Economics

-c » You are studying economics at a time of extraordinary events that future historians will call the Information Revolution. In this revolution, people who are able to embrace its new camputer-based technologies prosper on an unimagined scale. But the incomes and living standards of the less Aexible and less educated and mobile fall behind, and new social and political tensions are emerging. Our objective in this book is to make your study of economics productive and fun. With a decent understanding of economics you will become a full porticipont in the Information Revolution. You will also play a more effective role as a citizen and voter and be able to add your voice to those who are looking for solutions to our social and political problems. And you will enjoy the sheer fun of understanding the forces at play and how they are shaping our world. If you find economics interesting, think seriously about specialising in the subject. A degree in economics gives the best training available in problem solving, offers lots of opportunities to develop conceptual skills, and opens doors to a wide range of graduate courses and to a wide range of jobs.

CHAPTER 1

CHAPTER 2

JJ --I

PART 1

0

Introduction

A Definition of Economics All economic questions arise because we want more than we can get. We want a peaceful and secure world. We want clean air and rivers. We want long and healthy lives. We want good schools and universities. We want space and comfort in our homes. We want a huge range of sports and recreational gear, from running shoes to MP3 players. We want the time to enjoy sports and games, to read books and magazines, see movies, listen to music, travel, and socialise with friends. What each one of us can get is limited by time, the income we earn, and the prices we must pay. Everyone ends up with some unsatisfied wants. As a society, what we can get is limited by our productive resources. These resources include the gifts of nature, human labour and ingenuity, and tools and equipment that we have produced. Our inability to satisfy all our wants is called scarcity. Scarcity is not poverty. It is simply wanting more than is available. The poor and the rich alike face scarcity. A child wants a $1 smoothie and a 50¢ chocolate bar but has only $1 in her pocket. She faces scarcity. Millionaire tennis professional Lleyton Hewitt wants to spend the weekend improving his game and also filming a Yonex advertisement. He can't do both, so he, too, faces scarcity. As a society, we want to provide better health care and better education, a cleaner environment, and so on. Society faces scarcity. Even parrots face scarcity! Faced with scarcity, we must choose among the available alternatives. The child must choose

Not onfy do 1want a cracker-we 00 want a cracker! eThc New Yorker Collection 1~85 Fl1Ink Modell from c:artoonbank.oom. All Right'S Reserved.

between the smoothie and the chocolate bar. Lleyton must choose between improving his game and filming the advertisement. As a society, we must choose among health care, education, and the environment. The choices that we make depend on the incentives that we face. An incentive is a reward that encourages or a penalty that discourages an action. If the price of a smoothie falls, the child has an incentive to choose the smoothie. If Yonex increases the fee for filming to $1 million, Lleyton has the incentive to make the advertisement. If computer prices tumble, we have an incentive as a society to connect more schools to the Internet. Economics is the social science that studies the choices that individuals, businesses, governments, and entire societies make as they cope with scarcity and the incentives that influence and reconcile those choices. The subject divides into two main parts: o Microeconomics o Macroeconomics

MICROECONOMICS Microeconomics is the study of the choices that individuals and businesses make, the way these choices interact in markets, and the influence of governments. Some examples of microeconomic questions are: Why are people buying more mobile phones? How would a tax on downloading music affect the sales of CDs?

MACROECONOMICS Macroeconomics is the study of the performance of the national economy and the global economy. Some examples of macroeconomic questions are: Why did unemployment fall last year? Why has Japan's economy stagnated? Can the Reserve Bank bring prosperity by keeping interest rates low?

Find stories in today's news that illustrate the definition of economics and that include examples of scarcity, incentives, and choices in Australia and around the world. Find stories in teday's news that illustrate the distinction between microeconomics and macroeconomics. ~.HR·ljIm!) Study Plan 1.1

PART 1

0

Introduction

Economics: A Social Science Economics is a social science and, like all scientists, economists distinguish two types of statement: , Whatis 2 What ought to be

Statements about what is are called positive statements and they might be right or wrong. We test a positive statement by checking it against the facts. When a chemist does an experiment in her laboratory, she is testing a positive statement. Statements about what ought to be are called normative statements and they cannot be tested. When the Australian Parliament debates a motion, it is ultimately deciding what ought to be. It is making a normative statement. To see the distinction between positive and normative statements, consider the following statements about health care. 'Universal health care will cut the amount of work time lost to illness' is a positive statement. 'Every Australian should have equal access to health care' is a normative statement. The task of economic science is to discover positive statements that are consistent with what we observe in the economic world. TIlls task breaks into three steps: o Observation and measurement o Building models o Testing models

OBSERVATION AND MEASUREMENT Economists observe and measure data on such things as the quantities of productive resources natural, human, and capital resources - wage rates and work hours, interest rates, the prices of the different goods and services, taxes and government spending, and the items bought from and sold to other countries.

BUILDING MODELS The second step towards understanding how the economic world works is to build a model. An ec0nomic mod.1 is a description of some aspect of the economic world that includes only those features of

the world that are needed for the purpose at hand A model is simpler than the reality it represents. What a model includes and what it leaves out result from assumptions about what is essential and what are non-essential details. You can see how ignoring details is useful even essential- to our understanding by thinking about a model that you see every day: the TV weather map. The weather map is a model that helps to predict the temperature, wind speed and direction, and rainfall over the next few days. The weather map shows lines called isobars - lines of equal barometric pressure. It doesn't show the main roads because we assume that the pattern of air pressure, not the location of the highways, determines the weather. An economic model is similar to a weather map. For example, an economic model of a mobile phone network will include items such as the cost of using a mobile phone, but it will ignore such details as the tunes people use for ring tones.

TESTING MODELS The third step is testing the model. A model's predictions may correspond or be in conflict with the facts. By comparing the model's predictions with the facts, we are able to test the model and develop an economic theory. An economic theory is a generalisation that summarises what we think we undeIStand about the economic choices that people make and the perfonnance of industries and entire economies. It is a bridge between an economic model and the real economy.

en Key Points c s:: s:

GRAPHING DATA (PP. 19-22)

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A time-series graph shows the trend and fluctuations in a variable over time. A cross-sectian graph shows how variables change across the members of a population. A scatter diagram shaws the relatianship between two variables. It shows whether two variables are positively related, negatively related, or unrelated.

Ke Figures Figure Figure Figure Figure Figure Figure Figure

A 1.1 A 1.5 A 1.6 A 1.7 A 1.9 ALl 0 A 1.11

Making a Graph, 19 Positive [Direct) Relationships, 23 Negative (Inverse) Relationships, 24 Maximum and Minimum Points, 25 The Slope of a Straight Line, 26 Slope at a Point, 27 Slope Across an Are, 28

Ke Terms

GRAPHS USED IN ECONOMIC MODELS (PP. 22-25)

o Graphs are used to show relationships among o

variables in economic models. Relationships can be positive (an upward-slaping curve), negative (a downward-sloping curve), positive and then negative [have a maximum point), negative and then positive (have a minimum point), or unrelated [a horizontal or vertical curve).

THE SLOPE OF A RELATIONSHIP (PP. 26-28)

o The slope of a relationship is calculated as the change in the value of the variable measured on the )'Oxis divided by the change in the value of the variable measured on the x-axis - that is,

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A straight line has a constant slope. A curved line has a varying slope. To calculate the slope of a curved line, we calculate the slope at a point or across an arc.

