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ECON1102 NOTES-MACROECONOMICS

MEASURING MACROECONOMIC PERFORMANCE: OUTPUT AND PRICES

EVALUATING MACROECONOMIC PERFORMANCE (measures of economy)


1. RISING LIVING STANDARDS
Economic Growth
Tendency for output level(quantity and quality of goods and services) to
increase over time
OUTPUT/POPULATION=Output per capita
Trend rise in per-capita output over a period of time=economic growth

2. STABLE BUSINESS CYCLE


Low volatility in fluctuations of actual output around its trend/potential output
(Observe minor fluctuations)

3. RELATIVELY STABLE PRICE LEVEL


Low (positive) rate of inflation
Most developed countries are concerned about inflation

4. SUSTAINABLE LEVELS OF PUBLIC AND NATIONAL DEBT


2 types of debt:
1. Public debt-public sector borrow money from private sector (government budget
deficits/surpluses e.g. taxes, borrowing from abroad)
2. Foreign debt-domestic resident borrow money from foreign countries e.g. borrowing
from international market (account deficit/surplus)

5. BALANCE BETWEEN CURRENT AND FUTURE CONSUMPTION


Individuals-consumption rate
Aggregate economy-economy save/invest?

6. FULL EMPLOYMENT
Labour market-are individuals able to find a job?

STANDARD DESURED OUTCOMES FOR MACRO VARIABLES


High& stable growth rate of real per-capita output
Stable and low (but positive) rate of inflation
Low unemployment rate
Sustainable level of public/external debt (good to borrow from abroad as long as you
can pay debt back)
Balance between current and future consumption

GROSS DOMESTIC PRODUCT (GDP)


Market value of final goods and services produced during a given period
(Measure of countrys output)
Flow variable-measured over period of time
GDP IS A FLOW VARIABLE
Calendar Year March-December
Financial Year September-June
Excludes goods and services produced in other countries (imports)
Excludes goods and services produced in earlier period, but resold in current period
(Second hand goods)

GDP excludes intermediate goods and services. They are used in the production process e.g.
raw materials
Value Added=Sales-Cost of intermediate inputs

3 Equivalent Ways to Measure GDP


1. Production Method (value added approach)
The Production Method uses the values added approach which takes into account that for
any firm, the market value of its product or service minus the cost of inputs. By summing
the value added by all firms `(including producers of both intermediate and final goods and
services) gives the same answer as simply adding together the value of final goods and
services (GDP).

2. Expenditure Method
Expenditure on goods and services=value of production
Main Components of Expenditure
Consumption-purchases by Households (C)
Investment-purchases by Firms (I)
Government purchases (G)
Net Exports-net purchases by foreign sector (exports minus imports) (NX)

National Incomme Accounting Identity: GDP=Expenditure


Y=C+I+G+NX
The Expenditure method relies on the idea that all the final goods and services that are
produced in a country in a given year will be purchased by members of one or more of the
four groups (households, firms, governments and foreign sector). The amounts amounts
that purchasers spend on various goods and services should be equal to the market values
of those goods and services.

3. Income Method
GDP=Labour Income+ Capital Income in the production of goods and services
The Income Method is whenever a good or service is produced or sold, the revenue from
the sale is distributed to the workers and the owners of the capital involved in the
production of the good or service

NOMINALGDP VS. REAL GDP


Nominal: values quantities of goods and services produced at their CURRENT year prices
Real (constant price or chain volume measure): values quantities of goods and services
produced at BASE year prices-measures actual physical volume
NOTE: Choice of base yearinitial price=Laspeyres index, final price=Paasche index

Chain-weighted measure of real GDP


1. Take average of two growth rates and this is the chain-weighted growth rate
2. Pick either year as base year

IS GDP A GOOD MEASURE OF ECONOMIC WELLBEING?


