Take another example—1995. CPI inflation was almost three percentage points higher than CDP deflator inflation. During this year, commodity prices fell, which was partly responsible for the exchange rate depreciating to a historically low point. This meant that imports were much more expensive, and so the CPI increased much more than the CDP deflator.
In what follows, we will typically assume that the two indexes move together, so we don't need to distinguish between them. We will simply talk about the price level and denote it by Pt, without indicating whether we have the CPI or the GDP deflator in mind.
Why do economists care about inflation?
If a higher inflation rale meant just a laster proportional increase in all prices and wages—a case called pure inflation—inllation would be only a minor inconvenience. Relative prices wouldn't be allected by inflation.
Take, for example, the workers' real wage—the wage measured in terms ol goods rather than in dollars. In the economy with 10 per cent inllation prices would increase by 10 per cent a year. Bui so would wages—and real wages would remain the same. Inllation wouldn't be entirely irrelevant,- people would have to keep track ol the increase in prices and wages when making decisions. But this would be a small burden, hardly justifying making control ot the inflation rate one ot the main goals ot macroeconomic policy.
So, why do economists care about inflation? They care because there is no such thing as pure inflation:
• In the medium run—say, a decade—the second answer is the right one. Over the medium run, the economy tends to return to the level ol output determined by supply factors—the capital stock the level ol technology and the size of the labour force. And, over a decade or so, these factors don't move so much that it is a mistake to take them as given.
• In the long run—say, a half-century or more—the third answer is the right one. To understand why japan grew so much taster than, say, the United Slates lor the lorly years following World War II we must look at why both capital and the level ol technology increased so much faster in lapan than in the United Stales. We must lake into account factors such as the education system, the saving rate and the role of the government.
This way of thinking about the determinants of output underlies both macroeconomics and the
organisation of this book.
Equation 3.8) implies that the government, by choosing the level of spending, G, or the level of taxes, /. can choose the level of output it wants. Il it wants output to be higher by, say, $l billion, all it needs to do is to increase С by $ I — r, i billion this increase in government spending, in theory, will lead to an output increase of $ I -c() billion times the multiplier I/O — c,), thus $l billion.
Can governments really choose the level of output thev want? Obviously not. There are many aspects ol reality that we haven't yet incorporated in our model, and all complicate the government's task. We will incorporate them in due time. But it is useful to list them briefly here:
• Changing government spending or taxes may be far from easy. Getting the Australian House ol Representatives and the Senate to pass bills always takes time, and can often turn into a Treasurer's nightmare, especially when the two houses arc controlled by different parties (Chapters 25 and 27).
• We have focused on the behaviour of consumption. But investment is also likely to respond—and so arc imports, as some of the increased demand by consumers and firms lalls not on domestic goods but on foreign goods. All these responses are hard to assess with much certainty, and are likely to come with complex dynamic effects (Chapters 5. 18 and I9i.
• Anticipations are likely to matter, for example, the reaction ol consumers to a tax cut is likely to depend very much on whether they think ol the lax cut as transitory or permanent. The more they perceive ihe lax cut as permanent, the larger their consumption response will be (Chapters 16 and 17).
• Achieving a given level of output may come with unpleasant side-effects. Trying to achieve too high a level ol output may, for example, lead to increasing inflation and tor that reason, may become unsustainable in the medium run (Chapters 7 and 8i.
• Cutting taxes or increasing government spending may lead to large budget def icits and an accumula¬tion of public debt. Such debt may have adverse implications in the long run (Chapters 1 I and 27). In short the proposition that, by using fiscal policy, the government can affect demand and output
in the short run is an important one and a correct one. But. as we refine our analysis we will see that
The interest rate must be such that the supply of money Iwhich is independent of the interest rateI is equal to the demand for money (which does depend on the interest ratei.
implies a lower demand lor money. The supply ol money is drawn as the vertical line denoted АГ: the money supply equals .VI, and is independent ol the interest rate. Equilibrium is at point A, with interest rate /.
