ECO 120- Macroeconomics

Weekend School #24th June 2005

Lecturer: Rod DuncanPrevious version of notes: PK Basu

Topics for discussion

• Module 3- fiscal and monetary policy– The tools the Australian government controls to

smooth short-run fluctuations in the economy

• Module 4- inflation, unemployment and external trade– The causes and effects of inflation, the link between

inflation and unemployment, Australian trade with the rest of the world

• What will not be discussed– Answers to Assignment #2 (use the CSU forum for

this)

Fiscal policy

• Source: Chapter 9 of the book plus first part of Module 3.

• “Fiscal policy” is the government operation of government spending (G) and taxes (T).

• Typically we consider the problem of how the government can manipulate G and T so as to control economic variables such as output, inflation, interest rates, etc.

• Issues: how fiscal policy can “stabilize” the economy? what about government borrowing and public debt?

Definitions

• Budget deficit: the budget deficit is the extent of overspending by the government

Budget deficit = G – T• Expansionary fiscal policy: increasing

the budget deficit (G↑ or T↓) usually in a recession.

• Contractionary fiscal policy: decreasing the budget deficit (G↓ or T ↑) usually in an economic boom.

Budget deficits and surpluses

• If the government spends more than it brings in in taxes, what happens? (G > T)

• The money has to come from somewhere. For developed countries, this means borrowing (issuing government debt or “public debt”) from domestic residents or foreigners.

• If the government is spending less than it brings in in taxes, the government can reduce public debt. The Australian government has followed this policy in the last 10 years.

Types of fiscal policy

• We differentiate two types of fiscal policy:– Discretionary fiscal policy: This is fiscal policy that

comes about from planned changes in G and T that the government brings in in response to the economic situation.

– Non-discretionary fiscal policy: This is fiscal policy that comes about from the design of spending and taxes. There is no government official actively determining these changes.

Non-discretionary fiscal policy

• Certain parts of our spending and taxes automatically increase demand in a recession (when AD < potential GDP) and decrease demand in a boom (when AD > potential GDP).– Welfare spending and unemployment benefits are

part of G and increase in a recession and decrease in a boom.

– Income and company taxes are part of T and depend on GDP, they increase during a boom and decrease during a recession.

• These act as “automatic stabilizers” on the economy, reducing the variability of the economy.

Cyclically-adjusted budget deficits

• The automatic stabilizers raise the budget deficit in a recession and lower the budget deficit in a boom.

• This fact means that we can not just look at the budget deficit to determine whether the government is “overspending”, we also have to take into account where we are in the business cycle.

• Adjusting the budget deficit for the point we are in the business cycle is called “cyclically adjusting”. We would expect even a “sensible” government to be in a deficit in a recession.

Discretionary fiscal policy

• Discretionary fiscal policy is the manipulation of G and T by government officials typically to reduce the severity of shocks to the economy.

• It sounds like a good idea, but how does it work in reality?

• There are many problems and limitations to the use of fiscal policy to reduce recessions and booms.

Problems with discretion

• Scenario: Imagine a train driver that has only one control- an accelerator/brake that he or she can push or pull on to control the train. This is exactly the same situation as the government faces with fiscal policy.

• Now what limitations can the train driver face?

Problems with discretion

• Limitations:– Correctness of data: Is the train driver seeing the

tracks correctly? Or Does the government get the right data about where the economy is?

– Timing of data: Is the train driver seeing the tracks with enough time to react? Or Does the government get the statistics quickly enough to do anything?

– Decision lags: Can the train driver make a decision about the correct action before the train reaches the problem spot? Or does the government have time to design the correct fiscal policy?

Problems with discretion

– Administration lags: If the driver pulls on the control, how long will it take for the brakes to start to work? Or New spending and taxes have to be passed through parliament, which takes time, even after a decision is made.

– Operational lags: If the brakes start to work, how long before the train slows down? Or New government spending and taxes take time to affect the economy.

• So even the best-designed fiscal policies can go wrong if they are in response to the wrong data or if they take too long to affect the economy.

Political considerations

• There are further concerns we might have about the operation of fiscal policy.– Politicians have to remain popular. No one likes

taxes, and everyone likes new spending on themselves. Will a politician make an unpopular decision that may result in them losing the election if it is the best decision for the economy.

– Electoral cycles: Governments have to be re-elected every 3-4 years. So a politician would love to engineer a boom right before his or her election.