GRAPHING RELATIONSHIPS AMONG MORE THAN TWO VARIABLES (PP. 28-29)

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o

To graph a relationship among more than two variables, we hold constant the values of all the variables except two. We then plot the value of one of the variables against the value of another.

Give examples, different from those in the chapter, of a time-series graph and a crosssection graph. Give three examples, different from those in the chapter, of scatter diagrams that show a positive relationship, a negative relationship, and no relationship. Draw some graphs to show the relationships between two variables that (a) move in the same direction, [b) move in opposite directions, (c) have a maximum, and (d) have a

minimum. What are the two ways of calculating the slope of a curve? How do we graph relationships among more than two variables?

~.~H·j,im!) MyEconLab Study Plan 1.5

-u » The five chapters that you study in this port explain how markets work. The market is an amazing instrument. It enables people who have never met and who know nothing about each other to interact and do business. It also enables us to allocate our scarce resources to the uses that we value most highly. All markets determine the prices at which exchanges take place and enable both buyers and sellers 10 benefit. Everything and anything that can be exchanged is traded in markets. There are markets for goods and services; for resources such as labour, capital, and raw materials; for dollars and yen; for goods to be delivered now and for goods to be delivered in the future. Only the imaginotion places limits on what can be traded in markets. You begin your study of markets in Chapter 3 by learning about the laws of demand and supply. There, you will discover the forces that make prices adjust to coordinate buying plans and selling plans. In Chapter 4, you will learn haw to calculate and use the concept of elasticity to predict the responsiveness of prices and quantities 10 changes in supply and demand. In Chapter 5, )'Ou will discaver whether a competitive market achieves an efficient and foir use of scarce resources. In Chapter 6, )'Ou will study markets in action, learn how they cope with change, and discover haw they operate when governments intervene to fix prices, impose taxes or quotas, or make some goods illegal. Finolly, in Chapler 7, you will study global markets in action and discaver how we gain from international specialisation and trade.

CHAPTER 3

CHAPTER 4

CHAPTER 5

CHAPTER 6

CHAPTER 7

JJ --I

Demand and Supply 0

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money price of oil and the red line shows the ,./ative priC8 cf oil from 1970 .. 2005. o The relative price 01 a litre of oU is measured in I8rnu of 1M value of the dollar in 1970. It tells us how "tflt; opportvnfly COlt of a of oil ilos changed.

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o When a snack. raises the 'rpney priC* sharply {such CD the Nv. evenb Identifed in Fig. 11, the relative price of oil also rises. o But !tiara is no strong trend in tfl. relative price of oil.

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supply of oil deaeased, so til. equilibrium quantify incltlOSfld.

CHAPTER 3

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Efficienc.y and Equity

0

CHAPTER 5

THE INVISIBLE HAND The founder of modem economics, Adam Smith, writing in his Wealth of Nations in 1776, was the first to suggest that competitive markets send resources to the uses in which they have the highest value. Smith believed that each partldpant in Q competitive market is 'Ied by an invisible hand to

promote an end [the effi.dent use of resources] which was no part of his intention'. You can see the invisible hand at work in the cartoon. The cold drinks vendor has both cold drinks and shade. He has an opporhmity cost of

each and a minimum. supply price of each. The reader on the park bench has a marginal benefit from each and a willingness to pay for each. You can see from the transaction that occurs that the marginal benefit from shade exceeds the price of shade and the price of Q cold drink exceeds its marginal benefit. The transaction creates a producer swplus and Q consumer swplus. The vendor obtains a producer sUlpIns from selling the shade for more than its opportunity cost, and the reader obtains a consumer surplus from bUying the shade for less than im marginal benefit. In the third frame of the cartoon, both the consumer and the producer are better off than they were in the first frame. The umbrella has moved to its highestvalued use.

THE INVISIBLE HAND AT WORK TODAY Never has the market's invisible hand been working as hard as it is today. New technologies have rot the cost of producing a computer and increased the supply. The price of a computer has fallen and the quantity demanded has increased as people have found more and more uses for a computer. The marginal social benefit from a computer is brought to equality with its marginal social cost. A frost rom the supply of grapes. With fewer grapes available, the marginal benefit from grapes increases. A shortage of grapes raises their price, so the market allocates the smaller quantity available to the people who value them most highly. Market forces persistently bring marginal social cost and marginal social benefit to equality and maximise total surplus (the sum of consumer surplus and producer surplus).

@TheNewYorla:rCollecrion 1985

Mike Twohy from cartoonbank.com. All RighUl ReservM.

UNDERPRODUCTION AND OVERPRODUCTION Inefficiency can occur because either too little of an item is produced - underproduction - or too much is produced - overproduction. Underproduction In Fig. 5.6(a), the quantity of pizzo produced is 5,000 pizzas a month. At this quantity, consumers ore willing to pay $20 for a pizzo that costs only $10 to produce. The quantity produced is inefficient - there is underproduction. The scale of the inefficiency is measured by deodweight lou, which Is the decrease in toto! surplus thot results from ineffidency. The grey triangle in Fig. 5.6(a) shows the deadweight loss.

Efficiency and Equity

Economic AnaIY,;;;s;;;;is_ _ o Woter is 0 foetor of production, and the analysis in this chapter explains why it is misollocoted and what must happen for the use of our wahlr resources to be efficient. o The data in the news article provide the benchmark marginal

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social benefit curve, MSB, in Hg. l. The three stoles UM 12.3 gigolitras (gt.), whkh is the supply (shown

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by supply curve S, in Fig. 2«). Soutfl Australia uses too little wal&r

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in its productive grape and fnJit produaon and has a deodwelght loss shown in Fig. 2(0). New South Wales use.s too much wroter in its livestock. pasture, and

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and the amount of trading needed for efficiency is km.

only one possible estimate. If MS8 diminishes more rapidly than shown (if th. MSB curve is ~ .~, th. deadweight loss is smaller

weight loss shown in Fig. 2(bl. Victoria lnot shown) uses olmoa

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CHAPTER 5

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'23

Global Markets in Action

0

CHAPTER 7

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FIGURE 7.9

Effects of E.U. and U.S. Farm Subsidies an a Small Ecanamy E

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The demand for sugar in Australia is D... and the supply by Australian producers is SA' With free internatianal trade, the world price is $A per kilogram. Australia produces 14 millian Ionnes per year, consumes 1 million Ionnes, and exports 13 million Ionnes. E.U. and U.S. suwidies lower the world price 10

$2 per kilogram. Australian production and export! shrink and consumption increases. In part (b), Australia's consumer surplus expands from A to A + S, producer surplus shrinks from S + C + D 10 C, and Iotal surplus decreases by D - a deadweight loss.

Figure 7.9(b) shows the gains and losses for Austmlians. Consumer surplus increases from the green area A to the mea A plus B. Producer surplus shrinks from the sum of the areas B, C, and D to C. And a deadweight loss shown by area D arises.

The deadweight lo'se' created by E.U. and U.S. funn subsidies that full on the poor nations of Africa, Asia, and Central and South America me a source of tension and disagreement among nations today and remain a challenge for the WIO.

