Lecture Slides 2013 Vietnam Sem3

MODULE 1: CONCEPTS
ECONOMIC METHODOLOGY & THE ECONOMISING

PROBLEM
MEASUREMENT - GDP, UNEMPLOYMENT & INFLATION
Economic Methodology & the Economising Problem

Economics: Foundations and Models - Chapter 1
Choices and Trade-Offs in the Market - Chapter 2
Learning Objectives:
1.
2.
3.
4.
5.
6.
Discuss the following important economic ideas: people are rational; people
respond to incentives; optimal decisions are made at the margin.
Understand the issues of scarcity and trade-offs, and how the market
makes decisions on these issues.
Understand the role of economics in modern analysis.
Distinguish between microeconomics and macroeconomics.
Use a production possibility frontier to analyse opportunity costs and tradeoffs.
Understand the basics of trade.
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School of Economics, Finance and Marketing
Economics
A social science concerned with the allocation of
scarce/limited resources between unlimited and often
competing needs and wants.
Scarcity: The situation in which unlimited wants exceed
the limited resources available to fulfill them.
Trade-off: The idea that because of scarcity, producing
more of one good or service means producing less of
another good or service.
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Resource Categories
Resources are divided into 4 main categories.
Land: all natural resources.
Labour: Requires a fundamentally scarce resource -
TIME.
Capital:
Human capital: knowledge & skills that people develop
Physical Capital: buildings, machinery tools, etc.
Enterprise or entrepreneurial ability
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Economics and Individual Decisions

Three ideas are primary throughout the course:
1. People (economic agents) are rational.

2. People (economic agents) respond to economic
incentives.
3. Optimal decisions are made at the margin.
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Economic Models
Economics deals with generalities/statements about

regularities, concerning economic behaviour.
Models are simplified representations of the real world.
Ceteris Paribus
A hypothesis in an economic model: A statement about
an economic variable that may be either correct or
incorrect.
Economic variable: Something measurable that relates to
resources that can have different values.
In testing hypotheses, economists distinguish between
correlation and causality.
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Positive versus Normative

Positive: Claims that attempt to describe the world as it
is. Statements of facts. Can be tested empirically.
Normative: Claims that attempt to prescribe how the
world should be. Opinions. Cannot be tested empirically.
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Macroeconomics versus Microeconomics

Microeconomics: The study of how individuals make
decisions. Microeconomics considers how households
and firms make choices, how they interact in markets,
and how the government attempts to influence their
choices.
Macroeconomics: Enables us to better understand the

structure and behavior of the entire economy (regional,
national or global) and to consider issues associated with
measuring performance. Macroeconomics is the study of
the economy as a whole and includes topics such as
inflation, unemployment, and economic growth.
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Scarcity and Trade-offs

1.
What to produce
2.
How to produce it
3.
Who will receive the products

Commanding Heights Episode 1, Chapter 2: The Old Order Fails
Laissezfaire/Market
Economy
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WHO DECIDES?
Mixed
Economy
Command
Economy
Financial
Markets
Resource
Market
s
st
o
C
rces
u
o
Res
Borrowing & Lending

Private and Public
Mo
n
ren ey In
t, in com
tere
e
st, (wag
Lan
e
pro
d
fits s
Cap , Labo
)
ur,
it
Ente al,
rpri
se
Firm
Household
Re
v
en
ue
oo
ds
&
Se
rv
ic
es
s&
d
o
Go
Product
Market
s
i ce
v
r
Se
ing
d
en
Sp
Government
External
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Production Possibilities Frontier

How to achieve the greatest possible satisfaction of
societys material wants given scarce resources?
Full employment
Full production
Allocative efficiency
Productive efficiency
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Production Possibilities Frontier

Represents the maximum possible combinations of goods & services
that can be produced with a given quantity of factors of production and
given technology.
butter
10 A
W
Unattainable
U
Attainable but not desirable
E
4
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guns
12
Check Your Knowledge

An "increase in efficiency" suggests that an
economy:
a. Has moved from a point outside of, to a point on, its
production possibilities curve.
b. Has decided to produce more consumer goods and
fewer capital goods.
c. Is able to get less output from a given amount of input.
d. Is able to get more output from a given amount of input.
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Opportunity Cost
The opportunity cost of any
activity is the highest-valued
alternative that must be given
up to engage in the activity
under consideration.
butter
10
Any movement along the PPF

involves the concept of
opportunity cost.
E
1
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Can only obtain more of one

good by having less of the
other.
guns
14
Increasing & Constant Opportunity Costs

butter
10
9
pastries
10 A
B
C
8
6
C
E
2
E
1
guns
Scarce resources are not

equally suitable in all
productive activities.
Economic resources are not
completely adaptable to
alternative uses.
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cakes
Scarce resources are

equally suitable in all
productive activities.
Economic resources are
completely adaptable to
alternative uses.
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Trade-offs and disaster relief

More funds for one
disaster relief means
less funds for other
charities.
Consider the
opportunity cost as
well as the direct
financial costs
associated with the
Queensland floods.
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Economic Growth
computers
(good for the future)
Over time PPF can move outwards.

Achieved through economic growth.
The following will push the PPF out:
Capital accumulation.
Technological progress.
Increased resources
pizzas (good for the present)

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Here is a production possibilities table for watches and
bags in Consumer Land.
Production Alternatives
Type of product
Watches (in millions)
10
Bags (in millions)
10
15
20
a.
Draw a PPF that corresponds with the data in the table.
b.
Why must Consumer Land sacrifice successively larger

amounts of watches to acquire more bags. What type of
opportunity costs is it facing?
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c.
If the economy is currently at production alternative D:

i. What is the opportunity cost of five million more bags?
ii. What is the opportunity cost of three million more watches?
d.
Where would the economy be operating if a recession in Consumer

Land resulted in 2 million people losing their jobs?
e.
If the production possibilities frontier for Consumer Land was a

straight line, what would it indicate about the countrys opportunity
costs? What does this indicate regarding resources?
f.
Suppose improvement occurs in the technology of producing

watches but not in the production of bags. Illustrate the impact on
the original production possibilities frontier.
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Trade
We can use the production possibility frontier and the
concept of opportunity cost to explain the economic
gains from specialisation and trade. (ECON1086:
International Trade covers the important topic of
international trade in more detail).
Trade: the act of buying or selling a good or service in a

market.
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PPF and International Trade

Mercantilism held that countries would grow wealthy by
accumulating gold and silver. They would do so by exporting as
much as possible, and importing as little as possible.
Adam Smith put forward the idea that the wealth of a nation
depends on the incomes of the people in the country and what they
are able to consume, not on the gold and silver held by the
monarchs and the nobles.
According to Smith, imports rather than exports are the purpose of
trade. Imports of goods and services rather than the accumulation
of gold and silver improve peoples standard of living.
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Trade
Absolute and comparative advantage.
Absolute advantage: The ability of an individual, firm or
country to produce more of a good or service than

competitors using the same amount of resources.
Comparative advantage: The ability of an individual, firm
or country to produce a good or service at a lower

opportunity cost than other producers.
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The Benefits of International Trade

David Ricardos theory of comparative advantage (developed in
1817) showed how a country could improve the income of its
citizens by allowing them to trade with people in other countries.
International trade allows nations to increase the productivity of
their resources through specialisation and thereby to realise a
higher standard of living than is possible in the absence of trade.
Trade enables a country and the world to produce and consume
more than would be possible without trade.
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Trade
The basis for trade is comparative advantage not
absolute advantage.
Individuals, firms or countries are better off if they

specialise in producing goods and services for which
they have a comparative advantage and obtain other
desirable goods and services by trading.
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Measurement : GDP, Unemployment, Inflation

Measuring Total Production, Income and Economic Growth - Chapter 4
Economic Growth, The Financial System and Business Cycles Chapter 5 (pp.
119-120)
Unemployment - Chapter 9 ( pp. 246-262)
Inflation - Chapter 10 (pp. 272-280)
1. Explain how total production in an economy is measured.
2. Discuss whether GDP is a good measure of economic wellbeing.
3. Discuss the difference between real and nominal variables.
4. Understand how the economic growth rate is measured.
5. Define the unemployment rate and the labour force participation rate, and understand how
they are calculated.
6. Explain the economic costs of unemployment.
7. Identify the different types of unemployment
8. Define the price level and the inflation rate, and understand how they are calculated.
9. Use price indexes to adjust for the effects of inflation.
10. Distinguish between the nominal interest rate and the real interest rate.
11. Discuss the problems caused by inflation.
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GDP
Gross Domestic Product (GDP): The total market value of all
final goods and services produced in the economy during a
specific period.
Gross National Product (GNP): The total market value of all final
goods and services produced by residents of a country (eg.
Vietnamese residents) during a specific period.
GDP includes only the market value of final goods.
Final good or service: A good or service purchased by a final
user.
Intermediate good or service: A good or service that is an
input into another good or service, such as a tyre on a truck.
GDP includes only current production.
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Methods to Measure GDP

