Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.

com)
ECONOMICS

LECTURE 1

What is Economics = how to allocate limited resources efficiently

economics
Scarcity – limited resources in the industry
 Trade off = sacrifice one thing for another, choosing one option over another
 Rational = choosing the best for you – cost/benefit analysis

Cost/benefit of University
 Benefit = education, networking, knowledge construction, intellectual capabilities,
communication skills, time management, group tasks, negotiation skills
 Costs = tuition fees, time, sacrifice a full time salary, travel costs, uni textbooks
MB=MC
Two types of costs
 Accounting costs = how much you are going to pay for going to university
 Economic costs = opportunity costs (explicit cost+implicit cost/ EC+IC), the second best
alternative that you have to sacrifice – instead of being a full time job but full time university
student

Marginal = total benefit -‐ total cost = net benefit

To work out the difference between the both to make a decision
Is always small

Positive economics =related to reality and growth

Normative economics = related to ethics, thinking from a equity point of view, trying to maintain a good
life standard for each person e.g. disability benefits

We would love to buy this but due to scarcity of funds we can not
Supply & S&D
Demand Considers how buyers and sellers behave and interact with one another in competitive markets

Shows how the interaction between buyers and sellers determines the quantity of each good/service
produced and the price at which it is sold in a competitive market

Market & Market = group of buyers and sellers trading a g/s at a mall, ebay
Competition
Markets take many forms. Sometimes they are highly organized (e.g., fish market auction in Sydney),
sometimes less organized (e.g., market for ice-‐cream in Sydney)

Competitive market = is a market in which there are so many buyers and so many sellers that each has a
negligible impact on the market price

 The smaller the ability of each buyer/seller to affect the market price, the more competitive the
market.

Throughout this subject we will assume that markets are perfectly competitive (PC).

To reach this highest form of competition, a market must have two characteristics:

Page 1 of 43

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

 1. The goods being offered for sale are all exactly the same (homogeneous)
2. The buyers and sellers are so numerous that none can influence the market price.

Price takers = When buyers and sellers accept the price given

PC VS MONOPOLY

PC MARKETS = Agricultural or commodity markets e.g. Gold or Apples, same thing with many producers

Not competitive markets are MONOPOLIES = One seller e.g. Electricity suppliers years ago there was
only one, currently one type of bus company for a route

Demand Quantity demanded of a good is the amount of a good that buyers are willing and able to purchase.
 Willing = A buyer wants to buy that amount (given his/her tastes and preferences)
 Able = Given the price of the good, a buyer has enough income to buy the desired amount

Quantity demanded of a good depends on many factors such as the price of the good, tastes, income
and many others

Law of demand = Other things equal, the quantity demanded of a good falls (rises) when the price of the
good rises (falls).
CETERIS PARIBUS = Other things equal

Two ways of representing the relationship between price and quantity demanded:
1. Demand Schedule: A Table showing the relationship between the price of a good and the
quantity demanded.

How many ice-‐cream’s Catherine buys each month at different prices of ice-‐cream. Ceteris
Paribus assumption displayed

Page 2 of 43

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

 2. Demand Curve: A Graph showing relationship between the price of a good and the quantity
demanded.

Market demand vs. individual demand

Market demand is the sum of all individual

demands for a particular good or service.
 Graphically, individual demand
curves are summed horizontally to
obtain the market demand curve
 The market demand curve shows
how the total quantity demanded of
a good varies with the price of the
good, holding all other factors
constant

Shifts in the demand curve

A change in one or more of these “other factors” generates a shift in the demand curve, either to the
left or right. And the price stays constant…

Other factors = seasons such as winter where ice cream is not bought alot

Thus a change in a
demand

Page 3 of 43

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

 Other factors in depth

Income -‐ The relationship between income and demand depends on what type of good the product is.
 Normal good – a good for which, other things being equal, an increase in income leads to an
increase in demand

 Inferior good – a good for which, other things being equal, an increase in income leads to a
decrease in demand
e.g. homeless buying potatoes, gets money buys better quality food

Prices of related goods -‐ The relationship between the price of a related good and demand depends on
what type of goods the products are.
 Substitutes – two goods for which a decrease in the price of one good leads to a decrease in the
demand for the other good.

E.g. coke vs pepsi, coke prices decreases so demand for cheap pepsi decreses

 Complements – two goods for which a decrease in the price of one good leads to an increase in
the demand for the other good.
E.g. coke vs pepsi, pepsi prices lower thus demand for it is higher

Tastes -‐ If you like something you buy more of it. Economists do not normally try to explain people’s
tastes, however, they do examine what happens when tastes change

Expectations -‐ About your future income or About the future price of the good

Number of buyers -‐ Because market demand is derived

Supply Quantity supplied is the amount of a good that sellers are willing and able to sell
 Willing = Producer wants to sell that amount
 Able = The amount is feasible given resources and technology

The law of supply states that, other things being equal (ceteris paribus) the quantity supplied of a
good rises when the price of the good rises, and vice versa

Two ways of representing the relationship between price and quantity supplied:

Supply Schedule: Table showing relationship between the price of a good and the quantity supplied.

How many ice-‐creams Tony supplies

each month at different prices of ice-‐
cream.

How the monthly quantity of ice-‐

creams supplied by Tony changes as
the price of ice-‐cream changes.

Page 4 of 43

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

Supply Curve: Graph showing relationship between the price of a good and the quantity supplied.

Market supply is the sum of all individual supplies

for a particular good or service.

Graphically, individual supply curves are summed horizontally to obtain the market supply curve

Shifts in the supply curve

A change in one or more of these “other factors” (i.e. in a determinant other than price) generates a
shift in the supply curve, either to the left or right

Other factors
Input prices -‐ The quantity supplied is negatively related to the price of inputs used to make the good: If
the price of an input rises (falls), the supply decreases (increases)

Technology -‐ An improvement in production technology increases productivity: with the same inputs,
the producer can supply more

Expectations – eg If suppliers expect the price to rise they will be more likely to store some of the good
and supply less to the market today

Number of sellers -‐ Because market supply is derived from individual supply it positively depends on the
number of sellers

Page 5 of 43

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

 LECTURE 2
Equilibrium A situation in which supply and demand have been brought
into balance

Price – the price when both points meet

AKA – market clearing price

Quantity – Is both the quantity supplied and the quantity

demanded at the equilibriuxm
price.

Surplus = market price is higher than the equilibrium price

 Sellers need to lower the price to increase sales

Shortage = Market price is lower than the equilibrium price

 Sellers need to rise the price to increase sales

Sellers naturally move the price – and hence the market – towards equilibrium

LAW OF SUPPLY AND DEMAND

 This does not mean that markets are never out of equilibrium. Surpluses and shortages may
exist over certain period of time
 Once the equilibrium is reached, all buyers and sellers are satisfied and there is no upward or
downward pressure on price

Changes in Demand & Supply = market’s equilibrium

equilibrium
Shifts in D&S = change in equilbrium
 Events called ‘exogenous’ change D&S
 Subsequent change is ‘Endogenous’

The analysis of a change in equilibrium is called comparative statics. It is done in three steps:
1. Decide whether the exogenous event shifts the supply or demand curve (or perhaps both).
2. Decide in which direction the curve shifts.
3. Use the supply-‐and-‐demand diagram to see how the shift changes the equilibrium (endogenous
change).