Crowding out

• Another problem with fiscal policy is that an increase in G may increase output but at the expense of other components of aggregate expenditure.

Y = C + I + G + NX• Since the economy returns to potential GDP

over the long-run, an increase in G must come at the expense of either C, I or NX or all 3.

• If an increase in G reduces investment spending over the long-run, this could lead to lower future growth in the economy.

Crowding out

• How can this happen?– An increase in G shifts the AD curve to the right. – This results in higher Y and higher P.– The increased government borrowing in the market

for savings raises the interest rate.– Higher interest rates lead to lower investment

spending so I drops, shifting AD left.– Higher interest rates leads to an appreciation of the

A$ (as foreign investors put their money in Australia), so NX drops, shifting AD left.

Crowding out- I and NX

ASLS

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Government debt

• One problem that economic commentators always point to is the level of government debt- “Our debt is too high.”

• How do we evaluate the level of government debt? How do we know is it is “too high”.

• Government debt is like any other form of debt. You evaluate the debt relative to the income/wealth of the person incurring the debt.

• A $500,000 debt might be high to you and me, but it might mean nothing to Kerry Packer.

Government debt

• So we need to evaluate government debt relative to “government income”. But what is the appropriate form of “government income”, as the government doesn’t earn or produce anything.

• Generally we use the income of the country as the comparison, since the government is free to tax or claim any part of GDP.

Government debt

• So our criterion for “too much” is debt (B, since typically government debt is issued in government bonds) over GDP (Y):

B / Y• Banks would make much the same calculation

when considering whether to issue someone a home loan.

• In general debt is growing at the rate of interest each year, r, while GDP is growing at the growth rate of the economy, g.

Net Debt/GDP (%) Primary Surplus/GDP (%) Country 1985 1995 2000 2003 2000 2003 Australia 15.0 23.5 9.7 2.9 2.4 1.7 United States 41.9 58.9 43.0 47.1 4.1 -2.7 European Union 34.1 53.8 48.0 49.4 4.1 0.6 Japan 69.7 24.8 58.6 80.2 -6.1 -6.3 OECD 41.4 48.8 44.1 48.7 2.6 -1.5 .

Monetary policy

• Source: Chapter 12 of the book plus second part of Module 3.

• “Monetary policy” is the government operation of the money supply and interest rates.

• Typically we consider the problem of how the government can manipulate monetary policy so as to control economic variables such as output, inflation, interest rates, etc.

• Issues: how monetary policy can “stabilize” the economy? how will monetary policy affect interest rates or exchange rates?

Who operates monetary policy?

• The Reserve Bank of Australia (RBA) is responsible for monetary policy.

• The RBA was given 3 goals when it was created:– Maintain low inflation– Maintain low unemployment– Maintain value of the A$

• The RBA was only given one policy tool- the money supply to achieve 3 goals. In the mid 1990s, the RBA was simply told to have one aim:– Maintain low inflation.

Definitions

• The RBA implements monetary policy through its control of the cash rate.

• Cash rate: The cash rate is the rate the RBA charges bank for loans within the RBA reserves system. The cash rate is the base interest rate for the economy, and all other interest rates are derived from it.

• Easy monetary policy: When the RBA lowers the cash rate to stimulate AD.

• Tight monetary policy: When the RBA raises the cash rate to cut off AD.

Interest rates

• As we saw in the Investment section, the profitability of investment projects depends on the nominal interest rate.

• The lower are interest rates, the more projects will be profitable, so the higher will be investment spending.

• Since the RBA controls the cash rate, and since all interest rates depend on the cash rate, the RBA controls I, and so can shift the AD curve.

How monetary policy works

Cause–Effect Chain of Monetary Policy:Money supply impacts interest ratesInterest rates affect investmentInvestment is a component of ADEquilibrium GDP is changedEquilibrium GDP is changed

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Monetary policy and the open economy

• Net Export Effect– Changes in interest rate affect the value of the

exchange rate under floating exchange rate.An increase in interest rate appreciates the currency, resulting in lower net exports

– A decrease in interest rate leads to currency depreciation and a rise in net exports

• So an easy monetary policy is enhanced by the net export effect.

Quantity theory of money

• There is a nice, simple model of money which explains many features of money supply and demand. This model is called the quantity theory of money.

• If we imagine that money is needed for all of the purchases made each year, then demand for money is the vale of purchases: PY.

