Revised Supplementary Material Semester 2 2013

8/12/2019 Revised Supplementary Material Semester 2 2013

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Economics

Semester 2

Supplementary Material

2013


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UNSW Foundation StudiesUNSW Global Pty LimitedUNSWSydney NSW 2052

Copyright2013

All rights reserved. Except under theconditions described in the CopyrightAct 1968 of Australia and subsequentamendments, this publication may notbe reproduced, in part or whole, withoutthe permission of the copyright owner.


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Semester Two

WEEK 1

THE CIRCULAR FLOW MODEL

Macroeconomics is the study of the economy as a whole - the study of economic aggregates.Because all economic activity revolves around the production of output (0), the earning of income(Y), and expenditure (E) it follows that economists are interested in the size of these aggregates, therelationships between them, and the reasons why they change.The circular flow of income model is a good starting point for understanding macroeconomicrelationships. As illustrated on page 3, the circular flow model describes the continuous exchangesthat occur in our modified market economy.

The circular flow model is a simplification of the continuous process of exchange of goods andmoney throughout the economy. Households and business firms form the basis of the economic

system. in return for using the resources owned by households in the production process, firms payhouseholds an income, most of which is spent on consumption (goods and services produced byfirms).

In the factor market, firms hire resources from households, in return for which households receiveincome. In the goods market, households and business firms exchange income earned during the

production process in return for goods and services.

The goods and factor market part of the model (exchanges between households and firms) remindsus of the interdependent nature of our economy - one person's spending creates another person'sincome.

SECTORS

1. The household sector (or consumers) includes all families, groups and individuals in theirroles as consumers who buy the goods and services provided by other sectors of theeconomy. A large proportion of the household sector also provides the resources that gointo the production of those goods and services.

2. The firm sector (or producers) comprises all the units who employ the resources providedby households to produce the goods and services which are sold to consumers and otherfirms. Firms vary in size and complexity, from individual self-employed producers to hugecorporations.

3. The financial sector comprises the firms which specialise in financial services. Not all ofthe income earned in the production process is spent on goods and services (consumption).Most households choose to save some proportion of their income. The financial sector formsan important link between savers and investors. The sector includes banks, building societiesand other financial institutions. They act as intermediaries between people or firms withsurplus funds (savings) and those who wish to borrow them.

Economics Semester 2 1 Supplementary Material


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4. Thegovernment sector(or public sector) consists of all government authorities at national,state and local level. Some government services are provided free of charge but paid for bytaxation; others are sold to consumers just like the output of non-government firms. Many ofthe collective goods and services in the community are provided by the government sector,which raises most of its revenue from taxation. The government then spends this money to

provide goods and services for the community

5. The overseas sector(or international sector) includes the rest of the world with whom oureconomy has economic relations by way of trade and financial flows. Domestic resourcescannot satisfy all of our needs and wants, so the household and producer sectors spend someof their income overseas. Similarly, people in other countries purchase domestic goods andservices. Domestic goods and services sold overseas are called exports (X); goods andservices which flow into our economy are known as imports (M). The difference betweenthe two is called net exports.

The five sectors identified above serve as a useful classification of all the participants in theeconomy, and enable us to make more sense of the complex flows of money between the variouseconomic units. The production of goods and services by all sectors of the economy generatesincome for the people who contribute their effort and assets to that activity. Thus the incomeearned is equal to the value of goods and services produced. And in turn that income is disbursed

by consumers on spending, saving and taxes, and is subsequently used by firms and the governmentto pay employees to generate further income. Therefore we talk about the circular flow of incomearound the five sectors of the economy.



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STAGES IN DEVELOPING THE CIRCULAR ECONOMY

1. Simple circular flow model with firms and household sector. For equilibrium Y = E.

2. 3 sector model adds financial sector;

Y = C + S, E = C + I.For equilibrium Y = E.i.e. C + S = C + I.ie. S = I (leakages = injections)

3. 4 sector model adds government sector;Y = C + S + T, E = C + I + GFor equilibrium Y = E.i.e. C + S + T = C + I + G,ie. S + T = I + G (leakages = injections)

4. 5 sector model adds external sector;Y = C + S + T + M, E = C + I + G + X,For equilibrium Y = Ei.e. C + S + T + M = C + I + G + Xie. S + T + M = I + G + X (leakages = injections)

Income earned

Households

RESOURCES

Businessfirms

GOODS / SERVICES

Consumption expenditure

FinancialS

T

M

sector

Governmentsector

Overseassector

I

G

X

Leakages

In

jections

The full circular flow model



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Leakages and Injections

Savings, taxation, and imports are known collectively as leakages (or withdrawals). Spending onthese items reduces the spending power of households and firms (both money and real flows).Investment, government expenditure and exports, on the other hand, are injections that returnmoney to the circular flow.

Inequality of Leakages and Injections

At any particular point of time, it is highly unlikely that total leakages will exactly equal total

injections. That is Y E and the economy will not be in equilibrium. This means that usually thelevels of income, output and employment will be changing.

Total Leakages Greater Than Total Injections

If total leakages exceed total injections, more money is being withdrawn from the circular flow thanis being added to it.

The level of income, and hence the level of expenditure in the economy, will fall. A decliningdemand for goods and services will, in turn, lead business firms to cut back their production. Asthey do so, firms will purchase fewer productive resources from households and the level ofunemployment will rise.

Falling income, output and employment levels will cause the size of the circular flow to contract,leading to unemployment; (How can the Government counteract this?)

Total Injections Greater Than Total Leakages

In this case, more money is being added to the circular flow than is being removed from it.Consequently, income and expenditure will rise. As the demand for goods and services increases,firms seek to increase their production levels by hiring more resources.

Rising income, output and employment levels will lead to an expansion in the size of the circularflow, leading to inflation; (How can the Government act so as to try to control inflation?)



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CIRCULAR FLOW OF INCOME

1. The simple circular flow model assumes a two sector economy, composed mainly of:

a) government and business firmsb) government and consumers

c) business firms and householdsd) business firms and the finance market

2. In the circular flow model, the flow of resources to firms is matched by :

a) a return flow of incomeb) a return flow of savingc) a return flow of investmentd) a return flow of consumption

3. Which of the following is an injection into the circular flow?

a) savingb) taxationc) importsd) exports

4. When taxation is introduced into the circular flow, the size of the flow will:

a) contract as another leakage is createdb) contract due to the decline in investmentc) expand due to the added injection into the flow

d) expand due to increased consumer spending

5. The five sector circular flow is in equilibrium when :

a) S + I + T = G + X + Mb) S + T + M= I + G + Xc) S + G + M= I + T + Xd) S + I + G = T + X + M

6. Unemployment is most likely to occur when:

a) savings is greater than investmentb) there is a budget deficitc) there is a favourable balance of paymentsd) injections are greater than leakages

7. Exports have the same effect on the circular flow as:

a) taxationb) savingsc) capital outflow

d) investment



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8. An increase in savings in a closed economy will not result in unemployment if theincrease in savings is matched by a corresponding :

a) increase in taxation

b) increase in investmentc) decrease in investmentd) decrease in consumption

9. The simple two-sector circular flow model shows that:

a) incomes of consumers are the sales receipts of the firm in the next production periodb) cost of resources is equal to the cost of the finished goods they are used to producec) consumer spending on goods is equal to incomes derived from productiond) all of the above

10. The full 5 sector circular flow model is in equilibrium when:

a) total injections equal total leakagesb) government spending equals taxationc) savings equals investmentd) income equals consumption

11. The introduction of the overseas sector into the circular flow will:

a) increase the flow if there are more imports than exportsb) reduce the flow if there are more imports that exports

c) not alter the circular flow unless exports equal importsd) depend on where the imports are from and where the exports are going

12. Money may be withdrawn from the circular flow by all but one of the following:

a) restriction of bank lendingb) budget deficitc) reduced investment in Australiad) budget surplus

13. If the government considers that the level of private spending is too high:

a) it should make government expenditure greater than government revenueb) it should make government revenue equal to government expenditurec) it should make government revenue greater than government expenditured) it should employ more public servants

14. The government influences the circular flow of income by:

a) borrowingb) paying wages and social services

c) taxing consumers and firmsd) all of the above



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Unit 1

INFLATION

Economists define inflationas a 'persistent and appreciable rise in the general level of prices'. Theterm inflation is applied to price increases that occur across time, and across a range of goods.

