ECON1102 SUMMARY NOTES
Rohan Barar
October 2018
Contents
1 Aggregate Production and Prices 2
1.1 KEY CONCEPTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
1.2 FORMULAE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
2 Employment and the Labour Market 3
2.1 KEY CONCEPTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
2.2 FORMULAE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
3 Interest Rates, Investment and Saving 4
3.1 KEY CONCEPTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
3.2 FORMULAE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
4 Income Expenditure Model of GDP 6
4.1 KEY CONCEPTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
4.2 FORMULAE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
5 The Government Sector and Fiscal Policy 8
5.1 KEY CONCEPTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
5.2 FORMULAE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
6 Financial Assets, Money and Private Banks 11
6.1 KEY CONCEPTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
6.2 FORMULAE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
7 Central Banks and Monetary Policy 13
7.1 KEY CONCEPTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
7.2 FORMULAE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
8 Aggregate Demand and Aggregate Supply 15
8.1 KEY CONCEPTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
8.2 FORMULAE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
9 International Macroeconomics and Exchange Rates 17
9.1 KEY CONCEPTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
9.2 FORMULAE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
10 Economic Growth 19
10.1 KEY CONCEPTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
10.2 FORMULAE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
1
1 Aggregate Production and Prices
1.1 KEY CONCEPTS
• The definition of Gross Domestic Product (GDP)
• GDP Valuation Methodologies
1. Production Method (Value Added Approach)
2. Expenditure Method (C, I, G, NX)
3. Income Method (Labour, Capital & Net Indirect Taxes)
• Real and Nominal GDP (and the GDP Deflator)
• The Business Cycle
• GDP per capita and Economic Growth
• Inflation and the costs of inflation
1.2 FORMULAE
• GDP = C + I +G+NX (Expenditure Model of GDP)
• GDP = Labour Income+Capital Income+Net Indirect Taxes (Income Model of GDP, where Net
Indirect Taxes are Indirect Taxes− Subsidies
• GNI = GDP + Net Primary Income from non residents (we add primary income credits and
subtract primary income debits to GDP)
• Price Level = Nominal GDP
Real GDP
• Economic Growth Rate = % change in GDP per capita
• CPI = Basket of goods today
Basket of Goods in base year
(where the base year determines the quantities of goods and
services that will be held fixed for the calculation)
• Inflation = % change in CPI
(Percent Change =
New V alue−Old V alue
Old V alue
)
2
2 Employment and the Labour Market
2.1 KEY CONCEPTS
• Labour Market Definitions & Ratios
• Types of unemployment
1. Frictional/Search
2. Structural
3. Cyclical
• Okun’s Law and Output Gaps
• Supply and Demand for Labour
– Decreasing MPL as the demand curve
– Supply curve indicative of the number of workers willing to work at each real wage value
– Changes to Labour Force shift supply curve
– Changes to either the price of goods or the productivity of labour shift the demand curve
• Frictions within the labour supply and demand model
– Minimum Wage Laws (Price Floors)
– Income Taxation
2.2 FORMULAE
• Employment Rate = Employed Individuals
Working Age Population
• Unemployment Rate = Unemployed Individuals
Labour Force
• Participation Rate = Labour Force
Working Age Population
• Long Term Unemployment Rate = Separation Rate
Separation Rate+ Finding Rate
=
s
s+ f
• Natural Unemployment Rate = Frictional Rate+ Structural Rate
• Unemployment Rate = Frictional Rate+ Structural Rate+ Cyclical Rate
• Output Gap = Actual GDP − Potential GDP
• Output Gap (%) = Real GDP − Potential GDP
Potential GDP
• Okun′s Law : (Actual GDP − Potential GDP
Potential GDP
) ∗ 100 = −β(u − u∗) (where u − u∗ is cyclical unem-
ployment)
• VMPL = Price ∗MPL
• Marginal Benefit ≥Marginal Cost, and so VMPL ≥Wage
• Real Wage = Wage
Price
= MPL (real wage allows for a relative measure of wages independent of inflation)
3
3 Interest Rates, Investment and Saving
3.1 KEY CONCEPTS
• Real vs Nominal Interest Rates
• The Fisher Effect (r = i− pi)
• The Zero Lower Bound and Effective Lower Bound
• Investment
– Investment and Capital Stock (Investment and Depreciation recursive formula)