• The supply of money for purchases is the amount of cash in the economy.

• But each piece of money in the economy can be used multiple times during a year in transactions. We call the number of transactions the velocity of money “v”.

Quantity theory of money

• So the total supply of money for transactions in a year is v times M: vM.

• So demand equals supply requires that:

PY = vM

• So if Y goes up, but nothing else does, then average level of prices must fall.

• The QTM is good to use for thinking about money and inflation.

Unemployment

• A person becomes unemployed:– Job loser– Job leaver– New entrant or re-entrant into the labour force

• He or she is no longer unemployed:– Hired or recalled– Withdraws from the labour force

Population

Labour Force

Employed or

Unemployed

Labour Force Participation

Rate

Unemployment Rate

Working age population

Proportion of country’s population that takes part in its economic activities directly (either actually taking part or willing to)

Labour Force / Working Age Population X 100

LFPR In Australia, in September 2003 :

( 10.237 million / 15.955 million ) x 100 = 64.2 %

Labour force participation rate

Unemployment rate

Proportion of country’s labour force that is unemployed.

Number Unemployed / Labour Force( ) X 100

UR in Australia, in September 2003 :

(0.591 million / 10.237 million) x 100 = 5.8%

Types of unemployment

• Three main types of unemployment:– Cyclical unemployment– Frictional unemployment– Structural unemployment

Cyclical unemployment

• Associated with the ups and downs of the business cycle

• Takes place due to insufficient aggregate demand or total spending- reflects shifts in AD curve.

• High during recessions and low during booms.

• Fiscal and monetary policies can reduce cyclical unemployment - policies are relevant.

Frictional unemployment

• Associated with the period of time in which people are searching for jobs, being interviewed and waiting to commence duties.

• It is inevitable and always exist• Fiscal and monetary policies can not reduce

frictional unemployment – macroeconomic policies are irrelevant.

• Policies that make it easier to find new jobs will affect frictional unemployment.

Structural unemployment

• Associated with wider structural or technological changes in the economy that may make some jobs redundant.

• It is inevitable and always exist• Lasts longer than frictional unemployment• Fiscal and monetary policies can not reduce structural

unemployment – macroeconomic policies are irrelevant.

• Policies that encourage workers to retrain skills or to move to a new area with more jobs will decrease structural unemployment.

“Full” employment

• Full employment means when all productive resources in the economy are in full use - implies no cyclical unemployment - still frictional and structural unemployment exist - they can be low - but can never be zero.

• The full-employment rate of unemployment is called the “natural rate of unemployment”.

• Domestic output consistent with the natural rate of unemployment is “potential output” or “full employment level of GDP”.

Classical employment theory

• Economy always operates under full employment - it is automatic and self sustaining - if there is any unemployment that is only temporary.

• Price-wage flexibility– the assumption that all prices, including wages and

interest rates, are flexible and will, rapidly adjust to remove disequilibria

• Classical theory and laissez faire– the price system ensured that price-wage flexibility

and fluctuations in the interest rate was capable of maintaining full employment

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Real Domestic Output

Keynesian employment theory

• Full employment is not automatic - unemployment exists for longer periods - the Great Depression of the 1930s - sticky wages and prices.

• Horizontal aggregate supply curve during recession - ‘recessionary’ or ‘Keynesian’ range.– Change in AD impacts on unemployment - not on price level.

• Once the full employment level is reached - vertical AS curve - change in AD affects price level only.

• Unstable aggregate demand - especially investment, so that demand management and stabilisation policies by the government are essential.

Keynesian theory

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Real Domestic Output

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Measuring inflation

• We measure the general price level through a price index such as the Consumer Price Index (CPI)

• Inflation is a continuous rise in the general price level. We measure inflation:

InflationInflationraterate

Current year index - Previous yearCurrent year index - Previous year indexindex

Previous year indexPrevious year index

x 100100=

Inflation in Australia, 1970-2004

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1012141618

1970 1975 1980 1985 1990 1995 2000

Two types of inflation

• We can differentiate two different sources of inflation in an economy:• Demand-Pull Inflation

• Occurs when an increase in AD pulls up the price level.

• Cost-Push Inflation• Occurs when an increase in the cost of production

at each price level shifts the AS curve leftward resulting in increased prices.

Demand-pull inflation

• Short-run: There is an increase in demand, such as an increase in consumer spending, so AD shifts rightward. AS does not change in the short run, and we have a movement along the AS curve. Price level and GDP increases..

