I

Macroeconomics Unit 2 – Comprehensive Bullet-Point Notes

Unit 2 Road-Map & Syllabus Focus

• Scope: introduction to macroeconomics, circular-flow model (five sectors), GDP (expenditure approach), equilibrium, leakages/injections, skills in diagrammatic & mathematical communication.
• Core equation for GDP: GDP = C + I + G + (X - M).
• Skill expectations: precise terminology, calculation of circular-flow variables, clear diagram use.

Why Macroeconomics Matters

• Looks at the economy “as a whole”, whereas microeconomics zooms in on individual markets.
• Shapes employment, income, taxation, and the goods & services governments deliver.
• Political relevance: policy promises evaluated through macro lenses.
• Detective analogy: economists collect data, build hypotheses, test with models.
• Grand questions addressed:
– Why are nations rich/poor?
– What drives inflation/deflation?
– What sets unemployment rates & how do we create jobs?
• Standing on the shoulders of Ricardo, Keynes, Smith, etc.

Essential Macroeconomic Data to Track

• Output & income: GDP, retail sales, construction volumes.
• Price stability: CPI, inflation rate, Terms of Trade (export vs import prices).
• Labour market: unemployment rate, employed persons.
• External sector: balance on goods & services, current account balance, net foreign debt.
• Policy indicators: cash rate, budget surplus/deficit.
• Trend analysis > single-data-point observation.

Aggregate Demand (AD) & Aggregate Supply (AS)

• AD = total planned spending on domestic g&s over a period.
• AS = total real value of final output produced.

Australia’s Macroeconomic Objectives

• Sustainable growth: GDP target \approx 3.5\% pa.
• Price stability: CPI inflation 2\text{–}3\% pa.
• Full employment: unemployment \approx 4.5\% (zero cyclical).
• Equitable income distribution: monitored via Gini coefficient/Lorenz curve.
• Efficient resource allocation: achieve allocative & productive efficiency.

Economic Sectors & Their Motivations

• Households: resource owners, consumers, savers.
• Firms: producers, employers, investors.
• Government: regulator, producer, redistributor, tax collector.
• Financial institutions: intermediaries between savers & investors.
• Overseas: buyers/sellers of exports & imports.

Modelling the Economy – Circular Flow of Income (CFI)

Purpose & Insights

• Simplifies complex reality, reveals interdependence, highlights production ↔ income ↔ expenditure identity.
• Real flow (resources & g&s) mirrors money flow (payments & receipts).

Two-Sector Model (Households & Firms)

• Assumptions: no savings, all output bought by households, no government, no trade.
• Identity: O = Y = E.

Limitations → Need Extra Sectors

• Financial, Government, Overseas add realism & new leakages/injections.

Financial Sector

• Banks create capital market; channel S to I.
• Savings (leakage) = income not consumed.
• Investment (injection) = spending on capital goods, boosts future AS.

Government Sector

• Taxes T are leakages; government expenditure G reinjects funds.
• Transfer payments counted in C when households spend them.
• ~20 % of Australian workforce employed by government.

Overseas Sector

• Imports M = leakage; Exports X = injection.
• Globalisation has magnified export-led growth.

Flows & Markets

• Two flows:
– Real: resources → firms; g&s → households.
– Money: C, S, I, T, G, X, M.
• Four markets: factor, product, financial, overseas.

Leakages vs Injections

• Leakages = S + T + M.
• Injections = I + G + X.
• Equilibrium condition: S + T + M = I + G + X.

Measuring Economic Activity in CFI

• Aggregate Output (AS) – value of real flow from firms.
• Aggregate Income – money flow to households.
• Aggregate Expenditure (AD) – C + I_p + G + (X - M) money flow to firms.

Equilibrium & Disequilibrium Dynamics

• If leakages = injections → stable Y, O, E.
• \text{Leakages} > \text{Injections} → contraction, recessionary pressure.
• \text{Leakages} < \text{Injections} → expansion, upswing.

Adjustments Toward Equilibrium

• Starting premise: at equilibrium Y = C + S and S = I (two-sector).
• Example (slide 36):
– Output =\$2000 → Income =\$2000.
– Households spend \$1600 (80 %) → save \$400 (20 %).
– For equilibrium I must equal \$400.
• Disequilibrium scenario: firms raise I to \$600 → I>S → CFI expands.

