Exam Revision Flashcards
(249 cards)
1
Q
Scarcity
A
Scarcity refers to the limited nature of society’s resources.
2
Q
Economics
A
Economics is the study of how society manages its scarce resources.
3
Q
Opportunity cost
A
Opportunity cost is the best alternative that must be given up to obtain some items.
4
Q
Opportunity cost formula
A
Opp.Cost=what you give up/what you gain
5
Q
Microeconomics
A
Microeconomics is the study of how households and firms make decisions and how they interact in markets.
For example, microeconomics focuses on individual markets, examining how incentives and trade-offs influence buyer and seller behaviour.
6
Q
Macroeconomics
A
Macroeconomics is the study of economy-wide phenomena, including inflation, unemployment and economic growth. Macroeconomics is a branch of economics dealing with the performance, structure, behaviour, and decision-making of an economy as a whole. This includes national, regional, and global economies.
7
Q
Positive statements
A
Positive statements are claims that attempt to describe the world as it is.
An example of a positive statement is ‘minimum wage laws create unemployment’.
This can be tested.
8
Q
Normative statements
A
Normative statements are claims that attempt to prescribe how the world should be.
An example of a normative statement is ‘the minimum wage should be raised’.
This is subjective and can’t be tested. There will be arguments for and against this proposition.
9
Q
GDP
A
Gross domestic product (GDP) is a measure of the total income and expenditure of an economy.
It is the total market value of all final goods and services produced within a country in a given period of time.
GDP is the market value of all final goods and services produced within a country in a given period of time
10
Q
The components of GDP
A
Y = C + I + G + NX
GDP (Y) is the sum of the following: consumption (C) investment (I) government purchases (G) net exports (NX)
11
Q
Consumption (C):
A
The spending by households on goods and services, with the exception of purchases of new housing.
12
Q
Investment (I):
A
The spending on capital equipment, inventories and structures, including household purchases of new housing.
13
Q
Government purchases (G):
A
The spending on goods and services by local, state and federal governments.
Does not include transfer payments because they are not made in exchange for currently produced goods or services.
14
Q
Net exports (NX):
A
Exports minus imports.
15
Q
Nominal GDP
A
Nominal GDP values the production of goods and services at current prices.
16
Q
Real GDP
A
Real GDP values the production of goods and services at constant prices.
17
Q
Real and nominal GDP example
A
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18
Q
The GPD deflator
A
The GDP deflator is a measure of the price level calculated as the ratio of nominal GDP to real GDP times 100. It tells us the rise in nominal GDP that is attributable to a rise in prices rather than a rise in the quantities produced.
19
Q
The GDP deflator is calculated as follows:
A
Nominal GPD divided by real GPD multiplied by 100
20
Q
Inflation
A
Inflation (CPI) refers to a situation in which the economy’s overall price level is rising.
21
Q
inflation rate
A
The inflation rate is the percentage change in the price level from the previous period.
22
Q
consumer price index (CPI)
A
The consumer price index (CPI) is a measure of the overall cost of the goods and services bought by a typical consumer.
The Australian Bureau of Statistics reports the CPI each month.
23
Q
Calculating the CPI and the inflation rate: An example
A
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24
Q
CPI =
A
(cost of basket current year/cost of basket base year) x 100
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Inflation rate =
(CPI2 -CPI1)/CPI1 X100%
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Value in year 2 dollars =
value in year 1 dollars x price level 2 / price level 1
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The 2 problems of unemployment
The problem of unemployment is usually seen as two separate problems:
The long-run problem, and
the short-run problem
The long-run problem focuses on reducing the natural rate of unemployment
The short-run problem focuses on reducing the cyclical rate of unemployment
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Employed
A person is considered employed if he or she has spent 1 hour of the previous week working at a paid job or family business.
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3 categories of employment
A person is considered employed if he or she has spent 1 hour of the previous week working at a paid job or family business.
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Labour force
The labour force is the total number of workers, i.e. the sum of the employed and the unemployed.
A person who is neither employed nor unemployed is not in the labour force
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The unemployment rate
The unemployment rate is calculated as the percentage of the labour force that is unemployed.
unemployment rate = number unemployed/ labour force
multiplied by 100
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Discouraged workers
Discouraged workers, people who would like to work but have given up looking for jobs after an unsuccessful search, don’t show up in unemployment statistics
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3 causes of natural unemployment
Frictional
Structural
Classical
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Frictional unemployment
Frictional unemployment refers to the unemployment that results from the time that it takes to match workers with jobs. Search for the jobs that are best suit their tastes and skills. Inevitable because the economy is always changing.
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Structural unemployment
Mismatch between the skills required and offered
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‘classical unemployment’ occurs due to
Minimum-wage laws.
Unions.
Efficiency wages
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minimum wages
When the minimum wage is set above the level that balances supply and demand, it creates unemployment.
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Unions
A union is a worker association that bargains with employers over wages and working conditions.
In the 1970s and 1980s, when unions were at their peak, more than half of the Australian workforce was unionized. A union is a type of cartel attempting to exert its market power.
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Efficiency wages
Efficiency wages are above-equilibrium wages paid by firms in order to increase worker productivity.
The theory of efficiency wages states that firms operate more efficiently if wages are above the equilibrium level.
