module 1: concepts economic methodology & the economising problem measurement - gdp,...

MODULE 1: CONCEPTS

ECONOMIC METHODOLOGY & THE ECONOMISING

PROBLEM

MEASUREMENT - GDP, UNEMPLOYMENT &

INFLATION

RMIT University School of Economics, Finance and Marketing 2

Economic Methodology & the Economising Problem

Economics: Foundations and Models - Chapter 1Choices and Trade-Offs in the Market - Chapter 2

Learning Objectives:

1. Discuss the following important economic ideas: people are rational; people respond to incentives; optimal decisions are made at the margin.

2. Understand the issues of scarcity and trade-offs, and how the market makes decisions on these issues.

3. Understand the role of economics in modern analysis.4. Distinguish between microeconomics and macroeconomics.5. Use a production possibility frontier to analyse opportunity costs and

trade-offs.6. Understand the basics of trade.

Economics

• A social science concerned with the allocation of

scarce/limited resources between unlimited and often

competing needs and wants.

– Scarcity: The situation in which unlimited wants exceed the limited resources available to fulfill them.

– Trade-off: The idea that because of scarcity,

producing more of one good or service means producing less of another good or service.



Check Your Understanding

What does the adage ‘There is no such thing as a

free lunch’ mean?

a. To get something we like, we usually have to give up

another thing we like.

b. Even people on welfare have to pay for food these

days.

c. The cost of living is always increasing.

d. All costs are measured in dollars.

Resource Categories

• Resources are divided into 4 main categories.

– Land: all natural resources.

– Labour: Requires a fundamentally scarce resource -

TIME.

– Capital:

– Human capital: knowledge & skills that people

develop

– Physical Capital: buildings, machinery tools, etc.

– Enterprise or entrepreneurial ability


We study economics because of

a. resources.

b. money.

c. scarcity.

d. economists have convinced universities it is a

necessary field of study.



Three ideas are primary throughout the course:

1. People (economic agents) are rational.

2. People (economic agents) respond to economic incentives.

3. Optimal decisions are made at the margin.

Economics and Individual Decisions




Economists understand that people respond to:

a. the wishes of policymakers.

b. Incentives.

c. threats more than rewards.

d. tax breaks, but not tax hikes.

Economic Models

• Economics deals with generalities/statements about

regularities, concerning economic behaviour.

• Models are simplified representations of the real world.

• Ceteris Paribus– A hypothesis in an economic model: A statement

about an economic variable that may be either correct or incorrect.

– Economic variable: Something measurable that relates to resources that can have different values.

– In testing hypotheses, economists distinguish between correlation and causality.




Economic models are usually composed of:

a. plastic.

b. beautiful people.

c. assumptions only.

d. diagrams and equations.

Positive versus Normative

• Positive: Claims that attempt to describe the world

as it is. Statements of facts. Can be tested

empirically.

• Normative: Claims that attempt to prescribe how the

world should be. Opinions. Cannot be tested

empirically.


Which of the following is a positive economic

statement?

a. The government should close income tax

loopholes that enable people to avoid paying tax.

b. We should redistribute income to reduce poverty.

c. Everyone should live at the same standard of living.

d. If the price of petrol rises, a smaller quantity of it will

be bought.



Macroeconomics versus Microeconomics

• Microeconomics: The study of how individuals make decisions. Microeconomics considers how households and firms make choices, how they interact in markets, and how the government attempts to influence their choices.

• Macroeconomics: Enables us to better understand the structure and behavior of the entire economy (regional, national or global) and to consider issues associated with measuring performance. Macroeconomics is the study of the economy as a whole and includes topics such as inflation, unemployment, and economic growth.




State whether the following issues are

microeconomic or macroeconomic.

a. The overall unemployment rate

b. A tax that affects workers in the automobile industry.

c. The inflation rate

d. Prices of electronic goods

e. Real GDP

Scarcity and Trade-offs

1. What to produce

2. How to produce it

3. Who will receive the products

WHO DECIDES?

Laissez-faire/Market

Economy

CommandEconomy

MixedEconomy




A market economy rewards people according to:

a. their need for goods and services.

b. how willing they are to work.

c. their ability to produce things of cultural importance.

d. their ability to produce things that other people are

willing to pay for.

FinancialMarkets

ResourceMarket Money Income (wages

rent, interest, profits)

Land, Labour,Capital, Enterprise

Goods & Services

Spending

Goods & Services

Costs

Resources

Revenue

Firm

Government

ProductMarket

External

Household

Borrowing & LendingPrivate and Public


Production Possibilities Frontier

• How to achieve the greatest possible satisfaction of

society’s material wants given scarce resources?

– Full employment

– Full production

– Allocative efficiency

– Productive efficiency




Which of the following results in production

occurring at the lowest possible cost?

a. Productive efficiency

b. Allocative efficiency

c. Dynamic efficiency

d. All of these options are correct.

Production Possibilities Frontier

butter

guns

A

E

UAttainable but not desirable

WUnattainable

10

4

Represents the maximum possible combinations of goods & services that can be produced with a given quantity of factors of production and given technology.


An "increase in efficiency" suggests that an

economy:

a. Has moved from a point outside of, to a point on, its

production possibilities curve.

b. Has decided to produce more consumer goods and

fewer capital goods.

c. Is able to get less output from a given amount of

input.

d. Is able to get more output from a given amount of

input.



Opportunity Cost

butter

guns

A

E

3

10

9

1

7

2

4

B

C

D

4

Any movement along the PPF involves the concept of opportunity cost. Can only obtain more of one good by having less of the other.

The opportunity cost of any activity is the highest-valued alternative that must be given up to engage in the activity under consideration.




In economics, the cost of something is:

a. the out-of-pocket expense of obtaining it.

b. what you give up to get it.

c. always measured in units of time.

d. always higher than people think.

Increasing & Constant Opportunity Costs

10

butter

guns

A

E

3

9

1

7

2

4

B

C

D

4

Scarce resources are not equally suitable in all productive activities. Economic resources are not completely adaptable to alternative uses.

pastries

cakes

A

E

3

10

8

1

6

2

4

B

C

D

4

2

Scarce resources are equally suitable in all productive activities. Economic resources are completely adaptable to alternative uses.




Increasing opportunity costs will lead to the

production possibility frontier being

a. bowed inward from the origin.

b. bowed outward from the origin.

c. a negatively sloped straight line.

d. a positively sloped straight line.



Assume a firm can produce a combination of 60

units of X together with 80 units of Y but to produce

70 units of X, the firm can only produce 60 units of Y.

What is the opportunity cost to produce 10 more

units of X?

a. Two units of Y

b. 10 units of X

c. One-half a unit of X

d. 20 units of Y

• Trade-offs and disaster relief

More funds for one disaster relief means less funds for other charities.


Economic Growth

• Over time PPF can move outwards.

• Achieved through economic growth.

• The following will push the PPF out: – Capital accumulation. – Technological progress.– Increased resources

computers(good for the future)

pizzas (good for the present)




Which of the following would shift the country's

production possibility frontier inward?

a. An increase in the unemployment rate

b. Discovering a cheap way to convert sunshine into

electricity

c. Producing more capital equipment

d. A law requiring workers to retire at age 50

Refer to the above table. As compared to production

alternative D, the choice of alternative C would:

a. Tend to generate a more rapid growth rate.

b. Be unattainable.

c. Entail unemployment.

d. Tend to generate a slower growth rate.

Production possibilities (alternatives) A B C D E F

Capital goods 5 4 3 2 1 0Consumer goods 0 5 9 12 14 15



Here is a production possibilities table for watches and bags in Consumer Land.

a. Draw a PPF that corresponds with the data in the table.

b. Why must Consumer Land sacrifice successively larger amounts of watches to acquire more bags. What type of opportunity costs is it facing? ?

Production AlternativesType of product A B C D EWatches (in millions) 10 9 7 4 0Bags (in millions) 0 5 10 15 20



c. If the economy is currently at production alternative D: i. What is the opportunity cost of five million more bags?

ii. What is the opportunity cost of three million more watches?

d. Where would the economy be operating if a recession in Consumer Land resulted in 2 million people losing their jobs?

e. If the production possibilities frontier for Consumer Land was a straight line, what would it indicate about the country’s opportunity costs? What does this indicate regarding resources?

f. Suppose improvement occurs in the technology of producing watches but not in the production of bags. Illustrate the impact on the original production possibilities frontier.



We can use the production possibility frontier and the

concept of opportunity cost to explain the economic

gains from specialisation and trade. (ECON1086:

International Trade covers the important topic of

international trade in more detail).

Trade: the act of buying or selling a good or service in a

market.

Trade


PPF and International Trade

• Mercantilism held that countries would grow wealthy by

accumulating gold and silver. They would do so by

exporting as much as possible, and importing as little as

possible. • Adam Smith put forward the idea that the wealth of a

nation depends on the incomes of the people in the

country and what they are able to consume, not on the

gold and silver held by the monarchs and the nobles. • According to Smith, imports rather than exports are the

purpose of trade. Imports of goods and services rather

than the accumulation of gold and silver improve people’s

standard of living.RMIT University School of Economics, Finance and Marketing 34

Absolute and comparative advantage.

– Absolute advantage: The ability of an individual, firm

or country to produce more of a good or service than

competitors using the same amount of resources.

– Comparative advantage: The ability of an individual,

firm or country to produce a good or service at a lower

opportunity cost than other producers.

Trade


The Benefits of International Trade

• David Ricardo’s theory of comparative advantage

(developed in 1817) showed how a country could

improve the income of its citizens by allowing them to

trade with people in other countries.

• International trade allows nations to increase the

productivity of their resources through specialisation and

thereby to realise a higher standard of living than is

possible in the absence of trade.

• Trade enables a country and the world to produce and

consume more than would be possible without trade.


• The basis for trade is comparative advantage not

absolute advantage.

• Individuals, firms or countries are better off if they

specialise in producing goods and services for which

they have a comparative advantage and obtain other

desirable goods and services by trading.

Trade




The basic principle underlying free trade between

nations is

a. Absolute advantage

b. Comparative advantage

c. Mercantilism

d. Productivity growth


Review Your Understanding

Daniel decides to spend an hour swimming rather

than working at $6 per hour. His trade-off is:

a. nothing, because he enjoys swimming more than

working.

b. the increase in skill he obtains from swimming for

that hour.

c. the $6 he could have earned.

d. nothing, because he spent $6 for admission into the

sports complex to swim.



When society requires that firms reduce pollution:

a. there is no trade-off, since everyone benefits from

reduced pollution.

b. there is no trade-off for society as a whole, since the

cost of reducing pollution falls only on the firms

affected by the requirements.

c. there is a trade-off only if some firms are forced to

close.

d. there is a trade-off to the firms’ owners, workers and

customers.



When the government prevents prices from

adjusting naturally to supply and demand:

a. it stabilises the economy.

b. it adversely affects the allocation of resources.

c. the improvement in equity justifies the reduction in

efficiency.

d. the reduced uncertainty associated with fixed prices

is worth more than the cost in lower efficiency.



What is the basic cause of scarcity?



Opportunity cost is best defined as

a. the cost to producers that results from a failed

investment opportunity.

b. the additional cost of producing one more unit of

output.

c. the highest valued alterative that we forego when we

make a choice or decision.

d. the additional cost of purchasing one more unit of a

good.


