ECO 120- Macroeconomics

ECO 120- Macroeconomics Weekend School #2 9th June 2007 Lecturer: Rod Duncan Previous version of notes: PK Basu

Topics for discussion • Module 4- The role of the government • The tools the Australian government controls to smooth short-run fluctuations in the economy • Module 5- Macroeconomic applications • The link between inflation and unemployment, economic growth and Australian trade with the rest of the world • What will not be discussed • Answers to Assignment #2 (use the CSU forum for this)

Money • Money has three main functions in the economy. • Money is a medium of exchange. We use exchange money when we buy/sell to each other. • Money is a unit of account. Money is an agreed measure for stating the value of other goods and services. • Money is a store of value. Money can be kept under the bed or inside a jar and used to exchange for goods and services in the future.

Official measures of money • M1 is the amount of notes and coins (“currency”) in circulation plus current deposits with banks. • M3 is M1 plus all other bank deposits. • Credit cards are not counted as money, since using a credit card is accumulating debt, whereas deposits at a bank can be turned into money without accumulating debt.

Money multiplier • What happens when you take $1 cash to a bank to deposit it? (1) You deposit the cash in the bank, and the bank creates an account for you with $1 in it. Money = $1 (2) The bank doesn’t keep the cash. Instead the bank has to keep R, called the “reserve ratio” (0 < R < 1), of the $1 as reserves and then loans out $(1 - R). (3) The person who receives the loan of $(1-R) spends the cash, and the merchant who receives the $(1-R) puts that in his bank. This increases the merchant’s account by $(1-R). Money = $1 + $(1-R)

Money multiplier (4) The second bank keeps $R(1-R) as reserves and loans out $(1-R)(1-R) = $(1-R)2 as new loans. Money = $1 + $(1-R) + $(1-R) 2 + … • If this process continues, the value of money created is 1/R = 1 + (1-R) + (1-R)2 + ... • So for every $1 floating in the economy in currency, we have $1/R in currency plus deposits in the economy. This ratio m = 1/R is called the “simple money multiplier”. For every $1 in currency that the government prints, the money supply increases by m.

Equilibrium in the money market • Equilibrium in the money market means supply of money equals demand for money. • Supply of money • The supply of money depends on the level of currency in the economy and the money multiplier. The supply of money does not depend on the interest rate. • Demand for money • People require money to make purchases, ie. How much currency is in your pocket?

Demand for money • The higher is income and prices, the greater the amount of money required to make the purchases people will wish to make. • But a $1 in your pocket is a $1 not in the bank. In the bank, that $1 would be accumulating interest, but in your pocket, it accumulates no interest. So the interest rate is the price of holding money as currency rather than as a deposit in the bank. So we would expect that as the interest rate rises, people will lower the level of currency that they hold. • The demand for money is downward-sloping in the interest rate, i, and increases in income and prices.

Equilibrium in the money market • The supply of money does not depend on the interest rate, so it is vertical. • The interest rate is the price of holding wealth as currency, so money demand falls as i rises.

Monetary policy • The government can control the supply of money and thus the interest rate. These actions are called “monetary policy”. • “Open market operations” are a means of the government controlling the supply of money. The government (in our case the Reserve Bank of Australia or RBA) buys and sells government securities, such as government bonds to control the amount of money in the economy. • If the RBA buys a bond with currency, the RBA increases the money supply (by the change in currency times the money multiplier).

Monetary policy • If the RBA sells bonds for currency, it decreases the supply of money. • Monetary policy shifts the money supply curve and so changes the equilibrium interest rate.

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

Who operates monetary policy? • The Reserve Bank of Australia (RBA) is responsible for monetary policy. • The RBA was given 3 goals when it was created: • Maintain low inflation • Maintain low unemployment • Maintain value of the A$ • The RBA was only given one policy tool- the money supply to achieve 3 goals. In the mid 1990s, the RBA was simply told to have one aim: • Maintain low inflation- “inflation target” of 2-3%.

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

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

How monetary policy works Cause–Effect Chain of Monetary Policy: • RBA cash rate impacts interest rates • Interest rates affect investment • Investment is a component of AD • Equilibrium GDP is changed

SF1 SF2 10 8 6 0 10 8 6 0 Investment demand D1 Amount of investment, i AD1 AS Easy Monetary Policy Price level AD2 Y

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

Inflation targeting • The RBA makes known their target or desired level of inflation- 2-3% inflation. • The RBA will tighten monetary policy, raise i, if inflation appears to be too high. • The RBA will loosen monetary policy, lower i, if inflation appears to be too low. • The RBA has to “look ahead” to the level of future inflation.

RBA raises i AS2008 P AS2007 103 Target band 102 100 AD2008 AD2007 Y2007 Inflation targeting • How can we put this into our AD-AS model?

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.

Sample exam question QUESTION : B.3 Using the models from our subject, carefully explain the consequences if the government reduces the supply of paper money (or “cash”) by an amount, m. a) What are the consequences on the total level of money? b) What are the consequences in the money market? c) What are the consequences in the AD-AS model for the economy as a whole?

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

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

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

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

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

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

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

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

P LR AS AS AD Yn Y0 Y Stabilizing a boom

P LR AS AS AD Yn Y0 Y Stabilizing a recession

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

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

Train driver problem GDP Time June August

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

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

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

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

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

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

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

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

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

Debt Comparison

Sample exam question 1 QUESTION : C.2 A balanced budget fiscal policy would require the government to spend more when the economy is in a boom (and taxes are high) and require the government to spend less when the economy is in a recession (and taxes are low). (a) Explain the business cycle using the AD-AS model, assuming that it is changes to the AD curve that makes the cycle happen. Assume here that government spending is held constant over the business cycle. (b) Explain the effect of a balanced budget fiscal policy on the business cycle using the AD-AS model. (c) Is the balanced budget fiscal policy helping or hindering the economy?

Sample exam question 2 QUESTION : C.3 The monetarists believe that the aggregate supply (AS) curve is very steep, while the Keynesians believe the AS curve is flat. (a) Explain how fiscal policy would work in each case in the aggregate demand-aggregate supply (AD-AS) model. (b) What would you expect that the two camps have to say about the effectiveness of fiscal or monetary policy?

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

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

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 %

ECO 120- Macroeconomics