ECON1102 International Macroeconomics and Exchange Rates
International Macroeconomics and Exchange Rates
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ECON1102 SUMMARY NOTES
1 Aggregate Production and Prices
1.1 KEY CONCEPTS
• The definition of Gross Domestic Product (GDP)
• GDP Valuation Methodologies
1. Production Method (Value Added Approach)
2. Expenditure Method (C, I, G, NX)
3. Income Method (Labour, Capital & Net Indirect Taxes)
• Real and Nominal GDP (and the GDP Deflator)
• The Business Cycle
• GDP per capita and Economic Growth
• Inflation and the costs of inflation
1.2 FORMULAE
• GDP = C + I +G+NX (Expenditure Model of GDP)
• GDP = Labour Income+Capital Income+Net Indirect Taxes (Income Model of GDP, where Net
Indirect Taxes are Indirect Taxes− Subsidies
• GNI = GDP + Net Primary Income from non residents (we add primary income credits and
subtract primary income debits to GDP)
• Price Level = Nominal GDP
Real GDP
• Economic Growth Rate = % change in GDP per capita
• CPI = Basket of goods today
Basket of Goods in base year
(where the base year determines the quantities of goods and
services that will be held fixed for the calculation)
• Inflation = % change in CPI
(Percent Change =
New V alue−Old V alue
Old V alue
)
2
2 Employment and the Labour Market
2.1 KEY CONCEPTS
• Labour Market Definitions & Ratios
• Types of unemployment
1. Frictional/Search
2. Structural
3. Cyclical
• Okun’s Law and Output Gaps
• Supply and Demand for Labour
– Decreasing MPL as the demand curve
– Supply curve indicative of the number of workers willing to work at each real wage value
– Changes to Labour Force shift supply curve
– Changes to either the price of goods or the productivity of labour shift the demand curve
• Frictions within the labour supply and demand model
– Minimum Wage Laws (Price Floors)
– Income Taxation
2.2 FORMULAE
• Employment Rate = Employed Individuals
Working Age Population
• Unemployment Rate = Unemployed Individuals
Labour Force
• Participation Rate = Labour Force
Working Age Population
• Long Term Unemployment Rate = Separation Rate
Separation Rate+ Finding Rate
=
s
s+ f
• Natural Unemployment Rate = Frictional Rate+ Structural Rate
• Unemployment Rate = Frictional Rate+ Structural Rate+ Cyclical Rate
• Output Gap = Actual GDP − Potential GDP
• Output Gap (%) = Real GDP − Potential GDP
Potential GDP
• Okun′s Law : (Actual GDP − Potential GDP
Potential GDP
) ∗ 100 = −β(u − u∗) (where u − u∗ is cyclical unem-
ployment)
• VMPL = Price ∗MPL
• Marginal Benefit ≥Marginal Cost, and so VMPL ≥Wage
• Real Wage = Wage
Price
= MPL (real wage allows for a relative measure of wages independent of inflation)
3
3 Interest Rates, Investment and Saving
3.1 KEY CONCEPTS
• Real vs Nominal Interest Rates
• The Fisher Effect (r = i− pi)
• The Zero Lower Bound and Effective Lower Bound
• Investment
– Investment and Capital Stock (Investment and Depreciation recursive formula)
– VMPK (The Value of the Marginal Product of Capital)
– UC (User Cost of Capital)
• Saving
– Household Saving
∗ Assets, Liabilities and the Household Balance Sheet
∗ Saving and Net Capital Gains
∗ Types of Saving
· Life Cycle Saving
· Precautionary Saving
· Bequest Saving
– Business Saving
∗ Business savings exist in the form of retained profits
– Government (Public) Saving
∗ Exists in the form of the Budget Balance
∗ Budget Surplus and Budget Deficit
– National Saving
∗ Within a closed economy, National Savings are equal to investment (consider the expenditure
measure of GDP)
– Crowding out occurs when the budget balance reduces in size, resulting in reduced private sector
investment
– Business confidence can have a significant effect on shifting the investment demand curve
3.2 FORMULAE
• Nominal Rate = Repayment− Loan
Loan
• Real Rate =
Repayment
CPIt+1
− LoanCPIt
Loan
CPIt
• Fisher Effect: i = r − pi (at ZLB, r = −pi)
• K1 = K0 +I1 +δK0 (Existing capital stock is subject to new investment and depreciation each period)
• VMPK = Price ∗MPK (MARGINAL BENEFIT)
• User Cost of Capital = UC = PK(r + δ) = PK(i− pi + δ) (MARGINAL COST)
• MPK ≥ PK
P
(r + δ) since MB ≥MC
4
– This is why an increase in PK or r or δ discourage investment
• Y = Labour Income + Capital Income + Tax − Transfer Payments − Interest Payments (where
transfers are pensions, etc. and interest payments are things like coupon payments on government
bonds, etc.)