Review Your UnderstandingIf an economy had production problems which led to inefficiency, but then solved these problems and increased economic efficiency, how would this be shown on a production possibility frontier? a. The slope of the production possibility frontier would

become more elastic. b. There would be a movement from a point inside the

frontier to a point closer to or on the frontier. c. The slope of the production possibility frontier would

become more inelastic. d. The production possibility frontier would shift

outwards.


Review Your UnderstandingThe following Production Possibilities Frontier shows the maximum possible combinations of food and clothing that can be produced in a given time period in a particular country.

food

clothing

a. If the country moves upward along the curve and produces more food, does this involve increasing opportunity costs? Why/Why not?

b. Under what circumstances would the PPF be a straight line and what type of opportunity costs would exist?

c. Under what circumstances would the PPF be bowed out from the origin and what type of opportunity costs would exist?



Production possibilities (alternatives)

A B C D E F


Given the above production possibilities table for an economy, what would be the benefit of producing at production alternative C as compared to production alternative D?



Production possibilities (alternatives)

A B C D E F


Refer to the above table. If the economy is producing at production alternative C, what is the opportunity cost of the tenth unit of consumer goods?



Refer to the above diagram. If the economy moves from point C to point B, what is the opportunity cost of each additional baseball?

Measurement : GDP, Unemployment, Inflation

Measuring Total Production, Income and Economic Growth - Chapter 4

Economic Growth, The Financial System and Business Cycles – Chapter 5 (pp. 119-120)

Unemployment - Chapter 9 ( pp. 246-262)

Inflation - Chapter 10 (pp. 272-280)Learning Objectives:

1. Explain how total production in an economy is measured.

2. Discuss whether GDP is a good measure of economic wellbeing.

3. Discuss the difference between real and nominal variables.

4. Understand how the economic growth rate is measured.

5. Define the unemployment rate and the labour force participation rate, and understand how

they are calculated.

6. Explain the economic costs of unemployment.

7. Identify the different types of unemployment

8. Define the price level and the inflation rate, and understand how they are calculated.

9. Use price indexes to adjust for the effects of inflation.

10. Distinguish between the nominal interest rate and the real interest rate.

11. Discuss the problems caused by inflation.


GDP• Gross Domestic Product (GDP): The total market value of all

final goods and services produced in the economy during a specific period.

• Gross National Product (GNP): The total market value of all final goods and services produced by residents of a country (eg. Singaporean residents) during a specific period.

– GDP includes only the market value of final goods.– Final good or service: A good or service purchased by a

final user.– Intermediate good or service: A good or service that is an

input into another good or service, such as a tyre on a truck.– GDP includes only current production.




Gross Domestic Product is the total market value of

all

a. intermediate and final goods and services produced

in a time period within a country.

b. goods but not services produced in a time period

within a country.

c. final goods and services produced in a time period

within a country.

d. final goods and services produced in a time period by

citizens of a country, both within the country and by

its citizens working overseas.


Methods to Measure GDPThree alternative methods to measure GDP:

1. The Production or Value Added Method: The sum of the value of all goods and services produced by industries in the economy in a year minus the cost of goods and services used in production – leaving the value added.

2. The Expenditure Method: The sum of the total expenditure on goods and services by households, investors, government and net exporters (exports minus imports).

3. The Income Method: The sum of the income generated by resources used in the production of goods and services (includes the sum of wages, salaries and supplements plus rent, interest, profit and dividends).


Net Export Expenditure

FinancialMarkets

ResourceMarket

Income

Consumption Expenditu

re

Investment Expenditure

Productio

n

Govt. Expenditu

re

Firm

Government

ProductMarket

External

Household

Borrowing & LendingPrivate and Public

Value of Production = Value of Resources = Value of Income Generated = Expenditure Undertaken


Simple RelationshipsRGDP = Y = AE = C + I + G + NX

For a closed economy we simply remove the external sector which makes our income function:

Y = C+ I + GWe can re-arrange this to derive the investment function:

I = Y – C – G

Stotal = Sprivate + Spublic

Sprivate = Y + TR – C – T and Spublic = T – G – TR, hence

Stotal = (Y + TR – C – T) + (T – G – TR) = Y – C – G

S = I


One bag of flour is sold for $1.50 to a bakery, which uses the flour to bake bread that is sold for $4.00 to consumers. A second bag of flour is sold to a consumer in a grocery store for $2.00. Taking these three transactions into account, what is the effect on GDP?

a. GDP increases by $1.50.

b. GDP increases by $3.50.

c. GDP increases by $6.00.

d. GDP increases by $7.50.



Components of GDP

• Consumption: Spending by households on goods and services, not including spending on new houses.

• Investment: Spending by firms on new factories, office buildings, machinery (planned), and inventories (unplanned), and spending by households on new houses.

• Government purchases: Spending by federal, state, and local governments on goods and services.

• Net exports: The value of exports minus the value of imports.

GDP = C + I + G + NX



In the equation GDP = C + I + G + NX, the G

component refers to

a. the purchases of final goods and services by all

levels of government, excluding transfer payments.

b. government expenditures plus all transfer payments.

c. the taxes and expenditure of all levels of government.

d. government expenditures on transfer payments, such

as pensions and unemployment benefits.


GDP does not reflect total current production as production from the following sources are not reflected in its calculation:

– Household production: Goods and services people produce for themselves.

– The black economy: Buying and selling of goods and services that is concealed from the government to avoid taxes or regulations or because the goods and services are illegal.

Issues in the Measurement of GDP: Shortcomings of GDP as a measure of total

production


Shortcomings of GDP as a measure of wellbeing:– The composition and distribution of GDP is not captured

in GDP measures. – The value of leisure is not included in GDP.– The level, quality of and access to health care is not

measured in GDP.– GDP does not accurately reflect improvements in the

quality of products. – GDP is not adjusted for pollution or other negative effects

of production. – GDP does not reveal anything about social problems that

also impact on overall societal wellbeing.

Does GDP measure what we want it to measure?


Nominal (Money/Current) GDP vs Real GDP

• Inflation or deflation complicates the comparison of figures

measuring GDP over time, because GDP is a price-times-

quantity figure.

• Nominal GDP could increase over time because of increased output, increased prices or both.

• Suppose the economy had a money GDP of $1,000 in 2008, which results from the production of 1,000 apples that sell at a price of $1 per apple. Would it be better off in the year 2009 with a money GDP of $2,000?

– What would be your conclusion if you found out that the $2,000 GDP resulted from the production and sale of 1,000 apples at a price of $2 per apple?


Price and Quantities

Year Price of apples

Qty. of apples

Price of burgers

Qty. of burgers

2006 $1 100 $2 50

2007 $2 150 $3 100

2008 $3 200 $4 150

Year Calculating GDP using current prices

2006

2007

2008

Year Calculating GDP using constant prices (base year 2006)

2006

2007

2008

School of Economics, Finance and Marketing 62

Calculating Real GDP – Real GDP (RGDP): The value of final goods and services

evaluated at base year prices.– Nominal GDP: The value of final goods and services valuated

at current year prices.– Nominal GDP can change over time due to changes in either

price or output. RGDP shows changes in output only.– GDP statisticians select a base year and use this over a

specified period to measure RGDP in order to make meaningful comparisons of GDP over time.

– A simple rule: RGDP equals base year prices times current year quantities.

Real GDP versus Nominal GDP

100index price

GDP nominalRGDP

RMIT University


Check Your UnderstandingSuppose that a very simple economy produces three goods: movies, burgers, and bikes. Suppose the quantities produced and their corresponding prices for 2004 and 2009 are shown in the following table:

2004 2009Product Quantity Price Quantity PriceMovies 20 $6 30 $7Burgers 100 $2 90 $2.50Bikes 3 $1000 6 $1100

The base year is 2004. What is nominal GDP in 2009?a. $7035 b. $3690 c. $6360 d. $3320


Check Your UnderstandingGiven the following information, what can we say has happened in the economy from 2008 and 2009?

2008 2009Nominal GDP $10 000 $12 000Real GDP $9 500 $10 500

a. The price level has remained constant.

b. The price level has risen.

c. The price level has fallen.

d. Not enough information is available to determine

what has happened to prices.


The Economic Growth Rate: the rate of change in real GDP from one year to another.

Calculating Economic Growth

100 x GDP Real

GDP Real - GDP Real GrowthEconomic

Previous

PreviousCurrent

Slide 65


Measuring Unemployment

• Unemployment rate: percentage of the labour force that is unemployed.

• Labour-force Participation rate: percentage of the adult population in the labour force.

• Labour force = No. of employed + No. of unemployed

100Force Labour

Unemployed NumberRate ntUnemployme

100Population Adult

Force LabourRate ionParticipat force-Labour


Types of Unemployment• Frictional Unemployment

– Includes workers who are in the process of voluntarily switching jobs, workers who are temporarily laid off because of seasonality, and new entrants into the labour force. Largely due to imperfect information.

• Structural Unemployment– Unemployment due to fundamental changes in the

kinds of jobs that the economy offers. Workers may have inappropriate skills.

• Cyclical unemployment– Due to a deficiency in aggregate demand for goods and

services.


Full Employment and the Natural Unemployment Rate

• When cyclical unemployment is zero, there is full employment.

• Full employment is therefore achieved when real GDP is equal to its long-run potential GDP.

• At full employment, there will inevitably be some structural and frictional unemployment.

• The unemployment rate at full employment is termed the natural rate of unemployment.

• The natural rate of unemployment is not forever fixed and will vary as rates of frictional and structural unemployment change.


Issues in the Measurement of Unemployment

• Discouraged workers: individuals who have given up

looking for work but would like to work.

• Underemployment: All part-time workers are classified

as employed. Yet many part-time employees may

want to work full-time. (Underemployment may also

apply to causal workers who work in excess of 1 hour

per week and are counted as employed even though

they might like to work more hours).

• Truthfulness issues

RMIT University


Inflation

100Rate Inflation1

12

year

yearyear

PI

PIPI

– Price level: a measure of the average prices of goods and services in the economy.

– Inflation rate: The percentage increase in the price level from one year to the next.

– Deflation: A decline in the general price level in the economy.

RMIT University


– Consumer Price Index (CPI): An average of the

prices of the goods and services purchased by the

typical urban family of 4 in an economy.

– The Market Basket: the Department of Statistics

identifies:

–A typical or representative household.

–The goods and services purchased by the household (this

is the “market basket”).

Measuring Inflation


Consumer Price Index• The CPI is the most commonly known price index and is based

on changes in the price of a given basket of consumption g&s.Fixed basket of 4 apples and 2 burgers

Year Price of apples Price of burgers

2006 $1 $2

2007 $2 $3

2008 $3 $4

Year Cost of basket

2006

2007

2008

Year Consumer price index (2006 is the base year)

2006

2007

2008


Inflation

Inflation rate calculated used the CPI:

2007:

2008:


Check Your UnderstandingSuppose an economy has only three goods and the typical family purchases the amounts given in the following table. If 2000 is the base year, then what is the CPI for 2008?

Product Quantity Price (2000) Price(2008)Hair cuts 6 $50 $70Backpacks 4 $25 $30Tacos 100 $1.00 $5.00

a. 40.08b. 208c. 180d. 100


Check Your UnderstandingSuppose that the data in the following table reflects the prices in the economy. What is the inflation rate in between 2008 and 2009?

Year CPI(1990=100)

2008 1752009 180

a. 4.6% b. 7.5% c. 5% d. 2.9%


– The CPI is the most widely used measure of

inflation.