Three alternative methods to measure GDP:
1. The Production or Value Added Method: The sum of the
value of all goods and services produced by industries in the
economy in a year minus the cost of goods and services used
in production leaving the value added.
2. The Expenditure Method: The sum of the total expenditure
on goods and services by households, investors, government
and net exporters (exports minus imports).
3. The Income Method: The sum of the income generated by
resources used in the production of goods and services
(includes the sum of wages, salaries and supplements plus
rent, interest, profit and dividends).
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Financial
Markets
Pr
Resource
Market
n
io
t
uc
d
o
Inc
om
e
Borrowing & Lending

Private and Public
Firm
Household
Value of Production = Value of Resources = Value of Income Generated = Expenditure Undertaken

In
ve
s
tm
en
tE
xp
en
di
tu
re
Government
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Product
Market
m
su
n
Co
Ne
tE
xp
re
or
u
t
i
tE
d
en
xp
p
Ex
en
.
t
v
di
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tu
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i
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External
re
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Simple Relationships
RGDP = Y = AE = C + I + G + NX
For a closed economy we simply remove the external sector which makes our
income function:
Y = C+ I + G
I=YCG
Stotal = Sprivate + Spublic
Sprivate = Y + TR C T and
Spublic = T G TR, hence
Stotal =
Thus:
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One bag of flour is sold for $1.50 to a bakery, which
uses the flour to bake bread that is sold for $4.00 to
consumers. A second bag of flour is sold to a
consumer in a grocery store for $2.00. Taking these
three transactions into account, what is the effect on
GDP?
a. GDP increases by $1.50.
b. GDP increases by $3.50.
c. GDP increases by $6.00.
d. GDP increases by $7.50.
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Components of GDP
Consumption: Spending by households on goods and
services, not including spending on new houses.
Investment: Spending by firms on new factories, office
buildings, machinery (planned), and inventories
(unplanned), and spending by households on new houses.
Government purchases: Spending by federal, state, and
local governments on goods and services.
Net exports: The value of exports minus the value of
imports.
GDP = C + I + G + NX
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Some Actual Values

Table and graph of components of GDP, 2006/07
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Issues in the Measurement of GDP:

Shortcomings of GDP as a measure of total
production
GDP does not reflect total current production as
production from the following sources are not reflected in
its calculation:
Household production: Goods and services people
produce for themselves.

The black economy: Buying and selling of goods and
services that is concealed from the government to avoid

taxes or regulations or because the goods and services
are illegal.
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Does GDP measure what we want it to measure?

Shortcomings of GDP as a measure of wellbeing:
The composition and distribution of GDP is not captured in
GDP measures.
The value of leisure is not included in GDP.
The level, quality of and access to health care is not
measured in GDP.
GDP does not accurately reflect improvements in the quality
of products.
GDP is not adjusted for pollution or other negative effects of
production.
GDP does not reveal anything about social problems that
also impact on overall societal wellbeing.
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Nominal (Money or Current) GDP versus Real

GDP
Inflation or deflation complicates the comparison of figures
measuring GDP over time, because GDP is a price-times-quantity
figure.
Nominal GDP could increase over time because of increased
output, increased prices or both.
Suppose the economy had a money GDP of $1,000 in 2008, which
results from the production of 1,000 apples that sell at a price of $1
per apple. Would it be better off in the year 2009 with a money
GDP of $2,000?
What would be your conclusion if you found out that the $2,000
GDP resulted from the production and sale of 1,000 apples at a
price of $2 per apple?
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Price and Quantities

Year
Price of
apples
2006
$1
2007
2008
Year
Qty. of
apples
Price of
burgers
Qty. of
burgers
100
$2
50
$2
150
$3
100
$3
200
$4
150
Calculating GDP using current prices
2006
2007
2008
Year
Calculating GDP using constant prices (base year 2006)
2006
2007
2008
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Real GDP versus Nominal GDP

Calculating Real GDP
Real GDP (RGDP): The value of final goods and services
evaluated at base year prices.
Nominal GDP: The value of final goods and services valuated at
current year prices.
Nominal GDP can change over time due to changes in either price
or output. RGDP shows changes in output only.
GDP statisticians select a base year and use this over a specified
period to measure RGDP in order to make meaningful
comparisons of GDP over time.
A simple rule: RGDP equals base year prices times current year
quantities.
nominal GDP
RGDP
100
price index
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Calculating Economic Growth

The Economic Growth Rate: the rate of change
in real GDP from one year to another.
Real GDP Current - Real GDP
EconomicGrowth
Real GDP Previous
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Slide 38
Previous
x 100
38
Measuring Unemployment
Unemployment rate: percentage of the labour force that
is unemployed.
Number Unemployed
Unemployme nt Rate
100
Labour Force
Labour-force Participation rate: percentage of the adult
population in the labour force.
Labour Force
Labour - force Participation Rate
100
Adult Population
Labour force = No. of employed + No. of unemployed

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Slide 39
39
Types of Unemployment
Frictional Unemployment
Includes workers who are in the process of voluntarily
switching jobs, workers who are temporarily laid off
because of seasonality, and new entrants into the labour
force. Largely due to imperfect information.
Structural Unemployment
Unemployment due to fundamental changes in the kinds of
jobs that the economy offers. Workers may have
inappropriate skills.
Cyclical unemployment
Due to a deficiency in aggregate demand for goods and
services.
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Slide 40
40
Full Employment and the Natural

Unemployment Rate
When cyclical unemployment is zero, there is full employment.
Full employment is therefore achieved when real GDP is equal
to its long-run potential GDP.
At full employment, there will inevitably be some structural and
frictional unemployment.
The unemployment rate at full employment is termed the
natural rate of unemployment.
The natural rate of unemployment is not forever fixed and will
vary as rates of frictional and structural unemployment
change.
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Issues in the Measurement of Unemployment

Discouraged workers: individuals who have given up
looking for work but would like to work.
Underemployment: All part-time workers are classified as
employed. Yet many part-time employees may want to
work full-time. (Underemployment may also apply to
causal workers who work in excess of 1 hour per week
and are counted as employed even though they might like
to work more hours).
Truthfulness issues
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Inflation
Price level: a measure of the average prices of goods

and services in the economy.
Inflation rate: The percentage increase in the price level

from one year to the next.
Deflation: A decline in the general price level in the

economy.
PI year 2 PI year 1
Inflation Rate
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PI year 1
100
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Measuring Inflation
Consumer Price Index (CPI): An average of the prices of
the goods and services purchased by the typical urban

family of 4 in an economy.
The Market Basket: In Vietnam, the General statistics
office identifies:
A typical
The
or representative Vietnamese household.
goods and services purchased by the household
(this is the market basket).
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Consumer Price Index
The CPI is the most commonly known price index and is based on
changes in the price of a given basket of consumption g&s.
Fixed basket of 4 apples and 2 burgers
Year
Price of apples
Price of burgers
2006
$1
$2
2007
$2
$3
2008
$3
$4
Year
Cost of basket
2006
2007
2008
Year
Consumer price index (2006 is the base year)
2006
2007
2008
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Inflation
Inflation rate calculated used the CPI:
2007:
2008:
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Issues in the Measurement of Inflation

The CPI is the most widely used measure of inflation.
Is the CPI accurate?
Four sources of bias in the CPI may lead to its overstating
the inflation rate.
Substitution bias
Increase in quality bias
New product bias
Outlet bias
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Other Measures of Inflation

The GDP Deflator: GDP also allows us to calculate
changes in the price level over time. The GDP deflator is a
measure of the price level calculated by dividing nominal
GDP by real GDP and multiplying by 100.
The Producer Price Index (PPI): an average of the prices
received by producers of goods and services at all stages
of the production process.
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Using Price Indexes to Adjust for the Effects of

Inflation
The purchasing power of the dollar falls over time as prices
rise.
Price indexes, such as the CPI, allow us to adjust for the
effects of inflation so we can compare dollar values over time.
For example; we can find the 2008 purchasing power
equivalent of a $20,000 salary in 1980. We use the following
formula:
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Hyperinflation
Extremely rapid increases in the general price level.
In periods of hyperinflation, money loses value so rapidly,
that firms and households try to avoid holding it.
Hyperinflation is often associated with political instability
and usually accompanied by recession.
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Real versus Nominal Interest Rates

Nominal interest rate: The stated interest rate on a
loan.
Real interest rate: The nominal interest rate minus the
inflation rate.
Deflation: A decline in the general price level in the
economy.
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MODULE 2: MARKETS
THE PRICING MECHANISM
THE PRODUCT MARKET
THE LABOUR MARKET
EXCHANGE RATE MARKET
FINANCIAL MARKETS
MONEY MARKET
The Pricing Mechanism

Where Prices Come From: The Interaction of Demand and Supply
- Chapter 3
1.
2.
3.
4.
Understand the factors that influence the demand for goods and services.
Understand the factors that influence the supply of goods and services.
Explain how equilibrium in a market is reached and use a graph to illustrate
equilibrium.
Use demand and supply graphs to predict changes in prices and quantities.
Commanding Heights Episode 1, Chapter 3: Communism on the

Heights
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The Market for an Individual Good or Service

