Chapter 21

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					Chapter 20: Macroeconomic Challenges & Choices
   -   Keynes’ theory: depression & high unemployment stem from insufficient
       private spending (i.e. the government not spending enough); to cure the
       problem the govt should then increase spending
   -   Long-term problems of inflation & slow economic growth would return
       (increased govt spending might trigger inflation and lower long term growth
       of production; thus fewer jobs)

   -   Short term problems: Depression & economic fluctuation
   -   Long term problems: inflation, slow growth & unemployment

   -   Aim to explain why economic growth, unemployment, inflation & deficits are
       important factors for macroeconomics

Economic Growth:
          Expansion of the economy‟s production possibilities (an outward shift
            in the Production Possibility Frontier)
          Measured by the increase in real gross domestic product

                     Real GDP: value of total production of all nation‟s companies
                      & firms measured in prices of a single year
                     Real GDP measured in dollar prices, eliminating influence of
                      inflation (increase in average level of prices), determining
                      production growth
                     Not a perfect measure; excludes things self produced & the
                      underground economy (illegal activities) – still the best
                      measure of total production available

                     Trend Real GDP: Long run average level/growth rate of real
                      GDP. Rises for four reasons:
                          Growing labour force
                          Growing stock of capital equipment
                          Technological advances
                          Efficient use of current resources

                     Rate declines when resources diverted from most efficient uses
                     Productivity growth slowdown in 1970‟s sees Australia with a
                      smaller economy than if continued at pace from 1960‟s

                     Real GDP fluctuates around trend GDP in a business cycle.
                     Business cycle: Irregular (periodic) movement in production
                      (can fluctuate or increase). On average, lasts about four years.
                     Every cycle has two phases
                           Contraction – slowdown in economic activity, of
                              growth of real GDP
                           Expansion – acceleration of growth of real GDP
          Also has two turning points
               Peak – upper turning point, expansion turns into
               Trough – lower turning point (contraction into

   Recession: Occurs if contraction is severe. Is a downturn in economic
    activity, where real GDP declines for two successive quarters (negative
   Depression: A deep trough, or a slump (most recently 1990/91).
         Soft landing – Business cycle trough occurs, real GDP is still
            moderately strong
         Hard landing – Cycle trough and real GDP is weak/negative.

   Real GDP per person: Real GDP divided by population. For living
    standards to increase, real GDP must exceed rate of population growth.

   Economic growth around the world:
        Different long-term trends in real GDP: Asian countries in
          recent decades (Japan and South Korea) have near caught-up
          with countries at the forefront (like USA), in the most recent
          decade, the real GDP per person has stagnated somewhat and
          grew very little.
        Similar business cycles: Growth in economies for industrial
          countries (Australia, the US and the UK) has been similar.
          Rapidly growing Asian economies „insulated‟ from cycles in
          rest of the world.
        Similar productivity growth slowdown: World average growth
          of 3% per year. Production slow/shrinking in countries
          changing from state-managed economy to a market economy
          (i.e. Russia).

   Main cost of economic growth is forgone consumption. For high
    growth rate, resources must be devoted to advancing technology &
    accumulating capital, rather than producing goods for current
    consumption. Other costs include:
        Rapid depletion of natural resources (oil, gas)
        Increased pollution of air, rivers & oceans – can this be averted
           by technological advances? Cars using solar power, etc.
        More frequent job changes, movement of people from one part
           of a country to another.

   Sustainable economic growth: Rate where maximum economic
    growth sustained, beyond where rapid growth exceeds benefits.
   Government policies affect the quantity of resources devoted to
    research, development & invention.
Jobs & Unemployment:
          More jobs destroyed than created during a recession
          Strong positive relationship between economic growth (% change in
            real GDP) and job creation – when one fluctuates, so does the other

              Unemployment: where qualified workers available for work do not
               have jobs.
                   Labour force: Total number of people without jobs (employed
                      plus total number of people looking for jobs, but without jobs
                   Unemployment rate: Number of people unemployed, as
                      percentage of labour force. Excludes part-time workers seeking
                      full-time jobs. Measures unemployed people, rather than
                      unemployed labour hours.

              Why unemployment is a problem:
                  Lost production & income: Despite unemployment benefits,
                     safety net does not provide the same standard of living
                  Lost human capital: Prolonged unemployment damages job
                     prospects (becomes out of the loop, per se)

    - Upward movement in average price level. Deflation adversely is a downward
    - Price index: measures price level, average level of prices in one period as %
        of average level in earlier period (base year).

   -   Inflation rate: % change in price level over a period of time (usually one
       year). If positive, is rate at which average level of prices is rising; i.e. if
       inflation falls but is still positive, prices are rising slower.

   -   Formula:
       Inflation Rate = (Current year‟s price level – last year‟s price level) x 100
                                     Last year‟s price level
   -   Inflation rate commonly measured using CPI (Consumer Price Index), i.e. CPI
       for 2000 was 126.2, so price level = 126.2

   -   Inflation rate for Australia & the US similar with other industrialised countries
   -   Average inflation of industrialised countries very low, compared to developing

   -   Inflation is less of a problem if predictable; gains and losses occur due to
       changes in value of money. Amounts really paid & received fluctuate

   -   Hyperinflation – inflation rate exceeding 50% in a month. Workers often paid
       twice a day (money value becomes so nominal).

   -   Policies lowering inflation increases unemployment; higher unemployment
       can be a cost of low inflation.
Surpluses & Deficits:
   - Government Budget Deficit/Surplus:
           Govt budget surplus: Govt collects more in taxes than it spends
           Govt budget deficit: Govt spends more than it collects in taxes

             Surplus/deficit measured as percentage of GDP (total income in
              economy – NOT real GDP)

   -   International Deficit/Surplus:
            Current account balance: Exports – Imports – Net Income &
              Transfers paid abroad
            Current account surplus: Sell more to rest of world than is bought
            Current account deficit: Buy more from rest of world than is sold

             External debt: Total borrowings from the rest of the world

             Deficits: Spent > earned; borrow to cover deficit. Interest paid on
              deficit, and government must meet to cover these additional debts
             Government borrowing to increase consumption would see long term
              trouble; adversely a govt borrowing to buy assets earning a profit may
              be making a sound investment.

