12ECO EA

Topic 1 and 3 + assumed knowledge

Six goals of the government and RBA

1. OVERARCHING: Sustainable economic growth

   • Steady rise in real GDP that the economy can maintain over time

2. Macroeconomic objective 1: full employment

   • Everyone willing and able to work can find a job (low cyclical unemployment)

3. Macroeconomic objective 2: Price stability

   • Low, stable inflation that keeps money's purchasing power

4. Macroeconomic objective 3: external stability

   • A sustainable current account, foreign debt, and exchange rate

5. Macroeconomic objective 4: Sustainable development

   • Growth today that doesn't degrade the environment for the future

6. Macroeconomic objective 5: improved SOL

   • Higher real incomes plus better health, education and wellbeing

How we measure whether objectives are met

Objective	Target/benchmark	Key indicator	Latest (AU)
Economic growth	3-4% real GDP p.a.	Real GDP growth	2.5% p.a.
Full employment	4-5% (NAIRU)	Unemployment rate	4.5%
Price stability	2-3% inflation (RBA)	CPI/Inflation rate	4.2%
External stability	Sustainable CAD and debt	Current account, %GDP	Net foreign liabilities 24.5%
Living standards	Rising real income	Real GDP per capita	+1.0% through the year

Trade-off of Growth vs inflation

• Strong AD lifts output and jobs

• Near full capacity, demand-pull inflation rises

• Fash growth strains price stability

  • If the economy is growing too fast, AD can increase faster than the economy's ability to produce goods and services and when demand exceeds supply, businesses may rise prices leading to inflation

Trade-off for unemployment vs price stability

• Short-run Phillip’s curve: Lower unemployment causes inflation to rise because people have more income and therefore spending increases

• Stimulating AD through the gov or RBA reduces unemployment (employment increases) but increases inflation

• Long-run: no stable or permeant trade-off between inflation and unemployment due to the NAIRU -> This means that there is a level of unemployment that the economy naturally settles around

Trade-off for external stability vs domestic growth

• Rising incomes pull in more imports -> if people earn more money some of that spending will likely be on imported goods and services

• Current account deficit (CAD) widens -> occurs when the value of imports is greater than the value of exports and reduces external stability

• Balance-of-payments constraint on growth -> a country can't increase imports if it is not earning enough from exports otherwise foreign debt may increase etc.

  • Therefore, strong economic growth increases incomes and spending, however, if that spending is on imported goods and services, the CAD can widen, reducing Aus' external stability, creating ad trade-off between domestic growth and a sustainable BoP

Unemployment and infaltion trade-off graph

If you want lower unemployment in the short run, you have to accept higher inflation

*IMPORTANT NOTE:

• Unemployment increases ⟶ more people are without jobs

• Unemployment decreases ⟶ more people are employed

READ THIS GRAPH RIGHT TO LEFT - as unemployment decreases (employment increases), inflation increases and visa versa; if unemployment increases (more people without a job) then inflation decreases

Calculating the inflation rate

Inflation rate = (new CPI - Old CPI) x 100

                                     old CPI

Calculating the unemployment rate

Unemployment rate = unemployed x 100

                                         labour force

Calculating CPI

CPI = cost of basket x 100

        base-year basket

How demand and supply set output, prices, and jobs (graph)

Percentage change calculation

% change = (new - old) x 100

                           old

When to use it:

• Economic (real GDP) growth rates

• Inflation from a CPI series

• Comparing any value across time

Points and Basis Points

Percentage point (pp):

• The simple difference between two percentages

  • e.g. 4% to 4.5% = 0.5% pp (NOT +0.5%)

Basis point (bp):

• One-hundredth of a percentage point.

  • 100bp = 1pp

    • 0.25pp = 25 bp

Conversions

• 1 pp = 100 bp

• 0.25 pp = 25 bp

• 0.5 pp = 50 bp

When to use it:

• Interest rates (basis points)

• Unemployment (percentage points)

Nominal vs Real

Nominal: measured at current prices - includes inflation

Real: adjusted for inflation - constant prices, true volume

 

Why this matters:

• Strips out price changes to reveal real growth

• Shows true purchasing power of incomes

• Let's us compare fairly across years

Calculations:

• Real GDP = Nominal GDP x 100

                     GDP deflator -> REAL GDP?

