ECO 120- Macroeconomics

1. ECO 120- Macroeconomics Weekend School #2 3th June 2006 Lecturer: Rod Duncan Previous version of notes: PK Basu

2. Topics for discussion • Module 3- fiscal and monetary policy • The tools the Australian government controls to smooth short-run fluctuations in the economy • Module 4- inflation, unemployment and external trade • The causes and effects of inflation, the link between inflation and unemployment, Australian trade with the rest of the world • What will not be discussed • Answers to Assignment #2 (use the CSU forum for this)

3. Fiscal policy • Source: Chapter 9 of the book plus first part of Module 3. • “Fiscal policy” is the government operation of government spending (G) and taxes (T). • Typically we consider the problem of how the government can manipulate G and T so as to control economic variables such as output, inflation, interest rates, etc. • Issues: how fiscal policy can “stabilize” the economy? what about government borrowing and public debt?

4. Definitions • Budget deficit: the budget deficit is the extent of overspending by the government Budget deficit = G – T • Expansionary fiscal policy: increasing the budget deficit (G↑ or T↓) usually in a recession. • Contractionary fiscal policy: decreasing the budget deficit (G↓ or T ↑) usually in an economic boom.

5. Budget deficits and surpluses • If the government spends more than it brings in in taxes, what happens? (G > T) • The money has to come from somewhere. For developed countries, this means borrowing (issuing government debt or “public debt”) from domestic residents or foreigners. • If the government is spending less than it brings in in taxes, the government can reduce public debt. The Australian government has followed this policy in the last 10 years.

6. Types of fiscal policy • We differentiate two types of fiscal policy: • Discretionary fiscal policy: This is fiscal policy that comes about from planned changes in G and T that the government brings in in response to the economic situation. • Non-discretionary fiscal policy: This is fiscal policy that comes about from the design of spending and taxes. There is no government official actively determining these changes.

7. Non-discretionary fiscal policy • Certain parts of our spending and taxes automatically increase demand in a recession (when AD < potential GDP) and decrease demand in a boom (when AD > potential GDP). • Welfare spending and unemployment benefits are part of G and increase in a recession and decrease in a boom. • Income and company taxes are part of T and depend on GDP, they increase during a boom and decrease during a recession. • These act as “automatic stabilizers” on the economy, reducing the variability of the economy.

8. Cyclically-adjusted budget deficits • The automatic stabilizers raise the budget deficit in a recession and lower the budget deficit in a boom. • This fact means that we can not just look at the budget deficit to determine whether the government is “overspending”, we also have to take into account where we are in the business cycle. • Adjusting the budget deficit for the point we are in the business cycle is called “cyclically adjusting”. We would expect even a “sensible” government to be in a deficit in a recession.

9. Discretionary fiscal policy • Discretionary fiscal policy is the manipulation of G and T by government officials typically to reduce the severity of shocks to the economy. • It sounds like a good idea, but how does it work in reality? • There are many problems and limitations to the use of fiscal policy to reduce recessions and booms.

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

11. Problems with discretion • Limitations: • Correctness of data: Is the train driver seeing the tracks correctly? Or Does the government get the right data about where the economy is? • Timing of data: Is the train driver seeing the tracks with enough time to react? Or Does the government get the statistics quickly enough to do anything? • Decision lags: Can the train driver make a decision about the correct action before the train reaches the problem spot? Or does the government have time to design the correct fiscal policy?

12. Problems with discretion • Administration lags: If the driver pulls on the control, how long will it take for the brakes to start to work? Or New spending and taxes have to be passed through parliament, which takes time, even after a decision is made. • Operational lags: If the brakes start to work, how long before the train slows down? Or New government spending and taxes take time to affect the economy. • So even the best-designed fiscal policies can go wrong if they are in response to the wrong data or if they take too long to affect the economy.

13. Political considerations • There are further concerns we might have about the operation of fiscal policy. • Politicians have to remain popular. No one likes taxes, and everyone likes new spending on themselves. Will a politician make an unpopular decision that may result in them losing the election if it is the best decision for the economy. • Electoral cycles: Governments have to be re-elected every 3-4 years. So a politician would love to engineer a boom right before his or her election.

14. Crowding out • Another problem with fiscal policy is that an increase in G may increase output but at the expense of other components of aggregate expenditure. Y = C + I + G + NX • Since the economy returns to potential GDP over the long-run, an increase in G must come at the expense of either C, I or NX or all 3. • If an increase in G reduces investment spending over the long-run, this could lead to lower future growth in the economy.