GDP omits
Leisure time (extra holiday)
Household production (cook at home)
Environmental Degradation
Quality of Life (happiness)
Economic Inequality (distribution of income)
Surveys and Indexes can be alternatives to GDP

MEASURES OF PRICE LEVEL


GDP Deflator or Price Index
Consumer Price Index

Nominal GDP=price level x real GDP

CONSUMER PRICE INDEX


CPI-Cost of a given basket of goods and services relative to their cost in a fixed year(base
year) for a given period

INFLATION
Percentage change in CPI over given period
COSTS OF INFLATION
Shoe-leather cost: inflation reduces the purchasing power
Menu costs-real costs of changing prices
Distorts tax system
Unexpected re-distribution of wealth
Nominal Interest Rates-percentage increase in nominal(dollar) value of financial asset
Real Interest Rate-percentage increase in real purchasing power of financial asset

SAVING AND WEALTH


Saving= current income-current spending
Net wealth= value of assets- value of liabilities

Facts about Saving


1. Saving is a flow variable
If saving is positive then assets are being accumulated
If saving is negative then assets are being de-cumulated or liabilities accumulated
2. Saving rate = Saving/Income

Changes in Wealth and Saving


2 things can change Net Wealth:
Saving
Capital gains/losses

Capital Gains and losses


Fluctuations in the market value of assets

Why do households save? (3 standard motives)


1. Life-cycle Saving (meet long term goals)
2. Precautionary Saving
Saving can be used as a form of insurance against unexpected declines in
income or unexpected increases in consumption
Temporary unemployment
Medical expenses
3. Bequest Saving
People save to leave inheritance for their heirs and dependents

Saving and the Real Interest Rate


Saving=income minus consumption

Real interest rate=relative price of consuming today versus consuming in the future
(Higher real interest rate makes current consumption relatively more expensivereduce current
consumptionincrease in saving)
Standard economics predicts
individuals/households choose a
level of saving that maximises their
current and future welfare

Individuals under-save relative to


optimal level because of lack of will
power

Factors that might act to reduce saving


Availability of consumer credit e.g.
spending unnecessarily
Compulsory superannuation saving Demonstration effects (relative
Compulsory saving schemes will only increase total consumptionpeople around us
saving if individuals do not reduce their voluntary affecting us)
saving by an equal amount

National Saving
In an economy saving is undertaken by:
Households
Business
Government
National saving is a measure of aggregate saving in an economy

Y= C + I + G + NX
Assume X=0 (closed economy), then Y= C + I + G

Since Saving= Current Income minus Current Spending

S=Y-C-G (National Saving)


Exclude I because spending focuses on current needs and it is assumed that all
government spending is on current consumption and not public investment
Since closed economy: Savings=Investments
Y=C+I+G
Y-C-G=I=S

Private and Public Components of Savings


Decompose National Saving into:
PRIVATE SAVING
Households & Business

PUBLIC SAVING
Government
Investment and capital formation
National saving provides resources for investment
Investment is the purchase of new capital goods
Influences on the level of investment

3 components to Cost of Capital


1. Borrow funds at nominal interest rate= i, cost of new plane = Pk
2. Physical depreciation rate=
3. Over time the price may rise or fall (capital gain on capital loss)= PK
Cost of capital= price of capital (begin year) + interest cost price of (depreciated) capital (end
year)

2 influences on investment decision:


Price of capital goods
Real interest rate
The change in output for an increase in capital is called
marginal product of capital

Will invest if:


Value of marginal product of capital > cost of capital

Saving, Investment and Financial Markets


In an economy with no access to international capital markets: National Saving= Investment

Saving is an increasing function of the real interest rate


Investment is a decreasing function of the real interest rate

Crowding Out
Increase in government budget deficit will educe private investment spending
UNEMPLOYMENT AND THE LABOUR MARKET
DEMAND FOR LABOUR
MARGINAL PRODUCT OF LABOUR
A firm combines workers with a given amount of capital (machines and buildings) to produce
computers
As the firm employs more labour its output rises
Marginal product of labouradditional output generated by each additional worker
Diminishing Marginal Product
-The Nature of the production technology is such that each additional worker produces less
output than the existing workers

FIRMS DEMAND FOR LABOUR


Compare benefit of an additional worker (Value of Marginal Product= Px MPL)
Cost to the firm of employing an additional worker (Wage=W)

COMPETITIVE MARKETS
Assume that firm operates in a competitive market
It cannot set the wage it pays workers
It cannot set the price it receives for its product
Willing to employ labour until P x MPL= W (Value of MPL= Wage)
Or
MPL= W/P (Marginal Product of labour =real wage)
Since the MPL decreases as the firm employs more
workers, it must be the case that the real wage also has to
fall