– Is the CPI accurate?

– Four sources of bias in the CPI may lead to its

overstating the inflation rate.

• Substitution bias

• Increase in quality bias

• New product bias

• Outlet bias

Issues in the Measurement of Inflation

RMIT University



If consumers purchase fewer of those products that

increase most in price and more of those products

that decrease in price as compared to the CPI

basket, then

a. changes in the CPI understate the true rate of

inflation.

b. changes in the CPI are unrelated to the true rate of

inflation.

c. changes in the CPI accurately reflect the true rate of

inflation.

d. changes in the CPI overstate the true rate of inflation


• The GDP Deflator: GDP also allows us to calculate

changes in the price level over time. The GDP deflator

is a measure of the price level calculated by dividing

nominal GDP by real GDP and multiplying by 100.

• The Producer Price Index (PPI): an average of the

prices received by producers of goods and services at

all stages of the production process.

Other Measures of Inflation


• The purchasing power of the dollar falls over time as prices rise.

• Price indexes, such as the CPI, allow us to adjust for the effects of inflation so we can compare dollar values over time.

• For example; we can find the 2008 purchasing power equivalent of a $20,000 salary in 1980. We use the following formula:

Using Price Indexes to Adjust for the Effects of Inflation

Value in 2008 dollars = Value in 1980 dollars

1980inCPI

2008inCPI

=$ 20,000 098,46$82

189


Hyperinflation

•Extremely rapid increases in the general price level.

• In periods of hyperinflation, money loses value so rapidly, that firms and households try to avoid holding it.

•Hyperinflation is often associated with political instability and usually accompanied by recession.


– Nominal interest rate: The stated interest rate on a

loan.

– Real interest rate: The nominal interest rate minus

the inflation rate.

– Deflation: A decline in the general price level in the

economy.

Real versus Nominal Interest Rates



In the country of Hyrkania, the CPI in 2000 was 120 and the CPI in 2001 was 132. Jake, a resident of Hyrkania, borrowed money in 2000 and repaid the loan in 2001. If the nominal interest rate on the loan was 12 percent, what was the real interest rate?


Review Your UnderstandingWhich of the following is a TRUE statement about real and nominal GDP? a. If nominal GDP increases from one year to the next,

we know that production of goods and services has risen.

b. Increases in average prices do not affect the calculation of nominal GDP.

c. If real GDP increases from one year to the next, we know that production of goods and services has risen.

d. Nominal GDP is a better measure than real GDP in comparing changes in the production of goods and service year after year.


Review Your UnderstandingSuppose that a very simple economy produces three goods: movies, burgers, and bikes. Suppose the quantities produced and their corresponding prices for 2004 and 2009 are shown in the following table:

2004 2009Product Quantity Price Quantity PriceMovies 20 $6 30 $7Burgers 100 $2 90 $2.50Bikes 3 $1000 6 $1100

What is real GDP in 2009, using 2004 as the base year?a. $3690 b. $7035 c. $6360 d. $3320



In 1995, the Consumer Price Index was 118.5. In 1996, it

was 120.3, and in 1997, it was 120.0.

Calculate the inflation rate in 1996 and 1997.



Using the following table, fill in the missing cells:

Nominal GDP($ billion)

GDP Deflator RGDP Growth Rate

Inflation Rate

1991 361.1 103.11992 391.4 106.41993 441.7 109.21994 632 116.2



Suppose dishwashers are part of the market basket

used to compute the CPI.

Suppose also that the quality of dishwashers improves

while the price of dishwashers stays the same.

If the Department of Statistics is able to precisely adjust

the CPI for the improvement in quality, then, other things

equal, should the CPI increase, decrease or remain

unchanged?



Andrew is offered a job in Adelaide, where the CPI is 80,

and a job in Melbourne, where the CPI is 125. Andrew's

job offer in Adelaide is for $42,000. How much does the

Melbourne job have to pay in order for the two salaries

to represent about the same purchasing power?

MODULE 2: MARKETS

THE PRICING MECHANISM

THE PRODUCT MARKET

THE LABOUR MARKET

EXCHANGE RATE MARKET

FINANCIAL MARKETS

MONEY MARKET


The Pricing Mechanism

Where Prices Come From: The Interaction of Demand and Supply - Chapter 3


1. Understand the factors that influence the demand for goods and services.

2. Understand the factors that influence the supply of goods and services.3. Explain how equilibrium in a market is reached and use a graph to

illustrate equilibrium.4. Use demand and supply graphs to predict changes in prices and

quantities.


The Market for an Individual Good or Service

• The market is one method of producing and rationing scarce goods and resources.

• A market is when a group of buyers and sellers of a particular good or service interact.

• Supply and Demand refer to the behaviour of individual householders (or consumers) and firms as they interact with one another in the market.

• A competitive market is a market in which there are many buyers and sellers, so that each has a negligible impact on price.


Individual’s Demand for a Good or Service• A demand schedule shows the various amounts of a product

consumers are willing to purchase at each specific price point, ceteris paribus (all other things being equal).

• The negative or inverse relationship between price and the quantity demanded is known as the Law of Demand.



Demand shows the

a. quantity of a good that buyers will buy at a given

price.

b. quantity of a good that sellers will sell at a given

price.

c. quantities of a good that sellers will sell at all possible

prices.

d. quantities of a good that buyers will buy at all

possible prices.


Market and Individual Demand

Kate’s Demand

The market demand curve is the horizontal sum of the individual demand curves

Quantity of CDs Quantity of CDs

Price of CD Price of CD Price of CD

40 40 40

6 4 10

20 2020

12 8 20

Quantity of CDs

Paul’s Demand Market Demand

When the price is $40, Kate will demand 6 CDs.

When the price is $40, Paul will demand 4 CDs.

The market demand at $40 will be 10 CDs.

When the price is $20, Kate will demand 12 CDs.

When the price is $20, Paul will demand 8 CDs.

The market demand at $20, will be 20 CDs.


A Change in Demand versus a Change in the Quantity Demanded

• A change in demand occurs if any determinant of demand (other than the price of the good or service itself) changes. This will shift the demand curve.–An increase in demand shifts the demand curve to the right and will result in a new equilibrium (↑P and ↑ Q).

–A decrease in demand shifts the demand curve to the left and will result in a new equilibrium (↓P and ↓Q).

• A change in the quantity demanded occurs if the price of the good or service itself changes. This is reflected by a movement along an existing demand curve.–An increase in price will lead to a decrease in the quantity demanded.

–A decrease in price will lead to an increase in the quantity demanded.



A change in demand represents a ________ while a

change in quantity demanded is a ________.

a. shift to a new demand curve; movement along one

demand curve

b. movement along one demand curve; movement

along another demand curve

c. movement along one demand curve; shift to a new

demand curve

d. shift to a new demand curve; shift to a another new

demand curve


Determinants of Demand (Factors that will Shift the Demand Curve)

1. Tastes or Preferences

A change in tastes in favour of a product causes an increase in demand.

2. Population and Demographics

An increase in the number of consumers in the market represents an increase in demand.

3. Income

Normal goods: demand varies directly with income. An increase in income causes an increase in demand.

Inferior goods: demand varies inversely with income.


Determinants of Demand (cont.)

4. Prices of Related Goods

Substitutes: A good that can be used in place of another good. A decrease in the price of a substitute good causes the demand for the other good to decrease.

Complements: Goods that must be used jointly. A decrease in the price of one good causes the demand curve for the other good to shift to the right.

5. Expectations

Consumer expectations of higher future prices may result in an increase in demand.



If tyres and petrol are complements, then

a. an increase in the price of tyres will increase the

consumption of petrol.

b. an increase in the price of petrol will increase the

consumption of tyres.

c. an increase in the price of petrol will reduce the

consumption of tyres.

d. tyres and petrol consumption are unrelated.


Shifts and Movements


What effect will each of the following have on the demand for NIKE running shoes?

a. NIKE running shoes become more fashionable.

b. The price of REBOCK running shoes, a popular substitute, goes down.

c. Consumers anticipate that prices on all running shoes will fall next month.

d. There is a rapid increase in the population due to increased immigration.



Supply for a Good or Service• A supply schedule shows the various amounts of a product that

producers are willing and able to produce at various prices, ceteris paribus (all other things being equal).

• Positive or direct relationship between price and quantity supplied is known as the Law of Supply.


Market and Individual Supply

• Market supply refers to the sum of all individual supplies for all sellers of a particular good or service.

• Graphically, individual supply curves are summed horizontally to obtain the market supply curve


A Change in Supply versus a Change in the Quantity Supplied

• A change in supply occurs if any determinant of supply (other than the price of the good or service itself) changes. This will shift the supply curve.–An increase in supply shifts the supply curve to the right and will result in a new equilibrium (↓P and ↑ Q).

–A decrease in supply shifts the supply curve to the left and will result in a new equilibrium (↑P and ↓Q).

• A change in the quantity supplied occurs if the price of the good or service itself changes. This is reflected by a movement along an existing supply curve.–An increase in price will lead to an increase in the quantity supplied.

–A decrease in price will lead to a decrease in the quantity supplied.


Determinants of Supply (Factors that will Shift the Supply Curve)

1. Resource prices: A decrease in price of inputs lowers production costs and increases supply.

2. Technology: Technological improvements lowers production costs and increases supply.

3. Prices of Substitutes in Production

4. Expected Future Prices

5. Number of sellers: The larger the number of suppliers, the greater is market supply.


Shifts and Movements


Market Equilibrium• The intersection of the supply curve and the demand curve for the

product indicates the equilibrium price and quantity.• At the equilibrium price: quantity demanded = quantity supplied;

• The intentions of both buyers and sellers coincide. • There is no incentive to alter the price.



Which of the following describes what occurs at a

market equilibrium?

a. Everyone who wants to buy at the current price can

do so.

b. The market is cleared, there is no surplus and no

shortage.

c. Every seller who is willing to sell at the current price

can do so.

d. All these correctly describe what happens at a

market equilibrium.


Market Disequilibrium: Shortages & Surpluses

• A surplus causes a competitive bidding down of price by suppliers.

• A shortage causes a competitive bidding up of price by buyers.


Market Clearing

D0

Quantity

Price

S

P0

Q0

A

Quantity

Price

D0

S

P0

Q0

A



In the Figure above, if demand was to increase, then equilibriuma. price falls and quantity rises.b. price and quantity fall.c. price rises and quantity falls.d. price and quantity rise.


What will happen to the equilibrium price and

quantity of butter in each of the following cases?

State whether demand or supply (or both) have

shifted and in which direction.

a. A rise in the price of margarine;

b. A rise in the price of bread;

c. A tax on butter production and an increased

preference for butter over margarine.




If the price of a product increases from $12 to $15,

assuming all else remains constant, then the

a. demand for the product will decrease.

b. quantity demanded for the product will decrease

c. demand for the product will increase.

d. quantity demanded for the product will increase.



The expectation of higher future prices actually

causes higher prices now because

a. quantity demanded will increase now.

b. supply will increase now as firms try to sell before the

price rises.

c. demand will increase now as people try to buy before

price rises.

d. quantity supply will decrease now.



Pens are normal goods. What will happen to the

equilibrium price of pens if the price of pencils rises,

consumers experience an increase in income,

writing in ink becomes fashionable, people expect

the price of pens to rise in the near future, the

population increases, fewer firms manufacture pens,

and the wages of pen-makers increase?

a. Price will rise.

b. Price will fall.

c. Price will stay exactly the same.

d. The price change will be ambiguous.