Macroeconomic Challenges & Choices:
  - Keynes: „Economy won‟t fix itself‟, government objective should be to
       achieve and maintain full employment.
  - Five challenges for macroeconomic policy:
  i)      Boost economic growth
  ii)     Stabilise business cycle
  iii)    Reduce unemployment
  iv)     Keep inflation low
  v)      Reduce government deficit

   -   Tools to pursue such challenges:
           Fiscal policy: Changes in tax rates, government spending
           Try to boost long term growth, incentive to encourage savings,
              investment & technological change; “smooth out business cycle”
           For recession, government might cut taxes, or increase spending
           For expansion, government might increase taxes or cut spending to
              slow real GDP, prevent inflation

             Monetary policy: Changes in interest rates & amount of money in

             Controlled by RBA; aim is to keep inflation in check
             Prevent money from expanding too fast, “smoothes business cycle”;
             In recession, RBA lower interest rates, and inject money into economy
             In expansion, RBA might increase interest rates to slow real GDP,
              prevent inflation from increasing
Chapter 22: Measuring Employment & Unemployment
Employment & Wages
Labour Force Status:
   - Working age population is total number of civilians from 15 to 69 years
   - Labour force includes all people who are employed & also some unemployed

Key Labour Force Indicators:
   - Labour force participation rate: labour force as % of working age population
          Labour force           =       Labour force                 x 100
            Participation rate            Working age population

   -   Unemployment rate: # of people unemployed expressed as % of labour force
       (sum of employed & unemployed)
           Unemployment rate = Number of people unemployed
                                         Labour force

              =              Number of people unemployed                   x 100
                      # of people unemployed + # of people employed

   -   Number of discouraged workers rise during contractions and falls during
       expansions; thus participation rate falls during contractions and rises in

   -   Labour market indicators do not give information about quantity of labour
       used to produce GDP, and cannot be used to calculate the productivity of
            Productivity of labour important as it influences wages earned

   -   Labour measured in hours rather than in jobs to determine the amount of
       labour used to produce GDP

   -   Aggregate hours: total # of hours worked by all people employed during a
       year (recently increased as a result of increasing employment levels)

   -   Two most recent recessions coincide with a decline in both aggregate hours
       and average hours.
           Has been an increase in part time employment by 10% (to around
              26%), with a decrease in full-time employment adversely.

   -   Real Wage Rate: Quantity of goods and services an hour‟s work can buy –
       equal to money wage rate  price level
           It is a significant economic variable, because it measures the reward
               for labour
           Slowdown in real wages (mid 70s  late 80s) coincides with
               slowdown in growth of labour productivity – main reason for
               slowdown in growth of real wages.
Unemployment & Full Employment:
   -   Job losers: Laid off, either permanently or temporarily; involuntarily
   -   Job leavers: Depart from jobs voluntarily, seek better jobs or retire
   -   Entrants: First time job seekers (no full time job for at least 2 weeks)
   -   Re-entrants: Unemployed because they re-entered labour force but no job
   -   New entrants: Mainly school leavers, new to market and new to labour force

   -   Job leavers & losers decrease level of employment & increase level of
       unemployment, but don‟t change labour force
   -   Entrants & re-entrants increase both level of unemployment & labour force

   -   During contractions, job losers are largest source of unemployed people, and
       number of re-entrants declines
   -   During expansions, more people are attracted back into workforce; number of
       job leavers also increase

   -   Average duration of unemployment varies over business cycle, creating the
       unemployment cycle – usually 18 months behind business cycle (too costly to
       fire & hire to keep up with business environment)
   -   At unemployment cycle peak, more very short-term unemployed people and
       long-term unemployed people in pool of unemployed, than in an
       unemployment cycle trough.
            Duration of unemployment more evenly spread when unemployment
               rate is low in unemployment cycle trough

Types of Unemployment:
   - Frictional, Structural, Seasonal or Cyclical

   -   Frictional: Arises from normal labour turnover (people entering and leaving
       labour force, creation & destruction of jobs).
            Will always exist, permanent & healthy phenomena
            Job matching – people seeking jobs that suit them, and vice versa
            Frictional is whilst unemployed people are searching for employment
            Amount of frictional employment depends on rate which people
               enter/re-enter, and at which jobs are made and destroyed
                    Is influenced by unemployment compensation – greater number
                       covered by unemployment benefits, the longer average time
                       taken in job search is, and greater is the amount of frictional

   -   Structural: When changes in technology/international competition change
       skills needed to perform jobs, or changes location of jobs
            Usually lasts longer than frictional, workers must retrain & relocate
            Destroying jobs in traditional industries, need for new skills become a
               long term problem – many companies “downsize” as a result of
               structural unemployment
   -   Seasonal: Only available at certain times of the year.
           Arises because number of jobs has decreased because of seasonal
           Mainly include agricultural industries & tourism-related industries

   -   Cyclical: Fluctuating unemployment over business cycle; increases during
       recession & decreases during expansion, i.e. sacked during recession, and
       hired again during expansion
            Is high when economy expanding slowly, or contracting
            Is low when economy expanding rapidly

Full Employment:
   - Occurs when all unemployment is frictional, seasonal, or structural, with NO
      cyclical unemployment
   - Unemployment rate here is called the natural rate of unemployment
   - Real GDP is at potential real GDP, or natural rate of output
          Natural rate of unemployment varies due to variations in frictional and
              structural unemployment.

   -   Unemployment is always evident because workings of labour market create
       problems of job matching and rationing.
Chapter 21: Monitoring Macroeconomic Performance
Gross Domestic Product (the GDP)
   -   The aggregate value of all final goods and services produced in the economy
       during a given time period (i.e. a year) – cf. Australia‟s GDP of $670 billion in
       2000/01 (measured in current prices); with real GDP in 2000/01 at $641
       billion, measured in 1999/00 prices.
   -   Calculated by valuing everything produced, and adding all values together.

Flows & Stocks:
   - Flow: Measured as a quantity per unit of time. GDP – value of goods and
      services produced in a country during a given time period
   - Stock: Measured as quantity that exists at a point in time

                                 Capital & Investment
   -   Capital: Plant, equipment, buildings & inventories of raw materials & semi-
       finished goods use to produce other goods & services. Flows affecting stock of
       capital are investment & depreciation:
            Investment is purchase of new capital; increases stock of capital
               (addition to inventory)
            Depreciation decreases stock of capital, results from wear &
   -   Gross Investment – Total amount spent on adding to stock of capital, and on
       replacing depreciated capital
   -   Net Investment – Actual increase in stock of capital; equals gross investment
       minus depreciation

   -   Capital stock decreases as capital depreciates, and increases due to gross
       investment; change in capital stock annually is the net investment

                                     Wealth & Saving
   -   Wealth – value of all things people own; what people own is a stock; what
       people earn is a flow; i.e. the cash people earn is a flow, how much cash
       people have is a stock.

   -   Consumption expenditure – a flow; the amount spent on consumption goods
       & services
   -   Saving – a flow: the amount of income remaining, after meeting consumption
       expenditure. Saving ads to wealth; dis-saving (negative saving) decreases

   -   Wealth of a nation at beginning of a year equals wealth at the start of the
       previous year, plus its saving (or minus dis-saving) during the year. Saving
       equals income minus consumption expenditure

   -   Stocks & flows affect both long-term growth in trend GDP and short-term
       fluctuations in actual GDP.
   -   Trend GDP grows as capital stock grows
   -   Real GDP fluctuates as investment fluctuates
                               Income & Expenditure
   -   Income = expenditure = value of production
   -   Circular flow of expenditure and income; used to measure GDP

A Simplified Economy:
   - Two sectors; households & firms; transactions take place in markets
            Factor markets: Households sell services of labour, capital & land to
              firms – firms then make income payments to households.
                   Payments are wages for labour services, interest for use of
                      capital, rent for use of land, and profit to owners of firms.
                   Payments are household incomes.
                   Aggregate income: Total amount received by all households in
                      payment for services of factors of production

             Goods & services markets: Firms sell consumer goods & services to
              households. In exchange, payments households make to firms are the
              consumption expenditure.
                  Investment: Buying new plant, equipment, buildings and
                    additions to inventories

