eco120de- saturday session 1 0640

8/2/2019 Eco120DE- Saturday Session 1 0640

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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.

eco120de- saturday session 1 0640

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