Consider the housing market domestically and assume

that due to tax incentives, building and development

companies have dramatically increased the amount of

new housing available in the country, causing a surplus

in the market.

Using market demand and supply illustrate the above

situation.



Using the market for beer, consider the following

events and use the demand-supply model to

illustrate the effects of each event on quantity and

the price.

Briefly state the determinant assumption being

made for each event.

a. Decrease in the price of yeast.

b. The legal age for all alcohol consumption increases

to 21 in the country.


The Product Market

Economic Growth, the Financial System and Business Cycles - Chapter 5 (pp. 117-124)

Aggregate Expenditure and Output in the Short-Term - Chapter 7 (pp. 174, 177-187)

Aggregate Demand and Aggregate Supply Analysis - Chapter 8 (pp. 212-225)


1. Understand what happens during business cycles and their relationship to long-run economic growth.

2. Discuss the determinants of aggregate demand and distinguish between a movement along the aggregate demand curve and a shift of the AD curve.

3. Discuss the determinants of the four components of aggregate expenditure and define the marginal propensity to consume and the marginal propensity to save.

4. Discuss the determinants of aggregate supply, and distinguish between a movement along and a shift of the AS curve.


The Business Cycle• The economy grows over time, but there are irregular

fluctuations in its rate of growth from year to year.• The business cycle refers to the periodic but irregular

ups and downs in the level of growth in economic activity over a period of time.

Real GDP

Time

Peak

Recession

Exp

ansi

on

Trough


Economic Fluctuations

• Irregular and unpredictable.

• Most macroeconomic quantities fluctuate together.

• Changes in the economy’s output of goods and

services are strongly correlated with changes in the

economy’s utilisation of its labour force. – Potential real GDP: The level of real GDP attained

when all firms are producing at capacity.– Actual real GDP fluctuates around the long-run

potential in the Business Cycle.



During the expansion phase of the business cycle,

a. employment decreases.

b. income decreases.

c. unemployment increases.

d. production increases.

RMIT University School of Economics, Finance and Marketing 122Slide 122

Aggregate Demand• AD curve shows the amounts of goods and services (RGDP)

that will be purchased at any given price level.

• AD is the relationship between the price level and RGDP.

• Overall price level of goods and services– An increase in the price level decreases the value of money

because each dollar you have buys less.– When the price level increases how much we can buy with

$1 decreases, in other words, the value of money decreases in terms of goods and services purchased.

Price level

RGDP

AD = C+I+G+NX = AE


Aggregate Demand Slopes DownwardsThree key factors help explain the downward slope of the AD curve and hence the inverse relationship between the overall price level and the level of RGDP demanded.

1. Wealth Effect

– Changes in the price level, with other things remaining the same, change real wealth, thus changing the level of spending.

2. Interest Rate Effect

– Higher prices requires more money for purchases. Higher interest rates discourages business investment and reduces consumption expenditure on consumer durables.

3. International Trade Effect

– Higher prices causes consumers to spend less on domestically produced goods and services (g&s) and more on imported g&s.



Because of the slope of the aggregate demand curve

we can say that

a. a decrease in the price level leads to a higher level of

aggregate spending.

b. a decrease in the price level leads to a lower level of

aggregate spending.

c. a decrease in the price level leads to a higher level of

aggregate supply.

d. an increase in the price level leads to a higher level

of aggregate spending.


Components of AE - Shifts of AD• Changes in consumer spending

– Expenditures by households on durable goods, non-durable consumer goods, and on services.

• Changes in investment spending

– the purchase of capital goods - plant and equipment, residential structures, and changes in inventory - that can be used in the production of other goods and services.

• Changes in Government spending

– Conduct of fiscal policy: changes in government purchases

of goods and services and taxation.

• Changes in Net Foreign spending

– (Export - Imports) = Net Exports


C = CO + cY

If income is considered a primary determinant of consumption then:

C: Total consumption expenditure

CO: Autonomous/exogenous consumption. Captures the effect of

the non-income factors.

MPC: Marginal propensity to consume. Extra consumption

associated with an extra dollar of disposable income.

MPS: Marginal propensity to save. Extra savings associated with

an extra dollar of disposable income.

• Based on the principal that Yd = C + S

Y

SMPS

Y

CMPC

Consumption Spending


If consumption spending increases from $350

million to $358 million when income increases

from $412 million to $432 million it can be

concluded that the relevant marginal propensity

to consume is:

a. 0.2

b. 0.4

c. 0.6

d. 0.8


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If the MPC is 0.95, then a $10 million increase in

disposable income will

a. increase consumption by $5 million.

b. increase saving by $9.5 million.

c. increase saving by $0.5 million.

d. increase consumption by $950 million.


Consumption Spending

The level of consumption spending is influenced by:

• Wealth

• Level of consumer debt

• Expectations – e.g. future incomes or prices

• Availability and the cost of credit

• Age distribution of the population

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Investment Spending

The level of investment spending is influenced by:• Interest rate• Expectations and business sentiment• Acquisition, operating and maintenance costs• Business taxes• Technological change/innovation• Capital stock


Government SpendingThe level of government expenditure is influenced by:

• Discretionary Fiscal Policy: deliberate changes in government spending and tax revenue used to help stabilise the economy.

• Expansionary fiscal policy involves:– Increases in government spending– Lowering of taxes– A combination of the two

• Contractionary fiscal policy involves:– Decreases in government spending– Increasing of taxes– A combination of the two


Net Foreign Spending

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

• The price level in Singapore relative to the price level in other countries.

• The growth rate of GDP in Singapore relative to the growth rates of GDP in other countries.

• The exchange rate between the Singaporean dollar and other countries currencies.



If countries that imported goods and services from

Singapore went into recession, what would be the

impact on:

a. domestic net exports

b. the aggregate demand curve


– The short-run aggregate supply curve (SRAS) shows the relationship in the short-run between the price level and the quantity of real GDP supplied by firms.

Aggregate Supply

Price level

RGDP

AS

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The Slope of the Short-run Aggregate Supply Slope (SRAS)

The SRAS is upward sloping, showing that in the short-run firms will produce more in response to higher prices. The reason for this is that the price of inputs tends to rise more slowly than the price of final products due to wage and price rigidities.

• Nominal Wages Rigidities

– If the price level falls, real wages rise, production costs

increase; firms hire less labour, thus producing a smaller

output.

• Price Rigidities

– Not all firms adjust prices immediately in response to

changes in the price level; affecting their competitiveness,

sales and thus production.RMIT University


The variables that shift the SRAS curve include:

1. Expected changes in the future price level.

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

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

4. Plus any factor that shifts the LRAS curve.

Note: Factors 1-3 shift only the SRAS curve not the LRAS curve

Short-Run Aggregate Supply

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– The long-run aggregate supply curve (LRAS) shows the relationship in the long-run between the price level and the quantity of real GDP supplied.

Long-Run Aggregate Supply (LRAS)

– The long-run aggregate supply curve shows that in the long-run increases in the price level do not affect the level of RGDP.

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– Shifts in the long-run aggregate supply curve occur because potential GDP increases over time. Anything that shifts the LRAS also shifts the SRAS.

– Increases in GDP (or economic growth) which shift the LRAS are due to:

1. An increase in resources.

2. An increase in the capital stock.

3. New technology

4. Changes in government policy (Incentives to work and invest)

Factors that Shift the LRAS Curve

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The level of long run aggregate supply is NOT

affected by

a. changes in the price level.

b. changes in the number size of the labour force.

c. changes in the capital stock.

d. changes in technology.


Macroeconomic Equilibrium

Price Level

RGDP

SRAS

AD

Yf

P0

LRAS

Price Level

RGDP

SRAS

AD

Yf

P0

LRAS

Y0

Price Level

RGDP

SRAS

AD

Yf

P0

LRAS

Y0

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Suppose the economy is at full employment and

firms become more optimistic about the future

profitability of new investment. Which of the

following will happen in the short run?

a. Prices will decline.

b. Unemployment will decline.

c. Aggregate demand will shift to the left.

d. Output will decline.


What effects might each of the following have on

aggregate demand and/or aggregate supply and

which determinant has changed?

a. A widespread fear of depression among consumers.

b. A tax leading to a 2% increase in petrol prices.

c. A decrease in interest rates.

d. A decrease in government spending on higher

education.

e. The discovery of cheaper energy sources.


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The interest rate effect is described as an increase in

the price level which

a. lowers the interest rate thereby reducing government

spending.

b. lowers the interest rate thereby reducing investment

and consumption spending.

c. raises the interest rate thereby reducing government

spending.

d. raises the interest rate thereby reducing investment

and consumption spending.



The level of real GDP in the long run is called

a. potential GDP.

b. frictional GDP.

c. low capacity GDP.

d. short run GDP.



In the Figure above, which of the points are possible long run equilibriums? a. A and Bb. A and Cc. A and Dd. B and D



Macroeconomic equilibrium always occurs when

a. real GDP = potential GDP.

b. aggregate income = national savings

c. aggregate expenditure = C+ I + G + NX.

d. none of the above



If disposable income increases by $100 million, and

consumption increases by $90 million, then the

marginal propensity to consume is

a. 0.6

b. 0.9

c. 0.75

d. 0.8



In the Figure above, given the economy is at point A in year 1 and point B in year 2, what is the growth rate in potential GDP between those two years?



In each case, specify which of the four components

of AE will be impacted, and how:

a. Real interest rates increase.

b. Two of Singapore’s major trading partners,

experience high GDP growth relative to Singapore.

c. The business sector becomes pessimistic about

future profits.

d. Most households believe their income prospects are

positive for the foreseeable future.



Imagine that the economy is in long-run equilibrium. Then,

perhaps because of improved international relations and

increased confidence in policy makers, people become more

optimistic about the future and stay this way for some time.

a. What would be the impact on the AD curve?

b. In the short-run, how will this affect the price level and RGDP?

c. As a result of the impact on the price level in (b) what happens

to the expected price level and what’s the result for wage

bargaining?

d. How does the change in price expectations in (c) affect the

product market?

e. Illustrate the entire above scenario, highlighting the final long-

run equilibrium


The Labour Market

Unemployment - Chapter 9 (pp.262-264)


1. Explain what factors determine the unemployment rate.2. Explain labour market equilibrium and disequilibrium3. Explain the consequence of labour market disequilibrium4. Describe the changes that have occurred in the determination of wages

and discuss the possible effects on unemployment.

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The Labour Market• Through the workings of the supply of labour and demand

for labour, the levels of employment and the representative equilibrium wage rate is determined.

• The labour market is a resource market meaning that firms are the demanders and householders are the suppliers in this market.

• The labour market as presented, can be understood in terms of a representative model (in reality there are many distinct labour markets)Supply of labour: Quantity of labour provided by

households at various wage rates.Demand for labour: Quantity of labour hired by firms at

various wage rates.

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Real Wage Rate

• Real wage = nominal wage/overall price level = w/p

• Real wage is the amount of purchasing power that each worker receives and which the firm pays for each unit of labour.

• The wage rate can be viewed as the opportunity cost of leisure.

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Labour Market Equilibrium

Real wage

SL

DL

Labour

w

p0

0

N0

In a perfectly competitive labour market, the wage rate and level of employment is determined by the intersection of the demand and supply curves.