What are the tools that a country can use 10 restrict intematianaltrade' Have tariffs and quotas been on the increase ar the

decrease! Why' Explain the effects of tariffs on a country's autput and the price of the product on which a tariFF is applied when the importer is a small country in world trade. Who gains and who loses From the imposition of a IariFR What is the deadweight loss From a IarifFf How da E.U. and U.S. farm subsidies affect fanners and consumers in Australia'

The powerful forces of demand and supply shape the fortunes of families, businesses, and nations in the same unrelenting way that tides and winds shape rocks and coastlines. You've seen in Chaplers 3 to 7 how these forces raise and lower prices, increase and decrease quantities bought and said, and sometimes send resources to their higheshalued uses. These powerful forces begin quietly and privately with the choices thot each one of us makes. Chopter 8 probes these choices and shows you the neat idea of mapping people's preferences. We make our choices against the backdrop of ever-chonging technology. Every year, new goods appear and old ones disappear. New firms are born and old ones die. This process of change is managed by firms operating in markets. We begin our study of firms in Chapter 9 by learning about their costs and the relationship between technology and cost. Then we see how firms operate in various Iypes of markets. Some markets, like the ones we've studied sa far, are competitive. The most extreme competition, called perfect competition, is the topic of Chopter 10. At the other extreme is monopoly, a single firm with no competitors, which we study in Chapter 11. Then, in Chapter 12, we study a blend of competition and monopoly to explain the behaviour of the firms that produce the huge variely of brands and Aavaurs that confront us. Chapter 13 explores situations in which firms, like armies, act strategically, guessing the effects of their choices on the choices of others. Finally, in Chapter 14, we study markets for factors of production.

CHAPTER 8

CHAPTER 9

CHAPTER 10

CHAPTER 11

CHAPTER 12

CHAPTER 13

CHAPTER 14

PART 3

a

Households, Firms, and Iv'Iarkeffi

Predicting Consumer Behaviour

UWith the pork rd recommend an Alsatian white or a Coke. H

@ The

New Yorker Collection 1988 Robert Weber from cartoonbank.com. All RighI! Reserved.

quickly does the marginal rate of substitution diminish. Poor substitutes for each other have tightly curved indifference curves, approaching the shape of those shown in Fig. 8.5(c). & you can see in the cartoon, according to the waiter's preferences, Coke and Alsatian white wine are perfect substitutes and each is a complement of pork. We hope the customers agree with him.

We are now going to predict the quantities of movies and soft drink that Usa chooses to buy. Figure 8.6 shows Usa's budget line from Fig. 8.1 and her indifference curves from Fig. 8.3(b). To get the most value from her limited budget, Usa consumes at her best affordable point, which Is 2 movies and 6 Illres of soft drink - at point C. Here, Usa a Is on her budget line. a Is on her highest attainable indifference curve. a Has a marginal rate of substitution between movies and soft drink equal to the relative price of movies and soft drink. For every point inside the budget line, such as point I, there are points on the budget line that Usa prefers. For example, she prefers all the points

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FIGURE 8.6

The Best Affordoble Point 1:

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point

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;Ji What is an indifference curve and how does an indifference map show preferences? Why does an indifference curve slope downward and why is it bowed towards the origin? What do we call the magnitude of the slope of an indifference curve? What is the key assumption about a consumer's marginal rate of substitution?

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The two components of the model of household choice are now in place: the budget line and the preference map. We will now use these components to work out the household's choice and to predict how choices change when prices and income change.

Lisa's best affordable point is C. At that point, she is on her budget line and also on the highest attainable indifference curve. N a point such as H, Lisa is Willing to give up more movies in exchange for soft drink than she has to. She can move to point I, which is just as good as point H, and have some unspent income. She can spend that income and move to C, a point that she prefers to point I.

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Forget about writing Q shopping list your shopping trolley can now do your thinking for you. Shopping trolleys with their own checkout consoles attachedyou just scan the item when you drop it in - were on show at Q retail technology expo in Sydney this week. The trolleys will be used in the US from next month, and may make it into Australian supermarkets as early

as next year. The console allows you to download your shopping list and, backed by a network of in-store sensors, warns you when you are approaching an item you wish to buy. It will advertise shop specials as you pass them, and you can scan your loyalty card into the system as well. You can even place Q deli order and receive a message when it is ready for collection. Self-service checkout systems are being malled by all the big supermarket chains, and they are proving to be popular as an alternative to the old-fashioned manual checkout. Vernon Slack, of the system's manufacturer, Fujitsu, said one of the biggest problems supennarkets faced was losing shopping trips to convenience stores. So they are looking for ways to entice customers into their stores by making the shopping experience itself more convenient. And if you think you can add a few items to your trolley on the sly, think again. The number of items, and even the items themselves, will be cross-checked when they are bagged. Fujitsu's U-Scan trolley and similar technologies on show from the computer giant IBM and others promise to transform shopping - but isn't it just another way to cut costs and get rid of checkout staff? Not according to Mr Slack. He said checkout staff could be moved into more personalised customer service roles to provide improved customer service. Rob O'Neill

""""'" Morning Houdd

21 July 2005

Essence of the Sto"L- o Items are scanned as they are o

Supermarkets now have the option of investing in new smart trolleys that have scanners attached.

placed in the trolley and the customer can then check out at a self-service checkout.

PART 3

0

Households, Firms, and Markets

EFFICIENCY AND RENT SEEKING WITH PRICE DISCRIMINATION

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With perfect price discrimination, output increases to the point at which price equals marginal cost at the intersection of the marginal cost curve and the demand curve. This output is identical to that of perfect competition. Perfect price discrimination pushes consumer surplus to zero but increases producer surplus to equal the sum of consumer surplus and producer surplus in perfect competition. Deadweight loss with perfect price discrimination is zero. So, perfect price discrimination achieves efficiency. The more perfectly the monopoly can price discriminate, the closer its output gets to the competitive output and the more efficient is the outcome.

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Dozens of fares discriminate among many different types of business travellers and many new low fares with restrictions appeal to holiday travellers. With perfect price discrimination, Global's demand curve becomes its marginal revenue curve. Economic profit is maximised when the lowest price equals marginal cost. Here, Global sells 11,000 trips and makes an economic profit of $9.35 million a year.

The new fares between $900 and $1,200 have attracted 3,000 additional travellers and extracted the entire consumer surplus. Global is making an economic profit of more than $9 million a year. Real-world airlines are just as creative as Global, as you can see in the cartoon!

But there are two differences between perfect competition and perfect price discrimination. First, the distribution of the total surplus is different. It is shared by consumers and producers in perfect competition, while the producer gets it all with perfect price discrimination. Second, because the producer grabs the total surplus, rent seeking becomes profitable. People use resources in pursuit of rents, and the bigger the rents, the more resources get used in pursuing them. With free entry into rent seeking, the long-run equilibrium outcome is that rent seekers use up the entire producer surplus.

What is price discrimination and how is it used to increase a monopoly's profit? Explain how consumer surplus changes when a monopoly price discriminates. Explain how consumer surplus, economic profit, and output change when a monopoly perfectly price discriminates. What are some of the ways that real-world airlines use to price discriminate?

~i!i!M4+mS!) Study Plan 11.4

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V,r

You've seen that monopoly is inefficient and costly for consumers. Because of these features of monopoly, it is regulated. We'll now study the key monopoly regulation policy issues.

