3 b revision notes

What Is Meant By Resources? The word resources refers to anything which can be used in the production process. Resources are also called Factors of Production. Economists categorise all resources into four categories:

1. Land also known as natural resources

2. Capital also known as capital resources

3. Labour

4. Enterprise

Land:

This includes all elements of the natural environment. Examples include minerals, soil, forests, climate, water, marine stocks and scenic landscapes. Many natural resources are limited in their supply, for example coal, iron and oil. They are called exhaustible or non-renewable resources and cannot be replaced.

Other natural resources are non-exhaustible or renewable because with careful management they renew themselves and are available indefinitely. Examples include fish stocks, forests and water resources. However if used up to fast without any thought for their future availability, they will be exhausted too.

Labour: In economics labour includes all human intellectual and physical effort and skills which go into the production of goods and services. There are many different occupations which people do and which require different skills. Some jobs are labour-intensive and need lots of workers while others require fewer workers with higher skills because they work with complex machinery or equipment. The work they do is intellectual not physical. In our rapidly changing and competitive world, workers need higher levels of education and training and need to continually update their skills and knowledge.

Capital: Capital refers to man-made or manufactured goods used to make final products. It includes

tools and equipment, machinery, roads, dams, buildings, office furniture and equipment, motor vehicles used in business and industry, railways, computers and so on. Some manufactured goods may be both a consumer good and a capital good. A car or a computer is a consumer good if it is purchased by a household for personal use. However if the car or computer is purchased to be used in a business, then they are capital goods. A train or a jumbo jet are clearly capital goods because they are used to produce a service which consumers buy. Spending by a business on the purchase of capital goods is called investment or capital expenditure.

Enterprise:

This, like labour, is a human resource. It can also be called entrepreneurship or entrepreneurial skill. It refers to the ability to combine the other three factors of production into a production process which produces a good or service wanted by consumers. A successful entrepreneur is a person who sees an opportunity in the market and creates a new business. In doing this a consumer want is satisfied and jobs are created providing employment for people who are looking for work. A successful entrepreneur will choose a combination of factors which minimises costs and set a price for the final product which maximises profit but which doesn’t discourage consumers from buying the product. An enterprising person is a risk taker. Setting up and running a new business is a risky venture in a competitive environment. Things can go wrong and the business can fail leaving the entrepreneur bankrupt. Prosperous economies value and encourage entrepreneurship.

All these are used to pfinished gand services

roduce oods

also known as human resources

1. Write true or false for each of the following statements.

i) The word resources refers to anything which is provided by nature. ___________

ii) Iron ore and oil are examples of renewable resources. ___________

iii) Labour is a resource which includes intellectual and physical skills. ___________

iv) The family car is an example of a capital good. ___________

v) A farmer's tractor is an example of a capital good. ___________

vi) Being able to combine land, labour and capital into production is the objective of enterprise. ___________

vii) Investment is spending by households on capital ___________

2. In the table below write each of the items in the list under the appropriate resource heading in the table a) the Great Barrier Reef

b) Swan river

c) a computer

d) a hospital building

e) a migrant from Vietnam

f) a farmer's dam

g) coal deposits

h) a telecommunications satellite

i) a business owner

j) a shop assistant

k) fertiliser

Land Labour Capital Enterprise

SCARCITY

Scarcity – unlimited wants versus limited resources By now you should clearly understand that economics is about using available resources to satisfy as many needs and wants of as many people as possible. All societies are faced with this basic problem - the problem of scarcity. This means that the resources society needs to produce goods and services to meet people's needs and wants are limited. Remember the definition of economics on page 2? Therefore the supply of goods and services produced is limited relative to demand for them. This scarcity creates the need for need for choice. Consumers have to make choices as to what goods and services to buy and producers have to decide what resources to purchase and what goods and services to produce with those resources. This characteristic of scarcity allows us to classify goods into different categories. Goods which are scarce relative to wants we can call economic goods. Anything which has a price is an economic good. Its price reflects its scarcity. The scarcer a good is, the higher its price; the more available a good is, the lower its price. Think about the price of bananas last year and now. Prices went up drastically last year but are coming done now! Why? Some goods are free but these are very few. Obviously if they are free they are not scarce. Two examples of free goods are air and sunshine. Goods which households buy are called consumer goods. They are final products which are used directly to satisfy individual wants and needs. Things like food, clothing, a can of lemonade or a CD are examples of final consumer goods. Some consumer goods last a long time like a car, a television and furniture. Such goods are called consumer durables or durable consumer goods. Other final products are consumed quickly or in a relatively short space of time such as food, petrol, cosmetics and clothing. These products are called non-durable consumer goods. When you pay to ride on a bus or do a course at Canning College, you are buying a service. Intermediate goods are goods which are components or parts of final goods for example microprocessors in computers or the lights in a car. They are manufactured separately then purchased by the producer of the final product. Goods which are used to make other goods and services are called capital or producer goods. These are goods bought by producers which they use to produce something else. Examples include machinery, tools, or office equipment to name only some. Capital goods are used in the production process along with other resources. Money spent on the purchase of capital goods is called investment. The Economic Problem

Our discussion of wants, needs and resources allows us to focus on the economic problem in a concise, logical way:

• Wants are unlimited – this is the source of demand for goods and services.

• Resources which are used to satisfy wants, have alternative uses and are limited.

• Since resources are limited, choices have to made. Society must choose which wants it will satisfy with its resources.

The scarcity of resources in relation to wants is referred to as the economic problem. The goal of any society is to maximise human material well being by satisfying as many wants of as many people as possible. The task of an economic system is to devise ways to make national resources stretch as far as possible to achieve this aim. This is what economists study. The economic problem, with its central idea of choosing between wants, raises some important questions which we all face.

i) What is the cost of choosing? ii) Is there an order of choice? iii) What is the best choice?

WORD GRID Term Meaning Examples Economic goods

Free goods

Capital goods

Durable consumer goods

Non-durable consumer goods

Intermediate goods

What is Economics – a summary

• Economics is the study of how we can make first best choices

• Resources are limited (time and human, natural and capital resources) therefore we have to make choices in life.

• When a choice is made, a real cost is incurred. This is called Opportunity Cost.

• Opportunity Cost = next best alternative

• If we make first or best choices then we keep our opportunity costs as low as possible.

• When we make first best choices, we are achieving economic efficiency.

We can show the concept of opportunity cost with a Production Possibilities Frontier model (PPF).

The PPF shows us 3 things:

1. There is a limit to how much we can produce.

2. If we are already using all available resources and technology, then to produce more of one good means we have to shift resources away from the production of the other good so less of that is produced. This fall in the output of the other good = opportunity cost.

3. Over time, as population grows and more and better resources become available, more of all goods can be produced. This is known as Economic Growth

A

B

C

D

Good X

The PPF is curved which is due to the law of increasing costs. This happens because resources are not equally efficient at producing both goods.

Good Y

REVISION ACTIVITY ON THE PPF AND OPPORTUNITY COST

THE ECONOMIC PROBLEM

Unlimited wants

Limited resources

SCARCITY

CHOICE – individuals, firms and governments need to consider the

OPPORTUNITY or REAL cost of each alternative choice made by households, firms

and governments.

Therefore they must decide on four questions:

o What to produce o How much to produce o How to produce o For whom to produce

1. Graph the PPC from the data in the table below

Consumer goods Capital goods A B C D E F

0 10 20 30 40 50

100 80 60 40 20 0

a. The PPC (or PPF) is a (curved/straight) line __________________________

b. The opportunity cost of increasing consumer goods output from 10 to 20 is _________________

c. The opportunity cost of increasing consumer goods output from 20 to 30 is _________________

d. Label a new point G (30 units of consumer goods and 30 units of capital goods). Explain why this point represents a ‘waste of resources’.

_______________________________________________________________________________

2. The table below shows combinations of food and manufactured goods that could be produced by a fully employed economy.

R S T U V Food Manufactured goods

0 10 20 30 40100 90 70 40 0

a. Construct a PPF from the data. b. Calculate the opportunity cost of increasing food production by 10 units.

Food opportunity cost

0‐10 ____________

10‐20 ____________

20‐30 ____________

30‐40 ____________

c. Why does the OC increase?_______________________________________________________

_________________________________________________________________________________

___________________________________________________________________________

d. This is known as the law of ________________________________________________ e. Assume there is an increase in labour productivity that doubles the output of both food and

manufactured goods. Show this on your graph. f. Assume food production increases by 20% ‐ show the effect on the PPF.

g. What factors would cause the PPF to move inwards? _________________________________

_________________________________________________________________________________

___________________________________________________________________________

h. Assume the economy is at point T. Explain the adjustment process if society demands more food production.

_________________________________________________________________________________

___________________________________________________________________________

GRAPH CONSTRUCTIONS

STUDENT ACTIVITY 1.2 Examine the table of data below from the Australian National Accounts provided by the Australian Bureau of Statistics (January and November, 2009) and then complete the questions. The table shows the contribution to GDP as measured by expenditure from households (C), firms (I), government (G) and net exports (X-M).

Australia's National Accounts Nov 2009 ($millions)

Period Cons I Govt Bus G1 G2

Invent ∆ Exports Imports GDP

1994–95 370,421.0 110,370.0 14,199.0 127,069.0 14,463.0 3,479.0 129,105.0 91,514.0 681,004.0

1995–96 383,800.0 114,653.0 13,385.0 132,404.0 14,223.0 106.0 142,020.0 95,130.0 708,925.0

1996–97 393,269.0 126,463.0 11,285.0 134,938.0 15,467.0 958.0 157,668.0 104,500.0 736,573.0

1997–98 411,390.0 143,603.0 9,546.0 140,092.0 15,099.0 629.0 164,232.0 114,894.0 769,719.0

1998–99 431,961.0 146,079.0 13,846.0 146,363.0 15,835.0 5,894.0 167,853.0 120,592.0 809,744.0

1999–00 450,892.0 160,953.0 10,757.0 151,152.0 18,597.0 2,760.0 182,190.0 135,524.0 842,134.0

2000–01 467,187.0 143,083.0 10,248.0 154,309.0 18,848.0 2,469.0 195,980.0 134,161.0 858,134.0

2001–02 481,205.0 157,135.0 11,679.0 158,587.0 20,025.0 162.0 194,109.0 136,121.0 890,743.0

2002–03 497,721.0 182,769.0 12,441.0 163,610.0 20,648.0 905.0 193,255.0 153,919.0 919,247.0

2003–04 524,706.0 198,166.0 13,877.0 170,057.0 21,736.0 6,209.0 197,382.0 173,993.0 956,017.0

2004–05 548,015.0 209,562.0 15,659.0 176,447.0 23,057.0 6,102.0 203,407.0 195,124.0 982,786.0

2005–06 562,227.0 227,868.0 18,579.0 180,839.0 23,785.0 2,298.0 207,886.0 209,246.0 1,012,269.0

2006–07 584,924.0 238,948.0 18,756.0 186,203.0 27,003.0 2,652.0 215,695.0 228,452.0 1,045,674.0

2007–08 608,428.0 264,271.0 19,935.0 192,611.0 28,731.0 5,114.0 224,500.0 259,977.0 1,084,451.0

2008-09 617,114.0 272,593.0 22,394.0 198,964.0 31,229.0 -8,898.0 228,526.0 253,479.0 1,095,370.0

Annual % percentage change

Period Cons I Pub Corp G1 G2 Exports Imports GDP

1994–95 5.1 11.0 19.4 3.5 7.1 4.8 16.6 4.3 1995–96 3.6 3.9 -5.7 4.2 -1.7 10.0 4.0 4.1 1996–97 2.5 10.3 -15.7 1.9 8.8 11.0 9.8 3.9 1997–98 4.6 13.6 -15.4 3.8 -2.4 4.2 9.9 4.5 1998–99 5.0 1.7 45.1 4.5 4.9 2.2 5.0 5.2 1999–00 4.4 10.2 -22.3 3.3 17.4 8.5 12.4 4.0 2000–01 3.6 -11.1 -4.7 2.1 1.4 7.6 -1.0 1.9 2001–02 3.0 9.8 14.0 2.8 6.2 -1.0 1.5 3.8 2002–03 3.4 16.3 6.5 3.2 3.1 -0.4 13.1 3.2 2003–04 5.4 8.4 11.5 3.9 5.3 2.1 13.0 4.0 2004–05 4.4 5.8 12.8 3.8 6.1 3.1 12.1 2.8 2005–06 2.6 8.7 18.6 2.5 3.2 2.2 7.2 3.0 2006–07 4.0 4.9 1.0 3.0 13.5 3.8 9.2 3.3 2007–08 4.0 10.6 6.3 3.4 6.4 4.1 13.8 3.7 2008-09 1.4 3.1 12.3 3.3 8.7 1.8 -2.5 1.0

(ABS Australian Economic Indicators, Jan & Nov 2009, 1350.0)

2010

3BECO – ECONOMIC POLICIES

AND MANAGEMENT ESSENTIAL BACKGROUND/REVISION

3BECO – Economic policies and management 1. Essential Background/Revision Objectives: • distinguish between macroeconomics and microeconomics • explain the concept of the circular flow of income and expenditure • explain the concepts of total spending, total output and total income and the relationship between

them • explain the concepts of equilibrium, leakages and injections in the circular flow of income and

expenditure • explain how changes in leakages and injections can change the level of equilibrium in the

circular flow of income model • explain the concept of the business cycle • outline the phases of the business cycle The Difference between Microeconomics and Macroeconomics Microeconomics is the study of the economics of the individual parts which make up an economy. It deals with the behaviour of single economic agents like households and consumers and individual firms. It also studies the operation of particular sectors of the economy and industries as well as the operation of factor and product markets. Microeconomics deals with questions like what determines the prices of goods, peoples’ consumption patterns and decisions about production like what, how, and how much to produce. Macroeconomics is about the economy as a whole. It looks at the relationship between all the parts of the economy and aggregates such as inflation, employment, output and the balance of payments. Macroeconomics focuses on the three important measures of economic activity of total output, total spending and total income. Knowledge of macroeconomics is important because it allows us to answer questions such as what determines the general level of prices and interest rates and allows governments and businesses to develop policy and plan ahead to meet the needs of the community and achieve social and commercial objectives.

The Circular Flow of Income Model

Economic models are used to focus on the most important elements in a very complex real world. Their purpose is to reduce the complicated details of the economy to a simple form to allow us to understand the interrelationships between these elements. Models allow analysis to focus on important economic events that constantly go on around us and make it easier to predict and explain the behaviour of important economic variables. You have learned about the model of supply and demand. This is a model of a simple market. It can be called a microeconomic model because it shows us the operation of just a small part of an economy. Some models show us the operation of an economy as a whole. These are called macroeconomic models. The circular flow of income model is a macroeconomic model which you are going to learn about next. All countries have governments which are involved in economic decision-making to varying degrees. In a very few countries such as Cuba or North Korea governments make most of the decisions. In other countries like the USA and

Essential Background – Dave King 1

3BECO – Economic policies and management Australia, governments make fewer economic decisions than the private sector (households and firms). Economies like Australia’s and America’s are called market or mixed economies. They are also called free enterprise, private enterprise or capitalist economies. The free enterprise economy consists of three main parts or sectors: i) households or consumers, ii) firms or producers, iii) Governments. In a market economy firms and households are the most important sectors. The relationship between them is illustrated in the following diagram or simple model of the economy.

Resources include : land labour capital

enterprise

The return (income) to each of these resources is: rent wages & salaries interest profit

The diagram shows two sectors only – households and firms (or consumers

and producers). It shows us that firms purchase the resources they need from households who receive payments we call income (Y). The level of income paid for a resource will depend on the demand for the resource from firms and the supply of it. Obviously those resources which are in high demand will attract a high income compared to other resources. Therefore different individuals who possess different resources and quantities of resources, receive different levels of income. People who have no resources to offer in the market place would receive no income at all if governments didn’t step in with welfare payments.

Firms produce goods and services (O for output) with the resources they purchase from households. With the income received from selling their resources, households then buy these goods and services [consumption (C) or Expenditure (E)] in the market place for prices acceptable to both buyers and sellers. Obviously the goods and services firms produce will have to be those which consumers want to buy. When consumers change their preferences, firms must respond quickly and shift production into what consumers want (this is called consumer sovereignty). Firms make a profit by adding on a margin to the costs of the natural, labour and capital resources they use. This is their return (profit) for organising and coordinating the process of production (payment for enterprise). In the simple model the total value of consumption = the total value of output = the total value of income which gives us our equilibrium condition.

∑E = ∑O = ∑Y

Households

THE SIMPLE CIRCULAR FLOW OF INCOME MODEL

Firms

Consumption (payment for goods & services)

Income (wages, profits, interest, & rent) Factors of Production (land, labour, capital & enterprise)

Goods and Services

Total Income

Total Output

Total Expenditure


3BECO – Economic policies and management

Student Activity

Complete the following sentences.

a) The consumer or household sector supplies ________________________________

______________________________________________________________________________

b) In return for supplying these households receive _____________ in the form of

______________________________________________________________________________

c) Income levels vary. Why? __________________________________________________

______________________________________________________________________________

d) The producer sector supplies ______________________________________________

e) In return this sector receives ______________________________________________

which after costs are deducted leaves ______________________

f) Returns to producers vary because consumers _____________________________

______________________________________________________________________________

Let’s have another look at the model to see where our product and factor

markets fit in.

Factor P S (house holds) In all types of markets, when there is a change in either supply or demand, price should adjust so that S = D.

Households

Firms

Markets

D (firms) Q

Product P S (firms)Markets

households

Q

D (

)

Income Income

Factors or Resources

Consumption

Goods & Services (Output)

(spending)

Factors or Resources

Markets allow firms and households to interact.


3BECO – Economic policies and management In this simple two sector model of the economy, equilibrium is the natural state of the economy. In this state of balance, there is no change, ie no growth or contraction. This is obviously a simplification of the real world because economies are usually growing and sometimes they contract (have a recession) and they have more than two sectors. We need to build our model and make it more like the real world. Adding the Finance Sector/Market (eg banks, stockmarket and superannuation funds) The addition of the capital or finance sector to the model takes us a little closer to reality and introduces the leakage of saving and the injection of investment. Savings (S): Savings is defined as income not spent which is placed within the financial sector. Savings from households and firms (firms save too) form the “pool” of surplus funds from which investment is financed. Saving is a leakage from the circular flow of income. Households can either spend (consume) or save their income therefore Y = C + S.

Investment (I): Investment refers to the creation of new productive capacity through the purchase of capital goods. The funds used to do this are channelled from savers to investors by the financial sector or capital market. Obviously how efficient the financial sector is will be very important to the efficiency of the whole economy. Investment is an injection into the circular flow. Firms produce either consumer goods and services or goods and services for other firms (capital goods) therefore O = C + I. The value of output is always equal to income (Y) because firms pay households for resources. Therefore O = Y = C + I. For the economy to remain in a state of equilibrium, S = I. The Finance Sector: all savings → finance market → all investment This is our new equilibrium condition. For the economy to be in balance, savings and investment must be equal.

Households

Firms


Income (wages, profits, interest, & rent)

Goods and Services

Factors of Production (land, labour, capital & enterprise) THE CIRCULAR FLOW OF INCOME MODEL with S and I

Financial sector or market Savings Investment


3BECO – Economic policies and management Saving is a leakage from the flow of income in the simple two sector model because it is money not spent on output. Keep in mind that the model is a simplification of the real world. There are more flows than saving and investment between the finance sector and the household and firm sectors. Think about this. Student Activities

1. Saving can be defined as ____________________________________________________

2. Investment can be defined as ________________________________________________

________________________________________________________________

3. a) When the finance sector provides loans to the business sector for

investment purposes, the return to the finance sector is

_________________________________________

b) When firms save profits with the finance sector they receive in return

_________________________________________

c) Households access loans from the finance sector and in return have to pay

_________________________________________

4. a) Why do households and firms save? ______________________________________

______________________________________________________________________________

b) Which sector does most investing? Why? ________________________________

______________________________________________________________________________

5. If the word equilibrium means a state of balance with no tendency to change, then explain the meaning of the term disequilibrium with reference to the finance sector, ie. in terms of S and I.

________________________________________________________________________________

________________________________________________________________________________

________________________________________________________________________________

________________________________________________________________________________

________________________________________________________________________________


3BECO – Economic policies and management Adding the Public or Government Sector The public sector introduces the leakage of taxation and the injection of government spending and takes us even closer to the real world Australian economy. GOVERNMENT SPENDING (G): This includes expenditure by any of the three levels of government in Australia on capital works (public works such as roads, hospitals and defence equipment) and consumption (or recurrent) spending such as welfare or transfer payments, salaries of public servants, police, nurses, judges, etc and the running costs of government. Government spending plans are announced in budgets. TAXATION (T): Taxation is the main source of revenue for governments and includes all kinds of direct and indirect taxes at each government level. It is important for taxation to be seen as fair otherwise people will attempt to avoid paying taxes and undermine the tax system. Taxes should not distort private decisions to invest, produce, save, spend or work. In other words the taxation system should help improve the operation of the economy, not impede it. The equilibrium condition for the government sector is G = T. For the economy to remain in a state of equilibrium, S + T = I + G The Public Sector: all taxes → public sector → all government spending Again keep in mind that the model is a simplification of the real world. There are more flows than taxation and public spending between the public sector and the rest of the economy.

Households

Firms



Factors of Production (land, labour, capital & enterprise)

Goods and Services

Financial sector or finance market Savings Investment

Government (Public) Sector Taxation Government spending

THE CIRCULAR FLOW OF INCOME MODEL with T and G


3BECO – Economic policies and management Student Activities 1. How does taxation affect the economy? ______________________________________

________________________________________________________________________________

________________________________________________________________________________

2. Give examples of goods and services firms and households purchase from the public sector or receive in return for the taxes they pay.

________________________________________________________________________________

________________________________________________________________________________

________________________________________________________________________________

_______________________________________________________________________________

3. How does government contribute to the level of spending in the economy?

________________________________________________________________________________

_______________________________________________________________________________

Sometimes a government spends more money than it gets in taxes it. When it does this it is called a budget deficit. When government raises more tax revenue than it spends it is called a budget surplus.

Governments provide postal services

Governments provide defence

Adding the Overseas Sector or International Market

The international market includes all the buying and selling of products between Australia and the rest of the world. It introduces the leakage of imports and the injection of exports and completes the expanded model of income flow. IMPORTS (M): Imports are goods and services produced overseas and purchased by Australians so the money paid for imports goes out of the domestic economy. It is money not spent on domestically produced output. EXPORTS (X): Exports are goods and services produced in Australia and sold to overseas buyers so the money spent comes into the domestic economy and becomes income to the producers of the exports.


3BECO – Economic policies and management The equilibrium condition for the international market is X = M.

The Overseas Sector: imports → international market → exports

When added to the finance and public sectors:

S + T + M = I + G + X which is the equilibrium condition for the whole

economy.

Equilibrium occurs when total leakages = total injections,

ie. S + T + M = I + G + X {therefore Disequilibrium condition is: S + T + M ≠ I + G + X} The completed circular flow model looks like this:

THE EXPANDED CIRCULAR FLOW OF INCOME MODEL

Keep going. You can’t relax yet.

Households

Firms



Goods and Services

Factors of Production (land, labour, capital & enterprise)

Financial sector or finance market Savings Investment

Government (Public) Sector Taxation Government spending

Overseas Sector or International Market Imports Exports


3BECO – Economic policies and management Student Activities 1. Using the above diagram of the circular flow model, complete the following

activity. Identify the flow which best fits each situation:

a) A shop assistant in Myer is paid her weekly wage _____________________

b) A shoe factory borrows funds to install a new stitching machine

______________________

c) Primary producers sell wool to China ________________________

d) Cottesloe residents pay their local council rates _________________________

e) A small firm uses profits to employ labour _____________________________

f) Government pays unemployment benefits to the unemployed

________________________

g) A local shirt manufacturer receives a shipment of buttons from Indonesia

_______________

2. Again referring to the diagram on the previous page, Use the word expansion

or contraction next to each of the following changes to either leakages or injections to indicate the effect of the change on the equilibrium level of the economy, assuming no other changes occur.

CHANGE IN LEAKAGE OR INJECTION EFFECT ON ECONOMY

a) Increased government spending ___________________________________

b) Increased taxes ___________________________________

c) Higher spending on roads and ports ____________________________________

d) Increased saving ____________________________________

e) Decreased imports ____________________________________

f) Higher exports ____________________________________

g) Increased exports & lower taxes ____________________________________

h) Increased investment ____________________________________

i) Lower exports ____________________________________

3. Discussion topic: What is likely to be the natural state of an economy? Is it one of equilibrium or disequilibrium? Explain. Discuss this in groups of four with each group reporting to the whole class.



When there is disequilibrium, firms are either producing more output than consumers want to buy or not enough. They are either overproducing or underproducing. These situations cause problems for the economy. If firms produce more than consumers want to purchase, they will not be able to sell it all. Prices will drop and firms will cut production to avoid losses. Firms will then need fewer resources so demand in factor markets will decrease and the unemployment of resources (including labour) will rise. The economy overall will slow down and even fall into recession.

When consumers want to buy more than firms are producing, prices will begin to rise and firms will increase production in order to meet rising demand and make more profit. They will need more resources so demand in factor markets rises and unemployment will fall. The growth of the economy overall will speed up and if firms have difficulty keeping up with the pace of demand, inflation will occur. The speeding up and slowing down of an economy is normal. Over time economic growth changes as it moves through alternating periods of strong growth and slow or even negative growth (recessions). This path of varying economic activity is called the Business Cycle.

In this macroeconomic model of an economy, equilibrium occurs where total spending (aggregate expenditure or demand, AE or AD) = total output of all firms (aggregate supply or AS). Since the total value of all output is also equal to the total cost of producing that output, ie the total returns to all the factors of production involved in producing the output, total output = total income (Y). Thus AD = AS = Y at equilibrium. This is just another way of expressing E = O = Y Student Activity Extended writing activity: In terms of the circular flow of income, explain what is meant by equilibrium and disequilibrium. Do a draft first which you must proof read and edit. Write a neat final draft which you will hand to your teacher. Economic Activity Economic activity varies over time. The reasons for the variability in economic growth are to do with changes in the components of aggregate spending. There are many factors which cause these components to change, in particular the factors influencing the two most important components of consumption and investment expenditure. A knowledge and understanding of these determinants is very important to policy formulation at the business and government level and in making sound decisions at the household level. In standard Keynesian macroeconomic theory, the level of economic activity depends on aggregate (total) spending. Consumption (C) is the major component of aggregate expenditure and income (Y) is the main factor affecting the level of consumption. A large proportion of C is non-discretionary spending – this is spending on essential goods and services (needs). We can also call this autonomous consumption and it is independent of the level of income. This means that even when income is zero, there must be some spending going on as households need to buy food, clothing, accommodation, etc. Spending on wants and luxuries is called discretionary consumption.


3BECO – Economic policies and management The Business Cycle (introduction) An economy naturally goes through periods of strong growth when the rate of increase in output and employment is stronger than average (boom) and at periods of weak growth and sometimes even negative growth (contraction or recession). Neither booms nor recessions are desirable because of the problems associated with them. Therefore government has a role in smoothing this naturally volatile path of the economy over time. This is known as the government’s macroeconomic or demand management task which involves trying to influence the level of aggregate demand (AD) or total spending in the economy. The government has 3 tools with which to do this –

i) its own spending (G), ii) taxation (T) and iii) interest rates (r)

Government spending and taxation are known as FISCAL POLICY (FP) and adjusting interest rates is known as MONETARY POLICY (MP). Government spending and taxation changes are announced in May each year in the federal budget. Interest rate changes are the responsibility of the Reserve Bank of Australia (RBA) which is an independent government authority. If the economy is growing too slowly or is in recession (negative growth or contraction), the level of total spending in the economy needs to be boosted. A higher level of AD will mean firms will produce more goods and services and employ more factors of production. (Think of the circular flow model). Unemployment will fall, incomes will rise and the economy will move into an upswing in its growth cycle.

Smoother cyclical path due to fiscal and monetary policies

% Δ in Real GDP

Time

Peak or Boom Peak or Boom

Trough (sometimes recession) Trough

downswing upswing

Peak or boom: inflation and balance of payments problems occur, unemployment is low. Too much spending is the problem. Production of goods and services cannot keep up with demand (AD>AS) so the macroeconomic solution is to slow demand. The government can do this by cutting its own level of spending or increasing taxation (new taxes or raising tax rates). The RBA will increase interest rates which will slow down borrowing (credit growth) and hence spending by making the cost of loans higher. These actions are known as restrictive or contractionary FP and MP. Trough/recession: unemployment is high and economic growth is very low or negative. The problem here is total spending in the economy is too low. Output is


3BECO – Economic policies and management greater than demand so firms cut back on production and their demand for inputs (factors of production) and therefore employment and incomes fall. In this situation more demand is needed which government can directly provide by increasing its own spending or it can cut taxes and hope that the increase in disposable income will lead to more spending. The RBA will cut interest rates in this situation which lowers the cost of borrowing. These actions are known as expansionary FP and MP.

