Issue 1: Economic Growth

Syllabus Outline Economic Issues – Economic Growth Students learn to apply economic skills:  calculate an equilibrium position for an economy using leakages and injections  determine the impact of the (simple) multiplier effect on national income  explain the implications of the multiplier for fluctuations in the level of economic activity in an economy Students learn about economic issues in the Australian economy 3.1 Economic growth aggregate demand and its components: Y = C+I+G+X–M injections and withdrawals (I+G+X; S+T+M) the simple multiplier: k = 1/(1–MPC) measurement of growth through changes in real GDP sources and effects of economic growth in Australia business cycle — trends

Review of the Circular Flow  The circular flow of income is useful for explaining economic theory, often called the Keynesian revolution, which is that:  the level of Aggregate determines the level of economic activity (i.e. production, income and ).  developed in the 1930’s, as a response to the Great Depression, it represented a radical departure from the accepted economic theory of the time, known as the Classical theory.  Keynes used a three sector model comprising households, firms & financial sector to illustrate the impact of & investment on the level of economic activity.

 Savings (S) is regarded as a, or withdrawal, as it is income not spent - it aggregate demand.  Investment (I) is regarded as an injection because it increases the level of.  Financial institutions, such as banks, act as and provide a link between savers and investors. Circular Flow - 3 Sector Model Financial intermediaries, such as banks

Circular Flow - 3 Sector Model  If planned savings is than planned investment then the level of activity will fall.  This is because the increase in demand coming from is less than the decrease in demand coming from saving - with aggregate demand falling so does production, income and employment. IncomeConsumptionSavingInvestment Assume Y = , C =.75Y and I = Final Time period

Circular Flow - 3 Sector Model  If planned savings is than planned investment then the level of economic activity will rise.  This is because the increase in demand coming from investment is greater than the decrease in coming from saving - with aggregate demand rising so does production, income and employment. IncomeConsumptionSavingInvestment Assume Y= , C=.75Y and I = Final Time period

Circular Flow - Equilibrium  when the level of aggregate demand equals the level of production or aggregate supply the economy is said to be in.  this means that the business/firms sector is producing exactly what is being demanded and so there is no tendency for the level of economic activity to change.  In a three sector model, at equilibrium savings equals investment. 3 Sector Equilibrium: AD = C + I

Circular Flow - 4 Sector Model  Keynes advocated the use of budgets/fiscal policy to influence the level of economic activity because it is unstable.  if the level of economic activity was low and there was unemployment of resources, then a budget (G>T) could raise AD and national income by a multiplied amount.  if there was excessive in the economy causing inflation, then the most appropriate budget would be a budget (G<T) to lower AD and national income by a multiplied amount.

Circular Flow - 4 Sector Model  in a four sector model, for equilibrium to occur (ie no tendency for economic activity to change) leakages must equal injections. 4 Sector Equilibrium: AD = C + I + G

Circular Flow - 5 Sector Model  in a five sector model, for equilibrium to occur (ie no tendency for economic activity to change) leakages must equal injections. 4 Sector Equilibrium:

Aggregate Demand & Components  the level of Demand determines the level of economic (i.e. production, income and employment) – Keynesian economic theory  In a 3 sector model the components of Aggregate Demand are: AD = C + I  In a 4 sector model the components of Aggregate Demand are: AD = C + I + G  In a 5 sector model the components of Aggregate Demand are: AD =  if demand (ie Gross National Expenditure/GNE = C + I + G), is than the productive capacity of the economy (ie Gross Domestic Product/GDP) this will result in negative Net Exports - a current account deficit (CAD) will occur.