– VMPK (The Value of the Marginal Product of Capital)
– UC (User Cost of Capital)
• Saving
– Household Saving
∗ Assets, Liabilities and the Household Balance Sheet
∗ Saving and Net Capital Gains
∗ Types of Saving
· Life Cycle Saving
· Precautionary Saving
· Bequest Saving
– Business Saving
∗ Business savings exist in the form of retained profits
– Government (Public) Saving
∗ Exists in the form of the Budget Balance
∗ Budget Surplus and Budget Deficit
– National Saving
∗ Within a closed economy, National Savings are equal to investment (consider the expenditure
measure of GDP)
– Crowding out occurs when the budget balance reduces in size, resulting in reduced private sector
investment
– Business confidence can have a significant effect on shifting the investment demand curve
3.2 FORMULAE
• Nominal Rate = Repayment− Loan
Loan
• Real Rate =
Repayment
CPIt+1
− LoanCPIt
Loan
CPIt
• Fisher Effect: i = r − pi (at ZLB, r = −pi)
• K1 = K0 +I1 +δK0 (Existing capital stock is subject to new investment and depreciation each period)
• VMPK = Price ∗MPK (MARGINAL BENEFIT)
• User Cost of Capital = UC = PK(r + δ) = PK(i− pi + δ) (MARGINAL COST)
• MPK ≥ PK
P
(r + δ) since MB ≥MC
4
– This is why an increase in PK or r or δ discourage investment
• Y = Labour Income + Capital Income + Tax − Transfer Payments − Interest Payments (where
transfers are pensions, etc. and interest payments are things like coupon payments on government
bonds, etc.)
• Saving = Disposable Income− Consumption
• Public Saving = Budget Balance = (Taxes−Transfer Payments−Interest Payments)−Govt. Expenditure
• National Savings = Household Saving+Business Saving+Government Saving = NS(r) = I(r) =
[(Y − T −RE)− C] + [RE] + [T −G] (a function of the real interest rate in a closed economy)
– Note the difference between:
1. Public Sector Saving = Budget Balance = TA (Direct and Net Indirect)−TR−INT−G =
T −G
2. Net Indirect Taxes = Indirect Taxes− Subsidies
3. Private Sector Saving = Y − T − C
4. Household Disposable Income = Y−Retained Earnings+(Transfers+Interest Payments−
Direct and Net Indirect Taxes) = Y −RE + TRN + INT − TAX
5. Gross Household Saving = Household Disposable Income− Consumption = Y D − C
6. Net Household Saving = Household Disposable Income− Consumption−Depreciation
7. National Saving = [(Y − T −RE)− C] + [RE] + [T −G] = I = Y − C −G
5
4 Income Expenditure Model of GDP
4.1 KEY CONCEPTS
• The income expenditure model is inherently a model for short run analysis of GDP (long run changes
in expenditure affect inflation rather than GDP)
• Prices of goods and services are sticky (fixed) in the short run and so changes in demand are met by
a change in production levels (employment) rather than a change in prices (potentially due to menu
costs)
• Planned Aggregate Expenditure (PAE) is the total planned spending on domestically produced goods
and services. GDP differs from PAE due to unplanned inventories, which result when demand is higher
or lower than expected.
• It is only at short run equilibrium that GDP and PAE are equal
– If unplanned inventories are positive, more has been produced than has been demanded and so
firms partake in unplanned inventory investment. This signals businesses to reduce production.
– If unplanned inventories are negative, less has been produced than has been demanded and so
firms deplete reserves of inventory. This signals businesses to increase production.
• In both cases, the short run economy is influenced to move toward the equilibrium condition
• Consumption Function
– If we define disposable income as:
GDP − Taxes+ Interest Payments+Government Transfers = Y − T
– Then we can write the consumption function as:
C = C0 + c(Y − T )
– Where Y − T is disposable income, C0 is exogenous consumption and c is the MPC (Marginal
Propensity to Consume). The MPC is the gradient of the curve, and thus is the change in
consumption resulting from a change in disposable income.
– Another measure, the APC (Average Propensity to Consume) directly divides C by Y − T .
• Assuming a TWO SECTOR MODEL (closed economy, no government):
PAE = C + Iplanned = C0 + I0 + c(Y − T )
(where planned investment is entirely exogenous)
• Since equilibrium occurs when Y = PAE, equilibrium is found graphically by the point of intersection
between the 45 degree line Y = PAE and the PAE curve. (Y axis is PAE, X axis is GDP).
• The effect of output gaps can also be visualized on such a set of axes with a vertical line representing
potential output
• An additional dollar of exogenous PAE generates more than one dollar of GDP (the multiplier effect).