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THE THEORY OF EFFICIENCY WAGES
| A firm may prefer higher-than-equilibrium wages for the following reasons:
Worker health
Worker turnover
Worker effort
Worker quality
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The production function
Y = F(L, K, H, N, A)
Y = quantity of output
F( ) is a function that shows how the inputs are combined - available production technology
```
L = quantity of labour
K = quantity of physical capital
H = quantity of (intangible) human capital
N = quantity of natural resources
A = (intangible) technological knowledge
```
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Production functions basic explanation
Economists often use a production function to describe the relationship between the quantity of inputs used in production and the quantity of output from production.
The inputs used to produce goods and services are called the factors of production
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Constant returns to scale
A production function has constant returns to scale if, for any positive number x,
xY = F(xL, xK, xN, H, A)
That is, a doubling of all inputs causes the amount of output to double as well
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Productivity
```
The factors of production directly determine productivity.
natural resources, N
physical capital, K
human capital, H
technological knowledge, A
```
The data shows that sustained economic growth per capita is all about productivity (efficiency), A and H
While N and K are important, their effect on growth disappears over time.
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The Effect of K
One way to raise productivity is to invest more current resources in the production of capital
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Diminishing Returns
However, as the stock of capital rises, the extra output produced from an additional unit of capital falls; this property is called diminishing returns (to capital) Because of diminishing returns, an increase in the saving rate leads to higher growth only for a while
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Diminishing returns and the catch-up effect
In the long run, the higher saving rate leads to a higher level of productivity and income, but not to higher growth in these variables
The catch-up effect refers to the property whereby countries that start off poor tend to grow more rapidly than countries that start off rich
It is often called ‘convergence’ across countries (as opposed to ‘divergence’ which refers to a widening gap between countries)
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The Effect of H
In Australia, each year of schooling raises a person’s wage, on average, by about 8 percent. Thus, one way the government can enhance the standard of living is to provide schools and encourage the population to take advantage of them.
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The effect of A
The advance of technological knowledge has led to higher standards of living.
Most technological advance comes from private research by firms and individual inventors.
Government can encourage the development of new technologies through research grants, tax breaks, and the patent system
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Productivity definition
The quantity of goods and services that a worker can produce for each hour of work.
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Surplus of labour
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Rule of 70
70/growth rate = no. of years it takes to double
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categories of unemployment
Natural rate of unemployment (long run)
Cyclical rate of unemployment (short run)
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Natural rate of unemployment (long run)
Unemployment that does not go away on its own even in the long run (always positive). The amount of unemployment that the economy normally (on average) experiences.
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Cyclical rate of unemployment (short run)
Year to year fluctuations in unemployment around its natural rate. Associated with the short term ups and downs of the business cycle
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Classical unemployment
The real wage in the labour market is above the market clearing level that equates supply of and demand for labour.
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Although technological knowledge and human capital are closely related, there is an important difference. Which of the following statements is correct?
a. Human capital is the society’s understanding about how the world works, whereas technological knowledge is the resources spent transmitting this understanding to the labour force
b. Technological knowledge is the bridge that links physical and natural resources with human capital
c. Technological knowledge is the society’s
understanding about how the world works, whereas human capital is the resources spent transmitting this understanding to the labour force
d. Technological knowledge is the society’s understanding of human capital
C
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8. The production function is given as Y = F(L, K, N, H, A ), where Y is the quantity of output, A is the level of available production technology, L is the quantity of labour, H is the quantity of human capital and N is the quantity of natural resources. This equation provides:
a. a summary for the four determinants of productivity
b. a summary for the four determinants of production
c. a foundation for measuring inflation
d. a measure of the availability of natural resources
B
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8. The production function is given as Y = F(L, K, N, H, A ), where Y is the quantity of output, A is the level of available production technology, L is the quantity of labour, H is the quantity of human capital and N is the quantity of natural resources. This equation provides a summary for the four determinants of production
These determinants are the factors of production or inputs used in the production process and consequently a nation’s particular endowment of these “determinant” factors, does in fact determine the maximum amount of output that the economy is capable of producing.
60
Suppose that a firm is faced with an excess supply of workers. What would the firm do? Explain with standard economic theory and with efficiency wage theory.
a. Standard economic theory: assuming a firm maximises its profit, it should lower wages until the supply of workers is equal to the demand. This will reduce production costs and raise profits.
b. Efficiency-wage theory suggests that it might be profitable for a firm to keep wages above the equilibrium level in order to reduce worker turnover, increase worker quality, increase worker effort, and perhaps to increase worker health and therefore worker productivity.
61
15. Explain when minimum laws are binding and result in unemployment.
When the minimum wage is set above the equilibrium level, the result is unemployment. Minimum wages are binding most often for the least skilled and least experienced members of the labour force.
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Financial intermediaries: indirect borrowing
Banks
take deposits from people who want to save and use the deposits to make loans to people who want to borrow.
pay depositors interest on their deposits and charge borrowers slightly higher interest on their loans
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Recall the GDP formula
Recall that GDP is both total income in an economy and total expenditure on the economy’s output of goods and services:
Y = C + I + G + NX
64
Recall the GDP formula as a closed economy
Assume a closed economy – one that does not engage in international trade (imports and exports are zero):
Y = C + I + G
I = Y - C - G
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Y - C - G
the total income in the economy after paying for consumption and government purchases.
This is referred to as National saving, or just saving (S).
Substituting S for Y - C - G, the equation can be written as:
S = I
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National saving, or saving, is equal to:
S = I
S = Y – C – G
S = (Y – T – C) + (T – G)
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National Saving Consists of
Private and Public Components
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Private saving
Private saving is the amount of income that households have left after paying their taxes and paying for their consumption.
Private saving = (Y – T – C)
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Public saving
Public saving is the amount of tax revenue that the government has left after paying for its spending.