             Financial markets: Firms finance investment by borrowing from
              households here.
                  Household savings flow into financial markets, firm
                    borrowings flow out of financial markets
                  Income is payment for services of a resource
                  Expenditure is payment for goods or services

                          Gross Domestic Product (GDP)
   -   Aggregate value of all final goods produced in the economy during a year;
       production can be valued by
           What buyers pay for it; or
           What it costs producers to make it

   -   Value of production is the same, regardless of viewpoint taken above

                     Aggregate Expenditure = Aggregate Income
   -   Aggregate expenditure (C) + (I): Total amount buyers pay for goods and
       services produced
            Consumption expenditure (C) plus investment (I) is aggregate
               expenditure on final goods & services
   -   Aggregate income (Y): Incomes paid for resource services (include wages,
       interest & rent paid)

   -   Hence Y = C+I: Aggregate income equals aggregate expenditure (everything a
       firm receives from sale of output is paid as income to employees)
            Aggregate GDP = Agg. Expenditure = Agg. Income

   -   Equilibrium: Agg. Expenditure = Agg. Planned expenditure (all purchased)
                              Consumption & Saving
   -   Inward flow (aggregate income Y), outward flows consumption (C) and
       household savings (S).
   -   Everything earned by households is spent on consumption goods & services
           Y=C+S
   -   Savings = Income – Consumption:
           S=Y–C

Injections & Leakages:
    - Injection: Expenditure that doesn‟t originate with households, adds to the flow
        of aggregate expenditure
             In a simplified economy, injection is investment (financed entirely out
               of household savings)
    - Leakage: Income not spent on domestically produced goods & services,
        reduces flow of aggregate expenditure
             In a simplified economy, leakage is savings

   -   Y = C + I, flows into and out of households give Y = C + S
           Therefore C + I = C + S; i.e. I – S = 0; i.e. I = S
           Therefore injections equal leakages

GDP, Expenditure, and Income Flows with Government & The Rest
of The World
                                  Government Sector
   -   Government expenditure: Govt. purchases goods and services from firms in
       goods & services market
   -   Govt. use taxes to pay for expenditure
   -   Net taxes: Equal to taxes paid to governments minus transfer payments
       received from governments (transfer from households to govt.)
            Transfer payments: Flows of money or cash payments from
              governments, i.e. unemployment or social benefits (flow from govt. to

   -   Budget Deficit: When govt. expenditure (G) exceeds net taxes (NT); financed
       by borrowing in financial markets

                                 Rest of World Sector
   -   Net exports (NX): Equals exports (EX) minus value of imports (IX)
   -   If NX positive, exports greater, rest of world in deficit, government surplus
            To finance deficit, rest of world borrows from domestic economy, or
              sells domestic assets (in financial markets – foreign borrowing)

   -   If NX negative, imports greater, govt. in deficit, rest of world surplus
            To finance deficit, borrow from rest of world, or sell to foreigners
              assets owned
Expenditure Equals Income:
   - Aggregate expenditure still equals aggregate income; as with simplified
   - Expenditure flows are consumption expenditure (C), investment (I), govt.
      expenditure (G), and net exports (NX). Sum of four flows equals aggregate
      expenditure on final goods and services (represented as GDP, symbol Y)
           Y = C + I + G + NX
           Aggregate income = aggregate expenditure

GDP, Consumption, Saving & Taxes:
  - Inward flow for household is aggregate income Y, outward flows are
      consumption expenditure C, household savings S, and net taxes NT
  - Everything received by households is either spent on goods, saved, or paid in
      net taxes:
           Y = C + S + NT

   -   Disposable Income (YD): Aggregate income minus net taxes
           YD = Y – NT
           Either spent on consumption goods and services or saved by
                  Y – NT = C + S

             Household savings equals disposable income minus consumption
                  S = YD – C

Injections & Leakages:
    - Injections: Investment I, govt. expenditure G, exports EX are injections
    - Leakages: Net taxes NT, household savings S, imports IM are all leakages

   -   Given Y = C + I + G + NX; breaking net exports up gives NX = EX – IM
           Then Y = C + I + G + (EX – IM)
           From above, Y = C + S + NT, hence:
                  I + G + EX – IM = S + NT
                  Adding imports to both sides yields:
                          I + G + EX = S + NT + IM
                          (Injections) = (Leakages)

   -   Left side shows injections into circular flow of expenditure & income, right
       side shows leakages from flow. Thus injections = leakages.

How Investment is Financed:
  - One of determinants of rate of production growth, financed by:
          National saving
          Borrowing from rest of world
                                 National Saving
   -   National saving: Amount of saving by households & business, plus govt.
   -   Household & firms savings S, govt. saving equals net tax minus govt.
            National saving = S + (NT – G)
            Budget surplus: saving positive, budget deficit: saving negative

                         Borrowing from Rest of The World
   -   When investment opportunities exceed national savings
   -   Foreign borrowing equals imports IM minus exports EX, therefore (– NX)
   -   When value of imports IM exceeds value of exports EX, must borrow from
       world an amount equal to (IM – EX) to cover the debt:
           Part of world‟s saving finances negative NX, frees up amount of
              national saving for financing investment in Australia (locally)
           If foreigners spend more on Australian goods than we do on rest of
              world‟s, then they borrow from Australia to pay the difference
                   Part of national saving goes to rest of world, isn‟t available to
                     finance Australian investment

   -   Therefore:
           Investment = S + (NT – G) + (IM – EX)
           I.e. in 2000/01, Australian investment was $111 billion; national
              saving was $108 billion, net exports were $3 billion. Australia
              borrowed $3 billion from rest of world to supplement national saving

Australia’s National Income & Product Accounts
   -   Data used to measure GDP is collected with three independent approaches
       reflecting the measures of GDP identified in the circular flow of income
            Expenditure approach;
            Income approach; and
            Production (value-added) approach

   -   GDP formally defined as “the sum, for a particular time period, of gross value
       added of all resident producers, where gross value added is equal to output less
       intermediate consumption.
            Intermediate Consumption – Consists of value of goods & services
              consumed in production process, other than depreciation.

The Expenditure Approach:
   - Measures GDP by collecting data on all final expenditures on goods &
      services, adding on contribution from exports, subtracting value of imports:
           GDP = C + I + G + NX

              C: Private final consumption expenditure
              I: Private gross fixed capital expenditure
              G: Government gross fixed capital expenditure
              N: Net exports of goods & services
   -   Consumption expenditure: Enter national accounts as households’ final
       consumption expenditure – on goods & services produced by firms, sold to
   -   Investment: Enter national accounts as private gross fixed capital formation –
       expenditure on capital equipment by firms, and expenditure on new residential
       houses by households
   -   Changes in inventories: Addition to stock of raw materials, semi-finished
       goods & unsold final goods held by firms. Essential input into production
   -   Government expenditure: Purchase of goods & services recorded as general
       government final consumption expenditure, plus all expenditure on capital
       goods, by all levels of government, recorded as public gross fixed capital
   -   Net exports: Difference between value of exports & imports.