The idea is that money is spent more than once in a geometric progression, since a fraction of one
person’s income becomes another person’s income.
• The Saving Function
6
– If the consumption function is C = C0 + cY (no taxation in the two sector model), and saving is
defined as income minus consumption S = Y − C, then saving is given by:
S = −C0 + Y (1− c)
(where 1− c is the marginal propensity to save)
– We plot this curve on the x = GDP and y = Savings/Investment axes, and look for the point
of intersection between the constant I0 curve and the savings curve.
– The equilibrium condition found is identical to that found by the PAE and GDP method.
– The paradox of thrift describes the situation in which everyone looses money when everyone
makes an attempt to save money. An increase in exogenous savings shift the savings curve
upward, causing an intersection with the investment curve at a smaller value of GDP (output).
As a result, income has decreased → the fallacy of composition.
• Open Economy Model
– This simply implies that imports and exports now exist
PAE = C + Iplanned +X −M
– We describe M = mY , in which imports are proportional to GDP via a parameter known as the
Marginal Propensity to Import (MPI). Note the marginal propensity to import is the same as the
average propensity to import.
PAE = C0 + I0 +X0 + Y (c−m)
Yequilibrium =
1
1− (c−m) ∗ (C0 + I0 +X0)
(the introduction of the MPI has caused a reduction in the size of the multiplier)
4.2 FORMULAE
• Y = C + I +G+X −M
• PAE = C + Iplanned +G+X −M
• Y = PAE + ∆Unplanned Inventories
• CONSUMPTION FUNCTION: C = C0 + c(Y − T ) (T=0 if no taxes)
• TWO SECTOR MODEL: PAE = I0 + C0 + c(Y − T ) (T=0 if no taxes)
• T = Taxes− Interest Payments− Interest Payments
• Disposable Income = Y − T
• MPC = ∆C
∆(Y − T )
• APC = C
Y − T
• Yequilibrium = 1
1− c (C0 + I0) (for two sector model with no taxes)
• SAVING FUNCTION: S = −C0+Y (1−c) (for two sector model with no taxes, derived from S = Y −C)
• PAE = C0 + I0 +X0 + Y (c−m) (for two sector model with no taxes in open economy situation)
• Yequilibrium = 1
1− (c−m) ∗ (C0 + I0 +X0)
• 1
1− (c−m) ≤
1
1− c
7
5 The Government Sector and Fiscal Policy
5.1 KEY CONCEPTS
• Fiscal policy is essentially the study of the economics of the government budget
• We endeavour to introduce taxation to our existing two sector model from the previous chapter (Con-
sumption, Investment)
– The taxation function can be modelled by:
Tax = T0 + tY
Where T0 is some exogenous variable and t is the marginal tax rate (MTR).
– Substituting this into our existing consumption function C = CO + c(Y − T ):
C = C0 − cT0 + cY (1− t)
– Hence, our expression for planned aggregate expenditure now becomes:
PAE = (C0 − cT0 + I0 +G0) + cY (1− t)
YE =
1
1− c(1− t) ∗ (C0 − cT0 + I0 +G0)
∆YE =
1
1− c(1− t) ∗ (∆C0 − c∆T0 + ∆I0 + ∆G0)
∆YE
∆G0
=
1
1− c(1− t) > 0
∆YE
∆T0
=
−c
1− c(1− t) < 0
– NOTE: The multiplier for a change in government expenditure is much larger in magnitude than
the multiplier for the exogenous change in taxation. Hence changes in government expenditure is
a far more effective tool in fiscal policy than taxation changes.
• The balanced budget multiplier examines the effect on GDP when government expenditure and taxation
increase/decrease by equal amounts.
kbb = kG + kT =
1
1− c(1− t) +
−c
1− c(1− t) =
1− c
1− c(1− t)
• If taxation and expenditure are increased by equal amounts, the result is not zero. The forces that
cause the economy to grow are stronger than those that cause the economy to shrink, so GDP will
increase.
• In regards to output gaps, the government has three options in correcting a contractionary output gap:
1. Increase government expenditure (the best option due to the mighty multiplier)
2. Decreased taxation (not as effective due to the weaker multiplier)
3. Increase government transfers (not as effective either)
• Any one of these changes will shift the PAE curve up on the (Y, PAE) coordinate plane and thus
increase equilibrium GDP, correcting the output gap.
• Fiscal policy can stabilize the economy in two ways:
1. Automatic Stabilizers
– During economic expansion and peak, individuals move into higher taxation brackets and so
the peak is not as high as it would be without taxation.
