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ECO 120- Macroeconomics
Weekend School #18th April 2006
Lecturer: Rod DuncanPrevious version of notes: PK Basu
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Topics for discussion
Module 1- basic macroeconomic concepts Income determination, basic macroeconomic
theory, investment decision
Module 2- the money market The Australian financial system, the role of
money, the market for money
What will not be discussed Answers to Assignment #1 (use the CSUforum for this)
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Forms of economics
Microeconomics- thestudy of individualdecision-making
Should I go to collegeor find a job?
Should I rob thisbank?
Why are there somany brands ofmargarine?
Macroeconomics- thestudy of the behaviourof large-scale
economic variables What determines
output in aneconomy?
What happens whenthe interest raterises?
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Economics as story-telling
In a story, we have X happens, then Yhappens, then Z happens.
In an economic story or model, we have Xhappens which causes Y to happen whichcauses Z to happen.
There is still a sequence and a flow ofevents, but the causation is stricter in theeconomic story-telling.
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Kobe, the naughty dog
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Modelling Kobe
Kobe likes to unmake the bed.
Kobe likes treats.
We assume that more treats will lead tofewer unmade beds.
(Not a very good) Model:
Treats Unmaking the bed We can use this model to explain the past
or to predict the future.
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Elements of a good story
All stories have three parts
1. Beginning- description of how things areinitially- the initial equilibrium.
2. Middle- we have a shock to the system, andwe have some process to get us to a newequilibrium.
3. End- description of how things are at thenew final equilibrium- the story stops.
Equilibrium- a system at rest.
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Timeframes in economics
In economics we also talk in terms of threetimeframes:
short run- the period just after a shock has occurred
where a temporary equilibrium holds. medium run- the period during which some process
is pushing the economy to a new long run equilibrium.
long run- the economy is now in a permanent
equilibrium and stays there until a new shock occurs. You have to have a solid understanding of the
equilibrium and the dynamic process of a model.
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What are the big questions?
What drives people to study macroeconomics?They want solutions to problems such as:
Can we avoid fluctuations in the economy?
Why do we have inflation? Can we lower the unemployment rate?
How can we manage interest rates?
Is the foreign trade deficit a problem?
[How can we make the economy grow faster?] Nottaken up in this class. This class focuses on short-runproblems.
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Economic output
Gross domestic product- The total marketvalue of all final goods and servicesproduced in a period (usually the year).
Market value- so we use the prices inmarkets to value things
Final- we only value goods in their final form
(so we dont count sales of milk to cheese-makers)
Goods and services- both count as output
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Nominal versus real GDP
We use prices to value output incalculating GDP, but prices change all thetime. And over time, the average level of
prices generally has risen (inflation). Nominal GDP: value of output at current
prices
Real GDP: value of output at some fixed setof prices
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Nominal versus real GDP
So how to correct for rising prices overtime?
Measure average prices over time (GDP
deflator, Consumer Price Index, ProducerPrice Index, etc)
Deflate nominal GDP by the average level of
prices to find real GDP
Real GDP = Nominal GDP / GDP Deflator
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Some Australian economic historyAustralian GDP 1950-1995
0
100 000
200 000
300 000
400 000
500 000
600 000
1950 1960 1970 1980 1990 2000
MillionA$
GDP
GDP Change
Real GDP
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Business cycle
The economy goes through fluctuations overtime. This movement over time is called thebusiness cycle.
Recession: The time over which the economy isshrinking or growing slower than trend
Recovery: The time over which the economy isgrowing more quickly than trend
Peak: A temporary maximum in economic activity Trough: A temporary minimum in economic activity.
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Australian business cycle
Aust Business Cycle
-4
-2
0
2
4
6
8
10
1950 1960 1970 1980 1990 2000
% Ch RGDP
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Unemployment
To be officially counted as unemployed,you must:
Not currently have a job; and
Be actively looking for a job
Labour force- the number of peopleemployed plus those unemployed
Unemployment rate
(Number of unemployed)/(Labour force)
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Unemployment
Working agepopulation = Labourforce + Not in labour
force Labour force =
Employed +Unemployed
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Unemployment
Unemployment over the Business Cycle
-4
-2
0
2
4
6
8
10
12
1965 1968 1971 1974 1977 1980 1983 1986 1989 1992 1995
Percent(%)
Unemployment
Change in GDP
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Inflation
Inflation is the rate of growth of theaverage price level over time.