It is important for the economic authorities (government and RBA) to know where the economy is in its growth cycle. Obviously action should be taken before the economy enters into the extreme phases of the business cycle. Sound analysis of regular economic data is very important in achieving this task. Below is a graph of the real business cycle for Australia since the last recession based on data from the Australian Bureau of Statistics. Student Activities 1. Identify the significant troughs and peaks. 2. Look at the following list of economic indicators and discuss what you would expect them to be showing in the different phases of the business cycle. Suggest fiscal and monetary action which could be taken to smooth the economic cycle. Inflation

Peak ______________________________________________________________________

Trough ____________________________________________________________________

Action _____________________________________________________________________

Employment/Unemployment

Peak ______________________________________________________________________

Trough ____________________________________________________________________

Action _____________________________________________________________________




Retail sales (HH spending in retail outlets or shops)

Peak ______________________________________________________________________

Trough ____________________________________________________________________

Action _____________________________________________________________________

Interest rates

Peak ______________________________________________________________________

Trough ____________________________________________________________________

Action _____________________________________________________________________

Business investment

Peak ______________________________________________________________________

Trough ____________________________________________________________________

Action _____________________________________________________________________

Wage growth

Peak ______________________________________________________________________

Trough ____________________________________________________________________

Action _____________________________________________________________________

Credit growth

Peak ______________________________________________________________________

Trough ____________________________________________________________________

Action _____________________________________________________________________

2. Explain how changing interest rates can affect the level of economic activity. ________________________________________________________________________________

________________________________________________________________________________

________________________________________________________________________________

________________________________________________________________________________

2010

MACROECONOMIC THEORY I

- Macroeconomics – what is it about - Skills - data interpretation - Circular Flow and Disequilibrium

1. Macroeconomic theory I Objectives: • define and explain the difference between macroeconomics and microeconomics. • select and organise sources of economic information • apply appropriate methods of recording and organising macroeconomic information e.g. tables showing

changes in economic data over time. • apply mathematical techniques relevant to macroeconomic analysis specifically calculating and interpreting

rates of change in GDP, calculating percentage change in economic variables. • draw conclusions from collected economic information and data. • use the circular flow model to describe the interaction of sectors in the economy • describe the relationship between total spending, output and income • describe the concept of equilibrium • explain how changes in leakages and injections can alter the level of equilibrium (disequilibrium) What is Macroeconomics?

“I have called my theory a general theory. I mean by this that I am chiefly concerned with the behaviour of the economic system as a whole, with aggregate incomes, aggregate profits, aggregate output, aggregate employment, aggregate investment, aggregate saving rather than with the incomes, profits, output, employment, investment and saving of particular industries, firms or individuals.” (Keynes, J.M. The General Theory of Employment, Interest and Money, Macmillan, Cambridge University Press, 1936 p xxxii)

As the above quotation by John Maynard Keynes in his The General Theory of Employment, Interest and Money (1936) tells us, macroeconomics deals with the broad economic picture, ie. the economy as a whole. Understanding macroeconomics allows us to get an overview of the whole economy and understand the relationships between its parts, so that policy-makers can develop policies which achieve stable, sustainable economic growth and maximise human welfare. Broadly speaking macroeconomics deals with three interrelated measures of economic activity or aggregates:

• total output (production) of goods and services.

• total spending (expenditure) on goods and services.

• total income paid to the owners of all factors of production.

The Australian Bureau of Statistics (ABS) collects data on many types of economic activity under the above three categories and presents a systematic summary of national economic activity known as the Australian National Accounts (ANA). This information provides a statistical picture of the structure and performance of Australia’s economic system. The ANA have developed over the years to provide statistical information to allow analysis and policy-making from what is essentially a Keynesian perspective.

Macroeconomics as a field of study owes its origins to J. M. Keynes who published his ideas in his famous book quoted from above. In it he set out to challenge mainstream (neoclassical) economic thought which he claimed failed to explain or offer solutions to the high unemployment of the 1920s and 1930s in Britain. Keynes saw the Depression essentially as a failure of government to take action to compensate for declining private consumption and investment spending.


He was critical of the view that supply creates its own demand (Say’s Law), that is, the income paid to factors of production “... must necessarily be spent in the aggregate, directly or indirectly, on purchasing the product”. The belief was that firms as a whole group, will always sell what they produce and never face a situation of declining aggregate demand for their product and the resulting surplus in productive capacity. If aggregate household demand for goods and services falls, due to increased aggregate saving, then the rise in saving will be matched by an equivalent rise in aggregate investment spending, ie. S always equals I. To quote from Keynes again:

“Those who think in this way are deceived, nevertheless, by an optical illusion, which makes two essentially different activities appear to be the same. They are fallaciously supposing that there is a nexus which unites decisions to abstain from present consumption with decisions to provide for future consumption; whereas the motives which determine the latter are not linked in any simple way with the motives which determine the former.” (Keynes, p21)

In other words motives to save are very different from motives to invest.

The main premise of neoclassical economics is that all markets work by themselves via a flexible price mechanism which automatically adjusts in response to market forces and always guarantees the full employment of resources across the economy. This assumes perfectly flexible prices. There is therefore no need for government intervention. Keynes asserted there was no such automatic mechanism and that markets are imperfect. Some prices are “sticky” downwards, ie. do not fall readily in response to falling demand. This is particularly the case with wages. As money wages refuse to fall while the prices of goods, services, assets and factors of production other than labour drift downwards, unemployment rises. Therefore the economy could settle at a level (equilibrium) below the full employment of resources. In fact a below full employment equilibrium level of economic activity is more often the case. Therefore government should intervene by raising aggregate demand or aggregate expenditure which would shift the economy back towards full employment. This approach to macroeconomic management is known as demand management. Its premise is that economic activity is dependent on the total level of spending which can and should be managed. Keynes’s theory of income determination expands on this and seeks to answer three basic questions:

a) What determines the general level of economic activity? b) Why does the level of economic activity tend to fluctuate over time ? * c) How can governments influence the general level of economic activity?

Macroeconomics is concerned with:

1) Inflation - what determines the general level of prices, why is it important and what can be done about it?

2) Unemployment (UE) – what causes unemployment? Why does the unemployment rate fluctuate and why does high unemployment persist? What is the appropriate policy response to an unemployment problem?

3) Gross Domestic Product (GDP) - what determines a country’s level of aggregate output? Fluctuations in GDP cause fluctuations in living standards. What can governments do to sustain economic growth?

4) Interest Rates - what determines interest rates and what effect do interest rate changes have on an economy?

Macroeconomic Theory I 15


5) Balance of Payments (BOP) and Exchange Rates - why do fluctuations occur? Why does Australia have a persistent current account deficit and how do changes in the value of the Australian dollar impact on the economy? How can government action influence them? What is the link between the BOP, exchange rates and foreign debt?

Macroeconomics provides elected governments with:

• tools for analysing the performance of the economy overall.

• the knowledge and understanding to formulate policies aimed at stabilising the economy and maximising human welfare.

Measuring macroeconomic Activity The broadest aggregate indicator or measure of economic activity is Gross Domestic Product (GDP). There are three approaches to measuring it:

a) The income approach - measures GDP by summing up all incomes paid to factors of production (wages, salaries, profits, rent, interest).

b) The expenditure approach - measures GDP by summing up all spending on final goods and services produced in Australia. Export earnings are added and spending on imports is deducted.

c) The production approach - measures GDP by summing up the market value of final goods and services, ie. the gross output of firms minus the cost of intermediate goods and services (goods and services used in the production of final goods and services). This leaves the value added by all firms, the sum of which is GDP.

Theoretically, at equilibrium the three approaches result in identical estimates of GDP, however because of the complexities of the real world and the need to use different data sources for each method, the value of GDP obtained from each approach differs. Because of the difficulty in obtaining the great amount of accurate and detailed information on the outputs and inputs of producers, and the problem of double counting, only the expenditure and income approaches are published in the ANA.

What is microeconomics?

Microeconomics concerns the behaviour of single economic agents or units such as consumers or households, firms, industries, sectors and product and factor markets. While macroeconomics deals with the big picture, microeconomics looks at the economics of the small unit. Microeconomics deals with such questions as:

• what determines the relative prices of goods and services?

• what determines an individual’s consumption patterns?

• how are decisions made by firms as to what, how, how much and for whom to produce?

• how can individual units of the economy be made to work more efficiently?

Remember the total product (output) of an economy is made up of the

production of many individual units (in both product and factor markets). This includes both the private and public sectors. A knowledge of both macro and



microeconomics is necessary for understanding our economy. The macroeconomy is made up of many different sectors and markets. The

operation of these individual components determines the overall performance of the macroeconomy, therefore the more efficient the individual parts are, the more efficient the economy is as a whole.

VOCAB: Macroeconomic equilibrium - a point at which there is no tendency for the level of income, expenditure or output to change - a static state, ie. the economy is neither expanding nor contracting. Of course in the real world, the economy is always changing so equilibrium is not the normal state of the economy.

STUDENT ACTIVITY 1.1

Model Answer

Topic: Write a paragraph on the following question:

What is the essential difference between Neo-classical and Keynesian economic theory?

Step 1: To begin you must extract the essential ideas or concepts from

a reference or text. A retrieval chart is a very useful tool for summarising text particularly

with compare and contrast type questions like this one. Below is a completed chart with keywords/phrases selected from the text in this section which will form a basis for the answer to the question.

Retrieval Chart:

NEOCLASSICAL KEYNESIAN Markets work by themselves Flexible price mechanism Automatic adjustment to clear

markets Full employment guaranteed No government intervention

Markets are imperfect Prices are sticky downwards No automatic market clearing Unemployment is usual Government intervention

needed

Step 2: Construct a paragraph based on the information in the retrieval chart. Here is one possible example:

Neoclassical economists say that markets work by themselves automatically through the price mechanism. Keynesian economists on the other hand dispute this. They say that prices in some markets are sticky downwards. This means such markets are imperfect and will not clear. Neoclassical economists claim that automatic price adjustment will always mean full employment and therefore there is no need for government intervention in the economy. Keynesians however disagree and assert that unemployment will be a problem when prices fail to automatically adjust and governments should intervene to prevent this.



1. Use the same procedure to answer the following question: Distinguish between microeconomics and macroeconomics.

Step 1: Retrieval Chart:

MICROECONOMICS MACROECONOMICS

Step 2: Paragraph:

__________________________________________________________________________________________

__________________________________________________________________________________________

__________________________________________________________________________________________

__________________________________________________________________________________________

__________________________________________________________________________________________

__________________________________________________________________________________________

__________________________________________________________________________________________

__________________________________________________________________________________________

__________________________________________________________________________________________

__________________________________________________________________________________________

__________________________________________________________________________________________

__________________________________________________________________________________________

__________________________________________________________________________________________

2. Exchange answers with a partner. Read each other’s work and then discuss points of agreement and disagreement. Award a mark out of 5 for your partner’s work and write a constructive comment beneath the paragraph.



Interpreting Data

It is very important to develop a familiarity with statistical information in economics. Just as doctors diagnose the state of a person’s health from various data like body temperature, blood pressure, cholesterol level, etc, so economists diagnose the state of the economy’s health from statistical data on things like investment, prices, consumption, employment, company profits, credit, housing loans, wage growth, trade data and so on.

Examine the table of selected key data below and think about what it might tell you about the difference in the performance of the economy in 2000-01 and 2003-04.

Key Indicator 2000-01 % change from

previous year 2003-04 % change from

previous year GDP

Investment (private) Retail Turnover

Household Consumption Imports

Income Growth Unemployment

1.9 -11.1 0.9 3.7 -0.9 4.8 6.4

4.0 8.4 7.6 5.5

12.7 5.2 5.8

(source: Australian Economic Indicators, August 2006, 1350.0, ABS)

Analysis of Data • GDP or gross domestic product is the total value of all output (minus the value of intermediate goods ie. components or parts). We want to see this growing from year to year because by increasing production, jobs are created and more goods and services are produced to meet people's needs and wants. The data shows the economy was weak in 2000-01 but grew quite strongly in 2003-04. Economic growth is measured in terms of the change in GDP. Growth on average in Australia from 1996 to 2007 was about 3.5% per annum.

• Investment is a volatile indicator as you can see in the table. It fell in 2000-01 by 11.1% but bounced back the following year and remained strong until 2007-08. This is good because rising business investment shows firms are confident and optimistic which is a good sign for future economic activity. Investment is essential to increasing the economy’s productive capacity which Australia needs to do to meet strong domestic and global demand. • Retail turnover was very soft in 2000-01 due to the economic slowdown weakening consumer confidence, however, it rose in the following years and was strong in 2003-04. Retail turnover is the major component of household consumption. • Household consumption is the biggest component of aggregate demand accounting for between 55 - 60% of all expenditure in the economy. It grew over the period in the table and was the main reason for the GDP result in 2003-04. • Imports fell in 2000-01 year because the domestic economy slowed down and spending was weaker but in 2003-04 consumers and firms spent more as the economy strengthened. Much of this spending goes on imported consumer and capital goods. Imports increase with economic growth.



• Income growth effects household spending power and firm production costs. The rate of growth in wages and salaries reflects the strength of demand for labour relative to supply of labour in the labour market. The data in the table shows the growth in employee earnings which would strengthen demand in goods and services markets. • Unemployment fell between the two years which is to be expected since the economy grew over the period. As the demand for labour strengthened after the slowdown in the economy, labour costs rose.

This list of data and the brief analysis above is an important part of what

economics is about. By the end of this course you will have a pretty good idea of how to do this yourself. Remember knowledge is power and economic knowledge is especially empowering.

Don’t forget: GDP = AD = C + I + G + (X - M)

Anything which affects the components of AD obviously affects GDP and the rate of economic growth. Data enables us to see what is going on with each of the above components. The constant flow of economic data from sources such as the ABS will be a major focus for us through the year.



STUDENT ACTIVITY 1.2 Examine the table of data below from the Australian National Accounts provided by the Australian Bureau of Statistics (January and November, 2009) and then complete the questions. The table shows the contribution to GDP as measured by expenditure from households (C), firms (I), government (G) and net exports (X-M).

Australia's National Accounts Nov 2009 ($millions)

Period Cons I Govt Bus G1 G2

Invent ∆ Exports Imports GDP

1994–95 370,421.0 110,370.0 14,199.0 127,069.0 14,463.0 3,479.0 129,105.0 91,514.0 681,004.0

1995–96 383,800.0 114,653.0 13,385.0 132,404.0 14,223.0 106.0 142,020.0 95,130.0 708,925.0

1996–97 393,269.0 126,463.0 11,285.0 134,938.0 15,467.0 958.0 157,668.0 104,500.0 736,573.0

1997–98 411,390.0 143,603.0 9,546.0 140,092.0 15,099.0 629.0 164,232.0 114,894.0 769,719.0

1998–99 431,961.0 146,079.0 13,846.0 146,363.0 15,835.0 5,894.0 167,853.0 120,592.0 809,744.0

1999–00 450,892.0 160,953.0 10,757.0 151,152.0 18,597.0 2,760.0 182,190.0 135,524.0 842,134.0

2000–01 467,187.0 143,083.0 10,248.0 154,309.0 18,848.0 2,469.0 195,980.0 134,161.0 858,134.0

2001–02 481,205.0 157,135.0 11,679.0 158,587.0 20,025.0 162.0 194,109.0 136,121.0 890,743.0

2002–03 497,721.0 182,769.0 12,441.0 163,610.0 20,648.0 905.0 193,255.0 153,919.0 919,247.0

2003–04 524,706.0 198,166.0 13,877.0 170,057.0 21,736.0 6,209.0 197,382.0 173,993.0 956,017.0

2004–05 548,015.0 209,562.0 15,659.0 176,447.0 23,057.0 6,102.0 203,407.0 195,124.0 982,786.0

2005–06 562,227.0 227,868.0 18,579.0 180,839.0 23,785.0 2,298.0 207,886.0 209,246.0 1,012,269.0

2006–07 584,924.0 238,948.0 18,756.0 186,203.0 27,003.0 2,652.0 215,695.0 228,452.0 1,045,674.0

2007–08 608,428.0 264,271.0 19,935.0 192,611.0 28,731.0 5,114.0 224,500.0 259,977.0 1,084,451.0

2008-09 617,114.0 272,593.0 22,394.0 198,964.0 31,229.0 -8,898.0 228,526.0 253,479.0 1,095,370.0

Annual % percentage change Notes on tables: Cons = personal household consumption spending I = private fixed capital formation (investment) Govt Bus = government businesses like Australia Post Pub Corp = public or government corporation spending on investment eg investment spending by Telstra G1 = government final consumption spending eg wages of government workers and general daily running costs of government G2 = government fixed capital formation eg spending by government on infrastructure such as roads Invent = changes in value of unsold stock (inventories)

Period Cons I Pub Corp G1 G2

Exports

Imports GDP

1994–95 5.1 11.0 19.4 3.5 7.1 4.8 16.6 4.3 1995–96 3.6 3.9 -5.7 4.2 -1.7 10.0 4.0 4.1 1996–97 2.5 10.3 -15.7 1.9 8.8 11.0 9.8 3.9 1997–98 4.6 13.6 -15.4 3.8 -2.4 4.2 9.9 4.5 1998–99 5.0 1.7 45.1 4.5 4.9 2.2 5.0 5.2 1999–00 4.4 10.2 -22.3 3.3 17.4 8.5 12.4 4.0 2000–01 3.6 -11.1 -4.7 2.1 1.4 7.6 -1.0 1.9 2001–02 3.0 9.8 14.0 2.8 6.2 -1.0 1.5 3.8 2002–03 3.4 6.5 3.2 3.1 -0.4 13.1 3.2 2003–04 5.4 8.4 11.5 3.9 5.3 2.1 13.0 4.0 2004–05 4.4 5.8 12.8 3.8 6.1 3.1 12.1 2.8 2005–06 2.6 8.7 18.6 2.5 3.2 2.2 7.2 2006–07 4.0 4.9 1.0 3.0 13.5 3.8 9.2 2007–08 4.0 10.6 6.3 3.4 6.4 4.1 13.8 2008-09 1.4 12.3 3.3 8.7 1.8 -2.5

(ABS Australian Economic Indicators, Jan & Nov 2009, 1350.0) 1. Look at household final consumption expenditure for 1996-97. As a

percentage of GDP it accounts for: (Calculate all answers to two decimal places)

393,269 x 100 = 53.39% 736,573



a) What is the contribution to GDP of household final consumption expenditure for 2004-05?

________%

b) Do the same calculation for any other year. ________%

c) What observation can you make about these three figures?

_________________________________________________________________________________

2. Calculate the contribution to total GDP of private gross fixed capital

formation (private investment expenditure) for:

a) 2002-03 ________% b) 2008-09 ________% c) Calculate the percentage change for each year.

2002-03 _______________ 2008-09 _________________

3. Comment on the level of investment over the period in the table.

__________________________________________________________________________________

__________________________________________________________________________________

4. Calculate the combined contribution to total GDP of government consumption and general government fixed capital formation (government investment) for: a) 1996-97 ________% b) 2006-07 ________%

5. Calculate the annual growth rates in GDP in the last four years of the table and write your calculations in the spaces provided in the table above. (Calculate to one decimal place using the process below in the example) eg. By how much did the economy grow in 1997-98? GDP for 1996-97: $736,573 GDP for 1997-98: $769,719 calculation is: $769,719 - $736,573 x 100 = 4.5% $736,573

What do you notice about the progress of economic growth (GDP) over the period in the table? Discuss with a partner.

______________________________________________________________________________________

6. Examine the graph showing domestic demand (C+I+G) and GDP (C+I+G+X-M). (source: data from ABS on Reserve Bank website, http://www.rba.gov.au accessed on the 24th November 2009)


http://www.rba.gov.au/


a) The data in the graph shows that domestic or final demand is __________________ (greater or less) than GDP for most of the period in the graph.

b) The difference between the two is explained by ___________________________

c) In 2001, the economy would have slipped into recession but for a surplus on the trade account (net exports). True or False

____________________

The ABS releases economic data each week which reveals the state of the economy in the recent past. If students regularly follow this statistical information, they can develop a good feel for what is happening in the actual economy and relate it to the theory learnt in the classroom. This is an essential skill and those students who become competent in using economic data will add value to their written work and do well.

Some data are more significant and relevant than other data, eg. employment and wages growth figures. These two sets of numbers are very important indicators of what is going on in the economy at the macro level and they have an important bearing on Monetary Policy decisions by the Reserve Bank of Australia (RBA). Regular examination of this weekly flow of information will enable students to identify where the economy is likely to be in terms of the business cycle and suggest appropriate policy direction.

This information is covered in newspapers such as the Australian Financial Review each week. Get into the habit of looking for, reading and collecting informative articles on the economy each week.

VOCAB: Leading indicators - indicate change in economic activity before if happens. Examples include housing loans (indicate future building of houses), job vacancies (indicate demand for labour and hence future employment growth), surveys of consumer and business confidence (indicate future likely changes in household consumption and investment spending), interest rates such as the 10 year bond rate, stock market indices. Coincident indicators - indicate what is happening in the economy currently, eg. manufacturing, mining and rural output, retail turnover, motor vehicle registration, construction. The problem with this data is that by the time it becomes public, it is not current. Lagging indicators - indicate changes which are the result of past economic activity, ie. data which reflects changes which have already happened in the economy, eg. employment, unemployment, wages growth, company profits.



BACK TO THE CIRCULAR FLOW OF INCOME MODEL

Economic models are used to distil the most important elements from a very complex real world. Their purpose is to reduce the complicated details of the economy to a simple form to allow us to understand the interrelationships between these elements. Models allow analysis to focus on important economic events that constantly go on around us and make it easier to predict and explain the behaviour of important economic variables. One of the most useful and simple of economic models is the circular flow model. It shows the five major sectors of an economy:

1. household sector made up of consumers who provide consumption spending 2. firm sector made up of producers who provide investment spending 3. finance market also known as the money or capital market which enables

consumers to save and firms to invest 4. government or public sector which provides government spending 5. international market or foreign trade sector which provides net exports. The relationship between each of the above sectors is illustrated in the diagram of the circular flow model.

In this Keynesian macroeconomic model of an economy, equilibrium occurs where total spending (aggregate expenditure or demand, AE or AD) = total output of all firms (aggregate supply or AS). Since the total value of all output is also equal to the total cost of producing that output, ie. the total returns to all the factors of production involved in producing the output, total output = total income (Y). Thus AE or AD = AS = Y at equilibrium.


Let’s look at each sector of the model (in a state of equilibrium). 1. The Finance market: savings → finance sector → investment When added to the simple circular flow model of households and firms equilibrium is when Y = C + S and Y = C + I therefore C + S = C + I or S = I Explain the consequences of a rise in S on the circular flow of income (ie. on econ activity).

Households Firms

Finance market

Public sector

Foreign market Exports Imports

Government sector

Income

Consumption

Resources

Output Saving

Investment

Taxation



_____________________________________________________________________________

_____________________________________________________________________________

2. The Public Sector: taxation → public sector → government spending

when added to the finance sector equilibrium occurs when: Y = C + S + T and Y = C + I + G therefore C + S + T = C + I + G or S + T = I + G Describe the consequences of a fall in G on economic activity.

_____________________________________________________________________________

_____________________________________________________________________________

3. The Overseas market: imports → overseas sector → exports

when added to the finance and public sectors equilibrium occurs when: Y = C + S + T + M and Y = C + I + G + X therefore C + S + T + M = C + I + G + X or S + T + M = I + G + X which is the complete equilibrium

condition.

Describe the consequences of a rise in exports on the circular flow of income.

_____________________________________________________________________________

_____________________________________________________________________________

Total spending (AE or AD) is : C + I + G + X – M and since total spending = total

income, then: Y = C + I + G + X – M

Since total income = total output then: Y = AD = GDP = C + I + G + X – M

Equilibrium also occurs when total leakages = total injections,

ie S + T + M = I + G + X

In a simple closed economy with no government sector, equilibrium must be when S = I. In the expanded 5 sector model any change to leakages or injections will disturb equilibrium and cause the economy to contract or expand unless offset by an equal or opposite change in injections or leakages. The 5 sector model is a simplification of the real world. In reality all sectors are connected by a multitude of flows. Examine the diagram in the sample below. Look at the flows between the Firms, Financial and Public sectors.



4. Now you mark in the flows between the Households, Firms and the Financial sectors.



LEAKAGES, INJECTIONS, EQUILIBRIUM AND DISEQUILIBRIUM

VOCAB: Disequilibrium - a state of change due to disturbance in either leakages (L) or injections (Inj). The change sets off a chain reaction of adjustment throughout the economy. The economy itself adjusts towards a new equilibrium position above or below the previous one. In the real world such change is constantly going on because of unplanned and unpredictable changes to leakages and injections. Thus the economy is said to be dynamic

What happens when L ≠ Inj (or S ≠ I in the 3 sector model)? When disequilibrium occurs, the economy automatically begins an adjustment process which takes it to a new equilibrium position. How does this work? From the circular flow model we can see that L must equal Inj if equilibrium is to be preserved. However if domestic consumption happens to be less than anticipated by firms, which may be caused by a rise in S, T or M, then balance is disturbed (L > Inj). Keynes focused in particular on savings and investment (assume no government or overseas sectors). When households consume fewer goods and services than firms produce because they save more for some reason, inventories or stocks of unsold goods rise signalling to producers to cut production (O). Since the producer’s demand for factors of production (DF) or inputs, is derived from consumers’ demand for finished goods and services, producers will reduce their demand for inputs. As the employment of inputs (resources) falls, income falls. As income falls, all leakages fall (along with consumption). This process continues until at some point aggregate L again equal aggregate Inj (and S = I) where there is no further tendency to change (equilibrium is restored).

In summary form: if L > Inj → C↓ → inventories↑ → O↓ → DF↓ → UE↑ →�Y↓ → L↓ → L = Inj (economy contracts) and: if L < Inj → C↑ → inventories↓ → O↑ → DF↑ → UE↓ → Y↑ → L↑ → L = Inj (economy expands)

Note: disequilibrium (imbalance) is the normal condition of the economy. Equilibrium describes a static condition which does not exist. It is a theoretical goal to which the economy is constantly self-adjusting but never attains. In the real world the economy is constantly in motion, ie. it is dynamic. Keynes’ great contribution to economic theory was the notion that this elusive target of equilibrium did not naturally occur at a point where there was the full employment of all resources. Unanticipated Imbalance between Leakages and Injections and the Role of Inventories in the Three Sector Model If C < O then L > Inj (ie. AD < AS; excess output and inventories rise) If C > O then L < Inj (ie. AD > AS; shortage of output and inventories fall) If C = O then L = Inj (ie. AD = AS; no change to inventories) The amount which households intend to spend on finished goods and services and firms intend to spend on production in aggregate at the beginning of any period may be very different from what they actually end up spending because circumstances change.



Consumers and firms are very different groups of people who have different motives for spending and investing. The economy is complex and ever changing. Many factors influence decisions to spend, save and invest, so it is highly unlikely that the plans of these different groups and their millions of decisions, will coincide in aggregate. Firms plan ahead what they will produce depending on what they expect consumers to purchase, and therefore what they will invest in order to produce that anticipated output if extra productive capacity is needed. Some observations:

a) Imbalances are always occurring in any economy because of changes to injections and leakages.

b) Imbalances are eventually self-correcting. How quickly this occurs depends on policy and how flexible the economy is.

c) Serious imbalances may eventually self-correct with serious consequences. Can you think of examples?

Macroeconomic policy should aim to prevent serious imbalances developing in an economy. Let's assume a three sector model of the economy (ie. no government or overseas sectors). Assume that after making plans, firms decide they need to invest $20 million. Equilibrium will only be preserved if aggregate saving happens to also be $20 million which is unlikely. If it turns out that firms don’t sell all of that anticipated output, then their inventories rise (inventory investment) if they are goods producers, or they simply experience declining sales and unused capacity if they are service providers. Services cannot be stored like goods however for the purposes of this simple model we will assume they can. Using the simple circular flow model to illustrate: For equilibrium to exist S = I:

Households

Firms

Finance Sector

S = 20m I = 20m

C = 80m

Y = O = 100m

Let’s assume households save an extra $5 million. This means $5 million of goods and services remain unsold and are added to inventories (inventory investment). In other words, at existing income S > I (disequilibrium):



S > I by $5 million, ie. S = $25 million which is greater than I ($20 million). Changes in inventories or stocks (including the value of unsold services) = the shortfall in consumption. Firms decrease production anticipating reduced levels of consumption in the next time period. When S < I, stocks will decrease (inventory disinvestment). Firms will increase production to maintain stock levels (using surplus capacity) so they will be prepared for future increases in demand. So using the same example: when C rises by $5 million (ceteris paribus), savings fall by $5 million. STUDENT ACTIVITY 1.4 Using the model below, fill in the details when S < I, ie. when C increases unexpectedly by $5 million. In your file, describe what will happen in the economy as a result of this imbalance or disequilibrium condition.

Note: In this simple model illustrating the concept of disequilibrium, the real world complication of the services sector and technological change are ignored. We must acknowledge that much expenditure is on services which cannot be stored like physical goods as inventories, and when combined with the information technology revolution, have reduced somewhat the significance of inventories as a buffer between producers and consumers. The amazing improvements in software, computer power and the internet make possible the rapid transmission of information and data so that changes in market demand are communicated swiftly to producers, and allow for impressive improvements in productivity so that firms can respond quickly to these shifts in demand without maintaining large inventories. 'Just-in-time' supply management can make firms vulnerable to supply shocks. Eg car parts producer goes broke or workers go on strike → disrupts car assembly plant at Holden or Ford

Households Firms

Finance Sector

S = _____ I = 20m

C = _____

Y = O = 100m

Households

Firms

Finance Sector

S = 25m I = 20m

C = 75m

Y = O = 100m

(C↓ = 5m)

(S↑ = 5m) (inventory investment = 5m)



The important point to absorb is that disequilibrium (S ≠ I) triggers an adjustment process which takes the economy towards a new equilibrium level which has consequences for aggregate employment, income and output. This diagram below illustrates the adjustment process which occurs when S and I are not in equilibrium.