The market is one method of producing and rationing
scarce goods and resources.
A market is when a group of buyers and sellers of a
particular good or service interact.
Supply and Demand refer to the behaviour of individual
householders (or consumers) and firms as they interact
with one another in the market.
A competitive market is a market in which there are
many buyers and sellers, so that each has a negligible
impact on price.
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Individuals Demand for a Good or Service
A demand schedule shows the various amounts of a product consumers are willing
to purchase at each specific price point, ceteris paribus (all other things being equal).
The negative or inverse relationship between price and the quantity demanded is
known as the Law of Demand.
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Market and Individual Demand

When the price is $40, Kate
will demand 6 CDs.
When the price is $40, Paul

will demand 4 CDs.
Kates Demand
The market demand at $40

will be 10 CDs.
Pauls Demand
Price of CD
Price of CD
Market Demand
Price of CD
40
40
40
20
20
20
12
Quantity of CDs
When the price is $20, Kate

will demand 12 CDs.
Quantity of CDs
Quantity of CDs
When the price is $20, Paul

will demand 8 CDs.
20
10
The market demand at $20,

will be 20 CDs.
The market demand curve is the horizontal sum of the individual

demand curves
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A Change in Demand versus a Change in the

Quantity Demanded
A change in demand occurs if any determinant of demand (other than
the price of the good or service itself) changes. This will shift the
demand curve.
An increase in demand shifts the demand curve to the right and will
result in a new equilibrium (P and Q).
A decrease in demand shifts the demand curve to the left and will
A change in the quantity demanded occurs if the price of the good or
service itself changes. This is reflected by a movement along an existing
demand curve.
An increase in price will lead to a decrease in the quantity demanded.
A decrease in price will lead to an increase in the quantity demanded.
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Determinants of Demand
(Factors that will Shift the Demand Curve)
1. Tastes or Preferences
A change in tastes in favour of a product causes an increase in
demand.
2. Population and Demographics
An increase in the number of consumers in the market represents
an increase in demand.
3. Income
Normal goods: demand varies directly with income. An increase in
income causes an increase in demand.
Inferior goods: demand varies inversely with income.
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Determinants of Demand (cont.)

4. Prices of Related Goods
Substitutes: A good that can be used in place of another
good. A decrease in the price of a substitute good causes the
demand for the other good to decrease.
Complements: Goods that must be used jointly. A decrease
in the price of one good causes the demand curve for the
other good to shift to the right.
5. Expectations
Consumer expectations of higher future prices may result in
an increase in demand.
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Shifts and Movements
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What effect will each of the following have on the
demand for NIKE running shoes?
a. NIKE running shoes become more fashionable.
b. The price of REBOCK running shoes, a popular
substitute, goes down.
c. Consumers anticipate that prices on all running shoes
will fall next month.
d. There is a rapid increase in the population due to
increased immigration.
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Supply for a Good or Service
A supply schedule shows the various amounts of a product that

producers are willing and able to produce at various prices, ceteris
paribus (all other things being equal).
Positive or direct relationship between price and quantity supplied is

known as the Law of Supply.
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Market and Individual Supply

Market supply refers to the sum of all individual supplies
for all sellers of a particular good or service.
Graphically, individual supply curves are summed
horizontally to obtain the market supply curve
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A Change in Supply versus a Change in the

Quantity Supplied
A change in supply occurs if any determinant of supply (other than the
price of the good or service itself) changes. This will shift the supply
curve.
An increase in supply shifts the supply curve to the right and will
A decrease in supply shifts the supply curve to the left and will
A change in the quantity supplied occurs if the price of the good or
service itself changes. This is reflected by a movement along an
existing supply curve.
An increase in price will lead to an increase in the quantity supplied.
A decrease in price will lead to a decrease in the quantity supplied.
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Determinants of Supply
(Factors that will Shift the Supply Curve)
1.
Resource prices: A decrease in price of inputs lowers

production costs and increases supply.
2.
Technology: Technological improvements lowers

production costs and increases supply.
3.
Prices of Substitutes in Production
4.
Expected Future Prices
5.
Number of sellers: The larger the number of suppliers,

the greater is market supply.
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Shifts and Movements
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Market Equilibrium
The intersection of the supply curve and the demand curve for the
product indicates the equilibrium price and quantity.
At the equilibrium price: quantity demanded = quantity supplied;
The intentions of both buyers and sellers coincide.
There is no incentive to alter the price.
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Market Disequilibrium: Shortages & Surpluses

A surplus causes a competitive bidding down of price by suppliers.
A shortage causes a competitive bidding up of price by buyers.

Commanding Heights Episode 1, Chapter 9: Germanys Bold Move
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Market Clearing
Price
Price
S
P0
P0
D0
Q0
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D0
Quantity
Q0
Quantity
69

What will happen to the equilibrium price and
quantity of butter in each of the following cases?
State whether demand or supply (or both) have
shifted and in which direction.
a. A rise in the price of margarine;
b. A rise in the price of bread;
c. A tax on butter production and an increased preference
for butter over margarine.
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The Product Market

Economic Growth, the Financial System and Business Cycles Chapter 5 (pp. 125-133)
Aggregate Expenditure and Output in the Short-Term - Chapter 7
(pp. 174, 177-187)
Aggregate Demand and Aggregate Supply Analysis - Chapter 8
(pp. 212-225)
1.
2.
3.
4.
Understand what happens during business cycles and their relationship to

long-run economic growth.
Discuss the determinants of aggregate demand and distinguish between a
movement along the aggregate demand curve and a shift of the AD curve.
Discuss the determinants of the four components of aggregate expenditure
and define the marginal propensity to consume and the marginal propensity
to save.
Discuss the determinants of aggregate supply, and distinguish between a
movement along and a shift of the AS curve.
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The Business Cycle

The economy grows over time, but there are irregular
fluctuations in its rate of growth from year to year.
The business cycle refers to the periodic but irregular ups
and downs in the level of growth in economic activity over a
period of time.
Real GDP
Ex
Peak
p an
sio
Re
ce
ss
ion
Trough
Time
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Economic Fluctuations
Irregular and unpredictable.
Most macroeconomic quantities fluctuate together.
Changes in the economys output of goods and services
are strongly correlated with changes in the economys
utilisation of its labour force.
Potential real GDP: The level of real GDP attained when
all firms are producing at capacity.
Actual real GDP fluctuates around the long-run potential
in the Business Cycle.
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Aggregate Demand
AD curve shows the amounts of goods and services (RGDP) that
will be purchased at any given price level.
AD is the relationship between the price level and RGDP.
Overall price level of goods and services
An increase in the price level decreases the value of money
because each dollar you have buys less.
When the price level increases how much we can buy with $1
decreases, in other words, the value of money decreases in
terms of goods and services purchased.
Price
level
AD = C+I+G+NX = AE
RGDP
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Slide 74
74
Aggregate Demand Slopes Downwards

Three key factors help explain the downward slope of the AD curve
and hence the inverse relationship between the overall price level
and the level of RGDP demanded.
Wealth Effect
1.
Changes in the price level, with other things remaining the same,
change real wealth, thus changing the level of spending.
Interest Rate Effect
2.
Higher prices requires more money for purchases. Higher interest

rates discourages business investment and reduces consumption
expenditure on consumer durables.
International Trade Effect
3.
Higher prices causes consumers to spend less on domestically

produced goods and services (g&s) and more on imported g&s.
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Components of AE - Shifts of AD
Changes in consumer spending
Expenditures by households on durable goods, non-durable

consumer goods, and on services.
Changes in investment spending
the purchase of capital goods - plant and equipment, residential
structures, and changes in inventory - that can be used in the
production of other goods and services.
Changes in Government spending
Conduct of fiscal policy: changes in government purchases of goods
and services and taxation.

Changes in Net Foreign spending
(Export - Imports) = Net Exports
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Consumption Spending
If income is considered a primary determinant of
consumption then:
C
C = CO + cY
MPC
S
MPS
Y
C: Total consumption expenditure

CO: Autonomous/exogenous consumption. Captures the effect of the
non-income factors.
MPC: Marginal propensity to consume. Extra consumption associated
with an extra dollar of disposable income.
MPS: Marginal propensity to save. Extra savings associated with an
extra dollar of disposable income.
Based on the principal that Yd = C + S
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If consumption spending increases from $350 million
to $358 million when income increases from $412
million to $432 million it can be concluded that the
relevant marginal propensity to consume is:
a. 0.2
b. 0.4
c. 0.6
d. 0.8
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Slide 78
78
Consumption Spending
The level of consumption spending is influenced by:
Wealth
Level of consumer debt
Expectations e.g. future incomes or prices
Availability and the cost of credit
Age distribution of the population
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Investment Spending
The level of investment spending is influenced by:
Interest rate
Expectations and business sentiment
Acquisition, operating and maintenance costs
Business taxes
Technological change/innovation
Capital stock
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Government Spending
The level of government expenditure is influenced by:
Discretionary Fiscal Policy: deliberate changes in government spending and tax
revenue used to help stabilise the economy.
Expansionary fiscal policy involves:
Increases in government spending
Lowering of taxes
A combination of the two
Contractionary fiscal policy involves:
Decreases in government spending
Increasing of taxes
A combination of the two
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Net Foreign Spending