With this characterisation ol the equilibrium, we can look at the effects of changes in nominal income or in the money stock on the equilibrium interest rate.
• Figure 4.3 shows the effects of an increase in nominal income on the interest rate. The figure replicates Figure 4.2, so the initial equilibrium is at point A. An increase in nominal income from $Y to $V increases the level ol transactions, which increases the demand tor money at any interest rate. The money demand curve shifts to the right, from Л I-' to XV1'. The equilibrium moves from Л up to A'; the equilibrium interest rate increases Irom i to »".
In words: An increase in nominal income leads to an increase in the interest rate. The reason is that at the initial interest rate the demand for money exceeds the unchanged supply ol money. An increase in the interest rate is needed to decrease the amount of money people want to hold and re-establish equilibrium.
• Figure 4.4 shows the ellccts ot an increase in the money supply on the interest rate. The initial equilibrium is at point A. with interest rate i. An increase in the money supply, Irom JV1s = M to M"' = M', leads to a shilt of the money supply curve to the right, from M" to Ms'. The equilibrium moves from Л down to A': the interest rate decreases Irom i to i".
!n words: An increase in the supply of money leads to a decrease in the interest rate. The decrease in the interest rate increases the demand lor money so it equals the larger money supply.
Monetary policy and open-market operations
We can get a better feel for the results in Figures 4.3 and 4.4 by looking more closely at how the central bank actually changes the money supply, and what happens when it docs so.
To understand what determines the interest rate in an economy with both currency and bank current account deposits, we must first look at what banks do.
What banks do
Modern economies arc characterised by the existence of many types ol financial intermediaries, institutions that receive funds Irom people and lirms, and use these lunds to buy bonds or stocks or to make loans to other people and lirms. Their liabilities are what they owe to the people and firms from whom they have received funds. Their assets arc the stocks and bonds they own and the loans they have made.
Banks are one type ol linanciai intermediary. What makes banks special—and the reason we focus on hanks here, rather than financial intermediaries in general—is that their liabilities arc money. People can pay :or transactions by writing cheques or using FHTPOS up to the amount of their bank account balance. Let's look more closely at what they do.
Banks receive lunds Irom depositors. They keep some ol these funds as reserves and use the rest to make loans and to purchase bonds. Their balance sheet is shown in Figure 4.6, panel (h). Their liabilities consist ot currcnt account deposits, the lunds deposited by people and firms. (We are ignoring term deposits oi other non-transaction accounts. ) Their assets consist ol reserves, loans and bonds.
• Banks receive funds from people and lirms who either deposit lunds or have funds sent directly to their account (their salaries, lor example). At any point in lime, people and firms can write cheques or use EFTPOS or withdraw up to the lull amount of their account balance. Thus, the liabilities of the banks arc equal to the value of currcnt account deposits.
Lets lirst summarise what we learned in Chapter 3:
• Equilibrium in the goods market was characterised as the condition that production, Y, be equal to the demand for goods, 2. We called this condition the IS relation.
We have looked so lar at liscal policy and at a particular monetary policy in isolation. Our purpose was to show how each policy worked. In practicc, the two are often used together. The combination ol monetary and fiscal policies is known as the monetary-fiscal policy mix, or simply, thc policy mix. In this section, we will examine various policy mixes lo help understand recent macroeconomic episodes But to do that, we first need to introduce a slightly different type of monetary policy. From ihis, you will see an example ol why the policy mix matters.
Lip until now, we have assumed that the central hank chose the nominal money supply, M, and stuck with it. In the case ol fiscal policy changes in Section 5.3, we assumed lhat Л1 remained constant. In the case of monetary policy in Section 5.3 also, we assumed that the central bank changed the nominal money supply from M to M' and left it there.