• Saving = Disposable Income− Consumption
• Public Saving = Budget Balance = (Taxes−Transfer Payments−Interest Payments)−Govt. Expenditure
• National Savings = Household Saving+Business Saving+Government Saving = NS(r) = I(r) =
[(Y − T −RE)− C] + [RE] + [T −G] (a function of the real interest rate in a closed economy)
– Note the difference between:
1. Public Sector Saving = Budget Balance = TA (Direct and Net Indirect)−TR−INT−G =
T −G
2. Net Indirect Taxes = Indirect Taxes− Subsidies
3. Private Sector Saving = Y − T − C
4. Household Disposable Income = Y−Retained Earnings+(Transfers+Interest Payments−
Direct and Net Indirect Taxes) = Y −RE + TRN + INT − TAX
5. Gross Household Saving = Household Disposable Income− Consumption = Y D − C
6. Net Household Saving = Household Disposable Income− Consumption−Depreciation
7. National Saving = [(Y − T −RE)− C] + [RE] + [T −G] = I = Y − C −G
5
4 Income Expenditure Model of GDP
4.1 KEY CONCEPTS
• The income expenditure model is inherently a model for short run analysis of GDP (long run changes
in expenditure affect inflation rather than GDP)
• Prices of goods and services are sticky (fixed) in the short run and so changes in demand are met by
a change in production levels (employment) rather than a change in prices (potentially due to menu
costs)
• Planned Aggregate Expenditure (PAE) is the total planned spending on domestically produced goods
and services. GDP differs from PAE due to unplanned inventories, which result when demand is higher
or lower than expected.
• It is only at short run equilibrium that GDP and PAE are equal
– If unplanned inventories are positive, more has been produced than has been demanded and so
firms partake in unplanned inventory investment. This signals businesses to reduce production.
– If unplanned inventories are negative, less has been produced than has been demanded and so
firms deplete reserves of inventory. This signals businesses to increase production.
• In both cases, the short run economy is influenced to move toward the equilibrium condition
• Consumption Function
– If we define disposable income as:
GDP − Taxes+ Interest Payments+Government Transfers = Y − T
– Then we can write the consumption function as:
C = C0 + c(Y − T )
– Where Y − T is disposable income, C0 is exogenous consumption and c is the MPC (Marginal
Propensity to Consume). The MPC is the gradient of the curve, and thus is the change in
consumption resulting from a change in disposable income.
– Another measure, the APC (Average Propensity to Consume) directly divides C by Y − T .
• Assuming a TWO SECTOR MODEL (closed economy, no government):
PAE = C + Iplanned = C0 + I0 + c(Y − T )
(where planned investment is entirely exogenous)
• Since equilibrium occurs when Y = PAE, equilibrium is found graphically by the point of intersection
between the 45 degree line Y = PAE and the PAE curve. (Y axis is PAE, X axis is GDP).
• The effect of output gaps can also be visualized on such a set of axes with a vertical line representing
potential output
• An additional dollar of exogenous PAE generates more than one dollar of GDP (the multiplier effect).
The idea is that money is spent more than once in a geometric progression, since a fraction of one
person’s income becomes another person’s income.
• The Saving Function
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– If the consumption function is C = C0 + cY (no taxation in the two sector model), and saving is
defined as income minus consumption S = Y − C, then saving is given by:
S = −C0 + Y (1− c)
(where 1− c is the marginal propensity to save)
– We plot this curve on the x = GDP and y = Savings/Investment axes, and look for the point
of intersection between the constant I0 curve and the savings curve.
– The equilibrium condition found is identical to that found by the PAE and GDP method.
– The paradox of thrift describes the situation in which everyone looses money when everyone
makes an attempt to save money. An increase in exogenous savings shift the savings curve
upward, causing an intersection with the investment curve at a smaller value of GDP (output).
As a result, income has decreased → the fallacy of composition.
• Open Economy Model
– This simply implies that imports and exports now exist
PAE = C + Iplanned +X −M
– We describe M = mY , in which imports are proportional to GDP via a parameter known as the
Marginal Propensity to Import (MPI). Note the marginal propensity to import is the same as the
average propensity to import.