-c » Establishing a constitution Ihat makes despotic and tyrannical rule impossible is relatively easy. The framers of Australia's constitution have designed a sophisticated system of incentives of carrots and sticks - to make govemment responsive to public opinion and to limit Ihe ability of individual special interests ta gain at !he expense of Ihe majority. But no nation has managed to create a constitution !hat effectively blocks !he ability of special interest groups to copture Ihe consumer and producer surpluses that result from specialisation and exchange. Markets fail, and governments might help to overcome Ihat failure far four reasons. First, Ihe market would produce too small a quantity of Ihose public goods and services that we consume logelher, such as national defence and air-traffic contral. Second, monopolies restrict output and raise prices. Third, spill-over effects such as pollution occur. And fourlh, Ihere is too much economic inequality. Governments help to cope wilh Ihese problems. But just as markets fail, so can governments. When governments get involved in Ihe economy, people try to steer government actions in directions that bring personal gain. The four chapters in Ihis port explain !he problems wilh which Ihe market has a hard time coping. They also review Ihe roles of government in seeking better outcomes than Ihe market alone can achieve.

CHAPTER 15

CHAPTER 16

CHAPTER 17

CHAPTER 18

JJ --I

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aupp0s8 h:rt the polkJfion lax..

What is the lax pet tonne of PM! produced flat Wl1 odl~ on efficient ~ b Explain the connection bttw..n)"OUr cmwer to port to) (mel .. ~ to prob'-m 2. 5 Using lie information pravlcl«f in problem 1, suppose that no one owns th.lok. and that the government iuues two marketoble ponution a

permits, one to the farmer and one to the factory. Each may pollul8 the lake by the same gmount, and the total amount of pollution is the efficient amount.

What is the quantity of putlcid. produced' b What is the mam! prb of 0 polluOOn perm~ Who buys and who sella 0 pennit9 c What is the connection b.tw..n your CJN\IIl'W and the OMll'8l't to~. 1 and 3' 6 Using h inJormotion gr..n In problem 2, auppoH Ihat the gowmm.nl lUl* two marUlable pollution pennib, one to lie city and one to the smehret. Eodl may pol..1e lie air by the same amount, and tne total is the efficient

n

11.

6

~L l

••

.,

:I

1'

';,(

a.MIl

LL----c'----;;;;--;;,-----};;----;;'---10 20 30 40 ~O O,~lInlhy

(IhllUMInds. lIF

"ooMII plr yea~

(I

amount. o

How much sleM is pmcIuced¥

b What is the market price of Q penni" Who buys and who sells a permiflil c

What is the connection betMlen your amwer and the answer. to problems 2 and ..,

7 The marginal em! of educating

0

student is

$.4,000 a year and is constant. Th. figure at the top of the next column .hows the marginal private benefit curve. o With no government involvement and if the universities are competitive, how many stJdenb Qf'II enrolled and what is !he Iui~

b The e:xIBmaI benefil from education is $2,000 per student per ~r and is COO3k1nt.

I the QO'*TIment provlde,r. tM Jficient amount of education, how many university places does it offer and what it; lie tuition'

• A II
Economic Inequality and Redistribution

POVERTY Households at the lower end of the income distribution are so poor that they are considered to be living in poverty. There are two concepts of poverty. Absolute poverty is a situation in which a household's income is too low to function effectively in our society. Relative poverty is a situation in which a household's income is too low relative to the average. Operationally, relative poverty is defined as an income less than 50 per cent of the median income. On the relative definition of poverty, 11 per cent of Australian households had incomes that fell below the poverty line in 2001 (the most recent year for which we have data). Who are the poorest people in our community? We answer this question by calculating poverty rates - the percentages of people living below the poverty level in different categories. Figure 18.5 shows the result in 2001. The unemployed and those not in the labour force, such as retired persons, have the greatest incidence of poverty and these groups account for 58 per cent of Australia's poverty. We have to be careful about interpreting these poverty rates. They are measures of the proportions of a particular group of income units who are relatively poor. The concept of an absolute poverty line is more relevant for defining a circumstance in which people may be so poor that they cannot function effectively in our society. This situation isn't reflected in the relative poverty line. The definition of the poverty rate is a topic which is debated by many researchers.

0

CHAPTER 18

FIGURE 18.5 Poverty Rates in Australia Family type 65 years and older

55-64 year-olds 45-54 year-olds_ 35-44 year-olds_ 25-34 year-olds_ 15-24 year-olds • • • • • Working full time. Working part time_ Not in the labour force Unemployed Couples with no children. Couples with children_ Single parents Single persons • • • • • •

•o

•

•

•

10 20 30 Poverty rate (percentage)

•

40

•

50

The unemployed, not in the labour force, young, and single have the highest poverty rates. Source: Rachel Lloyd, Ann Harding, and Alicia Payne, 'Australians in Poverty in the 21 st Century', National Centre for Social and Economic Modelling (NATSEMI, paper presented at the 33rd Conference of Economists, September 2004.

RE¥IEW QUIZ 1

2 3 4

5

Which is more unequally: income or wealth? What does a Lorenz curve show, and how do we use it to gauge the degree of inequality? Which is the better measure of inequality: income or wealth? Why? Describe one measure of the poverty line, and explain how it is used. What are the likely characteristics of people living in poverty?

~i!l!DM4+mS;) Study Plan 18.1

We've now described economic inequality and poverty in Australia. Our next task is to explain why it arises. © Mitchell Illustrated Pty ltd, The Australian, 22 October 1990

-c » The goal of macroeconomists is to explain and inRuence the pace of economic growth, economic Ructuations, unemployment, and inRation. Chapter 19 looks at some facts about these topics. The next two chapters explain how we measure the macroeconomy. In Chapter 20, you learn how we measure totol output and the price level and use these measures to cakulale the economic growth rale, business cycle Ructuations, and inRation. In Chapler 21, you will learn how we measure the stole of the labour market - the levels of employment and unemployment and wages. You will then tum to macroeconomic theory. Chapler 22 explains the big-picture aggregate demanchaggregate supply model, which explains the Iong-lerm trends in economic growth and inRation and the shorHerm Ructuations in production, jobs, and inRation. Chapters 23 and 24 look at special cases of aggregate supply and aggregate demand. The first, the classical model, describes the economy in the long run, when there is full employment. The second, the Keynesian model, describes the economy in the short run when there is either unemployment or overheating. These chapters lay the foundation on which you will build an understanding of how the macroeconomy works and how palicy actions by the government and the Reserve Bank might make it work better. You will study these aspects of macroeconomics in subsequent choplers.

CHAPTER 19

CHAPTER 20

CHAPTER 21

CHAPTER 22

CHAPTER 23

CHAPTER 24

JJ -I

-u » Managing our economy is similar to managing our heahh. Economists must unders1and how the economy responds to the treatments they might prescribe. And sometimes, they try a cure even though they don't fully unders1and the causes of the problem afAicting the economy. But economists do know some things. And you've already discovered the basics of what they know about the forces that make our economy grow, AUduate, and experience inAation. You've seen how capital accumulation and tec:hnolagical change make potential GOP expand. You've leamed how Auctuations in aggregate demand and aggregate supply generole Auctuations of real GOP around potential GOp. And you've leamed about the key sources of those Auctuations. The four chopters in this port build on what you've studied and use the aggregate demancl-aggregate supply madelta explain maaoecanomic policy - actions that are designed to treat maaoecanomic ills and possibly cure them. Chapter 2S explains fiscal policy. It studies the effects of changes in govemment expenditures and taxes on aggregate demand, aggregate supply, real GOP, and the price level. Chapter 26 brings money into the picture. It explains what money is, describes the banking system, and explains what determines the quantily of money and the interest role. Chapter 27 explains the Reserve Bank's monetary policy. Finolly, Chapter 28 explains the inAuences on and effects of the Australian dollar exchonge rate.