 Injections increase Aggregate Demand and raise the level of economic activity. Injections are:  Investment (I)  spending ( ) and  ( )  Withdrawals or leakages decrease Aggregate Demand and lower the level of economic activity. Leakages are:  ( )  Taxation (T) and  ( )  if injections > leakages the level of economic activity will  if injections < leakages the level of economic activity will Injections and Withdrawals 3.1.2

Focus Questions 1.Define Keynesian economic theory. 2.Explain what happens to the level of economic activity in a 3 sector model when planned savings is greater than planned investment. 3.Explain the Keynesian view of the role of government. 4.Identify the components of aggregate demand in a 5 sector model. 5.Calculate the value of exports for the following economic system to be in equilibrium. 6.Calculate from the following what is going to happen to the level of economic activity. 7.Calculate the year in which there is a current account deficit. Investment (45)Savings (40)Taxation (35)Govt. Spending (40)Imports (25) Tax (30)Exports (40)Govt. Spend (40)Imports (50)Invest. (25)Savings (15) YearGDP $m.CIG

Circular Flow - 4 Sector Model  If planned leakages are than planned injections then the level of economic activity will rise.  This is because the in demand coming from the injections is greater than the decrease in demand coming from the leakages - with aggregate demand rising so does production, income and employment. Assume Y = , C =.75Y, I = 4 000, Taxation = 0 and Govt. Spending = 1000 Final Time period Income (Y) Consumption (C) Savings (S) Taxation (T) Investment (I) Government (G)

The Simple Multiplier  Fundamental to theory is not only the view that aggregate demand determines level of economic activity but also that play a key role in influencing economic activity.  Economic activity is inherently and will fluctuate over time (ie economic cycle) & government is needed to control economic activity.  During the Great Depression Keynes maintained, however, that government was not expected to take up all unemployed labour directly through its own spending programmes as any increase in spending would have a larger or effect on income levels.  In other words, a small increase in spending, including government spending, would generate through the (k) an even larger increase in income and employment levels.

The Simple Multiplier  The multiplier can be determined mathematically and any activity that spending will reduce the multiplier effect – so savings (S), taxation (T) and imports (M) all reduce the multiplier effect.  In a sector model, which is households, firms and financial sectors, the simple multiplier is the reciprocal of the marginal propensity to save (MPS).  Multiplier (k) = __1_ or __1___ 1 – MPC

The Simple Multiplier Consider the previous 3 & 4 sector tables:  In the 3 sector model, the equilibrium level of income is , while in the 4 sector model it is  When moving from 3 to 4 sectors the only change has been an increase in government spending (G) of and this has produced an income change ( to ) – therefore the multiplier is 4.  This can be verified by the multiplier formula for a 3 sector model:  Multiplier (k) = 1 or 1 MPS 1 – MPC  = 1/.25 or 1/  = 4

YCSI The Keynesian Y Diagram Assume: C = Y National Income Expenditure

YCSI Focus Question Assume: C = Y and I = 40 a. Complete the table: National Income Expenditure b. Calculate:  MPC  MPS  k  EqY 500 c. Graph & label:  Consumption  Savings  Investment  Y (C + S)  AD (C + I)

YCSI The Keynesian Y Diagram Assume: C = Y and I = National Income Expenditure Y = C + S C I C + I S I Note: if Y = C + S and if C = Y then Y = Y + S and S = Y Autonomous Consumption Induced Consumption = MPC

YCSI Focus Question Assume: C = Y and I = 40 a. Complete the table: National Income Expenditure b. Calculate:  MPC  MPS  k  EqY 500 c. Graph & Label:  Consumption  Savings  Investment  Y (C + S)  AD (C + I) C C + I Y S I

YCSI The Multiplier Effect National Y Expenditure Y = C + S C + I S I 500 If investment rose by 25 to 75 the new equilibrium level of income will be where: I1I1 C + I

Calculating Equilibrium National Y Expenditure Y = C + S C + I S I 500 I1I1 C + I Method 1: Savings = Investment Method 2: Multiplier Method