But, often, the central bank decides not to keep M constant, but rather the interest rate constant (or more precisely, the interest rate equal to some short-term target, f(t). We will see why and how in is chosen, later on in the book (for example, in Chapters 7, 9 and 26i. but, for many countries today (including Australiai, this is a good description ol what the central bank does: pick a value /„, and try to keep / close to it.
Can the central bank do this? Yes. How?
• Take a change in output, Y, which leads to an increase in money demand M''. As you saw in Figure 4.1 in Chapter 4, il the nominal money stock is kept constant, the interest rate would have to rise to achieve financial market equilibrium. But if the central bank wanted to keep the interest rate unchanged at /',,. all it has to do is increase the nominal money stock by the appropriate amount. It achieves this through open-market operations involving bond purchases.
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The effects of the initial decrease in investment demand and the monetary and fiscal responses in 2001 can be represented using the IS-LM model. In Figure 3. assume that the equilibrium at the end of 2000 is represented by point A, at the intersection of the initial IS and the initial LM curves. What happened in 2001 was the following:
• The decrease in investment demand led to a sharp shift of the IS curve to the left, from IS to IS'. In the absence of policy reactions, the economy would have been at point A', with output Y'.
• The easing of monetary policy led to a downward shift of the LM curve, from LM to LM'. An increased money supply was associated with lower interest rates.
• The decrease in tax rates and the increase in spending both led to a shift of the IS curve to the right, from IS" to IS'.
We have so far ignored dynamics. For example when looking at the effects ot an increase in taxes in Figure 5.9 ! or Figure 5.11)—or the effects of a monetary' policy expansion in Figure 5.10—it looks as il the economy moved instantaneously Irom A to A' as if output went instantaneously from У to У. This is clearly not realistic—the adjustment of output clearly takes some time. To capture this time dimension, we need to reintroduce dynamics.
Introducing dynamics tormally would be difficult. But, as in Chapter 3, we can describe the basic mechanisms in words. Some of thc mechanisms are familiar from Chapter 3, while some arc new:
• Consumers are likely to take some time to adjust their consumption to a change in disposable income.
• Firms are likely to take some time to adjust investment spending following a change in their sales.
• Firms arc likely to lake some time to adjust investment spending following a change in the interest rate.
• Firms arc likely to take some lime to adjust production following a change in their sales.
So, in response lo, say, an increase in taxes, it is likely to take some time for consumption spending to decrease in response to the change in disposable income, lor production to decrease in response to thc decrease in consumption spending, for investment to decrease in response to lower sales, lor consumption to decrease in response to the decrease in income, and so on.
In response to, say, a monetary policy expansion, it is likely to take some time lor investment spend¬ing lo increase in response lo the decrease in lhe interest rate lor production to increase in response to the increase in investment spending, for consumption and investment lo increase in response to the induced change in output, and so on.
i i ii i i i II i i i
4 8
Time (quarters)
• IS curve, %
• LM curve, 100
• tiscal contraction, liscal consolidation 102
• liscal expansion, 102
• monetary expansion, 105
• Vulgar Keynesians . by Paul Krugman. discusses the role ol monetary policy in the IIS economy. Read it and try lo see it you can restate his arguments in terms ol the IS-LM model. Internet address:
• Another interesting web page is by Brad DeLong, an economist at the University of California at Berkeley Internet address:
When unemployment rises, the ratio of the long-term unemployed to total unemployed also increases, usually with a log of a year.
unemployment rate began its descent. Thus, the two series in Figure 6.2 are positively related, with a lag. In other words, il you can imagine the long-term ratio line shifted to the left by one year, the two curves would match closely. In 2008, Australia's 14 per cent proportion of long-term unemployed is well below the OECD average ol 29 per cent, but it is above the United States' at Ю per cent. Long-term unemployment affects thc individuals suffering it. hut it also can have an impact on the performance ol the macroeconomy. As we will see later in the chapter, unemployment affects wage setters. However, the longer someone remains unemployed, the smaller their impact on wage bargaining. We will discuss this pathological issue 'also known as hysteresis in Chapter 13 when we discuss European unemployment problems, and in Chapter 23 when we examine the Great Depression.