But how do we arrive at an average price
level? The Consumer Price Index surveys
consumers and derives an average level ofprices based on the importance of goods for
consumers, ie. a change in the price ofhousing matters a lot, but a change in theprice of Tim Tams does not.
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Consumer Price Index
Then the CPI expresses average priceseach year relative to a reference year,which is a CPI of 100.
CPIt = (Average prices in year t)/(Averageprices in reference year) x 100
Inflation can then be measured as the
growth in CPI from the year before: Inflationt = (CPIt CPIt-1) / CPIt-1
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Inflation
Consumer Price Inflation
-2.0
0.0
2.04.0
6.0
8.0
10.0
12.014.0
16.0
18.0
20.0
Sep-70
Sep-72
Sep-74
Sep-76
Sep-78
Sep-80
Sep-82
Sep-84
Sep-86
Sep-88
Sep-90
Sep-92
Sep-94
Sep-96
Sep-98
Sep-00
Sep-02
Sep-04
Inflation
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Expenditure approach
GDP is calculated as the sum of:
Consumption expenditure by households (C)
Investment expenditures by businesses (I)
Government purchases of goods and services(G)
Net spending on exports (Exports Imports)
(NX)Aggregate Expenditure: AE = C + I + G + NX
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Consumption and savings
We assume consumption (C) depends onhouseholds disposable income: Disposable income YD = (Income Taxes)
The consumption function shows how Cchanges as YD changes.
Household savings (S) is the remainder of
disposable income after consumption. The savings function shows how S
changes as YD changes.
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Consumption function
Consumption is a function of YD or C =C(YD). We assume that this relationshiptakes a linear (straight-line) form
C = a + b YDwhere a is C when YD is zero and b is theproportion of each new dollar of YD that is
consumed. We assume that C is increasing in YD, so0 < b < 1.
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Savings function
Household savings is a function of YD or S =S(YD). We assume
S = c + d YD
where c is S when YD is zero and d is theproportion of each new dollar of YD that is saved.
We assume that S is increasing in YD, so 0 < d 0. If I put $1 in the bank today, it will grow to
be $(1+ i)1 in one years time, will grow to be$(1+i)(1+i)1 = $(1+i)2in two years time and will growto $(1+i)nin n years time.
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How much is a future $1?
In order to have $1 next year, we would have toput x in today:
$1 = (1+ i) $x
x = 1/(1+i) $1 next year is worth 1/(1 + i) today. Since i>0,$1 next year is worth less than $1 today.
In order to have $1 in n years time, we would
have to put x in today:x = 1/(1+i)n
$1 in n years time is worth 1/(1+i)n < 1 today.
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Net present value
NPV = R1/(1+i) + R2/(1+ i)2+ + Rn/(1+ i)n I If NPV >=0, then go ahead and make the
investment. If NPV < 0, then the investment isnot worthwhile.
As i rises, the PV of future profits will drop, sothe NPV will fall. If we imagine that there arethousands of potential investments to be made,as i rises, fewer of these potential investmentswill be profitable, and so investment will fall.
We expect then that I falls as i rises.
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Investment
If we graphed the investment demand forgoods and services (I), it would bedownward-sloping in i.
What can shift the I curve? Factors thataffect current and expected futureprofitability of projects: New technology
Business expectations
Business taxes and regulation
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Money
Money has three main functions in theeconomy.
1. Money is a medium of exchange. We use exchangemoney when we buy/sell to each other.
2. Money is a unit of account. Money is an agreedmeasure for stating the value of other goods andservices.
3. Money is a store of value. Money can be kept underthe bed or inside a jar and used to exchange forgoods and services in the future.
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Official measures of money
M1 is the amount of notes and coins(currency) in circulation plus currentdeposits with banks.
M3 is M1 plus all other bank deposits. Credit cards are not counted as money,
since using a credit card is accumulatingdebt, whereas deposits at a bank can beturned into money without accumulatingdebt.
