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Weekend School #1 8th April 2006 Lecturer: Rod Duncan Previous version of notes: PK Basu
Forms of economics
Microeconomics- the study of individual decision-making
Should I go to college or find a job? Should I rob this bank? Why are there so many brands of margarine?
Economics as story-telling
In a story, we have X happens, then Y happens, then Z happens. In an economic story or model, we have X happens which causes Y to happen which causes Z to happen. There is still a sequence and a flow of events, but the causation is stricter in the economic story-telling.
Modelling Kobe
Kobe likes to unmake the bed. Kobe likes treats. We assume that more treats will lead to fewer 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.
Timeframes in economics
In economics we also talk in terms of three timeframes:
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.
Economic output
Gross domestic product- The total market value of all final goods and services produced in a period (usually the year).
Market value- so we use the prices in markets to value things Final- we only value goods in their final form (so we dont count sales of milk to cheesemakers) Goods and services- both count as output
500 000
400 000
Million A$
100 000
0 1950
1960
1970
1980
1990
2000
Business cycle
The economy goes through fluctuations over time. This movement over time is called the business cycle.
Recession: The time over which the economy is shrinking or growing slower than trend Recovery: The time over which the economy is growing more quickly than trend Peak: A temporary maximum in economic activity Trough: A temporary minimum in economic activity.
1960
1970
1980
1990
2000
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 people employed plus those unemployed Unemployment rate
(Number of unemployed)/(Labour force)
Unemployment
Working age population = Labour force + Not in labour force Labour force = Employed + Unemployed
Unemployment
Unemployment over the Business Cycle
12 10 8 6 4 2 0 1965 1968 1971 1974 1977 1980 1983 1986 1989 1992 1995 -2 -4 Unemployment Change in GDP
Percent (%)
Inflation
Inflation is the rate of growth of the average 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 of prices based on the importance of goods for consumers, ie. a change in the price of housing matters a lot, but a change in the price of Tim Tams does not.
Inflation can then be measured as the growth in CPI from the year before:
Inflationt = (CPIt CPIt-1) / CPIt-1
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
Inflation
Calculating GDP
Gross domestic product- The total market value of all final goods and services produced in a period (usually the year). Alternates methods of calculating GDP
Income approach: add up the incomes of all members of the economy Value-added approach: add up the value added to goods at each stage of production Expenditure approach: add up the total spent by all members of the economy
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
The consumption function shows how C changes as YD changes. Household savings (S) is the remainder of disposable income after consumption. The savings function shows how S changes as YD changes.
Consumption function
Consumption is a function of YD or C = C(YD). We assume that this relationship takes a linear (straight-line) form C = a + b YD where a is C when YD is zero and b is the proportion of each new dollar of YD that is consumed. We assume that C is increasing in YD, so 0 < b < 1.
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 the proportion of each new dollar of YD that is saved. We assume that S is increasing in YD, so 0 < d < 1. But also households must either consume or save their income, so C + S = YD. This can only be true if c = -a and b +d = 1.
More terms
Average Propensity to Consume (APC) is consumption as a fraction of YD: APC = C / YD Average Propensity to Save (APS) is savings as a fraction of YD: APS = S / YD Since all disposable income is either consumed or saved, we have: APC + APS = 1
More terms
Marginal Propensity to Consume (MPC) is the change in consumption as YD changes: MPC = (Change in C) / (Change in YD) Marginal Propensity to Save (APS) is the change in savings as YD changes: MPS = (Change in S) / (Change in YD) For our linear consumption and savings functions, MPC = b and MPS = d. If YD changes, then consumption and savings must change to use up all the change in YD , so MPC + MPS = 1.
Changes in these factors will produce a shift of the whole C and S functions.
Exogenous variables
Exogenous variables are variables in a model that are determined outside the model itself, so they appear as constants. For the aggregate expenditure model, we treat as exogenous:
Investment (I) Government consumption (G) Taxes (T) Net Exports (NX)
Aggregate expenditure
In a closed (no foreign trade) economy: AE = C(Y) + I + G In an open economy: AE = C(Y) + I + G + NX Changes in a or the exogenous variables (I, G, T or NX) will shift the AE curve. A change in b will tilt the AE curve. Equilibrium occurs when goods supply, Y, is equal to goods demand, AE.
Expenditure multiplier
Imagine the government wishes to affect the economy. One tool available is government consumption, G, or government taxes, T. This is called fiscal policy. Any change in G (G) in our AE model will produce:
1 Y G 1 - mpc
Multiplier
If mpc=0.75, then the multiplier is (1/0.25) or 4, so $1 of new G will produce $4 of new Y. Our multiplier is equal to 1/(1-MPC). Since 0<MPC<1, our multiplier will be greater than 1. The larger is the MPC, the larger is our multiplier.
