We use prices to value output in calculating GDP, but prices change all the time. And over time, the average level of prices generally has risen (inflation).

Nominal GDP: value of output at current prices

Real GDP: value of output at some fixed set of prices

Nominal versus real GDP

So how to correct for rising prices over time?

Measure average prices over time (GDP deflator, Consumer Price Index, Producer Price Index, etc)

Deflate nominal GDP by the average level of prices to find real GDP

Inflation is the rate of growth of the average price level over time.

But how do we arrive at an “average price level”?

The Consumer Price Index surveys consumers and derives an average level of prices based on the importance of goods for consumers, ie. a change in the price of housing matters a lot, but a change in the price of Tim Tams does not.

Consumer Price Index

Then the CPI expresses average prices each year relative to a reference year, which is a CPI of 100.

CPIt = (Average prices in year t)/(Average prices in reference year) x 100

Inflation can then be measured as the growth in CPI from the year before:

Inflationt = (CPIt – CPIt-1) / CPIt-1

Inflation

Calculating GDP

Gross domestic product- The total market value of all final goods and services produced in a period (usually the year).

Alternates methods of calculating GDP

Income approach: add up the incomes of all members of the economy

Value-added approach: add up the value added to goods at each stage of production

Expenditure approach: add up the total spent by all members of the economy

The expenditure approach forms the basis of the AD-AS model.

Average Propensity to Save (APS) is savings as a fraction of YD:

APS = S / YD

Since all disposable income is either consumed or saved, we have:

APC + APS = 1

More terms

Marginal Propensity to Consume (MPC) is the change in consumption as YD changes:

MPC = (Change in C) / (Change in YD)

Marginal Propensity to Save (APS) is the change in savings as YD changes:

MPS = (Change in S) / (Change in YD)

For our linear consumption and savings functions, MPC = b and MPS = d. If YD changes, then consumption and savings must change to use up all the change in YD , so

MPC + MPS = 1.

Graphing the functions

When YD = 0, C + S = 0, so at point A, the intercept terms are both just below 2 and of opposite sign.

The 45 degree line in the top graph shows the level of YD. At point D, C is equal to YD, so S = 0.

MPC = 0.75 is the slope of the C function.

MPS = 0.25 is the slope of the S function.

What else determines C?

Household consumption will also depend on:

Household wealth

Average price level of goods and services

Expectations about the future

Changes in these factors will produce a shift of the whole C and S functions.

Shifts of C and S functions

A rise in household wealth will increase C for every level of YD, so C shifts up.

A rise in average prices will lower the real wealth of households and so lower C for every level of YD, so C shifts down.

Exogenous variables

Exogenous variables are variables in a model that are determined “outside” the model itself, so they appear as constants.

For the aggregate expenditure model, we treat as exogenous:

Changes in a or the exogenous variables (I, G, T or NX) will shift the AE curve. A change in b will tilt the AE curve.

Equilibrium occurs when goods supply, Y, is equal to goods demand, AE.

Equilibrium in the AE model

Supply of goods equals demands of goods (in the closed economy):

Y = C + I + G

Y = a + mpc(Y – T) + I + G

(1 – mpc)Y = a – mpcT + I + G

Finally we get:

Expenditure multiplier

Imagine the government wishes to affect the economy. One tool available is government consumption, G, or government taxes, T. This is called “fiscal policy”.

Any change in G (∆G) in our AE model will produce:

Multiplier

If mpc=0.75, then the multiplier is (1/0.25) or 4, so $1 of new G will produce $4 of new Y.

Our multiplier is equal to 1/(1-MPC).

Since 0

The larger is the MPC, the larger is our multiplier.

Deriving aggregate demand

How do average prices affect demand for goods and services?

Wealth effect: higher prices means our assets have less value so people are poorer and consume less.

Interest rates: higher prices drive up the demand for money and so drive up interest rates, at higher interest rates, investment falls (see later)

Net exports: at higher Australian prices, foreign goods are cheaper, so net exports falls (see later)

As the average price level rises, demand for goods and services should fall, with all else held constant.

Aggregate demand

We would like to have a relationship between the demand for goods and services and the price level. We call this the “aggregate demand” (AD).

The AD curve is downward-sloping in prices.