Firms demand for labour is a decreasing function of the


real wage

NOTE: Higher relative price of firms output and MPL will


shift curve out to right
AGGREGATE/ECONOMY-WIDE
DMAND FOR LABOUR

REAL Wage=Money Wage/Price Index

SUPPLY AND DEMAND MODEL OF THE LABOUR MARKET


Supply of labour
Suppliers of labour are workers and potential workers.
LABOUR SUPPLY DECISION
-At any given wage people have to decide if they are willing to work. Supply of labour is the total
number of people willing to work at each real wage W/P

FACTORS THAT SHIFT LABOUR SUPPLY CURVE


Size of working age population (birth rate,
retirement ages, immigration rates)
Participation rate-percentage of working age
population who seek employment

INCREASING WAGE INEQUALITY: TECHNOLOGICAL CHANGE


Technological change increases worker productivity and is the basic source of rising living
standards but can affect workers

Skill-based technical change:


Raises the marginal product of high-skill workers
Reduces the marginal product of low-skill workers

TYPES OF UNEMPLOYMENT
Labour Force=Employed+Unemployed
Working populationtotal population 15 years or older
EMPLOYED: Person worked full time or part time during past week
UNEMPLOYED: Person did not work during preceding week and made some effort to find work
NOT IN LABOUR FORCE: Person did not work in past week and was not actively seeking work
DISCOURAGED WORKERS: People who have given up looking for work and not so are not
counted as unemployed

Frictional or Search Unemployment


-Short Term unemployment that is associated with people searching for the right job
Structural Unemployment
-Longer term unemployment that can arise when distribution of skills of some workers
does not match the available jobs in the economy
-Some workers may have a lack of skills
-Structural change in the economy may result in a loss of jobs for certain types of
specialised workers
Cyclical Unemployment
-Typically associated with periods of slowdowns in economic activity, called recessions
COSTS OF UNEMPLOYMENT
Economic costs
Output that is foregone since workforce is not fully utilised
Psychological costs (personal or individual costs)
Long periods of unemployment can lead to loss of self esteem,unhappiness and depression

Social costs (external effects)


High unemployment can lead to increased crime and associated social problems

IMPEDIMENTS TO FULL EMPLOYMENT


Minimum Wage Laws
Legal minimum hourly wage that business must pay workers Known as award wages in
Australia
Standard labour demand and supply model predicts that setting too high a minimum
wage will produce unemployment.

LABOUR UNIONS
Workers may negotiate on an individual basis with a firm over wages and conditions
Alternatively workers may form labour unions to bargain collectively with a firm.
Presence of unions tends to produce a wage outcome that is above the market-clearing wage.
Minimum wage can be re-interpreted as the outcome for a unionised industry, where
Wmin = Wunion

UNEMPLOYMENT BENEFITS
Government transfer payment paid to the unemployed.
Provides a basic income to workers who are unemployed and searching for work.
Can have a disincentive effect on a workers search effort

SHORT RUN ECONOMIC FLUCTUATIONS


BUSINESS CYCLES
Economies experience periods of expansion and contraction
Contractionperiod when GDP falls
Expansionperiod when GDP rises
Moving between periods of expansions and contracts, economy will experience peaks and troughs
Peakbeginning of contraction (high point of GDP before down turn)
Troughend of contraction (low point of economic activity before recovery)
CLASSICAL BUSINESS CYCLE IN AUSTRALIA
Classical cycle refers to peaks and trough in GDP
Recessions last 18 months
Expansions last 60 months

NOTE: Recession occurs when GDP falls for at least


two consecutive quarters
POTENTIAL OUTPUT
Level of GDP an economy can produce when using its resources or factors of production (labour and
capital) at normal rates

Potential output= y*
(potential out put is not the same as maximum output)

Potential output increases over time with growth in:


Labour force
Capital Stocks
Growth in technology

ACTUAL OUTPUT AND POTENTIAL OUTPUT


Actual output (y) can vary (expand/contract) due to:
Changes in potential output (y*)
Changes in utilisation rate of labour and capital

OUTPUT GAP
Actual output doesnt always equal potential output (Difference is called output gap)

Contractionary gaps capital and labour not being fully utilised


Expansionary gapsfirms operating above normal capacity and can lead to inflation

NATURAL RATE OF UNEMPLOYMENT


Unemployment rate u is proportional to output gap
Contractionary gaps=high unemployment rate
Expansionary gaps=low unemployment rate