The three most important variables that determine the
level of net exports are:
The price level in Vietnam relative to the price level in
other countries.
The growth rate of GDP in Vietnam relative to the growth
rates of GDP in other countries.
The exchange rate between the Vietnam dollar and other
countries currencies.
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Aggregate Supply
The short-run aggregate supply curve (SRAS) shows
the relationship in the short-run between the price level
and the quantity of real GDP supplied by firms.
Price
level
AS
RGDP
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The Slope of the Short-run Aggregate Supply

Slope (SRAS)
The SRAS is upward sloping, showing that in the short-run firms will
produce more in response to higher prices. The reason for this is
that the price of inputs tends to rise more slowly than the price of
final products due to wage and price rigidities.
Nominal Wages Rigidities
If the price level falls, real wages rise, production costs increase;
firms hire less labour, thus producing a smaller output.
Price Rigidities
Not all firms adjust prices immediately in response to changes in
the price level; affecting their competitiveness, sales and thus
production.
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Short-Run Aggregate Supply

The variables that shift the SRAS curve include:
1. Expected changes in the future price level.
2. Adjustments of workers and firms to errors in past
expectations about the price level.
3. Unexpected changes in the price of an important
natural resource.
4. Plus any factor that shifts the LRAS curve.
Note: Factors 1-3 shift only the SRAS curve not
LRAS curve
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Long-Run Aggregate Supply (LRAS)

The long-run aggregate supply curve (LRAS) shows the
relationship in the long-run between the price level and
the quantity of real GDP supplied.
The long-run
aggregate supply
curve shows that
in the long-run
increases in the
price level do not
affect the level of
RGDP.
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Factors that Shift the LRAS Curve

Shifts in the long-run aggregate supply curve occur
because potential GDP increases over time. Anything
that shifts the LRAS also shifts the SRAS.
Increases in GDP (or economic growth) which shift
the LRAS are due to:
1. An increase in resources.
2. An increase in the capital stock.
3. New technology
4. Changes in government policy (Incentives to work
and invest)
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Macroeconomic Equilibrium
Price Level
Price Level
LRAS
SRAS
LRAS
SRAS
P0
AD
Y0
P0
Price Level
LRAS
SRAS
AD
Yf
RGDP
RGDP
Yf
P0
AD
Yf
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RGDP
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What effects might each of the following have on
aggregate demand and/or aggregate supply and
why?
a. A widespread fear of depression among consumers.
b. A tax leading to a 2% increase in petrol prices.
c. A decrease in interest rates.
d. A decrease in government spending on higher
education.
e. The discovery of cheaper energy sources.
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The Labour Market

Unemployment - Chapter 9 (pp.262-264)
1.
2.
3.
4.
Explain what factors determine the unemployment rate.

Explain labour market equilibrium and disequilibrium
Explain the consequence of labour market disequilibrium
Describe the changes that have occurred in the determination of wages in
Vietnam and discuss the possible effects on unemployment.
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The Labour Market

Through the workings of the supply of labour and demand for
labour, the levels of employment and the representative
equilibrium wage rate is determined.
The labour market is a resource market meaning that firms are
the demanders and householders are the suppliers in this
market.
The labour market as presented, can be understood in terms
of a representative model (in reality there are many distinct
labour markets)
Supply of labour: Quantity of labour provided by households
at various wage rates.
Demand for labour: Quantity of labour hired by firms at
various wage rates.
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Real Wage Rate

Real wage = nominal wage/overall price level
= w/p
Real wage is the amount of purchasing power that each
worker receives and which the firm pays for each unit of
labour.
The wage rate can be viewed as the opportunity cost of
leisure.
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Supply of Labour
A household decides on the allocation of time b/w
(a) market activity
(b) non-market activity
The real wage rate determines the quantity of labour
supplied.
Other determinants of labour supply include:
social attitudes towards work Real wage
and leisure
SL
number of workers with the
required skills.
Changes in any of these other
determinants will cause a
shift in the supply curve for
labour.
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w0
p0
N0
Labour
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Demand for Labour

The demand for labour ultimately depends upon, or derives
from, the demand for the final product(s) that the labour is
used to produce.
Firm decides on the benefits of hiring an extra worker by
looking at labour productivity.
Available production technology determines how much output
is produced from given amounts of capital and labour.
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Demand for Labour

A short-run Production function shows how much output a
firm can produce given various amounts of labour.
Output
Production
Function
200
174
144
100
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Most production functions

have the property of
diminishing marginal product.
The greater the number of
workers used in producing
output, the less additional
output that comes from each
additional worker.
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Labour Market Equilibrium

In a perfectly competitive labour market, the wage rate and
level of employment is determined by the intersection of the
demand and supply curves.
Real wage
Real wage
SL
SL
w0
p0
w0
p0
DL
N0
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DL
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Causes of Unemployment
When wages are set above their market-clearing level:
Minimum wage laws
Unions and collective bargaining: Prevent downward wage
flexibility
Efficiency wages: Firms may make higher profits by paying
above market-clearing wage rates (link between wages and
worker effort, worker quality and company turnover)
Government Policies that influence the incentive to work:
Job network & unemployment benefits and unemployment
insurance
Deficiency in Aggregate Demand
Cyclical unemployment
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Why did Henry Ford

pay his workers twice as
much as other car
manufacturers?
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When a union bargains successfully with an employer,
in that industry
a. The unemployment and wages increase.
b. Unemployment and wages decrease.
c. Unemployment decreases and wages increase.
d. Unemployment increases and wages decrease.
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Labour Market Regulation and Deregulation

Advantages of deregulation:
Numerical and functional labour market flexibility:
Numerical flexibility: ease with which firms can vary the

quantity of labour inputs.
Functional flexibility: ease with which the tasks performed

by workers can be altered.
Disadvantages of deregulation:
Relate primarily to equity, and in particular, the vulnerability of

workers in weak bargaining positions.
Such workers are often low paid and low skilled.
Minimum wages may be used to ensure greater equity.

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The Exchange Rate Market

Macroeconomics in an Open Economy - Chapter 14 (pp. 404-410)
1.
2.
3.
4.
Explain how exchange rates are determined.

The difference between the direct and indirect quotations of exchange rates.
How changes in exchange rates affect the prices of imports and exports.
The exchange rate market model.
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The Nominal Exchange Rate

The rate at which one currency is exchanged for another.
Direct: Vietnamese Dong required to purchase a unit of
foreign currency:
VND
21,113 VND
e
21,113
1 Foreign Currency
1USD
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Nominal Exchange Rate Movements

Depreciation: where a currency (say the AUD) is worth less in
terms of another currency (say the USD). In other words the
AUD has become less valuable. So, it takes more AUD to
purchase a unit of the USD ($1USD). In this case the AUD can
also be said to have weakened relative to the USD.
Appreciation: means a particular currency (say the AUD) is
worth more in terms of another currency (say the USD). So, it
takes less AUD to purchase a unit of the USD ($1USD). In this
case the AUD can also be said to have strengthened relative to
the USD.
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Nominal Exchange Rate

Depreciation: the VND is worth less in terms of another
currency. i.e. is less valuable. So, it takes more VND to
purchase a unit of foreign currency. Exchange rate
increases.
Appreciation: means the VND is worth more in terms of
another currency. So, it takes less VND to purchase a
unit of foreign currency. Exchange rate decreases.
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Check Your Understanding
When the dong weakens, each dong buys

a.more foreign currency, and so buys more foreign goods.
b.more foreign currency, and so buys fewer foreign goods.
c.less foreign currency, and so buys more foreign goods.
d.less foreign currency, and so buys fewer foreign goods.
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Exchange Rate Market

Market forces in the form of supply and demand determine the
level of the foreign exchange rate.
e
SFX
DFX
Quantity
SFX is derived from any transaction which involves a payment from nonresidents to residents. Converting foreign currency to domestic currency.
DFX is derived from any transaction which involves a payments from
residents to non-residents. Converting domestic currency to foreign
currency.
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Exchange Rate Market

Importing:
Exporting
Demand for FX.
Supply of FX.
Supply of VND
Demand for VND.
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Changes in Net Exports

Increased Exports
Decreased Imports
Exchange rate
Exchange rate
SFX
SFX
e0
e0
DFX0
Q0
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Quantity
DFX
Q0
Quantity
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Shifts in demand and supply

1. Changes in demand for Vietnam-produced goods and
services and changes in the demand for foreignproduced goods and services.
2. Changes in the desire to invest in Vietnam and
changes in the desire to invest in foreign countries.
3. Changes in the expectations of currency traders about
the likely future value of the dong and the likely future
value of foreign currencies.
Speculators: Currency traders who buy and sell
foreign exchange in an attempt to profit by changes
in exchange rates
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a.
b.
c.
d.
If domestically produced goods increased in price

relative to foreign produced goods,
exports would increase and imports would decrease
resulting in an appreciation.
exports would decrease and imports would increase
resulting in an appreciation.
exports would decrease and imports would increase
resulting in a depreciation.
exports would increase and imports would decrease
resulting in a depreciation.
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A rise in domestic interest rates relative to interest
rates in other countries may lead to
a. an exchange rate depreciation and an increase in net
exports.
b. an exchange rate appreciation and a fall in net
exports.
c. an exchange rate depreciation and a fall in net
exports.
d. an exchange rate appreciation and an increase in net
exports.
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The Financial Market

Economic Growth, the Financial System and Business Cycle Chapter 5 (pp. 117-124)
1.
2.
3.
4.
Discuss the role of the financial system in facilitating economic growth.