THE PROCESS OF ECONOMIC ADJUSTMENT IN A MARKET ECONOMY

markets for

goods & services

Households (consumers)

Firms

(producers)

inventories change

+ve or -ve

production changes

+ve or -ve

employment & income change

+ve or -ve

At a given level of Y, if C↓ → S↑ so that S > I Inventories↑ (inventory investment) & surplus capacity↑ Production↓ → firms demand fewer factors of production employment↓ → income↓ & S↓ til S=I and equilibrium is restored at a lower level of economic activity. economic contraction

At a given level of Y, if C↑ → S↓ so that S < I Inventories↓ (inventory disinvestment) & surplus capacity↓ production↑ → firms demand more factors of production employment↑ → income↑ & S↑ til S=I andequilibrium is restored at a higher level of economic activity. economic expansion

production consumption


1. a) What happens when saving and investment are not equal?

_____________________________________________________________________________

_____________________________________________________________________________

_____________________________________________________________________________



_____________________________________________________________________________

_____________________________________________________________________________

_____________________________________________________________________________

_____________________________________________________________________________

b) Explain in your own words why it is unlikely that aggregate savings and

aggregate investment would ever be equal. _____________________________________________________________________________

_____________________________________________________________________________

_____________________________________________________________________________

_____________________________________________________________________________

_____________________________________________________________________________

2. Multiple Choice: MC questions are an important assessment instrument in economics

because they really test your thinking skills, therefore they will appear frequently throughout this book. There are a number of strategies you can use to tackle MC questions. The most obvious are:

• first look for the correct answer or the “most correct”. Sometimes

more than one answer appears correct. • failing that, eliminate the incorrect ones. • focus on key words and read carefully. • if you are not sure, guess.

Complete the following questions: i. GDP is a measure of a) the value of a country’s total output of all goods and services.

b) the total supply of money flowing around the economy at any point in time. c) total annual output minus the value of government goods and

services. d) total annual output minus the value of intermediate goods and

services. ii. If planned leakages are greater than planned injections a) the level of output will remain the same. b) the level of output will go up. c) the level of output will fall. d) none of the above.

iii. Three leakages are a) taxation, import spending and government spending. b) savings, import spending and investment spending. c) import spending, taxation and savings. d) savings, taxation and export earnings,




iv. Which one of the following will not be included in the calculation of GDP to

avoid the problem of double counting? a) a loaf of bread sold by a delicatessan. b) white goods sold in department stores. c) microchips sold to computer manufacturers. d) a tennis professional’s winnings.

v. Output is always equal to a) GDP and inventory increases. b) investment plus saving. c) total saving plus total production. d) total spending and inventory adjustments. vi. If total injections are less than total leakages then a) aggregate demand must become greater. b) total expenditure must become smaller. c) exports will always restore equilibrium when they equal imports. d) it’s not possible to know what will happen. vii. In 1936 J. M. Keynes published a radically different analysis of economy activity.

His basic idea was that a) governments should help private enterprises when they get into

trouble. b) economic activity depends on the level of total spending. c) employment depends on the level of investment spending by the

private sector. d) governments should leave economic management to private business

to conduct. viii. Government spending has a similar effect on the circular flow of income as

a) investment. b) saving. c) imports. d) wages and profits.

ix. Macroeconomics is all about economic aggregates. Which of the following does

not accurately comply with this statement? a) It is about unemployment and the level of foreign investment in the Australia. b) It is about business activity and the general price level of goods and services.

c) It is about fluctuations in the cycle of economic activity and the level of national expenditure.

d) It is about government spending more on housing and the introduction of a GST.

x. In a closed economy traditional macroeconomic theory would have us accept that

the Federal government a) should balance its budget during a downturn. b) should ensure that G > T when investment is outstripped by saving. c) should always spend more than it taxes. d) should ensure that G < T when saving is less than consumption. Okay, now go back through this

section and make a quick list of the most important things you have learned on each page.

2010

MACROECONOMIC THEORY II

- The Business Cycle (continued) - Components of Aggregate Expenditure - Macroeconomic Equilibrium - The Multiplier

2. Macroeconomic theory II Objectives:

• explain the characteristics and causes of the business cycle • outline the components of aggregate expenditure i.e. consumption, investment,

government spending, net exports • explain the factors which affect the components of aggregate expenditure • demonstrate and explain the relationship between the consumption function, the

marginal propensity to consume and the marginal propensity to save • explain the concept of macroeconomic equilibrium • demonstrate and explain the impact of changes in aggregate expenditure on the

equilibrium level of income/output (Gross Domestic Product — GDP) • demonstrate and explain the multiplier process • examine the economic impact of changes in each of the components of

aggregate expenditure Features of the Business Cycle Peak or boom – the main features are low unemployment or overfull employment (eg lots of overtime). High demand and inflationary pressures mount as competition for resources bids up prices. Nominal interest rates (r) rise to compensate for inflation (ie. to preserve real interest rates). Upswing has peaked. This is the top of the cycle. The trade deficit has probably peaked too (M>X).

The main characteristics are:

Peak interest rates peak

inflation peaks reflecting high scarcity trade deficit peaks as imports peak (M>X) unemployment bottoms (full employment) shortages in factor & product markets peak

maximum productive capacity of the

economy is achieved overfull employment of resources → factor

prices rise productive investment is overtaken by

s

peculative investment Downswing – high inflation and high r cause C to fall → inventories rise above desired levels → production falls and firms cut prices to reduce stocks → investment declines and output, Y and employment fall. After the initial slowdown (early downswing) the economy may experience negative growth (recession). As AD continues to fall, the economy contracts and inflation and r fall. Business and consumer outlook becomes more pessimistic. The trade deficit declines as M fall and attention shifts to UE.


Macroeconomic Theory II 34


Trough - unemployment peaks with low or even negative inflation (deflation) if trough is deep (recession), low output, negative net investment, pessimism high, low r. Growth decline has bottomed. This is the bottom of the cycle. Upswing - inflation and r are low due to the trough. Discretionary C starts to rise. Since inventories are low and need to be increased to cater for early rises in C, production rises. The trough or recession ends and the economy moves into a new period of growth. As demand for goods and services rises, demand for factors of production increases → output, employment and Y increase → the recovery strengthens. Business and household optimism returns. The trade surplus starts to fall as more imports feed into economy.

Early downswing

Early downswing - inflation rate slows (disinflation) interest rates still high but start to decline Trade deficit starts to fall as % GDP AD growth slows as C slows and I falls → O↓ Employment growth slows & UE starts to rise.

Late downswing - Inflation falls further and may turn negative

(deflation) interest rates fall further Trade deficit turns to surplus as imports fall discretionary C & I decline → surpluses in

factor & product markets drive prices down in those markets - in labour markets quantity adjusts rather than price (wages slower to fall) → UE ↑

all forms of investment fall & trade surplus rises further

Late downswing


UE peaks as oversupply reaches maximum in the labour market

interest rates & inflation bottom imports decline bottoms and trade surplus

approaches peak GDP at lowest (negative if recession) begins to

rise at this point as stocks are depleted and firms have to rebuild inventories

maximum surplus capacity has been reached lowest level of demand in factor and product

markets is reached and wage decline bottoms

Trough



Early recovery - weak HH and firm spending

rise but UE is still high w since inflation is still low

ng starts to pick up → O↑ surplus (X>M) but starts to

n economy → firms increase O with

s closer to deficit as M rise

low inflation due to employment starts to interest rates are lo household spendi trade account is still in

decline large idle capacity still i

investment weak asexisting equipment

trade account move

Late recovery

Early recovery


Late recovery - inflation starts to pick up in factor &

product markets as demand increases

Understanding the phases of the business or economic cycle is essential to understanding the behaviour of the economy. interest rates rise

UE continues to fall → aggregate Y rises consumption is strong as wages and

sentiment rise the trade deficit rises as imports rise (M>X) surplus capacity diminishes → investment

in new plant & equipment picks up

Countercyclical policies (fiscal and monetary policies) attempt to reduce the size of business fluctuations by reducing AD in booms and increasing AD in recessions. However the problem with countercyclical policies is they are subject to time lags and may aggravate the stages in the business cycle, eg the 1990 - 1991 recession resulted from excessive rises in r when the economy was already starting to slow. The rises in r came too late in the cycle. The central bank now seeks to pre-empt rising inflation by raising r before inflation starts to take off. Government macroeconomic policies aim at managing the level of AD. They attempt to reduce the cyclical fluctuations shown in the diagram as the unbroken line so that the economy follows a flatter path (the broken line).

The steeper the downswing the more rapidly UE increases and investment falls. The conventional view (Keynesian) is that the recession will worsen and may become a depression without government intervention.

The steeper the upswing the more rapid inflation will be as AD outstrips growth in AS. This also causes CAD to accelerate. Authorities intervene to slow the rate in AD.

% Δ Real GDP

0

Time/years

Peak or boom

Trough/Recession – 2 quarters in a row of negative growth

Trough

Recovery or upswing downswing

Path of economy without countercyclical policies

Path of economy with sound countercyclical policies by government

–

Peak or boom

+


STUDENT ACTIVITY 2.1 1. Without referring back to the previous notes indicate next to each economic feature for each phase of the business cycle what you would expect to happen.

Upswing (early recovery)

Inflation: ________________________________________________________________________

Consumption: ____________________________________________________________________

Employment: ____________________________________________________________________

Imports: _________________________________________________________________________

Exports: _________________________________________________________________________

Investment: ______________________________________________________________________

Interest rates: ____________________________________________________________________

Confidence: ______________________________________________________________________

Upswing (late recovery)

Inflation: ________________________________________________________________________

Consumption: ____________________________________________________________________

Employment: ____________________________________________________________________

Imports: _________________________________________________________________________

Exports: _________________________________________________________________________

Investment: ______________________________________________________________________

Interest rates: ____________________________________________________________________

Confidence: ______________________________________________________________________

Peak (boom)

Inflation: ________________________________________________________________________

Consumption: ____________________________________________________________________

Employment: ____________________________________________________________________

Imports: _________________________________________________________________________



Exports: _________________________________________________________________________

Investment: ______________________________________________________________________

Interest rates: ____________________________________________________________________

Confidence: ______________________________________________________________________

Downswing (slowdown → recession)

Inflation: ________________________________________________________________________

Consumption: ____________________________________________________________________

Employment: ____________________________________________________________________

Imports: _________________________________________________________________________

Exports: _________________________________________________________________________

Investment: ______________________________________________________________________

Interest rates: ____________________________________________________________________

Confidence: ______________________________________________________________________

Trough (bottom of recession)

Inflation: ________________________________________________________________________

Consumption: ____________________________________________________________________

Employment: ____________________________________________________________________

Imports: _________________________________________________________________________

Exports: _________________________________________________________________________

Investment: ______________________________________________________________________

Interest rates: ____________________________________________________________________

Confidence: ______________________________________________________________________

A trough can deepen into a recession or even a depression if authorities pursue the wrong policies.



2. Examine the data (from Macro I). What evidence of a business cycle is apparent in the data?

Key Indicator 2000-01 % change from previous year

2002-03 % change from previous year

GDP Investment (private)

Retail Turnover Household Consumption

Imports Income Growth Unemployment

1.9 -11.1 0.9 3.7 -0.9 4.8 6.4

3.2 16.2 5.0 3.6

13.1 4.9 5.8

(source: Australian Economic Indicators, August 2006, 1350.0, ABS) ______________________________________________________________________________

______________________________________________________________________________

______________________________________________________________________________

______________________________________________________________________________

______________________________________________________________________________

______________________________________________________________________________

______________________________________________________________________________

______________________________________________________________________________

______________________________________________________________________________

3. Construct an answer plan for the following TEE style question using the note-making framework below.

a) Explain what is meant by the business cycle? (6 marks) b) Discuss the relationship between the business cycle and the rate of unemployment

and inflation. (10 marks)



Macroeconomic Theory II

39

a) Definition and diagram:

b) UE, inflation and the BC. i) Peak or Boom: ii) Downswing or slowdown: iii) Trough or recession: iv) Upswing or recovery:


4. Read the following article and identify (highlight) the key ideas.

The blessings of the recession by Stephen Koukoulas

In November 1990, then treasurer Paul Keating responded to the confirmation that the economy was in recession by commenting: “This is the recession that Australia had to have.” While this blunt assessment of the economy came back to haunt Keating and reinforced a perception that he was uncaring, it was a remarkably accurate comment. The legacy of the early 1990s recession is an economy that has performed better than at any time since the 1960s. The only negative factors prevailing are unemployment - which is always too high – and the current account deficit, which could be a problem if financial markets consider it so. It is enlightening to contrast Australia’s economic performance pre- and post-recession and to judge what the recession changed. In the late 1980s, inflation was bubbling at about 7 percent, having spent all of the 1980s many percentage points above the OECD average. It was a major factor undermining Australia’s international competitiveness. The recession enabled these previously entrenched price pressures to be squeezed out of the economy. Wages were, of necessity linked to productivity and central wage increases were finally dead, which enhanced the economy’s growth potential over the 1990s. Further, in 1993, Reserve Bank governor Bernie Fraser saw an opportunity in the aftermath of the recession to lock in low inflation by announcing a target for inflation of 2 to 3 percent over the course of the cycle. This enabled interest rates to fall, matching the inflation performance, to the extent that Australia is now a low interest rate economy. Low inflation has been fundamental to the tremendous growth record, which has seen annual GDP growth...average 4.3 per cent since 1991-92. The dominant contributor to this performance has been unprecedented growth in business investment. Some increase in investment was always likely after the recession as the capital stock recovered and rapid technological change demanded increased expenditure. The strength of business investment after the recession owes more to other factors – the low inflation climate; the opening of Australia to competitive pressures; and the corporate restructuring that chopped the dead wood from middle management and lowered operating costs. In addition, the investment strategy of many corporations returned to highly productive, medium-term investment plans. For the household sector, the distortion of investment

decisions in the 1980s caused by entrenched high inflation also undermined the equity market, encouraging savings to go into “unproductive” assets and forcing corporations to rely on debt to fund expansion. In an era of high inflation and high interest rates, this allocation was not sustainable. As an example of the change in consumer preferences for investment, the Westpac/Melbourne institute Consumer Sentiment survey reveals that shares are seen as “the wisest place for savings” by 30 percent of consumers, up from about 3 percent in the late 1980s... In the late 1980s, even with the booming economy, the unemployment rate was unsustainable below 7 percent. When it fell below that rate in 1989, wages spiralled. Little wonder most estimates of Australia’s natural rate of unemployment were horribly high, about 7 to 7.5 percent. The only significant disadvantage of the recession was the misery of cyclically high unemployment, failing businesses and general economic malaise. If the changes in the economy could have been brought about without a recession, then the pain could have been minimised or avoided. Unfortunately, the recession was needed to force changes. That might sound harsh but without a recession it was unlikely that the process of labour-market reform would have occurred... The urgency of the recession brought about changes that are now setting the scene for the structural rate of unemployment to fall, possible as low as 5 to 6 percent. For the business sector, the simple formula of maintaining profits by increasing prices had to change. While profits were reasonable under this scenario, it meant that innovation, capital productivity and efforts to develop new markets through export were second-order issues for many firms. These are first-order issues now and have made corporate Australia highly efficient... A recession is a harsh way to bring about change, but when an economy is so unbalanced and rigid, it can be the means to cleanse the system. ... If one wanted to be optimistic, the Australian experience could be seen as a model for the recent recessions in Asia. As the Asian tiger economies recover, they are likely to emerge in a structurally better position. The innovative skills, productivity, dynamism of industry, export focus and ability to expand in many Asian countries will support growth as the financial systems recover. ... (The Australian Financial Review, 21st June, 1999)

Why does the author of the article use the word “Blessings” in the title?

5. Practice examination question:

a) Discuss the characteristics of the boom phase of the business cycle. (9 marks)

b) Discuss why the business cycle peaks and eventually turns down. (6 marks)



Components of Aggregate Expenditure Read the notes in the table below

Introduction At equilibrium AE = total spending = GDP = Y, therefore when AE rises → GDP rises → Y rises. • AE = C+ I + G + X - M. When any of the components Δ, AE will Δ.

Consumption

• = 60% of GDP approx. – very stable due to non-discretionary nature of much spending. • refers to household final consumption expenditure – main determinant is disposable Y • includes spending on finished durable & non-durable consumer goods such as cars, household goods (appliances, furniture, white goods), clothing, food, holidays, and services such as health, education & entertainment.

Investment

• 15-20% of GDP approximately. • refers to spending on capital or producer goods (K) (also known as private fixed capital formation) • can be broken into machinery & equipment, housing and non-dwelling construction. • is most volatile of components due to durability of K goods, irregularity of innovation & different capital needs across different industries. • main determinants are expected profitability of firms and interest rates which is the cost of capital. As unit production costs ↑ (ceteris paribus) profitability ↓→ investment ↓ (see later section on accelerator). • investment is engine of economic growth and jobs.

Government Spending

• 20 - 25% of GDP approx. (ie. federal govt – much larger share if include other levels of government). • provides essential public services & goods like education, health, roads, welfare, defence. • revenue raised mainly by taxation – asset sales important too, eg. Telstra. • important tool of macroeconomic management – fiscal policy used to stabilise the economy – distributive (Y distribution) and allocative (resource use) roles important too. • spending needs determined by social needs, size of public sector and point the economy is at in the business cycle → determines taxation and borrowing needs of govt. • influence of pressure groups important, eg. environmentalists, unions, business & Aboriginal groups.

Net Exports

• varies monthly – strong growth in services and elaborately transformed manufactures (ETMs) over the last 2-3 decades. Minerals particularly important over the last 5 years or so. • types of exports & imports important → level of demand and prices affect X income + M payments. • influence of exchange rate and terms of trade on X receipts and M payments. • world economic activity very important especially since Australia is still mainly a commodity exporter (cyclical demand for our exports → affects net exports). • strong import demand tied to domestic economic cycle ie, during strong growth import demand rises → trade deficit rises (positive or direct relationship between level of income and import demand). • Australia’s international competitiveness is important → linked to domestic policies.

Conclusion

• knowledge of components important to understand nature of economic activity and for formulating stabilisation policy. • changes in AE components give clues to sources of economic instability. • aim of govt is to stabilise the economy (reduce the severity of fluctuations). • recession → expansionary policies to stimulate components – AE rises → UE falls. • boom → contractionary policies dampen components - AE falls → inflation falls.


Speed Writing Activity: Writing a full answer to an essay question is a time consuming way of preparing for exams, however, speed writing in short bursts for 5-15 minutes is an efficient way of improving writing skills and hence exam skills. Study the essay note-making framework on the components of aggregate demand for about 5-10 minutes. Then write as rapidly as you can for about 8 minutes on a piece of A4 file paper on the question below. Time yourself and stick to the time limit. Read through what you have written. Compare with notes in the framework and give yourself a mark out of 5. If possible get someone else to read your answer and mark it too.

Question: Describe the components of aggregate demand. Macroeconomic Theory II 41


Changes in macroeconomic activity are most often caused by changes in the components of aggregate spending. The most important components are consumption and investment. Think of the simple two sector circular flow model:

Households (consumers)

Firms (producers)

Resources

Income

Consumption

Output

Firms and households are the two major parts of an economy. Approximately 80% of economic activity is accounted for by the interaction of these two sectors in product and factor markets. So anything which causes changes in the behaviour of firms and households will have an effect on the level of economic activity.

Factors Affecting Consumption and Investment You could read about the factors affecting consumption and investment in any text book which you would then need to summarise in note form. Your notes can then be used for study purposes when needed. It is useful to ‘do something’ with the notes apart from simply reading them. Organising information into some sort of user friendly format is a good idea. You have to read it, re-read it and think about how to format it and in doing so you learn it. Information can be presented in diagram form which makes it easier to learn. Think about it. How hard is it to learn directly from a text book? Below is a diagrammatic presentation of factors affecting consumer spending.

CONSUMPTION

Stock of wealth (assets such as property & shares) – as wealth↑ → C↑. If asset prices↓ as in stock market fall, wealth↓ and C↓.

Disposable income (Yd ie. Y x) – if tax rate↓ or

e↑ → Yd↑ → C↑ and


after taincomvice versa.

Consumer confidence – when optimism ↑ → C↑ & when pessimism↑ → C↓. Employment & economic growth generally are factors affecting confidence which in turn feeds back to economic and employment growth.

Consumer indebtedness & Interest rates – as consumer debt↑, vulnerability to higher interest rates↑ therefore C↓ and S↑ when interest rates↑.

Distribution of Y – redistn to lower Y groups through tax and welfare system → C↑ (amount spent of each extra $ of income is higher for low Y groups).

Inflation→ destabpatterns.

ary expectations ilises consumption


Below is a diagrammatic presentation of factors affecting investment spending (capital expenditure or capex).


INVESTMENT

Market prospects for future sales (domestic and foreign markets) – as prospects↑→ I↑.

Profit expexpectedexpected

ectations or rate of return – if profits↑→ I↑.

Stockshand – faduring strong A→ I↑.

(inventories) on lling stocks

D → O↑

Govt policyencoura

& taxation may g

e or discourage I.

Technology investment will Biotech revo

Δ – in times of Δ ↑ (eg. I.T. &

lutions).

Extent of idle or surplus productive capacity – a low level of excess capacity as in period of strong economic growth → I↑.

Interest rates (r) – inverse relationship between I and r (ceteris paribus) r = opportunity cost of investing in productive capacity. Also r is cost of borrowing. If r > expected rate of return → I↓. If r < expected rate of return → I↑.

Δs in consumer spending → Δs in investment (induced I). As C↑→ I↑ and vice versa.

Inflationary expectations – concern about price Δs of inputs like labour and materials – if inflation expectations↑, I↓ and vice versa.

All the above factors influence the level of consumer and business confidence. When these factors are favourable C and I will rise and the economy will expand creating jobs and raising national income. However, if these factors are negative the economy will contract with employment and income falling. Knowledge of these factors helps policy makers manage AD through macroeconomic policies. STUDENT ACTIVITY 2.3

1. For each of the determinants listed below, write a paragraph explaining how it influences consumption and investment spending. Use the notes in the framework as your guide for ideas and develop them into sentences and paragraphs. When finished, read your paragraphs to a partner and assist each other to improve them. The first one (disposable income) has been done for you as a sample.


CONSUMPTION Disposable income: Most income is spent so when after tax income rises, either through a rise in income or a fall in the tax rate, consumption spending should rise ceteris paribus. When disposable income falls consumption will fall too. The fall in spending across all types of goods and services is not uniform. Discretionary spending on luxury items will fall more than spending on non-discretionary items such as food, shelter, power, telephone and water bills, etc.

a) Stock of wealth:

_________________________________________________________________________________

_________________________________________________________________________________

_________________________________________________________________________________

_________________________________________________________________________________

b) Consumer indebtedness: _________________________________________________________________________________

_________________________________________________________________________________

_________________________________________________________________________________

_________________________________________________________________________________

INVESTMENT a) Expected profitability: _________________________________________________________________________________

_________________________________________________________________________________

_________________________________________________________________________________

_________________________________________________________________________________

b) Interest rates: _________________________________________________________________________________

_________________________________________________________________________________

_________________________________________________________________________________

_________________________________________________________________________________



c) Government policy: _________________________________________________________________________________

_________________________________________________________________________________

_________________________________________________________________________________

_________________________________________________________________________________

d) Inflationary expectations: _________________________________________________________________________________

_________________________________________________________________________________

_________________________________________________________________________________

_________________________________________________________________________________

2. Read the following extract (from the Australian Financial Review, 23-8-06) on factors affecting consumption and answer the questions following it.


Asset rises offset growing debt: RBA by Mark Davis “Australian family finances are in good shape, contrary to a popular misconception that mounting debt is undermining the household sector’s financial position, according to a senior Reserve Bank of Australia executive. The RBA’s assistant governor …, said yesterday that rising household debt in recent years had been more than outweighed by the rising value of financial assets held by households…. [He] … said increases in the household debt interest burden – the share of disposable income needed to repay housing loans and other borrowings – had been more than offset by rising incomes families were earning on investments such as super funds. … Household financial assets had increased more than debts over the last decade. And while household net interest payments had increased as a share of income, so too had their investment earnings.”

a) What two factors affecting consumption are being discussed in the article?

i) _____________________________________________

ii) _____________________________________________


b) Explain how each factor would impact individually on consumer sentiment (confidence) and consumption spending. _________________________________________________________________________________

_________________________________________________________________________________

_________________________________________________________________________________

_________________________________________________________________________________

c) Explain the interplay of these two factors and their effect on consumer sentiment and expenditure in the view of the RBA official. _________________________________________________________________________________

_________________________________________________________________________________

_________________________________________________________________________________

_________________________________________________________________________________

d) What could happen to prove the RBA official wrong? _________________________________________________________________________________

_________________________________________________________________________________

_________________________________________________________________________________

_________________________________________________________________________________

3. Homework: Study your explosion diagram on the determinants of investment

for about 5 minutes. Repeat the speed writing procedure for the following question on a piece of paper in your file.

Outline the major determinants of the level of private investment expenditure.



Macroeconomic Theory II

47

4. Complete the multiple choice questions below: 4.1. Over time consumption and investment may both rise if

a) the level of marginal tax rates have risen. b) the level of disposable incomes are expected to increase. c) there has been a sustained rise in interest rates over several months. d) people expect inflation to rise over the following 6 months.

4.2. If the intersection of the consumption function and the 45 degree line

shifts up in the Keynesian model, then this indicates consumers have most likely decided to

a) increase their saving for some reason apart from an increase in income. b) increase their saving due to an increase in income. c) reduce their saving due to a decrease in income. d) reduce their saving for some reason other than a change in income.

4.3. The main determinant of consumer spending is

a) income distribution. b) extent of consumer optimism. c) availability of credit. d) level of disposable income.

4.4. Keynesian theory would suggest that in a closed economy government

should a) spend less than it taxes when S > I. b) spend more than it taxes when S > I. c) always balance budgets. d) always spend more than it taxes.

4.5. In Australia the largest component of AD is

a) consumption. b) government spending. c) private investment spending. d) net exports.

4.6. If firms underestimate household consumption spending (S<I), then

a) inventories will fall. b) inventories will rise. c) inventories will not change. d) confidence is likely to be negative.

4.7. In the Keynesian model, investment

a) is always equal to saving. b) is a leakage. c) depends entirely on interest rates. d) is strongly influenced by expectations about future sales.

4.8 When AD > AS

a) S > I b) S = I c) S < I d) E = O = Y



The Keynesian Model of Expenditure and Income Analysis AS = total or aggregate production of all firms in the economy. Firms will only produce what they can sell, so at equilibrium total output = total spending. Total spending of course equals the total income paid to factors of production used in the productive process which equals the total cost of production. This relationship is shown in the 45 degree line in the simple diagram below. At any point on this line total output = total income.

C Line of equilibrium – any point on the line is a

potential output level. If total spending = this value of total output, then this is the equilibrium level of output (macroeconomic equilibrium).

C3

C2 C1

45° Y Y1 Y2 Y3

Total output = GDP which also equals total income so the horizontal axis (x axis) is both GDP and Y. The vertical axis (y axis) indicates the total spending or expenditure required to consume that value of output. The line of equilibrium does not move in this model. It is always a 45º line because at any point on the line, total output = total income. AE (AD) = total spending (total demand) in the economy but in the three sector model of the economy, total spending consists of spending by households only (on goods and services) ie. AE = C+I. Consumption is the largest component of aggregate expenditure in the Australian economy and can be shown in a simple diagram:

C

AD=C Y

0

Note the slope of the AE or consumption function, reflects the fact that as income rises household consumption spending increases. In this Keynesian model of the economy, investment is assumed to be autonomous, ie. unrelated to changes in income. In other words, investment is constant at any level of income.


Topic 3 – Macroeconomic theory II 49

When investment is added to consumption (C + I) the consumption function shifts up with no change in its slope.

C

ΔI

C+I C

Y

0

Finding Equilibrium

When the AE function is combined with the line of equilibrium we get:

0

AE=C+I

45°

Y=C+I

AE=O

Ee

Y/GDP

Expenditure

Ye Equilibrium occurs at one point only – where AE and 45º line intersect. Only here will total spending = total output = total income. The point is known as the equilibrium level of income, output and employment (Ye). It is only at this point that the plans of producers match the spending decisions of consumers. Keynes’s major point was that equilibrium did not automatically occur at a full employment level (Yfe). Decisions to spend and produce are made by different groups of individuals for different reasons. It is largely a matter of chance if these decisions coincide at a level where all of a nation’s resources, particularly labour, are fully utilised.



Expenditure

AE=C+I

Y/GDP 0

Equilibrium

Ye

AE=O

45°

AE>O & S < I

y Disinvestment s fall)

Inventor(stock

AE<O& S > I

Inventory Investment(stocks rise)

(current sales = current output)

Y1 Y2

eEe

Disequilibrium occurs either side of Ye.

Below Ye - at Y1 AE > O or I > S. Firms cannot meet the current demand for goods and services because households are spending more than firms anticipated. Stocks or inventories fall (disinvestment) and production increases (upward movement along line of equilibrium). As O↑ employment rises, incomes ↑ → consumption ↑ and S↑ (movement up the AE curve). The economy moves towards equilibrium (Ye), the gap between AE and AS diminishes as they converge, and disappears at Ye. At this point savings have risen to equal the level of autonomous investment.


Above Ye - Explain in your own words.

__________________________________________________________________________

__________________________________________________________________________

__________________________________________________________________________

__________________________________________________________________________

__________________________________________________________________________

__________________________________________________________________________

__________________________________________________________________________



Changes in Equilibrium: AE Increases or Decreases

The previous diagram shows us why there is only one equilibrium point. However the equilibrium point will change when AE changes (ie any of the components of AE change).

i) If AD decreases: ii) If AD increases:

Note when the government sector is added, AE = C + I + G and when the overseas sector is added, AE = C + I + G + (X - M). STUDENT ACTIVITY 2.5 Describe with the aid of diagrams what the likely effect on economic activity would be, ie. on the equilibrium level of national income, when each of the following situations occurs (ceteris paribus):

i) A rapid decline in global economic growth causes commodity prices to collapse reducing Australia’s export revenue.