   -   Domestic final demand – Sum of final consumption expenditure & gross fixed
       capital formation

   -   Gross national expenditure – Sum of domestic final demand & changes in

The Income Approach:
   - Measures GDP by adding together factor incomes, plus net taxes on
      production & imports – market costs of production
   - Factor incomes divided into three components:
          Compensation of employees
          Gross operating surplus
          Gross mixed income

   -   Compensation of employees: Payment by firms to employees, the income of
       labour as factor f production. Include net wages & salaries, fringe benefits and
   -   Gross operating surplus: Primary source of income for firms, income of
       entrepreneurship factor of production. Calculated as residual from firms‟
       production, or gross output after paying for factors of production &
       intermediate consumption.
            Net operating surplus: Measure of firms‟ profits. Gross operating
              surplus minus consumption of fixed capital.
            Gross operating surplus calculated for following types of firms:
                    Non-financial corporations (production of market goods & non-
                      financial societies)
                    Financial corporations (general corporations)
                    General government (all government departments in production
                      of goods & services outside normal market mechanism)
                    Dwellings owned by persons (business where owner pays
                      market rent to himself.
            Operating surplus – income from production of corporate enterprises.
              Gross mixed income – income from production of unincorporated
             Total factor income: Sum of compensation of employees, gross
              operating surplus & gross mixed income.
                  Part of GDP counted as income to suppliers of factors of
                      production (land, labour, capital & enterprise).
                  Value of production as seen by producers – not a complete
                      measure of GDP (differs from value of total output at prices
                      purchasers pay)
                  One further adjustment to total factor income…

             Market prices & basic prices:
                 Market prices being the price people pay for a good/service.
                    Include tax payable, less subsidies received on production &
                    imports (indirect taxes less subsidies).
                 Basic price is the price producers receive. Market prices less
                    taxes payable, plus subsidy receivable. Measures amount
                    retained by producer for any good/service produced as output.

                     Indirect tax: Tax on production, sale, purchase, or use of
                      goods/services charged as cost of production (i.e. GST,

                     Subsidies: Grants/payments made by government to producers
                      (i.e. incentive grants). Lowers market price below factor cost –
                      consumers pay less for good than it costs the producer to make

                     GDP: Difference between GDP measured using market prices
                      (expenditure approach) & total factor income is accounted for
                      by indirect taxes & subsidies.
                           Income approach measure of GDP by adding total
                              factor income & taxes, less subsidies on production &

The Production Approach:
   - Value added: Value of firm‟s output minus value of intermediate goods
      bought from other firms = sum of incomes (including profits) paid to factors
      of production (used by a firm, to produce output)
           Consumer‟s expenditure on a product is sum of value added at each
             stage of production (i.e. to make, process, package, distribute)

   -   Production approach: Add up gross product of every industry in the
       economy. Also must add value of taxes less subsidies on products (as output
       valued at prices received by producers – basic prices).

   -   Final goods & intermediate goods:
           Final good: Sum of value added at each stage of production equals
              expenditure on final good.
           Intermediate good: Transactions between production process and final
              produced good/service.
             Double counting: Counting expenditure on both final goods &
              intermediate goods.
             Goods can sometimes be both – i.e. power for a car can be
              intermediate, but the same power in a house is final – depends on use.
             Gross Product (value added) found by subtracting value of purchases
              of intermediates from industry‟s total product (avoids double
                   Sum of value added in all industries gives domestic product (at
                      basic prices). GDP then found by adding indirect taxes, less
                      subsidies to GDP at basic prices.

The Price Level & Inflation
   -   Price level is average level of prices, measured by a price index
   -   Inflation rate is % change in price level from one year to the next
   -   Main price indexes used to measure price level:
            Consumer Price Index
            GDP Deflator

The Consumer Price Index (CPI):
   - Based on consumption expenditure of a typical family
   - First chooses base period
   - Selects „basket of goods/services‟ as typically consumed by metropolitan
      households in the first base period

   -   Fixed basket of goods valued in base period, and in current period

   -   CPI = (current period value of basket  base period value of basket) x 100
           i.e. CPI for base period = 100
           CPI current period = (total exp. current  total exp. base) x 100

GDP Deflator:
  - Measures average level of prices of all goods/services making up GDP
  - Purpose is to measure contribution of rising places, so can see what happened
     to Real GDP

   -   GDP Deflator = (Nominal GDP  Real GDP) x 100
          E.g. GDP deflator of 104.7 shows price level in current period is 4.7%
            higher than in base period

   -   Nominal GDP: GDP valued in current year‟s prices
   -   Real GDP: GDP in prices of base year

   -   Differences between two measurements:
            Range of items covered – CPI measures consumer prices, GDP deflator
              measures all final goods prices
            Period used for quantities – CPI uses base year quantities, GDP
              deflator uses current year quantities
The Consumer Price Index & The Cost of Living
   -   CPI used to measure inflation; data generated can be used with other
       information in calculations of real & nominal GDP & the GDP deflator.
   -   As percentage changes in bias of estimated inflation rate skews upward, same
       percentage in estimated growth of real GDP goes downward.
   -   Same translation not applicable for CPI, for following biases:
            New goods bias
            Quality change bias
            Commodity substitution bias
            Outlet substitution bias

New goods bias:
   - Arrival of new goods places upward bias into estimate of price level
          E.g. new PCs for old typewriters

Quality change bias:
  - Improvements to goods
  - If adjusting for quality change, price can be constant – but in calculating CPI,
       price will count as having increased (ignores change)
            E.g. car in 1995 vs car in 2001; 10% better and 10% increase in price

Commodity substitution bias:
  - Substitution of similar goods/services, where price rises for a certain
         E.g. beef price increases, chicken remains constant: consumers vie for
            chicken instead. CPI records an increase because substitution not taken
            into account

Outlet substitution bias:
   - Finding most cost-effective outlets
   - When prices rise, incentive to find cheaper outlets increases
   - CPI surveys do not monitor outlet substitutions made

   -   Due to above biases, based on a fixed basket, CPI overstates effect of price
       change on inflation rate – ABS then periodically revises this basket in
       calculating the CPI (i.e. published every quarter by ABS)

 Is the GDP Deflator biased?
   - Real GDP includes new goods & quality improvements
           Based on people‟s actual expenditures, so reflects substitutions of both
             commodities & outlets
           In principle, GDP deflator isn‟t subject to same biases as CPI

   -   HOWEVER, to arrive at estimate of real GDP, physical quantities produced
       isn‟t directly measured – estimates quantities by dividing expenditures by
       price indexes (one of which being the CPI)
            SO, a biased CPI injects a bias into the GDP deflator
The (Uses and) Limitations of Real GDP
   -   Estimates of real GDP & growth rate for three main purposes:
            Economic welfare comparison
            International comparison of GDP
            Business cycle assessment & forecasting