• Thc Hows in and out ol the Australian labour lorce are also surprisingly large. Going back to figure 6.1. you can see that in each month in 2007-08, 314,000 workers dropped out ol the labour force (232,000 + 92,000), and a roughly equal number joined the labour force (217,000 + 108,000). Each ot these (lows was about 7 per cent ol those out ot the labour force.
You might have expected these two flows to be small, thinking they comprised, on one side, those finishing school and entering the labour lorce lor the first time, and on the other side workers entering retirement. But both ot these groups actually represent a small fraction ol the total flows seen in Figure 6.1.
What this fact implies is that many ol those classified as out ot the labour force arc in tact willing to work and move back and forth between participation and non-participation. To understand this, it is important to appreciate that 61 per cent ol people out of the labour force are women. Among the 4.5 million Australians classilied as out ol the labour force, about a million today report that, although they weren't looking, they 'wanted a job. What they mean exactly is unclear, but the evidence is lhat many do lake jobs when ottered one.
This tact also has an important implication. The sharp focus on the unemployment rate hy economists, policy-makers and news media is partly misdirected. Some of the people classified as 'out of ihe labour force are thought ol as hidden unemployed', very much like the unemployed; they are in ellect discouraged workers and, while they are not actively looking for work, they will take ii il they lind it. This is why economists sometimes locus on the non-employment rate, the ratio ol population minus employment to population, rather than thc unemployment rate. Further, there is the important distinction between part-time and full-time employment. Many part-timers would like to work more hours, il they could only get the work. The unemployment rate should
Having looked at the nature ol unemployment, lets turn to wage determination, and to the relation between wages and unemployment.
Wages are set in a number ol ways. In Australia, they are set in collective bargains, in legal awards and in individual agreements.
• Collective bargaining is bargaining between one or more firms and trade unions. In 2006, 41 per cent of workers in Ausiralia had their wages set in collective bargaining agreements. Negotiations may take place at the level ol the firm or enterprise), at the level of industry, or at the national level. Sometimes contract agreements apply only to firms that have signed the agreement.- sometimes they arc automatically extended ю ail lirms and all workers in the sector or the economy. One of the major reforms of thc Keating l abor government from 1991 to l')<)6 was to encourage enterprise bargaining—lhat is, bargaining between an individual lirm I or enterprise and unions.
We have just seen how equilibrium in the labour market determines the rate of unemployment (we have called this equilibrium rate ol unemployment the natural rate of unemployment), which in turn determines the level of output iwe have called this level of output the natural level of output).
So, you may ask, what did we do in the previous three chapters? If equilibrium in the labour market determines the unemployment rate and, by implication, the level of output, why did we spend so much time looking at the goods and linanciai markets? What about our earlier conclusions that the level of output was determined by (actors such as monetary policy fiscal policy, consumer confidence, and so on—all factors that don't enter equation (6.8) and therefore don't affect thc natural level of output? The key to the answers is simple, yet important.
• We have derived the natural rate ol unemployment, and the associated levels of employment and output, under two assumptions, l irst, we have assumed equilibrium in the labour market. Second, we have assumed that the price level was equal to the expected price level, which is a feature of thc medium run.
• There is no reason for thc second assumption to be true in thc short run. Thc price level may well turn out to be different from what was expected by wage setters when nominal wages were set. Hence, in the short run there is no reason for unemployment to be equal to the natural rate, or lor output to he equal to its natural level.
As we will see in the next chapter, the factors that determine movements in output in the short run are indeed the factors we focused on in the preceding three chapters: monetary policy, fiscal policy, and so on. Your time (and ours) wasn't wasted.