3 TYPES OF UNEMPLOYMENT: FRICTIONAL, STRUCTURAL & CYCLICAL


Natural rate of unemployment= frictional + structural

For Australia B=1.8


SPENDING AND OUTPUT IN THE SHORT RUN
KEYNESIAN MODEL
Prices of goods are fixed in short run as firms fix their price and then meet demand by varying
level of production (Firms meet demand by changing production)Aggregate production is
determined by total level of desired spending

In the short run firms will:


Accommodate a cut in demand by reducing output and employment, not by reducing prices
Accommodate a rise in demand by increasing output and employment, not by increasing prices
Firms face some cost to changing pricesmenu costs
In the long run:
Sustained or persistent changes in demand will eventually lead firms to change their
prices and cause production to return to normal capacity

FRICTIONLESS VIEW OF THE WORLD


Fluctuations in demand will be accommodated by flexible
prices and wages without changes in output and employment
No excess production (firms will cut prices to sell it)
No persistent unemployment because workers will but wages
to keep/get jobs

Assume: all imports are household consumption

PLANNED AGGREGATE EXPENDITURE (PAE)


Total planned spending on final goods and services

Planned vs Actual expenditure


Suppose aggregate production (GDP)=100
Planned expenditure can differ from actual expenditure due to unplanned changes in inventory
Any extra units becomes an inventory of unsold goods (unplanned inventory investment)

MODEL OF CONSUMPTION EXPENDITURE


Important influence on consumption spending by households s current disposable income
Disposable income=income less net taxes=Y- T
MARGINAL PROSPERITY TO CONSUME (MPC)
MPC change in consumption when disposable income
changes by a dollar
Dollar increase in disposable income raises consumption
by less than one dollar

MPC AND APC

PAE AND EQUILIBRIUM OUTPUT

The second term is called induced expenditure


since it depends on output

SHORT RUN EQUILOBRIUM OUTPUT


Equilibrium is when firms produce a level of output=planned aggregate expenditure (Y=PAE)
MODEL TO DETERMINE THE LEVEL OF GDP
Building blocks
1. Planned Aggregate Expenditure

2. Condition for equilibrium in model


There will be no pressure for GDP to change when:
Y=PAE (Equilibrium condition) Production= Desired spending

3. Factors determining components of PAE

TWO SECTOR MODEL


Planned aggregate expenditure

Assumptions:
No government sector (G=T=0)
No foreign sector (Closed economy) (X=M=0)

Consumption function

Planned investments are assumed to be exogenous

MODEL TO BE SOLVED FOR Y (GDP) GRAPHICAL REPRESENTATION

Note: Measure Y on horizontal axis and everything else on vertical axis


DISEQUILIBRIUM
Adjustment to equilibrium
Firms experience unplanned decline in their
inventory
To rebuild inventory, firms will
increase their level of production
Causes GDP to increase and it will
move towards equilibrium value
(where PAE cuts 45 degree line)

THE MULTIPLIER
Y caused by the changes in PAE
An additional dollar of
exogenous PAE generates more
than a dollars worth of GDP

ALTERNATIVE WAY TO GRAPHICALLY REPRESENT OUR


MODEL
Injections and Withdrawals
Investment and Saving
Paradox of Thrift
Suppose that there is an
exogenous increase in
desire to save by
households

This can be represented


by an upward shift in
the saving function
PARADOX OF THRIFT
Although individual households can increase their savings, the attempts by all households to
increase their savings does not lead to an increase in aggregate level of saving

Injections and withdrawals in 4-sector model


FISCAL POLICY
INSTRUMENTS OF FISCAL POLICY
G: Government expenditure: current goods and services, investment and infrastructure
T: Taxes (direct, indirect)-income taxes, consumption taxes (GST)
: Transfer payments-unemployment benefits, pensions

INCOME-EXPENDITURE (KEYNESIAN MODEL)

FISCAL MULTIPLIERS IN 4-SECTOR MODEL

WHICH HAS THE LARGER EFFECT ON GDP


Exogenous Tax cut or Increase in Government Spending
Equal size changes in G and T
Increase G by 100 and cut T by 100
WHY IS GOVERNMENT SPENDING MULTIPLIER LARGER THAN TAX/TRANSFER MULTIPLIER?
NOTE: Government spending multiplier is larger than tax/transfer multiplier
Government purchases of goods and services are a component of PAE

Taxes and transfer payments affect the level of disposable income (Y-T) received by the private
sector
Exogenous changes in taxes and transfers only have an indirect effect on PAE

BALANCED BUDGET MULTIPLIER


Budget Surplus (Deficit) = T G
Suppose a government wanted to undertake a fiscal policy that affected the level of GDP, but didnt
change the initial value of the budget deficit.