As the average price level rises, demand for goods and services should fall, with all else held constant.
Aggregate demand
We would like to have a relationship between the demand for goods and services and the price level. We call this the aggregate demand (AD). The AD curve is downward-sloping in prices.
Aggregate supply
Likewise, there must be a relationship between goods supply and the average level of pricesthe aggregate supply (AS) curve. How do prices affect goods supply?
Short-term: Since wages are determined by contracts, wages do not change in the short-term. A rise in prices holding wages fixed means that firms are making higher profits on production, so firms will expand supply of goods. Long-term: Wage contracts will be renegotiated if prices rise. In the long-term, we would expect that there is no relationship between goods supply and prices.
Aggregate supply
There will be a short-run AS curve which is upward-sloping in prices. The long-run AS curve is vertical at the level of potential output, since wages will change proportionately to price changes. What factors will shift the AS curves?
Changes in prices of inputs, like land, capital energy or entrepreneurial skill Changes in technology that affect productivity Changes in taxes, subsidies or laws affecting business productivity
Shift in AD
Shift in AD in the SR
The price level rises, which pushes the AE curve back down to where the AD-AS curves intersect. But output is above the potential rate of output at point C. This means that there is a shortage of labour and will push up wages.
Shift in AD in the LR
In the long-run, workers renegotiate wages based on the higher prices. This raises the cost of production to firm and shifts the short-run AS curve to the left. It is only when we get back to potential output that wages stop rising, at point A.
Investment
Investment refers to the purchase of new goods that are used for future production. Investment can come in the form of machines, buildings, roads or bridges. What determines investment?
Businesses make an investment if they expect the investment to be profitable.
Investment decision-making
How to determine profitability of investment? Example: An investment involves the current cost of investment (I). The investment will pay off with some flow of expected future profits. The future stream of profits is R1 in one years time, R2 in two years time, up to Rn at the nth year when the investment ends. Net Present Value (NPV) = Present Value of Future Profits (PV) Investment (I)
Interest rates
Interest rates are a general term for the percentage return on a dollar for a year:
that you earn from banks for saving that you pay banks for borrowing or investing
For example, the interest rate might be 10%, so if you put $1 in the bank this year, it will become $(1+i) in one years time. Or if you borrow $100 today, you will have to repay $(1+i)100 next year.
Interest Rates
18.00 16.00 14.00 12.00 10.00 8.00 6.00 4.00 2.00 0.00
Jan-70 Jan-73 Jan-76 Jan-79 Jan-82 Jan-85 Jan-88 Jan-91 Jan-94 Jan-97 Jan-00 Jan-03
Investment
If we graphed the investment demand for goods and services (I), it would be downward-sloping in i. What can shift the I curve? Factors that affect current and expected future profitability of projects:
New technology Business expectations Business taxes and regulation
Money
Money has three main functions in the economy.
1. Money is a medium of exchange. We use exchange money when we buy/sell to each other. 2. Money is a unit of account. Money is an agreed measure for stating the value of other goods and services. 3. Money is a store of value. Money can be kept under the bed or inside a jar and used to exchange for goods and services in the future.
Money multiplier
What happens when you take $1 cash to a bank to deposit 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 keep R, called the reserve ratio (0 < R < 1), of the $1 as reserves and 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)
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 plus deposits in the economy. This ratio m = 1/R is called the simple money multiplier. For every $1 in currency that the government prints, the money supply increases by m.
Monetary policy
The government can control the supply of money and thus the interest rate. These actions are called monetary policy. Open market operations are a means of the government controlling the supply of money. The government (in our case the Reserve Bank of Australia or RBA) buys and sells government securities, such as government bonds to control the amount of money in the economy. If the RBA buys a bond with currency, the RBA increases the money supply (by the change in currency times the money multiplier).
Monetary policy
If the RBA sells bonds for currency, it decreases the supply of money. Monetary policy shifts the money supply curve and so changes the equilibrium interest rate.
Resources
There are many resources available to you. Often students hurt themselves by not taking advantage of the resources they have. Books: There are plenty of macroeconomics principles books. If you dont understand Jackson and McIvers coverage, get to a library and read a different textbook. There is also a study guide by Bredon and Curnow referenced in the subject outline. Online: There is an enormous amount of material on the Web. Just use a search engine and look around.
Resources
Forum: Get into a habit of reading the CSU forums once a week. Post questions on the forum and join in the discussion. Official websites: Have a look at the websites for government agencies like the Reserve Bank of Australia or the Australian Bureau of Statistics. CSU help: Student Services at CSU has a lot of help it can provide students with problems- look at http://www.csu.edu.au/division/studserv/.