PAE = C0 + I0 +X0 + Y (c−m)
Yequilibrium =
1
1− (c−m) ∗ (C0 + I0 +X0)
(the introduction of the MPI has caused a reduction in the size of the multiplier)
4.2 FORMULAE
• Y = C + I +G+X −M
• PAE = C + Iplanned +G+X −M
• Y = PAE + ∆Unplanned Inventories
• CONSUMPTION FUNCTION: C = C0 + c(Y − T ) (T=0 if no taxes)
• TWO SECTOR MODEL: PAE = I0 + C0 + c(Y − T ) (T=0 if no taxes)
• T = Taxes− Interest Payments− Interest Payments
• Disposable Income = Y − T
• MPC = ∆C
∆(Y − T )
• APC = C
Y − T
• Yequilibrium = 1
1− c (C0 + I0) (for two sector model with no taxes)
• SAVING FUNCTION: S = −C0+Y (1−c) (for two sector model with no taxes, derived from S = Y −C)
• PAE = C0 + I0 +X0 + Y (c−m) (for two sector model with no taxes in open economy situation)
• Yequilibrium = 1
1− (c−m) ∗ (C0 + I0 +X0)
• 1
1− (c−m) ≤
1
1− c
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5 The Government Sector and Fiscal Policy
5.1 KEY CONCEPTS
• Fiscal policy is essentially the study of the economics of the government budget
• We endeavour to introduce taxation to our existing two sector model from the previous chapter (Con-
sumption, Investment)
– The taxation function can be modelled by:
Tax = T0 + tY
Where T0 is some exogenous variable and t is the marginal tax rate (MTR).
– Substituting this into our existing consumption function C = CO + c(Y − T ):
C = C0 − cT0 + cY (1− t)
– Hence, our expression for planned aggregate expenditure now becomes:
PAE = (C0 − cT0 + I0 +G0) + cY (1− t)
YE =
1
1− c(1− t) ∗ (C0 − cT0 + I0 +G0)
∆YE =
1
1− c(1− t) ∗ (∆C0 − c∆T0 + ∆I0 + ∆G0)
∆YE
∆G0
=
1
1− c(1− t) > 0
∆YE
∆T0
=
−c
1− c(1− t) < 0
– NOTE: The multiplier for a change in government expenditure is much larger in magnitude than
the multiplier for the exogenous change in taxation. Hence changes in government expenditure is
a far more effective tool in fiscal policy than taxation changes.
• The balanced budget multiplier examines the effect on GDP when government expenditure and taxation
increase/decrease by equal amounts.
kbb = kG + kT =
1
1− c(1− t) +
−c
1− c(1− t) =
1− c
1− c(1− t)
• If taxation and expenditure are increased by equal amounts, the result is not zero. The forces that
cause the economy to grow are stronger than those that cause the economy to shrink, so GDP will
increase.
• In regards to output gaps, the government has three options in correcting a contractionary output gap:
1. Increase government expenditure (the best option due to the mighty multiplier)
2. Decreased taxation (not as effective due to the weaker multiplier)
3. Increase government transfers (not as effective either)
• Any one of these changes will shift the PAE curve up on the (Y, PAE) coordinate plane and thus
increase equilibrium GDP, correcting the output gap.
• Fiscal policy can stabilize the economy in two ways:
1. Automatic Stabilizers
– During economic expansion and peak, individuals move into higher taxation brackets and so
the peak is not as high as it would be without taxation.
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– When the economy is contracting or in a trough, people move into lower tax brackets and tax
revenue falls. Social security systems cut in with benefit payments etc. and so the contraction
is not as extreme as it would have been.
– In this way, fiscal taxation and social security policies automatically stabilize the economy.
An increased marginal tax rate results in increased stabilization (reduces the size of the
multiplier).
2. Discretionary Fiscal Policy
– Fiscal policy must be forward looking due to time lags and the less timely nature of fiscal
policy compared to monetary policy.
– Discretionary policy includes actions such as surplus packages, tax relief, etc.
• The budget balance is a measure of the government’s income vs. expenditure.
Budget Balance = T −G = TA− TR− INT −G
Dt = Dt−1 −BBt
(where D is the level of debt and BB is the budget balance for a particular period)
• A government has three options to finance its expenditures:
1. Increased taxation
2. Increased debt (selling govt. bonds)
3. Printing money (which is a horrible idea)
Gt + TRt + rDt−1 = Tt +Dt −Dt−1
• Government sources of funds are taxation and debt, and government uses of funds are expenditure,
transfers and payment of interest on debt.
• Balancing the budget over the business cycle implies governments should borrow to finance budget
deficits when needed and repay these debts during periods of economic expansion by running budget
surpluses.
• The golden rule for public investment implies that if government projects will only benefit the current
population, they should be financed by current taxes. If projects will provide benefits for future
populations as well, governments should borrow money and the debt should be paid off by current and
future populations.
• Debt only becomes a problem when interest payments begin to take up a significant portion of the
government’s sources of money.