15. Crowding out • How can this happen? • An increase in G shifts the AD curve to the right. • This results in higher Y and higher P. • The increased government borrowing in the market for savings raises the interest rate. • Higher interest rates lead to lower investment spending so I drops, shifting AD left. • Higher interest rates leads to an appreciation of the A$ (as foreign investors put their money in Australia), so NX drops, shifting AD left.

16. Crowding out- I and NX AS ASLS AD1 P3 P2 P1 AD3 AD2 Q1 Q2 Qp

17. Government debt • One problem that economic commentators always point to is the level of government debt- “Our debt is too high.” • How do we evaluate the level of government debt? How do we know is it is “too high”. • Government debt is like any other form of debt. You evaluate the debt relative to the income/wealth of the person incurring the debt. • A $500,000 debt might be high to you and me, but it might mean nothing to Kerry Packer.

18. Government debt • So we need to evaluate government debt relative to “government income”. But what is the appropriate form of “government income”, as the government doesn’t earn or produce anything. • Generally we use the income of the country as the comparison, since the government is free to tax or claim any part of GDP.

19. Government debt • So our criterion for “too much” is debt (B, since typically government debt is issued in government bonds) over GDP (Y): B / Y • Banks would make much the same calculation when considering whether to issue someone a home loan. • In general debt is growing at the rate of interest each year, r, while GDP is growing at the growth rate of the economy, g.

21. Monetary policy • Source: Chapter 12 of the book plus second part of Module 3. • “Monetary policy” is the government operation of the money supply and interest rates. • Typically we consider the problem of how the government can manipulate monetary policy so as to control economic variables such as output, inflation, interest rates, etc. • Issues: how monetary policy can “stabilize” the economy? how will monetary policy affect interest rates or exchange rates?

22. Who operates monetary policy? • The Reserve Bank of Australia (RBA) is responsible for monetary policy. • The RBA was given 3 goals when it was created: • Maintain low inflation • Maintain low unemployment • Maintain value of the A$ • The RBA was only given one policy tool- the money supply to achieve 3 goals. In the mid 1990s, the RBA was simply told to have one aim: • Maintain low inflation.

23. Definitions • The RBA implements monetary policy through its control of the cash rate. • Cash rate: The cash rate is the rate the RBA charges bank for loans within the RBA reserves system. The cash rate is the base interest rate for the economy, and all other interest rates are derived from it. • Easy monetary policy: When the RBA lowers the cash rate to stimulate AD. • Tight monetary policy: When the RBA raises the cash rate to cut off AD.

24. Interest rates • As we saw in the Investment section, the profitability of investment projects depends on the nominal interest rate. • The lower are interest rates, the more projects will be profitable, so the higher will be investment spending. • Since the RBA controls the cash rate, and since all interest rates depend on the cash rate, the RBA controls I, and so can shift the AD curve.

25. How monetary policy works Cause–Effect Chain of Monetary Policy: • Money supply impacts interest rates • Interest rates affect investment • Investment is a component of AD • Equilibrium GDP is changed

26. SF1 SF2 10 8 6 0 10 8 6 0 Investment demand D1 Amount of investment, i AD1 ASLR AS Easy Monetary Policy Price level P1 AD3 AD2

27. SF2 SF1 10 8 6 0 10 8 6 0 Investment demand D1 Amount of investment, i ASLR AS Tight Monetary Policy Price level P1 AD1 AD2 Real domestic output, GDP

28. Monetary policy and the open economy • Net Export Effect • Changes in interest rate affect the value of the exchange rate under floating exchange rate.An increase in interest rate appreciates the currency, resulting in lower net exports • A decrease in interest rate leads to currency depreciation and a rise in net exports • So an easy monetary policy is enhanced by the net export effect.

29. Quantity theory of money • There is a nice, simple model of money which explains many features of money supply and demand. This model is called the quantity theory of money. • If we imagine that money is needed for all of the purchases made each year, then demand for money is the vale of purchases: PY. • The supply of money for purchases is the amount of cash in the economy. • But each piece of money in the economy can be used multiple times during a year in transactions. We call the number of transactions the velocity of money “v”.

30. Quantity theory of money • So the total supply of money for transactions in a year is v times M: vM. • So demand equals supply requires that: PY = vM • So if Y goes up, but nothing else does, then average level of prices must fall. • The QTM is good to use for thinking about money and inflation.