Page 6 of 43

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

 INCREASE IN DEMAND
 Hot weather for ice cream – exogenois event
 More demand for ice cream, More supply
needed – new high price = new equilibrium

DECREASE IN SUPPLY
 Bushfire destroys ice cream factories
 Less supply, less demamd needed -‐ new low price
= new equilibrium

Free markets Two key roles of prices

and role of 1. Prices co-‐ordinate the actions of large numbers of buyers and seller, each acting independently
prices a. Price up, Buy less
2. Prices are a mechanism for allocating scarce resources (rationing function of prices)
a. The market mechanism of S and D means that any buyer who is willing and able to pay
the equilibrium price can purchase the good.
b. Similarly, any seller who is willing and able to produce and sell the good at the
equilibrium price, will do so.

Elasticity A good or service is considered to be highly elastic if a slight change in price leads to a sharp change in
the quantity demanded or supplied. Usually these kinds of products are readily available in the market
and a person may not necessarily need them in his or her daily life.
 You can live without

On the other hand, an inelastic good or service is one in which changes in price witness only modest
changes in the quantity demanded or supplied, if any at all. These goods tend to be things that are
more of a necessity to the consumer in his or her daily life.
 You need to live with
Elasticity: Measures how much demand responds to changes in its determinants
Demand  Price elasticity of demand
 Income elasticity of demand
 Cross-‐price elasticity of demand

The price elasticity of demand is a measure of how much the quantity demanded of a good responds to
a change in the price of that good.

Formula = 20% decrease in demand for milk/10% increase in price of milk = 2

Page 7 of 43

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

2 = how quantity demanded changes in proportion to a given change in price.
 You can conclude that a given change in price of MILK will lead to a change in quantity
demanded for wine that is twice as large

The higher the price elasticity of demand for a good, the higher the responsiveness of quantity
demanded of that good to a change in its own price.

What determines the elasticity of demamd

1. Availability of close substitutes
a. Price elasticity tends to be higher when there are many close substitutes
2. Necessities versus Luxuries
a. Elasticity tends to be higher for luxuries
3. Definition of the market
a. Elasticity tends to be higher when market is defined narrowly (‘food’ versus ‘ice cream’)
4. Time horizon
a. Elasticity tends to be higher the longer the time period considered

Demand Curves
This is related to the slope of the demand curve
Rule of thumb: the steeper (flatter) the demand curve, the lower (greater) the price elasticity.

Page 8 of 43

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

Elasticity of a linear demand curve = needing to know the demand – mid point of line

Total revenue and the price of elasticity of demand

 TR = Price x Quantity
 Amont paid by buyers, received by sellers

P increases = TR decreases

Inelastic – buyers do not respond the price, increase in

price = increase in TR

Elastic – buyers do respond to the price, increase in price = decrease in TR

Income elasticitiy = measures how much the quantity demanded of a good responds to a change in
consumers’ income

Normal goods have positive income elasticity (greater than 0)

Inferior goods have negative income elasticity (less than 0)

Income inelastic are necessities such as food, fuel, clothing, mediciene, utilities
Income elastic are luxuries such as porshe cards, yachts

Cross-‐price elasticity of demand measures how much the quantity demanded of a good (say good 1)
responds to a change in the price of a related good (say good 2)

Complements (e.g. cars and petrol) have negative cross-‐price elasticity

Substitutes (e.g. pepsi and Coke) have positive
cross-‐price elasticity

> Elastic
< Inelastic
= Unit elastic
∞ = perfectly elastic
O perfect inelastic

Page 9 of 43

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

Elasticity Supply
Measures how much supply responds to changes in its determinants
Supply  Price elasticity of supply

Price elasticity of supply is a measure of how much the quantity supplied of a good responds to a
change in the price of that good.

Supply is said to be:

 Elastic if price elasticity of supply is greater than 1
 Inelastic if price elasticity of supply is smaller than 1
 Unit elastic if price elasticity of supply is equal to 1
Determinants of price elastisity of supply

Ability of suppliers to change the amount of the good they sell

 The supply of a Picasso painting or beach-‐front land is inelastic
 The supply of books, cars, or manufactured goods tend to be elastic
Time period being considered
 Supply is more elastic over longer periods.

Page 10 of 43

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

 LECTURE 3
Market and Today we analyze policies that governments can implement to change free market equilibria:
Government 1. Price controls
Policies 2. Taxes

Price controls are used when policymakers believe the market price is unfair to buyers or sellers.

Price controls can be:

 A price ceiling
o A legal maximum on the price at which a good can be sold

o PIC 1: If the ceiling is above the equilibrium price (i.e. it is not binding) = No effect
o PIC 2: If the ceiling is below the equilibrium price (i.e. it is binding) = Shortage and non-‐
price rationing (long lines and queuing as people know there is not much in the market,
discrimination by sellers)

 A price floor
o A legal minimum on the price at which a good can be sold. – E.G. minimum wage

o PIC 1: If the floor is below the equilibrium price (i.e. it is not binding) = No effect
o PIC 2: If the floor is above the equilibrium price (i.e. it is binding) = Surplus and non-‐price
rationing (discrimination by buyers)

Minimum wage example of price floors

o Minimum-‐wage laws prevent employers offering wages below a certain level.

Page 11 of 43

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

 o Potential undesired effect: It can increase unemployment level of unskilled workers.

Taxes and All governments use taxes to raise revenue for public projects and services
market
outcomes We will consider in turn:
 A tax levied on sellers
 A tax levied on buyers

For sellers
 Tax is an additional production cost, increase the price to cover the extra cost of tax = higher
unit price – the supply curve will shift up the amount equal of the tax
 Sellers increase the price for buyers thus tax makes both buyers and sellers worse off
 In the new equilibrium buyers pay more for the good and sellers receive less.

For buyers
 Buyers have to pay the price to the seller plus any tax to government so to get buyers to buy
sellers need to push down the price of what it was including the new tax
 The demand curve shifts down by the equal amount to the tax

Though the buyers physically pay the $0.50 to the government, they share the burden of the tax with
sellers. In the new equilibrium buyers pay more for the good and sellers receive less.

Impact of Taxes result in a change in market equilibrium

taxes
In the new equilibrium, quantity traded is lower regardless whom the tax is levied on.
 Taxes discourage market activity
 However they are necessary to raise revenue to finance some projects and services

Buyers pay more and sellers receive less, regardless of whom the tax is levied.
 Conclusion: Buyers and sellers share the tax burden regardless of whom the tax is levied on.

But in what proportions is the burden of the tax divided?

The answer to this question depends on the elasticity of demand and the elasticity of supply.

Page 12 of 43

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

Elasticity General Rule: The burden of a tax falls more heavily on the side of the market that is less elastic.
and tax
incidence DEMAND IS LESS ELASTIC THAN SUPPLY
The price that buyers pay is more due to the
tax implemented.

If D is less elastic than S the burden falls

more heavily on consumers than on
producers.

SUPPLY IS LESS ELASTIC THAN DEMAND

As the graph sows, in this case the burden falls

more heavily producers that on consumers.

Page 13 of 43

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

 LECTURE 4

Welfare Welfare analysis tries to answer questions like:

economics  Is the allocation of resources that is generated by a free market desirable from the
standpoint of society?
 Broadly, we are asking ourselves whether the forces of D and S are determining a price
and a quantity of a good that are somehow “right”.

We want to increase welfare of the market

Welfare of market participants is measured using participants’ surplus, that is consumer surplus
(CS) and producer surplus (PS).