• Real wage growth = nominal wage growth - inflation

• Real interest rate = nominal interest rate - inflation

What moves the AD curve right (shift)

AD SHIFTS RIGHT

• RBA cuts the cash rate -> C and I rise

• $A depreciates -> X up, M down

• Rising consumer/business confidence

What moves the AD curve left (shift)

AD SHIFTS LEFT

• RBA raises the cash rate -> C and I fall

• Government cuts spending (G decrease)

• Falling confidence, higher taxes

SRAS vs LRAS: costs now vs capacity later

	SRAS	LRAS
Slope	upwards	vertical - set at the economy's potential output
Timeframe	short run - some input costs (wages) are sticky	long run: all costs adjusted; full employment
Shifts with	input costs - wages, energy oil, the $A, productivity	resources, labour force, capital, technology, skills - if the LRAS shifts outwards then the economy's productive capacity has increased
Exam cue	a cost sock moves SRAS (e.g. good price spike)	A capacity change moves LRAS (e.g. productivity gain)

What shifts the SRAS supply curve LEFT?

COST-PUSH

• Oil/energy price spike, drought, wage surge, or a weaker $A raising import costs -> production is dearer -> higher prices and lower output (stagflation risk)

What shifts the LRAS RIGHT?

CAPACITY INCREASE

• New technology, more skilled workers, investment in capital, or migration -> potential output grows -> sustainable growth with little inflation

Macroeconomic equilibrium - how AD, AS price level and employment connect

• Output (real GDP) - Y* is where AD meets SRAS which is the actual level of production this year

• Price level - P* is the equilibrium price level; changes in it are inflation or deflation

• Employment - more output needs more workers, so Y* sets the level of employment

Economic cycle and the multiplier

Connection: a spending injection sets off a multiplier ripple that lifts national income - and that’s what pushes the economy from one phase of the cycle to another.

1. Recovery

2. Boom

3. Contraction

4. Recession

Marginal Propensity to Consume (MPC)

• Tracking the money in the economy

• Consumers actual spending/incentive to send

• Bakery example: someone spends which gives someone else money, so they spend and give someone else money

  • The amount the money grows is the multiplier (K)

• Incitement for people to spend so that money can circulate through the economy

• K (multiplier) = 1/(1-MPC)

Marginal Propensity to Save (MPS)

• Government would add money into the economy to attempt to stimulate the economy but due to economic conditions e.g. uncertainty or instability, people would choose to save that money

• Based on economic conditions

• Leakage

• K = 1/MPS

Cyclical unemployment

Caused by an economic downturn - too little AD. It is characterised by a decrease in demand for goods and services leading to job losses as companies reduce their workforce to cut costs.

• DIRECTLY RELATES TO THE BUSINESS CYCLE → contraction

Structural unemployment

Long-term unemployment caused by economic changes or tech innovations that result in the skills of workers not aligning with the needs of employers.

• Skills, industry or location mismatch as the economy changes

Frictional unemployment

Short-term unemployment that occurs when workers look for new employment or transition out of old jobs and into new ones.

Seasonal unemployment

Temporary job loss that occurs at predictable times of the year due to fluctuations in demand for labour in certain industries.

