1. ECO1000 ECONOMICS Semester One, 2004 Lecture Eleven

2. Outline or Plan of Today’s Lecture Material Covered: Module Eight Material Covered: Module Eight Reading: Text Chapters 17, 18, 19 Reading: Text Chapters 17, 18, 19 Topics: Macroeconomic Policy and the Associated Debates Topics: Macroeconomic Policy and the Associated Debates

3. Purpose or Objectives of Today’s Lecture After this lecture you will know about: After this lecture you will know about: –The main macroeconomic models –How to use the main macroeconomic models to show the effect of selected macroeconomic policies –Discuss the trade-off between employment and inflation

4. The Use of Macroeconomic Policy

5. The Purpose of Macro Policy There are a few main reasons why a government may use macro policies: There are a few main reasons why a government may use macro policies: –Maintain long-term growth –Stabilise the economy Moderating the business cycle Moderating the business cycle –Maintain employment levels where possible –Control inflation

6. Policy Options for Recessions Do nothing Do nothing –Lower costs and wages will result in an eventual increase in output. Stimulate aggregate demand with monetary policy Stimulate aggregate demand with monetary policy Stimulate aggregate demand with fiscal policy Stimulate aggregate demand with fiscal policy

7. Option #1: Do Nothing (market correction) Quantity of Output Price Level 0 AS 1 Long-run AS AD 1 A B C P1P1 P2P2 P3P3 Y1Y1 Y2Y2 AD 2 AS 2

8. The Limits of Self-Correction Hardship for some households Hardship for some households Adds to long-term unemployment Adds to long-term unemployment Adds to consumer & producer pessimism Adds to consumer & producer pessimism Political unrest Political unrest

9. Policy Option #2: Monetary Policy

10. How Does Monetary Policy Affect Aggregate Demand? One part of the answer to this question is Keyne’s liquidity preference theory. One part of the answer to this question is Keyne’s liquidity preference theory. This theory suggests that the interest rate adjusts to equate money supply with money demand. This theory suggests that the interest rate adjusts to equate money supply with money demand. To examine this closely we need to model the the money market. To examine this closely we need to model the the money market.

11. The Money Market MS MD r Interest Rate Quantity of Money If Md < Ms, the surplus of money creates downward pressure on interest rates and vice versa.

12. The Money Market and AD AD Output Price Level Interest Rate Quantity of Money Y1Y1 Y2Y2 P1P1 P2P2 Md 2 Md 1 Ms r1r1 r2r2

13. Key Steps in the Process 1. A higher price level increases Md (people need more money to buy things) 1. A higher price level increases Md (people need more money to buy things) 2. Higher Md increases the interest rate 2. Higher Md increases the interest rate 3. A higher interest rate reduces the quantity of goods and services that people demand 3. A higher interest rate reduces the quantity of goods and services that people demand

14. What Happens to AD if Ms is Increased? Quantity of money Output Interest rate Price level AD AD 1 Md MsMs 1

15. Expansionary & Contractionary Central bank sells securities Central bank sells securities O’night cash rate increases O’night cash rate increases Interest rates increase Interest rates increase Increase in consumption & investment Increase in consumption & investment Increase in aggregate demand Increase in aggregate demand Central bank buys securities Central bank buys securities O’night cash rate decreases O’night cash rate decreases Interest rates decrease Interest rates decrease Decrease in consumption & investment Decrease in consumption & investment Decrease in aggregate demand Decrease in aggregate demand How Does the RBA Increase/Decrease Money Supply?

16. The Result of Expansionary Monetary Policy Quantity of Output Price Level 0 AS 1 Long-run AS AD 1 A B P1P1 P2P2 Y1Y1 Y2Y2 AD 2

17. When to Use Expansionary Monetary Policy Growth rate is low; and Growth rate is low; and Consumer and investor sentiment is pessimistic; but Consumer and investor sentiment is pessimistic; but Inflation should also be low Inflation should also be low –Stimulation increases prices

18. Policy Option #3 Fiscal Policy

19. Fiscal Policy… Fiscal policy refers to the government’s choices regarding the overall level of government purchases or taxes Fiscal policy refers to the government’s choices regarding the overall level of government purchases or taxes The Federal government’s control of the economy is both direct and indirect The Federal government’s control of the economy is both direct and indirect –Its expenditures have a direct effect on aggregate demand –Taxes and tax policy have an indirect effect on consumer spending

20. Fiscal Policy Government Purchases and Aggregate Demand

21. Government Purchases When the government decides to increase spending, this has a direct effect on aggregate demand. When the government decides to increase spending, this has a direct effect on aggregate demand. In short, the AD curve shifts to the right. In short, the AD curve shifts to the right. But because the government spending also stimulates further spending by consumers and investors, the effect is said to be multiplied. But because the government spending also stimulates further spending by consumers and investors, the effect is said to be multiplied.