(Initial) BS = T G
BS = (T+100) (G+100)
(No change on initial value)

HOW LARGE ARE FISCAL MULTIPLIERS IN PRACTICE?


Government Spending Multipliers
Plausible Range: 0.5 to 0.9 Tax/Transfer Multipliers
Plausible Range: 0.1 to 0.3

FISCAL POLICY AND OUTPUT GAPS


Model implies that changes in G and T can be used to close output gaps, i.e. to ensure Y=Y*
INCREASING G TO ELIMINATE NNEGATIVE (CONTRACTIONARY) OUTPUT GAP

INCREASING THE TAX RATE T TO ELIMINATE A POSITIVE (EXPANSIONARY) OUTPUT GAP


ROLE OF FISCAL POLICY IN STABILISING THE ECONOMY
Automatic stabilisers
Tendency for a system of taxes and transfers which are related to the level of income to automatically
reduce the size of GDP fluctuations
Discretionary fiscal policy
Refers to deliberate changes in the level of government spending, transfer payments or in tax rates e.g.
oneoff payments of up to $900, so called cash splash

AUTOMATIC STABILISERS

System of taxes and transfer payments that act as automatic stabilisers for the economy
As GDP declines, the level of taxes paid falls and the level of transfer payments made increase.
T T ( GDP) implies decline in budget surplus
This happens automatically (without any government action) and makes contractions and expansions in
GDP smaller than they would have been otherwise.

PERCEIVED LIMITATIONS WITH DISCRETIONARY FISCAL POLICY


Policy Lags
Useful stabilization tool, discretionary changes in fiscal policy need to be implemented in a
timely manner
Most changes in fiscal policy are made on an annual basis in a governments budget

WHAT WAS DIFFERENT ABOUT GFC?


Provided greater scope for governments to use fiscal policy in a timely manner

STRUCTURAL VS. CYCLICAL CHANGES IN BUDGET


Discretionary fiscal policy=structural changes in budget
Automatic stabilisers drive cyclical changes in budget

SUPPLY-SIDE EFFECTS OF FISCAL POLICY


Fiscal policy can have longrun affects (on potential output Y*) as well as its shortrun effects on
(Y Y*)
Government investment spending on infrastructure such as roads, airports and schools can play a
major role in the growth of potential GDP.
Ideally such investments should provide a satisfactory economic rate of return.
Avoid white elephants or uneconomic investments

INCENTIVE EFFECTS OF TAXES AND TRANSFERS


Taxes and transfer payments play a role in affecting incentives and economic behaviour
Taxes on labour
Income rates and structure of government payments can influence labour supply decisions
Taxes on capital
Company tax rates can influence a firms investment decisions and affect the level of private
capital
FISCAL POLICY AND PUBLIC DEBT
Budget Surplus (Deficit) = T G
Budget surplus/deficit is a flow variable
Budget deficits need to be financed in some manner
A standard source of financing is to borrow from the private sector.

Public debt equals the sum of all past deficits less any surpluses.

GOVERNMENT BUDGET CONSTRAINT


A government can fund its outlays in 3 ways:
Taxes
Borrowing (i.e. it can sell a government security)
Printing Money

COSTS OF PUBLIC DENT


Crowding Out: High levels of government borrowing may raise real interest rates and this will tend to
crowdout private investment and capital formation

Intergenerational Equity: Borrowing because of deficit budgets cant be sustained forever, and eventually
surpluses would be required to reduce debt.
BENEFITS OF PUBLIC DEBT
One use of public debt is to finance the provision of public infrastructure. Where infrastructure has the
characteristics of a public good it will be undersupplied by the private sector.
Public debt may have a net benefit for the economy, even when allowing for crowding out and
intergenerational equity effects