Consumer Consumer surplus = Willingness to pay for a good and what they value it to be at
Surplus  The buyer’s perceived benefit from purchasing the good

Example Demand Schedule:

Now we construct the demand curve:

Marginal buyer: the buyer who would leave the

market first if the price were any higher

We now know that a demand curve tells us two

things:
1. Given a price, it shows the quantity that
buyers are willing and able to purchase

2. Given a quantity, it shows the WTP for (or

value of) the last unit of the good.

So market price is $70:

CS in a market is measured as the area above the

market price and below the D curve

Page 14 of 43

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

 How does a change in price affect consumer surplus?
Market price falls:

Producer Producer Surplus (PS) is the amount a seller is actually paid minus the seller’s cost.
Surplus  Term cost to be interpreted as the seller’s opportunity cost;
 Seller’s cost is a measure of a seller’s willingness to sell, WTS;
 Willingness to sell is the lowest price a
seller
would

accept for providing his good/service.

Demand Curve example of painting houses >

Marginal seller: the seller who would leave the

market first if the price were any lower

So a supply curve tells us two things:

1) Given a price, it shows the quantity
that sellers are willing and able to sell

2) Given a quantity, it shows the sellers’ cost

to produce the last unit of the good.

Market Price is $800

Lesson from this example: PS in a market is measured as

the area below the market price and above the S curve

Page 15 of 43

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

 How the price affects producer surplus

Market How do we judge?

outcomes Is the outcome determined by a free market in any way desirable?

ANSWER=
1. Measure societies’ welfare/wellbeing to the market outcome
Total Surplus = CS + PS
CS = value to buyers – amount paid by buyers
PS = amount received by sellers – costs of sellers
Total Surplus = CS + PS = value to buyers – cost of sellers

 We want the good to be produced cheaply and consumed by the buyers who value it the
most
 If we do so for each good that we produce, we maximize total surplus.
 A market-‐outcome/resource-‐allocation that maximizes total surplus is said to be
efficient.
 By looking at total surplus, we ignore how benefits are distributed among consumers and
producers.
 Technically, we focus on efficiency and not equity.

Page 16 of 43

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

 2. Benevolent and all-‐knowing social planner? Would we leave the market as it is or
change it in increase society’s welfare/wellbeing?

Free markets 1. Allocate supply of goods to buyers who value them most highly
2. Allocate the demand for goods to the sellers who can produce them at least cost
3. Produce the quantity of goods that maximises the sum of consumer and producer surplus,
i.e. the equilibrium outcome is efficient

Adam Smith’s Invisible Hand – though markets contain self-‐interested buyers and sellers who
make independent decisions, market prices coordinate buyers and sellers and the result is not
chaos but efficiency.

A social planner with the goal of maximising total surplus would leave the market outcome as he
finds it. This policy approach is known as laissez-‐faire.

Page 17 of 43

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

 LECTURE 5

Externality An externality is the uncompensated impact of one person’s actions on the wellbeing of another (a
bystander)
 If the impact on a bystander is adverse we have a negative externality
o Car exhaust
o Cigarette smoking
o Barking dogs (loud pets)
o Lawn mowers
o Loud music in an apartment building

 If the impact is a bystander is beneficial we have a positive externality

o Immunization
o Restored historic buildings
o Research into new technologies

Uncompensated impact: the person whose activity generates a negative (positive) externality does
not pay (receive) any compensation for that effect’

Because buyers and sellers neglect the external effects of their actions when deciding how much
to demand or supply, the market equilibrium is not efficient in the presence of externalities

Negative Aluminum factories negative externality is pollution, this

Example -‐ cost is named a social cost to society
Production
Now we need to decide what is the best amount of
aluminum to produce in the presence of the unavoidable
negative externality of pollution?

The business would want a smaller quantity produced

than the free market outcome
THE MARKET FAILS

BECAUSE PRODUCERS ONLY TAKE INTO ACCOUNT THEIR

PRIVATE COSTS AND NOT THE COSTS THEY IMPOSE ON BY
STANDERS

Solution: Internalizing the externality: Altering incentives so that people take into account the
effects of their actions
 Introducing a tax for each unit of aluminum sold

Page 18 of 43

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

Positive The market for industrial robots positive externality of technology spillover
Example -‐
Production Social cost = producing a robot but is less than
the private cost

How can the social planner (i.e. the

government) internalize the positive externality?

Solution: introducing a subsidy on each robot

sold (i.e., a per unit subsidy in favour of robot
producers)
 Subsidy is a sum of money granted by
the state or a public body to help an
industry or business keep the price of a
commodity or service low.

This allows a socially desirable quantity to be

produced.

Externalities Externalities can also arise when people consume goods:

in Negative externality in consumption:
consumption 

 Consumption of excessive alcohol, smoking cigarettes

 Negative = markets produce larger qunaitty than what is socially desired
 Governments remedy is to TAX to internalise it

Positive externality in consumption:

 Vaccination
 Positive = markets proudce a smaller quantity than is socially desired
 Governments remey is to SUBSIDISE to internalise it
Private solutions that don’t always involve the government include incentives by either individuals
or private markets:
Individual solutions
 Moral codes and social sanctions
 Private donations (private version of government subsidies)
Private market solutions
 Integrating different types of businesses
 Contracts

Page 19 of 43

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

The Coase Coase theorem: If private parties can bargain without cost over the allocation of resources, they
Theorem can reach agreements or bargains that solve the problem of externalities on their own (without
government intervention).

Examples of the effectiveness of this theory:

Thus from both cases IT DOES NOT MATTER WHO HAS THE LEGAL RIGHT and the parties will do
what is MUTUALLY BENEFICIAL

Private solutions do not always work-‐

 This can occur due to transaction costs being too high for the parties to agree on
 Also if there is a large number of people involved it’s too difficult

If private solutions do not work course of action is to follow government policies:

1. Command and control policies (regulation)
a. Certain activities may be required or forbidden in this policy
b. For example, smoking is not allowed in certain places or pollution limited

2. Market based policies

a. These include taxes and subsidies to allign with social effiency/desire
b. Tax distort incentivies and move AWAY from socially effient outcome

c. Corrective taxes (pigovian) move TOWARD the socially efficient outcome

i. Pigovian taxes are taxes enacted to correct the effects of a negative
externality
ii. Preffered in pollution industry as it sets polluters with a stronger incentive
to use cleaner technology

d. Tradeable permits allows a certain quanitity of pollution for each owner and sets
a cap on the amount. Perfectly inelastic.
i. The
intersection between the supply and
the demand for pollution permits
determines the price at which each
permit is sold

Page 20 of 43

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

 LECTURE 6

Intro to Microeconomics: the study of how individual households and firms make decisions and how they
Macro interact with one another in markets.
Economics
Macroeconomics: the study of the economy as a whole. Its goal is to explain what occurs in the
economy as an aggregated system. To do this, it refers to the economy-‐wide factors involving, and
affecting, all households, firms and markets. It examines the economy’s overall performance.

Some of the questions answered are:

1. Why do total output and income vary over time (recessions and booms) and between
countries (rich and poor)?
2. Why do prices rise rapidly in some periods but are more stable in other periods? What
explains changes in inflation rates?
3. Why does employment expand in some years and contract in others?
4. Is the economy performing well or poorly?

Main method to answer these questions:

GROSS DOMESTIC PRODUCT (GDP)
The market value of all final goods and services produced within a country in a given
period of time.