_______________________________________________________________________________

_______________________________________________________________________________

_______________________________________________________________________________

_______________________________________________________________________________

Expenditure Expenditure

Y/GDP

Equilibrium Equilibrium

Y/GDP 0

Y2 Y1

e1

e2

AE1

AE2

0 Y1 Y2

e2

e1

AE2

AE1

If AE falls (ie total spending falls) → stocks rise → O falls → Y falls (Y1 → Y2) ie economic activity decreases

If AE rises (ie total spending rises) → stocks fall → O rises → Y rises (Y1 → Y2) ie economic activity increases



ii) The federal government increases government spending during a serious economic

downturn (recession) and rising unemployment.

_______________________________________________________________________________

_______________________________________________________________________________

_______________________________________________________________________________

_______________________________________________________________________________

_______________________________________________________________________________

Consumption and Saving Functions

Consumption is the major component of AE - its main determinant is income. Income and spending are directly related (ie. when Y↑, AE↑) which is expressed in the consumption function. Consumers do not necessarily spend all their income. Some is saved. The level of saving is also directly related to income. This can be illustrated with a saving function. The relationship between Y, C and S is shown in the following schedule:

Y C S

0

50

100

150

200

250

300

50

75

100

125

150

175

200

‐50

‐25

0

25

50

75

100

The data in the table is illustrated in the model on the next page.



You can see that Y = C + S and

a) If Y > C, then saving is positive. eg. Y = 200, C = 150, S = 50

b) If Y < C, then saving is negative. eg. Y = 50, C = 75, S = -25 (dissaving)

c) If Y = C, then saving is zero.

d) If Y = 0, then consumption is exactly balanced by dissaving.

Households have to spend a minimum amount to survive (eg. food, clothing, shelter, power, water and transport) in a modern economy. This is achieved by drawing on their savings (dissaving) or someone else’s (borrowing). This survival spending is called autonomous (or non-discretionary) consumption and explains why the consumption function begins on the vertical axis above the origin in the following diagram.

If you don’t get this then you must ask your teacher!

The Consumption and Saving Function Model before the addition of Investment (ie in the simple 2 sector model where C=O=Y.



C

C

e1

Ye

S

Saving (Y>C)

Saving

Dissaving (Y<C)

dissaving Y=C

Y

Y

S

‐50

100 75 50 0 100

0

Cool model!



Investment is autonomous – same at all levels of income

C,I

C

C+I

e2

e1

Y1 Y2

I=25

S S=I=25

Saving

Saving

dissaving

dissaving

Y=C+I

Y

Y

S,I

‐50

50

75

100 150 175 125

0

0

150

Add investment to the model. Assume I = 25. This means that investment is 25 at all levels of income.

∆I


1. Worked Example What happens at a disequilibrium level of income in relation to the top (C function) and bottom panels (S function) of the model above when Y = 175? At Y = 175, AS > AE and S > I. When AS > AE, firms will cut production as stocks rise (output falls). This will result in rising unemployment and falling income. Spending will fall → AE ↓. AE and production (O) will converge at Y = 150 where equilibrium will be restored. When S > I firms cut production they will demand less labour – as unemployment ↑ and Y ↓, savings ↓ until S = I and equilibrium is restored at Y = 150. Explain in your own words what happens when Y = 125? __________________________________________________________________________________________________

__________________________________________________________________________________________________

__________________________________________________________________________________________________



2. Multiple choice questions. Diagram for Q Expenditure

C

C+I

Y/GDP45◦

C

A

B

0 Ye

Equilibrium 2.1 At equilibrium national income in the

diagram, autonomous investment is a) OA b) AB c) OB d) OC

2.2. The level of autonomous consumption at

income level Ye is a) OA b) AB c) OB d) OC



CONSUMPTION AND SAVING FUNCTIONS - THE TECHNICAL APPROACH

VOCAB: Propensity - tendency or inclination. The propensity to consume means the tendency to spend while the propensity to save means the tendency to save

some income. These propensities are of two kinds - average and marginal.

What lies behind the consumption and saving functions?

APC and APS In the spaces below define each:

APC - _____________________________________________________________ = C/Y

APS - _____________________________________________________________ = S/Y

(APS is also known as the household savings ratio = 3.9% of GDP for September 2009) APC + APS = 1

MPC and MPS In the spaces below define each

MPC - ___________________________________________________________ = ΔC/ΔY

MPS - ___________________________________________________________ = ΔS/ΔY

MPC + MPS = 1 STUDENT ACTIVITY 2.7 1. If Y = 200, C = 170 , the APC = ____ , and the APS = _____

2. If ΔY = $20 and $16 of that extra income is spent then the MPC = _____ and MPS

= _____

Graphically:

Slope of C = MPC = ΔC/ΔY Slope of S = MPS = ΔS/ΔY

C

C

Y

ΔC

ΔY

Y1 Y2

ΔY

ΔS

S

S

Y1 Y2



Straight line = constant slope which means the MPC and MPS are constant. A straight AD function reflects constant MPC – in the real world the MPC falls as Y rises. Think about this. The proportion of each dollar saved increases as Y rises. So the AD function would be curved as shown in the diagram on the right. In this course we assume a constant MPC.

Expenditure Expenditure

Y/GDP Y/GDP

AE

AE Equilibrium

Equilibrium

MPC constant

MPC increases as Y↑

Think about the implications for AD of tax cuts and government expenditure and who gets the tax cuts and receives the expenditure. Algebraic Representation of C and S

Consumption function: C = a + bY where C = consumption

a = autonomous consumption when Y = 0. b = MPC Y = income

Saving function: S = -a + sY

S = saving -a = dissaving or survival consumption when Y = 0 s = MPS Y = income

If you know the level of autonomous consumption, and either the MPC or MPS, you can arrive at an equation for both C and S.


1. Given autonomous consumption = $100 and MPS = 0.4 what is the

a) consumption function _________________________ b) saving function ______________________________



2. Given autonomous consumption = $250 and MPC = 0.75 what is the a) consumption function _________________________ b) saving function ______________________________ 3. If the consumption function is C = 180 + 0.85Y, what is the a) MPS _________________________ b) level of autonomous consumption __________________________ 4. If the saving function is S = -140 + 0.3Y, what is the a) MPC _________________________ b) level of survival spending ______________________________ Worked Example Calculate mathematically the equilibrium value of income if a = $100 and the MPS = 0.4. It is possible to do this using the following process: Since at equilibrium, Y = C then: Y = a + bY (because C = a + bY)

subtract bY from both sides: Y - bY = a

simplify: Y(1 - b) = a

divide both sides by (1 - b): Y = a (1 - b)

note that (1 - b) = s, therefore: Y = a s

ie. Y = 100 = 250 0.4

so the equilibrium level of national income in the example above is Y = 250.

5. a) From the schedule below calculate the C and S functions.

Y C S

0

600

1200

1800

2400

100

550

1000

1450

1900

-100

50

200

350

500

i) C = ______________________ ii) S = ______________________



Check your answers by selecting any income level and substituting it into your C function equation. If the answer you get conforms to the consumption at that level of income in the table, your equation is correct. Do the same with the saving function. b) Using the process explained on the previous page and above, calculate

mathematically the value of the equilibrium level of national income __________________________________________________________________________

__________________________________________________________________________

__________________________________________________________________________

__________________________________________________________________________

__________________________________________________________________________

__________________________________________________________________________

THE MULTIPLIER By now you have well and truly got the idea of how the equilibrium level of GDP fluctuates in response to changes in total spending (AE) and that this only ever hits a full employment level by chance. The interesting thing is that a change in AE caused by a change in investment (I), exports (X) or government spending (G) produces a proportionally larger change in output, employment and income. Look at the diagram below: AD = C + I + G + (X - M) = (a + bY) + G + I + (X-M)

ΔI = $100 million

AE2

AE1

Y/GDP

Expenditure

400 600

ΔY = $200 million100

200

This is a powerful

phenomenon which explains why economic activity can fluctuate so much.

An increase in investment of $100 billion results in an increase in Y of $200 billion, a multiple of two. Similarly a decrease in investment causes a proportionally larger fall in income. The Keynesian concept behind this phenomenon is called the MULTIPLIER. It helps explain why the economy fluctuates so strongly and also why its management is difficult.



VOCAB: The Multiplier (k) - is a mechanism by which a change in an injection causes a proportionally greater change in national income. The multiplier in the above example is 2 (k = 2).

So ΔI x k = ΔY ie, $100 bill x 2 = $200 bill.

What determines the size of k? The value of k is derived from the MPC. (Note the complex multiplier is determined by the size of all leakages, ie. S, T & M) The multiplier effect is determined by two factors:

i) the size of a change to any injection into the economy, ie. I, G & X, and ii) the size of leakages, S, T & M (only S in the case of the simple k) This is a powerful phenomenon which explains why economic activity can fluctuate so much.

The Process of the Investment Multiplier An injection triggers a succession of rounds of earning and spending which results in a new level of Y which is proportionally greater than the initial injection. Assume MPC = 0.6 and I increases by $100. a) ΔI = $100 so Y rises by $100 to households (for the purchase of factors of

production). b) With an MPC of 0.6, households spend 0.6 x $100 = $60, so C rises by $60 and

S by $40. This new spending stimulates the production of more goods and services across the economy.

c) Extra output required to satisfy increased consumption of $60 means $60 more income will be paid to the owners of factors used in that production. So the initial injection of $100 → $100 more income → $60 more spending → another rise in income of $60.

d) The recipients of the second round of extra income of $60 will spend 0.6 x $60 = $36 so Y has risen by $100 + $60 + $36 ... and will go on rising but by decreasing amounts due to the leakage of saving until the process exhausts itself, ie. when ΔY = 0.

e) Therefore ΔY = ΔI + ΔI (MPC) + ΔI (MPC)2 + ΔI (MPC)3 + . . . ΔI (MPC)n or ΔY = 100 + 100 (0.6) + 100 (0.6)2 + 100 (0.6)3 + . . . 100 (0.6)n How much will Y change by? This can be calculated quickly using the investment multiplier. The formula is:

k = 1 or 1 1-MPC MPS Therefore in the above example: Δ I = $100 MPC = 0.6

k = 1 = 1 = 2.5 MPS 0.4

therefore Δ Y = Δ I x k = $100 x 2.5 = 250



Also the level of savings has increased too. If Δ Y = 250, the level of savings will be Δ Y x 0.4 = 100, therefore C = 150. STUDENT ACTIVITY 2.9 a) Calculate k if MPC = 0.9 and ΔY if Δ I = $100 million.

__________________________________________________________________________

__________________________________________________________________________

b) Calculate k if MPC = 0.7 and ΔY if Δ I = $150 million.

__________________________________________________________________________

__________________________________________________________________________

c) Notice the effect on k and ΔY the larger the MPC is! Explain this effect in your own words. __________________________________________________________________________

__________________________________________________________________________

__________________________________________________________________________

3.8 Note the k works in reverse. The effect of the multiplier on economic activity and the business cycle is very significant. Keynes saw investment as the most important aggregate in income and expenditure analysis partly due to the effect of the multiplier. d) Complete the following table showing the MPC, MPS and k.

MPC MPS k

0.1

0.3

0.75

5/8

_______

_______

0.85

_______

19/20

_______

_______

_______

_______

_______

7/10

0.2

_______

_______

_______

_______

_______

_______

_______

_______

_______

_______

_______

10

_______

5



e) Read the article and answer the questions below it. (from The West Australian, 19/2/00)

US gas plant deal to boost Pilbaraby Shaun Anthony & Julie Butler A cutting edge gas processing plant in the Pilbara is expected to create more than 1000 construction jobs and boost interest from overseas investors. American firm Syntroleum announced yesterday that it had chosen the Burrup Peninsula as the site for Project Sweetwater, a $600 million plant to turn natural gas into high‐value paraffin, synthetic lubricants and drilling fluids.

1. Aggregate expenditure will receive an injection of ____________ from this project.

2. How will this increase in investment affect total national income (GDP):

i) if there is a multiplier of 4? ___________________________

ii) if there is a MPC of 0.6? ___________________________

3. If there was substantial unemployment which economists calculated would need $2.6 billion of additional total spending to reduce to an acceptable level, would this injection be enough given a MPC of 0.75? Explain. __________________________________________________________________________

__________________________________________________________________________

__________________________________________________________________________

__________________________________________________________________________

f) You have a consumption function of C = 100 + 0.8Y. If Yfe = $600 billion but Ye = $550 billion, what fiscal action should government take? __________________________________________________________________________

__________________________________________________________________________

__________________________________________________________________________

__________________________________________________________________________



The Value of the MPC and the Level of National Income (Y): Note the different slopes of the three AD functions due to the different MPC for each.

Expenditure AE1 (gradient = MPC1)

AE2 (gradient = MPC2)

AE3 (gradient = MPC3)

Y3 Y2 Y1

A

MPC1 > MPC2 > MPC3

Y/GDP

The different MPC of each function results in a different equilibrium point on the 45o line and a different level of national income (Y). The implication of this is that if households decide to increase autonomous saving, ie. aggregate savings rise at any level of income (the MPS rises), aggregate income output and employment will fall. In other words the economy will contract. This is the Paradox of Thrift in action. This means that while it may be virtuous for an individual to save more (be thrifty), if all consumers increase their savings the result is a fall in consumption which, unless off-set by a rise in investment, will result in economic contraction. Economic Fluctuations The study of macroeconomics is all about the study of economic fluctuations, ie. departures from economic stability at full employment and price stability. An economy moves through successions of upswing and downswing with the respective rises and falls in employment, investment, output and income (the business cycle). The magnitude of these swings derives from the combined effects of the multiplier and the volatility of investment spending. This volatility is a consequence of both the timing of investment and the amount of investment, which takes place at a given time. A change in investment due to a change in aggregate spending brought on by a change in aggregate income is called induced investment.

a) when the rate of income growth is increasing, induced investment will rise.

b) when the rate of income growth slows, induced investment will fall.

When income rises and consumption increases, more output has to be produced to meet this growth in AD. If productive capacity is at or near maximum usage, then firms will have to create more capacity, ie. purchase more capital goods (I). The rise in investment spending will vary according to the nature of the industry. A firm in a capital intensive industry such as mining will spend more on investment than a firm in a labour intensive industry such as hospitality. In other words there will be a different ratio of investment expenditure (capital) to the value of the output produced in each



industry. This relationship is expressed as the capital-output ratio or accelerator. For example a capital-output ratio of 4 means that for every $1 of product, $4 of capital equipment is needed to produce it. At maximum capacity utilisation, if demand increased by $1 then an extra $4 of capital equipment is required (induced investment). This injection leads to increased employment and income which further stimulates demand and induces further investment. If consumer spending increased by $20 million then investment would rise by 4 x 20 = $80 million. Note this accelerator affect is likely to be more significant in the latter stages of a recovery when capacity utilisation is high. Interaction Between the Investment Multiplier and Accelerator and The Business Cycle The interaction of the accelerator (a) and the multiplier (k) explains the volatility of the business cycle (see section on business cycle).

1. When autonomous I rises → Y rises via k. 2. When Y rises → C rises → induced I rises via a. 3. When induced I rises → Y rises again via k, C will again rise causing further induced I and so on as the economy moves into a boom.

As income and demand continue to rise and capacity utilisation rises (excess capacity falls), investment will accelerate at a faster rate. As the economy gathers pace and experiences a boom, inflation will set in. A peak in the business cycle will be reached. At this point consumer and business confidence will decline and will be followed by a fall in both consumption and investment. This will cause national income to fall via the multiplier and the accelerator working together and the economy will move into recession, and possibly depression (ie without effective countercyclical government policies). As income and consumption go on falling, a point is reached where disinvestment occurs (worn out equipment is not replaced). Falling consumption eventually reaches a survival or non-discretionary level of consumption, let’s say for example $100 million. As disinvestment continues there will come a time when capital stock falls below that required to meet the survival level of demand of $100 million. If we use the same capital-output ratio of 4 then $400 million of capital will be needed for this survival level of demand. When capital stock is less than $400 million, replacement investment will have to take place to build it up to that level. Income will rise via the multiplier so will consumption which will induce further investment, and so with the multiplier and the accelerator working together, the economy comes out of recession into an upswing once more. These ongoing fluctuations or swings between expansion and recession constitute the business cycle.

✎




STUDENT ACTIVITY 2.10 a) Which two sectors do you think would have the greatest capital/output ratios (accelerator effect)?

i) ________________________

ii) ________________________

b) Explain your answer to a) _______________________________________________________________________________

_______________________________________________________________________________

_______________________________________________________________________________

_______________________________________________________________________________

c) Using your understanding of the multiplier effect, explain the link between the resources boom and the housing boom in WA. _______________________________________________________________________________

_______________________________________________________________________________

_______________________________________________________________________________

_______________________________________________________________________________



d) Complete the following multiple choice questions.

1. Assuming no leakages other than saving and households spend four fifths of their income, if investment rises by $30 million, national income will rise by:

a) $30 million. b) $150 million. c) $120 million. d) $6 million.

2. If an autonomous fall in AD of $40 million leads to further falls in spending of $36 million in the following period, $32.4 million in the one after that and so on, the value of the multiplier must be:

a) 0.9 b) 5 c) 10 d) 1.11

3. If the MPC = 0.75, the level of national income is $6000 million and the full

employment level of national income is $7000 million. By how much should the government increase its spending to raise economic activity to full employment?

a) $1000 million. b) $750 million. c) $250 million. d) None of the above.

4. If the marginal propensity to consume is 0.95, the multiplier will be:

a) 0.05 b) 95/100 c) 1/0.95 d) 20

5. The multiplier refers to the effect of a change in aggregate expenditure on the:

a) equilibrium level of national output or income. b) the volume of money in the economy. c) MPS. d) level of full employment.

6. The concept governing the relationship between a rise in household spending and

a rise in investment induced by that increase in spending, is called the: a) multiplier. b) MPC. c) accelerator. d) derived demand.

7. If the consumption function is C = 1200 + 0.9Y, then the MPS and the multiplier are

a) 0.1 and 0.10. b) 0.9 and 10. c) 0.1 and 10. d) 0.9 and 1/10.



8. The reason that an increase in government spending or private fixed capital expenditure has a multiplied effect on income is best summed up as:

a) both types of spending raise the capacity of the economy to produce. b) when one firm invests other firms feel compelled to invest too which enlarges total investment spending. c) investment and government spending create confidence causing people to spend more. d) such spending results in income rising which pushes up consumption which in turn stimulates further rounds of rising income and spending.

9. The multiplier-accelerator model suggests that the business cycle is;

a) both self-starting and self-terminating. b) due to a range of natural uncontrollable forces. c) due to poorly timed government policies. d) easily managed with sound macroeconomic policies.

10. The consumption function is C = a + bY. If C = $3000, a = $1500 and the MPC

is 0.75, what is Y? a) $1500. b) $2000. c) $2500. d) $3000.

11. In an economy with no taxes and no imports, consumers spend 60 cents in each additional dollar earned. If investment increases by $20 million, the equilibrium level of national income will rise by:

a) $60 million. b) $50 million. c) $33.33 million. d) $100 million.

e) Fill in the explosion chart on the model provided as a note-making strategy which would equip you to adequately answer the following question: Explain with the aid of an example, what is meant by the multiplier process. Such a question would require about 2 pages (A4) of writing, depending on the size of your writing. This type of diagram is a useful tool to use after extracting essential knowledge from a text. It assists in sifting through your rough notes, editing and organising them into a learnable form. By working through this process you learn the content and you end up with a visual map or plan of the essential knowledge. Visual cues are very important in learning and stimulating the memory. Multiplier f) Speed Writing Activity Do this activity as a follow up to question 3. Study your explosion diagram on the multiplier process for 10 minutes. Explain with the aid of an example, what is meant by the multiplier process. Read the following instructions carefully.

Write for 8-10 minutes and stop. Time yourself or get someone else to time you. When you have stopped writing read your answer. Think about how far you got through your



answer? What is the quality of your writing like? Did you use correct economic terminology and did you include a diagram? Speed and fluency are very important. Be concise and to the point, don’t waffle. Get someone else to read your answer. Ask him/her what he/she thinks of it. Get them to mark it out of 10.


70

3. Macroeconomic theory III

Objectives: • explain the aggregate demand curve (AD) and its determinants • explain the aggregate supply curve (AS) and its determinants • use the AD/AS model to illustrate macroeconomic equilibrium • demonstrate and explain the impact of changes in aggregate demand and

aggregate supply on the equilibrium level of income/output • use the AD/AS model to help explain the business cycle • discuss the causes and effects of inflation and unemployment and their

relationship to the business cycle Inflation – Causes and Effects

Upswing

Peak

Inflation rises as scarcity increases in factor and product markets. Rising AD and capacity utilisation takes the economy closer to full employment and maximum potential output

Upswing concludes with a peak where the negative distributional and allocative effects of inflation reduce consumer and business confidence. Rising uncertainty damages decisions to spend, invest, produce, save, employ, work, etc. A downturn commences.

trough

Definition: inflation is the sustained rise in the general level of prices. There are two basic types of inflation:

i) Demand pull or simply demand inflation: this occurs where AD increases at a rate faster than the capacity of the economy to produce goods and services (ie. AD > AS). This increased competition for goods and services drives up their prices (demand side causes).

ii) Cost push or simply cost inflation: prices are pushed up by rising costs to producers who compete with each other for increasingly scarce resources - they pass on cost increases to consumers (supply side causes). Types of Inflation i) Demand inflation

• any increase in C, I, G or X-M as the economy approaches full employment. • full employment causes labour shortages → employers bid up wages to attract

labour → Y ↑ → AD rises. • high levels of foreign investment → AD rises. • high export earnings → incomes rise → AD rises. • inflationary expectations - if expectation is that prices ↑ → Δs economic

behaviour → prices in product & factor markets ↑. • increasing consumption due to changes in consumption patterns (less saving

at any level of Y). This may happen if household wealth ↑ as in a stockmarket or housing boom. Saving ↓ as C ↑ → asset price inflation is transmitted to the rest of the economy.

• monetary problems - too much money/credit in economy → r↓ → AD↑ → prices ↑.

Macroeconomic Theory III


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ii) Cost inflation

• any input may become a major cost to business - eg. wage increases → higher production costs. Labour shortages in some sectors → wages rise in those sectors → may spread to other sectors. This assumes W rise > productivity of labour and producers pass on cost increase per unit of output to consumers. This depends on the level of competition in the industry or sector. The more competition there is, the more producers have to absorb cost increases themselves rather than pass them on to consumers. (Labour market reforms have contributed to reducing flow-on effects of W increases → lower aggregate W growth and less inflationary pressure).

• inflation imported from abroad, eg. the rise in the cost of intermediate goods and resources imported from other countries flows through in the form of higher prices domestically, eg. rising oil prices.

• falling $A pushes up the cost of imports - price of imported investment goods ↑→ production costs ↑, also prices of imported consumer goods ↑→ inflation. This effect can be reduced by making the economy more competitive → forces firms to absorb costs and become more efficient.

STUDENT ACTIVITY 3.1 Read the extract from the following article in The Australian Financial Review, 15/3/00 and complete the questions.

Macfarlane spurred by inflation concern Why does the Governor of the Reserve Bank care about the financial markets getting carried away by a few weak economic statistics? A big part of the answer is the $A. At its recent lows, it has the potential to become a significant inflationary problem later in the year. Moreover, if the markets keep talking themselves into a hate-Australia mood (we have already been downgraded from economic miracle to a country living beyond our means, in the eyes of some commentators), the problem of the soft $A might not immediately evaporate with the return of strong economic statistics. The thought of any inflationary problem later in the year, when the Government is in the process of introducing the GST, is enough to give a central banker nightmares for a month. The price effect of the GST will be big enough to make some people think the days of low inflation are over. Containing inflationary expectations will be even more difficult if the $A and oil prices are adding to the CPI.

a) How could the $A become a “significant inflationary problem”?

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b) In what sense could the GST and the price of oil be a problem?

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c) “...people might think the days of low inflation are over. Containing

inflationary expectations will be...difficult...” What is meant by inflationary expectations and how can expectations be a problem?

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Inflation hurts most households



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Effects of Inflation Impact on Output

In general inflation has major costs for the economy, the producer and the consumer.

a) Inflation → productive investment falls because profitability falls → speculative investment rises which has a negative effect on employment, output and income. Inflation causes resources to be misallocated away from productive, job creating uses to purely speculative activities such as property, commodity and share market speculative trading.

b) Inflation → uncertainty increases → business and consumer confidence ↓→ investment and consumption ↓→ negative effect on employment and production.

c) Inflation → interest rates ↑. Like other prices, the price of money rises to compensate suppliers of money (lenders/savers) for the falling value of the dollars they are repaid → reduces investment and consumption → negative effect on employment and output.

d) If Australia’s inflation rate > overseas inflation rates → exports ↓ because exports become relatively more expensive on world markets and imports ↑ because imports become cheaper relative to domestically produced products → (X - M)↓. This reduces output and employment → Australia becomes less internationally competitive → CAD ↑. This was a problem through the 1980s.

e) Governments may tighten fiscal and monetary policies to reduce inflation → unemployment ↑ and production ↓, eg. 1990-91 recession was product of this action. Inflation causes a redistribution and reallocation of resources away from the following groups:

1. Fixed income earners: real incomes ↓ as changes to money incomes lag well behind inflation, eg. the unemployed, public servants, etc. → living standards fall.

2. Weak unions or non-unionised sections of workforce: money incomes fall behind inflation because they lack industrial “muscle”.

3. Borrowers/lenders (depending on interest rates): borrowers lose if interest rates move ahead of inflation when lenders anticipate inflation and raise rates to protect real returns.

4. Firms in highly competitive or depressed industries: rising costs reduce profits when firms can’t easily raise prices.

5. Savers: savings in conventional low interest bank deposits lose real value. Inflation causes a redistribution and reallocation of resources to the following groups:

1. Speculators: buy and sell property, collectables (eg. art) precious metals (eg. gold), etc. during inflationary periods because these items rise faster in price than the general price level → speculator’s real income ↑.

2. Borrowers/lenders (depending on interest rates): borrowers benefit if inflation > r. They pay back dollars of less value and lenders lose.

3. Strong employee groups (unions eg CFMEU) in key industries: can use industrial “muscle” to gain wage/fee increases greater than other groups of employees and greater than inflation rate (distributive effect).

4. Monopolies/oligopolies in key industries: can raise their prices ahead of inflation and/or pass on cost increases to consumers to maintain or raise profits (distributive effect).

5. Government: revenue rises from bracket creep, ie. inflation lifts people into higher income and marginal tax brackets → pay a higher proportion of income tax to government (inflation tax) (distributive effect). Conclusion Inflation transfers income between competing income groups. It causes a redistribution of income away from weaker, low income earners to more protected high income earners in both private and public sectors. This worsens income distribution inequality.



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Effects of Inflation in Simpler Form High rates of inflation have important negative effects on income distribution, saving, production and trade. It is very important for governments to keep inflation low for the following reasons.

1. Inflation makes some people poorer and others richer. This makes the

distribution of income less fair. People who are well educated and highly skilled suffer less than unskilled and poor people. People who are well off can invest savings in assets which appreciate (rise in value) as inflation rises. They can keep up with inflation and they tend to have more power when it comes to wage and salary increases. If they are self employed eg doctors, dentists, lawyers and some business people, they can put their fees and prices up quite easily. Some workers eg nurses, policemen, teachers, public servants, truck drivers, shop assistants, waiters, etc. have less market power (ie less influence when it comes to negotiating wage and salary increases) and find their income growth falls behind inflation. Their purchasing power (real income) declines.

2. Savings lose value as inflation rises. A dollar saved today is worth less in the

future so saving is discouraged as people expect prices to rise rapidly so spend now rather than save and spend later. Since investment is funded out of national savings, less saving means less money available to finance investment. Businesses needing to borrow have to borrow from overseas which increases the country’s foreign debt.

3. Inflation creates uncertainty and makes business planning difficult. They

may worry about future capital costs and postpone investment plans. This leads to less output and less productive capacity being created. It also means fewer future jobs being created. Money which could be used for investing in more productive capacity, may go into unproductive, speculative assets eg property.

4. Exports increase in price due to inflation. If overseas inflation rates are lower than Australia’s, exports will be less competitive in world markets and imports will become cheaper. This will cause trade balance problems. Export and import competing industries will become less competitive and jobs will be lost in those industries.


1. Paragraph writing activity

Topic: What are the effects of inflation? Discuss with a partner first and then write your paragraph (about ½ page).

2. Group Activity: Discuss with one or two other students the following question.

Write your ideas in note form in your files.

Inflation averaged around 8% during the 1980s and around 2.5% in the 1990s! If high inflation has negative effects, what benefits has low inflation produced for Australia since the 1990s?



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The AD/AS Model

This model has a shiftable, upward sloping AS function and a shiftable, downward sloping AD function. The Keynesian 45º angle cross model you have learnt about shows the relationship between total spending, total income and total output. The AD/AS model shows the relationship between the general or aggregate price level in the economy and total income and output. Look at the AD diagram below. On the y-axis aggregate price changes are measured. Total purchasing power changes when the price level changes. At a lower price level (P2) real purchasing power increases → AD↑. If prices rise, aggregate spending power declines (other things remaining equal), ie. aggregate demand contracts along the AD function. The AD function shows how the level of demand changes when prices change and money income is constant. AD curve shows different levels of

aggregate expenditure and GDP at different price levels. AD and P are inversely related.