Common industries:

• agriculture, tourism, retail, and construction

Hidden unemployment

Hidden unemployment includes people who are technically employed but not fully utilizing their skills or working fewer hours than desired, as well as those who have stopped seeking work due to discouragement

Long-term unemployment

Unemployed for 52 weeks or more -> skills erode

Under-employment

Employed, but wanting and available for more hours

• Underutilisation of labour resources

Labour market concepts (4 main ideas)

1. Labour force: everyone of working age (15+) who is either employed or actively looking for work. Excludes students, retirees, and carers not seeking work

2. Participation rate: the share of the working-age population that is in the labour force -> a gauge of how engaged people are with work

   • Participation rate = labour force / working-age population x 100

3. Underutilisation: the unemployed PLUS the underemployed -> a broader measure of wasted labour capacity

4. NAIRU: the non-accelerating-inflation rate of unemployment -> the lowest jobless rate sustainable before inflation starts to rise

Unemployment/labour market calculations

Participation rate = labour force/working-age population x 100

Unemployment rate: unemployed/labour force x 100

Underutilisation rate = (U + UE) / labour force x 100

NAIRU

The lowest unemployment rate that can be sustained without causing inflation to accelerate.

Why isn't unemployment 0% at full employment?

Because even when the economy is strong, there will always be some people:

• changing jobs → frictional unemployment

• whose skills don't match available jobs → structural unemployment

NAIRU and cyclical unemployment

What happens when unemployment is above the NAIRU?

There is cyclical unemployment. The economy has spare labour resources, usually because aggregate demand is insufficient.

What happens when unemployment falls below the NAIRU?

Labour shortages increase → wages rise → production costs rise → inflationary pressure increases, causing inflation to accelerate if the situation persists.

*If there is no cyclical unemployment, the economy is at full employment

Three NAIRU situations

Recessionary Gap

A recessionary gap occurs when the economy is producing less than it could at full employment because aggregate demand is too low, leading to underutilised resources and higher unemployment.

• relates to cyclical unemployment → therefore BUSINESS CYCLE

• there is NO LONGER full employment

Recessionary gap diagram

Initial economy:

The economy starts at:

AD₁ + SRAS → Yf

Here, output is Yf, the full-employment level.

So, the economy is at full employment, with unemployment at approximately the NAIRU.

THEN

Something causes AD to fall for example:

• Consumer confidence falls → households spend less → C ↓

• Business confidence falls → firms invest less → I ↓

• Exports fall → X ↓

• Government spending falls → G ↓

• Interest rates rise → consumption and investment fall

Therefore, AD curve shifts left.

SO

Consumers/businesses are buying fewer goods and services → businesses reduce production → they don't need as many workers which leads to higher unemployment

• Unemployment increases above the NAIRU.

---

3. Businesses now sell fewer goo

NAIRU and AD curve movement

The key rule

AD falls → unemployment rises → unemployment goes ABOVE the NAIRU.

AD rises strongly → unemployment falls → unemployment can go BELOW the NAIRU.

Why lower unemployment creates inflation

If unemployment falls from 4% to 3% (below the NAIRU), there are more people employed and fewer unemployed workers available for businesses to hire.

Businesses then compete for workers by offering higher wages, which increases production costs. Businesses may then increase prices, creating upward pressure on inflation.

How to measure inflation

• CPI

• Headline and underlying inflation

Consumer Price Index (CPI)

The average price of a fixed basket of goods and services, set to 100 in a base year. Its % change is the inflation rate.

Percentage change = new-old/old x 100

Headline inflation

The % change in the whole CPI. It includes everything measured in the Consumer Price Index (CPI), including volatile things whose prices can jump around a lot, such as:

• petrol

• fruit and vegetables

• electricity

• other volatile items

Example:

Imagine the CPI basket costs $100 → then petrol prices suddenly rise and the basket costs $104.

➡ Headline inflation = 4%

It tells us about the actual overall change in the cost of the CPI basket.

Underlying inflation

A measure designed to remove temporary or unusually large price movements/volatile movements so we can see the more persistent inflation trend.

This is used, alongside headline inflation, to see whether inflation is between the target range of 2-3%.

Demand-pull inflation

This occurs when aggregate demand (AD) increases faster than the economy's ability to produce goods and services.

Triggers:

• Rising C, I, G, or X

• Tax cuts

• Low interest rates

• A spending or credit boom

Best cure:

• Cool demand: higher interest rates or a contractionary fiscal policy

Cost-push inflation

This occurs when the costs of producing goods and services increase, causing businesses to raise their prices.