Real wage

SL

DL

Labour

w

p0

0

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Causes of Unemployment

• When wages are set above their market-clearing level:– Minimum wage laws– Unions and collective bargaining: Prevent downward wage

flexibility

– Efficiency wages: Firms may make higher profits by paying

above market-clearing wage rates (link between wages and

worker effort, worker quality and company turnover)• Government Policies that influence the incentive to work:

– Job network & unemployment benefits and unemployment

insurance• Deficiency in Aggregate Demand

– Cyclical unemployment

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Why did Henry Ford pay his workers twice as much as other car manufacturers?

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Mary Sue is the newly appointed CEO of a company that manufactures CD drives on an assembly line. Her staff has told her that the output the firm produces, given the number of workers employed, indicates that some workers may be shirking. According to efficiency wage theory, what should she do?a. Pay all workers more than the equilibrium wage rateb. Pay all workers below the equilibrium wage rate to

make up for the loss from shirkingc. Make sure that workers are getting paid exactly the

equilibrium wage rated. None of the above is correct according to efficiency

wage theory.


When a union bargains successfully with an

employer, in that industry

a. The unemployment and wages increase.

b. Unemployment and wages decrease.

c. Unemployment decreases and wages increase.

d. Unemployment increases and wages decrease.


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Advantages of deregulation: – Numerical and functional labour market flexibility:

• Numerical flexibility: ease with which firms can vary the quantity of labour inputs.

• Functional flexibility: ease with which the tasks performed by workers can be altered.

Disadvantages of deregulation: – Relate primarily to equity, and in particular, the vulnerability of

workers in weak bargaining positions.– Such workers are often low paid and low skilled.– Minimum wages may be used to ensure greater equity.

Labour Market Regulation and Deregulation

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Which of the following have a tendency to raise the

unemployment rate?

a. The establishment of effective trade unions in an

economy

b. Firms deciding to pay efficiency wages in an

economy

c. Implementing a minimum wage in an economy

d. All of these are correct.



Trade unions cause unemployment because the

union contract wage is set

a. above the market wage, causing a shortage of

labour.

b. below the market wage, causing a surplus of labour.

c. below the market wage, causing a shortage of labour.

d. above the market wage, causing a surplus of labour.



What is the rationale behind the efficiency wage model?


The Exchange Rate Market

Macroeconomics in an Open Economy - Chapter 14 (pp. 404-410)


1. Explain how exchange rates are determined.2. The difference between the direct and indirect quotations of exchange

rates.3. How changes in exchange rates affect the prices of imports and exports.4. The exchange rate market model.

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Nominal Exchange Rate

• The rate at which one currency is exchanged for

another.

Direct: Singapore dollars required to purchase a unit

of foreign currency:

46.1 1

GD 46.1

1

$

USD

S

CurrencyForeign

SGDe

School of Economics, Finance and Marketing 164RMIT University

Nominal Exchange Rate

• Depreciation: the SGD is worth less in terms of

another currency. i.e. is less valuable. So, it takes

more SGD to purchase a unit of foreign currency.

Exchange rate increases.

• Appreciation: means the SGD is worth more in terms

of another currency. So, it takes less SGD to purchase

a unit of foreign currency. Exchange rate decreases.



When the dollar weakens, each dollar buys

a. more foreign currency, and so buys more foreign

goods.

b. more foreign currency, and so buys fewer foreign

goods.

c. less foreign currency, and so buys more foreign

goods.

d. less foreign currency, and so buys fewer foreign

goods.


Exchange Rate Market• Market forces in the form of supply and demand determine

the level of the foreign exchange rate.

– SFX is derived from any transaction which involves a payment from non-

residents to residents. Converting foreign currency to domestic currency.

– DFX is derived from any transaction which involves a payments from

residents to non-residents. Converting domestic currency to foreign

currency.

DFX

Quantity

e

SFX


Exchange Rate Market

• Importing:

– Demand for FX.

– Supply of SGD.

• Exporting

– Supply of FX.

– Demand for SGD.



Changes in Net Exports

DAUD0

Quantity

Exchange rateSAUD

e0

Q0

DAUD

Quantity

Exchange rate

e0

Q0

SAUD0

Increased Exports Decreased Imports

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1. Changes in demand for Singapore-produced goods and services and changes in the demand for foreign-produced goods and services.

2. Changes in the desire to invest in Singapore and changes in the desire to invest in foreign countries.

3. Changes in the expectations of currency traders about the likely future value of the dollar and the likely future value of foreign currencies.

– Speculators: Currency traders who buy and sell foreign exchange in an attempt to profit by changes in exchange rates

Shifts in demand and supply



If domestically produced goods increased in price

relative to foreign produced goods,

a. exports would increase and imports would decrease

resulting in an appreciation.

b. exports would decrease and imports would increase

resulting in an appreciation.

c. exports would decrease and imports would increase

resulting in a depreciation.

d. exports would increase and imports would decrease

resulting in a depreciation.


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A rise in domestic interest rates relative to interest rates in other countries may lead to

a. an exchange rate depreciation and an increase in net exports.

b. an exchange rate appreciation and a fall in net exports.

c. an exchange rate depreciation and a fall in net exports.

d. an exchange rate appreciation and an increase in net exports.

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Exchange rates are 120 yen per dollar, 0.8 euro per

dollar, and 10 pesos per dollar. A bottle of beer in

Singapore costs 6 dollars, 1,200 yen in Tokyo, 7.2 euro

in Munich, and 50 pesos in Cancun. Where is the most

expensive and the cheapest beer?



Ceteris paribus, assume the exchange rate changes

from 115 yen per dollar to 125 yen per dollar. Has the

dollar appreciated or depreciated and what may be the

impact for the consumption of Singaporean and

Japanese goods.



Singapore’s major trading partners experience a severe

recession.

Illustrate the impact on the exchange rate market and

state whether the currency has appreciated or

depreciated as a result.


The Financial Market

Economic Growth, the Financial System and Business Cycle

- Chapter 6 (pp. 125-133)


1. Discuss the role of the financial system in facilitating economic growth.2. Understand the link between savings and investment and how these

are facilitated by the financial system.3. To introduce the loanable funds model and understand the sources of

demand and supply in this market.4. To understand the significance of the real long term rate of interest in

driving investment decisions.

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• The Financial system: The system of financial markets and financial intermediaries through which firms acquire funds from households.

• Financial intermediaries include banks and non-bank financial institutions.

• Financial markets include the share and bond markets. ― Shares: financial securities that represent partial

ownership of a firm.― Bonds: financial securities that represent promises

to repay a fixed amount of funds.

Saving, Investment and the Financial System

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– Financial intermediaries, such as banks, mutual funds, pension funds, and insurance companies, act as go-betweens for borrowers and lenders.

– Financial markets enable firms to raise funds by selling financial securities (shares or bonds directly to savers).

– As well as facilitating the channeling of funds from savers to borrowers the financial system provides three key additional services for savers and borrowers:

1. risk sharing,2. liquidity, and3. information.

The Role of the Financial System

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– The demand for loanable funds is determined by the willingness of firms to borrow funds to engage in new investment projects.

– The supply of loanable funds is determined by the willingness of households to save, and by the extent of government saving or dissaving (borrowing / budget deficit).

– Equilibrium in the market for loanable funds

determines the real interest rate and the quantity of loanable funds exchanged.

Loanable Funds Market Model

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Loanable Funds Market

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Explaining Movements in Savings, Investment and Interest Rates

An increase in the demand for loanable funds

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Explaining Movements in Savings, Investment and Interest Rates

The effect of a budget deficit on the market for loanable funds

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– Who was better for economic growth: Scrooge the saver or Scrooge the spender?

Ebenezer Scrooge: Accidental promoter of Economic growth?

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Equilibrium in the loanable funds market determines

a. the current interest rate

b. the real interest rate

c. the expected interest rate

d. the nominal interest rate



Some economists have suggested that interest on

savings should be subject to a lower tax rate than is

currently being paid.

Use the market for loanable funds model to analyse the

impact of a policy change of this nature on savings,

investment, the interest rate and economic growth.

Illustrate the impact on the loanable funds market.


The Money Market

Money, Banks and the Monetary Authority of Singapore -

Chapter 11


1. Define money and discuss its functions.2. Discuss the definition of the money supply used.3. Explain how financial institutions create money.4. Illustrate and discuss the money market.

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– Money: Assets that people are willing to accept in exchange for goods and services or for payment of debts.

– Asset: Anything of value owned by a person or firm.– Barter: exchange of goods or services for other

goods or services.– Barter requires a double coincidence of wants.– Commodity money: A good used as money that also

has value independent of its use as money. – Fiat money: Money such as paper currency that is

authorised by the central bank and has no intrinsic value except in its function as money.

What is Money and Why do we Need it?

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Money is

a. the income a person earns over a period of time.

b. a person's assets net of liabilities at any point in time.

c. a liability that people are willing to accept in

exchange for goods and services.

d. an asset that people are generally willing to accept in

exchange for goods and services.



The problem with barter economies is that they

require

a. that there be a double coincidence of wants.

b. a banking system for trade to occur.

c. that there be a single coincidence of wants.

d. less time and trouble to trade as compared with a

money economy.


Money in a World War II prisoner of war camp.

– During World War II cigarettes were used as money in some prisoner of war camps.

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Check Your UnderstandingIn World War II, cigarettes were used as money in some prisoner of war camps. Given this, we would expect to see

a. prices of other goods expressed in terms of cigarettes.

b. people bartering instead of using cigarettes as money.

c. only government-issued cigarettes being accepted as money.

d. no one ever smoking cigarettes in the prisoner of war camps.

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• What can serve as money?• What makes a good suitable to use as a

medium of exchange? There are five criterion:

1. The good must be acceptable to most traders

2. It should be a standardised quality

3. It should be durable

4. It should be valuable relative to its weight

5. It should be divisible

What is Money and Why do we Need it?

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Functions of Money

1. Medium of exchange– Buying and selling goods and services– Money eliminates need for a coincidence of wants

required for trade to occur in a barter economy.

2. Unit of account– Assist the measurement of the relative worth of various

goods, services and resources.

3. Store of value– A form in which to store wealth due to its liquidity and

convenience

4. Standard of deferred payment

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The statement 'a Dell laptop costs $2500' illustrates which function of money?

a. Store of value

b. Medium of exchange

c. Standard of deferred payment

d. Unit of account

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How do we Measure Money Today?• M1: The narrowest definition of the money supply

which includes all the paper money and coins that are in circulation – meaning what is not held by the banks or the state and federal governments – plus the value of all demand deposits with banks.

• M3: M1, plus all other deposits with domestic and foreign owned banks operating in Singapore.

• Broad Money: M3, plus deposits into non-bank deposit-taking institutions less holdings of currency and deposits of non-bank depository corporations, such as finance companies, money market corporations and cash management trusts.

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• Reserves: Deposits that a bank keeps as cash in its vault or on deposit with the Central Bank.

• Reserve Ratio: A bank’s ratio of reserves to deposits.• Excess Reserves: Reserves above the normal ratio

of reserves to deposits. • Financial institutions such as banks are able to create

money through the simple deposit multiplier process.

Financial Institutions and the Creation of Money

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The portion of ________ that a bank does not loan

out or spend on securities is known as ________.

a. loans; reserves

b. loans; securities

c. deposits; reserves

d. deposits; securities


Banks and Money Creation• Assume the required reserve ratio is 10% and $1,000

is deposited into Bank A.