Features:
Measures total output or income (Y) of the entire economy.
Measures the total expenditure (AE) on the economy’s output of G/S
Measures performance of economy

Why does the one variable, GDP, measure all three things simultaneously?
1. Every transaction has a buyer and a seller.
2. The seller’s income = the buyer’s expenditure.
Hence total value of output (sales) =
Total income (Y) of all agents = total expenditure by all agents (AE). Y = AE **KNOW OFF BY
HEART FOR EXAM

GDP FORMULA GDP (Y): Y = AE = C + I + G + X – M

1. Consumption (C): spending by households on g and s (from any country), excluding
purchases of new domestic housing.

2. Investment (I): spending by firms on new capital equipment and inventories, and by
households on new domestic housing. (See below)

3. Government purchases (G): spending on g and s from any country by all levels of
government. Excludes transfer payments such as pensions, and subsidies.

4. Exports (X): spending on domestically produced G and S by foreigners.

-‐
5. Imports (M): spending on foreign g and s by domestic residents.

X – M = NX = Net Exports = Trade balance.

Why subtract M? Because C, I and G together include all M, and M is produced overseas, not
domestically

Page 21 of 43

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

 Three formal measures of income via the GDP

1. Expenditure approach (E) = Y = C + I + G + (X-‐M) or NX.

2. Income approach (Y): the sum of factor incomes, consumption of fixed capital
(depreciation) and net indirect taxes (= indirect taxes – subsidies).
Income = wages (employee benefits) + interest + rents + profits.

3. Production approach (P): uses a concept called value added to calculate GDP. Value
added is the value of a firm’s output minus the value of its inputs.

(All 3 measures give the same number)

 Nominal GDP: the output of goods and services measured at current prices.
 Formula: Base year goes up every year
 Is affected by changes in prices so includes inflation
 Real GDP: the output of goods and services measured at constant prices.
 Formula: Base year stays the same
 Not affected by changes in prices so excludes inflation
 Reflects changes in quantities produced – BETTER MEASURE OF ECONOMIES
PRODUCTION OF G/S

GDP Deflator is a measure of price level (ratio) – it compares both types to each other
Is a general price index giving a single number showing how much prices have risen on average in
!"#$%&' !"#
that year compared to the chosen base year.
!"# !"#$%&'( = ×100
!"#$ !"#

Thus GDP is a good measure of welfare for material purpose but is not an overall measure as it
does not include leisure, individual freedom, social inequality, quality of environment etc

Investment Investment is the purchase of any asset with an expected monetary return, either through annual
income streams or capital gains.

Economic meaning:
Investment refers to spending on new items of physical capital. These include capital equipment in
the form of (a) inputs to production such as machines, computers, buildings, ports, roads, railways
etc, and (b) outputs from production such as inventories, or new housing.

Page 22 of 43

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

Consumer A number representing the weighted average price of goods and services bought by consumers.
Price
Index Formula:
1. Pick a base year and conduct a customer survey – determine prices
2. Redo survey the following years
3. Calculate the cost of the goods each year
4. Calculate index as ratio of current expenditure on the fixed basket to the base year
expenditure on this same basket – base/current x 100 = %

CPI BASKET

The ABS collects and processes data on the prices of around 100,000 goods and services once each
quarter to calculate the quarterly inflation rate.

 Capital city CPIs -‐-‐ Sydney, Melbourne, Perth, Adelaide, Brisbane, Hobart, Darwin and
Canberra.
 Indexes for particular categories of goods and services: food, clothing, housing
 The producer price index (PPI) : a measure of the cost of a basket of goods and services
bought by firms.

Problems
1. Substitution bias = prices do not all change over time its dependent on the product, as
consumers usually substitute the good that decreases

2. Introduction of new goods = More consumer choices and changing spending patterns e.g.
Blackberry to iPhone

3. Cost of living = if a good appreciates over time even though it stays the same or if the good
depreciates

THUS CPI OVERSTATES INFLATION BY 0.5% TO 2%

GDP Deflator Both indexes relate the current level of prices to the level of base year prices, but in different
VS CPI ways.
 Economists and policymakers monitor both.
 Usually the two statistics usually tell a similar story.

But there are two important differences:

Page 23 of 43

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

Inflation Inflation is the proportional time rate of change of a set of prices.

Formula:
 Use a price index either GDP deflator or CPI – depends on purpose of analysis

∆P (delta p) = Change in P over the time period e.g. a quarter or a year

P = value of P, usually at the start of the time period

Nominal and 1. Nominal = the sum of money in dollars

real values 2. Real = the sum of money measured by its purchasing power of G/S

This formula shows the value of the sum of money compared to its purchasing power

M = sum of money
P = purchasing power
RV = real valuable
W = wage

1. Nominal interest rate tells you how fast the number of dollars in your bank account rises
over time.
■ Without a correction for the effects of inflation
2. Real interest rate tells you how fast the purchasing power of these dollars rises over time.
■ Corrected for the effects of inflation

Formula:
Real interest rate ≈ nominal interest rate – inflation rate
Nominal interest rates are generally always positive, whereas real rates can easily be negative

Page 24 of 43

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

 LECTURE 7

Unemployed 1. High unemployment and high inflation indicate poor performance by the macro-‐economy and
generate large costs for households, firms and governments

2. Unemployed resources mean lower incomes and greater inequality for some workers and some
firms, as well as psychological, health, social and political problems

3. High rates of inflation create uncertainty about the future, interfere with decision-‐making by
households, firms and governments, increase inequality, and create social and political
problems

Thus the best macroeconomic position is full employment with low and stable inflation.

Unemployment = Persons who want to work and are able to work but do not have a job

This excludes retirees, people who do not want to work, incapable of working like disabled people. This
minority is outside the labor force

Measuring unemployment by the ABS who surveys 0.45% of households (15 years and over)
1. Employed: if the person has worked ONE HOUR OR MORE within the previous week, including
self employment or family businesses

2. Unemployed: willing, able to work and actively looking for work

3. Not in labor force: not willing or not able or not looking e.g. retirement, poor health, wealthy or
discouraged

Statistics formulas
1. Labor force = number of employed + number of unemployed
2. Unemployment rate = number of unemployed/labor force x 100%
3. Participation rate = labor force/adult population x 100%

The official statistics are never accurate due to:

1. Under employment: The test for being employed is working one or more hours a week during
the survey week. Typically people want to work much more than one hour. If you want to
work 40 hours/week and are working 1 hour/week in that week, your 39 hours of
unemployment are not counted. The 1 hour criterion is very harsh.