Public saving = (T – G)
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Budget Surplus and Deficit
If T > G, the government runs a budget surplus because it receives more money than it spends.
The surplus of T − G represents public saving.
If G > T, the government runs a budget deficit because it spends more money than it receives in tax revenue
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The market for loanable funds
Financial markets ‘coordinate’ the economy’s saving and investment in the market for loanable funds.
The market for loanable funds is the market in which those who want to save supply funds and those who want to borrow to invest demand funds
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Loanable funds
Loanable funds refer to all income that people have chosen to save and lend out, rather than use for their own consumption
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the supply of loanable funds
The supply of loanable funds comes from people who have extra income they want to save and lend out.
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The demand for loanable funds
The demand for loanable funds comes from households and firms that wish to borrow to make investments.
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Interest rate
The interest rate is the price of the loan.
| It represents the amount that borrowers pay for loans and the amount that lenders receive on their saving.
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Interest
Interest represents a payment in the future for a transfer of money in the past.
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Nominal interest rate (i)
The nominal interest rate (i) is the interest rate usually reported and not corrected for inflation.
It is the interest rate that a bank pays or asks for
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Real interest rate (r)
The real interest rate (r) is the nominal interest rate that is corrected for the effects of inflation: r = i – inflation
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Supply and demand for loanable funds
Financial markets work much like other markets in the economy.
The equilibrium of the supply and demand for loanable funds determines the real interest rate.
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The market for loanable funds graph
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81
What government policies can affect saving and investment?
taxes on saving
taxes on investment
government budgets
82
Pros and cons of government budget deficits
Pros:
Stimulates the economy when in recession
Cons:
Accumulation of government debt
Crowding out effect
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The effect of a government budget deficit
1. A budget deficit decreases the supply of loanable funds for any interest rate
Shifts the supply curve to the left.
2. Which raises the equilibrium interest rate
3. And reduces the equilibrium quantity of loanable funds in dollars
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Crowding out effect (occurs during government budget deficits)
Crowding out refers to the tendency for increased government deficits to reduce investment spending. Specifically, the reduction in investment stems from the fact that a decrease in public saving reduces national saving, pushing up the real interest rate in the loanable fund market.
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What does a decrease in the tax rate on savings do to households’ incentive to save (at any given interest rate)?
The supply of loanable funds curve shifts to the right.
The equilibrium interest rate decreases.
The quantity demanded for loanable funds increases.
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86
What does an increase in the investment tax credit (i.e. a decrease in the effective corporate tax rate) do to firms’ incentive to borrow (at any given interest rate)?
Increases the demand for loanable funds.
Shifts the demand curve to the right.
Results in a higher interest rate and a greater quantity saved.
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87
4. The demand for loanable funds is downward-sloping because:
a. as the interest rate falls, the demand for loanable funds increases
b. as the interest rate falls, the demand for loanable funds falls
c. as the interest rate rises, the quantity of loanable funds demanded rises
d. as the interest rate rises, the quantity of loanable funds demanded falls
ANS: D The demand for loanable funds comes from businesses’ willingness and ability to invest in business productive capital and ventures. As the cost of investing (the real interest rate) increases, the potential profitability of investments decreases. Thus, as the real interest rate rises, businesses are less willing and less able to proceed with investment plans, consequently the overall quantity demanded of loanable funds (for business investment) declines.
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Using a graph representing the market for loanable funds, show and explain what happens to interest rates and investment if the investment tax credit is abolished.
As shown in the graph below, the economy starts in equilibrium at point E0, with interest rate r0 and equilibrium quantity saved and invested at q0. If the investment tax credit is abolished, the incentive to invest is reduced, and less investment will be undertaken at each interest rate. Therefore, the demand-for-loanable-funds curve shifts from D0 to D1. The new equilibrium is at E1, with a lower interest rate, r1, and a lower level of saving and investment, q1. Hence, elimination of the investment tax credit reduces interest rates and reduces investment.
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Money
The set of assets in an economy that people regularly use to buy goods and services from other people. Money includes cash, deposits and other types of assets, but not credit card (or cheques). In fact, if people use cheques instead of cash, money supply will increase as people no longer carry extra cash.
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The 3 functions of money
Medium of exchange
Unit of account
Store of value
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Medium of exchange
An item that buyers give to sellers when they want to purchase goods and services. Money is the most liquid asset available
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Unit of account
The yardstick people use to post prices and record debts.
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Store of value
An item that people can use to transfer purchasing power from the present to the future.
Money is not the best store of value (shares, bonds, real estate...). Value of money deteriorates when there are inflationary expectations.
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Liquidity
The ease with which an asset can be converted into the economy's medium of exchange.
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Kinds of money
When money takes the form of a commodity with intrinsic value, it is called commodity money (e.g. gold.)
Flat money: Money without intrinsic value that is used as money because of government decree.
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Monetary policy in Australia today
The RBA uses the cash rate to influence the level of economic activity rather than attempting to control the money supply. The RBA uses open-market operations to guarantee that its target rate is the equilibrium interest rate in the short-term money.
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Cash rate
The interest that financial institutions can earn on overnight loans of their currency or reserves.
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Open-market operations
The purchase and sale of Australian government securities by the RBA
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Problems in controlling the money supply
Can not control the amount that bankers chose to lend.
Trade-off between inflation and unemployment in short-run
Bank runs
Can not control the amount of money that households choose to hold as deposits in banks.