8
– When the economy is contracting or in a trough, people move into lower tax brackets and tax
revenue falls. Social security systems cut in with benefit payments etc. and so the contraction
is not as extreme as it would have been.
– In this way, fiscal taxation and social security policies automatically stabilize the economy.
An increased marginal tax rate results in increased stabilization (reduces the size of the
multiplier).
2. Discretionary Fiscal Policy
– Fiscal policy must be forward looking due to time lags and the less timely nature of fiscal
policy compared to monetary policy.
– Discretionary policy includes actions such as surplus packages, tax relief, etc.
• The budget balance is a measure of the government’s income vs. expenditure.
Budget Balance = T −G = TA− TR− INT −G
Dt = Dt−1 −BBt
(where D is the level of debt and BB is the budget balance for a particular period)
• A government has three options to finance its expenditures:
1. Increased taxation
2. Increased debt (selling govt. bonds)
3. Printing money (which is a horrible idea)
Gt + TRt + rDt−1 = Tt +Dt −Dt−1
• Government sources of funds are taxation and debt, and government uses of funds are expenditure,
transfers and payment of interest on debt.
• Balancing the budget over the business cycle implies governments should borrow to finance budget
deficits when needed and repay these debts during periods of economic expansion by running budget
surpluses.
• The golden rule for public investment implies that if government projects will only benefit the current
population, they should be financed by current taxes. If projects will provide benefits for future
populations as well, governments should borrow money and the debt should be paid off by current and
future populations.
• Debt only becomes a problem when interest payments begin to take up a significant portion of the
government’s sources of money.
Debt to real GDP ratio =
D
Y
∆dt =
(r − g)dt−1
1 + g
− pbbt
• Where:
– d is the debt to GDP ratio
– ∆d is the change in the debt to GDP ratio
– r is the real interest rate
– g is the growth rate of real GDP
– pbb is the primary budget balance divided by real GDP (
Tt − TRt −Gt
Y
) which does not include
interest payments on debt
9
• Hence if the real interest rate exceeds the growth rate of real GDP and the primary budget balance
ratio is negative, the debt to real GDP growth rate will be unsustainable.
• Introducing net exports to the three sector model, we can finally form our four sector model:
PAE = C + Iplanned +G+X −M = (C0 − cT0 +G0 + I0 +X0) + (c(1− t)−m)Y
YE =
1
1− (c(1− t))−m ∗ (C0 − cT0 +G0 + I0 +X0)
5.2 FORMULAE
(All relevant formulae were covered within the key concepts of this chapter)
Derivation of the Four Sector Model:
PAE = C + Iplanned +G+X −M
• C = C + 0 + c(Y − T )
• T = T0 + tY , so C = C0 + c(Y − T0 − tY ) = C0 − cT0 + cY (1− t)
• Iplanned = I0 (entirely exogenous)
• G = G0 (entirely exogenous)
• X = X0 (entirely exogenous)
• M = mY
Hence:
PAE = C0 − cT0 + cY (1− t) + I0 +G0 +X0 −mY
PAE = (C0 − cT0 + I0 +G0 +X0) + Y (c(1− t)−m)
Equating PAE and Y:
YE = (C0 − cT0 + I0 +G0 +X0) + YE(c(1− t)−m)
YE − YE(c(1− t)−m) = (C0 − cT0 + I0 +G0 +X0)
YE(1− (c(1− t)−m)) = (C0 − cT0 + I0 +G0 +X0)
YE =
1
1− [c(1− t)−m] ∗ (C0 − cT0 + I0 +G0 +X0)
10
6 Financial Assets, Money and Private Banks
6.1 KEY CONCEPTS
• Risk and return: The return on an asset increases as the riskiness of that asset increases (investors
must be compensated for risks)
• Know basic details regarding bonds from FINS1613. This includes:
– Definitions of terms such as maturity, principal, coupon rate and coupon payment.
– How to calculate the NPV of annuities and perpetuities
– Discount, par and premium pricing for a bond, and how the coupon and discount rates can be
used to determine this.