2. Discourage workers: Who want to work but have stop looking for work. They might do
something else as a substitute like studying

Four main types and causes of unemployment

1. Frictional unemployment = UF
a. The search time needed for workers find jobs and the time taken by the firm to find
workers e.g. graduates who are unemployed and looking for jobs

2. Structural unemployment = US
a. Shifts in demand patterns such as technology will cause demand swings changing
structure of the economy. Sectors will expand and sectors will contract (car industry in

Page 25 of 43

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

 Australia who build and wield cars)
b. Miss matches of skills and locations due to wielders living in South Australia where no
jobs for technology are available and they’re available in Sydney

3. Demand Deficient Unemployment = UDD

a. Lack of demand in the economy, economy is not generating enough jobs because the
demand is insufficient
b. People are not buying G/S so firms cut back production and fire workers
c. Occurs during recessions and depressions

4. Wage-‐induced Unemployment = UWI

a. The wage is above the market clearing real wage
b. The unions are in a strong bargaining position level
and set the wages really high (not that common)
c. Minimum wage laws by government set at a too high
level (debatable)
d. Firms may set wages above market level to motivate
loyalty, efficiency and productivity (common) – More
people want to work but firms will cut back on
employing a lot as it costs a lot thus pushing
unemployment rate up

The theory of efficiency wages

 Efficiency wage is an above-‐equilibrium wage paid by firms in order to increase worker
productivity and reduce other costs. Low turnover costs
 Worker effort: better paid workers work harder.
 Worker quality: higher wages attract higher quality workers.
 Worker health: better paid workers are healthier and more productive. Maybe more relevant
for developing countries.
 Worker loyalty: better paid workers are less likely to quit so that firms reduce costs of turnover
and new hiring

Total Employment Formula = add up all types of unemployment discussed above:

UT = UF + US + UDD + UWI
(UF and US are always present in a changing economy. UDD and UWI are usually present to some degree
but this depends on circumstances)

Full Employment (FE)

 Does not mean zero unemployment i.e. that everyone in the labour force is working.
 FE occurs when the economy generates a number of jobs equal to, or greater than, the size of
the labour force the (the number of people wanting to work).
 Note: the number of jobs generated is the key issue, not whether individuals occupy these jobs.

Implications of full employment

 FE does not mean UT = 0
 There is a full employment rate of unemployment, UFE. At FE, UT = UFE. Also called the ‘natural’
rate of unemployment, UN.

Page 26 of 43

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

Inflation Inflation is a persistent, proportional, time rate of change in the general price level. It can be positive or
negative.

E.g. when tax was introduced in Australia all G/S went up at 10%, however the rate of change went the
same

Change is P – Persistent

IJ Although individual prices may fall or rise, inflation refers to the overall change in P which is a

(quantity) weighted average of all prices.

IJ Inflation occurs when P rises, deflation occurs when P falls.

Desirable level of inflation
 Inflation is low and stable, position: all negatives of high inflation such as uncertainty is not
there
 Firm chooses to increase its prices rather than reducing costs (employment)
 High inflation is bad as prices were so high its expensive to live
 High Deflation is bad as wages will decrease, so if you borrowed money you will have to pay it
back on a smaller wage
The job of central banks (Australia Reserve Bank) have to keep the inflation rate between 2-‐3% to
maintain low stable inflation
This is the current monetary policy by changing the interest rates in accordance
Why did inflation spike in Australia in the early 1970s at 16%?
A = Oil price shocks, was the major energy import it pushed up the price up everywhere and threw the
world into turmoil
 Today the price is falling, now a negative oil shock – why? = Competition from north American
such as coal seam gas, they are completely self efficient on energy now.
 They are trying to get USA buyers to go back to oil by killing off the American competition
Causes of inflation
 When there is a mismatch in what agents want in their plans/goals and what the economy
actually delivers/supplies to them
 When your plans don’t work out you change your behaviour to make them happen
 Thus inflation, by pushing up prices
 Kind of plans:
o Expenditure plans: buying output, such as a house
o Income or earning plans: selling their factors of production, such as labour
 The outcomes delivered by the economy (B) are of two types:
o (i) The aggregate supply of output (goods and services)
o (ii) The components of aggregate income, that is, its division between wages, profits,
interest and rent.
The two types of inflation
1. Demand-‐pull inflation: People have the income and want to buy but the economy is not
Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)
 producing enough
2. Cost-‐push inflation: the total income that agents want to earn (wages, or profits, or both) is
greater than what they are actually earning.
a. Workers want to increase their wages by union bargaining

Page 27 of 43

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

Two types of wage-‐price spirals
1. Price led spirals = Caused by DP inflation where workers demand higher wages but their wages
return to its previous level and so on

2. Cost-‐led spirals =
a. Firms want higher profits so raise prices, workers want high wages and that leads firms
to raise prices again
b. Unions bargain for higher money wages reducing firms profits by responding to request

These are conflicts over the distribution of aggregate income.

The quantity theory of money and the monetarist theory of inflation (check textbook)

How often a note goes through the economy, how many cycles

Problems with quantity of theory of money

1. Ignores all cost push inflations.
2. Correlation is not causation. M and P may be correlated, but that doesn’t mean that M causes
P. It could just as easily be that P causes M.
3. Monetarist policy advice can’t be implemented. Central Banks can’t control M, the money
supply. This is why there was a shift from money supply targeting to the current policy of
inflation targeting.

Page 28 of 43

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

 LECTURE 8

Basic 1. Recessions: a period of declining real output and real incomes (Y) and rising unemployment
Macro (U).
Concepts 2. Depressions also occur occasionally: severe and prolonged recessions (2-‐4 quarters)

Economic changes cycles can be irregular and unpredictable:

 Business cycle = boom, bush, economy growth, recession, economic upturns, down turns
 Trade cycle = output falls, unemployment rises

1. Macro deals with variables that are aggregates or sub-‐aggregates of other variables.
a. Y = GDP = total final output of the entire economy (all industries/firms)
b. C = total consumption spending of all households.
c. I = total investment spending by all firms.
d. G = total government spending on goods and services by all levels of government.
e. T = total taxes.
f. S = total saving of all households.
g. X = total exports from the domestic economy.
h. M = total imports into the domestic economy.

2. Production
a. Inputs converted into outputs
b. Inputs are factors of production: labour (N), capital – physical and financial (K),
natural resources (R)

a. 𝑌 = 𝑓(𝑁, 𝐾, 𝑅) -‐ the production process formula

3. Production Function

b. F = technology, N K R = aggregate macro inputs

a. 𝐴𝑔𝑔𝑟𝑒𝑔𝑎𝑡𝑒 𝑜𝑢𝑡𝑝𝑢𝑡 ≡ 𝐴𝑔𝑔𝑟𝑒𝑔𝑎𝑡𝑒 𝐼𝑛𝑐𝑜𝑚𝑒 ≡ 𝐴𝑔𝑔𝑟𝑒𝑔𝑎𝑡𝑒

4. Certain relationships that hold at Macro level not Micro level. visa versa

𝑒𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒
b. Some of income is saved by individuals so not all of income is spent
c. Paradox of Thrift (saving)

5. Macro theories is based on 4 Sectors

a. Two sector model – households and firms
i. AD = C + I
b. Three sector model – households, firms and government
i. AD = C + I + G
c. Four sector model – households, firms, government and the external/international
sector
i. AD = C + I + G + (X – M)

6. Aggregate Demand
a. AD = total planned demand for, or planned expenditure on, final g & s by all sectors =
buying plans of all agents.
b. AD = C + I + G + X – M, where all variables are planned amounts
c. AD is the variable with the greatest explanatory power.
d. Both AD and AS are important determinants of performance, but:
i. AD is the more important cause of sub-‐optimal levels and fluctuations in
output and employment, and

Page 29 of 43
Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)
 ii. AS is most commonly caused by AD and uncertainty, with technology also
being important over longer periods.