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Bank runs
Large numbers of depositors all try to withdraw their deposits at the same time
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Banks and the money supply
100 per cent reserve banking
Fractional-reserve banking
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100 per cent reserve banking
Reserves: Deposits that banks have received but have not lent out
In banks hold all deposits in reserve, banks don't influence the supply of money.
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Fractional-reserve banking
A banking system in which banks hold only a fraction of deposits as reserves. Lend out a majority of their deposits thereby creating money.
Reserve ratio
Money multiplier
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Reserve ratio
The fraction of deposits that banks hold as reserves.
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The money multiplier
The amount of money the banking system generates with each dollar of reserves.
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Fractional reserve ratio example
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When banks hold only a fraction of deposits in reserve, banks create money. While new money has been created so has debt. There is no new wealth created by the process. The process of money creation does not continue forever. It stops when the actual reserve-deposit ratio is equal to the desired reserve-deposit ratio.
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Money in the Australian economy
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Money supply
The quantity of money available in the economy.
Currency
Current deposits
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Currency
The plastic notes and metal coins in the hands of the public.
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Current deposits
Balances in bank accounts that depositors can access on demand by using a debit card or writing a cheque.
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Central Bank (or The Reserve Bank of Australia)
An institution designed to oversee the banking system and regulate the quantity of money in the economy.
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Roles of the RBA
Monitor individual banks and ensure their stability
Act as a lender of last resort
Determine monetary policy
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Monetary policy
The management by the central bank of liquidity conditions in the economy. Liquidity conditions refers to the price and availability of funding for the economy's expenditure.
114
There is a _____:
a.short-run trade-off between prices and interest rates
b. long-run trade-off between inflation and unemployment
c. short-run trade-off between inflation and unemployment
d. short-run trade-off between inflation and the money supply
ANS: C The Reserve Bank of Australia (RBA) can choose to pursue the goal of “inflationary pressures” via the use of raised interest rates in order to reduce Aggregate Expenditures (AE) in the economy or it may choose to pursue the goal of “unemployment” by reducing interest rates in order to stimulate/ increase aggregate expenditures.Because the goal of inflation implies the use of high interest rates whilst the goal of unemployment implies the use of low interest rates, both goals cannot be successfully pursued by the RBA simultaneously. Further, the pursuit of one goal moves the economy further away from the attainment of the other goal. Therefore, there is a trade of between inflation and unemployment as the pursuit of one objective leads to worsening problems with the other objective.
115
If the public switches from doing most of its shopping with currency to using cheques instead, and the Reserve Bank takes no action, the money supply will:
Increase
Cheques are a method of deferred payment where the exact amount is transferred out of the cheque
116
If a bank uses $80 of reserves to make a new loan when the reserve ratio is 25 per cent, then:
The level of wealth in the economy will not have changed
New loans lead to an expansion of the money supply. Changes in true wealth however are linked to changes in GDP per capita. That is, the level of goods and services that each average person is endowed with. Increases in the money supply alone, that is not accompanied by increases in GDP per capita do not represent a true change in the wealth of a nation.
117
A decrease in reserve requirements will likely result in banks:
A decrease in reserve requirements means that banks are now required to hold a smaller portion of deposits as required reserves. This means banks have more money available for creating loans. As banks create a larger number of loans, the money supply increases.
118
If you withdraw $100 from your bank, then:
the reserves of your bank will initially fall by $100
119
If banks choose to hold more excess reserves, then:
By holding more reserves, banks are implicitly making fewer loans so the money supply decreases.
120
Store of value deteriorates when
There are inflationary expectations.
Money in currency form loses value when there is inflation because stored money is a fixed amount of money that does not increase in line with inflation. Specifically, when the prices of goods and services increase, stored money is worth less because it now exchanges for (buys) a smaller quantity of goods and services.
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Inflation
Inflation is an increase in the overall level of prices.
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Deflation
Deflation is a decrease in the overall price level.
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Hyperinflation
Hyperinflation is an extraordinarily high rate of inflation. Hyperinflation is inflation that exceeds 50 percent per month.
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The Causes of Inflation
The level of prices and the value of money
Money supply, money demand and monetary equilibrium
125
Money supply
Determined by the central bank. The RBA no longer targets the money supply. Instead it targets interest rates and inflation. Assuming the central bank targets the supply of money, the supply of money will be vertical (perfectly inelastic.
126
Money demand
Mainly determined by the price level. The higher prices are, the more money that is needed to perform transactions. A higher price level leads to a higher quantity of money demanded.
127
Nominal and real variables
Nominal variables are variables measured in monetary units.
Real variables are variables measured in constant units.
This separation is the classical dichotomy.
According to the classical dichotomy, different forces influence real and nominal variables.
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The classical dichotomy and monetary neutrality
Real economic variables do not change with changes in the money supply.
Changes in the money supply affect nominal variables but not real variables.
The irrelevance of monetary changes for real variables is called monetary neutrality.
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Velocity of money
The velocity of money refers to the speed at which the typical dollar bill travels around the economy from wallet to wallet.
130
Velocity (V)
= nominal GDP (P × Y) / money supply (M)
(P*Y)/M
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The quantity equation
M * V = P * Y
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Velocity and the quantity equation
The quantity equation shows that an increase in the quantity of money in an economy must be reflected in one of the three other variables:
the price level must rise
the quantity of output must rise, or
the velocity of money must fall.
133
Explaining the equilibrium price level, inflation rate and the quantity theory of money:
Assume the velocity of money is relatively stable over time.
When the central bank
changes the quantity of money, it causes proportionate changes in the nominal value of output (P * Y).
Because money is neutral, money does not affect output.