• The definition of money:
– Must behave as a medium of exchange
– Must behave as a store of value
– Must behave as a unit of account
• Bartering is inefficient due to ambiguity regarding the true value of goods and the double coincidence
of wants
• Forms of money:
– Commodity money → has some intrinsic value (e.g. gold and silver coins)
– Fiat money → has no intrinsic value, thus not directly convertible into other commodities on
demand
• Measuring money:
– MB/Currency → Physical notes and coins in circulation + physical money in bank vaults +
physical central bank reserves
– M1 → MB + Chequable accounts and other demand accounts
– M2 → M1 + Savings accounts and other time deposits
– M3→M2 + Time deposits (A time deposit is an interest-bearing bank deposit that has a specified
date of maturity)
– Broad Money → M3 + Borrowings from the private sector by financial intermediaries
• Quantitative easing→ The introduction of new money into the money supply by a central bank. Done
during GFC to purchase risky assets from commercial financial institutions to prevent further financial
damage.
• Demand for money
– An increase in GDP results in an increase in the amount of money individuals would like to hold
– An increase in the aggregate price level results in an increase in the amount of money individuals
would like to hold
– An increase in the real interest rate decreases the amount of money individuals would like to hold
(increases the opportunity cost of holding cash)
– We can use the GDP deflator as a measure of the price level. See the money demand formula
below.
• Financial innovation → how technology and regulation can make improvements to retail payments.
E.g. Apple Pay, Bitcoin. No significant effect on money supply.
11
• Banks are a special form of financial institution, as they can fund loans by simultaneously creating
deposits.
• The contribution of banks to the money supply are through its bank deposits.
• Since banks borrow short and lend long, they only have a limited supply of cash that can be paid out
to customers in the short term. If it is believed that the bank was unstable, they would all try to get
their money from the bank (which the bank would be unable to do due to the large volume of money
demanded simultaneously). This is called a bank run.
• In the case of a bank run or liquidity crisis, banks can borrow money from the reserve bank. Funds
only awarded by the RBA if the bank’s portfolio indicates it is solvent.
• Governments provide deposit insurance up to $250,000 to prevent bank run behaviour.
• Macro-prudential regulation→ APRA monitors all financial institutions and ensures a number of ratios
are within requirements. Builds a robust and secure financial sector.
• The Quantity Theory
– If we assume velocity is constant and real GDP is fixed (output is constant):
V =
P ∗ Y
M
→ VM = PY →M ∗ V0 = P ∗ Y0 → P = vM
– An increase in the price level should lead to an increase in the money stock (since v is constant)
6.2 FORMULAE
• Return on Asset = Pricet+1 + Interest Payments Received
Pricet
• Bond NPV (Annuity) = Coupon Payment
i
(
1− 1
(1 + i)t
)
+
Face V alue
(1 + i)t
• Bond NPV (Perpetuity) = Coupon Payment
i
• Money Demand : MD = P ∗ L(Y, i)
(the price level has a scalar effect on money demand, GDP and the nominal interest rate do not)
• Banking Formulae:
– Assets = Debt+ Equity (just like in FINS1613)
– Leverage Ratio =
Loans
Equity
=
Loans
Assets−Debt =
Loans
(Reserves+ Loans)− (Deposits)
(assuming all bank debt takes the from of deposits! Borrowing would also be included as debt!)
– Reserve to Deposit Ratio=
Reserves
Deposits
• Money V elocity = Nominal GDP
Money Stock
=
P ∗ Y
M
• P = vM (where v = V0Y0 ) (increase in P results in an increase in M as v is fixed)
• ∆P = ∆v + ∆M
• Since v is constant, ∆v = 0 and ∆P = inflation → pi = ∆M (the inflation rate is the growth rate of
money stock)
12
7 Central Banks and Monetary Policy
7.1 KEY CONCEPTS
• Central banks operate mostly independently from the government (avoid use as a political tool)
• Monetary policy → decisions taken regarding interest rates to influence short-run macroeconomic
outcomes
• Objectives of the RBA:
1. Contribute to the stability of currency (in regards to the inflation rate → inflation target of 2%
to 3% per annum)
2. Maintain full employment (in regards to demand and output gaps)
3. Contribute to the welfare and prosperity of Australians (ensure long term growth)
• Central banks only have a single monetary policy instrument, that being the overnight cash rate which
commercial banks use to lend and borrow to one another. The effects of this cash rate influence all
other rates within the economy over time.
• Headline vs Core Inflation
– Headline inflation is the measure of inflation using the consumer price index. Can be distorted
by one-off events.
– Core inflation measured by removing items within the CPI basket that are historically volatile.