CHAPTER 25

CHAPTER 26

CHAPTER 27

CHAPTER 28

JJ --I

GOVERNMENT BALANCING ACTS For every dollar eamed in 2006/07, Iile Commonweallil government proposed to spend 21.6 cents, collect taxes of 22.9 cents, and generate a surplus of 1.3 cents. Our state and locol governments' spending and toxing plans, when totolled, come close to doubling those of the Commonwealth government. How do government spending and taxes affect Iile economy? Do toxes harm employment and economic grawlh? Does it matter if a govemment runs a deficit or a surplus? In Iile previous chapter we saw Iilat Iile econamy doesn't operate like Iile shock absorbers on a car, srnooliling out Iile poIholes and bumps in the read. One component of expenditure Iilat the multiplier amplifies is government expenditure on goods and services. Con Iile government try to toke advantage of Iilis fact and srnoolil out Auctuotions in aggregate expenditure? Can it also vary transfer payments and taxes and affect the size of Iile mukiplier? These are Iile Fiscal policy issues you will explore in Iilis chapter. We begin by describing the Commonwealth budget and Iile process of creating it. We also look at Iile Australian budget in historical and global perspectives. We Iilen use the economic models that you've studied in previous chapters to study Iile effects of the budget on the economy. At the end of the chapter, in Reading Between the Unes, we look at altemaHve views on how the government might spend the onticipoted surplus in its 2005/06 budget.

""U :D

a

Go to ii.~:a·:,im., for solutions to odd-numbered problems ond odditionol exercises. 1 The economy is in a contraction and there is a

large recessionary gap. e

t:D

Describe the discretionary and automatic

b

Describe a discretionary fiscal stimulation package that could be used that would not

s:

c

Explain the risks of discretionary fiscal policy in this situation.

m

bring a budget deficit.

2

The government is proposing 10 increase the tax rale on labour income and asks you 10 report on the supply-side effects of such an action. Answer the following questions using appropriate diagrams. You are being asked about directions of change, not exact magnitudes.

o What will happen to the ,upply of lobour ond why? b What will happen to the demond for labour ond why?

fiscal policy actions that might occur.

r

en

5

c

ond why? d What will happen to the equilibrium pr&-lox

The economy is in an expansion and there is a

large inflationary gap. e

Describe the discretionary and automatic fiscal policy actions that might occur.

b

Describe a discretionary fiscal restraint

wage rate? e

g

produce serious negative supply-side effects.

3

4

Explain the risks of discretionary fiscal policy in this situation.

The economy is in a contraction. There is a large recessionary gap and a budget deficit. a

Do we know whether the budget deficit is structural or cyclical? Explain your answer.

b

Do we know whether automatic stabilisers are increasing or decreasing aggregate demand? Explain your answer.

c

If a discretionary increase in government purchases occurs, what happens to the structural deficit or surplus? Explain your answer.

The economy is in an expansion. There is a large inflationary gap and a budget deficit. a

b

c

Do we know whether the budget deficit is structural or cyclical? Explain your answer. Do we know whether automatic stabilisers are increasing or decreasing aggregate demand? Explain your answer. If a discretionary decrease in government expenditures occurs, what happens to the structural deficit or surplus? Explain your answer.

What will happen 10 the equilibrium after-tax wage rate?

What will happen to potential GDP?

package that could be u,ed thot would not c

What will happen 10 equilibrium employment

6

What evidence would you present to the government to support the view that a lower tax on labour income will have a significant effect on the labour market?

The government is proposing 10 lower the tax rale on labour income and asks you 10 report on the supply-side effects of such an action. Answer the following questions using appropriate diagrams. You are being asked about directions of change, not exact magnitudes.

a What will happen to the ,upply of labour and why? b What will happen to the demond for labour ond why? c

What will happen to equilibrium employment

ond why? d What will happen to the equilibrium pr&-lox wage rate? e

What will happen 10 the equilibrium after-tax wage rate?

What will happen to potential GDP? g

How would your answers 10 the above questions change if at the same time as CUlling the labour income tax rale, the government increased the indirect taxes 10 keep the amount of lex collected constant?

(")

I

JJ --I

productivity influences

-

Aggregote demond b Aggregote .upply c Reol GDP d The price level 0

(")

» r

e

2

Us. the links on following exercises:

2005/06 Budget, ond then on.wer the following questions: a

Aggregote demond b Aggregote .upply c Reol GDP d The price level e Employment The real wage rate

-

Z ~ 3

Describe the key differences in outcome between the two situations in questions 1 and 2 above. 0

What could the government do with its surplus if it doesn't choose either of the above options*

b What foctors might drive governments'

c

What contributed to the largest increases in expenditure?

d What were the most important new initiatives

in the 2005/06 budget? Did either lox cuts or infrastructure spending dominate? e

What was the reported size of the government's surplus in 2004/05? Was it as large as suggested in the Reading

Between IIIe lines? 2 Vi.it the OECD web.ite. Use the informotion thot you find there to describe the key difference between fiscal policies in large OECD countries. Comment where you can on different demandside and supply-side considerations. 3 Visit the web site of the Commonwealth of Australia and review the asset sales that governments have made since 1987. a

choices in deciding on whallo do with a

surplus?

What was the estimated level of revenue, expenditure, and the budget surplus?

b What contributed to the largest increases in revenue?

workers. Describe what happens to 0

iiM9.. ,1;0 to do the

1 Visillhe website of the Commonwealth Department of the Treasury and view the

Suppose the government cut its spending on

infrastructure capital and instead chose to spend some or all of its surplus on lex cuts for all

I

G)

Employment

The real wage rate

--I

Z

Study /leading Between !he lines on pp. 608-09 and then explain how government spending on infrastructure capital that adds to

What types have assets have governments

.old? b Which government department manages the sale of assets? c

What assets is the government planning to sell in the coming years?

d Why do you think the past governments have

.old off publicly-owned ossets? e

How do you think asset sales influence aggregate demand, aggregate supply, and

reol GOP?

:E

m OJ

m X

m JJ (")

-en m en

Go to " ' " , . . . for .... ution. to ocIcI· numboorecl problem. and ocIcIitianal

-.rei.... 1 Suppose that the Reserve Bonk hod on inflation target expressed as keeping inAction between 2 per cent and 3 per cent a yeer but with no requirement to keep trend inAation at the midpoint of the range.

a Slorting from a price level of 100 and the Reserve Bank ac~iev8S its target, Calcula'" the highest price level that might occur after ten years.

II Calculate the low"" price level that might occur after len years.

iii What is the range of uncertainty about

4 The torget for the cosh rate is 4 per cent a yeor and the Reserve Bank wan" to decrease it by 0.25 pe~nloge pain". a Ooos the Reserve Bank buy or sell securiH., in the open market to lower the cash rotei

b Oe>eribe the chong.. in the balance sheets of the Reserve Bank and a commercial bonk

following the open market aperaHon. c Orawa graph like Fig. 27.5 to iIIu,tra18 the effecb of the Reserve Bank's actions in the market for reserves.