Triggers:

• Oil/energy shocks, wage rises above productivity, dearer imports, a lower $AUD

Best cure:

• Ease the cost pressure; supply-side reform (MICROECONOMIC REFORM). Demand policy alone can't win

Deflation and the deflationary spiral

Deflation is a sustained fall in the general price level - negative inflation.

A deflationary spiral is a self-reinforcing cycle where falling prices cause consumers to expect further price falls which delays spending.

This reduces AD and firms' revenue, causing firms to cut production and employment, reducing household incomes and spending further, leading to even lower prices.

Causes:

• Deflation can happen when demand drops sharply. With fewer people buying goods and services, businesses lower their prices to attract customers.

Why is it dangerous:

• Falling prices raise the real burden of debt and delayed spending deepens downturn

Policy difficulty:

• Interest rates hit the zero lower bound (can't be lowered further), so cutting them further can't revive spending or stimulate AD

Stagflation

STAGFLATION = SUPPLY-SIDE

Stagflation is rising inflation and rising unemployment at the same time - stagnation plus inflation

Stagnation: a period of slow or no economic growth

Inflation: rising prices

e.g. businesses face higher production costs which leads to inflation but also has to produce less as they can’t afford to make more with inflation which leads to stagnation.

Cause:

• A supply shock shifts SRAS left causing prices to increase and output to decrease at the same time

Dilemma:

• Fight inflation and unemployment worsens; fight unemployment and inflation worsens. Needs supply-side intervention (MICROECONOMIC REFORM)

Types of fiscal policy

Expansionary fiscal policy - boosts AD through more spending or lower taxes to fight unemployment.

Contractionary fiscal policy - slows AD through less spending or higher taxes to fight inflation.

Budget revenue → how tax is raised

Most budget revenue is taxation. Tax is classified two ways: who collects it and how, and what happens to the tax rate as income rises

• By collection point

  • Direct taxation: levied on income or wealth and is paid straight to the government - personal income tax, company tax

  • Indirect taxation: levied on transactions and passed on in prices - GST, excise on fuel, alcohol and tobacco

• By rate structure:

  • Progressive: average tax rate rises as income rises - aims at vertical equity - AUSTRALIA'S TAX SYSTEM

  • Proportional: same rate at every income - a flat tax e.g. the 2% Medicare levy, company tax

  • Regressive: average rate falls as income rises - flat taxes on spending like GST take a bigger share of low incomes

Types of tax graphs - progressive, proportional, regressive

Calculation for average tax rate

Average tax rate = tax paid/income x 100

 

Government expenditure: where tax goes

• Current (recurrent) spending: day-to-day running costs - public sector wages, defence operations, service delivery

• Capital spending: investment in long-term assets - roads, hospitals, schools and rail; builds capacity

• Transfer payments: income support with no good or service in return - pensions, Jobseeker, family payments

• Public utilities: provision of essential services - water, electricity, and public transport

• Merit goods: goods society under-consumers if left to the market - education and healthcare

Automatic stabilisers - fiscal policy

• How: built in features that adjust with no new policy decision - progressive tax and welfare

• In a downturn: tax revenue falls and benefits rise, cushioning the fall in AD

• In a boom: tax rises and benefits fall, dampening AD and inflation

Discretionary stabilisers - fiscal

• How: deliberate changes announced in the budget - new spending or tax measures

• Example: a stimulus package (stimulate the economy), and infrastructure program, or an income tax cut

• Trade-off: powerful and target, but exposed to time lags and politics

Budget outcomes

The Budget outcome compares revenue with expenditure. Its direction of change - not just its sign reveals the fiscal stance.

 

Deficit - G > T (gov spending is greater than taxation revenue)

• Spending exceeds revenue; financed by borrowing, adding to public debt

Balanced G = T (spending = tax)

• Revenue equals spending; a neutral position over the year

Surplus T > G (tax is greater than spending)

• Revenue exceeds spending; can repay debt or save for the future

Fiscal stances with the budget outcome

Expansionary stance: deficit rising or surplus shrinking as the gov is saving less (spending more) → net injection boosts AD. Used to fight unemployment and recession.