Cash Rate→ Real Interest Rate→ Aggregate Demand→ Consumption and Investment
→ Inflation & Output Growth
This is the transmission mechanism, which is subject to inherent time lags
• Increasing the cash rate is contractionary policy (this increases real rate, discouraging investment and
consumption)
• Decreasing the cash rate is expansionary policy (this decreases real rate, encouraging investment and
consumption)
• Exchange Settlement Accounts (ESAs):
– Each commercial bank holds an account with the reserve bank called an ESA (Exchange Settle-
ment Account)
– ESAs must always have a positive balance. The bulk of a bank’s reserves are held within the
ESA. ESAs are used by banks to lend and borrow from each other at the interest rate set by the
cash rate. Repayments must be made within 24 hours.
• How is the cash rate influenced?
– The mechanism by which the RBA can influence the cash rate is by changing the supply of cash.
Increasing the supply of cash reduces the cash rate while decreasing cash increases the cash rate.
This is done through either ’the channel’ system or ’open market operations’ (OMO).
– The Channel System
∗ The RBA pays interest on reserves (IOR) held by banks in ESAs at a rate 25 basis points
below the cash rate.
∗ The RBA lends money out to banks at a rate that is 25 basis points above the cash rate.
∗ These two rates form a ’channel’ as no bank would borrow at a rate above what the RBA
offers and no bank would lend at a rate below the interest they could earn by keeping their
money in the ESA and doing nothing.
13
∗ A downward sloping demand curve for cash intersects this channel, becoming perfectly elastic
at the points of intersection with the upper and lower bounds of the channel.
– Open Market Operations (OMO)
∗ The RBA can influence the constantly changing supply of cash within the economy by buying
and selling government bonds with the private sector. Selling treasury bonds reduces the
supply of cash and buying back treasury bonds increases the supply of cash.
∗ These actions shift the vertical cash supply curve left and right, and this can be adjusted so
as to intersect the demand curve at the desired cash rate.
• The Taylor Rule is an example of a policy reaction function, which determines how the central bank
sets its policy interest rate. The Taylor Rule tells us how the nominal interest rate changes in response
to output gaps and inflation.
7.2 FORMULAE
• 1
n
∗ (i10 + i21 + ...+ inn−1)
(expectations hypothesis means long term interest rates are average of current and future expected
short term interest rates)
• TAYLOR RULE: i = 1 + 1.5pi + 0.5Yˆ (where Yˆ is output gap percentage)
• POLICY REACTION FUNCTION: Real Cash Rate = r0 + γpi
• POLICY REACTION FUNCTION V2: Real Cash Rate = r0 + γ(pi − pitarget)
14
8 Aggregate Demand and Aggregate Supply
8.1 KEY CONCEPTS
• To account for the impact real interest rates have on consumption and investment, we modify and
update the consumption and investment functions from our four sector model:
C = C0 + c(Y − T )− αr
Iplanned = I0 − βr
• This results in some new fun equations!
PAE = [C0 − cT0 + I0 +G0 +X0]− (α+ β)r + Y (c(1− t)−m)
YE =
1
1− (c(1− t)−m) ∗ [(C0 − cT0 + I0 +G0 +X0)− r(α+ β)]
• The implication of this is that the central bank can correct output gaps via modification of the cash
rate (cash rate influences real rate over time)
r = r0 + γpi (Policy Reaction Function)
YE =
1
1− (c(1− t)−m) ∗ [(C0 − cT0 + I0 +G0 +X0 − r0(α+ β))− γpi(α+ β)]
• We take this formula for equilibrium output as our aggregate demand curve (plotted on an x=output,
y=inflation coordinate plane). Hence there is a negative relationship between equilibrium output and
the rate of inflation.
• Shifts in this demand curve can be explained by a modification in either the exogenous or policy
reaction variables.
• Since we assume inflation to be sticky in the short run, and use inflation today as a predictor of
what inflation will be tomorrow, the aggregate supply curve is modelled by a perfectly elastic line
representing the rate of inflation.
• Shocks to inflation
pit = pit−1 +
– We introduce one-period shocks to the inflation rate. Epsilon < 0 is a favourable shock, whereas
epsilon > 0 is an unfavourable shock.
– When output is at potential output, inflation is constant.
– When output is above potential output, inflation is rising.
– When output is below potential output, inflation is falling.
• Aggregate Shocks to Supply
– UNFAVOURABLE SHOCK
Inflation increases and so the aggregate supply curve shifts upward. This intersects the aggregate
demand curve at a point where real GDP is lower than potential and so we have a contractionary
output gap. Inflation falls as a result and in the long run we return to initial conditions.