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Money multiplier
What happens when you take $1 cash to a bank todeposit it?(1) You deposit the cash in the bank, and the bank creates an
account for you with $1 in it.Money = $1
(2) The bank doesnt keep the cash. Instead the bank has to keepR, called the reserve ratio (0 < R < 1), of the $1 as reservesand then loans out $(1 - R).
(3) The person who receives the loan of $(1-R) spends the cash,
and the merchant who receives the $(1-R) puts that in his bank.This increases the merchants account by $(1-R).Money = $1 + $(1-R)
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Money multiplier
(4) The second bank keeps $R(1-R) as reserves and loans out$(1-R)(1-R) = $(1-R)2 as new loans.
Money = $1 + $(1-R) + $(1-R) 2+
If this process continues, the value of money
created is 1/R = 1 + (1-R) + (1-R)2
+ ... So for every $1 floating in the economy in
currency, we have $1/R in currency plusdeposits in the economy. This ratio m = 1/R is
called the simple money multiplier. For every$1 in currency that the government prints, themoney supply increases by m.
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Equilibrium in the money market
Equilibrium in the money market means supplyof money equals demand for money.
Supply of money
The supply of money depends on the level ofcurrency in the economy and the money multiplier.The supply of money does not depend on the interestrate.
Demand for money People require money to make purchases, ie. How
much currency is in your pocket?
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Demand for money
The higher is income and prices, the greater the amountof money required to make the purchases people willwish to make.
But a $1 in your pocket is a $1 not in the bank. In the
bank, that $1 would be accumulating interest, but in yourpocket, it accumulates no interest. So the interest rate isthe price of holding money as currency rather than as adeposit in the bank. So we would expect that as theinterest rate rises, people will lower the level of currency
that they hold. The demand for money is downward-sloping in the
interest rate, i, and increases in income and prices.
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Equilibrium in the money market
The supply of moneydoes not depend onthe interest rate, so it
is vertical. The interest rate is
the price of holdingwealth as currency,
so money demandfalls as i rises.
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Monetary policy
The government can control the supply ofmoney and thus the interest rate. These actionsare called monetary policy.
Open market operations are a means of the
government controlling the supply of money.The government (in our case the Reserve Bankof Australia or RBA) buys and sells governmentsecurities, such as government bonds to controlthe amount of money in the economy.
If the RBA buys a bond with currency, the RBAincreases the money supply (by the change incurrency times the money multiplier).
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Monetary policy
If the RBA sells bondsfor currency, itdecreases the supply
of money. Monetary policy shifts
the money supplycurve and so changes
the equilibriuminterest rate.
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Resources
There are many resources available to you.Often students hurt themselves by not takingadvantage of the resources they have.
Books: There are plenty of macroeconomics
principles books. If you dont understandJackson and McIvers coverage, get to a libraryand read a different textbook. There is also astudy guide by Bredon and Curnow referencedin the subject outline.
Online: There is an enormous amount ofmaterial on the Web. Just use a search engineand look around.
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Resources
Forum: Get into a habit of reading the CSUforums once a week. Post questions on theforum and join in the discussion.
Official websites: Have a look at the websites forgovernment agencies like the Reserve Bank ofAustralia or the Australian Bureau of Statistics.
CSU help: Student Services at CSU has a lot of
help it can provide students with problems- lookat http://www.csu.edu.au/division/studserv/.
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Tips for preparing for the exam
Practice. Do the problems in the back of thebook chapters. Do the problems on the bookswebsite. Do the problems in the study guide.
Read the question. Read carefully. Answer the question. Dont answer the
question you think was asked. Answer thequestion that actually was asked. Most exam
errors happen here. Remember to read thequestion.
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Tips for preparing for the exam
Be sure to answer all of the question. Dont put down too much. Dont provide a
whole background of a model unless thequestion asks for it. If the question asks you toanalyse a scenario, go straight into thescenario.
Dont put down too little. In an essayquestion, provide your reasoning and analysis.Draw a relevant graph and talk about thegraph. Dont just say Yes.
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Final exam tip
Dont panic! Relax and breath. You donot need to write for 3 hours to do well inan economics exam. Often a well-ordered
sentence is worth more than 2 pages ofsemi-coherent babbling. Stop and thinkabout your answer.