FISCAL POLICY CHALLENGES

MONEY, PRICES AND THE RESERVE BANK


ASSET PRICES AND YIELDS
The yield or return on a financial asset is inversely related to the assets price

BONDS
Legally enforceable promise to repay a debt
Principal = amount that is originally borrowed on the bond
Term of bond = length of time before bond has to be repaid (terms can range from 24 hours to 30 years)
(Maturation date)
Coupon payment = regular dollar payment of interest on the bond

MONEY
Medium of exchange
Double coincidence of wants; Sell goods for MOE and use MOE to buy goods they want

Unit of account
Good that is used to compare the value of all other goods and services

Store value
Good or asset that serves as a means of holding (or transferring) wealth over time (e.g. land, bonds,
stocks)

Money measures
Currency = notes and coin on issue (less what is held by RBA and banks)
M1 = Currency + Current deposits at banks
M3 = M1 + all other bank deposits of non-bank private sector
Broad Money = M3 + borrowings from private sector by non-bank depository corporations (less
what these non-banks hold with banks)

Banking systems balance sheet


Assetsreserves
LiabilitiesDeposits

Fractional Reserve Banking


Bank keeps a fraction and lends out the rest
Want to maintain a reserve-deposit ratio R/D=10%

i.e. Assets= Reserves, loans


LiabilitiesDeposits

Deposit Multiplier
Quantity Equation

RESERVE BANK OF AUSTRALIA (RBA)


Central Bank
x responsible for operation of monetary policy
x stability and efficiency of financial markets
x promoting efficiency of payments system
x inflation target of 2-3% per annum

1. Exchange Settlement Accounts (ESA)/ Exchange


Settlement Funds (called cash)
2. Banks borrow and lend cash on short-term basis.
There is a market for cash.
3. RBA intervenes in cash market:
x Sets interest rates at which it will borrow and lend to banks
x Conducts open market operations with banks

ROLE OF EXCHANGE SETTLEMENT ACCOUNTS AND EXCHANGE SETTLEMENT FUNDS (OR


CASH)

Banks hold reserves at RBA in exchange settlement accounts (ESA).


Banks not allowed to overdraw their ESA

ROLE OF ESAs
Banks use ESA to clear debts (or credits) with other banks

OVERNIGHT CASH MARKET


Specialised market where banks are able to trade cash
Borrowing and lending for periods up to 24 hours

HOW RBA MAINTAINS ITS CASH TARGET


RBA can buy and sell bonds (typically government bonds) from/to the banks.
If the RBA buys bonds it pays for the bonds by crediting the banks ESA.
If the RBA sells bonds it receives payment by debiting the banks ESA.

OPEN MARKET OPERATIONS


The action buying and selling bonds is known as Open Market Operations (OMO).
Open market operations provide a means by which the RBA can influence the overall level
of cash (exchange settlement funds).
They also provide the means by which the RBA is able to ensure the overnight cash rate is
equal to its target rate.

MAINTAINING CURRENT TARGET CASH RATE=2.5%


If there is excess cash in the system so that there is pressure for the cash rate to fall below
2.5%, RBA will sell bonds to banks and this will reduce the supply of cash.
If there is a shortage of cash in the system so that there is pressure for the cash rate to rise
above 2.5%, RBA will buy bonds from banks and this will increase the supply of cash.

CHANNEL FOR CASH RATE


Interest Rate on Reserves (IROR)
The RBA pays interest in funds held in ESA accounts at rate which is 0.25% below its cash rate
target. At present it would be 2.5 0.25 = 2.25%. Lower bound for cash rate.

Re-discount rate
Banks can, at any time, borrow cash (using bonds as security) from the RBA at a rate that is 0.25%
above the target cash rate (at present this would be 2.75%). Upper bound for cash rate

THE RESERVE BANK AND THE ECONOMY


MONETARY POLICY AND THA MONEY MARKET

MARKET FOR 90-DAY COMMERCIAL BILLS: SUPPLY AND DEMAND


Firms supply (issue) bills to borrow funds for 90-days
Supply of Bills = borrow for 90 days

SUPPLY OF BILLS
Borrow more when interest rates on bills is low
OR
Supply more when price of bills is high

SUPPLY CURVE FOR BILLS

DEMAND FOR BANK BILLS


Demand for Bills = desire to lend for 90 days
Lend more when interest rate on Bills is high. BUT, high interest rate implies a low price for Bills

DEMAND CURVE FOR BILLS

90-DAY COMMERCIAL BILL MARKET

EFFECT OF INCREASE IN CASH RATE ON 90-DAY BILL MARKET


WHEN CASH RATE INCREASES
The demand for commercial Bills (the willingness to lend to firms) will tend to fall: Demand curve
will shift to the left.
The supply of commercial Bills (the demand for 90-day loans) will tend to rise: Supply curve will shift
outwards.