– FAVOURABLE SHOCK
Inflation decreases and so the aggregate supply curve shifts downward. This intersects the ag-
gregate demand curve at a point where real GDP is higher than potential and so we have an
expansionary output gap. Inflation rises as a result and in the long run we return to initial
conditions.
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• Aggregate Shocks to Demand
– SHIFT LEFT
Suppose some shock causes the aggregate demand curve to shift to the left. This intersects the
aggregate supply curve at a point where real GDP is now less than potential and so a contrac-
tionary output gap results. Inflation thus falls and we reach potential output again at a lower
inflation rate in the long run.
– SHIFT RIGHT
Suppose some shock causes the aggregate demand curve to shift to the right. This intersects
the aggregate supply curve at a point where real GDP is now more than potential and so an
expansionary output gap results. Inflation thus increases until we return to potential output at a
higher rate of inflation.
• The economy is self correcting, but the correction is slow. Policy response can return the economy
to potential output much faster, but with some differences. For example, a shift left in the demand
curve could be corrected by a decrease in the real rate, returning output to potential. No decrease
in inflation would result if policy actions were taken. In the case of inflation shocks, monetary policy
can bring output to potential but with the downside of preserving these shocks (whereas the economy
naturally returns to prior levels of inflation).
• Shocks to Potential Output
– SHIFT LEFT
A fall in potential output throws the economy into an expansionary gap. Inflation increases until
the new lower level of output is achieved at a higher rate of inflation.
– SHIFT RIGHT
A rise in potential output throws the economy into a contractionary gap. Inflation falls until the
new, higher level of output is achieved.
• In the case of the GFC, monetary policy adjustments shifted the falling aggregate demand curve
partially back toward the right as much as they could, resulting in zero nominal interest rates. Fiscal
policy then also introduced surplus packages and government bailouts of certain industries. All of this
led to increased budget deficits.
8.2 FORMULAE
All relevant formulae were covered within the section above.
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9 International Macroeconomics and Exchange Rates
9.1 KEY CONCEPTS
• The Balance of Payments - A record of transactions between residents and non-residents.
– The Current Account
∗ Balance of Trade (Net Exports)
∗ Net Primary Income (Chapter 1)
∗ Net Secondary Income (Payments not related to goods and services e.g. pensions, money
transfer to overseas family, etc.)
– The Financial Account (Transfer of assets and liabilities)
∗ New liabilities are recorded as CREDITS - export of goods and services
∗ New assets are recorded as DEBITS - import of goods and services
– The Capital Account
∗ Net acquisition of non-produced, non-financial assets e.g. land, foreign aid, debt cancellation
• The sum of the above three accounts should be zero.
• Investment can either be ’direct investment’ (>10% ownership) or ’portfolio investment’
• Investment Savings Model
– If the world real rate is ABOVE the domestic equilibrium, there is a trade SURPLUS (NS > I)
(Nation becomes a net lender)
– If the world real rate is BELOW the domestic equilibrium, there is a trade DEFICIT (NS < I)
(Nation becomes a net borrower)
– National Savings− Investment = Net Exports
• Bilateral nominal exchange rate is the rate two currencies can be exchanged for
• ’Chain rule’ logic can be used to relate two currencies via bilateral exchange rates due to LOOP (e.g.
$AUD/$USD and $USD/$CAD
• $X/$Y = e → One unit of $Y can buy ’e’ units of $X currency.
– A rise in e represents either an increase in $X or a decrease in $Y, and so $Y has appreciated
whereas $X has depreciated
– A fall in e represents either an increase in $Y or a decrease in $X, and so $X has appreciated
whereas $Y has depreciated
• Real exchange rate measures the price of domestic goods relative to the price of foreign goods
• Purchasing Power Parity (PPP)
– Requires the real exchange rate to be ONE and so the nominal exchange rate must be e = P f/P
since the real interest rate is given by
e ∗ P
P f
– Some goods are impossible to trade internationally, and so different prices can exist (haircuts, taxi
prices, etc.) - PPP does not account for this. Similarly, PPP does not account for trade barriers
like tariffs and quotas that can also affect prices.
• Supply and Demand for Currency
– Supply curve → Australian households and firms who want to purchase foreign goods and assets.
– Demand curve→ Foreign households and firms who eant to purchase Australian goods and assets.
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– The currency on the denominator of the nominal exchange rate expressed on the vertical axis
(e.g.
$USD
$AUD
) is the currency that the supply and demand curves reflect. In this case, the supply
of the Australian dollar and the demand for the Australian dollar.