Price Level

Y/GDP

AD

P1

P2

Y1 Y2

Contraction or expansion of demand (shifts along AD) are due to price changes. If changes occur to any of the components of AD (C, I, G, net X), the AD curve will shift its position to the left or right as shown in the diagram below.

Y1 Y2

P

When any component of AD rises the AD function shifts to the right. This corresponds to the AD function moving upward in the 45º angle model.

AD1 AD2

Price Level

Y/GDP


Write a sentence explaining why the AD curve slopes down.

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When AS is added to the model it is complete. This model provides a more realistic explanation of what actually goes on in the macroeconomy than the Keynesian model of income analysis (45° angle model). The model demonstrates the effect on aggregate prices and aggregate production and income when either AD or AS. If demand rises due to a change in any of the components of AD, prices will rise due to increased scarcity in product and factor markets and firms will respond by expanding production. The AS function can shift position in response to changing circumstances in factor markets which will in turn impact on output and prices.

AS is upward sloping because firms increase output in response to rising AD as prices rise due to growing factor scarcity. Note the slope of AS reflects the availability of resources, technology and/or the efficiency of firms.

AD1 AD2

Price Level

Y/GDP Y1 Y2

P2

P1

AS

DIAGRAM 1

AS with lower gradient – output growth > price growth (early recovery)

DIAGRAM 2 What happens to inflation when AD rises? The slope of AS curve has implications for government policy. In a trough or recession the slope of the short run AS function is close to flat (diagram 1). Surplus capacity and unemployment means government policy can be expansionary. Increased government spending and lower interest rates can stimulate AD prompting firms to increase production without causing price pressures to build in factor and product markets. As economic recovery progresses and gets faster, surplus capacity and unemployment fall and price pressures increase causing inflation to rise. This is reflected in the steeper AS function (diagram 2).

AS with higher gradient – output g< price growth (late recovery)

rowth

AD1 AD2

Price Level

Y/GDP Y1 Y2

P1

P2

AS

AD1 AD2

Price Level

Y/GDP Y1 Y2

P1 P2

AS



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Diagram A Diagram B Diagram C

Diagram A: Trough (horizontal or Keynesian AS function) - at low levels of economic activity well below full employment of resources (Yfe), supply exceeds demand in factor markets. Firms have excess capacity and UE (unemployment) in labour markets is relatively high. Therefore firms can increase production without bidding up factor prices which means no price pressures being passed on to consumers. Hence no price changes as the economy expands from Y1 to Y2.

Diagram B: Recovery (sloping or intermediate range) - as unemployed resources are used up, factor markets tighten as competition between firms for factors of production begins to have an effect on factor prices. Production costs begin to rise, income rises, spending rises and therefore consumer prices begin to rise along with output (P1Y2 and to P2 Y2).

Diagram C: Peak (vertical or classical range (vertical) – at Yfe in theory all resources are fully employed (economy is on its PPF) so no further output growth is possible in the short run. Further rises in AD will pull up prices but not raise output.

The diagram below shows the full employment limit to economic growth in the form of a vertical long run AS line. This line simply marks the maximum output possible given available resources in the economy. Ideally an economy should try to maximise production from its limited resources to satisfy as many of society’s unlimited needs and wants as possible. The LAS function marks that limit. Production below that level of output means the economy is under performing (operating inside its PPF). AD can increase as far as Yfe (the LAS) after which inflation accelerates.

AS

AD1 AD2

Y

P

Y1 Y2

AS

AD1

AD2

Y

P

Y1 Y2

P1

P2

Trough – no inflation and rising output

Recovery – rising inflation and output Peak – high

inflation and no increase in output

AS

AD1

AD2

Y

P

Yfe

P1

P2

Long run AS (LAS) represents maximum potential output due to limited resources. AD can grow up to this point with output and employment growing along with inflation.

Price level as measured by price index (CPI)

P2

SAS (short run AS)

AD

GDP/Y

P1

Y1 Yfe

LAS

Inflation potential as output gap closes

Output gap



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Demand pull inflation results from increases in AD. This is particularly the case in the later stages of an upswing as the economy approaches Yfe.

Cost push inflation focuses on supply side sources or cost increases which shift the AS curve to the left.

The position of AD is unchanged but purchasing power falls as prices rise so output and employment fall. Both inflation and UE rise (stagflation) when the source of inflation is supply side or cost driven. The solution to stagflation is to address the sources of cost pressures where possible so that the AS function shifts back to the right. Using expansionary policy to increase demand would temporarily increase output and employment but make inflation worse and eventually result in output and employment falling back to Y2.

VOCAB: Real income - the purchasing power of money. Money income - the actual number of dollars received and available for

spending.

Short run AS shifts to the left representing a decrease in AS due to some supply side shock which increases production costs eg a rise in the price of oil.

P2


SAS1

AD

GDP/Y

P1

Y2 Y1 Yfe

LAS

Output gap


SAS2

fall in output & employment

rise in inflation

Pure inflation will result from AD pushing growth beyond the economy’s potential

When short run AS (SAS) grows beyond long run AS, output will briefly exceed Yfe but price rises will accelerate causing production costs to blow out and real purchasing power to decline. As real income falls, output falls back to Yfe or potential real GDP but at a higher inflation level.


SAS

AD1

GDP/Y

P1

Ye Yfe Yinf

LAS


P2

P3

AD2

AD3

Output gap

Inflationary gap Also known as a deflationary gap



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P LAS

P2 SAS P1 AD2 AD1 Y Y1 Yfe

Inflation rises as scarcity increases in factor and product markets. Rising AD and capacity utilisation takes the economy closer to a peak (full employment and maximum potential output) and beyond causing inflation to accelerate.

Upswing

Peak

trough

P LAS SAS

P2 P1 AD1 AD2

Y Y1 Y2 Yfe

In a trough weak demand in factor and product markets means price pressures are low. Rising AD can occur without causing inflation. As AD rises, output and employment increase but inflation remains low due to surplus productive capacity and abundant resources.


1. Study the graphs and then complete the questions.

Graph 1

Graph 1: shows the effects of an increase in AD - price level rises (ie inflation ↑) and output and employment increase.

Price level AS

AD1

Output (Y)

AD2

Graph 2Price level

AS

AD

Output (Y)

Graph 3Price level

AS

AD

Output (Y)

Graph 4Price level

AS

AD

Output (Y)



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a) Show on Graph 2 an increase in AS and explain the consequences.

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b) Show on Graph 3 a decrease in AD and explain its consequences.

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c) Show on Graph 4 a decrease in AS and explain its consequences.

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d) Which graph shows the most unfavourable change in the economy and explain why. _________________________________________________________________________________________

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2. Read the following extract from the Australian Financial Review (17/3/00) and answer the questions.

National accounts data yesterday showed that gross domestic product rose by 1% in the December quarter, and 4.3% over the year. Last year was the fourth consecutive year that GDP growth has exceeded 4% and the seventh year that growth has bettered the long-term average of 3.5%. However, many economists voiced concerns about the growth figures and the decline in productivity, which has slipped from 3% in the June quarter to 1% in December. “The decline in productivity over the last two quarters is of most concern for the Reserve Bank of Australia,” said Mr Matthew Drennan, chief economist at Deutsche Asset Management Australia. “Lower productivity in an environment of increased wage demands and low unemployment signals another risk to inflation.”

a) What is productivity? _____________________________________________________

b) Explain why the decline in productivity is a concern to the RBA.

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c) What is the link between productivity and inflation?

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d) If Diagram 1 shows the results of high productivity (a stable price level and rising Y), show on diagram 2 the effects of lower productivity. 3. Read the following article from the Australian Financial Review, 28th October, 1999 and write your answers in your own words in your file. a) “...the two usual, if old-fashioned drivers of inflation - ‘cost push’ and ‘demand pull’ pressures - are now working in harmony to underpin an inflation acceleration.” Define cost push and demand pull inflation. __________________________________________________________________________________________

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Price level AS1

AS2

AD1

AD2

Y1 Y2

Y/GDP

P

Diagram 1 Price level

AS

AD

Y/GDP

Inflation up and rates will follow by Stephen Koukoulas A simple question: Why is the cash interest rate in Australia at a 30-year low? A simple answer: Because inflation is (or until recently, was) also at a 30-year low. Yesterday’s 0.9 per cent increase in the September-quarter consumer price index marks the early stages of an acceleration in inflation. ... The simple conclusion from the acceleration in inflation is that interest rates must go up. On the inflation outlook, which will be important in determining how much interest rates will need to rise, the two usual, if old-fashioned, drivers of inflation - “cost push” and “demand pull” pressures - are now working in harmony to underpin as inflation acceleration. This is unlike in previous years where lower material costs and subdued growth in real labour costs were biasing inflation lower. The “cost push” component has at its source an upturn in commodity prices and a pick-up in labour costs as employment growth eats into the pool of unemployed. Higher commodity prices add to price rises for goods, while increases in labour costs add to prices of both goods and services. The “demand pull” component comes from the economy maintaining an above-trend growth rate and through an anticipation of the effects of large income tax cuts from next July that will allow firms to increase margins. Without strong demand, it is difficult for inflation to pickup as corporations shy away from margin widening because of competitive pressures. In other words, without strong demand, their ability to increase margins and hence push inflation higher is restricted. ...



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__________________________________________________________________________________________

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b) Identify the cost push factors the author says were contributing to inflationary pressures and explain how they were pushing prices up. __________________________________________________________________________________________

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c) Explain where the demand pull component was coming from in the economy in the latter part of 1999. Explain the connection between demand and company decisions to raise prices. __________________________________________________________________________________________

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d) Make a comparison between the circumstances described in the article and the present state of the economy. Work with a partner on this and jot your ideas below. __________________________________________________________________________________________

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POLICY SOLUTIONS The Keynesian view of the role of government concerns altering the level of AD in order to achieve a full employment (FE) level of national income. This is done primarily through fiscal policy, specifically via government spending. Changing monetary policy (altering r) and taxation are also available to economic authorities but are less direct or certain in their effects on AD. a) Deflationary gap situation due to inadequate AD – solution is to raise AD by increasing government spending (ΔG). ΔG↑→AD↑→O↑→Df↑→UE↓→Y and GDP↑. Output or GDP gap (Ydef→Yfe) begins to close. b) Inflationary gap situation due to excessive AD – solution is to reduce AD by decreasing government spending.

ΔG↓→AD↓→O↓→Df↓→UE↑→Y and GDP↓. Without countercyclical action, AD would push the economy into an unsustainable overfull employment position (Yinf) forcing the price level up to P3. The economy would eventually work its way back to Yfe but at the higher price level which we could call the pure inflation zone (P2 – P3). This begins to close as G is cut and AD decreases. Continued decrease in AD leads to lower inflation (P2 →P1) and a lower but more sustainable level of output (Yfe). UE may rise if the adjustment downward in AD below Yfe (where level of AD = maximum output of economy) is too great.

P1

P2

LAS

SAS

ADdef

ADfe

Ydef Yfe Y/GDP

Price Level

AD needs to be increased to the level needed for full employment (ADfe). Increasing government spending is the most direct way of achieving this.

G↑

deflationary gap

P3

P1

LAS

SAS

ADinf

ADfe

Yfe Yinf Y/GDP

Price Level

Inflationary gap

AD needs to be reduced to the level needed for full employment (ADfe). Cutting government spending is the most direct way of achieving this.

G↓

P2 Without contractionary FP & MP, inflation will rise to a higher level (P3) as the economy self adjusts back to Yfe (LAS). With appropriate policy ( G↓), inflation will fall back from P2 to P1.



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Note consumers and businesses may not respond in the expected way or may take some time to respond to changes in r and taxes. Changing the level of G is a more direct way of affecting the level of demand but there may be undesirable consequences and political and social factors which limit the use of fiscal policy.

Deflationary Gap Inflationary Gap Examine the graph showing inflation since 1973. What do you notice about the progress of inflation over the past three decades?

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10.012.014.016.018.020.0

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09Inflation - June 1973 - March 2009

Yue Yfe

ADfe

ADue

Y/GDP

Expenditure

Deflationary gap

Yfe Yinf

ADfe

ADinf

Y/GDP

Expenditure

Inflationary gap

Y needs to increaseY needs to decrease

from Yue to Yfe

from Yinf to Yfe

A deflationary gap An inflationary gap = amount of aggregate spending above

= amount of aggregate spending below what is

needed to achieve full employment level of outpu

what is needed to achieve a full employment

level of output. t.

Policy Solution: increase total spending through expansionary

fiscal and monetar

Policy Solution: decrease total spending through contractionary

fiscal and monetary policy. y policy.



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UNEMPLOYMENT

The UE rate = number of UE (those over 15 seeking work) x 100 number in labour force (those over 15)

TYPES OF UNEMPLOYMENT

Structural - Δs in the structure of economy over time due to technological Δ + Δs in pattern & nature of consumer spending - some industries decline or shed labour as they seek to become more competitive - may be due to cuts in protection & other microeconomic reforms. They may cease to be competitive in a rapidly changing global economy → workers’ skills no longer required → UE↑. It’s particularly difficult for older workers to find employment in newer industries. New technology eliminates many menial jobs. Although tech. Δ does do away with certain kinds of jobs, it generates new jobs in expanding and newer sectors of the economy. In the long run technological & structural Δ create many more jobs than they eliminate.

Frictional - always some UE due to workers voluntarily changing employment as they seek higher paid jobs – may reflect acquisition of more skills & training. Duration of UE depends on knowledge of labour market & efficiency of job searching.

Cyclical - falling AD during a recession → UE ↑. ie C ↓ → O ↓→ D for L ↓→ UE ↑. This is the main cause of unemployment in a contraction. Full employment is when cyclical UE is zero.

Underemployment – people who are in work but want more hours of work, ie working part-time but want full time work.

Long term - UE due to age, lack of skills and inadequate education and training eg. older workers who have lost their jobs due to structural change and lack the relevant skills needed to gain employment in another industry. Also a lack of education and experience (necessary for skill acquisition is particularly problematic for early school leavers.

Hidden UE - people discouraged due to lack of success in finding work withdraw from job searching - do not show up in official statistics - the hidden UE could add several more percentage points to the official rate.

Seasonal - some industries are seasonal eg. fishing, horticulture, viticulture → in off-season UE ↑.

Underutilisation rate = the unemployed + the underemployed x 100 number in the labour force

Participation rate % = number of people in work or looking for work (labour force) x 100 number of people of working age (popn over 15 years old)



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STUDENT ACTIVITY 3.5 1. Can the rates of unemployment and employment both increase at the same time? Explain. _____________________________________________________________________________________

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2. Study the chart above and answer the question: Why should society seek to reduce the rate of unemployment? Use the space below to plan your answer then write your response fully in your file.

EFFECTS OF UNEMPLOYMENT

Economic Social

1. Loss of output - unemployed resources - economy underachieving inside PPF → loss of welfare and income → lower living standards

2. Reduced govt revenue → budget deficit ↑ at a time when govt spending needs to ↑.

3. Redistribution of income - UE ↑ → income ↓ for low skilled and workers in declining industries + sectors. Those in secure employment may also benefit from deflation (or slower inflation) → real incomes ↑.

4. Erosion of skills - UE workers lose skills + are unable to gain new ones in a changing economic environment → less employable → in danger of becoming long term UE → quality of workforce declines.

1. Destruction of family life due to declining self-esteem and financial hardship.

2. Domestic violence - due to frustration & loss of self worth.

3. Drug abuse and alcoholism.

4. Crime and delinquency.

5. Rising costs of law enforcement, health and welfare services.

6. Long term urban decay in some areas - become ghettos of chronic long-term unemployment and poverty.

7. Overall social costs accelerate as unemployment increases.

PPF

• UE FE

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Causes of Unemployment • Lack of Demand - a fall in C, I, G or net X will reduce total expenditure → production ↓ → UE ↑ (cyclical). This is the type of unemployment which occurs in recessions.

• Technological and structural Δ - workers replaced by machines - in short run UE may rise as a result of new technology. In the long run new industries + new job opportunities are created by technological Δ. Tech Δ increases productivity - more output from inputs → releases factors of production for other areas of the economy → growth in other industries.

• Rising labour costs – rate of wages growth > productivity growth → labour substituted with more capital → reduction in employment (structural)

• Government policies - tightening FP and MP → UE ↑ (cyclical) - reducing tariffs and other forms of protection → UE rises in the short run (structural).

• Level of world economic activity - if world growth slows → demand for Australian exports ↓→ less output from export industries → demand for labour (DL)↓. Also export income ↓→ national Y → AD↓→ UE ↑ (cyclical). Policies to deal with Unemployment Demand side Policies: simply raising AD will increase the DL and other resources → UE ↓. This can be achieved with expansionary fiscal + monetary policies → C + I ↑→ DL ↑→ UE ↓ - in other words stimulating economic growth. This is appropriate in dealing with cyclical UE. Supply side Policies: • Microeconomic reforms → long run structural changes in the economy which make the economy more efficient and increase productivity → new + expanded industries → UE↓ - deregulation, tax reform, tariff reduction, labour market reform → improved competitiveness, efficiency + responsiveness to changing economic circumstances → sustainable employment growth in the long run. • Encourage entrepreneurialism and investment → employment ↑. • Training and education programs aim to improve employability of the unemployed. Federal governments must allocate funds to vocational training and support the



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apprenticeship system → better match between the skills of those looking for work and job vacancies. Improving training and flexibility of the workforce → unemployed should spend less time out of the workforce and become more productive. This will reduce inflationary pressures by removing skill blockages and labour shortages which usually occur as economic growth accelerates. Government policies can be used to encourage X and M-replacement industries. STUDENT ACTIVITY 3.6 1. Read the following extract from the Australian Financial Review, 16-2-06 STUDENT ACTIVITY 4.6

Asleep on the jobs growth by John Quiggin Unemployment hasn’t been front page news for some years. The main labour market story in the past couple of years has been the emergence, for the first time since the 1980s, of significant labour shortages for some classes of skilled worker. Despite these shortages, the number of people who are unemployed or underemployed remains high. The official rate is above 5 per cent, [at time of writing 4.9%] but when various forms of hidden unemployment are taken into account, the true rate exceeds 10 per cent. It seems to have been accepted that a headline rate of unemployment of 5 per cent is the best we can possibly do, though such a rate would have been considered disastrous in the 1950s and 1960s. ... If we do experience a recession, and a resurgence of unemployment, the long expansion of the past 15 years will look, in retrospect, like a wasted opportunity to achieve permanent reductions in unemployment.

What can governments do “...to achieve permanent reductions in unemployment”?

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2. Study the following table showing labour market data.

Period Labour Force (000s)

Total Employed (000s)

Unemployed 000s

Unemployment rate %

Participation rate %

1996-97 1997-98 1998-99 1999-00 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09

9,168.9 9,256.4 9,378.5 9,495.0 9,674.3 9,818.9

10,003.8 10,129.0 10,366.8 10,591.5 10,823.5 11,252.6 11,418.8

8,404.0 8,518.6 8,688.9 8,868.7 9,056.2 9,161.5 9,389.4 9,556.3 9,826.4

10,064.3 10,334.6 10,772.1 10,759.0

764.9 737.8 689.6 626.3 618.1 657.4 614.4 572.7 540.5 527.1 489.0 480.5 659.8

8.3 8.0 7.4 6.6 6.4 6.7 6.1 5.7 5.2 5.0 4.5 4.3 5.8

63.4 63.1 63.1 63.1 63.4 63.3 63.6 63.4 63.9 64.4 64.8 65.4 65.2

(Source: Australian Economic Indicators, ABS, April 2009 and March 2010, 1350.0)



89 Macroeconomic Theory III

a) Between 1996-97 and 2007-08, the number of unemployed people fell by

____________. By how many did unemployment rise in 2008-09? _______________

b) Over the same period calculate:

i) the increase in the number of employed people ____________

ii) the increase in the size of the labour force ____________

c) What do you notice about the participation rate over the period in the table?

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d) Give reasons for the change in the participation rate between 2003-04 and 2007-08. _____________________________________________________________________________________

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e) The unemployment rate is a function of the number and quality of people wanting to work, and the number and kinds of jobs available. What should government do to facilitate a greater match between the two? _____________________________________________________________________________________

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Get cracking. I wanna see you work dude.


Economic Policy Objectives 90

4. Economic Policy Objectives

Objectives • outline the economic objectives of the government e.g. sustainable economic

growth, low inflation (price stability), low unemployment (full employment), and more equitable income distribution

• outline the economic policy objectives of the Reserve Bank of Australia (RBA) • discuss the extent to which government economic objectives may conflict and

complement each other • account for the time lags which occur in the use of economic policies i.e.

recognition, implementation and impact lags The Reasons for Government Intervention A pure market economy does not naturally look after the interests of everyone in that economy. It rewards those who possess useful resources and those who do not possess useful resources get no income. Free markets are generally efficient but the concept of equity (fairness) does not happen automatically, certainly not in a socially acceptable way. Government intervention reflects a belief that an economy cannot solve the economic problem without some undesirable side effects, nor can it satisfy its peoples’ collective needs and wants. Neither does the economy conveniently follow a smooth growth path over time but left to itself can fluctuate significantly with damaging consequences. Such instances of market failure necessitate government action to:

i) neutralize or eliminate the undesirable side effects (negative externalities). ii) compensate individuals whose needs are not met by the interplay of market forces (welfare) iii) supplement the provision of goods and services which are underprovided by the market (merit goods/services) and provide those not provided at all by the market (pure public goods/services). iv) implement policies which smooth out the economy’s growth path.

Government action to achieve these broad functions constitutes the major roles of government.

Major Roles of Government 1. Provision of welfare services - provide income (transfer payments) to those who can’t earn adequate income for themselves. Severe inequalities in the distribution of income and wealth are socially unacceptable. The Federal government redistributes income through taxation, transfer payments and the provision of merit goods such as education and health. This is the distributive function of government in action.

2. Provision of public and merit goods - public goods or services are those which would not be provided by the private sector at all (eg. street lighting and defence) and merit goods are those which would be under provided by the private sector (eg. education) so govt needs to intervene to make sure a socially adequate supply is provided in the interests of fairness and social justice. This is the allocative function of government because it allocates resources into the production of goods and services not provided, or inadequately provided, by the private sector. High quality public health is

critical to the overall well-being of the economy. Can yimagine the country withoit?

ou ut



3. Influence business activity - can encourage socially and environmentally desirable economic activities or discourage undesirable activities through taxation, subsidies or legislation. This is also the allocative function at work because government actions affect the way resources are allocated in the economy. This role would apply to economic activities which produce what are called positive externalities (eg. green industries like waste treatment and disposal) and negative externalities (eg. Industries that pollute). Externalities cause the misallocation of resources because their true costs and benefits are not built into prices. This can be corrected by government action. Can you think of other examples of government action which regulate business activity in the interests of society? 4. Macroeconomic management - stabilising the business cycle. This is the stabilising function of government. Keynes’ main contribution to economics was the role he saw for government in reducing fluctuations in the business cycle. This could be done by influencing the level of AD. Countercyclical policies increase AD during recession and decrease AD during recovery. This will prevent economic activity rising or falling too rapidly and will smooth out the path of the business cycle, reducing the severity of swings towards inflation and unemployment.

VOCAB: Pure Public goods - are those where consumption by one person does not reduce the availability of a good to others, i.e. the Exclusion Principle does not apply e.g. street lighting cannot be allocated to consumers on the basis of price. One person’s use of street lighting does not mean there is less street lighting for others to consume ie. others are not excluded from consumption of street lighting. Such goods are provided by govt. because the private sector cannot provide the service directly to the consumer for a price.

NT ACTIVITY 12.1 STUDENT ACTIVITY 4.1 1. Explain the allocative, distributive and stabilising functions of government to a partner. 2. List next to each of the following which function of govt is being fulfilled, ie. the allocative, distributive or stabilisation function (maybe more than one). i) Single parent allowance _________________________________________________

ii) Purchasing a new submarine _______________________________________________

iii) Imposing a carbon tax on motorists ___________________________________________

iv) Providing funds to the Greening Australia program_______________________________



v) Raising marginal rates of income tax during an inflationary boom____________________

vi) Subsidising research and development by medical scientists working on cancer

research _________________________________________________

vii) Govt spending on more public housing ________________________________________

Size of the Public Sector The public sector consists of three levels of government: • Federal • State • Local The total public sector is all three collectively. The most frequently used yardstick (measure) of the size of the government sector is govt spending. Other ways of measuring the size of the public sector include the revenue it collects and the number of people it employs. The table below shows Australia compared with other OECD (Organisation for Economic Cooperation and Develoment) economies using two different indicators. Comparing the Size of Australia’s Public Sector with Other Countries Examine the table comparing OECD countries and the size of their public sectors in terms of expenditure and revenue for 2007. The figures include all levels of government within a country so for Australia, total general government refers to local, state and federal levels. (OECD in Figures, www.oecd.org)

Countries Total General Govt Revenue % GDP

Total General Govt Expenditure % GDP

Australia Austria Belgium Canada Czech Republic Denmark Finland France Germany Greece Hungary Iceland Ireland Italy Japan Korea Luxembourg Mexico Netherlands New Zealand Norway Poland Portugal Slovak Republic Spain Sweden Switzerland Turkey United Kingdom USA

35.8 47.9 48.6 40.4 41.0 55.6 52.6 49.7 43.9 40.2 44.6 48.3 37.2 46.6 34.6 33.8 41.0 21.7 46.3 44.4 58.3 40.5 43.1 34.0 41.0 56.0 34.7

- 41.8 34.2

34.9 48.5 48.8 39.3 43.6 50.8 47.3 52.4 43.9 43.3 50.1 43.1 34.2 48.5 36.0 30.2 38.0 21.1 45.9 39.9 40.9 42.6 45.8 37.7 38.7 52.6 35.4

- 44.6 36.6



STUDENT ACTIVITY 4.2ENT ACTIVITY 12.2

1. How many countries in the OECD achieved

a) public sector surpluses? _____________________

b) public sector deficits? _____________________

c) balanced budgets? ____________________

2. Which countries had the top two spending and taxing governments?

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3. How many countries had higher taxing and higher spending public sectors than Australia?

a) higher spending ________________________

b) higher taxing _______________________

4. Calculate the average figures for government spending and revenue for the OECD (to 2 decimal places).

a) av. expenditure ____________________ b) av. revenue ___________________

5. Which country has the highest surplus and what is it as a % of GDP?

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6. Which country has the highest deficit and what is it as a % of GDP?

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7. Comment on Australia’s position relative to other the countries in the list in terms of the size of its public sector. Is Australia’s public sector too big; are government spending and taxation too high?

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High quality, open and transparent, democratic and responsible government

is so important to the effective functioning of an economy.



THE MACRO PERSPECTIVE • Aggregate demand and aggregate supply interact to determine the level of economic activity which is subject to fluctuations over time (the business cycle).

• Keynesian theory focuses on the role of government in managing and minimising these fluctuations through its use of particular economic policies, in particular fiscal policy.

• These macroeconomic policies are countercyclical, ie. they are used to stabilise the economy by smoothing the fluctuations in the business cycle.

• The implementation of these macroeconomic policies have microeconomic effects because they influence the economic decisions of firms and households to spend, invest, produce, work, save, etc.

• Microeconomic reform targets particular underperforming sectors which make up the macroeconomy. The aim is to achieve a more efficient allocation of resources and enhance sustainable economic growth. TYPES OF ECONOMIC POLICIES

1 & 2 are macroeconomic policies since they influence total demand - they are interrelated in that Δs in one will have an impact on the other. No. 3 relates to the productive capacity or supply side of the economy.

1. Fiscal Policy (FP)

2. Monetary Policy (MP)

3. Microeconomic Policy (MER)

The Federal Government uses 1 & 2 together changing the emphasis according to changing economic circumstances. These two allow government to directly influence the level of AD and hence the level of economic growth, price stability and employment. Microeconomic policy works by government changing the economic environment in which economic agents operate so that these market participants can be more competitive and efficient and hence more productive. This in turn will have important effects on pricing pressures, income and employment growth and external balance.

MACROECONOMIC OBJECTIVES 1. Price stability - maintaining low inflation. (2 - 3% p.a. on average over the economic cycle)

2. Full employment - reducing UE to as low as possible without aggravating inflation.

3. Economic growth - achieving a sustainable rate of economic growth (ie. growth without inflation).

4. Equitable income distribution - removing socially unacceptable income disparities (inequalities).

5. Efficient resource allocation - attempting to ensure the nation’s productive factors are put to their most valued uses which will improve total factor productivity.

Achievement of all these goals simultaneously is very difficult. The main priority of authorities here and overseas is to minimise inflation while stimulating economic growth and therefore lowering unemployment. Microeconomic reform has taken on more of the burden of achieving sustainable (low inflation) economic growth by targeting inefficiencies in the economy, complemented by appropriate macroeconomic policy settings. This has meant moving to structural budget surpluses (ie. surpluses not reliant on asset sales) in the growth phase of the cycle



so that cyclically balanced budgets (ie. deficits and surpluses cancelling each other out over the course of the business cycle) and reasonably moderate monetary policy settings are achieved. Government economic objectives may be incompatible or compatible. STUDENT ACTIVITY 13.1 STUDENT ACTIVITY 4.3

Sketch a diagram of the business cycle indicating where each macro objective would receive priority. % change in real GDP

Time

COMPATIBLE OBJECTIVES • Economic Growth (EG) and “full” employment: rising EG means growing demand for factors of production. Unemployed resources including labour are utilised as production increases. EG since the recession of 1990-91 has seen UE come down from nearly 12% in 1992 to 4.0% in 2008.