7. Aggregate Supply
a. AS = total planned supply of domestically produced final g and s by all firms in the
economy = selling plans of all firms
b. Macro analysis AS and AD interactions in determining the determinants, outputs,
employment, inflation variables
c. AD = AS

Circular flow Illustrated by diagrams. These show the flows of money income in one direction in the economy, and
of income the flows of g and s in the opposite direction. To keep these diagrams simple, certain assumptions are
made as follows.
1. Only money flows are shown. The corresponding flows of g and s are in the opposite
direction.
2. The flows relate to the production and sale of domestic g and s.
3. Only firms buy/sell investment goods from/to other firms.
4. Households are assumed to own all factors of production, whether directly (labour) or
indirectly (firms).

General Determining how much a business should supply is done by estimates of the level of demand over
theory of time and then calculating it
Aggregate AS = AD
Supply
If the estimate is correct
 AD = AD
 Then all outputs produced are planned quantities, and are bought
 Thus no surplus or shortage and equals equilibrium

If estimation is wrong partly or altogether

 Disequilibrium
 Excess supply: (surplus) AD>AD or AS>AD. Too much unsold output
 Excess demand: (shortage) AD<AD or AD<AD. Not enough to meet demand

Components Income (y) = Used to pay taxes (t) , buy consumption (c) and save (s)
of income Y = C +S +T

Saving
 Withholding money in banks, bonds, shares, assets (property), land, collectibles (gold, art)
 Hard to determine

Page 30 of 43

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

Components 1. Consumption = current domestic income, tax, interest rate, wealth
of Aggregate 2. Investment = firms expectation of future profits, tax, interest rate, subsidies
Demand 3. Government Spending on G/S = fiscal policy, unemployment, economic growth, infrastructure
needs
4. Exports = level of world income, world economic growth, AUD exchange rate
5. Imports = level of domestic income, infrastructure needs, AUD exchange rate

Determinants The level of AD is the main component of employment

of ADest  AS  Y  employment and/or inflation.
employment
Three outcomes depending on AD
1. Unemployment equilibrium – Low or insufficient AD – most common
2. Full employment equilibrium – least common
3. Inflationary equilibrium -‐ here AD is excessive and generates both full employment (good)
and significantly high inflation (bad).

Paradox of Paradox: One persons spending is/dependent one persons income

Thrift
Fallacy of composition: These occur when individual plans do not generate the outcomes planned by
all the individuals.

Only way to save is to consume less, reduced incomes will make saving less

Fiscal Policy FP is the use of government spending and revenue instruments to influence the levels of aggregate
(FP) demand, output, employment and economic growth.

Instruments = Expenditure (railways, schools, hospitals, ports) and Revenue (tax)

 Transfer Payments = Indirectly encourages households and firms to spend more money such
as unemployment benefits or subsidies to firms. We ignore this in the GPA formula
 Tax = operate indirectly to make households and firms spend less. We also ignore this in the
GPA formula

Stimulatory FP Stimulation is used in low growth or recession. Done by lowering tax rates and increasing G
and AD  G = Fund buildings of second airport to directly affect production of G/S
 T = lowers personal income rates giving more money to the people and decreases company
tax rates will encourage I

Contractionary Contractionary is used in booming or fast growth. Done by increasing tax and decreasing G
FP and AD  G = Reduce funds for infrastructure
 T = Increase company tax rates and personal income tax to encourage lower C and AD

Government The government budget is the difference between government revenue and government spending.
Budget
The government budget can be in 3 possible states:
1. Budget surplus BS = T – G with T > G
2. Budget deficit BD = G – T with G > T
3. Budget balance BS = 0 with T = G

Older 20th Century view of the Budgetary policy

Page 31 of 43

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

  Budget should balanced every year so there is not budget left over

Current view since mid 20th century of the Budgetary policy

 A responsible economic view
o Budgets should be balanced over the economic cycle, in a recession it borrows money
(bonds), in a boom it repays the borrowings (bonds) from the previous years when in
recession
o Thus the cycle remains balanced

 Irresponsible political views

o Permanent Budget Deficits = Constant deficit, high spending to win voter approval of
doing something with economy while in recession (not good as that’s more debt)
Or in boom keep returning surpluses to private sector like tax cuts to win votes
(where in a boom you should try bring spending down)

o Alarmism over relatively small deficits -‐ Spending cuts, no tax rises, welfare cuts,
inequality-‐increasing policies, austerity

Multipliers The multiplier in the goods market is the ratio of the final change in output (or employment) to the
effect initial change in AD and output. Usually the multiplier is greater than 1.

Suppose the cost of the second Sydney airport is $20b. This is the initial change in AD (G) and hence
the initial change in output (Y). But the initial increase sets off a series of increases in subsequent
rounds of spending, with these increases diminishing over time. Suppose that, after all these
increases have occurred, the final change in output for the economy as a whole is $42b. Then the
multiplier in this case would be 42/20 = 2.1.

Multiplication Why does this multiplication occur?

process 1. The initial spending (G) leads to a rise in the incomes of households due to the employment
of some of the currently unemployed or underemployed.
2. These workers then spend their higher incomes on C g and s. Inventories of C g and s fall and
this leads producers to increase output and hire more workers in these industries.
3. These workers then spend their higher incomes on C goods.
4. And so on over time, until all the effects have been exhausted.

Note: The multiplier is not infinitely large because not all the new income is spent on domestic g and
s. The process dies out due to the presence of three leakages from spending: S, T and M.

Crowding out CO refers to contractions in C and I spending if expansionary FP causes higher interest rates.
(CO)
 CO occurs if and only if expansionary FP based on increased government borrowing leads to a
rise in interest rates, and hence to reduced C and I spending by households and firms
respectively.
 The expansion in public spending (G) is said to crowd out, or reduce, private spending (C,
I).
 The net effect (Y) may still be positive but it will be smaller due to the crowding out.

Page 32 of 43

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

 LECTURE 9

Money Money is whatever is generally used in society as a means of payment. Nowadays this means cash (notes
and coin), or money in bank deposits on which you can draw by means of plastic cards or cheques.
The three functions of money:
1. Means of exchange: whatever buyers give to sellers in any transaction. This means it is
something that has value in society.

2. Unit of account: the amount of money indicating prices, or the amount of money borrowed or
lent.

3. Store of value: because money has value in society, it can be used as a form of holding wealth
over time.
a. Also other items can have value: shares, bonds, gold property, paintings
b. Liquidity: asset converted into money with or any loss of value
c. Money is most liquid asset: best store of value

Kinds of money
1. Commodity money: consists of physical commodity with intrinsic value.
a. Intrinsic value is the value the item has when it is not used as money.
b. E.g. gold or silver made into coins, gold bullion as the backing of paper money

2. Fiat money: those items used as money solely because of a government decree or order
a. No intrinsic value or value on its own like gold would have
b. E.g. This Australian note is legal tender throughout Australia and its territories

Money Supply – The quantity of money available in the economy

Fiat money =
1. Currency: plastic or paper notes and metal coins
2. Current deposits: balances in bank accounts that depositors can access on demand

Thus, money supply = CP + D

The Regulates and manages system of fiat money

central  Oversees proper functioning and stability of banking system
bank  Improves performance of economy by controlling interest rates or quantity of money

Reserve bank of Australia –independent from government

o Determines monetary policy – influence level of inflation and growth rate. Controlling
the liquidity of price and availability

o Guarantor or stability – Facilitating the operation of the payment system (or the

Page 33 of 43

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

 settlement of payments between banks) and ensuring banks do not take excessive risks
when lending (capital controls).