• Monetary Policy
– Cash Rate → Real Rate → Exchange Rate. This means that by increasing the cash rate, the
reserve bank can cause an appreciation of the domestic currency (due to sticky prices in short
run). This will increase demand for Australian goods and shift the demand curve outward.
– A decrease in the cash rate increases GDP by increasing consumption and investment, but also
increases GDP by lowering the real exchange rate and thus encouraging more exports rather than
imports.
• Fixed currencies tether their value to another currency. This is done for the purpose of ensuring
certainty in regards to the value of the currency in the future.
• If the fixed rate is above the ’market equilibrium determined rate’, there is excess supply of the domestic
currency. The reserve bank then uses foreign reserves to purchase the excess supply of the domestic
currency.
• If the fixed rate is below the ’market equilibrium determined rate’, there is excess demand for the
local currency. The reserve bank then uses domestic currency to purchase increased amounts of foreign
currency to meet this demand.
• Speculative attack → If people believe the reserve bank is running low on foreign reserves and do not
want to:
1. Borrow foreign currency and thus increase national debt
2. Implement contractionary policy (higher r) to reduce the balance of payments deficit
then the only remaining option is to lower the fixed rate. This means the local currency will become
even less valuable and so everyone tries to sell this currency. Supply surges and the balance of payments
deficit gets worse, and the reserve bank depletes foreign reserves even faster.
9.2 FORMULAE
• Current Account = Balance of Trade+Net Primary Income+Net Secondary Income
• Current Account+ Financial Account+ Capital Account = Balance of Payments = 0
• Investment−National Savings = Net Capital Inflows = Net Exports (in an open economy)
• Real Exchange Rate = e ∗ P
P f
(where P is price of domestic goods and P f is price of foreign goods IN
DOMESTIC CURRENCY)
• PPP requires that Real Exchange Rate = e ∗ P
P f
= 1.00 and thus e =
P f
P
• ∆e = ∆P f−∆P = ∆pif−∆pi (percent changes in nominal exchange rate equal to difference of changes
in inflation rate)
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10 Economic Growth
10.1 KEY CONCEPTS
• Economic growth is defined as an increase in living standards and general economic conditions
• Economic growth is measured by the percentage change in real GDP per capita (not a perfect measure
due to neglect of wealth distribution)
• Rule of 69 (or rule of 70)
• Weak evidence for convergence of international income levels (possible in theory)
• Aggregate production function represents the output of an economy in terms of its inputs
– Must have constant returns to scale in labour and capital
– Must have diminishing marginal products for labour and capital
• Cobb-Douglas Production Function (& how to calculate MPK and MPL)
• Sources of economic growth
– Increase in population subject to diminishing marginal returns
– Increase in capital subject to diminishing marginal returns
– Proportional increase in both hard to maintain in the long run
– Increasing the participation rate can only help a little (bounded between zero and 1)
– Economic growth in the long run only achieved through continuous improvements in productivity
(technology)
– Forms of capital
– Influences on productivity
∗ Technology (stock of ideas and knowledge)
∗ Managerial skills
∗ Property rights (legalities)
∗ Culture and Social Capital (Openness to new ideas, work leisure balance, trust, etc.)
∗ Natural Capital (natural resources, climate, geography e.g. international exports easier due
to being a coastal nation, etc. Keep in mind this can also have no effect (Singapore, Japan)
or impede (Africa) economic growth)
– Economic growth policies should support education and research while ensuring no prohibitive
taxes are imposed on businesses. A high quality legal system for property rights should also be
imposed.
10.2 FORMULAE
• Real GDP per Capita = y = GDP
POP
• Economic Growth = yt+1 − yt
yt
• Y ears to double real GDP per capita 69
Growth Rate
• COBB DOUGLAS PRODUCTION FUNCTION: Y = AKαL1−α
• MPL = ∂
∂L
AKαL1−α = (1 − α)A(K
L
)α = (1 − α) ∗ Y
L
OR CAN BE EXPRESSED AS A ∗ kα
(where k is the capital labour ratio KL )
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• MPK = ∂
∂K
AKαL1−α = αAK1−αLα−1 = α ∗ Y
K
• y = Y
POP
=
Y
Labour Force
∗ Labour Force
POP
= GDP per Worker ∗ Participation Rate
• ∆Y = ∆A+ α∆K + (1− α)∆L
• ESTIMATING α: α = r ∗K
Y
(where r is the return to capital, or real interest rate)
• ESTIMATING 1−α: 1−α = w ∗ L
Y
(where w is the aggregate real wage (recall
Wage
Price
= Real Wage))
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