ECON1102 Macroeconomics Flashcards

Week 1: Intro to Macroeconomics

• Macroeconomics studies national and global economies, differing from microeconomics in questions and methodology.
• Key questions:
  • How do choices determine what, how, and for whom goods/services are produced?
  • When do self-interested choices promote social interest?
• Factors of production:
  • Land: natural resources.
  • Labor: work time and effort.
  • Capital: human (skills) and physical (tools, machines).
  • Ideas/Knowledge/Entrepreneurship: resources organizing land, labor, and capital.
• Trade-offs:
  • What: how incomes are spent, government revenue is allocated, and businesses choose production.
  • How: businesses select production technologies.
  • For whom: choices alter buying power distribution; government redistribution creates equality vs. efficiency trade-offs.
• Approaches to conceptualizing the macroeconomy:
  • Top-down: aggregate view.
  • Bottom-up: from micro details to aggregation.
  • Fallacy of composition: sum of parts ≠ whole.
• Model development:
  • Document facts, collect data, develop model.
  • Exogenous variables: inputs determined ahead of time.
  • Endogenous variables: model outcomes.
  • Parameters: fixed inputs, modifiable for experiments.
• Model evaluation:
  • Compare predictions to facts.
  • Test other predictions.
  • Experiment with parameter changes.
• Model usefulness:
  • Good predictive power.
  • Understandable mechanisms.
  • Non-trivial implications.
• Correlation:
  • Statistical relationship, indicates possible causation.
  • Spurious correlations occur by chance.
  • Models are consistent with/falsified by data.
  • Cause precedes and is empirically linked to effect.
  • Assumptions are accepted as true without proof; models are based on logical inferences.

Week 2: Measuring the Macroeconomy

• GDP measures the market worth of final goods/services within an economy over a set time.
  • Flow variable.
  • Production = Expenditure = Income.
• Expenditure Approach to GDP: $Y = C + I + G + NX$
  • Y = GDP.
  • C = consumption.
  • I = investment.
  • G = government purchases.
  • NX = net exports.

Topic 6: Economic Growth

• Drivers of Economic Growth:
  • Policies/legislation.
  • Resources.
  • Technology.
  • Physical capital.
• Production Function represents the relationship between factors of production and output.
• Mathematical Representation: $Y = AK^αL^(1-α)$
  • A: measure of ignorance - anything we don’t know
  • Diminishing marginal product of labor --> keeps capital constant and looks at what happens when labor increases
  • Return to scale concept - how does output increase when all production factors increase by the same out
• The reason that some countries are rich and some are poor is due to technology
• Growth Accounting:
  • Method of dividing a country's historical growth experience between growth in primary and growth in secondary factors of production
  • Economic growth occurs either because the capital stock has grown, the labour supply has grown, or there has been an improvement in the economy’s ability to use labour and capital
• Saving, Investment and Capital plays a key role

The Solow-Swan Growth Model

• Focuses on capital accumulation.
  • Production: $Y = AK^αL^(1-α)$
  • Resource Constraint: $Y = C + I$
  • Capital Accumulation: $K<em>(t+1) = I</em>t + (1 - δ)K_t$
    • δ = depreciation.
  • Labour: $L = L^-$
  • Investment: $I = sY$
    • s = constant investment rate.

Accounting for Productivity Differences

• Solved-swan model does not explicitly capture productivity dynamics  often referred to as a ‘black box’ model of productivity
• Factors: Human Capital, Technology, Institutions, Exogenous shocks
  • Human capital includes health and education
  • Technology includes blueprint of ideas to produce efficently
  • Institutions include property rights, the rule of law, government systems, organisational form of firms, contract enforcement
• Exogenous shocks such as war, famine, plague and death – or more mundane things like oil price shocks

World on Economies of Scale

• Increasing returns to scale are not so easy to model, leading to more mathematical complexity and less theoretical manageability.
• Actual economies are full of increasing returns to scale
• Innovation: OECD estimates that as much as 50 percent of economic growth in its member countries can be accounted for by innovation activity.
• Creative Destruction and Entrepreneurship: economist Joseph Schumpeter coined the term 'creative destruction' to describe the process of entrepreneurial innovation and competition.
• Knowledge, Research and Development and Innovation:The basic models focus on how an idea becomes manifest into physical form (especially a technology) and how that form then becomes commercialised to have impact on an economy.
• Capacity and Capacity Utilization:In the short-run, productive capacity of the economy is fixed.
• Potential v. Actual Output: Potential output is properly calculated at whatever utilization rate is maximum and sustainable (typically around 80-85%).