Shifts of the AD curve

Factors that affect the AE curve will affect the AD curve. For example, if household wealth rose, then C would increase for all levels of disposable income. Demand would be higher for all levels of prices, so the AD curve shifts to the right.

I: interest rates, business expectation about the future, technology

G and T: changes in fiscal policy

NX: the currency exchange rate, change in output in foreign countries

AD and the multiplier

A change in I will shift the AE curve up. This will produce a shift to the right of the AD curve.

The shift in the AD curve will be the change in I times the multiplier.

Aggregate supply

Likewise, there must be a relationship between goods supply and the average level of prices- the aggregate supply (AS) curve.

How do prices affect goods supply?

Short-term: Since wages are determined by contracts, wages do not change in the short-term. A rise in prices holding wages fixed means that firms are making higher profits on production, so firms will expand supply of goods.

Long-term: Wage contracts will be renegotiated if prices rise. In the long-term, we would expect that there is no relationship between goods supply and prices.

Aggregate supply

There will be a short-run AS curve which is upward-sloping in prices.

The long-run AS curve is vertical at the level of potential output, since wages will change proportionately to price changes.

What factors will shift the AS curves?

Changes in prices of inputs, like land, capital energy or entrepreneurial skill

Changes in technology that affect productivity

Changes in taxes, subsidies or laws affecting business productivity

Shift in AD

Shift in AD in the SR

The price level rises, which pushes the AE curve back down to where the AD-AS curves intersect.

But output is above the potential rate of output at point C. This means that there is a shortage of labour and will push up wages.

Shift in AD in the LR

In the long-run, workers renegotiate wages based on the higher prices. This raises the cost of production to firm and shifts the short-run AS curve to the left.

It is only when we get back to potential output that wages stop rising, at point A’.

Investment

Investment refers to the purchase of new goods that are used for future production. Investment can come in the form of machines, buildings, roads or bridges.

What determines investment?

Businesses make an investment if they expect the investment to be profitable.

Investment decision-making

How to determine profitability of investment?

Example: An investment involves the current cost of investment (I). The investment will pay off with some flow of expected future profits. The future stream of profits is R1 in one year’s time, R2 in two year’s time, … up to Rn at the nth year when the investment ends.

Net Present Value (NPV) = Present Value of Future Profits (PV) – Investment (I)

Interest rates

Interest rates are a general term for the percentage return on a dollar for a year:

that you earn from banks for saving

that you pay banks for borrowing or investing

For example, the interest rate might be 10%, so if you put $1 in the bank this year, it will become $(1+i) in one year’s time.

Or if you borrow $100 today, you will have to repay $(1+i)100 next year.

Interest Rates

Discounting future values

How do we place a value today on $1 in t years’ time?

This is called “discounting” the future value. One way to think about this question is to ask:

“How much would we have to put in the bank now to have $1 in t years’ time?”

Money in the bank earns interest at the rate at the rate i, i>0. If I put $1 in the bank today, it will grow to be $(1+ i)1 in one year’s time, will grow to be $(1+i)(1+i)1 = $(1+i)2 in two years’ time and will grow to $(1+i)n in n years’ time.

How much is a future $1?

In order to have $1 next year, we would have to put x in today:

$1 = (1+ i) $x

x = 1/(1+i)

$1 next year is worth 1/(1 + i) today. Since i>0, $1 next year is worth less than $1 today.

In order to have $1 in n years’ time, we would have to put x in today:

x = 1/(1+i)n

$1 in n years’ time is worth 1/(1+i)n < 1 today.

Net present value

NPV = R1/(1+i) + R2/(1+ i)2 + … + Rn/(1+ i)n – I

If NPV >=0, then go ahead and make the investment. If NPV < 0, then the investment is not worthwhile.

As i rises, the PV of future profits will drop, so the NPV will fall. If we imagine that there are thousands of potential investments to be made, as i rises, fewer of these potential investments will be profitable, and so investment will fall.

We expect then that I falls as i rises.

Investment

If we graphed the investment demand for goods and services (I), it would be downward-sloping in i.

What can shift the I curve? Factors that affect current and expected future profitability of projects:

New technology

Business expectations

Business taxes and regulation

Money

Money has three main functions in the economy.

Money is a medium of exchange. We use exchange money when we buy/sell to each other.

Money is a unit of account. Money is an agreed measure for stating the value of other goods and services.