Bank A

Assets ($1,000) Liabilities ($1,000)

Bank B

Assets ($900) Liabilities ($900)

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Banks and Money CreationBank C

Assets ($810) Liabilities ($810)

From the original deposit a new loan is created that result in

further deposits into the financial system

Bank A = $1,000

Bank B = $900

Bank C = $810

Bank D = $729

Bank……

Total change in demand account deposits = $10,000

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If Thrifty Bank receives a $10 000 deposit, and keeps

10% of its deposits in reserve, how much will the

bank loan out?

a. $1000

b. $9000

c. $11 000

d. $10 000


The Simple Deposit Multiplier

– The simple deposit/credit/money multiplier: The ratio of the amount of deposits created by banks to the amount of new reserves.

– Change in deposits = initial deposit x multiplier ($1,000 x 10 = $10, 000)

– Change in the money supply = change in demand account deposits – initial deposit ($10,000 - $1,000 = $9,000)

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If the reserve ratio is 0.05 then the simple deposit

multiplier is

a. 20

b. 10

c. 2

d. 5


Other things the same if reserve requirements are

decreased, the reserve ratio?

a. decreases, the money multiplier increases, and the

money supply decreases

b. increases, the money multiplier increases, and the

money supply increases

c. decreases, the money multiplier increases, and the

money supply increases

d. increases, the money multiplier increases, and the

money supply decreases


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Suppose Colin deposits $3000 into ABC Bank. Assume ABC

Bank has no excess reserves at the time of this deposit, and

the bank’s reserve ratio is 0.20

a. Show the initial impact of Colin’s deposit on the bank’s

balance sheet, and the maximum amount ABC Bank can now

lend as a result of this deposit.

b. What is the maximum increase in deposits that can result

from Colin’s initial deposit? What is the increase in the money

supply?

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Check Your UnderstandingImagine that the banking system receives additional deposits of $100 million and that allthe individual banks wish to retain their current liquidity ratio of 20 per cent.a. How much will banks choose to lend out initially?b. What will happen to banks' liabilities when the money that is

lent out is spent and the recipients of it deposit it in their bank accounts?

c. How much of these latest deposits will be lent out by the banks?

d. By how much will the money supply eventually have risen, assuming that none of the additional liquidity is held outside the banking sector?

e. What is the size of the bank multiplier?


Money Supply

rMs

Quantity of Money

• Notes and Coins; Bank deposits and Non-Bank Financial Institution deposits

• Ms determined exogenously

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The Money Market

The Demand for Money

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The money demand curve is downward sloping because

a. lower interest rates cause households and firms to switch from money to financial assets.

b. lower interest rates cause households and firms to switch from financial assets to money.

c. lower interest rates cause households and firms to switch from money to bonds.

d. lower interest rates cause households and firms to switch from money to shares.

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The Money Market

Shifts in the Money Demand Curve

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Money Market and Equilibrium

Quantity of Money

r

MD

r0

MS

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A decrease in real GDP can

a. increase money demand and increase the interest rate.

b. decrease money demand and increase the interest rate.

c. decrease money demand and decrease the interest rate.

d. increase money demand and decrease the interest rate.

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The money market model is concerned with

________ and the loanable funds market model is

concerned with ________.

a. short-term real interest rates; long term real interest

rates

b. short-term nominal interest rates; long term nominal

interest rates

c. short-term real interest rates; long term nominal

interest rates

d. short-term nominal interest rates; long term real

interest rates



When a grocery store accepts your $10 note in

exchange for bread and milk, this illustrates that the

$10 note is serving as a

a. store of value.

b. standard of deferred payment.

c. unit of account.

d. medium of exchange.



Suppose you deposit $2000 into a bank that has a

reserve ratio of 0.01. How does this affect the

bank's balance sheet?

a. Reserves rise by $200.

b. Excess reserves rise by $1800.

c. Required reserves rise by $2000.

d. Deposits rise by $1000.

RMIT UniversitySchool of Economics, Finance and Marketing 215


Mia puts money into a piggy bank so she can spend it

later. What function of money does this illustrate?



What will be the impact on the bank multiplier of a

decision by the banks to hold a higher liquidity ratio?


Review Your UnderstandingAn increase in real GDPa. decreases the buying and selling of goods and

decreases the demand for money as a medium of exchange.

b. increases the buying and selling of goods and decreases the demand for money as a medium of exchange.

c. increases the buying and selling of goods and increases the demand for money as a medium of exchange.

d. decreases the buying and selling of goods and increases the demand for money as a medium of exchange.


MID-SEMESTER TEST

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MODULE 3: INFLATION, UNEMPLOYMENT, GOVERNMENT

POLICY, DEVELOPMENT AND GROWTH

MONETARY POLICY

FISCAL POLICY

RECESSION, INFLATION & THE LONG-RUN

DEVELOPMENT & GROWTH


Monetary Policy

Monetary Policy - Chapter 12


1. Define monetary policy and describe the main goal of monetary policy.2. Describe how the Central Bank affects interest rates. 3. Use aggregate demand and aggregate supply graphs to show the effects of

monetary policy on real GDP and the price level.4. Discuss the Central Bank’s use of monetary policy.5. Discuss the role of the MAS.

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What Is Monetary Policy?

– Monetary policy: The actions taken by the Central Bank of a nation to affect interest rates and/or exchange rates.

– The main goals of Monetary policy in Singapore• Price Stability• Sustainable Economic Growth.


Monetary Authority of Singapore (MAS)

• Mission: promote sustained non-inflationary economic growth, and a sound and progressive financial centre.

• Main functions:– Conduct of monetary and exchange rate policy– Banker and financial agent of the Government– Banker to financial institutions– Regulation and supervision of the financial sector– Promotion and development of the financial sector


Monetary Authority of Singapore (MAS)

• “Central banks in most developed economies

usually describe their aims in terms of the pursuit of

non-inflationary growth.

• Today, there’s a consensus that price stability

should be the overriding objective of monetary

policy.

• In 1981, MAS moved to an exchange rate centred

monetary policy”.


External Balance• When there is an increase in the demand for Singapore

dollars and the market exchange rate strengthens and the exchange rate moves to the lower end of the established band, the MAS sells Singapore dollars to banks and/or buys government securities from banks.

• The money base (supply) will increase, pushing down Singapore dollar interest rates. Lower domestic interest rates relative to foreign interest rates restrain capital inflows into the nation, encouraging outflows.

• Supply of foreign currency (FX) decreases and demand for foreign currency increases, weakening the currency to restore stability.


External Balancep

AD0

Y0

p0

RGDP

AS

DFX0

Quantity

Exchange rate

e0

SFX0

Sell S$Increase in the money supply Lower domestic interest rates


External Balance• When there is a decrease in the demand for Singapore

dollars and the currency weakens; the exchange rate moves to the upper end of the established band, the MAS purchases Singapore dollars from banks and/or sells government securities to banks.

• The money base (supply) will decrease, pushing up Singapore dollar interest rates. Higher domestic interest rates relative to foreign interest rates induce capital inflows into the nation and reduce outflows.

• Supply of foreign currency (FX) increases and demand for foreign currency decreases, strengthening the currency and restoring stability.


External Balancep

Y0

p0

RGDP

AS

AD0

Quantity

Exchange rateSFX0

e0

DFX0

Buy S$Decrease in the money supply Increase domestic interest rates


Internal Balance• Goal: Maintain the inflation rate within a particular

band.• Sale and purchase of government securities changes

bank reserves and thus their ability to extend credit, thus changing the money supply and the interest rate.

• The Monetary Authority targets interest rates by affecting system liquidity.

• Monetary policy influences the size of bank reserves. This influences:– The size of the money supply.– The interest rate and the availability of credit.– Investment spending, interest-sensitive consumption

spending thus output, employment and the price level.


Open Market Operations• Monetary Authority actions designed to change

interest rates by changing system liquidity to change the cost of credit and thus economic activity and the price level.

• Easy Money: Authority announces its decision to reduce interest rates – it buys government securities to maintain the lower interest rates; expanding the money supply and reducing the cost of credit.

• Tight Money: Authority announces its decision to increase interest rates – it sells government securities to maintain the higher interest rates; reducing the money supply and increasing the cost of credit.


Internal Balance – Contractionary Policy

DFX0

Quantity

Exchange rateSFX0

e0

Q0

p

Y0

p0

RGDP

AS

AD0

Decrease in the money supply Increase domestic interest rates


Internal Balance – Expansionary Policy

Quantity

Exchange rate

e0

Q0

DFX0p

AD0

Y0

p0

RGDP

AS

SFX0

Increase in the money supply Lower domestic interest rates


If the interest rate is below the Central Bank's

target, the Central Bank would:

a. buy bonds to increase the money supply.

b. buy bonds to decrease the money supply.

c. sell bonds to increase the money supply.

d. sell bonds to decrease the money supply.





If the Central Bank pursues expansionary monetary

policy then interest rates will

a. fall and GDP will fall.

b. rise and GDP will rise.

c. fall and GDP will rise.

d. rise and GDP will fall.


Equilibrium in the Money Market

– With interest rate targeting, the money supply curve is a horizontal line at the Central Bank’s target interest rate.

Monetary Policy Effectiveness

• Responsiveness of capital flows,

consumption and investment to changes

to changes in interest rates.

• Phase of the business cycle

• Private decisions of lenders and

borrowers.

• Size of the expenditure multiplier



Suppose you are the monetary policy adviser for the

government. The economy is experiencing a large

and prolonged inflationary trend. What change in

open market operations would you recommend?



If the MAS buys bonds and securities in the open market, this is likely to lead to

a. a rise in interest rates and a depreciation of the Singaporean dollar.

b. a fall in interest rates and a depreciation of the Singaporean dollar.

c. a fall in interest rates and an appreciation of the Singaporean dollar.

d. a rise in interest rates and an appreciation of the Singaporean dollar.



Why Does The Share Market Care about Monetary Policy?

– The share market reacts when the Central Bank implements policy to either raise or lower interest rates.



Explain the process by which an easy money policy

affects equilibrium output and employment.



How may the business cycle impact on the effectiveness

of monetary policy?



If the stock market crashes and aggregate demand

decreases, what can the Central Bank do to offset this

decrease in aggregate demand?


Review Your Understandinga. If the Central Bank sells financial instruments in the

open market, what may happen to net exports – analyse the impact via the product market.

b. If the Central Bank sells financial instruments in the open market, what may happen to net exports – analyse the impact via the exchange rate market.


Fiscal Policy

Aggregate Expenditure and Output in the Short Run - Chapter 7 (pp. 195-200)

Fiscal Policy - Chapter 13

Learning Objectives:1. Define the multiplier effect and use it to calculate changes in equilibrium

GDP.2. Define fiscal policy.3. Explain how fiscal policy affects AD and how the government can use

fiscal policy to stabilise the economy.4. Explain how the multiplier process works with respect to fiscal policy.5. Discuss the difficulties that can arise in implementing fiscal policy.6. Explain how the federal budget can serve as an automatic stabiliser. 7. Discuss the long-run supply side effects of fiscal policy.


• Fiscal Policy: Changes in federal taxes and

purchases that are intended to achieve

macroeconomic policy objectives, such as full

employment, price stability, and healthy

sustainable rates of economic growth.

Fiscal Policy


There are two key approaches to fiscal policy; following rules

implied by automatic stabilisers or else implementing a

discretionary fiscal policy.

– Automatic stabilisers: Government spending and taxes that

automatically increase or decrease along with the business

cycle.