Understand the link between savings and investment and how these are
facilitated by the financial system.
To introduce the loanable funds model and understand the sources of
demand and supply in this market.
To understand the significance of the real long term rate of interest in driving
investment decisions.
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Saving, Investment and the Financial System

The Financial system: The system of financial markets
and financial intermediaries through which firms acquire
funds from households.
Financial intermediaries include banks and non-bank
financial institutions.
Financial markets include the share and bond markets.
Shares: financial securities that represent partial
ownership of a firm.
Bonds: financial securities that represent promises to
repay a fixed amount of funds.
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The Role of the Financial System

Financial intermediaries, such as banks, mutual funds,
pension funds, and insurance companies, act as gobetweens for borrowers and lenders.
Financial markets enable firms to raise funds by selling
financial securities (shares or bonds directly to savers).
As well as facilitating the channeling of funds from
savers to borrowers the financial system provides three
key additional services for savers and borrowers:
1. risk sharing,
2. liquidity, and
3. information.
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Loanable Funds Market Model

The demand for loanable funds is determined by the
willingness of firms to borrow funds to engage in new
investment projects.
The supply of loanable funds is determined by the
willingness of households to save, and by the extent of
government saving or dissaving (borrowing / budget
deficit).
Equilibrium in the market for loanable funds determines
the real interest rate and the quantity of loanable funds
exchanged.
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Loanable Funds Market
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Explaining Movements in Savings, Investment

and Interest Rates
An increase in the demand for loanable funds
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Explaining Movements in Savings, Investment

and Interest Rates
The effect of a budget deficit on the market for loanable
funds
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Ebenezer Scrooge: Accidental

promoter of Economic growth?
Who was better for
economic growth:
Scrooge the saver or
Scrooge the spender?
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The Money Market

Money, Banks and the Central Bank - Chapter 11
1.
2.
3.
4.
Define money and discuss its functions.

Discuss the definition of the money supply.
Explain how financial institutions create money.
Illustrate and discuss the money market.
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What is Money and Why do we Need it?

Money: Assets that people are willing to accept in
exchange for goods and services or for payment of
debts.
Asset: Anything of value owned by a person or firm.
Barter: exchange of goods or services for other goods or
services.
Barter requires a double coincidence of wants.
Commodity money: A good used as money that also
has value independent of its use as money.
Fiat money: Money such as paper currency that is
authorised by the central bank and has no intrinsic value
except in its function as money.
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Money in a World War II

prisoner of war camp.
During World War II
cigarettes were used as
money in some prisoner
of war camps.
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What is Money and Why do we Need it?

What can serve as money?
What makes a good suitable to use as a medium of
exchange? There are five criterion:
1.The good must be acceptable to most traders
2.It should be a standardised quality
3.It should be durable
4.It should be valuable relative to its weight
5.It should be divisible
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Functions of Money
1.
Medium of exchange
Buying and selling goods and services
Money eliminates need for a coincidence of wants

required for trade to occur in a barter economy.
2.
Unit of account
Assist the measurement of the relative worth of various
goods, services and resources.
3.
Store of value
A form in which to store wealth due to its liquidity and
convenience
4.
Standard of deferred payment

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The statement 'a Dell laptop costs $2500' illustrates
which function of money?
a.
Store of value
b.
Medium of exchange
c.
Standard of deferred payment
d.
Unit of account
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How do we Measure Money Today?
M1: The narrowest definition of the money supply

which includes all the paper money and coins that are
in circulation meaning what is not held by the banks
or governments plus the value of all demand deposits
with banks.
M3: M1, plus all other deposits with domestic and
foreign owned banks operate domestically.
Broad Money: M3, plus deposits into non-bank
deposit-taking institutions less holdings of currency and
deposits of non-bank depository corporations, such as
finance companies, money market corporations and
cash management trusts.
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Fractional Reserve Banking System
Banks are concerned with.

Providing safekeeping facilities
Making a profit
To be 100% safe, the banks would need to keep all

deposits safe in their vaults.
To make a profit, the banks would need to lend out
deposits at a higher rate of interest.
SOLUTION: recognition that only a small proportion of

depositors are likely to want to convert deposits to cash
on any given day. Banks need to keep enough to meet
reasonable day to day requirements and lend the rest to
make a profit.
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In World War II, cigarettes were used as money in
some prisoner of war camps. Given this, we would
expect to see
a. prices of other goods expressed in terms of cigarettes.
b. people bartering instead of using cigarettes as money.
c. only government-issued cigarettes being accepted as
money.
d. no one ever smoking cigarettes in the prisoner of war
camps.
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Financial Institutions and the Creation of Money

Reserves: Deposits that a bank keeps as cash in its vault
or on deposit with the State Bank of Vietnam.
Reserve Ratio: A banks ratio of reserves to deposits,
Excess Reserves: Reserves above the normal ratio of
reserves to deposits.
Financial institutions such as banks are able to create
money through the simple deposit multiplier process.
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Banks and Money Creation

Assume the required reserve ratio is 10% and $1,000 is
deposited into Bank A.
Bank A
Assets
Liabilities
Bank B
Assets
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Liabilities
130
Banks and Money Creation

Bank C
Assets
Liabilities
From the original deposit a new loan is created that result in

further deposits into the financial system
Bank A
= $1,000
Bank B
= $900
Bank C
= $810
Bank D
= $729
Bank
Total change in demand account deposits = $10,000
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The Simple Deposit Multiplier
The simple deposit/credit/money multiplier: The ratio of

the amount of deposits created by banks to the amount
of new reserves.
1
Simple deposit multiplier
RR
Change in deposits = initial deposit x multiplier ($1,000
x 10 = $10, 000)
Change in the money supply = change in demand
account deposits initial deposit ($10,000 - $1,000 =
$9,000)
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a.
b.
c.
d.
Other things the same if reserve requirements are

decreased, the reserve ratio?
decreases, the money multiplier increases, and the
money supply decreases
increases, the money multiplier increases, and the
money supply increases
decreases, the money multiplier increases, and the
money supply increases
increases, the money multiplier increases, and the
money supply decreases
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Money Supply
Notes and Coins; Bank deposits and Non-Bank Financial
Institution deposits
Ms determined exogenously
r
Ms
Quantity of Money
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The Money Market

The Demand for Money
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The Money Market

Shifts in the Money Demand Curve
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The money demand curve is downward sloping
because
a. lower interest rates cause households and firms to
switch from money to financial assets.
b. lower interest rates cause households and firms to
switch from financial assets to money.
c. lower interest rates cause households and firms to
switch from money to bonds.
d. lower interest rates cause households and firms to
switch from money to shares.
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Money Market and Equilibrium

r
MS
r0
MD
Quantity of Money
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Slide 138
138

A decrease in real GDP can
a.
increase money demand and increase the interest rate.
b.
decrease money demand and increase the interest rate.
c.
decrease money demand and decrease the interest

rate.
d.
increase money demand and decrease the interest rate.
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MODULE 3: INFLATION,
UNEMPLOYMENT, GOVERNMENT
POLICY, DEVELOPMENT AND
GROWTH
MONETARY POLICY
FISCAL POLICY
RECESSION, INFLATION & THE LONG-RUN
DEVELOPMENT & GROWTH
Monetary Policy
Monetary Policy - Chapter 12
1. Define monetary policy and describe the main goal of monetary policy in Vietnam
2. Describe how the State Bank of Vietnam affects interest rates.
3. Use aggregate demand and aggregate supply graphs to show the effects of
monetary policy on real GDP and the price level.
4. Discuss the State bank of Vietnams use of monetary policy.
5. Discuss the role of the State Bank of Vietnam
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What Is Monetary Policy?