When the central bank alters the money supply, these changes are reflected in prices.
Therefore, when the central bank increases the money supply rapidly, the result is a high rate of inflation.
134
Is the velocity of money relatively stable over time
Yes
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The equilibrium price level
If the price level is above the equilibrium level, people will want to hold more money than is available and prices will have to decline. If the price level is below equilibrium, people will want to hold less money than that available and the price level will rise.
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The effects of a monetary injection explained
The immediate effect of an increase in the money supply is to create an excess supply of money. People try to get rid of this excess supply by buying hoods and services with the funds or using these excess funds to make loans to others. The leads to increases in the demand for goods and services. Because the supply of goods and services has not changed, the result of an increase in the demand for goods and services will be higher prices.
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Maintaining Price Stability
An increase in the money demand. The central bank increases money supply. No change in the value of money. Price level stays constant.
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inflation tax
An inflation tax is like a tax on everyone who holds money.
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The Fisher effect
the Fisher effect: How does the nominal and real interest rate respond to the inflation rate?
Nominal interest rate = real interest rate + inflation rate
According to the Fisher effect, when the rate of inflation rises, the nominal interest rate rises by the same amount. The real interest rate stays the same.
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Inflation-induced tax distortion
Inflation exaggerates the size of capital gains and increases the tax burden on this type of income.
With progressive taxation, capital gains are taxed more heavily
The income tax system treats the nominal interest earned on savings as income
The after-tax real interest rate falls, making saving less attractive.
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How inflation raises the tax burden on saving
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Why do central banks commonly have inflation targets of around 2% rather than 0% (which would be perfect price stability)?
There are two main reasons:
Keeping well away from deflation
Being able to reduce interest rates by more in a downturnv
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Economists have identified 5 costs of inflation
Shoeleather costs
Menu costs
Confusion and inconvenience
Inflation-induced tax distortions
Relative-price variability and the misallocation of resources
144
P
Price Level (GDP Deflator)
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Y
Real GDP
146
M
Quantity of money
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When the central bank
| changes the quantity of money, it causes proportionate changes in the nominal value of output (P * Y).
The economy's output of goods and services (Y) is determined primarily by available resources and technology. Price level (P) increases proportionately with the change in M
148
The level of prices and the value of money
When the price level rises people have to pay more for the goods and services that they purchase. A rise in the price level also means that the value of money is now lower because each dollar now buys a smaller amount of goods and services. If P is the price level as measured by the CPI or the GDP deflator then the quantity of goods and services that can be purchased with $1 is equal to 1/P. If P increases, value of money (purchasing power) decreases.
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Money supply, money demand and monetary equilibrium
The value of money is determined by the supply and demand for money.
150
Quantity theory of money
The quantity of money available determines the price level and that the growth rate in the quantity of money available determines the inflation rate.
151
Shoeleather costs
Because inflation erodes the value of money that you can carry in your pocket, you can avoid this drop in value by holding less money. Holding less money generally means more trips to the bank. The resources wasted when inflation encourages people to reduce their money holdings.
152
Menu costs
During periods of inflation, firms must change their prices more often. The costs of changing prices.
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Confusion and inconvenience
When inflation occurs the value of money falls. This alters the yardstick that we use to measure important variables like incomes and profit.
154
Inflation-induced tax distortions
Law-makers rarely take into account inflation when they write tax laws.
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Relative-price variability and the misallocation of resources
Because prices of most goods change only once in a while (instead of constantly), inflation causes relative prices to vary more than they would otherwise. Consumer decisions are distorted and markets are less able to allocate resources efficiently.
156
1. Two countries, Alpha and Beta, are otherwise identical except that each dollar in Alpha is used more frequently than each dollar in Beta. For this to be true, it must be the case that, holding other factors equal, __________ in Alpha than in Beta.
If both countries are identical then this means that trade and inflation is identical across both. According to the below “quantity theory of money” formula, this implies that only the velocity of money (number of times each dollar circulates) and stock of money varies between the nations. Hence, the nation with the higher velocity will have a smaller stock of money and vice versa.
Money stock x velocity = price level x quantity (production)
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2. According to the quantity equation, if velocity and real GDP are constant and the Reserve Bank increases the money supply by five per cent, then the price level
a. decreases by 10 per cent
b. decreases by five per cent
c. is also constant
d. increases by five percent
ANS: D
Money stock X Velocity = Price Level X RDGP
With RGDP and velocity held constant, a percentage change in money stock must be fully reflected in an equal percentage change in the price level.
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3. The demand for money is:
positively related to the price level
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FOR ALL GRAPH 1 QUESTIONS
Photo 19/9
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5. At point B in Graph 1:
a. the value of money is less than its equilibrium level
b. money supply is greater than money demand
c. the price level is higher than its equilibrium level
d. money demand is greater than money supply
At point B Money supply and money demand are not equal. The value of money is ½ at this point, the corresponding quantity of money demanded is equal to M1 (point A) whereas the quantity of money supplied is equal to M2 (point B). M2 is greater than M1, thus money supply is greater than money demand at this point
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6. When the money supply curve in Graph 1 shifts from MS2 to MS1:
a. the equilibrium value of money increases
b. the equilibrium price level increases
c. the supply of money has increased
d. the demand for goods and services will increase
ANS: A
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7. When the money supply curve in Graph 1 shifts from MS2 to MS1:
a. the equilibrium price level increases
b. this may be due to the RBA selling government securities
c. this is due to the RBA buying government securities
d. the demand for goods and services increasing
ANS: B
The value of money and the price level move in opposite directions. Each dollar is more valuable when it can be used to purchase a larger amount of goods and services. Thus, the value of money is higher when prices are lower. A decrease in the money supply (M2 to M1) achieved by the RBA selling government bonds will lead to an increase in the value of money (1/4 to ½) as inflationary pressures are reduced (as prices begin to fall).