–Discretionary fiscal policy: when the government is taking

actions to change spending or taxes to achieve its objectives.

Rules (Automatic Approach) versus Discretionary Action



Discretionary fiscal policy is when

a. existing taxation policy automatically smoothes out

business cycle fluctuations in the economy.

b. politicians are discrete about policy changes, and do

not advise consumers or producers of new policies.

c. policy is left to the discretion of the MAS.

d. the government changes the levels of expenditure or

taxation.


Expansionary fiscal policy– Increasing government expenditure, or decreasing taxes, or

both. The goal is to shift aggregate demand to the right.–Appropriate when the economy is in a below full-

employment equilibrium.

Contractionary fiscal policy–Decreasing government expenditure, or increasing taxes, or

both. The goal is to shift aggregate demand to the left. –Appropriate when the economy is at an above full-

employment equilibrium.

Using Fiscal Policy to Influence Aggregate Demand


Fiscal policy refers to the

a. government's ability to regulate the functioning of financial markets.

b. spending and taxing policies used by the government to influence the level of economy activity.

c. techniques used by firms to reduce its tax liability.

d. the policy by the MAS to affect the cash rate.

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– The multiplier effect: The series of induced increases in consumption spending that results from an initial increase in autonomous expenditures. The process by which an increase in autonomous expenditure leads to a larger increase in real GDP.

– Autonomous expenditure: Expenditure that does not depend on GDP.

– Multiplier: The increase in equilibrium real GDP divided by the increase in autonomous expenditure.

The Government Purchases (Expenditure) and Tax Multipliers

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– An initial increase in autonomous government spending, such as building new railway lines, will increase aggregate demand by an amount that is more than the initial amount of new spending.

The Government Purchases or Expenditure Multiplier in Action

Figure 14.6 The multiplier effect and aggregate demand

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The government decides to fund the building of a new

bridge. The owner of the company that builds the bridge

pays her workers. The workers increase their spending.

Firms that the workers buy goods from increase their

output. This type of effect on spending illustrates

a. the multiplier effect.

b. the crowding-out effect.

c. None of the above is correct.

d. the Fisher effect.


The Multiplier Effect

eexpenditur autonomous in Change

GDP real mequilibriu in Change Multiplier eExpenditur

MPC-1

1 Multiplier eExpenditur

– The multiplier effect occurs both when autonomous expenditure increases and when it decreases.

– The multiplier effect makes the economy more sensitive to changes in autonomous expenditure than it would otherwise be.

– The larger the MPC, the larger the value of the multiplier.– Our formula for the multiplier is very simplified, but

nevertheless serves to illustrate the process.

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The Government Purchases (Expenditure) and Tax Multipliers

MPSMPCk e

1 or

1

1

TkY T

MPSMPC

kT

purchases governmentin Change

GDP real mequilibriuin Change Multiplier Purchases Government

taxes in Change

GDP real mequilibriu in Change MultiplierTax

GkY e RMIT University



Suppose the MPC is .75.

If the government increases expenditures by $200 billion

how far does the economy grow?

If the government decreases taxes by $200 billion how

far does the economy grow?



The tax multiplier

a. is negative

b. only works when taxes are cut

c. is larger in absolute value as compared to the

d. is less than one


Assume the consumption function for a

closed economy is C=50+0.8Y and that

investment is equal to $30bn.

a. Calculate the equilibrium level of income/output

for this economy.

b. Calculate what will happen to equilibrium income

and output if the government undertakes

expansionary policy of $15bn.



Multiplier Effectiveness

AD

YY

P

AD2

Quantityof Output

PriceLevel

AS

Fixed Price Variable Price


Crowding Out Effect

A D

Y1 RGDP

PriceLevel

AS

P1A


If crowding out occurs, an increase in government spending

a. decreases the interest rate and consumption and investment spending rise.

b. decreases the interest rate and consumption and investment spending decline.

c. increases the interest rate and consumption and investment spending rise.

d. increases the interest rate and consumption and investment spending decline.



Goals of Fiscal Policy

YfY

AD

Quantityof Output

Price Level

AD

Quantityof Output

Price Level

SRASSRAS

P1

P2

LRAS LRAS

Yf Y

GDP Gap GDP Gap

Recessionary Gap Inflationary Gap

Recessionary Gap = GDP Gap ke

Inflationary Gap = GDP Gap ke


Putting Everything Together

e

e

e

e

e

k

k

kG

Gk

GkY

Gap GDPGapry Inflationa

Gap GDPGapry Recessiona

Gap GDP

Gap GDP



If the MPS is 0.25 and the economy has a recessionary

gap of $5 billion, what is the size of the GDP Gap?


Successful Fiscal Policy

Real GDP

Time


Case Against Intervention

• FiscalLags

• Recognition

• Administrative/Legislative

• Operational/Implementation

– Expansionary bias leading to a Political

business cycle


– Budget deficit: The situation in which the government’s spending is greater than its tax revenue.

– Budget surplus: The situation in which the government’s expenditures are less than its tax revenue.

– The budget can serve as an automatic stabiliser.• Federal government deficits increase automatically

during recessions because: 1. Tax revenues fall.

2. Unemployment benefits increase.

• Federal government deficits decrease or surpluses increase automatically during expansions because: 1. Tax revenues increase.

2. Unemployment benefit payments decrease.

Deficits, Surpluses and Government Debt

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Which of the following is an automatic stabiliser?

a. Reductions in nominal wages as inflation rates

rise

b. Unemployment benefit payments to the

unemployed

c. Interest rate changes

d. Increases in government spending on schools


To counteract the effect of automatic stabilisers during a recession and keep the budget balanced, the federal government must ________ government spending, or ________ taxes, and which will ________ aggregate demand.

a. decrease; increase; reduce

b. increase; decrease; increase

c. increase; increase; reduce

d. decrease; decrease; increase



– Should the federal budget always be balanced?– Is government debt a problem?– These questions are related and the answer is

not always clear-cut.– Economists examine the debt, and the interest

on the debt in proportionate terms to determine if it is a problem.

Deficits, Surpluses and Government Debt


Supply side policies:

–Fiscal policies that have long-run effects by

expanding the productive capacity of the

economy and increasing the rate of economic

growth.

–These policy actions primarily affect aggregate

supply, by shifting the long-run aggregate supply

curve to the right.

The Effects of Fiscal Policy in the Long-Run


The long-run effects of tax policy:

– We can look at the effect on aggregate supply of each of the following taxes:

1. Individual income tax

2. Company income tax

3. Taxes on capital gains


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Tax simplification:

– There are also potential gains to be derived from

simplifying the tax law.

– Resources diverted to tax compliance and tax

minimisation can be put to more productive use.

– Tax simplification may improve the efficiency of

firm and household decision making.

The Effects of Fiscal Policy in the Long-

Run


Long Run Implications of Supply Side Policies

Supply side policies can increase long run aggregate supply, thereby reducing the upward pressure on prices following an increase in aggregate demand



Expansionary fiscal policy ________ the price level

and ________ equilibrium real GDP.

a. increases; increases

b. increases; decreases

c. decreases; decreases

d. decreases; increases



To try to combat inflation, the government could

a. conduct expansionary fiscal policy.

b. lower interest rates.

c. decrease taxes.

d. decrease government spending.



If crowding out occurs, an increase in government

spending

a. decreases the interest rate and consumption and

investment spending rise.

b. decreases the interest rate and consumption and

investment spending decline.

c. increases the interest rate and consumption and

investment spending rise.

d. increases the interest rate and consumption and

investment spending decline.



Refer to the figure above. If the economy moves from A to B, which of the following would be the appropriate fiscal policy to achieve potential GDP?a. Increase taxesb. Decrease interest ratesc. Contractionary fiscal policyd. Increase government spending



Increases in government spending will lower the

long term growth rate of GDP, if it lowers ________

spending and the government purchases ________

and not ________ goods.

a. net export spending; investment; consumption

b. investment; consumption; investment

c. net export spending; consumption; investment

d. consumption; investment; consumption



Use the information in the table to answer the questions.a. At what level of RGDP does the market clear?b. What is the MPC?c. Suppose government purchases increase by $500 billion.

What will be the new equilibrium level of real GDP? Use the multiplier formula to determine your answer.



Given the above data what actions might the government take to move the economy to the full-employment level of output?


Recession, Inflation and the Long-Run

Aggregate Demand and Aggregate Supply Analysis - Chapter 8 (pp. 226-234)

Unemployment - Chapter 9 (pp. 256-257)Inflation - Chapter 10 (pp. 280-287)

Learning Objectives:1. Use the aggregate demand and aggregate supply model to illustrate

the difference between short-run and long-run equilibrium.2. Use the dynamic aggregate demand and aggregate supply model to

analyse macroeconomic conditions.3. Understand the difference between demand-pull and cost-push

inflation.4. Explain the quantity theory of money and use it to explain how high

rates of inflation can occur.


The short-run and the long-run effects of a decrease in aggregate demand

Macroeconomic Equilibrium in the Long Run and the Short Run


Costs to the economy as a whole:– Loss of gross domestic product.– Loss of human capital.– Net drain on the budget.– The opportunity cost of funds directed towards welfare

payments.

Costs to the unemployed:– Loss of income.– Loss of skills.– Loss of self esteem.– Unemployment may contribute to family break-ups, health

problems, mental illness, crime and political unrest.

The Costs of Unemployment

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• In general, wages rise with inflation. Inflation can, however, affect the distribution of income. The extent of redistribution depends partly on the degree to which inflation was anticipated or unanticipated.

Costs of Inflation

• The problem with anticipated inflation: – Menu costs – the costs to firms of changing prices.– Risk – particularly for contracts with a ‘time’ element

• The problem with unanticipated inflation:– There are winners and losers, depending on whether inflation is

higher or lower than anticipated.– For example: those on fixed incomes, such as aged pensions,

will lose if inflation is higher than anticipated.– Borrowers may gain and lenders lose when inflation is higher

than anticipated.

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Causes of Inflation

• Monetary growth greater than growth in RGDP

• Demand-pull inflation

― Increases in AD

• Cost-push inflation

― Supply Shocks

―Stagflation: a combination of inflation and

recession, usually resulting from a supply shock.

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– Connecting money and prices: The equation of exchange. The connection between money and prices is expressed in the following equation.

– Velocity of money: The average number of times each dollar in the money supply is used to purchase goods and services included in GDP.

The Quantity Theory of Money

x YP x V M

M

x YPV

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According to the assumptions of quantity theory, if the money supply increases 5% then at full employment

a. nominal and real GDP would rise by 5%.b. nominal GDP would rise by 5%; real GDP would be

unchanged.c. nominal GDP would be unchanged; real GDP

would rise by 5%.d. neither nominal GDP nor real GDP would change.


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– The quantity equation is transformed to:

Growth rate of money supply + growth rate of velocity = growth rate of the price level + growth rate of real

output

– Which we can rearrange as:

Inflation rate = growth rate of money supply + growth rate of velocity - growth rate of real output

– If Irving Fisher is correct and velocity is constant, then the growth rate of velocity is zero, so we can rewrite the equation as:

Inflation rate = growth rate of the money supply – growth rate of real output

The Quantity Theory of Inflation

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According to the quantity theory of money, inflation is caused by

a. GDP growing faster than the money supply.b. GDP growing at the same rate as the money

supply.c. the money supply growing faster than GDP.d. the money supply growing slower than GDP.