22. The Multiplier Effect of Government Purchases Government purchases are said to have a multiplier effect on aggregate demand. Government purchases are said to have a multiplier effect on aggregate demand. Each dollar spent by the government can raise the aggregate demand for goods and services by more than a dollar. Each dollar spent by the government can raise the aggregate demand for goods and services by more than a dollar. The total impact on the quantity of goods and services demanded can be much larger than the initial change in government spending. The total impact on the quantity of goods and services demanded can be much larger than the initial change in government spending.

23. The Multiplier Effect of Government Purchases AD 1 AD 2 Quantity of Output 0 Price Level 1. An increase in government purchases of $5 billion initially increases aggregate demand by $5 billion… AD 3 2. …but the multiplier effect can amplify the shift in aggregate demand.

24. A Formula for the Government Purchases Multiplier The formula for the multiplier is: The formula for the multiplier is: Multiplier = 1/(1 - MPC) An important number in this formula is the marginal propensity to consume ( MPC ). An important number in this formula is the marginal propensity to consume ( MPC ). It is the fraction of extra income that a household consumes rather than saves. It is the fraction of extra income that a household consumes rather than saves. If households spend 80 cents out an extra $1 they earn, then the MPC is 0.8 If households spend 80 cents out an extra $1 they earn, then the MPC is 0.8

25. An Example of the Multiplier Effect MPC = 0.9 MPC = 0.9 Multiplier = 1/(1- 0.9) = 1/0.1 = 10 Multiplier = 1/(1- 0.9) = 1/0.1 = 10 Government spends $200,000 Government spends $200,000 Extra activity = 10 x $200,000 = $2,000,000 Extra activity = 10 x $200,000 = $2,000,000 This is the same mathematical principle as the money multiplier This is the same mathematical principle as the money multiplier

26. Fiscal Policy Tax Changes and Aggregate Demand

27. Changes in Taxes When the government cuts taxes, it increases households’ take-home pay. When the government cuts taxes, it increases households’ take-home pay. Households save some of this additional income. Households save some of this additional income. Households also spend some of it on consumer goods. Households also spend some of it on consumer goods. Increased household spending shifts the aggregate-demand curve to the right. Increased household spending shifts the aggregate-demand curve to the right. The size of the resulting shift in aggregate demand is affected by the multiplier effect. The size of the resulting shift in aggregate demand is affected by the multiplier effect.

28. The Crowding Out Effect How the Multiplier Effect May be Offset

29. The Crowding-Out Effect Fiscal policy may not affect the economy as strongly as predicted by the multiplier. Fiscal policy may not affect the economy as strongly as predicted by the multiplier. An increase in government purchases causes the interest rate to rise (because of increased money demand). An increase in government purchases causes the interest rate to rise (because of increased money demand). A higher interest rate reduces investment spending. A higher interest rate reduces investment spending. This is called ‘crowding out’ This is called ‘crowding out’

30. The Crowding Out Effect of Fiscal Stimulation AD 1 AD 2 Quantity of Output 0 Price Level 1. An increase in government purchases initially increases aggregate demand AD 3 2. …but higher interest rates lead to a decrease in investment and a decrease in aggregate demand.

31. Automatic Stabilisers

32. Automatic Stabilisers… Automatic stabilisers are changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policymakers having to take any deliberate action. Automatic stabilisers are changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policymakers having to take any deliberate action.