Economic Welfare:
   - The state of well-being, standard of living.
   - GDP per person today much higher than in 1960‟s ($14,000  $33,000).
   - HOWEVER economic welfare depends on other factors (not measured
     accurately by Real GDP):
          Over-adjustment for inflation: Price indexes give upward-biased
            estimate of true inflation & downward biased estimate of growth rate
            of real GDP – however, exact magnitude of bias (though less than bias
            in CPI) isn‟t exactly known.
          Household production: Everyday household activities not counted as
            part of DP. Much more capital-intensive over past years – less labour
            used (i.e. microwave meals; high capital, low labour).
                 Almost certainly cyclical – In recession, household production
                    increases (unemployed produce fewer goods & provide
                    themselves more services). In expansion, employment outside
                    home increases, production inside home decreases.
          Underground economic activity: Avoids taxes & regulations (or
            because goods are illegal). Illegal activity, using illegal labour, cash-in-
            hand employment as well. (Large factor, i.e. for European regions
            changing from communist to a market economy).
                 Underground expands relative to rest of economy, if taxes are
                    high or regulations restrictive – adversely, shrinks if taxes are
          Environmental quality: Depletion of exhaustible resources, major
            environmental consequences of industrial production. Industrial
            societies produce more atmospheric pollution than primitive, or
            agricultural societies.
                 Resources used to protect the environment are counted as part
                    of GDP; but the effect it is used to counter against (i.e. polluted
                    breathing air) is not.
          Health & life expectancy: Higher real GDP enables more spending on
            medical research & health care. As real GDP increases, life expectancy
            has lengthened. Real GDP overstates improvements in economic
            welfare given other factors such as AIDS, drug abuse & young deaths.
          Leisure time: An economic good, adds to economic welfare. The more
            leisure time, the better off we are. Time spent working is counted as
            part of GDP; leisure time is not (though is as valuable as work – if it
            wasn‟t then we would be working all the time).
          Economic equality & social justice: Economies with few extremely
            wealthy people, and the majority living in poverty can still have a large
            real GDP per person. Less economic welfare with above than if equally
Are The Omissions a Problem?
   - If real GDP increases with no changes in other factors, then economic welfare
   - Depends on following questions:
           Business cycle questions
           Living standard & economic welfare questions

Business cycle questions:
   - In downturn, household production increases & so does leisure time, but real
      GDP doesn‟t record these.
   - In expansion, leisure time & household production probably decline – not
      recorded as part of GDP.
   - Directions of change of real GDP and economic welfare are likely to be the

Living standard & economic welfare questions:
    - Factors omitted from real GDP makes unreliable comparisons of living
       standards, i.e. underground economy for Australia v Nigeria
    - Living standards depend not only on value of output, but also composition of
       output & its distribution.
            E.g. an economy mass-markets weapons, whilst another mass-market
              users. Or if an economy is commanded by a small group of
              individuals; consumers will choose between which economy to live
Chapter 24: Expenditure Multipliers
The components of aggregate expenditure
   -   Components of aggregate expenditure are:
          Consumption expenditure, C
          Planned investment, I
          Government expenditures on goods & services, G
          Net exports, NX  exports, EX, minus imports, IX

   -   Consumption expenditure has historically been the most stable component of
       aggregate expenditure, with investment being the most volatile

   -   Consumption expenditure & imports depend on level of real GDP – as real
       GDP influences these two, and these two are components of aggregate
       expenditure, there exists a feedback loop between aggregate expenditure &
       real GDP.

Consumption & saving
   -   Disposable income (YD) is the most direct influence on consumption
       expenditure & savings.
   -   Disposable income: Real GDP or aggregate income (Y) minus net taxes (NT)
           YD = Y – NT

             Either spent on consumption goods & services, (C or S).
                   YD = C + S

             Greater the disposable income, the greater is consumption expenditure
              & greater is savings.
             At each level of disposable income, consumption expenditure plus
              savings equals disposable income (C + S = YD)

Consumption & saving plans:
   - Consumption function: Relationship between consumption expenditure &
     disposable income (everything else constant)
   - Saving function: Relationship between saving & disposable income
     (everything else constant)

   -   Consumption function:
           Horizontal axis: Disposable income (YD)
           Vertical axis: Consumption expenditure (C)
           As YD increases, C also increases
           Autonomous consumption expenditure: Independent of disposable
            income (YD = 0, C > 0). Factors other than income determine
            autonomous level of C.
           When C > YD, past savings used to pay for current consumption
           Induced consumption expenditure: Expenditure caused by increase in
            YD (in excess of autonomous expenditure)
   -   Saving function:
           Horizontal axis: Disposable income (YD)
           Vertical axis: Saving (S)
           As YD increases, saving also increases
           If YD > 0, but saving < 0, then negative saving (dis-saving) occurs

   -   The 45 degree line:
           Constant where C = YD.
           If consumption function is above this line, C exceeds YD
           If consumption functions is below, C is less than YD
           Where consumption function intersects 45 degree line, C = YD

Marginal Propensity to Consume (MPC):
  - Change in disposable income that is consumed; determines amount by which
      C changes when YD changes.
  - The change in C divided by change in YD
           MPC = C  YD

   -   Fraction of each additional dollar of YD received that is spent on
   -   Is the slope of the consumption function (rise over run)

Marginal Propensity to Save (MPS):
  - Change in disposable income that is saved; determines amount which S
      changes when YD changes
  - Change in S divided by change in YD
           MPS = S  YD

   -   Fraction of each additional dollar of YD that is saved
   -   Slope of saving function

   -   MPC + MPS always = 1
   -   E.g. C + S = YD
   -   As YD increases, part of each additional dollar of YD is consumed, and
       remainder is saved, therefore: C + S = YD
   -   Dividing both sides by YD  (CYD) + (SYD) = 1

Other influences on Saving & Consumption Expenditure:
   - Changes in YD change C and S, causing movement along consumption &
       saving functions.
   - Changes in other influences on C & S shift the functions
   - Such influences are mainly:
            Expected future disposable income
            Interest rates
            Wealth
   - Expected future income – Increases make people feel better off, leading to an
       increase in C and a decrease in S
   - Interest rates – A drop encourages increased borrowing & C, decreases S
   - Wealth – Increased wealth stimulates C & decreases S
   -   If expected future income increases, or interest rates fall, or wealth increases,
       C increases & S decreases.
            Consumption function shifts UP, saving function shifts DOWN
   -   Decrease in expected income, rise in interest rates or decrease in wealth
       shifts, C decreases & S increases.
            Consumption function shifts DOWN, saving function shifts UP (i.e.
               from (–40,0) for (S, YD) to (-20, 0)

   -   In an expansion, consumption function shifts upward
   -   In a recession, consumption function shifts downwards

The Australian Consumption Function:
   - Interest rates, wealth & expected income fluctuate, bringing both upward &
      downward shifts in consumption function
   - Rising wealth & rising expected income brings an upward shift in
      consumption function
   - As consumption function shifts upwards, autonomous consumption
      expenditure increases

Consumption as a Function of Real GDP:
   - C changes with change of YD; YD changes when real GDP changes or when
     NT changes (NT = Net taxes = taxes – transfer payments)
   - When real GDP increases, taxes increase & transfer payments decrease
   - YD & C both depend on real GDP

   -   Most of changes in C result from changes in real GDP
   -   Thus C is relatively stable in aggregate expenditure; other components are
       more important sources of fluctuations of real GDP; i.e. investment…

   -   Gross investment: Purchase new buildings/plant/equipment, addition to
       inventories or increase in stocks
           o Gross investment = Replacement investment + net investment