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8. What is the classical dichotomy
The classical dichotomy refers to the division of all economic variables into two groups, nominal variables and real variables
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9. Define the quantity equation and illustrate how it affects the price level in the economy.
The quantity equation describes the relationship between money and nominal GDP. Recall that nominal GDP is the price level times real GDP. The quantity equation can then be written as money supply times velocity equal to price level times real GDP, or in symbols, M xV = P x Y.
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Business cycle
Fluctuations in the economy are often called the business cycle
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AD
The aggregate-demand curve (AD) shows the quantity of goods and services that households, firms, and the government want to buy at each price level
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Components of AD
The aggregate demand for goods and services has four components:
Aggregate Demand = C + I + G + NX
Aggregate Supply = Y
In equilibrium, supply = demand
Therefore, in equilibrium Y = C + I + G + NX
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The aggregate-demand curve illustrated
Photo 15/9
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Shifts in the Aggregate Demand Curve
PHOTO 15/9
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Why the Aggregate-Demand Curve Might Shift
Shifts arising from
Consumption: consumer optimism, tax rates, prices of assets (stocks, bonds, real estate)
Investment: technological progress, business confidence, tax rates, money supply
Government Purchases
Net Exports: foreign GDP, expectations about exchange rates
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The aggregate-supply curve
The aggregate-supply curve (AS) shows the quantity of goods and services that firms choose to produce and sell at each price level.
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The long-run aggregate-supply curve
Photo 15/9
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Why the Long-Run Aggregate-Supply Curve Might Shift
Any change in the economy that alters the natural rate of output will shift the long-run aggregate-supply curve.
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Any change in the economy that alters the natural rate of output will shift the long-run aggregate-supply curve.
Labor: population growth, immigration, natural rate of unemployment
Capital, physical or human
Natural Resources: price of imported oil
Technology
Laws, government policies
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The short-run aggregate-supply curve
We empirically observe that in the SR, unlike the LR, an increase in the overall level of prices in the economy tends to raise the quantity of goods and services supplied.
A decrease does the opposite
Put differently, P has temporary but not permanent positive effect on Y
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The short-run aggregate-supply curve
Photo 15/8
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Why is the SRAS upward sloping
(1) the misperceptions theory
(2) the sticky-wage theory
(3) the sticky-price theory
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How the SRAS curve shifts
SRAS1 shows the aggregate supply curve for 2010
the expected price level and the natural rate of output, must be on the SRAS curve
If either Pe↓ or YN↑, the green dot moves down or to the right
When the green dot shifts, so must the AS curve
Photo 15/9
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The long-run equilibrium
Photo 15/9
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Two causes of recession
Case 1
| Case 2
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Case (1): A Contraction in Aggregate Demand
3 photos
| 15/9
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Case (1): ECONOMIC FLUCTUATIONS: AD
Contraction (leftward shift) in Aggregate Demand (AD)
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Case (1): ECONOMIC FLUCTUATIONS: AD
In the short run
output decreases,
the overall price level decreases, and
the unemployment rate increases
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Case (1): ECONOMIC FLUCTUATIONS: AD
In the long run
the overall price level decreases,
| but output and the unemployment rate remain unchanged at their long-run levels
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Case (2): ECONOMIC FLUCTUATIONS: AS
A leftward shift in Short-Run Aggregate Supply
Output falls below the natural rate of employment
Unemployment rises
The price level rises
If the government does nothing, the SRAS will shift back to where it was.
The price level, total production and unemployment will be unaffected in the long run.
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Case (2): An Adverse Shift in Aggregate Supply
photo
| 15/8
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Stagflation
Adverse shifts in aggregate supply cause stagflation — a period of recession and inflation
Output falls and prices rise.
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Accommodating an Adverse Shift in Aggregate Supply
photo
| 15/8
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Why is the aggregate demand curve downward sloping
Inflation rate and investments (Interest rate effect)
Inflation rate and wealth (Pigou's wealth effect)
Inflation rate and net exports (Mundell-Flemings exchange rate effect)
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(Mundell-Flemings exchange rate effect)
A lower inflation rate lowers the interest rate. Investors will seek higher returns by investing abroad. The increase in net foreign investment raises the dollar supply, lowering the real exchange rate. Domestic goods become relatively cheaper compared to foreign goods. Net exports rise thereby increasing the quantity of goods and services demanded.
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(Interest rate effect)
A lower inflation rate induces the RBA to reduce the interest rate which encourages greater spending on investment goofs. It therefore increases the quantity of goods and services.
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(Pigou's wealth effect)
A decrease in the inflation rate (overall price level decreases) makes consumers feel wealthy. In turn it encourages them to spend more.
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Why the aggregate supply curve is vertical in the long run
In the long run an economy's supply of goods and services depends on its supplies of resources along with the available production technology. Because the inflation rate does not affect the determinants of output in the long run, the LRAS curve is vertical at the natural rate of output.
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The new classical mispercetions theory
Changes in the inflation rate (overall price level) can temporarily mislead suppliers about what is happening in the markets in which they sell their output. Suppliers respond to changes in the level of prices and thus the SRAS curve is upward sloping.