The Measurement of Inflation

The main method of reporting the level of inflation in Australia is the Consumer Price Index(CPI).As an index number, the CPI summarises the overall change in the prices of a large numberof goods and services. The CPI is based on a sample basket of prices of consumer goods andservices, and is compiled on a quarterly basis - the Australian Bureau of Statistics (ABS) collectsapproximately 100,000 price quotations in compiling the data on which the index is based.The list of items covered in the CPI basket " ranges from steak to motor cars, and from dentalfillings to restaurant meals."

International Influences on Inflation

Prices in Australia are not isolated from events in the rest of the world. Movements in internationalimport priceshave a considerable influence on inflation. A good example is the price of fuel;

particularly because it is an important inputat all stages of the production process - from gatheringresources to manufacture to distribution. Therefore, it can increase input costs and force up prices offinal goods and services.

Imported goods and servicescan bring inflationary pressure. As imported goods become moreexpensive, those more expensive consumer imports will feed into higher price levels, as they areincluded in the CPI basket.

The Consequences of Inflation

Inflation reduces purchasing power if incomes do not rise in line with price rises. That is, realincome falls, and households become worse off because they cannot purchase as many goods andservices.

If inflation rises, this places upward pressure on interest ratesbecause lenders wish to becompensated for lower real income. Creditors (lenders) lose and debtors (borrowers) gain during

periods of inflation. Lenders lose unless the rate of interest they are charging is enough to cover the

rate of inflation, and allow for a real return on money lent. Long term lenders will be repaid ininflated dollars which have reduced purchasing power. Savers see the real value of deposits reducedduring inflationary periods. Borrowers tend to benefit from inflation, because they can build uptheir assets on borrowed money, knowing that the real value of their repayments will fall over time.

Inflation causes a lack of confidencein money as a store of value, and people often seekalternatives against price rises that they expect in the future e.g. assets which are likely toappreciate in value, such as property, antiques or precious metals.

The burden of inflation does not fall evenly on all sectors of the community. Some householdsare worse off than others. Those able to anticipate inflation may be able to arrange their financial

affairs to benefit from expected price increases. As explained above, households that are able topurchase real assets which rise in value with inflation (e.g. property) insulate themselves from fallsin real purchasing power.



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Living standards of low income earners and recipients of transfer income (e.g. pensions) will fallduring periods of inflation unless these payments are indexed to the price index. Sectors of theeconomy with market power (perhaps business owners who can pass on price increases to theircustomers) seem more capable of maintaining their real incomes.

Inflation promotes uncertainty. Both savings and investment are discouraged, reducing potentialoutput and employment. Uncertainty about future costs and prices makes it difficult for decision-makers to be certain about the rate of return which can be earned.

There is evidence to suggest that capital-for-labour substitutionoccurs when wages (the price oflabour) rise when workers demand a wage increase during inflation. Employers may replace labourwith machines which don't ask for pay rises.

International competitivenessis influenced by relative inflation levels. A country will be at adisadvantage if its domestic inflation is greater than its competitors. It is likely that an importer willtend to favour a cheaper competitors product.

Inflation affects the CADbecause the demand for exports falls as prices rise, and because importsbecome more competitive as their prices fall relative to those charged by domestic competitors.

_______________________________________________________________________________

UNEMPLOYMENT CALCULATIONS

The Labour Force

The proportion of the working age population who are either in work or are actively seeking work is

known as the participation rate. It includes people who were employed and people activelyunemployed.

TOTAL POPULATION

1,000 000

____________________________________

POPULATION < 15 POPULATION AGED 15+

200 000 800 000

______________________________

LABOUR FORCE NOT IN WORKFORCE

600 000 200 000

Participation rate = 75%

________________________________

EMPLOYED UNEMPLOYED

500 000 100 000

unemployment rate = 16.7%



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UNEMPLOYMENT and INFLATION

Questions 1 and 2 are based on the following data collected in a particular region.

Employed Persons Number

full-time 70,000

part-time 30,000

Unemployed persons 25,000Job Vacancies 10,000

1. The size of the labour force in this region is:

a) 70,000 personsb) 95,000 personsc) 100,000 personsd) 125,000 persons

2. The unemployment rate in this particular region is:

a) 8%b) 10%c) 20%d) 25%

3. Official ABS ( Australian Bureau of Statistics) figures tend to underestimate Australiasunemployment rate because they do not include:

a) those only seeking part-time workb) those absent from work due to illnessc) those waiting to start a new jobd) those discouraged from actively seeking work

4. That kind of unemployment caused by a general downturn in the level of economic activityis:

a) cyclicalb) seasonal

c) frictionald) structural

5. Which of the following is regarded as a major cause of structural unemployment inAustralia?

a) rapid rates of inflationb) rapid rates of technological changec) rising numbers of discouraged workersd) increasingly unfavourable attitudes to work



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6. Unemployment which arises because the skills of job-seekers do not match those requiredby employers is known as:

a) hiddenb) cyclicalc) hard-core

d) structural

7. The opportunity cost of unemployment is the

a) unemployment benefits paid by the governmentb) income tax foregone by the governmentc) goods and services purchased with unemployment benefitsd) goods and services which the unemployed could have produced

8. Inflation is most likely to benefit :

a) people on fixed incomesb) Australian exportersc) long term saversd) long term borrowers

9. Cost push inflation is characterised by rising :

a) factor pricesb) exchange ratesc) aggregate demandd) export prices

10. An example of hidden unemployment would be :

a) Louise leaving teaching and waiting to find a new teaching positionb) Glenys not being able to find work due to poor economic conditionsc) Peters teaching skills not being demanded in the marketd) Phil taking early retirement from the workforce as work is difficult to find



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Unit 2CALCULATION OF GDP

Avoiding Double Counting

To measure total output accurately, all goods and services produced in any given year must be

counted once, but not more than once. Only the value of final goods and serviceswill be counted.Final goods and services are goods and services that are being purchased for final use and are not to

be subject to further processing, manufacturing or resale. Intermediate goods and services,on theother hand, are goods and services that aresubject to further processing, manufacturing or resale.

Most products go through a series of production stages before reaching a market. Throughout theseproduction stages, parts or components of most products are bought and sold many times; thesetransactions represent part of the cost of the different stages of production. To avoid counting the

parts of final products that are sold more than once, GDP includes only the market value of the finalgoods and services and ignores the value of intermediate goods and services. Why? Because thevalue of final goods and services includes any intermediate goods required during the production

process. To count intermediate goods separately would involve double-countingand provide anexaggerated estimate of GDP.

An example will clarify this point. Suppose there are five stages of production in getting a suitmanufactured and into the hands of a consumer who, of course, is the ultimate or final user. AsTable 1 indicates, firm A, a wool grower, provides $40 worth of wool to firm B, a wool processor.Firm A pays out the $40 it receives in wages, rents, interest and profits. Firm B processes the wooland sells it to firm C, a suit manufacturer, for $160. What does firm B do with this $160? Asnoted, $40 goes to firm A, and the remaining $120 is used by B to pay wages, rents, interest and

profits for the resources needed in processing the wool. The manufacturer sells the suit to firm D, aclothing wholesaler, who in turn sells it to firm E, a retailer, and then, at last, it is bought for $400

by a consumer, the final user of the product. At each stage, the difference between what a firm haspaid for the product and what it receives for its sale is paid out as wages, rent, interest and profitsfor the resources used by that firm in helping to produce and distribute the suit.