Debt to real GDP ratio =
D
Y
∆dt =
(r − g)dt−1
1 + g
− pbbt
• Where:
– d is the debt to GDP ratio
– ∆d is the change in the debt to GDP ratio
– r is the real interest rate
– g is the growth rate of real GDP
– pbb is the primary budget balance divided by real GDP (
Tt − TRt −Gt
Y
) which does not include
interest payments on debt
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• Hence if the real interest rate exceeds the growth rate of real GDP and the primary budget balance
ratio is negative, the debt to real GDP growth rate will be unsustainable.
• Introducing net exports to the three sector model, we can finally form our four sector model:
PAE = C + Iplanned +G+X −M = (C0 − cT0 +G0 + I0 +X0) + (c(1− t)−m)Y
YE =
1
1− (c(1− t))−m ∗ (C0 − cT0 +G0 + I0 +X0)
5.2 FORMULAE
(All relevant formulae were covered within the key concepts of this chapter)
Derivation of the Four Sector Model:
PAE = C + Iplanned +G+X −M
• C = C + 0 + c(Y − T )
• T = T0 + tY , so C = C0 + c(Y − T0 − tY ) = C0 − cT0 + cY (1− t)
• Iplanned = I0 (entirely exogenous)
• G = G0 (entirely exogenous)
• X = X0 (entirely exogenous)
• M = mY
Hence:
PAE = C0 − cT0 + cY (1− t) + I0 +G0 +X0 −mY
PAE = (C0 − cT0 + I0 +G0 +X0) + Y (c(1− t)−m)
Equating PAE and Y:
YE = (C0 − cT0 + I0 +G0 +X0) + YE(c(1− t)−m)
YE − YE(c(1− t)−m) = (C0 − cT0 + I0 +G0 +X0)
YE(1− (c(1− t)−m)) = (C0 − cT0 + I0 +G0 +X0)
YE =
1
1− [c(1− t)−m] ∗ (C0 − cT0 + I0 +G0 +X0)
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6 Financial Assets, Money and Private Banks
6.1 KEY CONCEPTS
• Risk and return: The return on an asset increases as the riskiness of that asset increases (investors
must be compensated for risks)
• Know basic details regarding bonds from FINS1613. This includes:
– Definitions of terms such as maturity, principal, coupon rate and coupon payment.
– How to calculate the NPV of annuities and perpetuities
– Discount, par and premium pricing for a bond, and how the coupon and discount rates can be
used to determine this.
• The definition of money:
– Must behave as a medium of exchange
– Must behave as a store of value
– Must behave as a unit of account
• Bartering is inefficient due to ambiguity regarding the true value of goods and the double coincidence
of wants
• Forms of money:
– Commodity money → has some intrinsic value (e.g. gold and silver coins)
– Fiat money → has no intrinsic value, thus not directly convertible into other commodities on
demand
• Measuring money:
– MB/Currency → Physical notes and coins in circulation + physical money in bank vaults +
physical central bank reserves
– M1 → MB + Chequable accounts and other demand accounts
– M2 → M1 + Savings accounts and other time deposits
– M3→M2 + Time deposits (A time deposit is an interest-bearing bank deposit that has a specified
date of maturity)
– Broad Money → M3 + Borrowings from the private sector by financial intermediaries
• Quantitative easing→ The introduction of new money into the money supply by a central bank. Done
during GFC to purchase risky assets from commercial financial institutions to prevent further financial
damage.
• Demand for money
– An increase in GDP results in an increase in the amount of money individuals would like to hold
– An increase in the aggregate price level results in an increase in the amount of money individuals
would like to hold
– An increase in the real interest rate decreases the amount of money individuals would like to hold
(increases the opportunity cost of holding cash)
– We can use the GDP deflator as a measure of the price level. See the money demand formula
below.
• Financial innovation → how technology and regulation can make improvements to retail payments.
E.g. Apple Pay, Bitcoin. No significant effect on money supply.
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• Banks are a special form of financial institution, as they can fund loans by simultaneously creating
deposits.
• The contribution of banks to the money supply are through its bank deposits.
• Since banks borrow short and lend long, they only have a limited supply of cash that can be paid out
to customers in the short term. If it is believed that the bank was unstable, they would all try to get
their money from the bank (which the bank would be unable to do due to the large volume of money
demanded simultaneously). This is called a bank run.
• In the case of a bank run or liquidity crisis, banks can borrow money from the reserve bank. Funds
only awarded by the RBA if the bank’s portfolio indicates it is solvent.
• Governments provide deposit insurance up to $250,000 to prevent bank run behaviour.
• Macro-prudential regulation→ APRA monitors all financial institutions and ensures a number of ratios
are within requirements. Builds a robust and secure financial sector.