 Federal Reserve System of United States or Bank of England or Bank of Japan or China

The The market in which the agents who demand or want money meet the agents who supply, have or can
money generate money.
market
 This market determines the interest rate – more specifically, the nominal interest rate.
The  We use a simple model to explain how this happens – the liquidity preference model.
demand
for Our simple model has two assets:
money 1. Money on which no (or very low) interest is paid.
2. Bonds, an interest-‐bearing asset paying a higher interest rate than money.

People hold both money and bonds in their portfolios, but the proportions vary with agents and with
circumstances.

 Holding money:

IJ Pro: liquidity, no capital loss (in nominal terms).

IJ Con: no (or low) interest, no capital gain

 Holding bonds:

IJ Pro: interest payment, possible capital gain.

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

 IJ Con: no liquidity, possible capital loss.

Trade offs are required in deciding to hold variable mixtures of money and bonds. Wealth = money +

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

bonds.

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

IJ If Rates high, hold more bonds, less money.

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

IJ If Rates low, hold more money, fewer bonds.

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)
 Page 34 of 43

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

Supply of
money

Equilibrium in he money market

 Occurs when supply and demand of money is equal

 𝑀S = 𝑀D. (money demanded an money supplied)

 Ms control = People want to hold all money supplied by bank, interest rate varies to make people
willing to hold money
 Rates control = People want money at a controlled interest rate so central bank supplies the rate
to satisfy demand
If the money supply or interest rate is at a disequilibrium level, actions will be taken that adjust people’s
portfolio of assets to equilibrium through the buying and selling of bonds

Bonds A bond is an interest-‐bearing financial asset used in the borrowing and lending of money. Also called a

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

fixed interest security.

1. A bond is a debt investment in which an investor loans money to an entity (typically

corporate or governmental) which borrows the funds for a defined period of time at a

variable or fixed interest rate. Bonds are used by companies, municipalities, states and
sovereign governments to raise money and finance a variety of projects and activities
It is structured in a particular way which differs from other types of loans.
1. The interest payment is a fixed amount of money which stays constant until maturity. Called the
coupon payment (C).
2. After the bond is first issued, it can be bought and sold in the bond market.
3. The price of the bond (Pb) varies over its life, and mainly depends on the current interest rate
(R).

Page 35 of 43

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

 4. For consols (or bonds with infinite maturity), the formula is Pb = C/R

NOTE: Pb is inversely related to R, since C is fixed. This is true for all types of bonds and their different
formulae.

Disequilibrium and adjustment

 Interest rate emerges as a consequence of the money supply money supply affects interest rate -‐
like a lever visa versa to keep interest rate constant they have to keep levering the money
supply, by buy or selling bonds in example, recession
 Bank wants to stimulate economy buy bonds from private sector, gives them money in their
accounts to kick off money supply -‐ to make it attractive, lower rates and buys it back at a higer
price then what they paid for -‐ thus making profit and making a capital gain once they reach their
target interest rate they stop buying back bonds and leave the rate as it is

Page 36 of 43

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

Monetary MP is conducted by the central bank not by the government
Policy  Supply of money and inflation rate
 Inflation targetting
o Controlling interest rates in order to control inflation
o In aus the inflation rate lies between 2-‐3% on average
o If inflation is too high, the RBA increases the interest rate  slows down borrowing and
spending  lower inflation and output.
o If inflation is too low, the RBA lowers the interest rate  stimulates borrowing and
spending  higher inflation and output.
 Inflation rate
o The RBA considers both the CPI inflation rate, and the core or underlying inflation rate
which removes volatile and seasonal components from the CPI. For example, weather
events affecting food prices. The underlying rate is the more important of the two.

 Interest rate
o The CB uses the cash rate which is the one it can control directly. This is the rate on short
term (overnight) loans between banks in the Payment Settlement System. All other
interest rates in the economy are typically higher than the cash rate, so the cash rate
normally acts as a floor to all other sales.
o Interest rates are changed to influence aggregate demand – improve economic
performance

Transmission Mechanism of MP

Australian MP situation
 We have low inflation and steady unemployment
 Lowering rates to stimulate investments and consumption. Stimulating net exports through
exchange rates
 But lower R creates higher levels of borrowing (gearing or leverage) in asset markets and hence
creates price bubbles for property (residential and commercial) and shares. Only higher R will
prevent future financial stress or crises for agents in the financial sector.

Page 37 of 43

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

 LECTURE 10

International An open economy interacts with other countries in three ways.

Flows of 1. It buys and sells goods and services in world product markets.
Goods, services 2. It buys and sells assets in world asset markets.
Capital and 3. It makes/receives transfer payments to/from other countries.
Transfers
Flows of goods and services: Exports, imports, and net exports.
1. Exports (X): domestically produced goods and services that are sold to foreigners.
2. Imports (M): foreign-‐produced goods and services that are sold to domestic residents.
3. Net exports (NX = X – M): spending on domestically produced g and s by foreigners
(exports) minus spending on foreign g and s by domestic residents (imports).

Flows of goods and services: Exports, imports, and net exports

Balance of Trade: BT = X (exports) – M (imports) = NX (net exports)

o Trade surplus: an excess of exports over imports. BT +
o Trade deficit: an excess of imports over exports. BT −
o Balanced trade: exports and imports are equal. BT = 0

Factors that influence a country’s exports, imports and net exports.

o The tastes of consumers for domestic and foreign goods.
o The prices of goods at home and abroad.
o The rates at which people can exchange domestic currency for foreign currencies.
(Exchange Rates)
o The policies of governments towards international trade.
o The cost of transporting goods from one country to another.

Australia is a small, open economy

Increases in international trade allows advances in our transport, technology and changes in
government policies favoring free trade

The international flows of assets

 Financial = shares, bonds
 Physical = factories, houses

Page 38 of 43

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

 Net foreign investment (NFI) – domestic residents overseas
1. Capital Outflow (Ko) – purchase of foreign assets by domestic residents
2. Capital Inflow (Ki) – the purchase of domestic assets by foreigners
3. THUS NFI = Ko - ‐ Ki

1. Foreign direct investment: e.g. when an Australian company opens up a branch in India –
more control by the Australian owner.
2. Foreign portfolio investment: e.g. when an Australian buys shares in an Indian corporation
– less control by the Australian owner.

Factors influencing NFI

 Interest rates on both foreign and domestic financial assets – interest rate differential
 Rates on foreign and domestic shares
 Exchange rates
 Economic and political risks and rewards for holding assets abroad
 Government policies that affect foreign ownership of domestic assets

Transfers are donations or gifts (e.g. foreign aid of any kind). Can be regular or irregular, given as
money or as goods and services. Transfers are usually a small fraction of total external
transactions, are less important, and are often not explicitly mentioned.

Balance of (Total incoming payments from overseas) - ‐ (Total outgoing payments to overseas)
payments = Total net incoming payments

𝐵𝑃 = 𝑇𝑜𝑡𝑎𝑙 𝐷AUD − 𝑇𝑜𝑡𝑎𝑙 𝑆AUD

It can be shown that in the Foreign Exchange Market (FEM)

Two senses of BP:

1. Accounting sense (BP), which includes the transactions of the central bank in FEM.
BP = 0 always
2. Economic sense (BP’), which excludes central bank transactions in FEM.

BP’ = Net incoming payments (without central bank)

BP’ can be in surplus (+), deficit (−) or balance (0).

This summarizes the domestic economy’s transactions with the rest of the world. It is divided into
two sub-‐accounts:
1. Current account, CA. Includes all payments relating to goods, services and current
transfers
2. Capital account, KA. Includes all payments relating to assets, (including those by the

𝐵𝑃 = 𝐶𝐴 + 𝐾𝐴
central bank) and capital transfers.