Monetary policy: The actions taken by the Central
Bank of a nation to affect interest rates and/or

exchange rates.
Generally the main goals of Monetary policy are
Price Stability
Sustainable Economic Growth.
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State Bank of Vietnam
The State Bank of Vietnam defines its principal roles as:

Promoting monetary stability and formulating monetary policy.
Promoting institutions stability and supervising financial institutions.
Providing banking facilities and recommending economics policies
to the government.
Providing banking facilities for the financial institutions.
Managing the countrys international reserves.
Printing and issuing banknotes.
Supervising all commercial banks activities in Vietnam. Lending
state money to the commercial banks.
Issuing government bonds, organising bond auctions.
Being in charge of other roles in monetary management and
foreign exchange rates.
Slide 143
State Bank of Vietnam

Central banks in most developed economies usually
describe their aims in terms of the pursuit of noninflationary growth.
Today, theres a consensus that price stability should
be the overriding objective of monetary policy.
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External Balance
When there is a decrease in the demand for Vietnamese

Dong and the currency weakens; the exchange rate
moves to the upper end of the established band, the
Authority purchases VND from banks and/or sells
government securities to banks.
The money base (supply) will decrease, pushing up

Vietnamese dong interest rates. Higher domestic interest
rates relative to foreign interest rates induce capital
inflows into the nation and reduce outflows.
Supply of foreign currency (FX) increases and demand

for foreign currency decreases, strengthening the
currency and restoring stability.
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External Balance
p
AS
p0
Buy VND
Decrease in the money supply
Increase domestic interest rates
AD0
Y0
Exchange rate
RGDP
SFX0
e0
DFX0
Quantity
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External Balance
When there is an increase in the demand for Vietnamese
Dong and the market exchange rate strengthens and
the exchange rate moves to the lower end of the
established band, the authority sells Vietnamese dong to
banks and/or buys government securities from banks.
The money base (supply) will increase, pushing down
Vietnamese Dong interest rates. Lower domestic interest
rates relative to foreign interest rates restrain capital
inflows into the nation, encouraging outflows.
Supply of foreign currency (FX) decreases and demand
for foreign currency increases, weakening the currency
to restore stability.
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External Balance
p
Sell VND
Increase in the money supply
Lower domestic interest rates
AS
p1
p0
Capital
AD1
Outflows
Increase DFX
Y0
Y1
AD0
RGDP
Increase IM (DFX) &

Decrease EX (SFX)
Exchange rate
SFX1
SFX0
e0
DFX1
DFX0
Quantity
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Internal Balance
Goal: Maintain the inflation rate within a particular band.

Sale and purchase of government securities changes
bank reserves and thus their ability to extend credit, thus
changing the money supply and the interest rate.
The Monetary Authority targets interest rates by affecting
system liquidity.
Monetary policy influences the size of bank reserves.
This influences:
The size of the money supply.
The interest rate and the availability of credit.
Investment spending, interest-sensitive consumption
spending thus output, employment and the price level.
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Open Market Operations

Monetary Authority actions designed to change interest
rates by changing system liquidity to change the cost

of credit and thus economic activity and the price level.
Easy Money: Authority announces its decision to
reduce interest rates it buys government securities to
maintain the lower interest rates; expanding the money
supply and reducing the cost of credit.
Tight Money: Authority announces its decision to
increase interest rates it sells government securities
to maintain the higher interest rates; reducing the
money supply and increasing the cost of credit.
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Internal Balance Contractionary Policy

Decrease in the money supply
Increase domestic interest rates
Exchange rate
SFX0
e0
p
AS
DFX0
p0
Q0
Quantity
AD0
Y0
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RGDP
151
Internal Balance Expansionary Policy

Increase in the money supply
Lower domestic interest rates
SFX0
Exchange rate
e0
DFX0
AS
Q0
Quantity
p0
AD0
Y0
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RGDP
152

If the interest rate is below the Central Bank's
target, the Central Bank would:
a.buy bonds to increase the money supply.
b.buy bonds to decrease the money supply.
c.sell bonds to increase the money supply.
d.sell bonds to decrease the money supply.
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If the Central Bank pursues expansionary monetary
policy then interest rates will
a.fall and GDP will fall.
b.rise and GDP will rise.
c.fall and GDP will rise.
d.rise and GDP will fall.
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Equilibrium in the Money Market
With interest rate targeting, the money supply curve is

a horizontal line at the Central Banks target interest
rate.
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Monetary Policy Effectiveness

Responsiveness of capital flows,
consumption and investment to changes to

changes in interest rates.
Phase of the business cycle
Private decisions of lenders and borrowers.
Size of the expenditure multiplier
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156

Suppose you are the monetary policy adviser for the
government. The economy is experiencing a large and
prolonged inflationary trend. What change in open
market operations would you recommend?
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157

If the central bank buys bonds and securities in
the open market, this is likely to lead to
a. a rise in interest rates and a depreciation of the
Vietnamese dong.
b. a fall in interest rates and a depreciation of the
Vietnamese dong.
c. a fall in interest rates and an appreciation of the
Vietnamese dong.
d. a rise in interest rates and an appreciation of the
Vietnamese dong.
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158
Why Does The Share Market Care

about Monetary Policy?
The share
market reacts
when the
Central Bank
implements
policy to either
raise or lower
interest rates.
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159
Fiscal Policy
Aggregate Expenditure and Output in the Short Run - Chapter 7
(pp. 195-200)
Fiscal Policy - Chapter 13
1. Define the multiplier effect and use it to calculate changes in equilibrium
GDP.
2. Define fiscal policy.
3. Explain how fiscal policy affects AD and how the government can use fiscal
policy to stabilise the economy.
4. Explain how the multiplier process works with respect to fiscal policy.
5. Discuss the difficulties that can arise in implementing fiscal policy.
6. Explain how the federal budget can serve as an automatic stabiliser.
7. Discuss the long-run supply side effects of fiscal policy.
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Fiscal Policy
Fiscal Policy: Changes in Government taxes and
purchases that are intended to achieve macroeconomic
policy objectives, such as full employment, price stability,
and healthy sustainable rates of economic growth.
Commanding Heights Episode 1, Chapter 5: Global Depression

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161
Rules (Automatic Approach) versus Discretionary

Action
There are two key approaches to fiscal policy; following rules
implied by automatic stabilisers or else implementing a
discretionary fiscal policy.
Automatic stabilisers: Government spending and taxes that
automatically increase or decrease along with the business

cycle.
Discretionary fiscal policy: when the government is taking
actions to change spending or taxes to achieve its objectives.

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162
Using Fiscal Policy to Influence Aggregate

Demand
Expansionary fiscal policy
Increasing government expenditure, or decreasing taxes, or
both. The goal is to shift aggregate demand to the right.
Appropriate when the economy is in a below full-employment
equilibrium.
Contractionary fiscal policy
Decreasing government expenditure, or increasing taxes, or
both. The goal is to shift aggregate demand to the left.
Appropriate when the economy is at an above full-employment
equilibrium.
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163

Fiscal policy refers to the
a.
government's ability to regulate the functioning of

financial markets.
b.
spending and taxing policies used by the government to

influence the level of economy activity.
c.
techniques used by firms to reduce its tax liability.
d.
the policy by the State Bank to affect the interest rate.
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164
The Government Purchases (Expenditure) and

Tax Multipliers
The multiplier effect: The series of induced increases

in consumption spending that results from an initial
increase in autonomous expenditures. The process by
which an increase in autonomous expenditure leads to
a larger increase in real GDP.
Autonomous expenditure: Expenditure that does not

depend on GDP.
Multiplier: The increase in equilibrium real GDP

divided by the increase in autonomous expenditure.
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165
The Multiplier
the theory of the multiplier states that in initial increase
in public spending will lead to an eventual increase in
the level of output of some multiple of that initial
spending
if the multiplier is 2, then $10 million in initial spending
will lead to an increase of $20 million in total output
if the multiplier is 4, then an initial increase of whatever
amount will lead to spending rising four times as much
each person receiving the first round of expenditure
spends some themselves and saves some
same with each subsequent round
saving causes the expenditure growth to peter out but
the continuing round of spending continues past the first
recipient
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166
The Government Purchases or Expenditure

Multiplier in Action
The multiplier effect and
aggregate demand
An initial increase in autonomous
government spending, such as

building new railway lines, will
increase aggregate demand by an
amount that is more than the initial
amount of new spending.
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167
The Multiplier Effect

Change in equilibrium real GDP
Expenditure Multiplier
Change in autonomous expenditure
1
Expenditure Multiplier
1 - MPC
The multiplier effect occurs both when autonomous expenditure

increases and when it decreases.
The multiplier effect makes the economy more sensitive to
changes in autonomous expenditure than it would otherwise be.
The larger the MPC, the larger the value of the multiplier.
Our formula for the multiplier is very simplified, but nevertheless
serves to illustrate the process.
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168
The Government Purchases (Expenditure) and

Tax Multipliers
Government Purchases Multiplier
Change in government purchases
1
1
k e
or
1 MPC
MPS

Tax Multiplier
Change in taxes
MPC
kT
MPS
Y k e G
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Y kT T
169

Assume the consumption function for a closed
economy is C=50+0.8Y and that investment is equal
to $30bn.
a. Calculate the equilibrium level of income/output for this
economy.
b. Calculate what will happen to equilibrium income and
output if the government undertakes expansionary policy
of $15bn.
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170
Multiplier Effectiveness
Fixed Price
Variable Price
Price
Level
AS
AD2
AD
Y
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Quantity
of Output
171
Crowding Out Effect
Price
Level
P1
AS
AD
Y1
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RGDP
172
Crowding out effect Money Market and

Loanable Funds Market
r
MS
r0
MD
Quantity
of Money
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173

If crowding out occurs, an increase in government
spending
a. decreases the interest rate and consumption and
investment spending rise.
b. decreases the interest rate and consumption and
investment spending decline.
c. increases the interest rate and consumption and
investment spending rise.
d. increases the interest rate and consumption and
investment spending decline.
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174
Goals of Fiscal Policy