33. Examples of Automatic Stabilisation The most important automatic stabiliser is the tax system The most important automatic stabiliser is the tax system –Taxes automatically decline in a recession –Helps maintain disposable income Another is government welfare payments Another is government welfare payments –Welfare payments increase in total in recessions –Maintains some level of aggregate demand

34. What We Now Know About the Economy in the Short Run and the Long Run

35. In the Short Run… Price level is sticky (predetermined) Price level is sticky (predetermined) Interest rate balances supply/demand for money Interest rate balances supply/demand for money Output responds to changes in aggregate demand Output responds to changes in aggregate demand

36. In the Long Run… Output is fixed (natural rate) Output is fixed (natural rate) Interest rate balances supply/demand for loanable funds Interest rate balances supply/demand for loanable funds Price level balances supply/demand for money Price level balances supply/demand for money

37. The Trade-Off Between Inflation and Unemployment

38. The Trade-off Society faces a short-run trade-off between unemployment and inflation. Society faces a short-run trade-off between unemployment and inflation. If policymakers expand aggregate demand, they can lower unemployment, but only at the cost of higher inflation. If policymakers expand aggregate demand, they can lower unemployment, but only at the cost of higher inflation. If we reduce aggregate demand, they can lower inflation, but at the cost of temporarily higher unemployment. If we reduce aggregate demand, they can lower inflation, but at the cost of temporarily higher unemployment.

39. The Phillips Curve The Phillips curve illustrates the short-run relationship between inflation and unemployment. The Phillips curve illustrates the short-run relationship between inflation and unemployment. It shows the short-run combinations of unemployment and inflation that arise as shifts in the aggregate demand curve move the economy along the short-run aggregate supply curve. It shows the short-run combinations of unemployment and inflation that arise as shifts in the aggregate demand curve move the economy along the short-run aggregate supply curve.

40. Aggregate Demand, Aggregate Supply, and the Phillips Curve The greater the aggregate demand for goods and services, the greater is the economy’s output, and the higher is the overall price level. The greater the aggregate demand for goods and services, the greater is the economy’s output, and the higher is the overall price level. A higher level of output results in a lower level of unemployment. A higher level of output results in a lower level of unemployment. Monetary and fiscal policy can shift the aggregate demand curve, thus moving the economy along the Phillips curve. Monetary and fiscal policy can shift the aggregate demand curve, thus moving the economy along the Phillips curve.

41. Phillips Curve Unemployment Rate (percent) 047 Inflation Rate (percent per year) B A 6 2 Phillips curve

42. The Employment/Growth Trade- Off 6 Unemployment rate (%) 0 3. …Unemployment decreases but inflation increases. (a) AD/AS Model 1. Output = $5 b & Unemployment = 8 percent Output ($b) 0 AD 1 AS 1 106 102 2. Demand increases to output of $6b (b) The Phillips Curve 38 Inflation rate 2 Price level (deflator) * * * * 56 AD 2

43. In the Long Run… In the long run, there is no trade-off between unemployment and inflation (according to the Monetarist school of macroeconomic theory). In the long run, there is no trade-off between unemployment and inflation (according to the Monetarist school of macroeconomic theory). This is because the unemployment rate eventually returns to its natural rate. This is because the unemployment rate eventually returns to its natural rate. This is equivalent to saying that the Long Run Phillips Curve is vertical. This is equivalent to saying that the Long Run Phillips Curve is vertical.

44. The Phillips Effect in Australia 1960s-1990s

45. The Phillips Curve in the 1960s Include figure 18.8 here Generally low inflation rate and low unemployment rate

46. The Phillips Curve in the 1970s and Early 1980s Include figure 18.11 here Generally high inflation and medium to high unemployment rate

47. The Phillips Curve in the Late 1980s and Early 1990s Insert Figure 18.12 Generally low inflation rate and medium to high unemployment rate

48. Policy Trends in Australia Growth a priority in the 1960s Growth a priority in the 1960s Wage control in the mid-1980s reduced supply-side wage pressures on inflation. Wage control in the mid-1980s reduced supply-side wage pressures on inflation. Restrictive monetary policy in the late 1980s Restrictive monetary policy in the late 1980s –Inflation fell but unemployment rose. Current RBA policy is generally keeping inflationary expectations low. Current RBA policy is generally keeping inflationary expectations low. –Medium unemployment rate

49. MACROECONOMIC POLICY DEBATES

50. Should Policymakers Try to Stabilise the Economy? The economy is inherently unstable. The economy is inherently unstable. Monetary and fiscal policy can influence aggregate demand and offset this. Monetary and fiscal policy can influence aggregate demand and offset this. No reason for society to suffer through the booms and busts of the business cycle. No reason for society to suffer through the booms and busts of the business cycle. Stabilising aggregate demand will boost production and employment. Stabilising aggregate demand will boost production and employment. There are time lags between decision & response for both monetary & fiscal policy There are time lags between decision & response for both monetary & fiscal policy This means intervention will be largely ineffective in the short run and may be harmful by exacerbating downturns or upswings This means intervention will be largely ineffective in the short run and may be harmful by exacerbating downturns or upswings Yes VSNo