The basic question is this: how much should we include in GDP in accounting for the production ofthis suit? Just $400, the value of the final product! Why? Because this figure includes all theintermediate transactions leading up to the products final sale. It would be a gross exaggeration tosum all the intermediate sales figures and the final sales value of the product in column 2 and addthe entire amount, $1090, to GDP. This would be a serious case of double-counting that is,counting the final product and the sale and resale of its various parts in the multi-stage production

process.



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To avoid double-counting, national income accountants could calculate only the value added byeach firm. Value added is the market value of a firms output (its revenue) less the value of theinputs it has purchased from others (its intermediate consumption). So, for example, we note incolumn 3 of Table 1 that the value added by firm B is $120, the difference between the $160 valueof its output minus the $40 it paid for the inputs provided by firm A.

By adding together the values added by the five firms in Table 1, the total value of the suit can beaccurately determined. Similarly, by calculating and summing the value added by all firms in theeconomy, national income accountants could determine GDP.

Table 1

(1)

Stage of production

(2)

Sales value of

materials or product

(3)

Value added

Firm A, wool grower $ 40 $ 40

Firm B, wool processor 160 120Firm C, suit manufacturer 220 60

Firm D, clothing wholesaler 270 50

Firm E, retail clothier 400 130

Total sales volume $1,090

Value added $400



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GDP and Economic Wellbeing.

GDP is the most common single measure of economic wellbeing of a society. A high GDP doesallow people to enjoy a better standard of living. GDP measures the production, income andexpenditure within the economy. If more goods and services are being produced then there are moregoods and services for the society to use and share.

GDP is not however, a perfect measure of wellbeing. Some things that contribute to a good lifeare left out. Economic wellbeing (sometimes called economic welfare) is a broader concept used toassess the societys quality of life. To measure the quality of lifewe should not only look at thematerial level of output (GDP) but also at other variableswhich influence how satisfied people arewith their lives. These other variables include the pattern of distribution, the composition of

production, leisure time, the levels of pollution, the levels of crime, the levels of political freedomand even the weather.

GDP does not measure the hours that are workedand the quantity of leisure time. People whowork very long hours to produce a large number of goods and services may not have enough time to

enjoy them. The welfare gained by increased output may be due to reduced leisure time.

GDP excludes the quality of the environment. The production of more goods and services mayalso result in more pollution. The deterioration of the quality of the air, oceans, forests and riversmay reduce wellbeing and more than offset increases in output. Pollution may also increase theincidence of some illnesses further reducing wellbeing.

Also excluded from measures of GDP is the composition of output(the type of goods and servicesproduced). If a nation concentrates its production on building more military equipment then it mustdivert output of goods and services away from consumer products. Likewise, nations whoconcentrate on the production of capital and infrastructure (attempting to achieve rapid growth) willneed to reduce the output of consumer goods, at least in the short run..

GDP does not directly measure the quality of the health or education systems.

GDP only counts the production good and services that are bought and sold for money. Manyservices are often done by those who are not paid (e.g. child rearing by grandparents) and are notcounted. If the same services were provided by child care centres then they would be counted.

A high level of average income does not mean that all the people have high incomes. A society inwhich a large share of the total GDP flows to a small proportion of the economy will mean

extremes of rich and poor. Where the pattern of distributionis very uneven, a high average figurewill be misleading and the general standard of living is likely to be quite low while a few in thepopulation may have enormous wealth.

We can see by now that GDP gives only part of the picture when observing the general standard ofliving. Other indicators may add to our understanding of wellbeing. These indicators includethe infant mortality rate, the literacy rate, the proportion of doctors in the population, the averagenumber of calories consumed per day and life expectancy.

In conclusion, we should regard GDP as a good but incomplete measure of the standard of living.There are distortions and omissions. There are abstract aspects of life that cannot be measured in

money terms such as political freedom. It is important to understand what the measure GDPincludes and what it leaves out.



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ECONOMIC GROWTH

The Sources of Economic Growth

From an economic viewpoint, output is a function of the resourcesused to produce that output andif we are to search for the reasons for growth, we need to examine the factors that influence those

resources and the skillswith which they are combined to increase output. Ultimately, a countrysgrowth rate is determined by the quantities of labour, capital and natural resources it possesses and

by the quality / skill of combining these, utilising improvements in technology, (i.e. productivity).

Demand factors

A significant source of growth is demand for an increased number and variety of goods andservices. The basis of increased demand in the long term is population growth, and the desire by

people to increase their economic welfare. Population increaseresults from natural increase (birthsminus deaths) and net migration (the increase from immigration minus the loss from emigration).Also, the development of a trading economy may stimulate growth because trade provides access tooverseas markets and increased potential demand. Migration creates immediate supply of labour,

and immediate demand for goods and services. Migration has also increased the quality of thelabour force by adding to its level of education, training and skills.

The following characteristics of a countrys population would be conducive to economic growth.

A high proportion of the population in the workforce, i.e. productive

A well-educated population

A healthy population

A population that wants economic growth - it must be motivated by material incentive

So it is not just the size of the population that matters - these other factors are fundamental tosupplying the human resources necessary for growth.

Supply factors

A major determinant of growth concerns the resources available to supply the demand for greatersatisfaction of wants. Economic resources consist of natural and human resources, and physicalcapital. Economic growth arises in part from an increase. in the available quantity or quality(productivity) of these resources. The key to economic growth is how a country develops itsresources: either expanding its resource base, or using its available resource base more effectively.

Increased productivity

More efficient use of available resources is an important general source of economic growth. Otherthings being equal, growth will occur if an increased quantity of outputs can be produced from thesame or smaller quantity of inputs - combining resources more productively, so that the sameamount of resources can produce greater quantity or value of goods and services.

1. Human resources and growth

Increasing the quantity and quality of human resources leads to economic growth because labour isa productive resource (supply side), and people demand goods and services (demand side).

Of great importance, is increases in human capital. Human capital can be defined as the stock ofknowledge and skills that people develop through education and experience. Improvements in

labour productivity generally occur as a result of education, training, the incentive of competition,better organisation of production within firms and more efficient allocation of resources betweenindustries. Human capital can be developed through:



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the provision of the basic building blocks of a productive workforce - social infrastructuresuch as schools, hospitals, communication etc.

the provision of education, which develops the skills, knowledge and understandings thatenable people to take their place in the community, as well as developing knowledge andskills which can be used in the workplace.

the provision of on-going training, which develops job-related skills

2. Investment and capital accumulation

In order to grow, an economy needs to divert some of its resources away from current production toproduce goods which will increase our capacity to produce in the future. Such goods are capitalgoods (the produced means of production) and add to the capital stock of the nation. The process ofadding to the capital stock of a nation is known as new investment. This is to be distinguishedfrom depreciationwhich is the process of replacing the worn-out items of capital equipment. Thesum of net investment and depreciation is gross investment.

The capital stock of the economy includes capital equipment, building structures, and inventories.Improvements in the capital stock occur as a result of invention, research and innovation. Anotherkey to economic growth is an increase in the capital to labour ratio to equip workers with a greaterstock of physical capital to enable them to work more productively. Two types of investment incapital can be distinguished:

Public or government investment, which creates the framework on which economicactivity is founded. Public investment provides the majority of infrastructure such as roads,schools, hospitals, water supply and power. These are the parts of the capital stock on which

private sector productivity is founded. Public investment is often referred to as social

overhead capital. In general terms, public investment contributes to economic growth bylaying the foundation on which the private sector can do business e.g. Roads enable thetransport of goods, communications enable the interchange of products and ideas.

Private or business investment, which includes buildings, machinery and equipment.Private investment in capital equipment is undertaken in order to produce final goods andservices.