• Long run: Workers will realise their real wages have fallen and will demand and receive increased nominal wages. As costs rise, supply decreases and the AS to shift to the left. Price level increases, and GDP declines.

• May be caused by expansionary fiscal and monetary policies - can be countered by contractionary policies by the government.

Demand-pull inflation- SR and LR

P3cc

A decrease inA decrease inaggregateaggregatesupply....supply....

Increases the priceIncreases the pricelevel and outputlevel and output

returns to originalreturns to originallevellevel

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Cost-push inflation

• Short-run: Increased prices and decreased real output (and more unemployment). Causes can be:• Wage push : increase in wage rate - power of

trade unions• Supply shocks - increase in prices of major

raw materials - oil etc.• Profit push : increase in profit requirement of

large monopoly businesses.• The AS curve shifts to the left/up as prices and

costs rise, and firms cut back on output.

Cost-push inflation

• Long-run: There are two scenarios.– Government intervention ( shift in AD): If government

intervenes to increase AD, prices and output will rise, moving us back to the natural rate of output.

• No Government intervention (no shift in AD): If government does not intervene to increase AD, a severe recession will result. However nominal wages will eventually decline and will restore AS to its original position, moving us back to the natural rate of output.

Cost-push inflation- SR and LR

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An attempt toincrease AD

will only furtherincrease theprice level

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Phillips curve

• Suggests an inverse relationship (or a trade-off) between inflation and the unemployment rate

• Named after A W Phillips who originally discovered the relationship between unemployment and nominal wages, using British data in 1950s.

• In general, inflation is associated with economic expansion, and unemployment with economic recession.

• During expansion : the greater the rate of growth of AD - inflation is high, and unemployment is low.

• During recession : the slower the rate of growth of AD - inflation is low, and unemployment is high.

Phillips curveA

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Policy implications of Phillips curve

• Trade-off suggests : a rise in inflation should lead to a decline in unemployment, and vice versa.

• In general, both can not be brought down to the minimum level.

• The society must make a choice between low inflation and low unemployment.

Phillips curve in Australia

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Unemployment (%)

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Stagflation

• Simultaneous experience of high and increasing unemployment and inflation - cost-push inflation.

• Caused by :• Aggregate supply shocks such as severe

increases in fuel costs, and devaluations;• Productivity declines; or• Inflationary expectations and wages -

expectations about the likely future path and rate of increase of the general price level.

Stagflation in Australia

• 1973-74 : Cost push - caused by international oil price rise.

• 1979 : cost-push - caused by international oil price rise.

• 1981-82 : cost push - caused by rapidly rising wages.

Closed and open economies

• A closed economy is one that does not interact with other economies in the world.– There are no exports, no imports, and no

capital flows.

• An open economy is one that interacts freely with other economies around the world.

An open economy

• An open economy interacts with other countries in two ways.– It buys and sells goods and services in world

product markets.– It buys and sells capital assets in world

financial markets.

• The Australian economy is a medium-sized open economy—it imports and exports relatively large quantities of goods and services.

Exports and imports

• Exports are domestically produced goods and services that are sold abroad.

• Imports are foreign produced goods and services that are sold domestically.

• Net exports (NX) or the trade balance is the value of a nation’s exports minus the value of its imports.

– NX = X - M

Net exports

• A trade surplus is a situation where net exports (NX) are positive.

Exports > Imports

• A trade deficit is a situation where net exports (NX) are negative.

Imports > Exports

Net Exports (1949-1996)

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Net exports and domestic GDP

• Aggregate Expenditure = C + I + G + X - M

• Level of X depends on foreign countries’ income, not domestic income

• Level of M is dependent on domestic income or GDP.

What affects net exports?

• The tastes of consumers for domestic and foreign goods.

• The prices of goods at home and abroad.• The exchange rates at which people can use

domestic currency to buy foreign currencies.• The costs of transporting goods from country to

country.• The policies of the government toward

international trade.

Exchange rate

The exchange rate is the rate at which a person can trade the currency of one country for the currency of another.The nominal exchange rate is expressed in two ways.

•In units of foreign currency per one Australian dollar•In units of Australian dollars per one unit of the foreign currency

Exchange rate

At an exchange rate between the US dollar and the Australian dollar is 0.70 US cents to one Australian dollar.