Incoming payments are credits (+), outgoing payments are debits (−).

Australia usually has a current account deficit (CAD) and a capital account surplus (KAS).
That is, BP = CAD + KAS = 0.

Page 39 of 43

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

ABS Accounting Here ABS often uses different names (unfortunately)
Framework for A. Current Account
standard 1. Goods
balance of 2. Services – that is, non-‐factor services only eg. banking, tourism
payment 3. Income – payments for factor services, such as dividends, interest and wages
4. Current transfers
Note: A negative income component is usually why Australia’s CA is in deficit, even if its balance of
trade is positive.

B. Capital and Financial Account

1. Financial Account (FA) – all financial and other asset transactions
a) Direct investment – primarily long term
b) Portfolio investment – primarily short term
c) Other investment
d) Reserve assets – transactions by central bank

2. Capital Account (KA) – includes capital transfers

3. Net errors and omissions – this item has to be included to force a perfect balance with

(To ensure calculate 𝐵𝑃 = 𝐶𝐴 + 𝐾𝐴 = 0, calculate the net errors and

imperfect measurements.

omissions as |CA + KA| and subtract from the measured total).

Simplified equations

1. 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑐𝑐𝑜𝑢𝑛𝑡 = 𝑁𝑋′ + 𝑁𝑌 + 𝑁𝑇

NX′= NetNY
services exports
= Netof goodspayments
income plus non-factor
(factor services)
NT = Net transfers

2. 𝐾𝑎𝑝𝑖𝑡𝑎𝑙 𝐴𝑐𝑐𝑜𝑢𝑛𝑡 = 𝐾i − 𝐾o = −𝑁𝐹𝐼

NFI = Net foreign investment by Australians overseas

3. 𝐵𝑎𝑙𝑎𝑛𝑐𝑒𝑑 𝑃𝑎𝑦𝑚𝑒𝑛𝑡𝑠 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑐𝑐𝑜𝑢𝑛𝑡 + 𝐾𝑎𝑝𝑖𝑡𝑎𝑙 𝐴𝑐𝑐𝑜𝑢𝑛𝑡

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

 BP = 0  Kapital Account = − Current Account

That is, CAD (current account deficit) = KAS (capital account surplus)

= −𝑁𝐹𝐼 = 𝐾i − 𝐾o

CAD & KAS

 CAD COUNTRY = Buys more G/S from money paid on surplus on Kapital Account
 KAS COUNTRY = (China) Surplus on current accounts are used to buy foreign assets
resulting in KAD
But for the world as a whole, BP = 0 and CA = – KA.

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

Exchange Rates Nominal and Real exchange rates

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

Nominal = Is the rate of exchange between two national currencies. It is also the price of one

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

national currency in terms of another national currency. e.g. 1 aud = 0.73 usd

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

Foreign exchange market (FEM)

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

 How the nominal rates are determined

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

 A huge global network of banks, foreign exchange dealers, fund managers and central

Page 40 of 43

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

 banks
 Operates 24/7 around the world without an international supervisory agency.
 The largest market in the world, with a total turnover of approx USD 5.5 trillion per day
(USD 5,500,000,000,000).
 Less than 10% of this turnover is for world trade (exports and imports); more than 90% is
for asset transactions, chiefly financial assets.

Let FC stand for any or all foreign currencies.

IJ Selling AUD is the same as buying FC

IJ Buying AUD is the same as selling FC

Hence 𝑆AUD ≡ 𝐷FC

Selling is the same as supplying, and buying is the same as demanding.

and 𝐷AUD ≡ 𝑆FC

Supply curve of The supply of AUD to the FEM is generated by Australian purchases of foreign g, s and a.

AUD in FEM

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

(Foreign
Four main sources:

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

exchange
1. Imports of g and s

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

market)
2. Income payments to overseas

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

3. Financial capital outflow (purchase of foreign assets)

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

4. Central bank sales of AUD

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

All these involve AUD being supplied for sale in the FEM to obtain FC to pay foreigners.

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)
ER = Exchange rate

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

Saud = supply of aud

Page 41 of 43

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

Demand curve The demand for AUD in the FEM is generated by foreign purchases of Australian g, s, and a.
of aud in FEM
Four main sources:
(Foreign 1. Exports of g and s
exchange 2. Income payments from overseas
market) 3. Financial capital inflow
4. Central bank purchases of AUD

All these create demand for AUD by agents wanting to acquire Australian g, s and a.

If CB wants to raise or support ER, it buys AUD and sells FC, so its reserves of FC fall.)
The demand curve for AUD shows the relationship between the AUD exchange rate (the price) and
the number of AUD demanded from the market (the quantity).

Exchange Rate Two pure or ideal types of exchange rate regimes:

Systems 1. Floating or flexible system in which ER is free to vary
2. Fixed or Managed System in which ER is controlled.

Most real systems are hybrids in which the properties of one system are dominant, but are
modified by some of the properties of the other. E.g. dirty float; crawling peg.

1. SYSTEM WE USE: Flexible ER systems, the economy adjusts to exogenous shocks via
changes in ER with the money supply remaining constant.
a. Rise in ER = appreciation, fall in ER = depreciation. ER subject only to market forces
b. Domestic money supply not changed by Foreign exchange market

c. State of world economy exogenous force = It affects EXPORTS and hence the
demand of AUD. Rising world income = increased demand for Australian G/S,
recession is opposite

d. State of Australian economy exogenous force = it affects IMPORTS and hence the
supply of AUD. An expanding domestic economy with more foreign G/S purchases,
slow down in domestic economy is opposite

e. Relative inflation rates exogenous force = Affects both imports/exports hence both
supply and demand of AUD curves which will shift. If our inflation rate falls relative

Page 42 of 43

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)

 to inflation in other countries, our output becomes cheaper to them and their
output dearer to us. Hence exports rise which means D shifts rightwards, and
imports fall which means S shifts leftwards.

f. Interest rate differentials exogenous force = These affect financial asset purchases
and hence the inflow and outflow of financial capital. If R falls in Australia, ceteris
paribus, then Ki decreases because foreigners get a better rate of return
elsewhere, and Ko rises because Australians can get better returns overseas.
Hence D shifts to the left, and S to the right.

2. In fixed ER systems, the ER is kept constant by the central bank and the money supply
changes when shocks occur.

Flexible How are they determined?

exchange rates  By the market supply and demand
 No central banks in FEM
 The exchange rate adjusts until there is an equilibrium at point E on graph
 Thus Demand AUD = Supply AUD – and from this we get the market-‐determined exchange
rate

How and Why?

1. When Exchange Rates are more than

𝑆AUD > 𝐷AUD and either a surplus

the Exchange Rate M which causes
Disequilibria in FEM occurs when Demand
or AUD DOES NOT EQUAL Supply AUD excess supply of AUD.
a. Competition between sellers =
fall in ER, in supply and a rise
between demand

(REVERSE – VISA VERSA)

the Exchange Rate M which 𝐷AUD

2. When Exchange Rates are less than

>
𝑆AUD causes a shortage of excess
demand for AUD
a. Competition between sellers =
rise in ER, fall in Demand of
AUD and rise of Supply in AUD

Page 43 of 43

Downloaded by Ibrahim Merhi (ibrahimmerhi2007@gmail.com)