• Economic growth and income distribution: EG is necessary for incomes to rise. As incomes rise, tax revenue increases and government can redistribute income via transfer payments and public services of various kinds. Income support schemes and the provision of merit goods such as health care are sometimes referred to as the ‘social wage’. This depends on appropriate redistributive policies being in place. EG by itself will not guarantee equity (fairness) in income distribution but it is a necessary condition for it to occur.

INCOMPATIBLE OBJECTIVES • Price stability and “Full” employment: FE requires high level of EG which may → AD > AS → inflation (demand pull). As production ↑ → demand for inputs ↑→ input prices ↑ → cost push inflation. As production↑→ demand for labour ↑ → UE ↓. The lowest UE since the early 1970s has been achieved without inflation being a problem until very recently. An average rate of about 2½% since the 90/91 recession until 2007 has been achieved through microeconomic reforms which have made the economy more flexible and significant global economic changes, particularly the emergence of China as a low cost manufacturing centre have contributed too. Trade liberalisation and labour market reforms have reduced inflationary pressures. Liberalising trade has meant greater access to low priced manufactured goods for Australians and decentralising wage setting has reduced cost pressures from wage increases



• Price Stability + Economic Growth: If EG ↑ too strongly → inflation↑. As AD↑ → demand for inputs ↑ → cost push inflation. As EG↑ → Y↑ → AD↑ → consumer prices↑ if output can’t keep up. Note in the late 90s economic growth exceeded 4% without inflation being a problem because there was surplus capacity being created by MER. Price pressures have mounted over 2007 into 2008 as growth has taken the economy closer to maximum capacity. Inflation for the year ending June 2008 = 4.5%.

STUDENT ACTIVITY 4.5 ACTIVITY 13.2

Explain how a high rate of economic growth affects the ability of the government to achieve its other economic objectives.

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Economic Policy Objectives

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THE PUBLIC SECTOR – FUNCTIONS AND REVENUE SOURCES

The structure, some of the functions and the main sources of revenue for governments in Australia are indicated in the diagram below.

LOCAL STATE FEDERAL

• local roads • footpaths • drains • oval & parks • libraries • swimming pools • building standards • garbage collection • street lighting • parking laws • salaries to employees

• education • water supply • hospitals • railways • main roads • buses • police & law courts • agriculture • mining & forestry • housing • power • salaries to employees

• foreign affairs • defence • trade • post and telecommunications • social services (welfare) • immigration • health • territories (NT, ACT) • economic management • education • salaries to employees • payments

LOCAL STATE FEDERAL

• land rates • building fees • hall hire • parking meters & fines • oval hire • admission charges to pools • government grants from both state and federal governments

• special grants and the GST revenue from federal govt

• land tax • payroll tax • selling government land • privatising govt business enterprises, eg Bankwest,

Alinta • railway fares & freight

charges • charges for water, power & sewerage • driver’s licences • motor vehicle licences • stamp duties on property and

other transactions • harbour charges

• personal income tax • company tax • indirect taxes eg. tariffs & excise taxes, GST • postage stamps • Telstra charges • airport charges • privatising government

businesses eg. Qantas, Telstra

Tables are a very useful way of presenting

information which is user friendly.

The money to pay forall these services

comes from the sources below.

5 Fiscal Policy Objectives. GOVERNMENT ECONOMIC POLICIES You should be able to: • explain the concept of fiscal policy • outline different budget outcomes i.e. balanced, surplus and deficit budgets • account for differences between planned and actual budget outcomes • explain the methods of financing a budget deficit and the uses of a budget surplus • distinguish between automatic fiscal stabilisers and discretionary fiscal policy • explain the concepts of fiscal policy expansionary, contractionary (restrictive), neutral

stances • demonstrate and explain the impact of different fiscal policy stances on the level of

economic activity • evaluate the strengths and weaknesses of fiscal policy • evaluate recent fiscal policy stances.

FISCAL OR BUDGETARY POLICY 1. Fiscal policy refers to government spending and revenue raising (taxation) in order to influence the level and nature of economic activity, ie. to achieve macroeconomic goals like full employment and price stability and to provide the public goods and services not provided or inadequately provided by the market. In simple terms, FP is used in the following way:

During a recession – G ↑ and T ↓→ AD ↑→ equilibrium level of income, employment and output ↑.

During a boom – G ↓ and T ↑→ AD ↓→ equilibrium level of income, employment and output ↓.

2. Fiscal policy does more than change the level of economic activity. It influences the nature of activity through its allocative and distributive functions. The main method of implementing fiscal policy is through the federal budget.

3. The budget contains information on:

a) government expenditure and revenue.

b) the performance of previous year and predictions of future economic performance.

c) current economic problems eg. UE or inflation.

d) new measures and predicted effects.

4. The deliberate changing of G and T is called discretionary fiscal policy. It is discretionary because it requires judgement and decision making as to what the economy needs to achieve stability. This is the focus of Keynesian demand management theory - manipulating AD in order to get as close as possible to a full employment equilibrium level of national income. BUDGET OUTCOMES This refers to 3 possible outcomes:

i) budget deficits: G > T - achieved by G↑ or T↓ or both (expansionary) eg. 1993/94 actual budget outcome = $18.18 billion or 4% of GDP.

ii) budget surplus: G < T - achieved by G↓ or T↑ or both (restrictive) eg. 2007/08 actual

98

budget outcome = $19.7 billion or 1.7% of GDP.

iii) balanced budgets: G = T (neutral effect) – rarely do economic circumstances justify balanced budgets.

An actual Budget outcome is likely to be different to the planned outcome. Why?

• EG may exceed expectations → tax revenue ↑→ surplus ↑ or deficit ↓.

• EG may fall short of expectations → tax revenue ↓→ surplus ↓ or deficit ↑.

• Unforeseen events or economic shocks e.g. natural disasters (drought, earthquake, bushfire, cyclone), external or overseas events (natural disasters and economic problems in trading partners eg. currency and debt crises in Indonesia, Thailand and S. Korea 1997-98, or wars and terrorism eg. Gulf wars 1990 and 2003, September 11, 2001, the 2007-08 global credit and economic crisis and the volcanic eruption in Iceland), and domestic economic events eg. Industrial strife or wages blowout → declining GDP → worse budget outcome than expected.

• Unexpected positive events eg. breaking of a drought, larger jump in TOT (terms of trade which is a measure of changes in the prices of exports relative to changes in the price of imports ), than expected or some technological breakthrough or greater progress in microeconomic reform → greater economic efficiency → major boost in productivity → higher national income → better outcome than budget expected.

• Generally an intended budget outcome rests on the assumptions about economic performance in the future - impossible to predict accurately growth rates, interest rates, CPI, TOT, AUD, investment, etc. It is really just intelligent, informed guess work. STUDENT ACTIVITY 5.1 Read the following article extracts. Discuss with a partner the consequences of the events mentioned in the articles on the federal budget outcome. Jot down your ideas in the space after the articles. Article 1 (Australian Financial Review, 17-10-06)

Prime Minister John Howard yesterday provided an extra $350 million to extend drought relief payments beyond the next election and said the government would consider expanding assistance to cover small businesses in rural areas. ... The changes announced yesterday will allow the country’s 18 drought-declared areas to receive income and interest rates assistance until March 2008. A federal election is expected by the end of 2007. ... This comes as Australia battles its worst drought in 100 years, which is expected to reduce farm incomes by 60 per cent this year and wipe up to 0.8 percentage points from GDP growth. This follows heatwaves and bushfires over the weekend after one of the driest winters on record. ... Since 2001 the government has spent $1.2 billion on drought relief and said yesterday that 38 per cent of the country’s agriculture land was affected.

Parched bush promised relief into 2008 by Angus Grigg

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Article 2 (Australian Financial Review, 12-10-06)

The total tax take collected by Australia’s federal, state and local governments grew faster than the rest of the country’s economy in 2004 but this reflected strong economic growth rather than a rise in tax rates, an international report has found. The total tax take as a proportion of gross domestic product grew faster than the average of 30 developed countries in 2004, the Organisation for Economic Cooperation and Development says in a report released in Paris last night. Australia’s total tax revenue rose 0.5 percentage points to 31.2 per cent of GDP between 2003 and 2004, compared to an average 0.1 per cent of GDP for all developed countries. Treasurer Peter Costello said Australia was the eighth-lowest taxing country in the OECD, according to the latest edition of the group’s Revenue Statistics. ... ... the OECD report also showed Australia had the third-highest reliance on taxes on income and profits as a single source of tax revenue, behind only New Zealand and Denmark.

Economic growth inflates tax take, says OECD by Fleur Anderson

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VOCAB: Fiscal balance - is now the key indicator of the fiscal position - the aim of budget policy is to achieve fiscal balance over the course of the economic cycle (surpluses in times of growth balanced by deficits in times of recession and recovery). Fiscal balance uses the accrual method to measure the difference between revenue and expenditure (accrual method: recording transactions when they are made not when payments are made or received). Underlying Cash Balance - formerly known as the underlying budget outcome. This measures the actual cash position of the government, ie. records cash payments made over the fiscal year and does not necessarily coincide with the fiscal balance. It excludes asset sales. The headline cash balance includes asset sales.

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AUTOMATIC STABILISERS The term automatic stabiliser refers to the effect of cyclical changes in the economy which occur automatically and counterbalance economic fluctuations and reduce the size of the multiplier effect of injections and leakages. An automatic stabiliser tends to increase the government’s deficit during a recession and increase its surplus during inflation without requiring any deliberate (or discretionary) action by policy makers.

a) Progressive personal income tax - tax revenue increases when GDP and income rise due to bracket creep (income earners moving into higher tax brackets as their income rises over time) and falls when GDP declines. This acts as a brake on the growth of AD when growth is too strong and cushions the fall in AD that occurs in a recession.

b) Transfer payments - such as UE benefits, work in the opposite way, ie. increase during recession and rising UE, and fall when UE falls during periods of economic growth. The above examples relate directly to the government’s fiscal outcome, however there are other automatic cyclical changes which have countercyclical effects and do not work through government finances.

The automatic stabilisers of progressive personal income tax and UE benefits contribute to the cyclical component of the budget, ie. automatic adjustments to G and T due to the movement of the economy through the business cycle.

[Additional stabilising effects come from spending on imports and having a flexible exchange rate. For example spending on M rises and provides an outlet for AD in times of strong economic growth. Rising M → net X↓→ AD↓. During slowdowns - M↓→ net X↑→ AD↑. A flexible AUD during an economic slowdown → depreciation → X cheaper and more competitive and M more expensive → net X↑→ AD↑. During strong growth → appreciation → X less competitive and M cheaper → net X↓→ AD↓. A flexible ER helps insulate the domestic economy from the effects of external shocks such as the Asian financial crisis or strong commodity prices so FP can be used to target domestic problems such as inflation and UE.]

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Fiscal drag may occur as the economy emerges from recession, ie. as GDP increases and incomes increase, tax receipts increase also and blunt the effect of the growth of demand. This may be unwanted in the early stages of recovery.

During a recession G > T - budget deficit (to cure a deflationary gap)

During a boom G < T - budget surplus (to cure an inflationary gap)

Discretionary FP contributes to the structural component of the budget, ie. deliberate Δs to government spending and to tax rates. BUDGET OUTCOME = STRUCTURAL COMPONENT + CYCLICAL COMPONENT. STUDENT ACTIVITY 5.2CTIVITY 15.2 1. Use Keynesian model of income analysis to illustrate budgetary action by government in a recession and inflationary boom. a) In a recession (deflation). b) In a boom (inflation). 2. Complete the following multiple choice questions. i) Which of the following would have an automatic stabilising effect on the economy during a slowdown?

a) rising savings. b) falling transfer payments. c) an appreciating currency. d) declining income tax payments.

ii) Discretionary fiscal policy can be defined as

a) changes in the categories of taxing and spending that are the result of political pressure on governments. b) automatic changes in government spending and taxation to smooth out the business cycle. c) deliberate changes in government spending and taxation to smooth out the business cycle. d) changes that occur in automatic stabilisers as a result of growth in the welfare state.

iii) A pure public good is

a) a product when consumed by one person does not make that product less available to other consumers. b) it is any good produced by the public sector. c) it cannot be produced at a profit by firms. d) it must be provided for all members of society.

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Fiscal policy should be with economic stability as theprimary objective.

implemented

This is very difficult in the real world of politics and influential

sectional interests.

VOCAB: Public Sector Borrowing Requirement - Total borrowings of all sectors and levels of government in Australia. This includes Federal, State and Local govt plus govt authorities such as Australia Post and Western Power.

It is very important to be able to apply the theory you learn in class and from your texts. You must be able to fit the annual federal budget into the theoretical picture. You could be asked a question on this year’s budget and perhaps be required to put it into an overall macroeconomic context. Examine the diagram of the business cycle showing annual change in RGDP.

-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

6.0

1979

–80

1980

–81

1981

–82

1982

–83

1983

–84

1984

–85

1985

–86

1986

–87

1987

–88

1988

–89

1989

–90

1990

–91

1991

–92

1992

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1993

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1994

–95

1995

–96

1996

–97

1997

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1998

–99

1999

–00

2000

–01

2001

–02

2002

–03

2003

–04

2004

–05

2005

–06

2006

–07

2007

–08

2008

-09

2009

-10

Dec

Annual % change in RGDP 1979-80 to 2009-10 Dec

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STUDENT ACTIVITY 5.3CTIVITY 1. Work with a partner on the following task. If you were in charge of fiscal policy, what would you have done over the course of the business cycle? What would your key objectives be and how would you adjust fiscal policy to achieve them? What problems might you have in implementing your fiscal policy? __________________________________________________________________________________

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2. Examine the pie graphs below for the 2009-10 Budget.

(source: www.budget.gov.au/2009-10/content/overview/html/overview_40.htm) Where the money comes from (government revenue)

Where the money is spent (government expenditure)

a) In the budget of 2009-10 which type of tax provided most revenue?

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What percentage of total revenue (to 2 decimal places) did it contribute? ______________% b) What proportion of total revenue did company & petroleum resource rent tax

contribute? _________________%

c) On what area of public expenditure was the greatest share of this revenue spent?

_______________________________________. What percentage of total revenue (to 2

decimal places) did it account for? _______________%

d) Health, welfare and education together account for _______________% of total Commonwealth expenditure.

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3. Calculate expected total expenditure and revenue for 2009-10. Expenditure ____________________

Revenue ____________________

4. All the budgets from 1996-97 to 2008-09 aim to achieve surpluses. The current budget plans for a deficit. Explain the reason for the change from surpluses to deficit? __________________________________________________________________________________

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5. Examine the graph showing the level of Commonwealth public debt over the period 1981-2006.

a) Suggest reasons for the increase in Commonwealth public debt in the mid 1980s

and 1990s.

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b) Why do governments incur debt?

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c) What problems may arise from governments having high levels of debt?

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6. Examine the graphs below showing public debt. (Source: http://www.budget.gov.au/2009-10/content/bp1/html/bp1_bst4-06.htm)

a) Which country has the highest level of public debt? __________________ Suggest

reasons for this.

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b) Which country had no public sector debt in 2008? _________________________

c) How can countries reduce debt?

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THE AIMS OF FISCAL POLICY IN THE FIRST DECADE OF THE 21st CENTURY • Increasing the level of national savings is a priority of the federal government in order to reduce the need to borrow abroad and to put downward pressure on interest rates. If the public sector is a net saver (by running budget surpluses) then it does not compete with the private sector for funds to finance its deficit spending and thus will not contribute to the national saving-investment imbalance (Australia’s investment needs > national savings). This helps keep interest rates down which is good for economic growth. The relationship between the budget outcome and the current account balance (CAD) can be illustrated in simple terms using the leakages/injections model of equilibrium:

S + T + M = I + G + X therefore: M - X = I - S + G – T

In other words: CAD = savings/investment gap (I-S) + budget balance (G-T)!

The implication is that when the private sector’s need for investment funds is increasing due to economic growth, government should be achieving growing surpluses.

• Budget surpluses will enable the federal government to reduce accumulated commonwealth debt and thereby reduce the need to spend on interest payments on debt in annual budgets. This will allow government to make more equitable adjustments to social policy and more competitive adjustments to taxation.

• By running surpluses, the government believes it will boost international confidence in the Australian economy which will help keep interest rates down and encourage the private sector to invest. By implementing responsible fiscal policy it is hoped sustainable economic growth will be higher.

• Along with continued improvements to the tax system and microeconomic reform in general, surplus-oriented budgetary policy should underpin strong, non-inflationary economic growth and rising employment and allow monetary policy settings to achieve interest rates lower than they would otherwise be.

• By accumulating surpluses and paying off debt during the good times, the government can be in a strong financial position when the next recession occurs.

Public debt has opportunity costs but it also plays an important role in financial markets providing an investment option for managed funds (eg. super funds). If debt is manageable and increases public infrastructure

g overall economic growth, the opportunity costs of debt may be justified. enhancin

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Complete the following questions.

i) Fiscal policy directly affects the level of national income and output through its effects on

a) financial markets and interest rates. b) merchandise trade. c) wage levels. d) aggregate demand.

ii) Financing a commonwealth budget deficit can be by

a) raising marginal tax rates. b) using foreign exchange reserves. c) selling bonds to the public. d) retiring public debt.

iii) Some people argue that persistent budget deficits and the resulting growth in government debt create economic problems. Which of the following is not such a problem?

a) Their demand for funds crowds out real investment. b) They cause increased costs of servicing external debt. c) The resulting impact on AD leads to deflation. d) They worsen the balance on the current account.

iv) An increased budget deficit would raise AD but it could reduce investment spending by

a) indirectly causing interest rates to rise. b) damaging household sector confidence. c) selling government securities which are more attractive than real assets. d) reducing disposable household income.

v) Since the 1996 budget, surpluses have been a goal of the Federal Government. A consequence of this policy has been:

a) a worsening in the BOP. b) a rise in unemployment. c) a fall in interest rates and stronger private sector expenditure. d) a growing problem with inflation.

vi) Inflation is likely to increase when a budget

a) deficit is the outcome during a boom . b) deficit is the outcome during a recession. c) surplus is the outcome during a boom. d) surplus is the outcome during a recession.

vii) Which of the following defines discretionary fiscal policy?

a) Deliberate changes in government spending and taxation to smooth out the business cycle. b) Automatic changes in government spending and taxation to smooth out the business cycle. c) Changes in government purchases of financial assets to smooth out the business cycle. d) Changes that occur in automatic stabilisers as a result of economic growth.

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viii) Fiscal policy may act on determinants of demand as follows: a) earnings from exports are increased when government spending is increased. b) saving is increased when interest rates are increased. c) consumption is reduced when levels of taxation are increased. d) investment spending is increased when governments run deficits.

STUDENT ACTIVITY 15.4 ix) The Commonwealth Government finances a budget deficit partly by

a) using portfolio investment fl owing in from overseas. b) selling government securities on the open market. c) buying back government securities on the financial market. d) using its savings generated by previous budget surpluses.

x) Expenditure

C+I+G

GDP 45◦

Yfe

Given the situation depicted in the diagram above, the most likely government fiscal policy action would be to

a) reduce government spending to lessen inflationary pressures in the economy. b) increase government spending to raise the level of employment . c) leave government spending unchanged, but decrease taxes on households and firms. d) decrease tariffs to encourage spending on imports and thus reduce domestic employment.

EFFECTIVENESS OF FISCAL POLICY Some disadvantages of FP 1. Unforeseen changes in economic circumstances may undermine fiscal policy goals, eg. changes in wages, investment, consumption spending, exports, natural disasters and overseas events (eg. war in Afghanistan and GFC).

2. Problems of forecasting effects of FP - eg. will consumers increase spending or saving with tax cuts? Will investment rise when the company tax rate is lowered?

3. Information for assessing the state of the economy and trends may be inadequate. Data is always out of date – it reflects the state of the economy in the past.

4. Political problems - restrictive fiscal policy can be avoided when needed or reversed when it should continue due to political or electoral factors. Governments are subject to pressures from various lobby groups (eg. conservationists, trade unions, business groups, welfare groups, etc) particularly close to elections so that

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fiscal policy may be strongly influenced by social and political factors instead of the needs of the economy. In fact it could be said that given Australia’s three year electoral cycle, fiscal policy in the hands of politicians is something of a liability. Governments are reluctant to cut spending to rein in deficits or increase surpluses when the economy demands it because they don’t want to upset voters, and they don’t want to leave a large surplus to their political opponents if they lose control of government. This tends to weaken FP as an economic tool.

5. Time lags:

i) recognition lag – it takes time to recognise the need for a particular course of fiscal action (the role of statistical data is important).

ii) implementation lag – deciding and implementing policy takes time – budgets must be approved by Parliament and may be held up for several months if the government does not have the numbers in both houses of Parliament.

iii) impact lag – it takes time for fiscal policies to take effect and have the desired impact once implemented.

6. Crowding out (if in times of late upswing):

a) Expansionary FP → public sector saving ↓→ budget surplus ↓ or deficit ↑. b) Government borrows from money (capital) market by selling bonds – increases demand for funds pushing up interest rates. In the diagram below demand for money D1money increases to D2money. This leads to a rise in interest rates from r1 to r 2 . This adds to Public Debt.

c) Private investment falls from I1 to I2 , ie. investment is crowded out.

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S money

D2money

D1money

Qmoney

Interest rate

I2 I1 Investment

Demand function for investment funds

Interest rate r2 r1

Some advantages of FP a) Can be selective eg. taxes and subsidies can be specifically targeted at particular industries, sectors or income groups unlike monetary policy (MP) - has allocative and distributive effects.

b) Impact lag is shorter than for MP - more immediate results particularly in recession when MP may be ineffective.

c) Built-in stabilisers give some flexibility eg. fiscal drag in times of demand inflation, ie as incomes rise people move into higher tax brackets - they lose more of their income in taxes and can’t spend it. Therefore government spending cuts need not be as severe → political benefits. Discretionary fiscal changes can be reinforced by automatic adjustments.

6. Monetary Policy Objectives. GOVERNMENT ECONOMIC POLICIES You should be able to: • explain the concepts of monetary policy and the cash rate • outline the circumstances under which the RBA may change the cash rate • explain the concepts of expansionary, contractionary and neutral monetary policy

stances • demonstrate and explain the impact of different monetary policy stances on the level of

economic activity • evaluate the strengths and weaknesses of monetary policy • evaluate recent monetary policy stances. MONETARY POLICY Definition and Function

• Monetary policy refers to RBA actions to affect monetary and financial conditions (chiefly interest rates) for the purpose of achieving low inflation and sustainable economic growth. It is defined as central bank action to manipulate the price and availability of credit in the economy. By doing this, the RBA influences the borrowing and lending activities of the financial sector.

• The RBA announces its desired monetary policy position in terms of the cash rate (interest rate or r) on funds in the short term money market (overnight cash market). The bank then operates in the market each day to maintain the target cash rate. The bank does this through its open market operations ie, its buying (or selling) of securities to increase (or reduce) the level of funds banks have available to them to lend to bank customers (borrowers). The aim is to manipulate the supply of funds in order to bring about equilibrium between supply and demand in the cash market at the desired cash rate.

• By changing the cash rate, the RBA changes the whole structure of interest rates (r) across the economy and hence the level of economic activity. The ultimate goal is to keep the underlying inflation rate between 2 - 3% on average over the business cycle.

• MP is conducted by RBA on behalf of the federal government which has the legal power to override RBA decisions. Ultimately the federal govt. has responsibility for the general level of economic activity however the RBA’s independence in conducting MP has been well established in recent years. The following extract is taken from the RBA Statement on the Conduct of Monetary Policy of 14th August 1996. Statement on the Conduct of Monetary Policy In this statement the government acknowledged the high degree of independence the RBA has in the conduct of MP and endorsed the bank’s inflation target range of 2 - 3% on average over the business cycle.

“Monetary Policy is a key element of macroeconomic policy and its effective conduct is critical to Australia’s economic performance and prospects... The Reserve Bank Act gives the Reserve Bank Board the power to determine the Bank’s monetary policy and take the necessary action to implement policy changes. ...”

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The Reserve Bank Act of 1959 sets out the objectives as:

i) the stability of the currency of Australia (low inflation) ii) the maintenance of full employment in Australia, and iii) the economic prosperity and welfare of the people of Australia.

The RBA focuses on price stability because it is an essential precondition for the other objectives. Low inflation and low inflation expectations “... assist business in making sound investment decisions, underpin the creation of new and secure jobs, protect the savings of Australians and preserve the value of the currency.” The government also acknowledges the importance of disciplined fiscal policy and its role in assisting and complementing monetary policy in achieving these objectives. (For further information on the RBA and its history go to www.rba.gov.au and click on ‘About the RBA’ on the top left side of the home page) Regulatory Structure of the Financial System • On July 1st, 1998, a new financial regulatory structure came into place. The new structure consists of:

i) the Australian Prudential Regulation Authority (APRA) ii) the Australian Securities and Investment Commission (ASIC) iii) the Reserve Bank of Australia (RBA)

• APRA - is responsible for the prudential supervision of financial institutions : banks, life and general insurance companies, superannuation funds, building societies, credit unions and friendly societies. Its role is to look after the deposits of the public and maintain public confidence in the banking system.

• ASIC - has responsibility for ensuring ‘market integrity’ and consumer protection across the financial system. It sets and enforces standards for financial market behaviour and for selling financial products including investment, insurance, superannuation and deposit-taking activities.

• RBA - retains responsibility for the conduct of monetary policy and the maintenance of overall financial stability. It no longer has responsibility for the prudential supervision of banks. It remains the ‘lender of last resort’ , ie. “... the only agency which is able to provide emergency liquidity support in the event of any threats to the stability of the financial system” (RBA Bulletin, July 1998). It will continue to supervise the payments system.


1. Explain to a partner the role of MP and the RBA 2. Write a paragraph on the role of the MP and the RBA.

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THE FINANCIAL SYSTEM The financial sector fulfils the very important task of collecting + mobilising surplus funds (savings, both domestic & foreign) in the economy and making them available to borrowers. The efficiency with which this is done is central to the economic health of the nation. It facilitates economic growth (ie. output + employment growth). CIRCULAR FLOW

Financial Sector Consists of financial institutions: • RBA • Banks • Non Bank Financial Institutions (superannuation funds, credit unions, building societies, finance companies, insurance companies, merchant banks) • Sharemarket

HH Firms

I S The Money Supply may be defined as the volume of money which exists in the economy at any point in time. STUDENT ACTIVITY 6.2

Explain why and how the financial sector is important to the functioning of the economy. WHAT IS MONEY? • Money is a medium of exchange. How well it fulfils this function depends on its ability to retain and measure value, how convenient it is to use and above all the degree of confidence the public has in money to do these things. People will accept money whether it be notes and coin or electronic money, only if they are confident that the money they receive can be exchanged for the goods and services they want, or alternatively that it will substantially hold its value if they choose to store their spending power in a bank for later use. In other words it should still be exchangeable for the same quantity of goods and services at some later time. So the test of what constitutes money is purchasing power, ie. its ability to be exchanged for goods and services.

Glenn Stevens, Governor of the RBA, stressed the main role of the RBA when he said “Preserving the purchasing power of money is the most important contribution that monetary policy can make to sustainable prosperity” (October 2006). • There is no single, official definition of the money supply. There are a number of measures of the money supply called monetary (or financial) aggregates. The most important are:

1. M3 = currency + bank deposits. 2. Broad money = M3 + deposits with non-bank financial institutions (NBFIs). 3. Credit = loans by all financial intermediaries. 4. Money Base = currency + private sector deposits with the RBA.

• RBA has tended to focus on credit because it gives a guide to the total volume of borrowing and lending in the economy which is directly linked to the level of total spending (AD) ie. the level of economic activity. Bank deposits are important because it is from bank deposits that loans and advances come – banks create credit from their lending activities.

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FACTORS AFFECTING INTEREST RATES The rate of interest is the price of money or debt. The price of money like the price of anything, is determined by supply and demand. When either supply or demand shift, the equilibrium rate of interest will change too. The primary influence on interest rates in Australia is action by the Reserve Bank (monetary policy) although there are other factors which impact on interest rates.

r

Qm

Sm

Dm

r

Q Q1

Dm1

r1

When demand for money rises as during an expansion, interest rates rise. More money is required by HH and firms for purchasing goods and services and investment. Credit growth and liquidity rise.

r

Qm

Sm

Dm

r

Q

The price of money is the rate of interest (r)

Supply of money comes from the RBA, banks and other financial institutions including overseas sources

Equilibrium rate of interest is where the demand for money and the supply of money are equal

Demand for money comes from HH, firms and governments

r

Qm

Sm

Dm1

r1

Q1 Q

Dm

During a contraction, AD falls causing the demand for money to decrease and interest rates to fall. The Dm function would shift to the left and credit growth falls.

r

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r

• Federal budgets: the effects depend on the way the deficit is financed which can be done in three ways:

a) Borrowing from the RBA - increases liquidity (money supply or MS grows) → r↓ (known as “printing money”).

b) Borrowing from the private sector (the Australian public) - liquidity remains unchanged because the govt takes money out of the economy through its sales of securities (borrows) and puts it back again through its own spending so there is no net change. However since the public sector competes with the private sector for funds this may contribute significantly to the demand for funds during periods of economic growth causing interest rates to rise (deficit spending → Dm↑→ r↑ where Dm is the demand for money). This is known as the ‘crowding out’ effect. Borrowing from the public may include from overseas sources as well - in theory liquidity does not change under a floating exchange rate. The exchange rate adjusts to absorb external sources of increased liquidity. In reality other factors may counteract this exchange rate adjustment so that liquidity may increase as the borrowed capital flows into the economy.

