to the consumption function, when disposable income rises, households spend more, thus a tax cut or increase in transfers should ↑ PAE. Vice versa. A transfer payment like the baby bonus can be thought of as a negative exogenous tax.

3. What are the three limitations on the ability of fiscal policy to stabilise the economy? • These days fiscal policy is not often used to stabilise the economy. This is because 3 limitations of fiscal policy include: o Fiscal policy may have effects for the supply side of the economy that might have undesirable long-run consequences o Expansionary discal policies may lead to large budget deficits that reduce national savings

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ECON1102 PASS Notes

Disclaimer- The ASB Economics Faculty accepts no responsibility for the content of these pages. These notes were created by a past student for their personal revision purposes and as such may contain errors, typos, outdated statistics etc. Students are advised to read all material critically and for best results, to make their own notes based on official ECON lecture slides and notes and the BOF textbook.

o Fiscal policy is relatively inflexible as gov. expenditure and taxes are not able to be changed quickly→ unlike MP which is more timely as it is adjusted monthly. • Fiscal policy may affect potential output as well as PAE: o On the spending side for example investment in public capital e.g. schools can play a major role in the growth of potential output. On the other side, tax and transfer payments may affect the incentives of households and firms. o E.g. a high tax rate on interest income may reduce the willingness of people to save for the future, while tax breaks on new investment may encourage firms to ↑ their capital formation.→ such changes in savings and investment will in turn affect potential output. o Supply-siders→ a term used to describe people who support the need for tax cuts to encourage people to work harder, save more and innovate. • The need to avoid large and persistent budget deficits o Sustained deficits reduce national saving, which in turn reduces investment in new capital goods- an important source of long-run economic growth. o The need to keep deficits under control may make ↑ing spending or cutting taxes to fight a slowdown a less attractive option, both economically and politically. • Fiscal policy is not always flexible enough to be used for stabilisation: o Gov. spending or taxes go through a lengthy legislation process→ reduces their ability to respond in a timely way to economic conditions. o Policy-makers have other objectives besides stabilising aggregate spending, form ensuring adequate national defence to providing income support to the poor.→ such conflicts of interest can be difficult to resolve through the political process. • Despite these, fiscal policy is an important stabilising force because: o Presence of automatic stabilisers: taxes and transfer payments respond automatically to output gaps→ when GDP declines, income tax collections fall (households fall into lower tax brackets) while u/e and other welfare ↑es. o Automatic stabilisers→ provisions in the law that imply automatic ↑ in gov. spending or ↓ in taxes when real output declines. o Automatic stabilisers help to ↑ planned spending during contractions and reduce it in expansions without the delays inherent in the legislative process. o Although fiscal policy may be difficult to change quickly, it is still useful for dealing with prolonged episodes of recession. 4. How does fiscal policy impact on the distribution of income? • Fiscal policy affects the distribution of income in the economy since taxes and transfers shift income between different groups in society. • With perfect income equality, the Lorenz curve would be a straight 45 degree line (equality). When there is any income inequality, the Lorenz curve lies below the line of equality. J II ℎ H J J J I IJ HJJ J J J = J I J II J ℎ H J J J I • Gini coefficient is a summary measure of income inequality, while the Lorenz curve is a graphical representation of income inequality. • The lower the value of the Gini coefficient, the more qual the distribution of income→ since the closer is the Lorenz curve to the line of equality. • A value closer to 1 suggests a high level of income inequality. • Disposable income is more equally distributed than pre-tax and pre-transfer income in all OECD countries.

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ECON1102 PASS Notes

Disclaimer- The ASB Economics Faculty accepts no responsibility for the content of these pages. These notes were created by a past student for their personal revision purposes and as such may contain errors, typos, outdated statistics etc. Students are advised to read all material critically and for best results, to make their own notes based on official ECON lecture slides and notes and the BOF textbook.