It is necessary to distinguish between capital accumulation caused by capital wideningfrom thatcaused by capital deepening. The stock of capital is widened when it grows in proportion to other

productive inputs. Capital wideningmaintains the stock of capital per head. As population grows,there will be a necessity to increase the stock of capital - providing more houses, roads, schools,medical facilities and factories to keep up with the level of demand.

Capital deepeningis an increase in the stock of capital relative to the stock of other productiveresources. This causes production to become more capital intensive i.e. deepening the stock ofcapital increases the capital/labour ratio; or the capital/land ratio. Capital deepening tends toincrease productivity, making it possible for the workforce to produce a larger total output.



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3. Technological progressTechnology the ideas or methods used in production. Technological progress can best be definedas changes in scientific and technical knowledge which involve new discoveries and newtechniques, and the application of these to the production process in order to raise the productivityof the economy, i.e. output per worker per unit of time.

The application of improved technology to the productive process will increase the productivity ofthe resources used. A greater volume of output can then be produced for the same volume of inputs

better utilisation of resources. The economy can achieve higher levels of output in the future byadopting more technology. Economic growth is more likely to be founded upon a consistent effortto develop and apply product and process innovations. Such effort is often referred to as researchand development (R&D).

The potential for growth is increased when effort directed at research is improved. Such effortsoften involve a high degree of risk, however. Technological progress may also have negative effectsin some sectors of the economy. It is a cause of structural unemployment, because job losses may

be due to capital for labour substitution. Technological change favours those who hold highlyskilled jobs at the expense of those who have fewer skills those who are more likely to bereplaced by technology, rather than be assisted by it. Most of these effects, however, occur in theshort term, and people can take measures to counteract them over time, such as further educationand retraining.

4. Government PoliciesShould seek to create a favourable climate and optimum conditions for growth, e.g.

a) Policies to promote full employment, low inflation, promotion of business confidence forcontinued investment.

b) Encouraging steady expansion of demand (e.g. immigration).

c) Policies to ensure high rates of capital accumulation - e.g. investment allowances on newequipment, low company taxes, or increased government spending on capital works.

d) Providing protection for local industries against overseas competition, while attempting toencourage the development of efficient, export orientated industries.

e) Promoting competition to help new ideas, innovation, etc.

f) Expenditure on education (apprenticeships, job training and research (e.g. C.S.I.R.O., grantsto Universities).

g) Provision of social overhead capital - infrastructure e.g. water, power, transport facilities -the conditions necessary for the growth of industry, mining by private producers.



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THE BENEFITS OF GROWTH

The benefits of economic growth are to be found in improved living standards, increasedemployment opportunities, improved economic and social mobility, increased levels of socialwelfare, increased leisure time, increased participation in international trade, increased levels ofassistance to less-developed countries, and in the self-generating, cumulative nature of the growth

process itself. These are, of course, interrelated.

Improved living standards

The major overall benefit of economic growth is the improved living standards of the population asa whole. Rising living standards mean higher levels of material well-being. These find theirtangible expression in a greater volume and variety of consumer goods and services, improvementsin the quality of all commodities, better standards of health and nutrition, improved housingconditions, and so on.

Increased employment opportunities

Economic growth provides improved employment opportunities for an expanding workforce.

The structural changes which accompany growth involve, among other things, the development ofnew markets and the expansion of existing ones. Now, because of demand for labour is a derivedone, such structural changes necessarily give rise to new avenues of employment in some sectors ofthe economy and growing employment opportunities in others.

Improved economic and social mobility

Economic growth necessarily involves a reallocation of resources. Resources are attracted away

from existing industries and towards new ones. By providing new employment opportunities,therefore, growth is said to increase the economic mobility of resources that is, it improves theease with which resources of all kinds move between various avenues of employment. Increasedmobility of resources means a more flexible economy; it promotes structural change and isconducive to rapid economic growth.

Economic growth also means increased social mobility. Rising incomes, improved access tohigher education and a wider range of occupational choice allow individuals to move more easily

between social groups or social classes. These classes are closely connected with the status oneenjoys by reason of income, wealth, family name or occupation. Increased social mobility helps to

break down the class barriers because it means, in effect, that children do not necessarily followin their parents footsteps.

Increased social welfare

Economic growth makes possible a greater provision for the aged, sick and unemployed membersof society. Rising incomes and expenditures which accompany growth provide increased taxrevenue for the government, and so allow increased transfer payments in the form of pensions andunemployment benefits. Such payments reduce income inequalities and, in so doing, raise thegeneral living standard as a whole.



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Increased leisure time

The rising productivity levels which accompany growth allow for a reduction in working hours and hence an increase in leisure time.

Along with rising real incomes, increased leisure time generates increased expenditures on

recreational activities. These, in turn, promote the development of leisure-oriented industries(entertainment, sport, travel, etc.), with their accompanying employment opportunities.

Increased participation in international trade

Economic growth allows each country to participate more fully in world trade and thus enjoy theadvantages of international specialisation. For a growing economy, these advantages are to befound in the greater volume and variety of commodities available for domestic consumption (viaimports), greater access to raw materials supplies, more efficient use of existing resources, and thetransfer of new technologies.

THE COSTS OF GROWTH

The costs of economic growth include structural unemployment, lower present living standards,inflation, balance of payments difficulties, the concentration of economic power, as well as thesocial costs associated with environmental damage and the deteriorating quality of life.

Structural unemployment

Structural change necessarily involves a reallocation of labour resources. As new industriesdevelop, the demand by employers for certain kinds of skills will increase, as some of the moretraditional industries decline in importance, the demand for some existing skills will fall. Thus,while new industries boast increasing employment opportunities, more established industries arecharacterised by rising unemployment levels.

Such unemployment is called structural unemployment. It arises, in effect, because the skills ofthe unemployed no longer match those required by employers.

Structural unemployment is regarded as a serious problem. Firstly, it involves animportant opportunity cost to society in terms of goods and services which those unemployed

persons could otherwise have produced. The result is a reduction in the ability of society to satisfy

its material wants.

Secondly, evidence suggests that structural unemployment tends to be long-term in nature. It is notalways so easy for displaced workers to take advantage of employment opportunities in newlyemerging industries. The acquisition of new skills takes time and poses particular problems forolder workers.

Inflation

High rates of economic growth are likely to be accompanied by inflation. On the one hand, rising

money incomes and increasing demand for goods and services mean greater pressure on scarceresources in general and on labour in particular. As the economy approaches full employment,competition between firms for increasingly scarce labour forces up wages and salaries. Higher



21/98

wages and salaries mean increased production costs and these, in turn, are passed on to consumersin the form of higher prices. This kind of inflation is called cost-push inflation.

On the other hand, inflation may occur because the rate of growth in output is insufficient to meetthe demand for additional goods and services by the population. This kind of inflation is calleddemand-pull inflation.

Inflation poses a number of important problems for a growing economy. Among other things, itlowers real incomes, increases income inequality and leads to a misallocation of scarce resources.It also presents an important dilemma for government policy makers. In particular, it means that the

pursuit of rapid growth may have to be at the expense of another desirable economic objective thestability of costs and prices.

Balance of payments difficulties

Rapid economic growth may pose balance of payments difficulties in several related ways. Firstly,a nations international competitivenesstends to decline if its domestic rate of inflation exceeds

that of its major trading partners. Declining international competitiveness means rising imports,falling exports and larger current account deficits.

Secondly, the increasing demand for imports which accompanies growth tends to put downwardpressure on the exchange rate. Unless the growth in imports is more than matched by increasedexports, the current account deficit will rise and a nation will be forced to borrow more fromoverseas. The result is a rising level offoreign debt.

Thirdly, economic growth may pose long-term balance of payments difficulties if new investment isfinanced mainly byoverseas borrowing. Repayment of the foreign debt in the form of interest anddividends necessarily places a future strain on the current account.