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The Keynesian sticky wage theory
Wages do not adjust to changes in prices in short run therefore real wages change and suppliers adjust their output levels. A lower rate of inflation makes employment and production less profitable leading firms to lower the quantity of goods and services supplied.
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The new Keynesian sticky price theory
The prices of some goods and services are also sometimes slow to respond to changes in the economy (menu costs). An unexpected fall in inflation rate leaves some firms with higher than desired prices which depresses sales and induces the firms to lower the quantity of goods and services supplied.
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Why the short run supply curve might shift
Events that shift long run
Inflation rate expectations
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Events that shift long run
Events that shift the LRAS will shift the SRAS as well e.g. production costs, technology, minimum wages.
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Inflation rate expectations
People's expectations of the inflation rate will affect the position of the SRAS curve even though it has no effect on the LRAS curve. A higher expected inflation rate will decrease the quantity of goods and services supplied and shift the SRAS curve to the left whereas a lower expected inflation rate increases the goods and services supplied and shifts the SRAS curve to the right.
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If the world oil price increases
If the world oil prices rise, then short-run AS would decrease
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Keynes attempted to explain:
short-run economic fluctuations and advocated policies to increase aggregate demand
The Keynesian school of thought argues that due to the multiplier effect, a relatively small increase in aggregate expenditures will have a larger final effect on total expenditures over time and therefore only a proportionally small boost to national spending is required to close a relatively large gap in GDP (being the gap between the actual level of GDP and the full employment level of GDP). Thus, Keynes advocated aggregate demand focused policies.
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13. When an increase in the minimum wage raises the natural rate of unemployment:
both short-run and long-run aggregate-supply curves shift to the left
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How fiscal policy influences aggregate demand
Changes in government purchases
Changes in taxes
Supply side economics
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Changes in government purchases
When the government changes the level of its purchases it influences aggregate demand directly. A decrease in government purchases shifts the aggregate demand curve to the left. An increase in government purchases shifts the aggregate demand curve to the right.
The multiplier effect and the crowding out effect
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The multiplier effect
The additional shifts in aggregate demand that result when expansionary fiscal policy increases income and thereby increases consumer spending.
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Expansionary fiscal policy
A planned decrease in the budget surplus (e.g. tax cut) to increase household's income and consumption.
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Contractionary fiscal policy
A planned increase in the budget surplus (e.g. reduced government spending without any reduction in taxes.)
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The crowding out effect
The offset in aggregate demand that results when expansionary fiscal policy raises the interest rate and thereby reduces investment spending.
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The multiplier and crowding out effect
If the multiplier effect e.g. 3 billion is greater than the crowding out effect e.g. 2 billion, aggregate demand will rise by more than 1 billion and vice versa
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Changes in taxes
Changes in taxes affect affect a households take-home pay. If the government reduces taxes, households income will increase which results in higher saving and consumption. The aggregate-demand curve will shift to the right and vice versa. The size of the shift in the aggregate demand curve will also depend on the sizes of the multiplier and crowding-out effect.
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Supply side economics
Tax policy and work incentives
Fiscal policy and AS curve
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Tax policy and work incentives
A decrease in tax rates may cause individuals to work more because they get to keep more of what they earn. The aggregate supply curve would increase (shift to the right). However most economists believe that a cut in tax rates only has a small effect on the AS curve
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Fiscal policy and AS curve
If the government increases spending on capital projects or education, the productive ability of the economy is enhanced, shifting aggregate supply to the right.
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Using policy to stabilise the economy
Active stabilisation economy
Automatic
Against active stabilisation policy
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Active stabilisation policy
The level of aggregate demand can be influenced by a change in government spending or taxation (fiscal policy) or a change in the interest rate (monetary policy). Keynesians believe that it is necessary for the central government to use its tax, government purchase ad interest rate (open market operation) policies aggressively to stimulate the economy during recession and slow the economy down during inflationary times.
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Automatic
Fiscal policy
Government spending
Tax system
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Fiscal policy
Changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policymakers having to take any deliberate action.
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Government spending
Government spending is also an automatic stabiliser. More individuals become eligible for transfer payments during a recession. E.g. unemployment payments to the unemployed.
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Tax system
The most important automatic stabiliser is the tax system. The government's revenue falls during a recession. Tax cut stimulates aggregate demand and reduces the magnitude of this economic downturn.
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Against active stabilisation policy
Fiscal and monetary policy tools should only be used to help the economy achieve long run goals such as low inflation and economic growth. Policy tools may affect the economy with a large time lag.
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Policy tools may affect the economy with a large time lag.
With monetary policy, investment decisions are usually made well in advance, so the effects from changes in investment will not likely be felt in the economy very quickly.
With fiscal policy the lag is generally due to the political process. Changes in spending and taxes must be approved by both the House and the Senate.
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How monetary policy influences aggregate demand
The aggregate demand curve is downward sloping.
The theory of liquidity preference
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The aggregate demand curve is downward sloping
3 reasons
Pigou's wealth effect
Keyne's interest rate effect
Mundell-flemings exchange rate effect
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Pigou's wealth effect
Keyne's interest rate effect
Mundell-flemings exchange rate effect
All three effects occur simultaneously but are not of equal importance. Household's money holdings are a small part of the total wealth (small wealth effect). Imports and exports are a small fraction of Australian GDP, the exchange rate effect is also fairly small for Australia. The most important reason for the downward sloping aggregate demand curve is the interest rate effect.
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The most important reason for the downward sloping aggregate demand curve is the interest rate effect.
A higher inflation rate induces the RBA to reduce interest rate. A higher interest rate reduces the quantity of goods and services demanded.