5 The

~gure

shows the economy of Freezone. The

aggregate demand curve is AD and the short-

run aggregate supply curve i$ SAS•. Poleniial GOP ;$ $300 billion.

the price level after ten years?

2

]' 140

b Would this type of inRotion torget $srve the Financial markets well and provide an anchor for inRation expectations~

~

Suppose the Reserve Bank had an inAation target expressed as keeping inRation between

]

120

~

110

o per cent and 4

per cent a year but was also

~ 130

required to keep trend inRotion at the midpoint of the rang8. a

100

Starting from a price level of 100, what is

the likely price level after "'n years if the bank achieves its target? b Compering this economy with the one In problem 1, which economy has the greeter certainty about inRation over the longer

term' Which has the gneal8r ,hart-term certainty' 3 The cash rate target is .4 per cent a year and the R...rve Bank wan" to increa.se it by 0.25 percentage poi"". a Does the Reserve Bank buy or sell securities in the open market to raise the cosh ratelJ' b o.>eribe the chang., in the balance ,hee" of the Reserve Bonk and a commercial bonk following the open market operation.

c Draw a graph like Fig. 27.5 to illu,trate the efleeb of the Reserve Bank', aeli"", in the market for reserves.

o'\'

1()0

200

300

.00

500

Real GOP (billions af 2003/04 doilanJ

a What i$ the price level and real GOP*

b

Does freezane have on unemployment

problem or on inRaHan problem? Why' c What do you predict will happen in Freezone if the central bonk tokes no monetary policy actionslJ'

d What monetary policy action would you advise the central bank to toke, and what do you predict will be the eRect of that acHon? 6 Suppose that in Freezone, shown in problem 5, the aggregate demand curve is

AD and

potenHal GOP i$ $300 billion, but the ,hort-run aggregate $UPPIy curve i$ SASs. a What i$ the price level and real GOP*

'1J JJ

o

OJ

r

m

s:

U>

()

1 Study /leading aetween the Un.. on pp. 656-57, ond then onswer the following questions.

JJ

---I () » r

a

G>

and obtain the latest data on M1 and M3 money supply and short-term interest rates. Then answer the following questions.

o Is the Reserve Bonk trying to slow the

critically evaluate the Reserve Bank's cash

rote decisions in 2004, 2005, ond 2006. c Write a note to the Commonwealth treasurer

economy or speed it upi How can you telli b

explaining why you think the Reserve Bank

What open market operations do you think the Reserve Bank has undertaken in the last

should have been more aggressive or les5

few

aggressive in raising the cash rote target.

and the quantity of moneyV

Do you

agree that the cash rote should not

()

Review the three episodes of monetary policy

a

What decision on the interest rate was taken by the Reserve Bank board at its last meetingi

b

What action will the Reserve Bonk be taking in the money market to implement the boardfs decision~

policy easing illustrated in Fig. 27.2 Ip. 645). a

Describe the state of the economy at the

beginning of each episode. b

Was the economy always under an inAation threat when the Reserve Bank tightened~

c

Was the economy always experiencing high unemployment when the Reserve Bank easedi

c

d

Describe the state of the economy at the end of each episode.

d

e

Was the economy always free from an inAation threat when the Reserve Bank

stopped tightening? Was the economy always free from high unemployment when the Reserve Bank stopped easing~ g

What was the state of the economy two years after an episode of tightening or easingi

h

What is your overall assessment of the Reserve Bankfs performancei

m

d What do you think will be the effect on bond

tightening and the three episodes of monetary

Explain your answer.

><

JJ

prices and share prices~ 2

m

actions, what ripple effects do you expect over the coming monthsi

Visit the website of the Reserve Bank of Australia to check the most recent media statements by the governor of the Reserve Bank on monetary policy. Then answer the following questions.

be raised above 6 per cent per year? 2

months~

c In the light of the Reserve Bank's recent

d If the Reserve Bonk hod roised the cosh rote more aggressively, what would have hoppened to the quontity of bonk reserves e

.43- ,I;" to work

1 Visit the website of the Reserve Bank of Australia

Describe the course of CPI inAction since

2001. b looking ot the trend of the CPI since 2004,

--I I

-z

Use the links on

the following exercise.

Using appropriate economic modelsf explain

why the Reserve Bonk boord mode the decision it did on the interest rate. In light of recent Reserve Bank actions f what ripple effects do you expect over the coming monthsi

-en m en

The Exchange

The Foreign Exchange Market An exchange rate is Q price - the price of one Ol!rency in terms of another - and llke all pri.c:es, it is

dctennlned in Q market: - the foreign exchange market. The AustIulian dollar is traded by tens of t:housands of troden every bour of every business day. Dealers in the foreign excbange market must react quickly to the information they receive on their video monitors. And $Ometimes they follow each other like the sheep In the cartoon below!

Because it has many traders and no restrictions on who may trade, the foreign exchange marltet is Q competitive market. In Q competitive marltet, dcm.and and supply detetmlne the price. So to understand the forces that detennine the exchange rate, we study the fact:ots that influence demand and supply in the tore1gn exdlange market. But there is a feature of the fon!lgn exd1ange IJXlJi
THE DEMAND FOR ONE MONEY 15 THE SUPPLY OF ANOTHER MONEY When people who are holding the money of some

other country want to exdlange it for Austrol1an dollars, they demand Austrollan dollars and supply that other muntry's money. And when people who are holding Awtn:l1Jan dollars want to exchange them for the money of some other country, they supply Austrullan doUom and demand

Role 0

CHAPTER 28

that other country's money. So the factor:s that influence the demand for Au$trallon dollars abo Influence the supply of U.s. dollars, LU. euros, U.x. pounds, and. Japanese yen. And the fu.cton that influence the demand for those other coun-

tries' money also influence the supply of Au.rtra1ian dollars. We'llloolr. first at the influences 00 the demand for Austrolian dol1ms in the foreign exdJ.ange rruuket.

DEMAND IN THE FOREIGN EXCHANGE MARKET People buy Australian dollars in the foreign exchange market so that they CQJl buy Austro.lianmode goods and services - Austm1ion exports. They also buy Australian dollars so they can buy Australian assetJ such as bonds, stocks, businesses, and real estate, or so that they cao keep part of their money holding in an AustroJ1an dollar bank ao:ounl The qumrtlty of AwbWlan doUom demanded In the foreign exdlange martet is the amount that trodem plan to buy during a given time period at a given exchange mre. Thls quanttty depend> on many factors, but the main ones are 1 The exchange rote 2 World demand for Australian exports 3 lnterest rates in Au5trolla and other countries .. The expectEd future exchange rate So that we am finrt i50late the exchange rote and see haw it i5 determined, we'll look first at the relationship between the quantity of Australian dollars demanded in the foreign exchange market

ond the exchonge rate when the other three influences remain the same - the law of demand in the foreign exchange markel In the next .section, we'll consider what happens when these other influences change.