   -   Replacement investment: Purchase of replacements for worn-out or
       depreciated capital (depreciation)
   -   Net investment: Purchase of addition to existing capital, after accounting
       replacement investment

   -   Determinant of gross investment & key to fluctuation lies in firm’s investment
Firms’ Investment Decisions:
Main influences:
   - Real interest rates
   - Profit expectations

   -   Real interest rates:
          o Nominal interest rate, adjusted for inflation. Nominal interest rate is
              interest rate, expressed in terms of money.
          o Real interest rate = nominal interest rate – inflation rate
          o Is part of opportunity cost; one of:
                   Real interest paid on borrowed funds, as a direct cost, or
                   Real interest cost of using retained earnings; real interest
                      income forgone is opportunity cost of using retained earnings
                      to finance an investment project
                   If real interest rate rises, movement up investment demand
                      curve; planned investment decreases
                   If real interest rates drop, movement down investment demand
                      curve, planned investment increases

                     Position of investment demand curve depends primarily on
                      profit expectations…

   -   Profit expectations:
          o The higher the expected profitability (of new capital investment), the
               greater the amount of investment.
          o When firms become optimistic about future profits, investment
               demand increases (curve shifts right, increased investment)
          o When firms become pessimistic about future profits, investment
               demand decreases (curve shifts left, decrease in investment)

   -   Why investment is volatile:
         o Requires purchase of durable assets – might be delayed until future
             periods, small changes in real interest rates can affect investment
         o Profit expectations can be volatile – bringing rapid changes in
             investment demand

   -   Autonomous Investment:
          o Real GDP is not significant influence on investment decisions
          o Autonomous expenditure: Independent of real GDP
                I = Ī (or I = /I, following notation will be used herein)
                Investment is constant, I. Factors influencing investment,
                   change the value of that constant
Government expenditure on goods & services & net exports
Other components of aggregate expenditure, contributing to fluctuations in GDP:
   - Government expenditure on goods/services; and
   - Net exports

Government Expenditure on Goods & Services:
   - Measured to include government/public consumption/investment expenditure
   - Government expenditure influences GDP but isn‟t directly influenced by it;
      follows autonomous expenditure – government expenditure is constant, in
      respects to changes in real GDP.
          o G = /G

Net Exports:
   - Net exports: Expenditure on foreign goods/services
          o Australian exports minus Australian imports

          o Exports: Influenced by three main factors
                Real GDP in rest of world
                Prices of Australian-made goods & services, relative to prices
                  of similar ones in other countries
                Foreign exchange rates

                     The greater the real GDP in rest of world, greater is demand by
                      foreigners for Australian goods/services
                           E.g. recession in Japan decreases Japanese demand for
                             Australian goods/services, decreasing Aust. exports
                     The lower the price of Australian goods/services, greater the
                      quantity of Australian exports
                     The lower the value of the Australian dollar, the larger the
                      quantity of our exports

                     Exports don‟t rely on level of real GDP; thus autonomous
                          EX = /EX

          o Imports: Determined by three factors:
                Australian real GDP
                Price of foreign goods/services relative to Australia‟s
                Foreign exchange rates

                     The greater Australia‟s real GDP, the greater is the quantity of
                      imports into Australia.
                     The higher the price of Australian-made goods/services relative
                      to foreign ones, the higher the quantity of imports into
                     Similar with higher value of Australian dollar (we buy more)

                     Imports do rely on real GDP.
                    Marginal propensity to import: Fraction of increase in
                     Australian real GDP, spent on imports when other imports
                     remain the same
                         Identifies relationship between real GDP & imports
                         E.g. $100bn increase in Aust. real GDP, increases
                            imports by $25bn, MP to Import is 0.25

          o Net Exports: NX = EX – IM
                Exports are constant; autonomous expenditure depending on
                  real GDP for rest of world, relative prices & exchange rate
                  BUT not depending on Australia‟s real GDP

                    Export & import curves shift when real GDP for rest of world
                     changes, or Australian goods/services‟ prices change.
                         If real GDP in rest of world increases, export curve
                            shifts upward
                         If Australian goods/services are cheaper, relative to rest
                            of world, export curve shifts upward, import curve
                            shifts downward

Equilibrium expenditure at a fixed price level
   -   Prices at set level for a certain period of time; during this period, such
       quantities sell dependent on demand, not supply
   -   Relationship between aggregate planned expenditure & real GDP when prices
       are fixed.

The Aggregate Implications of Fixed Prices:
Fixed prices with two implications for economy as a whole:
   - Price level is fixed (each firm‟s price is fixed)
   - Aggregate quantity of goods/services demanded at fixed price level
       determines real GDP (as quantity demanded determines quantity sold)

   -   Aggregate planned expenditure: Determines aggregate demand
          o Planned C + planned I + planned G + planned EX – planned I

   -   RECAP: C and IM are influenced by real GDP
         o I, G & EX aren‟t influenced by real GDP (they fluctuate, but not
            because of real GDP)

The Aggregate Expenditure Model:
   - Aggregate expenditure schedule: lists aggregate planned expenditure
      generated at each level of real GDP
   - Aggregate expenditure curve: graph of the schedule mentioned above
Aggregate Planned Expenditure & Real GDP:
   - Aggregate planned expenditure: Calculated at a given real GDP by adding
      components together:
          o AE = C + I + G + (EX – IM)  C + I + G + NX

   -   Aggregate expenditure curve: Real GDP on horizontal axis, AE on vertical
       axis (see Figure 24.9)
           o To create AE curve, subtract IM from I + G + EX + C line
                    AE is expenditure on Aust. goods/services; BUT components
                      of AE  C, I, G, EX  include expenditure on imported goods
                      & services

   -   Induced expenditure: Sum of components of AE that vary with real GDP
   -   Autonomous expenditure: Sum of components of AE not influenced by real
       GDP (equal to level of aggregate planned expenditure when real GDP = 0)
          o Components are I, G, EX & Autonomous C (part of C not varying)

Actual Expenditure, Planned Expenditure & Real GDP:
   - Actual aggregate expenditure always equals real GDP
   - Planned aggregate expenditure isn‟t always equal to real GDP

   -   Differs due to unplanned excess/shortage of inventories in firms
           o If aggregate planned expenditure < real GDP, firms sell less than they
               produce, inventories increase
           o If aggregate planned expenditure > real GDP, firms sell more than is
               produced, inventories decrease

Equilibrium Expenditure:
   - Equilibrium expenditure: Level of AE which occurs when aggregate planned
       expenditure equals real GDP (i.e. AE – GDP = 0)
          o When spending plans fulfilled; price level fixed, equilibrium
             expenditure determines real GDP
          o Convergence; real DP adjusts so moves planned & actual towards

Convergence to Equilibrium:
   - E.g. Planned expenditure exceeds real GDP; inventories decrease; production
      increases to restore the level of inventories – cycle ends when real GDP
      reaches equilibrium
          o No unplanned inventory changes, firms do not change production
          o Y = C + I + G + NX  C + I + G + (EX – IM)

   -   When price level fixed, real GDP determined by equilibrium expenditure.
   -   Unplanned changes in inventories bring convergence to equilibrium
The multiplier
   -   As autonomous expenditure increases, aggregate expenditure increases too, so
       does equilibrium expenditure & real GDP
   -   Increase in real GDP is larger than change in autonomous expenditure

   -   Multiplier: Amount which change in autonomous expenditure is multiplied, to
       determine change in equilibrium expenditure & real GDP

The basic idea of the multiplier:
   - Multiplier determines magnitude of increase in aggregate expenditure,
      resulting from an increase in autonomous expenditure
           o If investment increases, expenditure by businesses means aggregate
              expenditure increases, as does real GDP.
                    Real GDP increases YD, bringing increase in consumption
                          Increased consumption expenditure adds to more
                              aggregate expenditure.