Topic 6 – Introduction to the Short Run

• Contractions, expansions, business cycle, and growth cycle.
• Key terms: peak, contraction, trough, expansion.
• Economic fluctuations: irregular, global impacts, increased unemployment, decreased inflation in recessions.
• Output gaps:
  • Potential output (Y*): output using resources at normal rates.
  • Output gap: $(Y – Y<em>)/Y</em>$
    • (Y – Y*) < 0: contractionary gap.
    • (Y – Y*) > 0: expansionary gap.
• Natural rate of unemployment (U*): frictional + structural unemployment.
  • (U – U*) > 0: contractionary gap.
  • (U – U*) < 0: expansionary gap.
• Okun’s Law: relationship between cyclical unemployment and output gap.
  • $100×(Y − Y<em>)/Y</em>=−β(U − U*)$
    • β = 1.8 for Australia.
• Short-term fluctuations occur due to:
  • Changes in potential output.
  • Actual output deviating from potential output; firms adjust to demand changes, governments influence total spending; prices adjust to eliminate output gaps long-term.

Topic 7: Spending and Consumption in the Short Run

• Keynesian model applies when firms meet demand at preset prices.
• Aggregate Expenditure: $AE = C + I + G + NX$
  • Planned Aggregate Expenditure (PAE) refers to total planned spending on final goods and services
• Actual and Planned Investment:
  • Let IP denote the firm’s planned investment including a level of planned inventory investment
• Planned Aggregate Spending $PAE = C + I^p + G + NX$
• Consumer Spending and the Economy = Consumption Function:
  • $C=C^- + c(Y-T)$
• Short-Run Equilibrium Output: In the short run: Y = PAE
• Circular Flow of Income: INJP = WD S + T + M = IP + G + X
• Disequilibrium: If PAE>Y INJP >WD or If PAE<Y  INJP <WD
• Consumption in the Two-Sector Model: $C=C^- + cY$
• Savings in the two-sector model: $S = -C^- + (1-c)Y$
• Investment in the Two-Sector Model: $I= I^p$
• The 45-degree diagram, or Keynesian cross diagram, is a diagrammatic representation enabling the identification of the equilibrium level of GDP.
• Withdrawals and Injections
• Paradox of thrift:aAn attempt by the community to increase saving will fail and the economy will be worse off as a result of the attempt.
• The Four-Sector Model is given by:PAE=C+IP +G+NX
• Planned Spending and the Output Gap: The Keynesian model shows spending in the economy can lead to output gaps.
• The Income-Expenditure Multiplier:
  • The effect of a one-unit increases in exogenous expenditure on short-run equilibrium output
• Stabilisation Policy: Policies used to affect planned aggregate expenditure, to eliminate output gaps

Topic 8: Fiscal Policy

• Fiscal policy includes government purchases, taxes, and transfers to achieve a desired output level.
• Fiscal policy is designed and implemented by the government to achieve a predetermined level of output in the economy.
• Taxes, Transfers and Aggregate Spending: Tax cuts and increases in transfer payments increase disposable income and raise planned aggregate expenditure.
• Balanced Budget Multiplier refers to the short-run effect on equilibrium GDP of an equal change in government expenditure and net taxes.
• Three Qualifiers to Using Fiscal Policy and a Stabilisation Tool: fiscal policy and the supply side, the problem of deficits, fiscal policy is relatively inflexible.
• Taxes and transfer payments play a role in affecting incentives and therefore economic behaviour.
• ‘Automatic stabilisers’ refer to provisions in the law that imply automatic increases in government spending or decreases in taxes when real output declines.
• Three key roles of fiscal policy in Australia today are: affecting income distribution, responding to demographic change, managing public debt.
• A key function of fiscal policy is to influence the distribution of income between households in the economy.
• Australia has a system of progressive income taxes, which levies higher tax rates on additional dollars earned as income increases.
• We can get an indication of relative income inequality through the use of Gini coefficients and Lorenz curves.
• Government Budget Constraint: ‘Government budget constraint’ refers to the concept that government spending has to be financed either by raising taxes or by government borrowing.
• Increasing and Decreasing Public Debt: Gt +Qt +rBt–1-Tt = +(Bt –Bt–1)
• LOW PUBLIC DEBT: Low levels of public debt may be desirable to reduce crowding out, which occurs where government borrowing increases interest rates and therefore decreases investment.