•One Australian dollar trades for 0.70 of US$. [This is the form we will use.]•One US$ trades for 1.43 (1/0.7) of an Australian dollar.

Determination of exchange rates

• The market price of something is determined in the market.

• Under the Floating Rate system, price of a currency (its exchange rate) in the international market for currency is determined by its demand and supply.

• A$ is a floating currency - floated in December 1983.

Value of A$ (1949-1996)

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Determination of exchange rates• Demand for A$ (people who want to buy

A$): – By overseas buyers of Australian goods

and services (including their tourist visits to Australia)

– By overseas investors who want to buy Australian physical and financial assets.

• Supply of A$ (people who want to sell A$): – By Australian importers (including

overseas trips by Australians)– By Australian investors who want to buy

physical and financial assets overseas.

Appreciation/Depreciation

If a dollar buys more foreign currency, there is an appreciation of the dollar -- say, one A$ buys one US$ instead of 70 US cents at present.

If it buys less there is a depreciation of the dollar -- say, one A$ buys 50 US cents instead of 70 US cents at present.

Demand for A$

• As exchange rate (US$ per A$) increases (say, from US$ 0.70 to US$ 1), exports become more expensive. Overseas buyers will buy less of Australian goods and services. Demand for A$ falls.

(Just opposite when the value of A$ decreases)

So, Demand curve for A$ (or any other currency) is downward sloping - as exchange rate increases, demand for the currency falls, and vice versa.

Supply of A$•As exchange rate increases (say, from US$ 0.70 to US$ 1), imports become cheaper. Australians will buy more of foreign (imported) goods and services. Supply of A$ increases.

(Just opposite when the value of A$ decreases)

So, Supply curve of A$ (or any other currency) is upward sloping - as exchange rate increases, supply

of the currency increases, and vice versa.

Determination of exchange rates

Exchange rate (cost of 1 A$ in terms of US$)

Amount of A$

Demand for A$

Supply of A$

Balance of payments

Reflected in international balance of payments accounts.

Records all transactions between the entities in Australia and those in foreign nations

Two basic accounts:•Current Account•Capital Account

Balance of payments

•Current account of a country’s international transaction refers to the record of receipts from the sale of goods and services to foreigners (exports), the payments for goods and services bought from foreigners (imports), and also property income (such as interest and profits) and current transfers (such as gifts) received from and paid to foreigner.

•Capital account is a summary of country’s asset transactions with the rest of the world.

Balance of payments

Current Account Balance (+,-) = Capital Account Balance (+,-)

Demand for A$ equals Supply of A$.

If we have a current account deficit (we are importing more than we are exporting), then we must also have

a capital account deficit (investors overseas are accumulating Australian assets).

CAD (Current Account Deficit) and exchange rate

CAD impacts on :•Inflow of foreign investment - higher the CAD, higher the surplus in capital account - higher investment in Australia by the foreigners - higher the demand for A$.•Outflow of foreign currency - income (interest & profit) on foreign investment goes out of the country- higher the CAD, higher the demand for foreign currency - higher the supply of A$. Exact impact depends on relative strengths of the

two opposing forces.

Current Account Deficits (1949-1996)

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Is the Current Account Deficit a Problem?

• Represents a debt we will have to repay in the future.

• Just as for a household, the extent of the problem depends on our ability to service the debt- but notice that CAD as a percentage of GDP (ability to service debt) is still low.

Terms of TradeThe ratio of average price of goods and services exported by a country to the average price of its imports.

If prices of imported goods are rising at a faster rate than the prices of exported goods, then the terms of trade for that economy is considered as deteriorating. The economy is loosing in the process of foreign trade.

Terms of Trade (1949-1995)

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Purchasing Power Parity (PPP)

The purchasing-power parity theory is the simplest and most widely accepted theory explaining the variation of currency exchange rates.

According to the purchasing-power parity theory, a unit of any given currency should be able to buy the same quantity of goods in all countries.

Intuition for PPP

In an open economy, I have the choice of buying an orange in Australia or an orange from Indonesia and importing the orange back to Australia.

If transport costs are low, the price of traded goods should be the SAME, once we translate into a common currency.

This is called the law of one price.

Purchasing-Power Parity

• Law of one price – When converted to a common currency value

through the exchange rate, the price of identical goods should be the same across countries:

Pd = E x Po/s,

• Where Pd is the domestic price, Po/s is the foreign price and E is the exchange rate.