Recessionary Gap
Price Level
Inflationary Gap
Price Level
LRAS
LRAS
SRAS
SRAS
P2
P1
AD
AD
GDP Gap
Yf
Quantity
of Output
Recessionary Gap = GDP Gap

ke
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GDP Gap
Yf
Quantity
of Output
Inflationary Gap = GDP Gap

ke
175
Putting Everything Together
Y k e G
GDP Gap k e G
GDP Gap
G
ke
GDP Gap
Recessionary Gap
ke
GDP Gap
Inflationa ry Gap
ke
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176
Successful Fiscal Policy

Real GDP
Time
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177
Is it that Simple? Does it matter what the type of

government expenditure?
Government goods
600
PPF2
400
PPF1
100
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200
Private goods
178
Case Against Intervention

FiscalLags
Recognition
Administrative/Legislative
Operational/Implementation
Expansionary bias leading to a Political business cycle
Commanding Heights Episode 1, Chapter 11: Chicago Against

the Tide
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179
Deficits, Surpluses and Government Debt

Budget deficit: The situation in which the governments
spending is greater than its tax revenue.
Budget surplus: The situation in which the governments
expenditures are less than its tax revenue.
The budget can serve as an automatic stabiliser.
Federal government deficits increase automatically during
recessions because:
1. Tax revenues fall.
2. Unemployment benefits increase.
Federal government deficits decrease or surpluses increase

automatically during expansions because:
1. Tax revenues increase.
2. Unemployment benefit payments decrease.
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180

To counteract the effect of automatic stabilisers
during a recession and keep the budget balanced, the
government must ________ government spending, or
________ taxes, and which will ________ aggregate
demand.
a. decrease; increase; reduce
b. increase; decrease; increase
c. increase; increase; reduce
d. decrease; decrease; increase
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181
Deficits, Surpluses and Government Debt

Should the federal budget always be balanced?
Is government debt a problem?
These questions are related and the answer is not
always clear-cut.
Economists examine the debt, and the interest on the
debt in proportionate terms to determine if it is a
problem.
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182

During the 1990s the Australian Federal government
operated successive government deficits of over $10
billion dollars. Clearly the government of the day was
engaging in vigorous expansionary policy.
Do you agree with this statement?
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183
The Effects of Fiscal Policy in the Long-Run

Supply side policies:
Fiscal policies that have long-run effects by expanding the
productive capacity of the economy and increasing the
rate of economic growth.
These policy actions primarily affect aggregate supply, by
shifting the long-run aggregate supply curve to the right.
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184

The supply side effects of a tax change
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185

The long-run effects of tax policy:
We can look at the effect on aggregate supply of each of the
following taxes:
1. Individual income tax
2. Company income tax
3. Taxes on capital gains
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186

Tax simplification:
There are also potential gains to be derived from
simplifying the tax law.
Resources diverted to tax compliance and tax
minimisation can be put to more productive use.
Tax simplification may improve the efficiency of firm
and household decision making.
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187
Long Run Implications of Supply Side Policies

Supply side policies can increase long run aggregate supply,
thereby reducing the upward pressure on prices following an
increase in aggregate demand
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188
Recession, Inflation and the Long-Run

Aggregate Demand and Aggregate Supply Analysis - Chapter 8
(pp. 226-234)
Unemployment - Chapter 9 (pp. 256-257)
Inflation - Chapter 10 (pp. 280-287)
1. Use the aggregate demand and aggregate supply model to illustrate the
difference between short-run and long-run equilibrium.
2. Use the dynamic aggregate demand and aggregate supply model to
analyse macroeconomic conditions.
3. Understand the difference between demand-pull and cost-push inflation.
4. Explain the quantity theory of money and use it to explain how high rates of
inflation can occur.
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189
The Costs of Unemployment

Costs to the economy as a whole:
Loss of gross domestic product.

Loss of human capital.
Net drain on the budget.
The opportunity cost of funds directed towards welfare
payments.
Costs to the unemployed:

Loss of income.
Loss of skills.
Loss of self esteem.
Unemployment may contribute to family break-ups, health
problems, mental illness, crime and political unrest.
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190
Recession
The short-run and the long-run effects of a decrease in aggregate
demand
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191
Costs of Inflation
In general, wages rise with inflation. Inflation can, however, affect the
distribution of income. The extent of redistribution depends partly on
the degree to which inflation was anticipated or unanticipated.
The problem with anticipated inflation:
Menu costs the costs to firms of changing prices.
Risk particularly for contracts with a time element
The problem with unanticipated inflation:
There are winners and losers, depending on whether inflation
is higher or lower than anticipated.
For example: those on fixed incomes, such as aged pensions,
will lose if inflation is higher than anticipated.
Borrowers may gain and lenders lose when inflation is higher
than anticipated.
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192
Causes of Inflation
1. Monetary growth greater than growth in RGDP
2. Demand-pull inflation
Increases in AD
3. Cost-push inflation
Supply Shocks
Stagflation: a combination of inflation and recession,
usually resulting from a supply shock.
Commanding Heights Disc1, Chapter 12: The Spectre of Stagflation
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193
Monetary Growth > Growth in GDP

The Quantity Theory of Money
Connecting money and prices: The equation of

exchange. The connection between money and prices is
expressed in the following equation.
Mx V P x Y
Velocity of money: The average number of times each

dollar in the money supply is used to purchase goods
and services included in GDP.
PxY
V
M
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194

According to the assumptions of quantity theory, if
the money supply increases 5% then at full
employment
a. nominal and real GDP would rise by 5%.
b. nominal GDP would rise by 5%; real GDP would be
unchanged.
c. nominal GDP would be unchanged; real GDP would
rise by 5%.
d. neither nominal GDP nor real GDP would change.
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195
The Quantity Theory of Inflation
The quantity equation is transformed to:
Growth rate of money supply + growth rate of velocity = growth

rate of the price level + growth rate of real output
Which we can rearrange as:

Inflation rate = growth rate of money supply + growth rate of
velocity - growth rate of real output
If Irving Fisher is correct and velocity is constant, then

the growth rate of velocity is zero, so we can rewrite the
equation as:
Inflation rate = growth rate of the money supply growth
rate of real output
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196

According to the quantity theory of money,
inflation is caused by
a. GDP growing faster than the money supply.
b. GDP growing at the same rate as the money supply.
c. the money supply growing faster than GDP.
d. the money supply growing slower than GDP.
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197

Suppose the money supply is currently growing at 4 %
per year, while real GDP is growing at 2%, calculate the
inflation rate assuming Irving Fisher is correct in his
assumption regarding the velocity of money.
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198
Demand-Pull Inflation
The short-run and long-run effects of an increase in aggregate
demand - Demand-pull inflation and a price-wage spiral
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199

An increase in aggregate demand causes an
increase in ________ only in the short run, but
causes an increase in ________ in both the short
run and the long run.
a. the price level; real GDP
b. real GDP; real GDP
c. real GDP; the price level
d. the price level; the price level
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200
A Dynamic AD and AS Model

We can create a dynamic aggregate demand and
aggregate supply model by making three changes to the
basic model:
1. Potential real GDP increases continually, shifting the
long-run aggregate supply curve to the right.
2. During most years the aggregate demand curve will
be shifting to the right.
3. Except during periods when workers and firms expect
high rates of inflation, the short-run aggregate supply
curve will be shifting to the right.
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201
A Dynamic AD and AS Model
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202
Cost-Push Inflation
The short-run and long-run effects of a supply shock - Cost-push inflation
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203

Which of the following is considered a supply
shock?
a. The increasing investment in the economy causing the
capital stock to rise
b. A decline in wages
c. An improvement in technology
d. An unexpected large increase in the price of natural gas
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204
Supply Shocks and Policy Choices

Policy Options:
Price Level
SRAS0
P0
AD
Y0
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RGDP
205
Fighting Inflation Reducing AD

Price Level
P0
LRAS
SRAS0
AD0
Yf
RGDP
Commanding Heights Episode 2, Chapter 12: The Miracle Year

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206
a.
b.
c.
d.
Why might the short run aggregate supply curve shift to

the right in the long run, following a decrease in
aggregate demand?
Workers and firms adjust their expectations of wages and
prices downward and they push for higher wages and prices.
prices upward and they accept lower wages and prices.
prices upward and they push for higher wages and prices.
prices downward and they accept lower wages and prices.
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207
Economic Development and Growth

Economic Growth, the Financial System and Business Cycles Chapter 5 (pp. 110-117)
Long-Run Economic Growth: Sources and Policies - Chapter 6
1. Explain the basic idea of how a market system works.
2. Understand why property rights are necessary for a well-functioning
economy.
3. Discuss the importance of economic growth and its impact on living
standards.
4. Describe the trends in economic growth in the world.
5. Use the economic growth model to explain why economic growth rates differ
between countries.
6. Explain the fluctuations in productivity growth in the twentieth and twentyfirst centuries.
7. Discuss why many poor countries have not experienced rapid economic
growth.
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208
Long-Run Economic Growth is the Key to Rising