Topic 10 – Money, Prices and the RBA

• A well-functioning financial system improves the allocation of saving in two ways: It provides information to savers, It helps savers to share the risks
• The banking system consists of commercial banks that accept deposits from individuals and businesses and use those deposits to make loans.
• Banks help borrowers as well, by providing access to credit that might otherwise not be available. People hold bank deposits to facilitate transactions.
• A bond is a legal promise to repay a debt, usually including both the principal amount and regular interest, or coupon, payments.
• A general principle is that bond prices and interest rates are inversely related
• Stock refers to a claim to partial ownership of a firm.
• Financial investors’ dislike of risk, and the resulting risk premium, lowers the prices of risky assets like stocks.
• Informational Role of Bond and Stock Markets: Both markets help to direct funds to their best uses Bond and stock markets help to reduce risk by giving savers a means to diversify their financial investments.
• Historically, money was backed by gold or silver, but today currency is “fiat money” – paper that the government simply declares is worth a certain price.
• Money can be any asset used in making purchases.
• Money has three main uses. Medium of exchange, Unit of account, Store of value
• Fractional-reserve banking system has multiplied the money supply.
• This process of excess reserves used to make loans, which are then deposited, which then cause excess reserves, will continue until reserves equal 10% of bank deposits.
• The money supply is important because in the long run, there is a close link between the amount of money circulating in the economy and the general level of prices.
• Velocity is a measure of the amount of expenditure that can be financed from a given amount of money over a particular time period.
• Velocity= Value of Transactions / Money Stock = NominalGDP / Money Stock
• The quantity equation is an identity that states that the nominal value of expenditure in the economy must be equivalent to the stock of money multiplied by its velocity of circulation.
• The RBA is Australia’s central bank, Responsible for monetary policy and Oversight
• Monetary policy is now conducted by the Reserve Bank directly targeting interest rates
• Objectives of monetary policy Open Market Operations (OMO): Influencing the level of interest rates in the economy Exchange settlement accounts are kept by the commercial banks with the Reserve Bank
• Flow-on Effects of Cash Rate: Monetary policy seeks to affect all interest rates in the economy, not just the overnight cash rate.
• At its monthly meeting, the Reserve Bank board of governors decides what changes, if any, shall be made to the cash rate.
• The government budget constraint says that the government’s uses of funds (G) must equal its sources of funds: tax revenue (T), borrowing (B), and changes in the stock of Money (M)
• Hyperinflation results from excessive printing of fiat money
• Results from excessive printing of fiat money, Inflation has strong redistributive properties
• Deflation: General price level fell sharply in most countries in early 1939s, Debt become more costly to repay and In theory, deflation is good for creditors

Topic 11 – The RBA and the Economy

• Policy reaction function: Long-run interest rates will also trach the case rate
• In LR interest rate returns to equilibrium set by saving and investment
• In the short run there will be increase in output/supply
• The Reserve Bank conducts monetary policy by setting the overnight cash rate to a target and allowing all the other interest rates in the economy to adjust.
• With a high cash rate, it is most likely that banks will be more inclined to lend money in the overnight cash market than leave those funds as deposits in their exchange settlement accounts.
• The Reserve Bank has ultimate control over the quantity of base money in circulation. The money supply does not depend on interest rates.
• However, many important decisions such as saving and investing are based on the real interest rate.
• r = I – π, The real interest rate, r, is the nominal rate, i, minus the inflation rate, π.
• Therefore, the Reserve Bank can use changes in the real interest rate to eliminate output gaps and stabilise the economy