• Credit Creation: the credit creation process of banks, ie. their lending activities generate new deposits which leads to new lending and in turn more deposits and so on increasing the MS → r↓. This process is started off by an initial rise in bank liquidity which forces down interest rates across the economy. Lower r → borrowing↑→ (C + I)↑→ AD↑→ national income, output and employment↑ via the multiplier. The level of economic activity increases - the economy expands. Demand for money for spending

Qm

Sm

Dm

When the supply of money increases, the scarcity of money falls making it cheaper (ceteris paribus). HH and firms respond by expanding their demand for money. In a trough the RBA may be worried about rising unemployment and so increases the availability of money (liquidity) hoping people will borrow and spend (credit growth rises).

r

Q Q1

Sm1

r1

r

Qm

Sm1

Dm

During strong growth, inflation may concern the RBA so it will decrease the Sm and the Sm function will shift to the left. Interest rates rise and the demand for money contracts. Q falls to Q1 representing falling liquidity (credit growth declines)

r1

Q1 Q

Sm

r

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purposes expands because lower r makes holding money in interest bearing assets less attractive (higher opportunity cost of saving).

• Market Operations: this is the primary function of the RBA and refers to the sales and purchases of Commonwealth Govt Securities (CGSs) by the RBA in the money market for the purpose of influencing r. These transactions between the RBA and the financial sector (banks and some other financial institutions like super funds) alter the supply of funds in the money market relative to the demand for those funds and thus the general level of r.

Market sales of securities by the RBA decreases the MS → r ↑.

Market purchases of securities by the RBA increases the MS → r ↓.

Factors influencing r level relate to factors determining the supply and demand for money. The main factor is the point in the business cycle the economy is at. In recession, r↓ & in boom, r↑. Overseas r levels, balance of payments and exchange rates have their impact too. The level of competition between financial institutions is a very important factor in today’s financial sector. More competition puts downward pressure on r. Demand factors relate to household, firm and government reasons for wanting money. Demand for money is like the demand for a currency or a factor of production - it is a derived demand, ie. it relates to private sector (consumer and producer) demand for goods, services and factors of production and public sector fiscal outcomes (deficits or surpluses). Interest rates are determined by the supply and demand for money. In very simple terms RBA actions increase or decrease credit supply in the banking system which in turn causes the price of money (r) to fall or rise which in turn causes the demand for credit to expand or contract. This will stimulate or slow AD and therefore influence the level of economic activity. STUDENT ACTIVITY 6.3

i) Oral activity – topic: Factors affecting interest rates.

ii) Speed writing exercise: Study the previous section on the factors which affect interest rates for about 5-10 minutes. On a piece of A4 paper write as rapidly as you can for 5-10 minutes on the topic ‘Factors which influence interest rates’. Swap your work with your partner and read it and give a mark out of 5. Provide feedback. _____________________________________________________________________________________

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MARKET OPERATIONS BY THE RBA - LIQUIDITY MANAGEMENT

“Most of the operations the RBA undertakes in financial markets are for the purpose of implementing monetary policy. Monetary policy changes are announced in terms of a target for the cash rate - the interest rate on overnight interbank loans in the monetary market - and domestic money market operations are undertaken each day to maintain the cash rate around the target level... The cash rate is determined in the market each day by the interaction of the demand for and supply of Exchange Settlement (ES) funds - funds banks use to settle transactions with each other and with the RBA. The RBA’s ability to influence this rate rests on the fact that it is the sole supplier of these funds. It can increase or decrease the supply of ES funds by undertaking domestic market operations.” (p5, Reserve Bank Annual Report, August 2000). Central banks such as the RBA implement MP by engaging in transactions to influence short term interest rates, in particular the overnight cash rate. All banks in Australia maintain accounts with the RBA called Exchange Settlement Accounts (ESAs). They must maintain a surplus in these accounts at all times. When a cheque is used to pay a bill for example, the cheque which is written against the writer’s (drawer) account at Bank A, is deposited in the receiver’s (payee) account at Bank B. This means funds will have to be transferred from Bank A (from the drawer’s account) to Bank B (into the payee’s account). The transfer of funds between banks to settle such transactions each day occurs through these ESAs. The balances (funds) in these ESAs are called Exchange Settlement (ES) funds. If a bank does not have enough funds in its ESA, it has to borrow from other banks. The need for ES funds to settle daily interbank transactions provides the demand in the short term money in the cash market. Banks receive interest from the RBA at 0.25% below the prevailing cash rate on the funds in their ESAs. The demand for ES funds is fairly predictable although it does fluctuate daily. The RBA adjusts the supply of ES funds to offset the changes in demand so that the price of those funds, the cash rate, is preserved. So if the demand for ES funds rises for some reason (eg increased tax payments to the Federal Government), the RBA would inject funds into the ESAs of the banks thus preventing the cash rate rising. It does this by purchasing short term securities (treasury notes or bonds) from the banks. They receive the required quantity of cash from the sales of these securities which is deposited in their ESAs. When there is a rise in the level of funds in ESAs, the RBA sells securities to the banks which draws money out of their ESAs preventing the cash rate falling. This is done each day to maintain the cash rate at the target level. The following diagrams illustrate RBA actions to maintain the cash rate when the demand for ES funds increases. The RBA’s actions are calculated to ensure the banking system has the funds it needs (and no more than that) to conduct its daily interbank transactions. The RBA’s operations are always done with the effect on the cash rate in mind. When the RBA wants to change the cash rate it simply targets the level of funds in the banks’ ESAs

Cash rate

Cash rate would rise when D for ES funds increases if RBA did not inject funds into ESAs

Aggregate ES funds (Sm)

D2

D1

r2

r1

Demand for funds by banks in overnight cash market increases (D1 → D2)

Q cash in money market

Cash rate ES funds (S1) ES funds (S2)

D2

D1

Cash rate (stable)

ES funds increase after RBA intervenes by buying securities from banks and injecting funds into their ESAs – this maintains the cash rate at r1

Q cash in money market

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through its open market operations. If it wants to raise the cash rate (tighten MP) it increases its sales of securities relative to daily purchases thus reducing the funds in the bank’s ESAs (supply of ES funds ↓ - reduces financial system’s liquidity). The yield on short term securities = the cash rate which is also the rate at which banks borrow from each other on the overnight cash market. If the RBA wants to lower the cash rate (loosen MP), it will increase its purchase of securities relative to sales thus pumping more cash into the ESAs (supply of ES funds ↑ - increases financial system’s liquidity). Since financial institutions are engaged in the buying and selling of many kinds of securities, the change in the cash rate will flow through to all categories of securities. These securities include short term securities (eg. 90 day bank bills) and long term securities (eg. 10 year government bonds). Yields adjust right across the economy in all asset markets - government bonds, the stock market and the property market.

Price of assets

The shift in interest rates and hence all yields will change the relative opportunity costs of saving, borrowing, investing and spending and therefore the level of economic activity. The effect of a change in the cash rate is transmitted very quickly to the rates banks charge households and firms which in turn impacts on AD. The impact on AD may take quite a long time to fully wash through the economy - 12 to 18 months usually. (For further information go to www.rba.gov.au then go to Monetary Policy and Market Operations across the top of the home page). STUDENT ACTIVITY 6.4

Read the following extract from the AFR 29-8-00, p4: Explain the likely action the RBA would have taken to preserve the cash rate. _____________________________________________________________________________________

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“The first tax instalment under the new tax system put the overnight money market $3.45 billion in deficit last week, a surprisingly high figure that indicates the Federal Government could be in for a GST revenue bonanza. ... Last week companies with a turnover of $20 million were required to remit their first GST payment, and this created the substantial deficit in the money market. Government sources confirmed that the Government’s accounts were substantially in surplus as a result of the payments, and that this was somewhat larger than expected.”

Quantity of assets traded in the market

S of assets

D2 for assets D1 for assets

P2

P1

Q1 Q2

Greater liquidity caused by RBA action → prices in wider market for all kinds of assets ↑ (bonds, shares, property, etc.) (P1→P2) → yields↓. The process of adjustment in prices is triggered across the whole economy. As liquidity↑ and short term rates↓, funds move to where yields are relatively more attractive which drives up their prices and in turn their yields down too. In this way a new equilibrium level of higher prices and lower yields is established across the economy. Think about the reverse process if the RBA reduced liquidity.

Note: an asset price and its yield are inversely related

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How RBA purchases of securities affects macroeconomic activity. Examine the following diagrams. r r

Investment (in ‘real’ or

S1 S2 Market sales of securities by the RBA: everything is reversed in the above diagrams.

productive projects)

r1

r2

Overnight cash market

Qm

Investment demand function

I1 I2

Investment rises when interest rates fall (cet par)

Total expenditure (line of potential equilibrium points)

45◦ Y1 Y2

Y/GDP

AD2

AD1 ΔI

ΔY

Also C rises when r falls → ΔI↑ → ΔY increases further as does employment and output via the multiplier → expansion

Securities purchases → liquidity↑ (S1→S2) → r↓→ C↑ & I↑ → Y↑, E↑ + O↑ → economy expands

Why do C + I ↑ when r↓? 2 reasons: a) cost of borrowing ↓ b) opportunity cost of spending + investing ↓

Expected rate of return must be > cost of capital (r) for investment to take place

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VOCAB: Short Term Security - the most frequently used security is a treasury note (essentially just a electronic IOU) which is sold by the RBA to participants in the financial sector at a given price then repurchased at a guaranteed higher price at a future date. The length of time between selling and buying back the security varies but is not very long (eg. 5 weeks) hence the name short term security. The yield is calculated by dividing the difference between the sale and buyback price by the sale price times 100. This yield or rate is called the cash rate or cash target. The RBA in its daily transactions of short term securities maintains equilibrium between the value of sales and the value of repurchases (redemptions) when it wants to preserve the existing cash rate. When it wants the cash rate to fall it will increase repurchases relative to sales (liquidity rises) with the aim of causing the cash rate to drop to a target level. When the RBA wants to raise the cash rate and hence all interest rates, its sales will exceed repurchases (liquidity falls) to achieve a higher cash target. It decides on a particular target yield and hence target price for the securities and issues an appropriate quantity of securities. This achieves the desired change in liquidity which triggers change throughout the whole financial system. eg. sale price = $94 and repurchase price = $100 therefore the cash target = $100 - $94 x 100 = $6 x 100 = 6.38% $94 $94 If RBA wants to lower r to a target of around 4.7% for example then it would need to lower the repurchase price to about $98.43 for new securities: $98.43 - $94 x 100 = $4.43 = 4.71% $94 $94

STUDENT ACTIVITY 6.5 1. Using diagrams show how RBA market operations can reduce the level of economic activity. _____________________________________________________________________________________

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2. Examine the table showing interest rate movements in Australia between Jan 1990 and May 2010 and complete the activities which follow.

Interest Rate Decisions ‐ Changing the CASH RATE Monetary policy decisions are expressed in terms of a target for the cash rate, which is the overnight money market interest rate. A media release is issued at 2.30 pm after each ReserveBank Board meeting, with the Board's decision taking effect the following day. .

Effective Date

Change in cash rate

Percentage points

New cash rate target

Per cent

5 May 2010 +0.25 4.50 7 Apr 2010 +0.25 4.25 3 Mar 2010 +0.25 4.00 2 Dec 2009 +0.25 3.75 4 Nov 2009 +0.25 3.50 7 Oct 2009 +0.25 3.25 8 Apr 2009 -0.25 3.00 4 Feb 2009 -1.00 3.25 3 Dec 2008 -1.00 4.25 5 Nov 2008 -0.75 5.25 8 Oct 2008 -1.00 6.00 3 Sep 2008 -0.25 7.00 5 Mar 2008 +0.25 7.25 6 Feb 2008 +0.25 7.00 7 Nov 2007 +0.25 6.75 8 Aug 2007 +0.25 6.50 8 Nov 2006 +0.25 6.25 2 Aug 2006 +0.25 6.00 3 May 2006 +0.25 5.75 2 Mar 2005 +0.25 5.50 3 Dec 2003 +0.25 5.25 5 Nov 2003 +0.25 5.00 5 June 2002 +0.25 4.75 8 May 2002 +0.25 4.50 5 Dec 2001 -0.25 4.25 3 Oct 2001 -0.25 4.50 5 Sep 2001 -0.25 4.75 4 Apr 2001 -0.50 5.00 7 Mar 2001 -0.25 5.50 7 Feb 2001 -0.50 5.75 2 Aug 2000 +0.25 6.25

Effective Date

Change in cash rate

Percentage points

New cash rate target

Per cent

3 May 2000 +0.25 6.00 5 Apr 2000 +0.25 5.75 2 Feb 2000 +0.50 5.50 3 Nov 1999 +0.25 5.00 2 Dec 1998 -0.25 4.75 30 Jul 1997 -0.50 5.00

23 May 1997 -0.50 5.50 11 Dec 1996 -0.50 6.00 6 Nov 1996 -0.50 6.50 31 Jul 1996 -0.50 7.00 14 Dec 1994 +1.00 7.50 24 Oct 1994 +1.00 6.50 17 Aug 1994 +0.75 5.50 30 Jul 1993 -0.50 4.75

23 Mar 1993 -0.50 5.25 8 Jul 1992 -0.75 5.75

6 May 1992 -1.00 6.50 8 Jan 1992 -1.00 7.50 6 Nov 1991 -1.00 8.50 3 Sep 1991 -1.00 9.50

16 May 1991 -1.00 10.50 4 Apr 1991 -0.50 11.50

18 Dec 1990 -1.00 12.00 15 Oct 1990 -1.00 13.00 2 Aug 1990 -1.00 14.00 4 Apr 1990 -1.00 to -1.50 15.00 to 15.50 15 Feb 1990 -0.50 16.50 to 17.00 23 Jan 1990 -0.50 to -1.00 17.00 to 17.50

MONETARY POLICY CHECKLIST :

What the RBA observes when deciding on its MP position

Overseas events - inflation and r levels, especially in the USA. Exchange rate - if $A falls too low it may cause M prices to rise - could cause inflation. Wages growth - wants to keep W growth < 4.5% otherwise could → inflation. Also wants W↑ related to productivity. Housing finance growth & building approvals - indicator of strength of AD. Consumption - motor vehicle and retail sales are important indicators of the strength of household spending which is important to inflation. Sentiment indicators are important too. BOP - especially the CAD - if it is over 5.5% of GDP it maybe a cause for concern. Inflation - wants to keep the CPI between 2-3% annum. Fiscal Policy - wants to see growing surpluses as growth continues. Business Investment - wants to see investment in creating productive capacity and raising productivity. Business sentiment and conditions indicators are important too.

a) Suggest reasons for the cuts in the cash rate between 1990 – 1993 early 2009.

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b) Changes in interest rates are mostly less than 1%. Why?

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3. Read the following article extract from the AFR, 8-11-99.

How the rate rise will work by Stephen Koukoulas The Reserve Bank of Australia’s raising of the cash rate from 4.75 per cent to 5 per cent last week is aimed at keeping annual inflation at between 2 and 3 per cent. The banks, as the mechanism for transmitting the interest-rate adjustment, have been quick to pass on the rise to variable mortgage rates and business loan rates. For this, the RBA and the Government must be pleased as the banks’ prompt action speeds up the transmission from the official policy change to its impact on the real economy. How will an increase in the cash rate help the RBA to achieve its inflation objective? There are two main drivers of the link between higher interest rates and, eventually, lower inflation than would otherwise be the case. Importantly, higher interest rates increase the cost of borrowing for those with variable interest-rate facilities. As the cost of servicing a loan of a given size increases with a higher interest rate, demand elsewhere in the economy will be reduced. This will be particularly so if the growth in real incomes is not strong enough to cover the higher debt servicing costs. ... Borrowers must therefore limit or stop spending in one part of the economy to cover the higher interest cost imposed by the RBA. As spending elsewhere decreases, the ability of corporations to

increase selling prices diminishes. The other effect of higher interest rates is that it encourages savings. In broad terms, as interest rates approach zero, the incentive to save is not strong. Conversely, as interest rates rise, the inclination of people - householders and corporations – will be to save in order to receive the higher, almost risk-free return from the higher interest rate. This encourages money to move away from consumption and investment, slowing the rate of economic growth and making it difficult for prices - and hence inflation - to accelerate too rapidly. So will last week’s 25 basis point increase in rates be enough to limit inflation pressures? Not likely. ... When the impact on household incomes of the massive income tax cuts from July next year reach consumers, demand will be boosted and any impact from last week’s interest rate rise will be swamped. Given the resilience of consumer spending, a slowly improving outlook for business investment - so far the only weak part of the economy - and the impetus for growth from the external environment getting stronger by the day, the balance of probabilities suggests that interest rates will need to rise by about two percentage points over the next 12 to 18 months. ...

i) Explain how the role of banks is important in transmitting monetary policy changes through the economy. _____________________________________________________________________________________

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ii) Explain in your own words how a rise in interest rates will reduce aggregate demand. _____________________________________________________________________________________

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4. Study the transmission mechanism below and write in full essay form how the transmission mechanism works to bring about a change in the real economy when the RBA changes its monetary policy setting. Monetary Policy Transmission Mechanism Banks change

rates on loans & deposits

Cost of borrowing & return to saving change

RBA changes cash rate

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Y/GDP

Total spending

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Total spending AD2

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When the cash rate falls When the cash

rate rises

Borrowing and saving change

Consumption & investment change

AD changes → inventories changes → O, UE, Y Δ change → GDP changes as the economy moves to a new equilibrium point

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5. Research Activity: Describe the strengths and weaknesses of MP using the chart below (use you text book as a reference).

STRENGTHS WEAKNESSES

6. Complete the following multiple choice questions.

i) When the Reserve Bank enters the market to buy government securities, it probably intends to

a) increase the liquidity of the market. b) push up interest rates in the economy. c) decrease funding for a Federal government budget deficit. d) reduce the money supply.

ii) In the open bond market a fall in interest rates will mean the market value of previously issued government bonds will

a) depend on what share prices do. b) remain unchanged. c) rise. d) fall.

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iii) The transmission mechanism for MP refers to the process by which a change in the cash rate by the RBA is transmitted throughout the whole economy and impacts on the decisions of households and firms to spend and invest. The speed of this process will be improved by:

i) spread of and improvements in information technology ii) transparency of RBA decision making iii) reduction of RBA independence iv) reduction of discretionary power of banks to alter interest rates

a) i) & ii) b) ii) & iv) c) ii) & iii) d) iii) & iv)

iv) If the Reserve Bank implements expansionist market operations then it will a) encourage banks to increase their lending activities. b) borrow from overseas. c) sell government securities on the open market. d) buy short term securities from banks.

v) If the Reserve Bank sells Commonwealth Government securities to the private sector then the quantity of ‘cash’ in the market will

a) decrease and short term interest rates will fall. b) decrease and short term interest rates will rise. c) increase and short term interest rates will rise. d) increase and short term interest rates will fall.

vi) The main difference between monetary policy and fiscal policy is that a) monetary policy is action influencing the cost and supply of loanable funds whereas fiscal policy is taxing and spending by the government. b) monetary policy deals with money matters whereas fiscal policy deals with budgetary matters. c) monetary policy is determined by the RBA whereas fiscal policy is determined by the government (Treasury). d) monetary policy affects the exchange rate whereas fiscal policy concerns taxation rates.

vii) The aim of the RBA’s daily market operations is to make sure a) that banks have enough funds for their day-to-day interbank requirements. b) the RBA can regulate bank lending. c) ensure customers don’t stop saving and borrowing from banks. d) the RBA can be ‘the lender of last resort’.

viii) The main weakness of monetary policy is its a) lack of flexibility due to the need to receive specific approval by Parliament. b) tendency to become highly political and subject to constant adjustment to meet the demands of interest groups. c) tendency to encounter time lags which slow its rate of operation. d) inability to have much effect on the level of activity during periods of sustained economic boom.

ix) If the RBA were to increase bank ES funds the most likely effect would be a) a decrease in interest rates. b) a decrease in the price of government bonds. c) a decrease in the demand for money. d) a decrease in investment spending.

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x) Which of the following pairs of economic indicators is the RBA likely to least take account of when deciding on MP?

a) overseas interest rates and motor vehicle registrations. b) consumption spending and housing loan approvals. c) employment and wages growth. d) inflation and the value of the Australian dollar.

7. Read the statement by the RBA governor on the change in MP.

MEDIA RELEASE

Date: 7 April 2009

At its meeting today, the Board decided to lower the cash rate by 25 basis points to 3.0 per cent, effective 8 April 2009.

Recent information from abroad indicates that the contraction in the global economy continued during the first few months of this year, and most assessments of the near-term outlook have been further marked down. Considerable economic policy stimulus is in train in most countries, the full effects of which are not yet discernible, but which should help contain the downturn over the rest of the year. There are tentative signs of stabilisation in several countries, including China, though it is too early yet to judge how durable these will prove to be.

Conditions in global financial markets have continued to improve gradually, helped by progress towards a resolution of banking system difficulties in the United States and other major countries. Sentiment remains fragile, however, and the contraction in economic activity is affecting asset quality of financial institutions.

The Australian economy is contracting, though by less than those of its trading partners. Capacity utilisation has fallen from its peak, and will decline further over the rest of the year. With demand for labour weakening, growth in labour costs will probably also fall. Hence inflation over the medium term is likely to be lower than it has been over the past two years. Demand for credit is weak overall, though credit for owner-occupied housing is picking up.

There has already been a major change in both monetary and fiscal policy in Australia. Market and mortgage rates are at very low levels by historical standards and business loan rates are below recent averages, reducing debt-servicing burdens considerably. Nonetheless, the Board judged that there was scope for a further modest adjustment to the cash rate. The stance of monetary policy, together with the substantial fiscal initiatives, will provide significant support to domestic demand over the period ahead.

a) List the reasons for the fall in the cash rate in dot point form. _____________________________________________________________________________________

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b) What factors may have acted to reduce inflationary pressures in the economy. _____________________________________________________________________________________

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c) “At its meeting today, the Board decided to lower the cash rate by 25 basis points to 3.0 per cent, effective 8 April 2009.” Explain how the RBA will achieve this.

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IN SUMMARY: THE RBA, THE INTERBANK PAYMENTS SYSTEM AND MONETARY POLICY

Money flows back and forth between the RBA and banks.

When MP is tightened: Flows to the RBA from banks as payment for CGS > flows from the RBA to the banks when CGS are repurchased by the RBA. Level of funds in ESAs ↓ (liquidity falls) → r rise.

When MP is loosened: flows to the RBA from banks as payment for CGS < flows from RBA to banks as CGS are repurchased. Level of funds in ESAs ↑ (liquidity rises) → r fall.

ESAs – all banks and some other major financial institutions have these accounts with the RBA which is banker to the banks and lender of last resort. These accounts must have an adequate level of funds so that the banks can conduct their daily interbank payments activities (settling cheques, etc.) Money flows between the banks via their Exchange Settlement Accounts (ESAs) on a daily basis to meet their obligations to each other. Reserve Bank of Australia

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Financial Institution A

Financial Institution B

Financial Institution C

Financial Institution D

Financial Institution E

The RBA sets the overnight cash rate which banks must charge each other if they need to borrow to cover their daily interbank payments. The RBA also uses the ESAs to manipulate the availability of credit in the financial system and therefore influence interest rates throughout the economy. The RBA does this by altering the level of funds in the ESAs through its open market operations (OMO), ie. its buying and selling of short term government securities. These are risk free securities which are issued by the RBA. Banks bid for them daily. When they buy them the money goes to the RBA and is not available for the banks to use in their normal business of lending to the public. When the RBA buys the securities back on the date of maturity, the money goes back into the ESAs. The banks want to maintain a level of funds in their ESAs which meets their daily interbank needs and no more than that because it can be put to better use out in the economy. However they are not allowed to go into overdraft in their ESAs so maintaining the right level of liquidity in their ESAs makes the banks very sensitive to RBA actions. The yield on these securities is set by the RBA and is the same as the overnight cash rate. Changing this rate through OMO (open market operations) is known as Monetary Policy.

7. Microeconomic Reform I Objectives. GOVERNMENT ECONOMIC POLICIES You should be able to: • explain the concept of microeconomic reform policy • explain the concept of productivity • outline common measures of productivity • explain the concept of economic efficiency • discuss examples of microeconomic reform e.g. labour market reform, deregulation

of financial markets, taxation reform, reducing levels of protection • explain the relationship between microeconomic reform and structural change • demonstrate and explain the impact of microeconomic reform on aggregate supply • evaluate current microeconomic reform policy.

Microeconomic Reform Economies undergo change over time. Old industries are transformed or disappear and are replaced by new industries. This is a natural process which is uneven in its speed and in the range and number of industries affected. This historical structural change process can be facilitated through microeconomic reform.

Microeconomic reform refers to policies introduced by government (State and Federal) which aim to improve the operation of individual segments of the economy ie. markets, sectors, industries + firms, both public and private, for the purpose of improving the overall efficiency and performance of the macroeconomy.

Microeconomic reform (MER) improves competition and thus efficiency This results in better resource allocation and more output from existing inputs (increased factor productivity). This lowers unit production costs which makes possible lower consumer prices and improved consumer welfare.

MER improves product and factor market responsiveness to market signals allowing greater economic flexibility. This improves international competitiveness leading to stronger economic growth, lower UE and higher real incomes.

MER is part of a global trend to improve economic performance by: • removing unnecessary regulation and government intervention which inhibit the efficient operation of markets. • achieving improved resource allocation in response to price signals. • encouraging competition which will reduce production costs. The importance of MER is highlighted in the following extract from the Autumn 2000 edition of Economic Roundup (Commonwealth Treasury):

“Increased competition and more dynamic markets have contributed to lifting the medium-term potential growth rate of the Australian economy to around 3.5 to 4 per cent per annum. This means that the rate of growth that the Australian economy can sustain without producing significant inflationary pressures is now above the average rate of growth achieved during the past three decades.” (P35)

Three Types of efficiency are achieved by MER:

a) Technical efficiency: producing output at the least cost combination of resources (achieving the long run minimum average cost of production) through competition → raises productivity of factors of production and lowers unit

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production costs. This is achieved through structural reform at the firm and industry level.

b) Allocative efficiency: resources allocated to their most valued uses - competition in factor + product markets → more efficient resource use. Requires removal of artificial barriers to efficient operation of markets so that resource supply and demand is more responsive to price signals. Examples include removing subsidies, tariffs, quotas, discriminatory taxes such as the former wholesale sales tax, artificial barriers to entry (telecommunications, airlines) which promotes competition and therefore efficiency. Price flexibility improves resource allocation.

c) Dynamic efficiency: this refers to firms adjusting to the changing patterns of consumer demand + technological change → quick response from competitive firms in producing new products + adopting new methods of production. Uncompetitive or less competitive firms get left behind and don’t survive without govt support (subsidies). Govt should ensure a competitive environment exists and provide quality infrastructure and incentives for research and development. Competition → incentives for firms to keep up or get ahead of rivals in the creation of new products and production techniques and restructure work and management practices → productivity ↑.

STUDENT ACTIVITY 17.1STUDENT ACTIVITY 17.1 STUDENT ACTIVITY 7.1

Read the following extract from Economic Roundup, Autumn 2000 and complete the question below.

“The Australian economy is reaping the rewards of a broad agenda of structural reforms. A common goal of many of these reforms is increased competition and improved market dynamism. As a consequence, competition in the Australian economy is now much stronger than it has been at any time in the post-war period. One characteristic of a competitive market is that purchasers can readily choose between a range of sellers to find the best combination of quality and price. In such a market, the most successful sellers are those who best judge market conditions when setting their prices. Those who set excessive prices are forced to pull their prices into line or risk losing business. Competition drives dynamism because the speed of change in offering alternatives to the customer is of fundamental importance. The competitive nature of markets for most goods and services in Australia today means that vigorous, dynamic competition is now the driving force behind market prices. Competitive markets have a range of other benefits. On the supply side, producers wishing to

increase their profitability are forced to focus on alternatives to charging higher prices. For example, they may seek to reduce their costs, find more efficient innovative production methods or pursue new markets. Australian businesses are proving that they can respond to competition by continuously improving their performance in all these ways. Demand side factors have also added to competitive pressures in Australian markets. For example, firms that have improved their marketing techniques have made it easier for consumers to compare quality and price, thus making markets even more competitive. Increased consumer awareness and ‘shopping around’ have played an important part in the transformation of the Australian economy to one characterised by highly competitive markets. This trend will continue as new technologies, such as the internet and e-commerce, make consumers better informed and further reduce the effective distance between consumers and potential suppliers.”

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Identify in your own words, how competitive markets are beneficial. __________________________________________________________________________________

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PRODUCTIVITY

The level of economic growth is determined by the quantity and quality of available resources. More output requires:

a) an increase in the quantity of inputs and/or b) an increase in the quality of inputs (productivity)

The main resources are physical capital (equipment, buildings, infrastructure), human capital (skills and knowledge of the workforce) and technology (new methods, products and the science embedded in capital) Rising living standards can only come from productivity growth. Productivity improvements result from:

• new technology • better methods of using resources (improved management) • training and education • removing regulatory barriers to trade and commerce so markets can operate more efficiently (MER)

Productivity growth means producing the same amount of output with fewer resources or alternatively, producing more output with the same amount of inputs. It may result in job losses in the short term but in the longer term more jobs are created as a result of better resource allocation, innovation and change. Higher productivity lowers production costs which get passed on as lower consumer prices, as higher wages for workers, or higher returns to firms and shareholders (higher profits and/or dividends). Higher wages and lower consumer prices result in higher demand for goods and services generally which results in the creation of new jobs.