Contractionary stance: surplus rising or deficit shrinking as the gov is saving more → net leakage slows AD. Used to fight inflation and an overheating economy

*TRICK - opposite to what you would think

Expansionary fiscal policy on AD/AS

• The mechanism: higher G (gov spending) or lower T (tax) injects spending; the multiplier re-spends it, so AD shifts right by a multiple

• The effect: real output rises from Y1-Y2 towards full employment; jobs grow with a small rise in the price

Strengths of expansionary fiscal policy

• Direct and target: Government spending injects straight into the economy and can be aimed at regions or sectors

• Strong in deep recessions works when monetary policy is weak - rates near zero can't fall much further

• The multiplier effect: the initial injection is re-spent, amplifying the impact on output and jobs

Limitations of expansionary fiscal policy

• Time lags: recognition, decision (the Budget cycle) and implementation delay the impact

• Crowding out: government borrowing can raise interest rates and lead to less private investments (due to less money available)

  • Crowding out occurs when increased government borrowing raises interest rates, making it more expensive for businesses to borrow and invest, reducing private sector investment.

• Deficits and politics: raising debt and interest costs, and spending that is easy to start but hard to reverse

  • if the gov spends more money, then the budget deficit will increase

When expansionary fiscal policy should be used

Expansionary fiscal policy is most effective in a deep downturn with spare capacity and least effective when the economy is near full employment as this mainly adds to inflation and debt.

RBA role and goals → monetary policy

Role:

• Sets the cash rate -> sets the overnight cash rate target at its monthly board meetings - the anchor for all interest rates

• Acts independently -> operates at arm's length from the government, so decisions rest on economic not political grounds 

Goals/objectives:

• Price stability: keep consumer price inflation within the 2-3% target band

• Full employment: support maximum sustainable employment - low unemployment without fuelling inflation

• Economic prosperity: promote the economic welfare and prosperity of the Australian people over the medium term

Monetary policy → Inflation targeting

• The target: keep annual CPI inflation between 2-3% over the medium term

• Why a band not a point: a range gives flexibility to look through temporary price shocks without overreacting

• On average, over time: met across the cycle, not every quarter, so short spikes need to trigger a move

• Anchoring expectations: a credible target keeps household and business inflation expectations stable and self-fulfilling

• Above the band: if inflation runs too high, the RBA tightens its policy by raisin the cash rate to cool demand back into the target

Loosening vs tightening monetary policy

Expansionary (loosening)

• How: cut the cash rate so borrowing is cheaper and saving is less rewarding

• Used when: the economy is weak - unemployment rising and inflation below target -> to stimulate the economy

• Effect: spending and investment rise, lifting AD, output and jobs

Contractionary (tightening)

• How: raise the cash rate so borrowing is more expensive and saving is more attractive

• Used when: the economy is overheating - inflation above the 2-3% band

• Effect: spending and investment fall, easing AD and cooling inflation

The transmission mechanism → monetary policy

A change in the cash rate does not hit output directly. It works through a chain of steps that takes 12-18 months to play out.

Step 1: cash rate

• The RBA moves the cash rate; banks pass it on to lending and deposit rates

Step 2: behaviour

• Cheaper credit lifts borrowing, consumption and investment; a lower dollar aids exports

Step 3: economy

• AD shifts, changing output, employment, and finally inflation

*A rate cut: cash rate decreases, -> borrowing increases -> savings decrease -> the AUD depreciates -> C, I and net exports increase -> AD increase -> output and jobs increase

*a rate rise: cash rate increases -> borrowing decreases -> saving increases -> the AUD increases -> C, I, and net exports decrease -> AD decreases -> inflation eases

A cash rate cut on the AD/AS

• The mechanism: a lower cash rate cuts borrowing costs, lifting consumption and investment so AD shifts right to AD2

• The effect: real output rises from Y1->Y2 towards full employment; jobs grow, with a small rise in the price level

Strengths of monetary policy

• Flexible and fast: the RBA board can change the cash rate every month - far quicker than the annual Budget

• Independent and credible: free of the political cycle, so decisions target inflation and are trusted by markets

• Broad reach: rate changes ripple through borrowing, spending, the AUD, and asset prices economy-wide

Limitations of monetary policy

• Time lags: the full effect on inflation can take 12-18 months to arrive

• Blunt instrument: one national cash rate cannot target particular regions or struggling sectors

• Weak when rates are low: near zero, there is little room to cut, and low confidence may deter borrowing anyway.