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Australia has a progressive income tax system→ a system of taxation that levies higher tax rates on additional dollars earned as income increases. • The progressive nature of our tax system has allowed relatively affluent households to be taxed at a higher rate, with at least part of those funds then being transferred to the relatively less affluent by means of the welfare system. • Gov. transfers further target low-income earners e.g. the baby bonus which is means tested. 5. What effect will demographic change have on fiscal policy? • Demographic changes over the next 50 years such as an increase in our population, declining fertility rates and increased longevity, which means people aged 65 and over will increase from 13% to 28%, will have serious implications for fiscal policy. • Declining fertility rates and an ageing population will decrease the pool of income-tax paying individuals, resulting in a fall in taxation revenue for the government. • Additionally the increasing number of elderly people will see increased government spending in health, aged care and pension payments over that time. • An increase in the elderly dependency ratio is thus likely to see worsening fiscal positions in the future, through increased expenditure, possibly compounded by decreasing taxation revenue. • To fund the projected long term deficits in the government’s primary budget balance, fiscal policy in the short to medium term should be focused on tax smoothing, so running budget surpluses in the present through either cuts in spending or increased taxation. • Australia faces an ageing population in the next 50 years. The decline in fertility rates as well as improvement in medical technology will increase the number of people over 65. • An ageing population will increase government spending on health, aged care, and pension. The Australian treasury predicts that spending on health will increase from 4%7%, aged care from 1% to 2%, and age pensions increase from 3% to 4%. (Of GDP in 2046). This will divert government spending from high beneficial public goods like education, and infrastructure spending. • Declining spending on education and infrastructure could potentially reduce Australia’s productivity and international competitiveness through the decline of labour quality and quality of infrastructure. In the end, fiscal policy will be focused on relatively nonproductive public spending as oppose to productive public spending which will increase future • If the government wants to maintain spending on education and infrastructure, it has to finance it through taxes rises, borrowings or print money. However, taxes rises will discourage business activities, borrowings will create possible crowding house effect and intergeneration inequality, and printing money may accelerate spending. 6. How is fiscal policy related to the level of public debt? • The government budget constraint refers to the concept that government outlays (purchases, transfer payments and interest payments) in any period must be financed through taxes, borrowing (i.e. selling government securities) or printing money. • Printing money is problematic since it increases inflationary pressures, so the former two are the main methods used. Financing large budget deficits through excessive taxation is also not preferred as it leads to electoral disgruntlement. • The government budget constraint can thus be re-arranged as: • When the government runs a deficit budget, the left hand size is positive, and we will be adding to the stock of public debt.

Nithilla

38

ECON1102 PASS Notes

Disclaimer- The ASB Economics Faculty accepts no responsibility for the content of these pages. These notes were created by a past student for their personal revision purposes and as such may contain errors, typos, outdated statistics etc. Students are advised to read all material critically and for best results, to make their own notes based on official ECON lecture slides and notes and the BOF textbook.

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Sustained budget deficits as a result of expansionary fiscal policy are harmful because they increase public debt, as governments increasingly need to borrow from the private or foreign sector to finance deficits. Intergenerational equity→ the concept that the current generation shouldn’t impose an unfair burden on future generations. Recent budget surpluses and the proceeds from sales of public assets e.g. Telstra have allowed the gov. to pay off debt accumulated as a result of past budget deficits. Government budget constraint describes the situation where a government budget should be balanced; i.e government expenditure should equal government income. If the government decides to spend more than its income, it produces a deficit and it must find ways to fund the deficit. A deficit can be funded in three ways, taxes, borrow, and printing money. I.E a government is “constraint” to how much it can spend through income and borrowings. Denote the spending activities of the government as G for expenditure and Q for transfer payments. Government can finance this expenditure through taxes denoted by T, or borrowing money. B(t-1) can represent the money owing at the end of the last period. New borrowing in the period t will be represented by B(t) and interest paid is represented by rB(t-1). G(t)+Q(t)+rB(t-1)=T(t)+[B(t)-B(t-1)]. The left-hand side represents the required government spending, and the right hand side details the sources of funding to finance this expenditure. This equation is known as the government budget constraint. The equation can be re-arranged to find the link between fiscal policy and the stock of public debt: { { + { { − { { + J { − 1{ = { { − { − 1{ o When G(t)+Q(t)-T(t) is positive, the government runs a budget deficit because B(t)>B(t-1). Budget deficits lead to an increase in the stock of public debt over time. o When G(t)+Q(t)-T(t) is negative, a budget surplus is run. Assuming interest payments can be covered on accumulated debt, time the stock of debt will fall over time as B(t)