                             So real GDP & YD increase, as does consumption

   -   Initial increase in investment brings a bigger increase in aggregate
       expenditure, as it induces an increase in C.
   -   Works for both increase & decreases in autonomous expenditure

Why is the multiplier greater than 1?
  - Equilibrium expenditure increases by more than increase in autonomous
       expenditure; multiplier then is greater than 1.
           o Reason for this is that increases in autonomous expenditure induces
             increase expenditure (further increases)

          o Additional income induces additional expenditure, creating additional

The size of the multiplier:
   - Multiplier is amount which change in autonomous expenditure is multiplied,
       to determine change in equilibrium expenditure it generates.
   - Divide change in equilibrium expenditure by change in autonomous
           o Multiplier =  equilibrium expenditure   autonomous expenditure
                   E.g. $200bn  $50bn = 4
The multiplier & the slope of the AE curve:
   - Slope of AE curve determines magnitude of multiplier
   - Steeper the AE curve, larger the multiplier is (AE curve indicates how much
      induced expenditure increases, when real GDP increases)

   -   Change in real GDP equals change in induced expenditure (N) plus change
       in autonomous expenditure (A)
           o Y = N + A
           o Multiplier = Y  A
                   = 1  (1 – slope of AE curve)

          o With no income taxes & no imports, slope of AE curve = MPC
                Multiplier = 1  (1 – MPC)

          o As MPC + MPS = 1
                Multiplier = 1  MPS

Imports & income taxes:
   - Multiplier also determined by marginal tax rate & marginal propensity to
   - Income taxes & imports make AE curve less steep, and multiplier smaller than
      what it would be:
          o Income taxes: e.g. increase in autonomous expenditure
                  Increases real GDP; income & income taxes increase
                  YD increases by less than increase in real GDP
                  C increases by less than it would if taxes didn‟t change
                  Larger is marginal tax rate; smaller is change in YD & real

          o Imports: e.g. increase in autonomous expenditure
                Increases real GDP, increasing C
                Part of increase in C is on imports
                Only expenditure on domestics increase real GDP
                Larger is MP Import, smaller is change in real GDP

   -   MP to Import, and marginal tax rate, with MPC determine multiplier

   -   Multiplier equal to 1  (1 – slope of AE curve):
          o No imports, no income taxes: slope of AE curve = MPC
          o Imports, income taxes: decreases slope of AE curve (thus decreases
                   Lower MPC, higher marginal tax rate, higher MP to import all
                      decrease size of multiplier

   -   RECAP: Initial change in autonomous expenditure leads to magnified change
       in aggregate expenditure & real GDP
Business cycle turning points:
   - Forces which bring business cycle turning points are swings in autonomous
      expenditure, like investment & exports
   - Mechanism which gives momentum to economy‟s new direction is multiplier

   -   As expansion begins:
          o Increase in autonomous expenditure, increases aggregate planned
             expenditure (which exceeds real GDP at expansion)
          o Firms increase production, raising real GDP
                  Higher incomes, which stimulate C
          o Multiplier then kicks in, expansion picks up speed

   -   As contraction begins:
          o Decrease in autonomous expenditure, decreasing aggregate planned
          o Real GDP exceeds aggregate planned expenditure (at point of
              contraction) – firms see inventories piling up
          o Firms cut production, real GDP decreases
                   Lowers incomes, cuts C
          o Multiplier reinforces initial cut in autonomous expenditure; if
              contraction severe enough, recession ensues

             (The multiplier & the price level done later…)
Toolkit: Algebra of the multiplier
 Aggregate planned           Real GDP, Y                Consumption expenditure,
 expenditure, AE                                        C
 Investment, I               Government expenditure,    Exports, EX
 Imports, IX                 Net taxes, NT              Disposable income, YD

 Autonomous               Marginal propensity to    Marginal propensity to
 consumption expenditure, consume, b                import, m
 Marginal tax rate, t     Autonomous expenditure, A

Aggregate Expenditure:
Aggregate planned expenditure (AE) is as follows:
AE = C + I + G + EX – IM

Consumption function: C depends on YD
C = a + bYD  C = a + b(Y – NT)
 NT = tY
 C = a + b(1 – t)Y         consumption expenditure as function of real GDP

Import function: IM = mY

Aggregate expenditure curve: Using consumption & import functions to replace C, M
AE = a + b(1 – t)Y + I + G + EC – mY
 AE = [a + I + G + EX] + [b (1 – t) – m]Y
 AE = A + [b(1 – t) – m]Y

Equilibrium Expenditure:
Equilibrium expenditure when AE = Y (intersection of AE curve and 45 deg line)

AE = A + [b(1 – t) – m]Y  AE = Y
 Y = A + [b(1 – t) – m]Y
Y=           1            xA
      1 – [b(1 – t) – m]

The Multiplier:
Is change in equilibrium expenditure & real GDP results from change in autonomous
expenditure, divided by change in autonomous expenditure
Y =           1          x A
       1 – [b(1 – t) – m]
       =              1
               1 – [b(1 – t) – m]

So slope of AE curve is b(1 – t) – m; so
Multiplier =          1
              1 – Slope of AE curve
Chapter 25: Fiscal Policy
Government Budgets
   -   Commonwealth budget: Statement of expenditures & tax revenues of
       government, with laws & regulations approving & supporting expenditures &
   -   Federal budget has two purposes:
           o Finance business of government
           o Pursue governments Fiscal Policy
                   Fiscal Policy: Use of federal budget to achieve macro
                     objectives (i.e. full employment, sustained long-term economic
                     growth, price-level stability)

The Commonwealth Government Budget:
   - Revenues
   - Expenses
   - Budget balance

   -   Revenues: Government‟s receipts, comes from four sources:
          o Taxes on individuals (capital gains tax, Medicare levy)
          o Taxes on companies (super-annuation tax, other taxes)
          o Indirect taxes (petrol, beer, spirits, wine, tobacco & luxury cars)
          o Non-tax revenue (receipt from sale of goods/services, interest)

   -   Expenses: Classified in three categories:
          o Expenditure on goods/services (government cars, PCs, highways)
          o Transfer payments (pay personal benefits to individuals & others)
          o Interest & other payments (interest on debt, other financing costs)

   -   Budget balance = Revenues – Expenses
          o If revenues > expenses; budget surplus
          o Expenses > revenues; budget deficit
          o Revenue = expenses; balanced budget

   -   Underlying surplus/deficit: Measure of budget balance adjusting for impact of
       asset sales and other pure financial transactions, not affecting governments net
       borrowing requirements/net worth.
   -   Headline surplus/deficit: Unadjusted figure of above

   -   Deficit & debt: Government debt is sum of past deficits minus sum of past
           o When government has deficit, debt increases
                   When deficit is persistent, level of debt grows
                          Deficit leads to increased borrowing, thus larger debts
                            & larger interest payments
                               o Increased deficit therefore more increased debt
State & Local Government Budgets:
    - General government sector deliver non-market services & income transfer for
       public policy purposes
    - Public trading enterprise sector includes government business enterprises
       (GBEs), i.e. Australia Post
    - Public sector defined to include all entities majority-owned and/or controlled
       by Commonwealth, state or local governments
    - Governments make transfer payments to the public (as personal benefit
       payments, or other subsidies) and also to other governments (expense by
       government making grant, receipt to recipient of grant)

   -   Commonwealth government: Collects most of tax revenue; expenses are
       mainly transfers to public/other governments

   -   State government: Most of Australia‟s govt expenditure on goods/services.
       Collects some taxes from goods/services and other sources. Largest source of
       revenue is transfers/grants from Cth govt.