31. Unemployment • A person becomes unemployed: • Job loser • Job leaver • New entrant or re-entrant into the labour force • He or she is no longer unemployed: • Hired or recalled • Withdraws from the labour force

32. Population Working age population Labour Force Participation Rate Labour Force Employed or Unemployed Unemployment Rate

33. Labour force participation rate Proportion of country’s population that takes part in its economic activities directly (either actually taking part or willing to) / Labour Force Working Age Population X 100 LFPR In Australia, in September 2003 : ( 10.237 million / 15.955 million ) x 100 = 64.2 %

34. Unemployment rate Proportion of country’s labour force that is unemployed. ( / ) Number Unemployed Labour Force X 100 UR in Australia, in September 2003 : (0.591 million / 10.237 million) x 100 = 5.8%

35. Types of unemployment • Three main types of unemployment: • Cyclical unemployment • Frictional unemployment • Structural unemployment

36. Cyclical unemployment • Associated with the ups and downs of the business cycle • Takes place due to insufficient aggregate demand or total spending- reflects shifts in AD curve. • High during recessions and low during booms. • Fiscal and monetary policies can reduce cyclical unemployment - policies are relevant.

37. Frictional unemployment • Associated with the period of time in which people are searching for jobs, being interviewed and waiting to commence duties. • It is inevitable and always exist • Fiscal and monetary policies can not reduce frictional unemployment – macroeconomic policies are irrelevant. • Policies that make it easier to find new jobs will affect frictional unemployment.

38. Structural unemployment • Associated with wider structural or technological changes in the economy that may make some jobs redundant. • It is inevitable and always exist • Lasts longer than frictional unemployment • Fiscal and monetary policies can not reduce structural unemployment – macroeconomic policies are irrelevant. • Policies that encourage workers to retrain skills or to move to a new area with more jobs will decrease structural unemployment.

39. “Full” employment • Full employment means when all productive resources in the economy are in full use - implies no cyclical unemployment - still frictional and structural unemployment exist - they can be low - but can never be zero. • The full-employment rate of unemployment is called the “natural rate of unemployment”. • Domestic output consistent with the natural rate of unemployment is “potential output” or “full employment level of GDP”.

40. Classical employment theory • Economy always operates under full employment - it is automatic and self sustaining - if there is any unemployment that is only temporary. • Price-wage flexibility • the assumption that all prices, including wages and interest rates, are flexible and will, rapidly adjust to remove disequilibria • Classical theory and laissez faire • the price system ensured that price-wage flexibility and fluctuations in the interest rate was capable of maintaining full employment

41. Classical theory P1 Price Level P2 AD1 AD2 Q1 Real Domestic Output

42. Keynesian employment theory • Full employment is not automatic - unemployment exists for longer periods - the Great Depression of the 1930s - sticky wages and prices. • Horizontal aggregate supply curve during recession - ‘recessionary’ or ‘Keynesian’ range. • Change in AD impacts on unemployment - not on price level. • Once the full employment level is reached - vertical AS curve - change in AD affects price level only. • Unstable aggregate demand - especially investment, so that demand management and stabilisation policies by the government are essential.

43. Keynesian theory AS P1 Price Level AD1 AD2 Q2 Q1 Real Domestic Output

44. Current year index - Previous year index Inflation rate x = 100 Previous year index Measuring inflation • We measure the general price level through a price index such as the Consumer Price Index (CPI) • Inflation is a continuous rise in the general price level. We measure inflation:

45. Inflation in Australia, 1970-2004

46. Two types of inflation • We can differentiate two different sources of inflation in an economy: • Demand-Pull Inflation • Occurs when an increase in AD pulls up the price level. • Cost-Push Inflation • Occurs when an increase in the cost of production at each price level shifts the AS curve leftward resulting in increased prices.

47. Demand-pull inflation • Short-run: There is an increase in demand, such as an increase in consumer spending, so AD shifts rightward. AS does not change in the short run, and we have a movement along the AS curve. Price level and GDP increases.. • Long run: Workers will realise their real wages have fallen and will demand and receive increased nominal wages. As costs rise, supply decreases and the AS to shift to the left. Price level increases, and GDP declines. • May be caused by expansionary fiscal and monetary policies - can be countered by contractionary policies by the government.

48. Demand-pull inflation- SR and LR ASLR Price Level AS1 A decrease in aggregate supply.... Increases the price level and output returns to original level P3 c P2 b P1 a AD2 AD1 Real GDP o Q1 Q2

49. Cost-push inflation • Short-run: Increased prices and decreased real output (and more unemployment). Causes can be: • Wage push : increase in wage rate - power of trade unions • Supply shocks - increase in prices of major raw materials - oil etc. • Profit push : increase in profit requirement of large monopoly businesses. • The AS curve shifts to the left/up as prices and costs rise, and firms cut back on output.

50. Cost-push inflation • Long-run: There are two scenarios. • Government intervention ( shift in AD): If government intervenes to increase AD, prices and output will rise, moving us back to the natural rate of output. • No Government intervention (no shift in AD): If government does not intervene to increase AD, a severe recession will result. However nominal wages will eventually decline and will restore AS to its original position, moving us back to the natural rate of output.