Focus Questions 1.Explain what happens when leakages exceed injections in a 4 sector model. 2.Define the ‘multiplier’. 3.Provide the multiplier formula for a 3 sector model. 4.Distinguish between autonomous and induced spending. 5.If C = Y and I = 100, Calculate: a)marginal propensity to consume (MPC) b)marginal propensity to save (MPS) c)the multiplier (k) d)equilibrium level of income 6.Calculate from the following table: a)MPC b)MPS c)Multiplier d)Equilibrium level of income YCSI

Measurement of Growth –real GDP  growth is measured by the growth in real Gross Domestic (GDP) over time. This is the total value of goods and services produced in an economy adjusted for any inflation.  or money Gross Domestic Product (GDP) is inappropriate as it will artificially increase if there are price increases/.  Converting nominal GDP into GDP to accommodate for inflation changes and provide a more accurate measurement of production is achieved by the formula:  real GDP = nominal GDP x 100

Measurement of Growth – real GDP  Real GDP is often seen as an inadequate indicator of living standards for a number of reasons:  hours worked per week or the length of working life is not taken into account.  quality of life indicators, including the value of leisure are ignored. The exclusion of economic development issues can be overcome by other measures, such as the Human Development Index (HDI).  income distribution inequalities are not reflected in the measurement.  negative externalities, such as pollution and increased traffic congestion, generated by production are not taken into account.  changing population makes real GDP an unreliable measurement. To overcome this problem real GDP per capita, where population divides it, may be used.

Sources & Effects of Economic Growth  The sources of economic growth can come from any of the components of, being:  consumption,  investment,  government spending and  net exports.  Private expenditure is the largest component of demand by far and provides approximately 60 per cent of all spending in the Australian economy.  It has also provided the largest change in growth throughout the last decade to 2004.

Sources & Effects of Economic Growth  Economic growth provides a number of for the economy:  increases in real per capita/standard of living for those employed resources.  growth may occur, particularly if the existing employed resources cannot meet the increased demand for goods and services despite their productivity increases.  higher as increased demand for goods and services will eliminate any excess productive capacity. Investment is a particularly important component of aggregate demand as it adds to the nation’s stock of real capital and so provides scope for further economic growth.  government budget benefits, through both a reduction in its expenditure on benefits and increased taxation revenue – ‘ dividend’

Sources & Effects of Economic Growth  A number of costs may be associated with economic growth :  structural may result from any structural change accompanying economic growth.  inequality in income becomes greater if the benefits of economic growth are not shared equally.  deterioration in quality, through pollution of the natural environment or depletion of non-renewable resources as a result of excessive growth.  other economic may suffer, such as external stability and low inflation.

Trends in the Business Cycle Level of Economic Activity Time Trend Line Business Cycle A – No Govt. Intervention  capitalist market economies experience fluctuations in the level of economic activity over time - the cycle  for many years, ‘ -faire’ government meant no govt. attempt to control economic activity and swings in the business cycle resulted in numerous and recessions.

Trends in the Business Cycle Level of Economic Activity Time Trend Line Business Cycle A – No Govt. Intervention Business Cycle B – with Govt. Intervention  acceptance of Keynesian theory, meant now had a role in controlling economic activity to minimise swings in the business cycle, particularly to reduce unemployment and control inflation.  use of demand weapons, such as fiscal & monetary policies as counter-cyclical policies reduced swings in the business cycle.

Trends in the Business Cycle  The business cycle is fluctuations in the level of economic activity over time and:  since 1992, the Australian economy entered a phase of uninterrupted economic, albeit with different growth rates, for the rest of the decade and  economic growth has prevailed into this decade.

Focus Questions 1.Distinguish between nominal GDP and real GDP. 2.Explain why real GDP is regarded as an inadequate measure of economic growth. 3.Identify the sources of economic growth. 4.Discuss the costs and benefits of economic growth for individuals, businesses and governments. 5.Outline the role of government counter-cyclical polices in moderating swings in the business cycle. 6.Describe the trends in the Australian business cycle.

YCSI The Keynesian Y Diagram Assume: C = Y and I = National Income Expenditure Y = C + S C C + I S I