Harmful externalities and social costs

One of the most serious problems associated with economic growth is the presence of harmfulexternalities. Externalitiesrefer to those indirect costs and benefits associated with the productionand consumption of certain goods and services which the price mechanism fails to take intoaccount. Externalities are also known as spill-over effects.

Negative externalitiesarise, when cars pump carbon monoxide into the atmosphere, when afactory discharges waste into a river and kills fish downstream, and even when a picnicker throws

beer cans into the bush. These harmful externalities are called spill-over costs or social costs.

There can be little doubt that economic progress has been accompanied by air and water pollution,the destruction of the natural environment and the extinction of certain species of wildlifeAlso, economic growth has been accompanied by increasing urbanisation. This has a number ofdeleterious effects on the quality of life. These include increasing noise and traffic congestion,overcrowding, the development of slum areas as dwelling construction and urban renewal fail tokeep pace with an expanding urban population, the ugliness of the big city itself, the growing

problem of garbage disposal, increasing pressure on urban amenities, and the growing incidence ofthe physical and emotional problems which accompany the increasing pace and pressure of urbanliving.



22/98

Unit 3THE BUSINESS CYCLE

Over a long period of years, real GDP will grow as a result of population growth; resourcedevelopment; productivity improvements; and the demand for a higher standard of living. Aninherent characteristic of all developed economies is that the rate of growth and the level of

economic activity fluctuates about the trend, or average rate of growth. In some years, countriesexperience higher rates of growth - a boom. In other years, economic growth may be lower thanaverage, perhaps even negative. This cycle of booms and recession is known as the business cycle -characterised by four phases - boom, downswing, trough, and upswing.

The Phases of the Business Cycle

The business cycle is a regular oscillation of economic activity. Four phases of the cycle are usuallyrecognised - boom, (peak) downswing (contraction), trough (recession) and upswing (recovery).As Fig 1 shows, real GDP rises in the recovery phase, reaches a peak, declines through the

recession to a trough and then rises in another recovery. .

trough

time

boom boom

downswing upswing

%GDP

0

1. The boomThe boom is a period when the general level of economic activity is above average. The levels ofaggregate expenditure are at, or beyond, levels required for full employment. Typical characteristicsof the boom include:

high levels of consumption expenditure a general feeling of confidence in the economy.

firms have increased output unemployment is relatively low



23/98

inflationary pressure is more likely. imports (of both consumer and producer goods) are relatively high.

2. The downswing

The level of economic activity cannot keep rising forever. In the upswing to the boom, investmentincreases productive capacity and productivity and higher levels of aggregate expenditure mean

resources such as labour are fully employed. But investment becomes more risky after some pointbecause of limits to capacity. Once investment levels off this translates into lower output andincome.

The rates of increase in potential output fall as shortages of labour or productive capacity occur. It isnot possible to produce more and more output from fully utilised stocks of capital equipment, anddemand pressure may result in price increases rather than increases in output.

At the peak of the cycle, the rates of increase of income, output and expenditure which havecharacterised the boom tend to level off. Investment will decline. The effects of falling aggregateoutput and income levels start to spread throughout the economy, and it becomes obvious that the

economic climate has deteriorated.

Any of these events may give rise to uncertainty as consumers and firms change their expectationsabout the future and change their planned spending habits as a result. The mood of the economymay also change as the government introduces contractionary fiscal and monetary policy in order toreduce the level of activity in the booming economy. Interest rates usually rise during the upswingand boom, and may reach a level where they start to discourage borrowing (because repaymentswill be high) and expenditure on durables (because the opportunity cost of spending onconsumption or investment is high).

3. The trough

The trough (otherwise called contraction or recession) is when the level of aggregate expenditure(income, consumption and investment) is below the economy's potential during the trough, which isoften characterised by:

higher levels of unemployment

lower consumer expenditure

lower inflation (or deflation)

lower levels of consumer and business confidence

levels of saving may rise as some people put off consumption

4. The upswingThe decline in economic activity will not continue indefinitely. Productive capital is eventuallyworn out and requires replacement. Businesses will develop process and product innovations asthey fight to develop a competitive advantage over their rivals. Higher levels of expenditure,income, and output affect both firms and consumers. The level of economic activity gradually risesas the economy resumes its long term growth path. The upswing can also he called the expansion

phase of the cycle.



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KEYNESIAN ECONOMICS

Until the late 1930s, the existence of large scale unemployment in an economy was regarded byeconomists as a temporary affair which would right itself. Influenced by this view, governmentsadopted a laissez-faire attitude towards unemployment. It was believed that only at fullemployment was the economy at equilibrium and that at anything less than full employment the

self-adjusting mechanism would begin to work. If labour was unemployed, wages would fall; theprofits of firms would therefore rise and, as a consequence, more labour would be employed.

During the late 1920s and early 1930s, however, it became obvious that unemployment was notemporary matter. For most industrial economies, the unemployed in this period were rarely lessthan 10 per cent of the total labour force and, at some stages, reached as high as 25 per cent.Governments, however, by accepting the theories of orthodox economics, appeared powerless to doanything to correct it. It was Keynes achievement to break with orthodox economics and showhow large scale unemployment may be avoided.

The Great Depression resulted in a considerable re-evaluation of the role of government in the

market economy. Up to this time government was expected to match its revenue with itsexpenditure.

The economist John Maynard Keynes argued in book, The General Theory of Employment,Interest and Money (1936), that the traditional approach to fiscal policy especially maintaining

balanced budgets in periods of recession of depression was unsound. He had studied economictrends during the 1920s and had come to the conclusion that existing economic policies wereunable to solve problems faced by the governments of his day.

Keynes laid heavy emphasis upon the importance of demand in his economic theory and hestressed the point that it was within the power of governments to influence the level of

unemployment and inflation by policies which changed the total amount of spending within theeconomy. He rejected the view which had been put forward by the Classical economist, Jean Say.Says Law stated that supply creates its own demand. Say had argued that where productionoccurred, the incomes generated during the production process would be sufficient to purchase theoutput and indeed would result in the output being purchased.

Keynes, on the other hand, noted that this approach had ignored the role of leakagesand injectionsin to the circular flow. He saw that an economy is in a state of equilibrium when leakages (savings,taxation and imports) are equal to injections (investment, government expenditure and exports) inthe circular flow. He saw that an economy need not be in a condition of full employment for itto be in equilibrium.

Consider the example of an economy at full employment and in equilibrium when the level of

national income is $4000 million. In such an economy, S + T + M = I + G X. Should the sale ofexports drop, the economy is now in a state of disequilibrium: S + T + M > I + G + X. Leakagesfrom the circular flow are greater than injections. Incomes fall, demand curves for goods andservices shift to the left and unemployment rises. Full employment can only be restored whennational income is greater than, or equal to, $4000 million. Keynes saw that it was possible for aneconomy to be in equilibrium yet not at full employment in our example all that is necessary isthat leakages from the circular flow equal injections when national income is less than $400 million.



25/98

Keynes and Unemployment

The Keynesian explanation of unemployment is a theory of effective demand. Unemploymentexists, according to Keynes, not because workers want too high wages, but because the demand forgoods and services is too low and is stabilised at this low level. Fundamentally, then

unemployment occurs because people and firms do not demand the products that the labour forcecan produce. The basic proposition is that, if a persons income rises, only a part of the incrementwill be spent on consumption; the rest will be saved.

From the point of view of aggregate incomes in the economy (national income) it is clear thereforethat the community is not prepared to spend all its income on current consumption. That is, thecommunity does not ask the labour force to produce consumption commodities of a value equal toits own income.