• But expectations are unlikely to be systematically wrong (say, always too high or always too low) forever. That is why, in the medium run. unemployment tends to return to the natural rate, and output lends to return to the natural level.
In the medium run, thc lactors that determine unemployment and output arc the factors that appear in equations (6.7) and (6.8).
These, in short, are the answers you might be looking lor. Developing these answers in detail will be our task in the next three chapters.
SUMMARY
• Thc labour force is composed of those who are working (employed) or looking for work (unemployed). The unemployment rate is equal to thc ratio of thc number of unemployed to the number in thc labour force. The participation rate is equal to the ratio ot the labour force to thc population of working age.
• 1 he Australian labour market is characterised by large llows between employment, unemployment and 'out ol tile labour force. Each month, on average, about 40 per cent of the unemployed move out of unemployment, either to take a job or to drop out of the labour force.
• Unemployment is high in recessions, low in expansions. During periods ol high unemployment, the probability of losing a job increases, and the probability of finding a job il unemployed decreases.
• A further discussion of unemployment along the lines of this chapter is given by Richard Fayard, Stephen Nickell and Richard Jackman in The Unemployment Crisis (Oxford: Oxlord University Press, 1994).
• A related hut alternative treatment ol many ot the issues in this chapter is given by Ian Macdonald in Macroeconomics. 2nd edn (Brisbane: John Wiley & Sons. 1996).
• The ABS is an excellent resource for details about the Australian labour market. Go to
An increase in government spending increases output at a given price level, shifting the aggregate demand curve to the right A monetary contraction shifts the aggregate demand curve to the left
To summarise:
• Starting from the equilibrium conditions for the goods and financial markets, we have derived the aggregate demand relation.
• This relation implies that the level ot output is a decreasing function of thc price level. It is represented by a downward-sloping curve, called the aggregate demand curve.
• Changes in monetary or fiscal policy—or more generally in any variable, other than the price level that shifts the IS or the LM curves—shift the aggregate demand curve.
Deriving the AD curve with an interest rate rule
We have derived the aggregate demand relation for the case where the central bank keeps the money stock lixed. allowing the interest rate to be determined by market equilibrium conditions. But. as you saw in Chapter 5 Section 5.4, most central banks in developed countries don t keep the money stock fixed. Rather, they conduct their monetary policy by choosing the interest rate. Let's see what that means lor the AD curve.
Suppose the monetary authority decides to have an interest rate i = i,„ but now the value they choose for thc interest rate depends on the value ol thc price level. P. Why do we introduce this new feature? It is important because central banks do set interest rates in response to what is happening in the economy. Most central banks are concerned with what is happening to prices, since one ol their main goals is to ensure that domestic money retains its purchasing power. Therelore, they will typically respond when they see prices rising. When prices go up, they will usually raise thc interest rate lo slow down demand.
Let's assume that the central bank has a particular price level target, P1, which ii aims to achieve in the medium run. It adjusts the interest rate whenever the current price level is diftereni from its target price level. (In Chapter У, we develop the analysis tor a central bank with an inflation target, 77 ".) So, if P - P' > 0, the current price level is too high and the sensible response will be to raise the interest rate. II P — P1 < 0, the current price level is too low and the central bank will lower the interest rale. In medium-run equilibrium, the price will reach a constant value with P = P!. and then lhe interest rate will also be ai its constant medium-nin value, which we call i„. Thus, the central bank's interest rate rule can be written as:
Interest rate rule: i = i„ + a(P - P')
There were two sharp increases in the nominal price of oil :n the 1970s. followed by a decrease in the 1980s and the 1990s. There was a short-lived spike during the first Gulf War in the early 1990s, and a general rise from mid-1999 to prior to the second war in Iraq in 2003. The relative price of oil index (nominal price/US PPI) varied much less, and apart from 1974-84 remained little changed.The nominal price and the relative price of oil spiked dramatically in 2007-08 but fell precipitously after mid-2008.
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