Why do governments use supply-side policy

The goal: expand what the economy can produce

• shift LRAS to the right

Supply-side and macroeconomic policies aim to lift the economy's productive capacity and its efficiency, shifting LRAS right rather than just managing demand.

1. Productivity: more output per worker and per unit of input - the engine of real income growth

2. Efficiency: resources flow to their most valued use; less waste in production and allocation

3. Competitiveness: lower costs and better-quality lift export capacity and international competitiveness

4. Long-run growth: a sustained rightward shift in the LRAS raises potential GDP without added inflation

SRAS

A rightward shift in SRAS occurs when production costs decrease or productivity increases, allowing firms to produce more at each price level.

Examples:

• Lower wages

• Lower energy costs

• Lower business taxes

• Improved productivity

LRAS

A rightward shift in LRAS occurs when the economy's productive capacity increases through growth in resources, skills, capital, or technology.

Examples:

• More workers

• Better education and training

• Increased investment in capital

• Technological advancements

Distinguishing between SRAS and LRAS

• SRAS shift affects how much firms can produce now because production costs change.

• LRAS shift increases the economy's potential/full-employment output and raises the economy's long-term "ceiling".

SRAS: upward sloping and shifts with current production costs. Moving it changes prices and output in the short run.

Trigger words:

• Wages

• Energy

• Input prices

• Business tax rates

Effect:

• Prices and output move along the cycle for the short run

LRAS: vertical at potential output and shifts only when productive capacity changes. Moving it right is genuine, sustainable future economic growth

Trigger words:

• Infrastructure

• Education and skills

• R&D

• Innovation

• Deregulation

• Competition reform

Effect:

• Potential GDP rises - sustainable, non-inflationary growth

Five supply-side levers - and the curve that it moves on the AD/AS

1. Infrastructure

   • Transport, energy, and digital networks cut logistic costs and unlock private investment

   • LRAS right shift - increased productive capacity

2. Education and training

   • A more skilled workforce raises labour productivity and the quality of human capital

   • LRAS right shift - increased productive capacity

3. Research and development

   • R&D grants and tax offsets expand the technology frontier and future output

   • LRAS right shift - increased productive capacity

4. Innovation

   • New products, processes and firms lift productivity and dynamic efficiency

   • LRAS right shift - increased productive capacity

5. Deregulation

   • Removing barriers boosts competition and allocative efficiency and can also ease current costs

   • LRAS right shift - increased productive capacity

Four reasons governments intervene → economic management

1. Efficiency: steer resources to their most valued use - productive and allocative efficiency

2. Equity: a fairer distribution of income and access to essential goods and services

3. Trade-offs: goals conflict - growth vs inflation, equity vs efficiency. Managing means choosing.

4. Stabilise the cycle: smooth booms and busts: contain unemployment and inflation over the business cycle

*Link between fiscal and monetary policy -> they both manage AD

Demand management vs supply-side policy

Demand management vs supply-side policy

Demand management manages AD

• Tools: fiscal budget and monetary cash rate

• Focus: the short-run business cycle

• Targets: unemployment and inflation

• Acts fast but effects can fade

Supply-side policy raises productive capacity and efficiency

• Tools: infrastructure, education, R&D, deregulation

• Focus: the long run (shifts LRAS right)

• Targets: growth, productivity, competitiveness

• Powerful but works with long lags

*For exam: use demand management to stabilise the cycle then use supply-side policy to lift the long-run growth ceiling