THE LAW OF DEMAND FOR fOREIGN EXCHANGE The low of demand applies to dollOJ"ll just 05 it does

Carman. b,.}I;'idocMmD fnna

n,,~

~~_.,

to anything e15e that people vol.... Other things remaIning the same, the higher the exchange rate, the maUer is the quantity of Aust:ro.llan dollars demanded in the foreign exchange madr.et. For example, if the price of an Austrolian dollar rose

eMgS- ,i;O

""U

Go to for solution. to oddnumbered problems and additional

JJ

exercises.

o

OJ

1 The Australian dollar exchange rate increased from 80 U.S. cents in 2004 to 85 U.S. cents in 2005.

r

m

s::

en 2

d What are the numbers that go in the third row of the table and what do those numbers tell you? e

What are the numbers that go in the fourth row of the table and what do those numbers tell you?

a

Did the Australian dollar appreciate or depreciate against the U.S. dollar?

What are the numbers that go in the lost row of the table and what do those numbers tell

b

What was the value of the U.S. dollar in terms of Austrolion dollars in 2004?

you~

c

What was the value of the U.S. dollar in terms of Austrolion dollars in 2005?

d

Did the U.S. dollar appreciate or depreciate in terms of the Australian dollar?

The Australian dollar exchange rate decreased from 73 aura cents in 2000 to 65 aura cents in

2005.

a

Did the Australian dollar appreciate or depreciate in terms of the aura?

b What was the value of the eura in terms of Australian dollars in 200011 c

4 The table sets out some cross exchange rates. Use the table to answer the follOWing questions.

I!:!III E!lII E:l:II

Did the aura appreciate or depreciate

against the Australian dollar?

3 The table sets out some cross exchange roles.

I:!DE!lIIE:l:IIImIIIlD

a

. .

1.17

~

1.32

a

What do the numbers in the first column tell you?

b What are the numbers that go in the first row of the table and what do those numbers tell you~

c

What are the numbers that go in the second row of the table and what do those numbers tell you?

1.89

0.85

0.76

What do the numbers in the first row tell you?

b What are the numbers that go in the first column of the table and what do those numbers tell you~ c

What are the numbers that go in the second column of the table and what do those numbers tell you?

d

What are the numbers that go in the third column of the table and what do those numbers tell you~

e

What are the numbers that go in the fourth column of the table and what do those numbers tell you?

0.79 0.53

1.27

~

Use the table to answer the follOWing questions.

I!D E!lII E:l:II

I:!DE!lIIE:l:IIImIIIlD

..

What was the value of the aura in terms of

Australian dollars in 200511 d

g What do the numbers in the second through to the lost column of the table tell you?

What are the numbers that go in the lost column of the table and what do those numbers tell you? g What do the numbers in the second through to the last row of the table tell you?

()

1 Study Reading Selween the Un.. on pp. 676-79 ond then onswer the following questions.

JJ

---I () » r --I I

-Z A -Z

Use the links on following exercise..

1 Visit the Reserve Bank's website and find data

a What do the daily, weekly, and monthly

on the Australian dollar exchange rate.

changes in the exchange rate tell us?

0

b What, according to the news article, caused

b When did the Australian dollar depreciate

22 August 2006?

most recently?

c 15 the explanation given in the news article consistent with interest rate parity? d If Australia has an inAation rate persisten~y below that of the United States, what will happen to the Australian dollar over the longer term (other things remaining the 2 Suppose the government cut its spending on

c

G>

Reserve Bank have taken such action?

2 Visit PACIFIC Ion exchonge rote servicel ond read the page on purchasing power parity. 0

Aggregate demand Aggregate supply Real GDP The price level

b What factors might drive governments' choices in deciding on what to do with a surplus?

m

OJ

m >< m JJ ()

en m en

e Do you think that the information on overvaluation and undervaluation is useful to currency speculators? Why or why not?

Describe the key differences in outcome between the two situations in questions 1 and 2 above. surplus if it doesn't choose either of the above options?

:E

some currencies are overvalued and some ore undervolued?

Employment

a What could the government do with its

Whot is purchosing power parity?

b Which currencies are the most overvalued relative to the U.S. dollar today? c Which currencies are the most undervalued relative to the U.S. dollar today? d Can you offer some suggestions as to why

The reol wage rate

3

When was the last lime the Australian dollar exchange fate was fixed?

d Is there any evidence that the Reserve Bank has intervened in the foreign exchange market in the past 12 months? If so, why might the

infrastructure capital and instead chose to spend some or all of its surplus on tax cuts for all workers. Describe what happens to

a b c d e

When did the Australian dollar appreciate most recently?

the change in the exchange rote on

same)?

'iMMS- ,IS" to do the

3

The Economist magazine uses the price of a Big Mac to determine whether a currency is undervalued or overvalued. Vist the Economist online and answer the following questions.

a What is the price of a Big Mac in the United States? b Using the current exchange rate, what is the U.S. dollar price of a Big Mac in Australia?

c

Given purchasing power parity, is the Australian dollar undervalued or overvalued

relative ta the U.S. dollar? d Which currencies are undervalued relative to the U.S. dollor? Or is the U.S. overvolued relative to these currencies? Is there a difference?

8

When inAation hits 1,000 per cent a year, as it did in Zimbabwe in 2006, money becomes worthless and the economy collapses. 'InAation is always and everywhere a monelary phenomenon,' said Milton Friedman. But behind the monelary phenomenon is a dire fiscol situation in which government expenditures outstrip revenues and the central bank prints money 10 pay the governmenl's bills. Today, Australia's inAation is mild. But it was not always sa. During the 19705, our inAation hit double digits. Can we count on low inAation' Or is there a danger that one day inRation will become rampont as it was during the 1970s? Chapter 29 examines the inAation challenge. Economic growth, mainlained at a steady rate over a number of decades, is the single most powerful inAuence on any society. It brings transformations that continue 10 amaze. Economic growth that is mainlained at a rapid rate can transform a society in years, not decades. Such transformations are laking place right now in many Asian countries. These transformations are economic miracles. Chapter 30 examines the challenge of economic growth. The Great Depression is now more than 70 years behind us. And recent recessions hove been mild. Have economists conquered the business cycle' Chapter 31 studies this question. Our international trade and payments is an ongoing concern. Are we borrowing 100 much from the rest of the world to suslain our appetite for goods and services'

CHAPTER 29

CHAPTER 30

CHAPTER 31

CHAPTER 32

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FROM ROME TO RIO At the end of the third century AD, the Roman emperar Diodetian struggled to contain an inAation that raised prices by more than 300 per cent a year. At the end of the 20th century, Brazil's inAation rate hit 40 per cent per month - or 5,600 per cent a year. Today, Australia has remarkable price slability, but during the 1970s, the Australian price level more than doubled - an inAation rate of more than 100 per cent over the decade. Why do inAation rates vary? And why do serious inflations break out from time to time? Can we be confident that the Reserve Bank will keep inAation in check? Or might inflation increase so our sovings buy less? Or might inAation decrease so our debts are harder to repay? To make good decisions, we need good forecasts of inAation, and not for just next year but for many years inla the future. How do people try to forecast inAation? And how do expeclations of inflation influence the economy? In its attempt to keep inflation in check, does the Reserve Bank foce a tradeoff between inAation and unemploymenl? And does a low unemployment rate signal a rising inflation rate? How does inflation affect the interest rate? We'll answer these questions in this chapter. We explain the forces that generate inflation and study the inAation process. We'll end, in Reading Between Lines, by looking at Australia's recent inAation experience and the challenge it poses for the Reserve Bank.