Living Standards
Long-run economic growth: The process by which
rising productivity increases the average standard of
living.
Real GDP per capita is used to measure changing
living standards over time.
Real GDP
Real GDP per capita
population
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209
Calculating Economic Growth Rates

Recall: economic growth is calculated using the following
equation:
Real GDP Current - Real GDP
EconomicGrowth
Real GDP Previous
Previous
x 100
For longer periods we look at average annual growth

rates. Note: the long-term could be 50 or 100 years or
more.
An approximation of average annual growth for shorter
periods is a simple average.
3.1% 2.4% 3.2%
2.9%
3
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210
Calculating Economic Growth Rates and the Rule

of 70
One way to judge how rapidly real GDP per person is
growing is to calculate the number of years it would take
to double.
70
Number of years to double
Growth rate
This rule shows small differences in growth compound
over time.
This leads to large differences in the number of years it
takes for real GDP to double.
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211

The rule of 70 states that
a. the number of years it takes an economy to double is
the growth rate times 70.
b. the number of years it takes an economy to double is
70 divided by the growth rate.
c. it takes an economy 70 years to double in size.
d. the number of years it takes an economy to double is
the growth rate divided by 70.
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212

Use the table below to answer the following
questions:
a. How long will it take China to double its real GDP?
b. How long will it take Vietnam to double its real GDP?
RMIT University
GDP growth
(annual %)
China
Vietnam
2005
10.1
8.2
2006
10.7
8.5
2007
10.4
6.8
213
Economic Growth Over Time Around the World

Average annual growth rates for the world economy
Source: J. Bradford DeLong (1998), Estimating World GDP, One Million B.C. Present, working paper,
University of California, Berkley.
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214

Why do growth rates matter?
An economy that grows too slowly fails to raise living
standards.
In the 1980s and 1990s, a small group of Asian countries,
such as Taiwan and Singapore, achieved high rates of
growth. These are sometimes referred to as the newly
industrialising countries.
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215
GDP per capita, 2007
Commanding Heights
Episode 3, Chapter 18: The Global Divide
Episode 3, Chapter 20: The Bottom End of Globalism
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216
What Determines How Fast Economies Grow?

Labour productivity: The quantity of goods and
services that can be produced by one worker or by one
hour of work. Two key factors determine labour
productivity.
1. Increases in Capital per Hour Worked
Capital: Manufactured goods that are used to
produce other goods and services; examples are
computers, factory buildings, and machine tools.
Human capital: The accumulated knowledge and
skills that workers acquire from education and
training, or from their life experiences.
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217

2. Technological Change: Change in the ability of a firm
to produce a given level of output with a given quantity of
inputs.
Accumulating more inputs such as labour, capital, and
raw materials will not ensure that an economy
experiences economic growth unless technological
change also occurs.
Three main sources of technological change:
Better machinery and equipment.
Increases in human capital.
Better means of organising and managing production.
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218

Which is more important for economic growth: More
capital or technological change?
Technological change is the key to sustaining economic
growth.
Endogenous growth theory: a model of long-run
economic growth that emphasises that technological
change is influenced by economic incentives, and so is
determined by the working of the market system.
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219
The Market System and Economic Growth
Free Market: A market with few government restrictions on how

a good or service can be produced or sold, or on how a factor of
production can be employed.
Adam Smith argued the benefits of a free market system in his
famous book The Nature and Causes of the Wealth of Nations
(published in 1776).
Smith assumed individuals act in a rational, self-interested way.
If not restricted by government, then firms would be led by the
invisible hand of the market to provide consumers with what
they wanted.
The price mechanism in the free market leads producers to
change supply in accordance with consumer demand.
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220

Which of the following will result in an increase in
labour productivity?
a.
A decline in the capital stock per hour worked
b.
A decline in the amount of human capital per worker
c.
An increase in technology
d.
A decrease in the number of people attending

institutions of higher education
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221
Property Rights
Private property rights provide the legal basis of a free

market system.
Property rights: The rights individuals or firms have to the

exclusive use of their property, including the right to buy
or sell it.
Commanding Heights Episode 3, Chapter 19: Capitalism Redefined
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222

A well established and legally enforced system of
property rights
a. encourages investment growth but reduces
entrepreneurial activity.
b. reduces economic efficiency which reduces the rate of
economic growth.
c. encourages economic growth by increasing the
incentive to be innovative.
d. discourages economic growth by discouraging
innovation.
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223

Government policy can increase the accumulation of knowledge
and capital in three ways:
1.Protecting intellectual property rights with patents and copyrights.
Patent: the exclusive right to a product for a period of time
from the date the product was invented.
2.Subsidising research and development.
3.Subsidising education.
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224

What is the ultimate purpose of patents and
copyrights?
a. To provide owners with large profit forever.
b. To encourage the expenditure of funds on research and
development to create new products.
c. To protect firms from being taken advantage of by
producing firms.
d. To do all of these things.
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225

Joseph Schumpeter and Creative Destruction.
To Schumpeter, the entrepreneur is central to economic
growth:
The function of entrepreneurs is to reform or revolutionise
the pattern of production by exploiting an invention or, more
generally, an untried technological possibility for producing
new commodities or producing an old one in a new way.
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226
Why Isnt the Whole World Rich?

Catch Up: the prediction that the level of GDP per
capita in poor countries will grow faster than in rich
countries.
Some poorer countries have experienced rapid growth
rates, but many have not.
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227

The rule of law and growth
Source: Based on David Dollar and Aart Kraay (2000), Property Rights, Political Rights, and the Development
of Poor Countries in the Post-Colonial Period, World Bank Development Research Group Working Paper, October
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228

There is no one answer to the question as to why all countries do
not experience economic growth.
Most economists identify 5 key factors:
1. Failure to enforce the rule of law:
Rule of Law: the ability of a government to enforce the laws
of a country, particularly with respect to protecting private
property and enforcing contracts.
2. Wars and revolutions:
Many countries that were poor in 1960 have experienced
extended periods of
violent changes of government during
the years since. Eg. Afghanistan,
Angola and Ethiopia.
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229

3. Poor public education and health:
Many low-income countries have
weak public school
systems, so many workers are unable to read and write.
People who are sick work less, and are
less productive
when they do work.
4. Slow technological development:
The economic growth model shows the
importance of
technological change.
5. Low rates of saving and investment:
The low savings rates in developing countries contribute to a
vicious cycle of poverty.
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230

Which of the following is a reason why low income
countries might experience economic growth?
a. The country has endured extended periods of war.
b. The country fails to enforce a rule of law.
c. The country has a high rate of savings and investment.
d. The country suffers from poor health infrastructures.
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231
Globalisation
The benefits of globalisation:
Foreign Direct Investment: The purchase or building by
a corporation of a facility in a foreign country.
Foreign Portfolio Investment: The purchase by an
individual or firm of stock or bonds issued in another
country.
Globalisation: The process of countries becoming more
open to foreign trade and investment.
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232
Globalisation
Criticisms of Globalisation
Globalisation undermines distinctive cultures.
Multi-national firms exploit low wages and poor health,
safety and environmental regulations in the
developing world.
Economic growth contributes to global warming,
deforestation and other environmental problems.
Commanding Heights Episode 3, Chapter 16: The Battle Joined
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233

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MODULE 1: CONCEPTS

ECONOMIC METHODOLOGY & THE ECONOMISING

Economic Methodology & the Economising Problem

School of Economics, Finance and Marketing

School of Economics, Finance and Marketing

School of Economics, Finance and Marketing

Economics and Individual Decisions

1. People (economic agents) are rational.

School of Economics, Finance and Marketing

Economics deals with generalities/statements about

Models are simplified representations of the real world.

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Positive versus Normative

School of Economics, Finance and Marketing

Macroeconomics versus Microeconomics

Macroeconomics: Enables us to better understand the

School of Economics, Finance and Marketing

Scarcity and Trade-offs

Who will receive the products

Borrowing & Lending

School of Economics, Finance and Marketing

Production Possibilities Frontier

School of Economics, Finance and Marketing

Production Possibilities Frontier

School of Economics, Finance and Marketing

Check Your Knowledge

School of Economics, Finance and Marketing

Any movement along the PPF

Can only obtain more of one

School of Economics, Finance and Marketing

Increasing & Constant Opportunity Costs

Scarce resources are not

Scarce resources are

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Trade-offs and disaster relief

School of Economics, Finance and Marketing

Over time PPF can move outwards.

pizzas (good for the present)

School of Economics, Finance and Marketing

Check Your Knowledge

Watches (in millions)

Bags (in millions)

Draw a PPF that corresponds with the data in the table.

Why must Consumer Land sacrifice successively larger

School of Economics, Finance and Marketing

Check Your Knowledge

If the economy is currently at production alternative D:

Where would the economy be operating if a recession in Consumer

If the production possibilities frontier for Consumer Land was a

Suppose improvement occurs in the technology of producing

School of Economics, Finance and Marketing

Trade: the act of buying or selling a good or service in a

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PPF and International Trade

School of Economics, Finance and Marketing

country to produce more of a good or service than

or country to produce a good or service at a lower

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The Benefits of International Trade

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Individuals, firms or countries are better off if they

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Measurement : GDP, Unemployment, Inflation

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