This occurs because some banks will leave the Bill market in favour of the higher returns in the
overnight cash market.

ARBITRAGE
While RBA targets a very short interest rate, changes in cash rate eventually lead to changes in longer-
term interest rates.
Market Rates = Cash Rate + Premium

NOMINAL AND REAL RATES


RBA has direct control of nominal interest rates. But it is the real interest rate that matters for saving and
investment decisions

PAE AND THE REAL INTEREST RATE


Higher real interest rates will lead households to defer current consumption
Higher real interest rates will raise the cost of borrowing and reduce investment by firms

AGGREGATE DEMAND AND AGGREGATE SUPPLY


POLICY REACTION FUNCTION
Real reaction function for RBa, real interest rate responds to inflation rate

DERIVE AD CURVE
Why does AD Curve slope downwards?
When inflation is high, the RBA will raise
the real interest rate. The increase in r
reduces consumption and investment
(i.e. PAE) and this produces a fall in
equilibrium output.

Also, wealth, distributional and


uncertainty effects
SHIFTS IN THE AD CURVE

REASONS FOR INFLATION INERTIA


Inflation expectations
Feed into current wage and price setting decisions
Expectations are slow to adjust (backward-looking)
Long-term nominal wage and price contracts
Build-in expected inflation for a number of years
Disinflation reduces the long-run rate of inflation
In the short-run disinflation can be costly in terms of lost output.
Once a country has attained a low inflation rate, it may introduce institutional arrangements to help
ensure the low rate is sustained.

OPEN ECONOMY MACROECONOMICS


Let e denote the nominal exchange rate, and define it as:
e = number of units of foreign currency that one unit of the domestic currency will buy
If we treat Australia as the domestic (or home) country then: e = Yen/$A or $US/$A
A rise in e corresponds to an appreciation of the $A
A fall in e corresponds to a deprecation of the $A

Real exchange rate

Rise in the real exchange rate implies that domestic goods are becoming more expensive

PURCHASING POWER PARITY (PPP)


Law of One Price
If transportation costs are relatively small, the price of an internationally traded good must be the same in
all locations
Implications of PPP
Exchange rate is determined by relative price levels
Exchange rate adjusts so that price levels in two countries are equal
Countries that experience relatively high inflation will tend to have depreciating currencies
Empirical evidence provides stronger support for PPP in long run

SHIFTS IN THE DEMAND CURVE


Increase in Demand curve
Increased preference for Australian goods
Increase in Japanese GDP (income effect)
Expected increase in real return on Australian assets

Monetary policy and the exchange rate


If the RBA tightens monetary policy (by raising the real interest rates), this will increase demand
for the dollar and produce an appreciation of the exchange rate
Higher value of dollar will reduce level of next exports=reduce in aggregate demand

INTERNATIONAL RESERVES
To maintain fixed value for exchange rate, country needs sufficient level of international
reserves of foreign currency to purchase excess supply of domestic currency
Balance of payments deficit: net decline in a countrys stock of international reserves
Balance of payments surplus: net increase in a countrys stock of international reserves
Speculative Attack: massive selling of domestic currency assets by financial investors

Flexible verses Fixed Exchange Rates


Advantages of a Flexible Regime
Countries can use monetary policy for domestic stabilization
Automatic adjustment to equilibrium in the foreign exchange market
Advantages of Fixed Regime
(Potentially) stable exchange rate, may promote trade
Countries cannot use monetary policy for domestic stabilization

Balance of Payments
Record of transactions between residents of a country and non-residents
Current Account
Transactions leading to a change of ownership of commodities or a direct flow of income
Capital Account
Transactions involving the purchase or sale of assets

Current Account Capital Account

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