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PART 7

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Moacroeconomlc Polley Challenges

FIGURE 29.1

Inflation: Demand-pull and Cost-push The main task of the Reserve Bank is to keep inflation under control. You will learn about the tools and strategies that the Reserve Bank. uses in the next chapter. Here, we explain what causes inflation and explore the short-run tradeofD between inflation and output and between inflation and unemployment We begin by distinguishing between inflation and a change in the price level.

INFLATION AND A CHANGE IN THE PRICE LEVEL Inflation is a process in which the price level is rising and money is losing value. A change in one price is not inflation. For example, if the price of a meat pie jumps to $10 and all other money prices fall slightly so that the price level remains constant, there is no inflation. Instead, the relative price of a meat pie has increased. But if the price of a meat pie and all other prices rise by a similar percentage, then there is inflation. Inflation is an ongoing process, so a one-time jump in the price level is not inflation. Figure 29.1 illustrates this distinction. The red line shows the price level rising continuously. That is inflation. The blue line shows a one-time jump in the price level. That is not inflation. To measure the inflation rate, we calculate the

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InAation versus a One-time Rise in the Price Level 160 • Inflation, on ongoinll proc:_ of ri,inll price I_I

140 •

S-O; 130_ l120 _ 1110 _

]100 _ .!..

90 __ 2002

•

2000

•

2004

•

2005

•

2006

•

2007

Along the red line, an economy experiences inAaHon because the price level is rising persistently. Along the blue line, an economy experiences 0 one-time rise in the price level.

annual percentage change in the price level. For example, if this year's price level is 126 and last year's price level was 120, the inflation rate is 5 per cent per year. That is, Inflation rote = 126 - 120 x 100

120

= 5 per cent per year.

This equation shows the connection between the inflation rote and the price level. A high price level isn't the same as a high inflation rate. For a given price level last year, the higher the price level in the current year, the higher is the inflation rote. If the price level is rising, the inflation rote is positive. And if the price level is falling, the inflation rate is negative. If the price level rises at a faster rate, the inflation rate increases. And if the price level rises at a slower rote, the inflation rote decreases. Inflation can result from either an aggregate demand shock or an aggregate supply shock.. These two sources of impulses are called o Demand-pull inflation o Cost-push inflation We'll first study demand-pull inflation.

Go to eMS3· ,i;D for solution. to oddnumbered problems and additional exercises. 1 The figure shows an economy's long;un

level was 200, ond the velocity of circulation of money was 20. In year 2, the quantity of money was 20 per cent higher than in year 1. a

aggregate supply curve lAS; three aggregate

b Whot was the quontity of money in yeor 2?

demand curves ADo, AD1, and AD2 ; and three short;un aggregate supply curves SASo, SAS1, and SAS2 • The economy starts out on the curves

c

What was the price level in year 2?

d Whot was the level of real GDP in year 2?

ADo and SAS.

e LAS

What was the quantity of money in year 1lJ

4

What was the velocity of circulation in year 2?

In Quantecon described in problem 3, in year 3

a

List the events that might cause a demand-

b

Using the figure, describe the initial effects of a demand-pull inAation.

c

Using the figure, describe what happens as a demand-pull inAation spiral unwinds.

pull inflation.

2

In the economy described in problem 1, some events then occur that generate a cost-push inAation. a

List the events that might cause a cost-push inAation.

b

Using the figure, describe the initial effects of a cost-push inflation.

c

Using the figure, describe what happens as a cost-push inflation spiral unwinds.

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What is the quantity of money in year 3?

c

Whot is the level of real GDP in yeor 3?

d

What is the velocity of circulation in year 3?

e

If it takes more than one year for the full quantity theory effect to occur, what do you predict happens to real GDP in Quantecon

in yeor 3? Why?

a

List the events that might cause a perfectly anticipated inflation.

b

Using the figure, describe the initial effects of on anticipated inAation.

c

Using the figure, describe what happens as on anticipated inAation proceeds.

In the economy described in problem 1, suppose

that people anticipate deflation (0 falling price level) but aggregate demand turns out not to change. a

What happens to the short-run and long-run aggregate supply curves? IDraw some new curves if you need to.)

b

Using the figure, describe the initial effects of on anticipated deAation.

c

Using the figure, describe what happens as it becomes obvious to everyone that the anticipated deflation is not going to occur.

3 Quaniecon is a country in which the quantity theory of money operates. The country has a constant population, capital stock, and technology. In year 1, real GDP was $400 million, the price

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5 The economy described in problem 1 starts out on the curves ADo and SASo. Some events now occur that generate a perfectly anticipated inAation.

6

o

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Real GOP (billions of 2003/04 dollars)

Some events occur that generate a demand-pull inAation.

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the quantity of money falls to on..fikh of its year 2 level. b Whot is the price level in yeor 3?

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1 Study Reading aetween the Un.. on pp. 706-07 ond then onswer the following questions. 0

Why did

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Use the links on following exerci.e.: 1

some economists think that the

Reserve Bank would soon act to raise the interest rateV

b Why did other economists think thot the Reserve Bank would wait to raise the cash rate? c Can you tell from looking at Figs 1 and 2 on p. 707 what will happen to inAation over 2005? Why or why not? d Use the AD-AS model to exploin whot must be believed for the Reserve Bonk to tighten monetary policy. Explain how the Reserve Bank's policy works to hold down the

On its website, the Reserve Bank of Australia maintains a series of graphs that summarise macroeconomic and financial market trends in

Australia. It is called Chart Pack. Visit Chart Pack and use information from the relevant graphs to answer the follOWing questions. It is normally very difficult to attribute any particular period of inAation to either a cost-push source or a demand-pull source because usually there will be a number of different but interconnected sources. Use the graphs from Chart Pack to determine these causes for the most recent two quarters. a

What has happened to the inflation rate on a year-on-year basis for the most recent two quartersi

b

Are you able to recognise any demand pressures on the price level? What are they?

c

Are you able to recognise any cost pressures on the price level? What are they?

inAation rate.

2 Do you agree with the Reserve Bank's policy of trying to keep the inflation rote inside a target range of 2-3 per centV Explain your answer in detail with reference to all the relevant indicators of economic welfare that you think ore relevant.

3 If the Reserve Bank used monetary policy to lower the inflation rate to 1 per cent, what do you predict would happen to a

d Explain the large jump and then drop in the inflation rote for 2000/01. e

Unemployment in the short run and long run?

not.

b Inflation in the short run and long runi

Were expectations of inRation, on average, higher or lower than actual inAation for these two quartersi How would these expectations influence the actual inAation rate?

c The short-run and long-run Phillips curves? d Reol GOP ond the growth rote?

e

The real wage rate in the short run and the long run?

Is there any evidence that wages have contributed to inAation? Explain why or why

g Use an AD-AS model to explain how the various pressures you have mentioned impact on the price level.

2 Obtain dato on the growth rote of money and the inAation rate in Australia since 2000. a

Calculate the average growth rate of the quantity of money.

b

Calculate the average inAation rate.

c Make a groph of the money growth rate and the inflation rate. What does it tells you about the forces that generate inAation and the relationship between money growth and inflation.

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