Keynes makes the assumption that the level of employment in the economy depends upon the levelof national income. In other words, employment depends on the volume of production (since allincomes arise directly or indirectly from production). More production means more jobs, and vice

versa. In a relatively developed economy with full employment, only a part of the national incomeis spent on current consumption. Similarly, only part of the domestic product is composed ofconsumption commodities. The rest of the domestic product must be composed of investmentgoods. Under conditions of full employment, the amount of labour required to produce theseinvestment goods, together with that required for consumption commodities, equals the total labourforce. Obviously, the demand for investment goods must come from expenditure of income notrequired for consumption. It comes from savings. Now, if the community is not prepared to spendsufficient of its savings on investment to create full employment, the level of national income will

be less than that required for full employment. Keynes calls this the point of under-employmentequilibrium. Unless more can be spent on producing a greater quantity of commodities (either forconsumption or investment), unemployment will be permanent.

Keynes and Government Policy

Keynes theory gives emphasis to two important features. The first is the stress placed on thenational aggregates. If an individual saves a greater part of his income, he may be doing a soundthing. For a community as whole, however, such an action may be positively harmful unless thatcommunity is prepared to invest sufficiently to compensate for the lower consumption level. Thesecond feature is the crucial importance of aggregate investment. (Keynes used the terminvestment in its economic sense of expenditure on investment goods, i.e. on physicalcommodities such as machines, factories and houses. He did not mean investment in government

bonds, stocks and shares, etc.) Keynes noted that consumption habits of persons are relatively fixedfor any given level of income. If national income is insufficient for full employment, it would helpif the community spent more on consumption commodities. But this is difficult to achieve. Thekey to unemployment, therefore, is investment. In his favour investment multiplier analysis,Keynes demonstrated that investment created jobs not only for those directly producing theinvestment goods. Part of the extra incomes earned would create more incomes (and jobs) out ofwhich some would be spent on consumption and so on.

Thus, the main conclusion of Keynes analysis is that investment is the main factor determining thelevel of employment. Because of the importance of this conclusion, much of Keynes analysis isconcerned with explaining what actually determines investment. He emphasised the role ofmonetary factors and especially interest rates and the supply of credit and money. The flow offunds from savings into investment will only take place if the expected rate of profit (Keynes calledthis the marginal efficiency of capital) on such investment is high enough. If interest earnings on,



26/98

say, government bonds or other securities are higher than can be obtained by investing, then savingswill be put into securities rather than investment. Thus low interest rates help investment, andKeynes was a firm advocate of a cheap money policy as a cure for unemployment.

Since the publication of The General Theory, its influence has been profound. In the opinion ofmany, Keynes ranks as the greatest of all economists. His emphasis on investment and monetary

factors has been largely responsible for many features of government policy since World War II.Since there is a tendency for investment by private firms to fall short of the level required for fullemployment, Keynes advocated public (i.e. government) investment in public works and a cheapmoney policy. To Keynes, the government should undertake public works as a balancing factorto create the extra jobs needed when the private sector did not invest sufficiently for fullemployment. Thus, charity and soup lines were not the answer to unemployment; the governmentshould stimulate the economy through the purchase of commodities in the markets. Such spendingmust be new spending and not substitution for private expenditure. In a situation of unemployment,therefore, public spending should be financed from loans and not from taxes. Tax-financerepresents income removed from the community which would have been spent if left in privatehands. Loan-finance, normally represents a net addition to total spending.

Thus Keynes believed that government intervention in the economy could help restore fullemployment. In periods of recession, the government should increase rather than reduce itsexpenditure. Since S > I in such times, it made sense for the government borrow in order tofinance its spending. Increased government spending should have the effect of increasing thedemand for goods directly as the government would be acquiring goods and service in return forits expenditure and it would have a multiplier effect on the economy as a whole. Resourcesneeded to create the goods and services purchased by government would create an increase inderived demand, so the incomes for factors of production would rise. Potentially, greater incomeswould result in higher levels of consumer spending, greater demand for capital (thus increasinginvestment), and lower unemployment.

In periods of high demand and inflation, Keynes believed that a government should run a surplusbudget that it should spend less than it received. In this way it would be able to reduce the totaldemand for goods and services in the economy. By increasing the level of leakages from thecircular flow, the economy could be moved to a state of equilibrium at a lower level of nationalincome.

From the end of World War II, Demand Management, the regulation of aggregate demand byfiscal policy in an effort to counter swings in the business cycle, has been used by government inWestern market economies.



27/98

DETERMINANTS OF CONSUMPTION AND SAVING

We now consider the factors which are likely to affect household spending decisions. In doing so,we must keep in mind the special relationship between consumption and saving, since those factorswhich alter the level of household spending will also alter the level of household saving.

Factors Affection Consumption

The level of disposable incomeThe level of disposable income is the key determinantof the level of consumption expenditure. Ingeneral, the higher the level of disposable income within the community, the higher is its level ofhousehold consumption.

As total disposable income rises, of course, total household consumption increases. We can qualifythis statement in two respects.

1. Increases in disposable incomes are accompanied by increases in the Average Propensity tosave (APS). Thus the higher the level of disposable income, the greater is the proportion ofthat income which is saved.

2. Increases in disposable income are unlikely to be completely absorbed by increases inconsumption expenditure. Some will be reflected in increased saving. The extent to whichconsumption and saving will increase depends, of course, on the sizes of the MPC and theMPS respectively.

Finally, let us note that it is quite possible (in the short run) for individual households to spend morethan their current disposable incomes simply by borrowing or by drawing on their own past savings.This reduction in accumulated savings is called dissaving.

The distribution of income

If the distribution of income is uneven, households in upper income groups receive a relatively largeproportion of total disposable income. The APC for these groups is relatively low(while their APSis relatively high). A more even distribution of income, on the other hand, means that households inthe lower income groups receive a relatively larger share of total disposable income. The APC forthese groups is relatively high.

Thus, the more even is the distribution of income, the higher is the APC and the higher is the levelof consumption expenditure.

Wealth

It is often argued that, in the making their spending and saving decisions, households are heavilyinfluenced by their levels of wealth. The term wealth basically refers to the total value of eachhouseholds assets (cash, bank deposits, securities, and property such as cars and houses). (Noticethat wealth and income are differentconcepts.)

Given the same level of current disposable income, those households with accumulated wealth aremore prepared to spend than those with little or no accumulated wealth. There are three reasons forthis. Wealthy households:

1. have a greater capacity to borrow, since they can use their assets as collateral.2. tend to have a greater volume of past savings on which they can draw.3. are more likely to spend because their economic futures are relatively secure.



28/98

Consumer expectations

If households expect inflation to continue at relatively high rates, they will be encouraged to buynow and beat the price rise. As households bring their expenditure plans forward the level ofconsumption will rise. If they expect prices to fall, households are likely to postpone some of theirspending plans, and the level of consumption will fall.

Households are also likely to increase their current spending of they expect their incomes to rise inthe near future. The prospect of improved employment opportunities and rising incomes promotesconsumer optimism and tends to make households somewhat more carefree in their spending

behaviour. If, on the other hand, households face the prospect of unemployment and low futureincomes, they tend to reduce their current spending and increase their level of saving.

Generally, we can say that current economic conditionsare likely to have an important influence onconsumer expectations and a significant impact, therefore, upon household decisions to spend andto save

The rate of interest

For households, interest rates represent both the cost of borrowing and the reward for saving. Risinginterest rates make borrowing relatively more expensive, and saving relatively more attractive.Falling interest rates, on the other hand, make borrowing relatively cheaper and saving relativelyless attractive.Thus, rising interest rates tend to reduce the level of consumption and increase the level ofhousehold saving; falling interest rates tend to increase the level of consumption and reduce thelevel of household saving.Changes in interest rates are particularly important in the case of consumer durables. Cars, electricalappliances, and the like are relatively expensive, and households tend to finance their purchases ofthese items by borrowing. Yet, the relatively long useful life of these goods is such that householdsmay well be able to postpone planned expenditures on them. Thus, spending on consumer durablestends to be highly sensitive to interest rate movements.

The availability of creditFor the individual household, credit is a source of additional funds which can be used to finance itscurrent spending. As credit becomes more readily available, the level of total household expendituretends to rise. If credit becomes more difficult to obtain, households are likely to postpone some oftheir planned purchases, and the level of consumption tends to fall.