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Suppose the money supply is currently growing at 4

% per year, while real GDP is growing at 2%,

calculate the inflation rate assuming Irving Fisher is

correct in his assumption regarding the velocity of

money.


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The short-run and long-run effects of an increase in aggregate demand - Demand-pull inflation and a price-wage spiral


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An increase in aggregate demand causes an increase in ________ only in the short run, but causes an increase in ________ in both the short run and the long run.

a. the price level; real GDP

b. real GDP; real GDP

c. real GDP; the price level

d. the price level; the price level


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– We can create a dynamic aggregate demand and aggregate supply model by making three changes to the basic model:

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

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

3. Except during periods when workers and firms expect high rates of inflation, the short-run aggregate supply curve will be shifting to the right.

A Dynamic AD and AS Model

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A Dynamic AD and AS Model

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The simple static aggregate demand and aggregate

supply model assumes

a. potential real GDP increases continuously.

b. the economy experiences continuing inflation.

c. the economy's aggregate demand curve shifts to the

right in most periods.

d. the economy does not experience long run growth.


The short-run and long-run effects of a supply shock - Cost-push inflation


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Which of the following is considered a supply shock?

a. The increasing investment in the economy causing the capital stock to rise

b. A decline in wages

c. An improvement in technology

d. An unexpected large increase in the price of natural gas


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Supply Shocks and Policy Choices

Policy Options:

1. Do nothing

2. Do something

a.↓AD ↓INF but further ↑UNE

b.↑AD ↓UNE but further ↑INF

AD

RGDP

Price Level

P0

Y0

SRAS0

A

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Fighting Inflation – Reducing AD

RGDP

Price Level

SRAS0

P0

LRAS

Yf

AD0

A

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Why might the short run aggregate supply curve shift to the right in the long run, following a decrease in aggregate demand?

a. Workers and firms adjust their expectations of wages and prices downward and they push for higher wages and prices.

b. Workers and firms adjust their expectations of wages and prices upward and they accept lower wages and prices.

c. Workers and firms adjust their expectations of wages and prices upward and they push for higher wages and prices.

d. Workers and firms adjust their expectations of wages and prices downward and they accept lower wages and prices.


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The level of real GDP in the long run is called

a. potential GDP.

b. frictional GDP.

c. low capacity GDP.

d. short run GDP.




Because of a supply shock, in the short run

a. the aggregate supply curve shifts to the left.

b. equilibrium real GDP rises.

c. unemployment falls.

d. the price level falls.



Which of the following is NOT an assumption made by the dynamic model of aggregate demand and aggregate supply?a. Aggregate demand shifts to the right during most

periods.b. Aggregate supply shifts to the right except during

periods when workers and firms expect higher wages.

c. Aggregate demand and potential real GDP decrease continuously.

d. Potential real GDP increases continuously.



Which of the following can cause cost-push inflation

if the economy is currently in equilibrium at full-

employment GDP?

a. A decrease in personal income tax rates, which

increases after tax income

b. A flood which destroyed much of the country's crops

c. An increase in the size of the labour force

d. An increase in the capital stock in the country



If a supply shock occurs in the economy, what is the

likely impact for inflation and unemployment?


What are the policy options available to the government

to combat a supply shock and what are the costs of

each policy option?



Illustrate and explain the implications for the

inflation/unemployment trade-off if we persist in

undertaking expansionary policy in an attempt to reduce

the unemployment rate below the natural rate of

unemployment.


Economic Development and Growth

Economic Growth, the Financial System and Business Cycles - Chapter 5 (pp. 110-117)

Long-Run Economic Growth: Sources and Policies - Chapter 6

Learning Objectives:1. Explain the basic idea of how a market system works.2. Understand why property rights are necessary for a well-functioning

economy.3. Discuss the importance of economic growth and its impact on living

standards.4. Describe the trends in economic growth in the world. 5. Use the economic growth model to explain why economic growth rates

differ between countries. 6. Discuss why many poor countries have not experienced rapid

economic growth.

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Long-Run Economic Growth is the Key to Rising Living Standards

– Long-run economic growth: The process by which rising productivity increases the average standard of living.

– Real GDP per capita is used to measure changing living standards over time.

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Recall: economic growth is calculated using the following equation:

Calculating Economic Growth Rates

100 x GDP Real

GDP Real - GDP Real GrowthEconomic

Previous

PreviousCurrent

– For longer periods we look at ‘average annual growth rates’. Note: the long-term could be 50 or 100 years or more.

– An approximation of average annual growth for shorter periods is a simple average.

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Use the table below to answer the following questions: – Calculate the growth rate of real GDP for each

year from 2004 – 2007.– Calculate the average annual growth rate over the

same period.

Year Real GDP, $ (billions in 2004 prices)

2004 790

2005 810

2006 825

2007 850




– One way to judge how rapidly real GDP per person is growing is to calculate the number of years it would take to double.

Calculating Economic Growth Rates and the Rule of 70

– This rule shows small differences in growth compound over time.

– This leads to large differences in the number of years it takes for real GDP to double.

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The rule of 70 states that

a. the number of years it takes an economy to double is the growth rate times 70.

b. the number of years it takes an economy to double is 70 divided by the growth rate.

c. it takes an economy 70 years to double in size. d. the number of years it takes an economy to

double is the growth rate divided by 70.


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Use the table below to answer the following questions:

a. How long will it take China to double its real GDP?

b. How long will it take the UK to double its real GDP?

GDP growth (annual %) China UK

2004 10.1 2.7

2005 10.7 2.5

2006 10.4 2.8


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Average annual growth rates for the world economy

Economic Growth Over Time Around the World

Source: J. Bradford DeLong (1998), Estimating World GDP, One Million B.C. – Present, working paper, University of California, Berkley.

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Why do growth rates matter?

• An economy that grows too slowly fails to raise living standards.

• In the 1980s and 1990s, a small group of Asian countries, such as Taiwan and Singapore, achieved high rates of growth. These are sometimes referred to as the newly industrialising countries.


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GDP per capita, 2007


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– Labour productivity: The quantity of goods and services that can be produced by one worker or by one hour of work. Two key factors determine labour productivity.1. Increases in Capital per Hour Worked

– Capital: Manufactured goods that are used to produce other goods and services; examples are computers, factory buildings, and machine tools.

– Human capital: The accumulated knowledge and skills that workers acquire from education and training, or from their life experiences.

What Determines How Fast Economies Grow?

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2. Technological Change: Change in the ability of a firm to produce a given level of output with a given quantity of inputs. Accumulating more inputs such as labour, capital, and raw materials will not ensure that an economy experiences economic growth unless technological change also occurs.Three main sources of technological change:–Better machinery and equipment.–Increases in human capital.–Better means of organising and managing production.


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– Which is more important for economic growth: More capital or technological change?

– Technological change is the key to sustaining economic growth.

– Endogenous growth theory: a model of long-run economic growth that emphasises that technological change is influenced by economic incentives, and so is determined by the working of the market system.


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Endogenous growth theory

a. states that the rate of technological change is caused

by economic incentives.

b. does not adequately explain the factors that

determine productivity.

c. states that the rate of technological change is

unaffected by economic incentives.

d. states that the rate of technological change is

determined outside the working of the market

system.


Which of the following will result in an increase in labour productivity?

a. A decline in the capital stock per hour worked

b. A decline in the amount of human capital per

worker

c. An increase in technology

d. A decrease in the number of people attending

institutions of higher education


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– Free Market: A market with few government restrictions on how a good or service can be produced or sold, or on how a factor of production can be employed.

– Adam Smith argued the benefits of a free market system in his famous book – The Nature and Causes of the Wealth of Nations (published in 1776).

– Smith assumed individuals act in a rational, self-interested way.

– If not restricted by government, then firms would be led by the invisible hand of the market to provide consumers with what they wanted.

– The price mechanism in the free market leads producers to change supply in accordance with consumer demand.

The Market System and Economic Growth

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– Private property rights provide the legal basis of a free market system.

– Property rights: The rights individuals or firms have to the exclusive use of their property, including the right to buy or sell it.

Property Rights

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A well established and legally enforced system of property rights

a. encourages investment growth but reduces entrepreneurial activity.

b. reduces economic efficiency which reduces the rate of economic growth.

c. encourages economic growth by increasing the incentive to be innovative.

d. discourages economic growth by discouraging innovation.


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– Government policy can increase the accumulation of knowledge and capital in three ways:

1. Protecting intellectual property rights with patents and copyrights.

Patent: the exclusive right to a product for a period of time from the date the product was invented.

2. Subsidising research and development.

3. Subsidising education.


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What is the ultimate purpose of patents and copyrights?

a. To provide owners with large profit forever.

b. To encourage the expenditure of funds on research and development to create new products.

c. To protect firms from being taken advantage of by producing firms.

d. To do all of these things.


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Joseph Schumpeter and Creative Destruction.

– To Schumpeter, the entrepreneur is central to economic growth:

–The function of entrepreneurs is to reform or revolutionise the pattern of production by exploiting an invention or, more generally, an untried technological possibility for producing new commodities or producing an old one in a new way.


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– ‘Catch Up’: the prediction that the level of GDP per capita in poor countries will grow faster than in rich countries.

– Some poorer countries have experienced rapid growth rates, but many have not.

Why Isn’t the Whole World Rich?

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Figure 7.8 The rule of law and growth


Source: Based on David Dollar and Aart Kraay (2000), Property Rights, Political Rights, and the Development of Poor Countries in the Post-Colonial Period, World Bank Development Research Group Working Paper, October

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There is no one answer to the question as to why all countries do not experience economic growth.

Most economists identify 5 key factors:

1. Failure to enforce the rule of law: • Rule of Law: the ability of a government to enforce

the laws of a country, particularly with respect to protecting private property and enforcing

contracts.

2. Wars and revolutions: • Many countries that were poor in 1960 have

experienced extended periods of violent changes of government during the years since. Eg. Afghanistan, Angola and Ethiopia.


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Why Isn’t the Whole World Rich?3. Poor public education and health:

• Many low-income countries have weak public school systems, so many workers are unable to read and write. People who are sick work less, and are less productive when they do work.

4. Slow technological development: • The economic growth model shows the

importance of technological change.

5. Low rates of saving and investment: • The low savings rates in developing countries contribute

to a vicious cycle of poverty.

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Which of the following is a reason why low

income countries might experience economic

growth?

a. The country has endured extended periods of war.

b. The country fails to enforce a rule of law.

c. The country has a high rate of savings and

investment.

d. The country suffers from poor health

infrastructures.



Globalisation is defined as the process of

countries becoming ________ open to foreign

trade and ________ open to foreign

investment.

a. less; less

b. more; less

c. more; more

d. less; more


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The benefits of globalisation:– Foreign Direct Investment: The purchase or

building by a corporation of a facility in a foreign country.

–Foreign Portfolio Investment: The purchase by an individual or firm of stock or bonds issued in another country.

–Globalisation: The process of countries becoming more open to foreign trade and investment.

Globalisation


Criticisms of Globalisation

– Globalisation undermines distinctive cultures.

– Multi-national firms exploit low wages and poor

health, safety and environmental regulations in

the developing world.

– Economic growth contributes to global

warming, deforestation and other

environmental problems.

Globalisation


REVISION OF MODULES 1, 2 & 3

module 1: concepts economic methodology & the economising problem measurement - gdp,...

Documents

role of economics

economic incentives

people economic agents

economic variable

economic behaviour

economising problem

concepts economic methodology

rational people