MER → productivity ↑→ jobs growth > job losses

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Productivity ↑ → output per unit of input ↑ → unit production cost ↓ →

benefits shared between: • consumers (lower

prices) • workers (higher

wages) • producers (higher

profits)

Factors affecting Productivity • Level of skill and knowledge of workforce. • Willingness to adopt new ideas and methods. • Having an open and competitive economy. • Minimising rules and regulations which restrict the operation of markets

and hinder change. • Size of the market – large markets encourage specialisation and productivity

growth. Trade liberalisation grows markets. • Quality of public and private infrastructure – transport routes,

communications, education, health system, power and water systems. • Capital deepening – this means increasing the quantity and quality of

capital per worker. This requires investment.

Price level

P1 P2

MER increases the productive potential of the economy – Yfe1 shifts to Yfe2. This means more output at lower prices ceteris paribus). In other words real income rises.

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AD

Yfe1 Yfe2

Yfe1 Yfe2

By increasing the potential of the economy, AD can increase along with the output potential of the economy without causing an inflation problem.

Price level

Y/GDP AD1

AS1 AS2

P2 P1

AD2

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Main trends in Australia's productivity performance

Official Australian Bureau of Statistics measures of Australia's productivity performance are available from the mid-1960s. These show that there have been three phases of productivity growth:

• relatively rapid productivity growth in the 1960s through to the mid-1970s, corresponding to the tail end of Australia's rapid development phase after the Second World War;

• very slow productivity growth from the mid-1970s to the end of the 1980s; and • a return to more rapid productivity growth in the 1990s, accelerating to a record underlying rate

from the mid-1990s (labour productivity growth of 3.1 per cent a year and multifactor productivity growth of 1.7 per cent a year from 1993-94 to 1999-00).

Figure 1: Australia's productivity growth (Percentage average annual rate of growth)

Australia's productivity performance compared with other high-income countries was relatively poor over a number of decades, up until the 1990s. However, Australia was only one of a few high-income countries to show an acceleration in productivity growth in the 1990s. (Source: http://www.pc.gov.au/research/productivity/primer/trends)

Multifactor productivity measures reflect output per unit of some combined set of inputs. A change in multifactor productivity reflects the change in output that cannot be accounted for by the change in combined inputs. As a result, multifactor productivity measures reflect the joint effects of many factors including new technologies, economies of scale, managerial skill, and changes in the organization of production.

Whereas labor productivity measures the output per unit of labor input, multifactor productivity looks at a combination of production inputs (or factors): labor, materials, and capital. In theory, it’s a more comprehensive measure than labor productivity, but it’s also more difficult to calculate. (Source: http://en.wikipedia.org/wiki/Multifactor_productivity) A nation's productivity is the volume of goods and services it produces (its output) for a given volume of inputs (such as labour and capital). A nation that achieves productivity growth produces more goods and services from its labour, capital, land, energy and other resources. Much, but not all, of Australia's output growth can be accounted for by increases in the inputs to production. The amount by which output growth exceeds input growth is the productivity improvement. Productivity growth can generate higher income and benefits might also accrue in the form of lower consumer prices. Productivity can be measured in a variety of ways. The most comprehensive Australian measure available at present is multifactor productivity for the market sector. Multifactor productivity represents that part of the growth in output that cannot be explained by growth in labour and capital inputs. Examples of multifactor productivity growth include improved production techniques, better management practices, and organisational change. Technological change, such as increased computing power, is embodied in the asset, and as such is captured in the capital inputs. (Source: ABS 1383.0.55.001)


Explain the importance of productivity to economic growth and living standards. Answer this question in your file.

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http://en.wikipedia.org/wiki/Labor_productivity

PRODUCTION FUNCTION – a model of productivity When inputs are increased, eg more labour and/or capital is employed (I1 to I2), output rises from O1 to O2. When productivity increases given input level I2, output rises further to O3. EXAMPLES OF MICROECONOMIC REFORMS

The following are examples of economic reforms which have been implemented. The goal is to improve competition and create more efficient and dynamic markets. The results have been mixed.

a) Tax reform: In 2000 the tax system saw the replacement of a range of narrowly based, inefficient indirect taxes with a single, uniform, broadly based goods and services tax (the GST). This will achieve greater efficiency in the allocation of resources across the economy by eliminating the discriminatory and distorting effects of multiple taxes at different rates on a narrow range of economic activities. Other changes have improved compliance (getting people to pay the taxes they should pay) which improves the revenue raising capacity of the tax system making reductions to tax rates possible which are good for growth.

b) Tariff reductions: this is the most outstanding example of reform - 1988 Industry Statement by Federal government advocated reducing tariff protection + import quotas. Tariff reduction program began in 1991 → has resulted in a shift of resources out of protected manufacturing industries eg. motor vehicles, clothing, footwear, into new and improved manufacturing industries and the rapidly growing service sector. There was intense debate on tariff reductions between those who receive tariff protection and its critics but there is no doubt consumers have benefited from the increased competition in the form of lower prices and more choice.

Y/GDP

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O2

O1

Inputs eg labour

I1 I2

Production Function 2 MER increases productivity which is reflected in the shift in the PF u

Output increase due to productivity growth pward

Production Function 1

Output increase due to ase in inputs incre

Movement along PFrepresents increasing production using existing skills and technology. Decreasing gradient reflects diminishing returns to inputs.

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c) Competition policy: National Competition Policy is aimed at: i) reducing the anti-competitive conduct of firms. (role of ACCC) ii) reducing regulations which restrict competition without good reason. iii) the reform of public monopolies to expose them to more competition eg Telstra. iv) creating more competition between public and private sectors by removing public sector privilege → lower infrastructure costs.

d) Transport: • coastal shipping & port authority (waterfront) reforms → increased productivity → lower prices. • aviation - deregulated → competition → lower air fares.

e) Telecommunications: Telstra’s monopoly ended in 1997 and since then the number of firms in the industry (licensed carriers and providers of telephone and internet services) has grown greatly. This growth in competition has produced greater efficiency which has lowered costs & prices and increased consumer choice.

f) Financial deregulation: → competition by opening up the market to foreign financial institutions and reducing controls on the operation of banks → greater range of financial services to consumers at lower cost. Reforms have facilitated the flow of financial resources for investment into new and expanding businesses and increased the range of financial services available to consumers.

g) Privatisation and corporatisation of government owned businesses: eg. Commonwealth Bank and Qantas - exposes former public enterprises to competitive forces → more market focussed → efficiency ↑ and lower real prices for consumers. An example is the electricity industry where the generation, transmission and distribution functions of former public monopolies have been divided into separate businesses, some privatised others publicly owned. A National Electricity Market has been established in Queensland, NSW, ACT, Victoria and South Australia to foster inter-state trade and competition in the electricity industry.

h) Labour market reform: significant reforms have been implemented since the late 1980s. Reforms before 1996 included the following measures:

• Award restructuring • Multi-skilling • Productivity-based wage increases • Enterprise bargaining.

VOCAB: Enterprise Bargaining - decentralising the wage determination process to the enterprise level, where employers and employees bargain directly over industrial matters such as wages and conditions of work. The process need not involve a third party. They focus on productivity based wage increases and usually cover large numbers of workers. Workplace Agreements - written agreements between employers and individual employees. They do not involve third parties. They focus on wage increases based on productivity improvements and tradeoffs.

Like all MERs, the purpose of the above reforms was to improve the economy’s efficiency and competitiveness by achieving greater flexibility in the operation of the labour market. This would help to reduce inflationary pressures and thus boost Australia’s international competitiveness. Diagrammatically this effect could be

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illustrated with a shift to the right in the AS function in the AD/AS model illustrating higher output at lower prices. Further reform of the labour market was to be achieved by deregulating and decentralising workplace relations and wage negotiations. This inevitably meant reducing the power and role of the Australian Industrial Relations Commission (AIRC) and trade unions in the process of determining wages and working conditions. This was the objective of the Workplace Relations Act of 1996 (WRA) and the recent Workplace Relations Amendment Act of 2005 (Work Choices). STUDENT ACTIVITY 7.3 1. Write a sentence on each of the following topics:

a) Microeconomic reform:

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b) Competition:

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c) Productivity:

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d) Privatisation:

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e) Financial deregulation:

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2. Explain in your own words the primary goal of industrial relations reforms since 1996. __________________________________________________________________________________

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3. Read the following article and complete the exercise below it by Katharine Murphy

Deregulation raises skill levels Economic reform dating from the mid-80s has created a sea change in Australian workplaces, with deregulation prompting a surge in demand for skilled workers, according to a new study by the Productivity Commission. The study, released today, concludes that microeconomic reform led to increased take-up of new technology in Australia, which in turn created a demand for highly skilled workers across a number of industries. Key reforms creating the demand shift in the Australian labour market include the 1983 decision to float the dollar, tariff reductions, competition and government-sector reform, industrial relations changes and the introduction of government incentives for research and development. Australia’s focus on developing world-competitive exports has also been a factor fuelling the demand for skilled employees, the Productivity Commission finding a positive association between exports and the demand for highly trained personnel. “For the industries where information is available on software assets, it is found that the more computer intensive

an industry, the more likely it is on average to employ high- skilled workers,” the report says. “When trade variables are included, there is a consistent and positive association between exports and skilled workers.” Against the backdrop of anti-globalisation protests at this week’s World Economic Forum, the study also contends that expanding import competition has not resulted in the widespread loss of low-skilled jobs from the economy. It argues that while opponents of globalisation says the trend towards high-skilled workers reflects Australia’s and other industrialised nations’ expanding trade with low-wage countries, new technology is actually playing a pivotal and understated role in shaping the new patterns of demand. “Changing employment patterns are more closely associated with a pull toward skilled workers rather than a push away from lower-skilled workers,” it says. The study also claims that while economic reform has created a growing dispersion in earnings between high-skilled and low-skilled workers, the gap is relatively modest, with the differential rising only 4 per cent between 1986 and 1998.

(Australian Financial Review, 14th Sept 2000) With statements a) to e), state whether you agree or disagree and explain your position. a) Microeconomic reform has resulted in a serious deterioration in income distribution in Australia. __________________________________________________________________________________

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b) Economic reform has resulted in a greater take-up of new technology.

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c) The labour force overall has improved its level of productivity since the mid 1980s.

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d) Structural change in the economy has impacted on the nature of the labour force.

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e) Microeconomic reform has resulted in a massive decline in low-skilled jobs.

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f) In your own words explain the relationship between the labour force, economic reform, technology and skill levels. __________________________________________________________________________________

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4. Read the article provided from the AFR 21-6-00 below and answer the following questions.

We can’t afford reform retreat by Graeme Samuel For all those competition sceptics let me be clear - we must continue to remove barriers to competition if Australians want lower prices, better goods and services, job growth and an improved ability to compete in world markets. On an economy-wide basis, recent IMF and OECD reports have linked Australia’s recent economic strength and resilence - including sustained growth and declining unemployment - with structural reform policies like National Competition Policy. Australia’s annual productivity growth has averaged 2.4 per cent over the last six years, a rate matched only by Norway among the world’s developed nations. Increased competition in specific sectors is bringing clear benefits for consumers and businesses across Australia. For example the introduction of competition into telecommunications has resulted in substantial price falls, with an expansion in the range of new products and services offered and improved consumer access to those services. Reductions in business costs have then flowed on to assist our entire community. However, we are by no means alone. Other countries are getting in on the act, using greater competition to strengthen their economy and improve living standards. Not surprisingly, historically pro-competitive countries such as the United States and United Kingdom have achieved substantial community benefits through reducing market restrictions and regulations. Perhaps more telling is the fact that countries such as the Netherlands, Spain, South Korea and Japan, previously heavily reliant on market regulation, are also increasing their emphasis on competition and market forces.

In the European Union, studies have confirmed gains of 3-7 per cent of GDP as a result of the Single Market Program which enhances competition throughout the EU by establishing the free movement of labour, capital, goods and services. ... While the benefits of increased competition are widespread, governments need to manage change to ensure that a range of labour-market and welfare initiatives minimise any short to medium-term disadvantage to a specific sector or area. In particular, reforms tend to encounter difficulty where the costs are borne by a relatively small, but often vocal, group while the benefits are spread among the greater community. ... If public support for reform is to be maintained, governments need to ensure that the benefits of increased competition are widely enjoyed. The role of the consumer is particularly important in reform implementation. Competition reform ultimately has the consumer as a major beneficiary, through driving down prices, increasing innovation and responsiveness to customer needs. ... Undoubtedly competition policy in Australia is part of a far wider trend by nations towards greater reliance on competition and market forces. Traditionally pro-competition as well as government interventionist nations are deriving significant social and economic benefits from competition reform. Australia cannot afford to ignore international trends nor attempt to ‘turn back the clock’, because of the risk that future benefits for the Australian community will be lost.

a) OECD and IMF reports claim Australia’s economy has improved due to structural reform (MER). What evidence or criteria do they point to?

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b) Australia is not alone in terms of economic reform. Other countries “are getting in on the act” and catching up. What are the implications for Australia?

__________________________________________________________________________________ c) The main problem with structural change is that the burden of the reform process is usually borne by a small, vocal and highly visible group (eg. textile

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workers or dairy farmers) whereas benefits are less visible and dispersed across the whole community. i) What is the usual result of this?

__________________________________________________________________________________ ii) What needs to be done by government to smooth the path of reform?

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5. Read the following article from the Australian Financial Review, 10 November 2005. Identify the main points the author makes to support his view that microeconomic reform is not responsible for a productivity-based rise in economic growth over the past decade and a half.

The surge we didn’t have by John Quiggin One of the during myths of the Australian public-policy debate is the claim that the micro-economic reforms of the 1980s and 1990s have generated a surge of productivity growth. This claim is constantly used as a basis for suggesting that, whatever the problem, the answer is that more reform is needed. Claims of a productivity surge were fi rst generated in 1998, when the Australian Bureau of Statistics published experimental estimates of multifactor productivity (MFP) growth (the term ‘multifactor’ refers to the fact that capital as well as labour inputs are taken into account) showing a stunning productivity growth rate of 2.4 per cent for the period after 1993-94, about double the historical average. Not surprisingly, these estimates were greeted with enthusiasm. Commentators claimed micro-economic reform was transforming Australia into a ‘new economy’. The initial ABS estimates were subsequently revised downward to yield a productivity growth rate of 1.8 per cent for the period 1993-94 to 1998-99, compared to the historical average of 1.2 per cent. This increase could have been explained as a once-off cyclical recovery from the very low productivity growth rates of the preceding years, encompassing the “recession we had to have”. However, such a prosaic explanation was rejected, particularly by the Productivity Commission, which staked its case for micro-economic reform on the new economy thesis. Another possible explanation was that the increase in measured productivity reflected the increase in work pressure and work intensity that was obvious to all in the mid-1990s. This was also dismissed. Although productivity growth slowed from 1998-99 onwards, the decline was explained away as the result of a variety of temporary factors, from drought to the disruptions associated with the introduction of the GST. These would, it was claimed, work themselves out over the course of the

productivity cycle. The latest national accounts, … should settle the question once and for all. ABS now identifies the period from 1998-99 to 2003-04 as a complete productivity cycle and reports: “During the most recent MFP growth cycle (1998-99 to 2003-04), MFP grew annually, on average, by 1.0 per cent – slightly lower than the long-term average between 1964-65 to 2003-04 of 1.2 per cent.” The acceleration of productivity growth in the mid-1990s was not sustained. The results for 2004-05 are even worse. Productivity actually declined 1.7 percentage points. … The low point for productivity growth was the period from 1984-85 to 1993-94, when micro-economic reform was well under way, and when substantial benefits were already being claimed. … If productivity growth generated by micro-economic reform does not explain the generally strong performance of the economy over the past decade, what does explain it? Thanks to a combination of good luck and good management Australia has not suffered a recession since 1991 (unlike New Zealand, where monetary policy was bungled at the time of the Asian crisis). … In the past couple of years, another factor has come into play. Thanks to strong demand from China for mineral exports, our terms of trade have improved dramatically to levels unparalleled since the commodity boom of the early 1970s. As a result, the value of output per worker has improved much more than physical productivity. This favourable shock may or may not persist, but either way it has nothing to do with micro-economic reform. Particular instances of micro-economic reform should be assessed on their merits. The claim that micro-economic reform is a primary source of growth has been tested empirically, and shown to be false.

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LABOUR MARKET REFORM CONTINUED - THE WORKPLACE RELATIONS ACT OF 1996 This act was passed in the federal parliament at the end of 1996. Its purpose was to breathe new life into labour market reform by accelerating the decentralisation process. It aimed to increase labour market responsiveness to structural and cyclical changes in the economy which have been imposed on Australia by the reduction of protection and the globalisation of the economy. The focus is on removing restrictive workplace practices and boosting productivity.

Under the WRA, employers and employees can strike individual agreements or non-union collective agreements even in workplaces where employees are union members. Under the new act, collective agreements must be approved by a “valid majority” of employees. It aims to achieve this by nurturing a labour market which is governed by negotiation at the enterprise level, not centrally in the AIRC and which is not constrained by detailed and comprehensive award regulations. Wage settlements will more commonly occur at the enterprise level and take account of productivity. The belief is that this will encourage a more efficient allocation of resources across the economy in the longer term and result in a more competitive economy.

Some of its main features include:

• It retains Awards but simplifies them by stripping them back to 20 core conditions or “allowable matters”.

• It introduced Australian Workplace Agreements (AWAs) as an alternative to enterprise agreements. The act allows individual workplace agreements (AWAs) to be negotiated between employers and employees but they have to meet a “no disadvantage” test. This means a worker who enters into a workplace agreement must not be worse off than he/she would be under the Award covering their particular job.

• The task of overseeing AWAs is the job of the Employment Advocate, a new institution in the industrial relations landscape.

• The role of the AIRC is restricted to certifying agreements and administering the award system.

• Tough new sanctions have been introduced under the Act to combat industrial action by unions. Unfair dismissal laws have been changed to make it less difficult for employers to dismiss unsuitable and undesirable workers.

• Unions have lost their monopoly as the workers’ representative in negotiations with employers over wages and conditions. The Act encourages direct agreement-making between employers and employees and locks into place the shift to workplace bargaining which began in the last years of the Accord. Australia’s labour market has become more flexible. Demographic and social changes are contributing to the already powerful structural and industrial changes that are forcing microeconomic reform on the economy. The composition of the workforce has changed with female participation being the most significant change over the past two decades. The shift towards more part-time and casual work is another factor which is being driven by the growth and deregulation of the services sector. Over this period since the late 1980s, the power of unions has declined as

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has their membership. Skilled workers who are able to take advantage of new technology and are more adaptable to new work arrangements, are more highly paid. Unemployment is overwhelmingly an affliction of those with the lowest levels of educational achievement. This supply side reform has seen the devolution of wage setting to the enterprise level as a major goal, the central purpose of this reform being the more flexible use of labour at the enterprise level and an emphasis on productivity growth. Other programs seek to improve the quality of the labour force through changes to the apprenticeship system, the introduction of the ‘work for the dole’ scheme and improving vocational education in secondary schools which will reduce mismatches between supply and demand in the labour market. In short these policies → quality of labour ↑→ fewer shortages of skilled labour → rate of labour cost growth ↓→ rate of inflation slows. However more needs to be done to educate and train the workforce to the level demanded of a modern economy at the beginning of the 21st century. Australia needs to match its major competitors in terms of its commitment of resources to education, training, innovation and research. So in summary the WRA divides workers into three categories: Those dependent on

a) Awards: workers who are the least skilled and in the weakest bargaining position and are unable to negotiate an enterprise agreement. Wage increases tend to be lower and dependent on the ACTU negotiating ‘living wage’ increases in the AIRC on the workers’ behalf. The proportion of the workforce covered by awards has declined from over 70% before reforms began in the early 1980s to around 20% in recent times.

b) Certified Agreements (Enterprise Agreements): these are collective agreements which workers enter into after the enterprise bargaining process with employers has concluded. Workers are usually represented by a union in their negotiations at the enterprise or industry level.

c) AWAs: for workers who negotiate on an individual basis without trade union involvement. AWAs can be negotiated collectively like enterprise agreements but must be signed individually. They can cover any matters which the bargaining parties wish to include. THE WORK CHOICES LEGISLATION 2006 The Work Choices legislation builds on the WRA of 1996. The legislators regard the existing industrial relations (IR) system as being too complex, despite all the reforms too date. They believe the new laws will make the system simpler and more accessible and effective. It is believed that continuing the decentralisation of the IR system will produce a more flexible labour market. Some of the main changes Work Choices will implement are (according to government):

• it will establish the Australian Fair Pay Commission to protect minimum and award wages – this will further simplify awards by reducing the number of allowable matters and take over the role of the AIRC in determining wage increases for workers on awards. This takes the process of wage determination for the lowest paid out of the adversarial environment of a court setting and puts it into the

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hands of the Fair Pay Commissioner who will make decisions on the basis of economic circumstances and research;

• it will simplify the agreement making process at the workplace – a more streamlined bargaining process;

• it will ensure an ongoing role, for the Australian Industrial Relations Commission – one confined to dispute resolution;

• it will ‘better balance’ the unfair dismissal laws – exempt from current laws, businesses with up to 100 employees; and

• it will introduce a national system of workplace relations – ultimately the government hopes it will cover up to 85% of Australian workers and replace the state systems and reduce expensive duplication in the area of industrial relations. The government claims the reforms will:

• not cut minimum and award classification wages • not abolish awards • not remove the right to join a union • not take away the right to strike • not outlaw union agreements • not abolish the AIRC.

The new government elected at the end of 2007 has introduced new labour market legislation which will abolish Work Choices and replace it with Fair Work Australia legislation. This will abolish AWAs and apply unfair dismissal laws to all businesses. It will enhance the role of unions in the negotiation process between employees and employers.

FEDERAL BUDGET 2010‐11

Government Revenue 2010‐2011

Government Expenditure 2010‐2011

Detailed economic forecasts for 2010-11 and 2011-12

Historical budget and net financial worth data

Inflation

Inflation is the sustained rise in the general level of prices in the economy. When prices go up consumers can’t purchase the same quantity of goods and services they could before prices went up with the same amount of money. Neither can producers purchase the same quantities of resources used in the production process so the cost of making goods and services increases. Purchasing power declines so people find themselves worse off.

Suppose a consumer has $100 to spend on goods and services and after a period of time prices rise by 10%. The consumer will need $110 to buy the same goods and services at the end of the period due to inflation. With $100 he/she will only be able to buy 100/110 or 91% of the goods and services they could buy before prices went up by 10%. The consumer’s real income has fallen. The higher the inflation rate the more serious the problem is. The only way to keep pace with inflation is for income (for both workers and firms) to rise by the same rate as inflation and thus maintain real income. However this is difficult to achieve for all workers and firms. This is one of the major reasons why governments are concerned with inflation.

It is the job of the Australian Bureau of Statistics to keep track of inflation. The ABS collects data on price changes on a large selection of goods and services which the average Australian family purchases. It measures the changes in the prices of these products over time with a mathematical tool called the Consumer Price Index (CPI). It releases the CPI every 3 months. The CPI is a very important piece of statistical information because it influences the behaviour of consumers and producers.

The CPI collection of goods and services which the ABS collects price data on covers the following categories: Food Household furnishings supplies & services Recreation Communication Clothing & footwear Transportation Education Miscellaneous Housing Tobacco and alcohol Health

Prices are collected from many sources: supermarkets, department stores, shoe shops, car dealers, service stations, hotels, schools, hairdressers, newsagents, travel agents, government departments and so on. Something like 100,000 prices are collected each quarter. The most volatile are collected monthly for example milk, fresh fruit and vegetables, meat, bread, alcohol, petrol, holiday travel and accommodation. For most other items, prices are not so volatile and are collected quarterly.

To calculate the CPI you need to know the dollar value of the basket goods and services of the base or reference year and the year being calculated. For example, if the total cost of the CPI basket for the base year (year 1) is $1500 and for year 2 it is $1575, then the CPI is calculated as follows:

$ value of basket in a year 2 x 100 $ value of basket in the base year CPI year 2 = $1575 x 100 $1500 = 105 If the cost of the basket rises to $1600 in year 3 then the CPI for year 3 is: CPI year 3 = $1600 x 100 $1500 = 106.7

The CPI can be used to calculate the inflation rate for a particular year. For example, what is the inflation rate for year 3 above? This is calculated using the following formula. Calculating the inflation rate for year 3 = CPI for year 3 - CPI for year 2 x 100 CPI for year 2 Year 3 inflation rate = 106.7 - 105 x 100 105 = 1.6% The inflation rate is the percentage change in the CPI from one year to the next. Student Activities Use the table below to answer the questions which follow.

Consumer Price Index for June each year (base year 1989-90 = 100)

1996-97 1997-98 1998-99 1999-00 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09

120.3 120.3 121.8 124.7 132.2 136.0 140.2 143.5 147.0 151.9 157.5 164.6 167.0

eg. what was the inflation rate in 1998 – 99? 121.8 - 120.3 x 100 = 1.25% 120.3

(ABS: Australian Economic Indicators 1350.0) 1. Calculate the inflation rate to two decimal places for each year:

a) 1999-00 ____________________ b) 2000-01 ____________________ c) 2001-02 ____________________ d) 2002-03 ____________________ e) 2003-04 ____________________ f) 2004 - 05 ____________________ g) 2005 - 06 ____________________ h) 2006-07 ____________________ i) 2007-08 ____________________ j) 2008-09 ____________________

2. Which year in the table had the highest inflation rate? ________ and the lowest rate? ________ 3. If the total cost of a basket of goods and services is $2623 in the reference year, calculate the CPI to one decimal place for the following years:

a) if the total cost of the basket of goods and services rises to $2695? ____________ b) if the total cost of the basket of goods and services rises to $2948? ____________ c) if the total cost of the basket of goods and services rises to $3119? ____________

4. Discuss the following topics with a partner and write your answers briefly in the spaces provided.

a) Workers naturally want to maintain real incomes. How do they do this? What problems can this lead to?

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b) Inflation pushes up the prices of inputs into the production process increasing costs to producers. How might they respond to inflation and what problems might this cause?

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c) Imported goods from countries with a lower level of inflation will be relatively cheaper than locally made goods. How will this effect local producers and how might they respond to the increased competition from overseas products?

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d) How might the CPI affect the behaviour of consumers and producers? Think about how you would react if you expected inflation to rise in the future and your wage (if you were a worker) or profits (if you were a business person) were to decline making it difficult for you to “make ends meet”. What would you do?

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THE KEYNESIAN MODEL OF INCOME AND EXPENDITURE ANALYSIS

Autonomous (a) consumption or survival spending (spending on needs or non‐discretionary goods and services).

C (total spending by HH in the 2 sector CFM) Line of potential equilibrium points where C=O=Y

C=O=Y (equilibrium)

C

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Y (total income to HH in the 2 sector CFM)

a

AD or AE (includes all forms of expenditure)

Y or GDP

Equilibrium points where O=Y

Equilibrium shifts with the addition of each injection increasing economic growth

Y Y1 Y2 Y3

C C+I

C+I+G

C+I+G+Xn

When we add the other sectors to the model we have C plus all the injections (I, G and Xn)

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PRODUCTION FUNCTION – a model of productivity

When inputs are increased, eg more labour and/or capital is employed (I1 to I2), output rises from O1

to O2. When productivity increases, given input level I2, output rises further to O3.

A nation's productivity is the volume of goods and services it produces (its output) for a given volume of inputs (such as labour and capital). A nation that achieves productivity growth produces more goods and services from its labour, capital, land, energy and other resources. Much, but not all, of Australia's output growth can be accounted for by increases in the inputs to production. The amount by which output growth exceeds input growth is the productivity improvement. Productivity growth can generate higher income and benefits might also accrue in the form of lower consumer prices. Productivity can be measured in a variety of ways. The most comprehensive Australian measure available at present is multifactor productivity for the market sector. Multifactor productivity represents that part of the growth in output that cannot be explained by growth in labour and capital inputs. Examples of multifactor productivity growth include improved production techniques, better management practices, and organisational change. Technological change, such as increased computing power, is embodied in the asset, and as such is captured in the capital inputs.

Source: ABS 1383.0.55.001

Output

O3

O2

O1

Inputs eg labour

I1 I2

Production Function 2 after productivity growth

Production Function 1 before productivity growth

Output increase due to productivity growth

Output increase due to increase in inputs

THE ROLE OF INVENTORIES

The Production‐Distribution Chain (or the Supply chain)

Stage 1 Production

Goods are produced in factories using capital and labour. Finished goods are stored in warehouses until they are sent out to customers. While they are stored they are called inventories.

Stage 2 Wholesaling

Goods are purchased from the producers by firms which sell to businesses which sell to consumers. The wholesale stage is where large quantities of goods are ordered and stored in large warehouses before being sent out to shops and department stores where consumers see them and buy them. While goods are waiting to be transported to shops they are in storage and are called inventories.

Stage 3 Retailing

Goods are sent out to small and large shops where consumers buy them. Goods arrive at the retailers where some are put into the showrooms and shop fronts were consumers can inspect them and the rest are kept in storage out the back of the shop or somewhere relatively nearby until they are needed to replace the goods in the showroom when they are sold. While in storage they are also considered inventories.

So at every stage in the production and distribution chain, there are inventories. When consumers increase their spending and buy more goods, retailers shift more out of storage into their shop fronts for sale. They need to order more to replace their reduced inventories.

Wholesalers receive more orders from retailers so they immediately shift more of their stock out of storage to the retailers. They in turn will need to restock so send their orders through to producers. Producers will increase their supply of goods to wholesalers and in turn will need to increase production to build up their inventories so they are ready to meet further increases in demand from their customers. As production increases, the demand for resources will increase. More employment will occur and incomes will rise making possible further household spending. More consumption will put further pressure on stocks and production will accelerate. Pressure in product and factor markets will cause prices to rise. As incomes rise, leakages will increase too eventually helping to slow the pace of growth as the economy moves to a new higher equilibrium level of national income.

3 b revision notes

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