Calculating Period-by-Period Adjustments

  1. Compare I and S; compute \Delta Y = I - S.

  2. Add \Delta Y to previous income to get new Y.

  3. Re-compute C and S using original propensities.

  4. Iterate until I = S.

The Multiplier (Shortcut to New Equilibrium)

• Marginal Propensity to Consume (MPC) = share of extra income spent.
• Formula: k = \frac{1}{1 - MPC} (Keynesian multiplier).
• Total income change: \Delta Y = k \times \Delta I (or any injection).
• Illustration (slide 50):
– MPC = 0.8; k = 5.
– Initial \Delta I = \$50 (because 250 - 200).
– \Delta Y = 5 \times 50 = \$250 → new Y = 1250.

Worked Examples Recap

Question 1 (Base Y=1000, MPC 0.8, I\uparrow 250)

• Period adjustments: Y moves 1000 → 1050 → 1090 → 1122 … trending to 1250.

Question 2 (Base Y=4000, MPC 0.75, I\uparrow 1500)

• k = 4, final Y = 4000 + 4(500) = 6000 (note slide typo shows 5×50).

Question 3 (Base Y=8000, MPC 0.75, I\uparrow 3000)

• k = 4, \Delta Y = 4(1000) = 4000 → new equilibrium Y = 12000.

Consolidated Take-Aways on Equilibrium

• In a multi-sector CFI equilibrium is rare; shocks & independent decisions keep S \neq I, T \neq G, M \neq X.
• Macro policy aims to modulate injections/leakages to stabilise growth & employment.

Aggregate Expenditure (AE) Framework

• Definition: AE = C + I + G + (X - M).
• Typical Australian shares:
– C \approx 55\% of GDP.
– I \approx 16\text{–}25\% (volatile).
– G \approx 25\%.
– (X-M) \approx -3\% \text{ to } +5\%.

Key Term Glossary

• Consumption (C): household spending on g&s.
• Disposable income: post-tax income available for spending/saving.
• Private investment (I): capital goods purchases to expand productive capacity.
• Government expenditure (G): all three levels; split into G1 (recurrent) & G2 (capital/stabilisation).
• Net exports (X-M): export revenue minus import spending; trade balance.

Consumption Component in Detail

• Durable goods (~15 %): furniture, appliances; discretionary & postponable.
• Non-durable goods (~35 %): food, fuel; necessities.
• Services (~55 %): healthcare, insurance; largest & growing share.
• Five drivers of C:

  1. Disposable income level.

  2. Cost & availability of credit.

  3. Household wealth (housing, shares).

  4. Expectations / consumer confidence.

  5. Fiscal policy (tax changes, transfers).

Planned Investment Component

• Sub-categories: fixed (machines/buildings), residential, inventories.
• Alters capital stock → shifts long-run AS.
• Five drivers of I:

  1. Risk/uncertainty (political, global, consumer tastes).

  2. Real interest rate r{real} = r{nominal} - \pi (inflation-adjusted).

  3. Business confidence/expectations.

  4. Current profit levels & retained earnings.

  5. Government policy incentives (tax concessions, subsidies).

Real vs Nominal Interest Rate Illustrations

• Example 1: r{nominal}=3\%, \pi = 2\% \Rightarrow r{real}=1\% → modest cost of capital.
• Example 2: r{nominal}=3\%, \pi = 5\% \Rightarrow r{real}=-2\% → investors repay with “cheaper dollars”, encouraging borrowing.

Government Spending Component

• \approx\$400\text{bn} injection annually; surged during COVID-19 response.
• Budget split:
– Structural (allocative & redistributive) e.g.
• Public/merit goods: health, education.
• Transfers: social security.
– Cyclical (stabilisation) adjusts with business cycle.
• Two determinants of G:

  1. Position in business cycle (expansionary vs contractionary fiscal stance).

  2. Political ideology (interventionist vs market-oriented).

Net Exports Component

• Trade balance = exports minus imports; currently surplus.
• Four determinants:

  1. Domestic business cycle (income-elastic imports).

  2. Trading-partner business cycles (export demand).

  3. Exchange rate movements (AUD appreciation → X↓, M↑).

  4. Terms of Trade (export price:import price ratio).

Ethical & Practical Implications Highlighted

• Equitable income distribution objective underscores fairness in policy design.
• Government’s stabilisation role raises debates: size of public sector, inter-generational debt.
• Real interest rate concept protects lenders’ purchasing power & guides responsible borrowing.

Big-Picture Summary

• Macroeconomics uses models, data and theory to decode real-world phenomena, guide policy, and predict outcomes.
• CFI establishes foundational identity O = Y = E; adding sectors reveals crucial leakages & injections.
• Equilibrium is an analytical benchmark; dynamic disequilibrium (shocks) is the norm.
• The multiplier magnifies initial injections, informing fiscal-policy potency.
• Understanding each AE component and its determinants is essential for explaining and managing aggregate demand—and ultimately, the level of national income, employment, and price stability.