Money is a store of value. Money can be kept under the bed or inside a jar and used to exchange for goods and services in the future.

M1 is the amount of notes and coins (“currency”) in circulation plus current deposits with banks.

M3 is M1 plus all other bank deposits.

Credit cards are not counted as money, since using a credit card is accumulating debt, whereas deposits at a bank can be turned into money without accumulating debt.

Money multiplier

What happens when you take $1 cash to a bank to deposit it?

(1) You deposit the cash in the bank, and the bank creates an account for you with $1 in it.

Money = $1

(2) The bank doesn’t keep the cash. Instead the bank has to keep R, called the “reserve ratio” (0 < R < 1), of the $1 as reserves and then loans out $(1 - R).

(3) The person who receives the loan of $(1-R) spends the cash, and the merchant who receives the $(1-R) puts that in his bank. This increases the merchant’s account by $(1-R).

Money = $1 + $(1-R)

Money multiplier

(4) The second bank keeps $R(1-R) as reserves and loans out $(1-R)(1-R) = $(1-R)2 as new loans.

So for every $1 floating in the economy in currency, we have $1/R in currency plus deposits in the economy. This ratio m = 1/R is called the “simple money multiplier”. For every $1 in currency that the government prints, the money supply increases by m.

Equilibrium in the money market

Equilibrium in the money market means supply of money equals demand for money.

Supply of money

The supply of money depends on the level of currency in the economy and the money multiplier. The supply of money does not depend on the interest rate.

Demand for money

People require money to make purchases, ie. How much currency is in your pocket?

Demand for money

The higher is income and prices, the greater the amount of money required to make the purchases people will wish to make.

But a $1 in your pocket is a $1 not in the bank. In the bank, that $1 would be accumulating interest, but in your pocket, it accumulates no interest. So the interest rate is the price of holding money as currency rather than as a deposit in the bank. So we would expect that as the interest rate rises, people will lower the level of currency that they hold.

The demand for money is downward-sloping in the interest rate, i, and increases in income and prices.

Equilibrium in the money market

The supply of money does not depend on the interest rate, so it is vertical.

The interest rate is the price of holding wealth as currency, so money demand falls as i rises.

Monetary policy

The government can control the supply of money and thus the interest rate. These actions are called “monetary policy”.

“Open market operations” are a means of the government controlling the supply of money. The government (in our case the Reserve Bank of Australia or RBA) buys and sells government securities, such as government bonds to control the amount of money in the economy.

If the RBA buys a bond with currency, the RBA increases the money supply (by the change in currency times the money multiplier).

Monetary policy

If the RBA sells bonds for currency, it decreases the supply of money.

Monetary policy shifts the money supply curve and so changes the equilibrium interest rate.

Resources

There are many resources available to you. Often students hurt themselves by not taking advantage of the resources they have.

Books: There are plenty of macroeconomics principles books. If you don’t understand Jackson and McIver’s coverage, get to a library and read a different textbook. There is also a study guide by Bredon and Curnow referenced in the subject outline.

Online: There is an enormous amount of material on the Web. Just use a search engine and look around.

Resources

Forum: Get into a habit of reading the CSU forums once a week. Post questions on the forum and join in the discussion.

Official websites: Have a look at the websites for government agencies like the Reserve Bank of Australia or the Australian Bureau of Statistics.

CSU help: Student Services at CSU has a lot of help it can provide students with problems- look at http://www.csu.edu.au/division/studserv/.

Tips for preparing for the exam

Practice. Do the problems in the back of the book chapters. Do the problems on the book’s website. Do the problems in the study guide.

Read the question. Read carefully.

Answer the question. Don’t answer the question you think was asked. Answer the question that actually was asked. Most exam errors happen here. Remember to read the question.

Tips for preparing for the exam

Be sure to answer all of the question.

Don’t put down too much. Don’t provide a whole background of a model unless the question asks for it. If the question asks you to analyse a scenario, go straight into the scenario.

Don’t put down too little. In an essay question, provide your reasoning and analysis. Draw a relevant graph and talk about the graph. Don’t just say “Yes.”

Final exam tip

Don’t panic! Relax and breath. You do not need to write for 3 hours to do well in an economics exam. Often a well-ordered sentence is worth more than 2 pages of semi-coherent babbling. Stop and think about your answer.