Population size, growth, and age structureObviously, the larger the population, the greater the level of total consumption expenditure. Rapid

increases in the population (for example, through immigration programs) are likely to lead to sharprises in the level of household spending.The age structure of the population is also an important factor. A relatively young population tendsto spend more (and save less) than an ageing population. Young couples, for example, typically

borrow to buy a home, and thus spend in excess of their current incomes. Repaying home loans andraising children tend to keep household savings low for some considerable time. As the childrengrow up and leave the family home, and as mortgages are paid off, however, household savingtends to rise.

Cultural attitudesIf contemporary values are such that social status depends on how much we spend, then the level of

consumption is likely to be relatively high. If, on the other hand, society attaches a high value topersonal thrift, people will tend to save a significant proportion of their current income.



29/98

INVESTMENT

Investment is expenditure on producer or capital goods that are used to produce final goods andservices in the future, e.g. on new plant, capital equipment, machinery, and so on. The level ofinvestment is a very important determinant of aggregate demand and the overall health of theeconomy. Aggregate private investment is the most volatile element of aggregate expenditure

Factors Influencing Investment Expenditure:

Expected Rate of Net Profit

The level of investment spending is guided by the profit motive; the business sector buys capitalgoods only when it expects such purchases to be profitable For example, Suppose the owner of asmall shop is considering investment in a new machine that costs $1000 and has a useful life ofonly one year. The new machine will presumably increase the firms output and sales revenue.Specifically, let us suppose that the net expected revenue from the machine is $1100. In otherwords, after operating costs have been accounted for, the remaining expected net revenue issufficient to cover the $1000 cost of the machine and leave a return of $100. Comparing this $100return or profit with the $1000 costs of the machine we find that the expected rate of net profit ofthe machine is 10 % (=$10 / $1000).

The Real Interest Rate

But there is more important cost associated with investing which our example has ignored. Andthat, of course, is the interest rate the financial cost the firm must pay to borrow the money capital

required for the purchase of the machine. If the expected rate of net profits (10 %) exceeds theinterest rate (say 7 %), it will be profitable to invest. But if the interest rate (say, 12 %) exceeds theexpected rate of net profits (10 %), it will be unprofitable to invest.

The rate of interest is a major influence on investment decisions. Other things being equal, interestrates and the level of investment expenditure are inversely related. This concept is formalised as theinvestment demand curve, on the next page. The investment demand curve shows the relationship

between the (real) interest rate and quantities of planned investment. Interest rates (on the vertical-axis) represent the price of money. There is an inverse relationship between the rate of interestand the level of investment.

Lower rates of interest (i) tend to induce higher investment expenditure (I). So if interest rates fallfrom i to i1, we would expect a movement along the investment demand curve from Q to Q1. Theline I shows a shift of the whole investment demand schedule brought about by a change in non-interest rate factors. An increase in aggregate investment from I to I would be due to a non-pricefactors affecting investment, such as positive expectations about the future business climate.

The difference between nominal and real rates of interestmust be noted here. Nominal rates arethe current price of borrowed money (i.e. the face value of the money. The real rate of interest,however, takes the rate of inflation into account. If nominal rates of interest are at 8 %, and inflationis 4 %, then the real rate of interest is 4 % (8 minus 4). Real rates of interest are a greater influenceon business decisions than nominal rates.



30/98

Fig. 1 The investment-demand curve

RealRateofInterest

I

Investment1

i

I

i1

There are two reasons for the inverse relationship between i and I. As noted, interest rates representthe price of borrowed money, so when interest rates are high, so too are repayments for capitalitems purchased with borrowed funds. Secondly, interest rates represent the opportunity cost ofmoney. Firms have the choice of using money capital for new investment, or for some alternative

purpose. The opportunity cost of investment increases when interest rates are high. For example, ifbusiness interest rates were 12 % p.a., the prospective rate of return on capital equipment mustexceed 12 % before a rational firm would consider investment to be a wise decision, other things

being equal.

Shifts in Investment Demand

Let us briefly consider several of the more important non-interest determinants of investment-demand noting how changes in these determinants might shift the investment-demand curve. Anyfactor that increases the net profitability of the investment will shift the investment-demand curve tothe right. Conversely, anything that decreases the expected net profitability of investment will shift

the investment-demand curve to the left.

A major determinant of the level of investment is business expectations-what business thinksabout the current level of economic activity, forecasts for the future, and the impact these will haveon profitability. Business expectations are formed as a result of current economic events such aslevels of sales and enquiries from buyers. If business expectations about future sales arid profitlevels are positive, then it is likely that the investment demand curve will shift to the right. On theother hand, a downturn in the level of business confidence would see a reduction in plannedinvestment.



31/98

Technological progress

Technological progress the development of new products, improvements in existing products, thecreation of new machinery and new production processes is a basic stimulus to investment. Thedevelopment of a more efficient machine, for example, will lower production costs or improve

product quality so increasing the expected net rate of profit from investing in the machine. A rapidrate of technological progress shifts the investment-demand curve to the right, and vice versa.

Acquisition, maintenance and operating costs

As our machine example revealed, the initial costs of capital goods, along with the estimated costsof operating and maintaining those goods, are obviously important considerations in gauging theexpected rate of net profitability of any particular investment. To the extent that these costs rise, theexpected net rate of profits from prospective investment projects will fall, shifting the investment-demand curve to the left. Conversely, if these costs decline, expected net profit rates will rise,shifting the investment demand curve to the right. Wages also may affect the investment-demand

curve because wage rates are a major operating cost.

Business taxes

Businesses look to expected profits after taxes in making their investment decisions. Hence, anincrease in business taxes will lower profitability and tend to shift the investment-demand curve tothe left; a tax reduction will tend to shift to the right.

The stock of capital goods on hand

To the extent that a given industry is well-stocked with productive facilities and inventories of

finished goods, investment will be lessened in that industry since such an industry will be amplyequipped to fulfil present and future market demand. If an industry has enough, or even excessive,

productive capacity, the expected rate of profit from further investment in the industry will be low,and therefore little or no investment will occur. Excess productive capacity tends to shift theinvestment-demand curve to the left; a relative scarcity of capital goods shifts it to the right.

ExpectationsWe noted earlier that business investment is based upon expected profits. Capital goods are durable

they may have a life expectancy of 10 or 20 years and thus the profitability of any capitalinvestment will depend upon business planners expectations of the future sales and future

profitability of the product that the capital helps produce. Business expectations may be based uponelaborate forecasts of future business conditions that incorporate a number of business indicators.

Nevertheless, such elusive and difficult-to-predict factors such as changes in the domestic politicalclimate, of overseas events, population growth, stock market conditions and so on must be takeninto account on a subjective or instinctive basis. For present purposes we note that if businesses areoptimistic about future business conditions, the investment-demand curve will shift to the right, a

pessimistic outlook will shift it to the left.



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KEYNESIAN THEORY AND THE LEVEL OF ECONOMIC ACTIVITY

The aggregate expenditure (AE)model is based on the ideas first published by John MaynardKeynes in the 1920s and 1930s. It examines the 'building blocks' of macroeconomic activity - thecomponents of aggregate expenditure.

Aggregate expenditurecan be defined as the total amount that firms and households plan to spendon goods and services at each level of income. The elements of aggregate expenditure can beexpressed in the equation:

AE = C + I + G + (X-M)

where C = consumption expenditure; I = investment expenditure; G = government expenditure ; X= exports; and M = imports.

Understanding aggregate expenditure patterns enables us to identify and explain trends in economicactivity. This section will introduce how changes in expenditure affect the level of income in the

economy. This analysis is an important background for later topics.