   -   Local government: Rates on property account for majority of their revenue.
       Largest expenditure on local roads & infrastructure.

The Public Sector as a Whole:
   - Impact of public sector as a whole is measured by public sector‟s deficit or net
      borrowing requirement
          o Deficit = Total public sector expenses – total public sector revenue –
             increases in total public sector provisions

   -   Net public sector borrowing requirement (PSBR) adjusts public sector deficit
       for advances. Measures public sector‟s impact on financial markets.
   -   When borrowing to finance deficit, public sector competes in financial
       markets with private sector firms for funds
   -   In surplus, public sector is net lender to financial markets

Fiscal Imbalance:
   - Vertical fiscal imbalance: Severing link between revenue generation &
        expenditures at different government levels
           o Hinders management of fiscal policy; then requires close cooperation
              with different levels of government (not always possible)

Fiscal Policy Multipliers
   -   Discretionary or automatic
   -   Discretionary: Initiated by Act of Parliament. Requires change in tax laws or
       some spending program (i.e. increase in defence spending)
   -   Automatic: Change triggered by state of economy (i.e. increase in

   -   Autonomous taxes: Not varying with real GDP – government fixes them, they
       change only when the government says so (not varying with economic state)
   -   If recession takes hold, unemployment increases and incomes drop
   -   If expansion is too strong, inflation sets in
            o To minimise effects of the above two, government uses fiscal policy &
               change either expenditure on goods/services or taxes (thus influencing
               aggregate expenditure & real GDP)

   -   Each fiscal policy creates multiplier effect on real GDP:
          o Government expenditures multiplier; and
          o Autonomous tax multiplier

Government Expenditures Multiplier:
   - Amount by which a change in government expenditure on goods/services is
      multiplied to determine change in equilibrium expenditure, and real GDP it
   - When government expenditure changes, so does AE and real GDP
         o Change in C, bringing further change to AE (thus multiplier process)

   -   Equilibrium expenditure & real GDP occur when AE = actual expenditure
   -   When AE exceeds real GDP, inventories decrease, firms increase production
       (to adjust for the forecast)
           o Output, incomes & expenditures increase
                    Increased incomes induce further increase in expenditure

   -   Government expenditures multiplier =            1
                                                    1 – MPC

   -   So when price level is fixed, increase in govt expenditures increases real GDP
          o To produce more output, need more jobs, so increase can create jobs
                  Therefore changing goods/services expenditure is one way govt
                     can influence real GDP…

Autonomous Tax Multiplier:
   - Amount by which change in autonomous taxes is magnified or multiplied, to
      determine change in equilibrium expenditure & real GDP it generates
   - Increase in tax decreases YD, decreasing C (thus decreasing real GDP)

   -   As change in autonomous taxes changes AE initially by only MPC multiplied
       by tax change, tax multiplier is:
           o Autonomous tax multiplier =                 – MPC
                                                         1 – MPC

Automatic Transfer Payments:
   - Increase in transfer payments works like decrease in taxes (increasing AE)
          o So autonomous transfer payments multiplier is positive:
          o Autonomous transfer payments multiplier =               MPC
                                                                  1 – MPC
Automatic Stabilisers:
   - Mechanism that dampens fluctuations in real GDP, without explicit policy
     action by govt; decreases multiplier effect of fluctuations in I and EX
   - Two features create automatic stabiliser:
          o Induced taxes & transfer payments
          o Imports

Induced Taxes & Transfer Payments:
   - Induced taxes: Varies with real GDP
          o Tax revenues depend on real GDP
          o In expansion, induced taxes increase because real GDP increases
          o For outlay; transfer payments increase during times of recession &
             hardship, adversely decrease in expansion
          o Act as automatic stabilisers & decrease size of multiplier

           o Automatic stabilisation: Arises due to influence of induced taxes &
             transfer payments on YD
                  Induced taxes & transfer payments make fluctuations in YD
                     smaller than in real GDP; slows expansions & moderates

           o Smaller multiplier effect: Weaken link between real GDP & YD,
             decreasing effect of change in real GDP on C, thus decreases multiplier
             effect of changes in AE
                  Marginal tax rate: Proportion of additional dollar of real GDP
                     flowing to government in net taxes (taxes – transfer payments)
                  Higher the marginal tax rate, larger is proportion of additional
                     dollar of real GDP paid to government, smaller change in C
                          Induced by change in real GDP, then the smaller is
                             multiplier effect

   - Effect of imports on autonomous expenditure in Ch 24
   - Proportion of additional dollar of real GDP spent on imports is determined by
      MP to import.
         o Larger the MP to Import, smaller the increase in expenditure on
             domestic goods/services, so smaller autonomous expenditure
             multiplier & smaller fluctuations in real GDP (less drastic)

Cyclically Adjusted Deficit:
   - Determine if budget balance is temporary & cyclical, or persistent:
   - Structural surplus/deficit: Budget balance of economy at full employment,
       when real GDP = potential GDP
   - Cyclical surplus/deficit: Actual surplus/deficit – structural surplus/deficit

       (Fiscal Policy Multipliers & The Price Level done later…)
Toolkit: Algebra of the Fiscal Policy Multipliers
 Aggregate planned           Real GDP, Y                   Consumption expenditure,
 expenditure, AE                                           C
 Investment, I               Government expenditure,       Exports, EX
 Imports, IX                 Net taxes, NT                 Disposable income, YD

 Autonomous               Marginal propensity to    Marginal propensity to
 consumption expenditure, consume, b                import, m
 Marginal tax rate, t     Autonomous expenditure, A

Equilibrium Expenditure:
Aggregate planned expenditure: AE = C + I + G + EX – IM

Consumption function: C = a + b(Y – NT)

Equilibrium expenditure:     Y=                1           xA
                                      1 - [b(1 – t) – m]

Government expenditures multiplier:
A = G

GEM =        1
     1 – [b(1 – t) – m]

where t = 0, m = 0, GEM = 1(1 – b)

Autonomous tax multiplier:
   1 – [b(1 – t) – m]

where t = 0, m = 0, ATM = –b(1 – b)

Autonomous transfer payments multiplier:
   1 – [b(1 – t) – m]

where t = 0, m = 0, ATrPM = b(1 – b)

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