51. Monetary Policy ‘Rules’ VS ‘Discretion’ Discretionary policy can easily be mismanaged Discretionary policy can easily be mismanaged Policy is manipulated in the political business cycle Policy is manipulated in the political business cycle Policy makers don’t follow through on announcements Policy makers don’t follow through on announcements Economic actors are sceptical about announcements Economic actors are sceptical about announcements Need moderate and steady growth of the money supply to limit the problems Need moderate and steady growth of the money supply to limit the problems The problems of discretionary policy are not proven The problems of discretionary policy are not proven Need flexibility for changing circumstances Need flexibility for changing circumstances Leave it to the experts Leave it to the experts What rules are valid anyway? What rules are valid anyway? Rational Expectations Rational Expectations

52. The Central Bank Should Aim for Zero Inflation No benefits but many costs to inflation No benefits but many costs to inflation –eg shoeleather, menu, etc Reducing inflation is a policy with temporary costs and permanent benefits. Reducing inflation is a policy with temporary costs and permanent benefits. –Once the disinflationary recession is over, the benefits of zero inflation would persist. Zero inflation is probably unattainable and output and unemployment costs from policy are too high. Zero inflation is probably unattainable and output and unemployment costs from policy are too high. Instead aim for a low inflation. Instead aim for a low inflation. Policymakers can reduce many of the costs of inflation without actually reducing inflation. Policymakers can reduce many of the costs of inflation without actually reducing inflation. Yes VS No

53. The Government Should Balance the Budget Deficits are a burden on future generations Deficits are a burden on future generations –Need more taxes or less spending Deficits reduce savings & therefore investment in capital & therefore lower growth Deficits reduce savings & therefore investment in capital & therefore lower growth The problem of deficits is often exaggerated. The problem of deficits is often exaggerated. Current govt spending may produce benefits well into the future. Current govt spending may produce benefits well into the future. Need flexibility in spending for emergencies etc Need flexibility in spending for emergencies etc Govt debt can increase because population growth and technological progress increase the nation’s ability to pay the interest on the debt. Govt debt can increase because population growth and technological progress increase the nation’s ability to pay the interest on the debt. Yes VS No

54. Tax Laws Should be Reformed to Encourage Saving A nation’s productive capability is determined largely by how much it saves and invests for the future. A nation’s productive capability is determined largely by how much it saves and invests for the future. A nation’s saving rate is a key determinant of its long-run economic prosperity. A nation’s saving rate is a key determinant of its long-run economic prosperity. When the saving rate is higher, more resources are available for investment in new plant and equipment. When the saving rate is higher, more resources are available for investment in new plant and equipment. We heavily tax the income from capital and reduce benefits for those who have accumulated wealth. We heavily tax the income from capital and reduce benefits for those who have accumulated wealth. This reduces saving, capital accumulation, labour productivity and economic growth. This reduces saving, capital accumulation, labour productivity and economic growth. YES

55. Tax Laws Should be Reformed to Encourage Saving Such changes in tax laws would primarily benefit the wealthy. Such changes in tax laws would primarily benefit the wealthy. High-income households save a higher fraction of their income than low-income households. High-income households save a higher fraction of their income than low-income households. Any tax change that favours people who save will also tend to favour people with high incomes. Any tax change that favours people who save will also tend to favour people with high incomes. Reducing the tax burden on the wealthy would lead to a less egalitarian society. Reducing the tax burden on the wealthy would lead to a less egalitarian society. Raising public saving by eliminating the government’s budget deficit would provide a more direct and equitable way to increase national saving. Raising public saving by eliminating the government’s budget deficit would provide a more direct and equitable way to increase national saving. NO

56. Conclusion Choosing among alternative policies is not easy. Choosing among alternative policies is not easy. No policies come with benefits but no costs (remember, everyone faces trade-offs). No policies come with benefits but no costs (remember, everyone faces trade-offs). The study of economics should make you a better participant in our national debates. The study of economics should make you a better participant in our national debates. You should be able to objectively list the pros and cons of policies and make a rational decision based on the facts. You should be able to objectively list the pros and cons of policies and make a rational decision based on the facts.

57. In Light of the Objectives of the Lecture… We now know about: We now know about: –The main macroeconomic models –How to use the models to show the impact of policy –The pros and cons of the various policies that the government or its agencies may deploy to manage economic fluctuations.

58. Next Week REVISION

59. THE END