The Keynesian model is based on the relationship between the level of income received byhouseholds, and the level of consumption and savingwhich occurs. This is known as theconsumption schedule, or consumption function. Initially, we assume that there is no governmentsector and no overseas sector - in which case, there are only two possible things that people can dowith their income: spend it (C for consumption), or save it (S for saving) i.e.

Y=C+S

A hypothetical aggregate consumption schedule for the community is shown in the table below,

which shows the planned levels of consumption and savings expenditure at each level of income.The schedule is also shown graphically.

150

-60

60

0

a

S

C

C+S

Y

expY = C + S

0 60 60

100 120 20

200 180 20

300 240 60

400

300

100

500 360 140

600 420 180



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The level of aggregate expenditure is shown on the vertical axis, and income and output levels areshown on the horizontal axis. It is important to review the concept of macroeconomic equilibriumhere. Equilibriumrefers to the level of economic activity at which there is no change in the levelsof output, income or expenditure. That is, E=Y=O.

On the Keynesian model, where AE intersects any point along the 45 linerepresents a point of

equilibrium. Along the 45 line C + S is equal to the level of Y. Where AE intersects the 45 line, atpoint 'a', the total level of expenditure is equal to the level of Y, so there is overall balance and notendency to change. Planned spending consumes all output.

Consumption rises by some proportion of income, but it does not start from zero. If the incomelevel in the economy was zero, the aggregate level of consumption would still be $60 billion,(where the consumption function intersects the vertical axis). This is referred to as autonomousconsumption, as it occurs independently of the level of income.

Consumption can exceed income if households draw on their savings or rely on transfer payments(e.g. unemployment benefits), or borrow. At levels of income below $150 billion, aggregate

spending is greater than aggregate income. This is referred to as `dissaving'. After the 'break even'point, where C = Y and S = 0, (at point a where Y = $ .150 billion) there is a positive level ofsaving in the economy.

The Keynesian consumption functionproposes that consumption increases as disposable incomerises, but not by as much as the increase in income.C exceeds Y until the C function crosses the 45 line (point a). This is also the point at which thesavings = zero but then becomes positive.The consumption function is generally written as an equation C = a +bY, where a represents theautonomous componentof consumption (here $60 billion), and b represents the marginalpropensity to consume, (MPC), which is the slope of the C line.

The MPC can be defined as the fraction of the last (marginal) dollar of income which is spent onconsumption when income changes. Thus:

MPC = C / Y

The level of spending on consumption rises by a proportion of any increase in income - in the table,this proportion is 0.6, and is assumed to be constant, so the equation is a straight line). For every $1increase in income, the consumption function shows that households will spend 60 cents, and save40 cents. The MPC in this case = 0.6.Therefore, the equation for the C function in this case is C = 60 + 0.6Y.

The fraction of marginal income that is saved is the marginal propensity to save(MPS).MPS = S / Y

Our assumption specified that there was no government or overseas sectors in the economy. As aresult, all income is either spent (C) or saved (S). Therefore:

MPC + MPS = 1

The value of the MPC (0.6) in the equation for the consumption function represents the slope of theC line. If MPC .s 0.6, then MPS must be 0.4, because C S = Y. if consumers spent 70 per cent of

any additional income, and saved 30 per cent, then MPC = 0.7, and MPS = 0.3. The slope of theline with MPC = 0.7 would be greater (steeper) than the consumption function shown in thediagram above. A consumption function with a slope of 0.9 would be steeper again. A steeper



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consumption function means that households spend a greater proportion of any increase in income(Y) they receive. Economists generally believe that the MPC and MPS are relatively stable as Yrises as the MPC and MPS do not vary with proportion of total income which is spent

The overall proportion of income that is spent or saved at any level of income is the APC {averagepropensity to consume) and APS (average propensity to save). The APC is defined as the proportion

of total income which is spent. APS is defined as the proportion of total income which is saved.APC and APS vary as the level of income changes.

The consumption function is regarded as the cornerstone of Keynesian aggregate expendituretheory. We can now begin to add to the model by relaxing our assumption that consumers can onlyspend and save their income.

Adding the Financial Sector

Aggregate saving creates a pool of funds in financial intermediaries which re-enters the circularflow through a stream of investment.

To introduce the concept, we assume that business investment decisions are independent of theaggregate level of income in the economy - that is, they are autonomous. Autonomous investmentmeans that the investment is independent of income.

Assuming that there is no government or overseas sector, then the level of aggregate expenditure inthe whole economy must now be equal to the sum of consumption expenditure plus investmentexpenditure:

AE = C + I

Y C S I C+I

0

60

60

60

120

100 120 20 60 180

200 180 20 60 240

300 240 60 60 300

400 300 100 60 360

500 360 140 60 420

600 420 180 60 480

300

-60

exp

Y

C

S

0

b C+I

I60

C+S



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Equilibriumin this economy occurs where the levels of leakages and injections are equal. Thismodel extends the consumption function by adding an investment function. C+I is the aggregateexpenditure (AE). Equilibrium occurs where Y =$300 billion. (i.e. where S = I; and where the C + Iline crosses the 45 line (point b on the diagram). At the equilibrium level of income, there is no

tendency for the level of income to change.

There is always an automatic tendency towards equilibrium in the economy. If Y = $400 billion, forexample, the savings leakage is greater than the investment injection. Aggregate expenditure (C + I) is insufficient to support the level of output which firms have already produced, so firms cut

production and aggregate output and income fall, until equilibrium is restored at point b (Ye levelof income).

On the other hand, at the level of income Y = $200 billion, the total amount of expenditure (C + I)in the economy is greater than the planned output (i.e. 45 line). Investment exceeds savings,leading to a reduction in stock, an increase in production, and higher levels of income.

Only at Y = $300 billion can the economy be in equilibrium, with the levels of aggregateexpenditure matching planned output (where the C + 1 line cuts the 45 line).



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Unit 3

INCOME AND EXPENDITURE ANALYSIS

1. Induced investment will decrease as a result of a decrease in:

a) business expectationsb) savingc) the level of technologyd) income

2. An increase in autonomous investment will:

a) reduce the level of savingb) reduce the level of consumptionc) shift the total expenditure line upwardsd) shift the total expenditure line downwards

3. Which of the following will cause a decrease in autonomous investment?

a) a fall in interest ratesb) areduction in business taxesc) a fall in business expectations/confidenced) a fall in the level of income in the economy

4. The marginal propensity to consume is:

a) consumption expenditure divided by savingb) the increase in income divided by the increase in consumptionc) the increase in income divided by consumptiond) the increase in consumption expenditure divided by the increase in income

5. If national income rises, owing to a rise in investment, we would expect:

a) consumption and savings to riseb) consumption and savings to fallc) consumption to rise, savings to falld) consumption to fall, savings to rise

6. If C = 200 + .75 Y and I = 100, the equilibrium level of income is:

a) 600b) 750c) 1050d) 1200



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7. If C = 200 + .75 Y and I = 100 and the level of national income (Y) is 1,100 then:

a) there will be a build up of stocksb) consumption is less than savingsc) total expenditure exceeds total outputd) savings exceeds investment

8. I = 50 and S = -100+0.25Y, then the equilibrium level of national income is equal to:

a) 150b) 300c) 600d) 900

9. A rise in income of $2,000 causes consumption spending to rise by $1,600. The M.P.C. isequal to:

a) 0.2b) 0.8c) 1.6d) 2

10. In the diagram below CC is a consumption function. The marginal propensity to consume isequal to:

a) the distance BX

b) the ratio BX/ABc) the ratio BX/YAd) the ratio BX/OY

E C

XA--------B

C

0 Y Z INCOME



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Unit 4

Changes in the Level of Spending

Changes may occur in any of the components of aggregate expenditure. Because one man'sspending is another man's income, any addition to (or reduction of) the level of spending in theeconomy will have far-reaching effects on the level of income. A change in any of the withdrawalsfrom the circular flow, or injections to

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Revised Supplementary Material Semester 2 2013

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