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The theory of liquidity preference
An explanation of the supply and demand for money and how they relate to the interest rate. 29/9
The money supply is assumed to be controlled by the central bank. Since the money supply does not depend on other economic variables, it's a vertical line.
Interest rate is the opportunity cost of holding money. As the interest rate rises the quantity of money demanded will fall. Therefore, the demand for money will be downward sloping.
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5. Which of the following policies would Keynes have supported when the economy is experiencing unemployment?
a. An open-market purchase
b. A reduction in tax rates
c. An increase in government purchases
d. All of the above
Keynes would have supported a policy that directly increases spending within the economy. An open market purchase by the RBA would lower interest rates, encouraging increased consumption and investment spending. A reduction in tax rates would encourage greater consumption spending. An increase in government purchases would directly contribute to an increase in national expenditure. Thus, Keynes would have supported all the possible options presented here.
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9. Why do people still hold cash in their wallets, despite the fact that they receive no returns compared to storing cash in their bank accounts?
According to the liquidity preference theory, people hold cash because it is by far the most liquid asset for completing transactions. In other words, people derive the benefit from holding cash not by receiving interest payments; the benefit flows through in the form of convenience.
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10. What are the key determinants of the interest rate in the short run? What are the key determinants of the interest rate in the long run?
In the short run, we can think of the interest rate as being determined in the money market, so its key determinants are the supply of and demand for money. In the long run, we can think of the interest rate as being determined in the loanable funds market, so its key determinants are the supply of and demand for loanable funds.
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11. What are the impacts of an expansionary fiscal policy on output and the inflation rate in the short run? How about in the long run?
An expansionary fiscal policy will raise both output and the inflation rate in the short run. However, without corresponding changes to long-run aggregate supply, such a policy will only lead to a permanent increase in the inflation rate.
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12. Define expansionary and contractionary fiscal policy, giving examples of each.
expansionary = a planned decrease in the budget surplus (T-G); e.g. a tax cut
contractionary (or tight) = a planned increase in the budget surplus (T-G); e.g. reduced government spending without any reduction in taxes
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The flow of financial resources: Net foreign investments
The purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners.
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Foreign direct investment
A capital investment is owned and operated by a foreign entity.
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Factors that influence a country's net foreign investment
The real interest rate being paid on foreign assets
The real interest rates being paid on domestic assets
The perceived economic and political risks of holding assets abroad
The government policies that affect foreign ownership of domestic assets
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The international flow of goods:
Exports are goods and services that are produced domestically and sold abroad.
Imports are goods and services that are produced abroad and sold domestically.
Net exports NX refers to the value of a nation's exports minus the value of its imports, also called its trade balance.
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Trade balance
The value of a nation's exports minus the value of its imports.
A trade surplus refers to an excess of exports over import.
A trade deficit refers to an excess of imports over exports.
Balanced trade refers to a situation in which exports equal imports.
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Factors that influence a country's exports, imports and net exports
The taste of consumers for domestic and foreign goods
The prices of goods at home and abroad
The exchange rates at which people can use domestic currency to buy foreign currencies
The incomes of consumers at home and abroad
The cost of transporting goods from country to country
The policies of the government toward international trade
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Saving and its relationship to international flows
Saving is equal to the sum of domestic investment and net foreign investment
S = I + NFI
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The prices for international transactions
Real and nominal transactions
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Nominal exchange rate
The rate at which a person can trade the currency of one country for the currency of another.
Appreciation refers to an increase in the value of a currency as measured by the amount of foreign currency it can buy
Depreciation refers to a decrease in the value of a currency as measured by the amount of foreign currency it can buy
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Real exchange rate
The rate at which a person can trade the goods and services of one country for the goods and services of another. The real exchange rate is a key determinant of bow much a country exports and imports.
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Real exchange rate formula
= Nominal exchange rate (e) * domestic price (p) divided by foreign price (P')
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Real exchange rate, appreciation and depreciation
A depreciation in the Australian real exchange rate means that Australian goods have become cheaper relative to foreign goods. Australian exports will rise, imports will fall and NX will increase.
An appreciation in the Australian real exchange rate means that Australian goods have become more expensive relative to foreign goods. Australian exports will fall, imports will rise and NX will decline
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The current account
The current account measures the imbalance between a country's exports and imports in world markets for goods and services (NX) as well as the flow of net income (NY) and net transfers (NT)
CAB = NX + NY + NT
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The capital and financial accounts
The capital and financial accounts measure an imbalance between the amount of foreign assets bought by domestic residents and the amount of domestic assets bought by foreigners, that is NFI
CAB = NFI
This equation holds as every transaction that effects one side of the equation must affect the other side by the same amount.
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Theory of purchasing power parity (PPP)
A theory of exchange rates in long-run whereby a unit of any given currency should be able to buy the same quantity of goods in all countries. The law of one price suggests that a good must sell for the same price in all locations. `
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PPP and arbitage
If a good i sold for less in one location then another, a person could make a profit by buying the good in the location where it is cheaper and selling in in the location where it is more expensive. The process of taking advantage of differences in prices in different markets is called arbitrage
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PPP and the nominal exchange rate
PPP means that the nominal exchange rate between the currencies of two countries will depend on the price levels in those countries
e = P/P*
If the central bank increases the supply of money in a country and raises the price level, it also causes the country's currency to depreciate relative to other currencies in the world.
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Limitations of PPP
Tradeable goods are not perfect substitutes when they are produced in different countries
Many goods are not easily traded
Exchange rates do not always move to ensure that a dollar has the same real value in all countries
