Economics

-c » You are studying economics at a time of extraordinary events that future historians will call the Information Revolution. In this revolution, people who are able to embrace its new camputer-based technologies prosper on an unimagined scale. But the incomes and living standards of the less Aexible and less educated and mobile fall behind, and new social and political tensions are emerging. Our objective in this book is to make your study of economics productive and fun. With a decent understanding of economics you will become a full porticipont in the Information Revolution. You will also play a more effective role as a citizen and voter and be able to add your voice to those who are looking for solutions to our social and political problems. And you will enjoy the sheer fun of understanding the forces at play and how they are shaping our world. If you find economics interesting, think seriously about specialising in the subject. A degree in economics gives the best training available in problem solving, offers lots of opportunities to develop conceptual skills, and opens doors to a wide range of graduate courses and to a wide range of jobs.

CHAPTER 1

CHAPTER 2

JJ --I

PART 1

0

Introduction

A Definition of Economics All economic questions arise because we want more than we can get. We want a peaceful and secure world. We want clean air and rivers. We want long and healthy lives. We want good schools and universities. We want space and comfort in our homes. We want a huge range of sports and recreational gear, from running shoes to MP3 players. We want the time to enjoy sports and games, to read books and magazines, see movies, listen to music, travel, and socialise with friends. What each one of us can get is limited by time, the income we earn, and the prices we must pay. Everyone ends up with some unsatisfied wants. As a society, what we can get is limited by our productive resources. These resources include the gifts of nature, human labour and ingenuity, and tools and equipment that we have produced. Our inability to satisfy all our wants is called scarcity. Scarcity is not poverty. It is simply wanting more than is available. The poor and the rich alike face scarcity. A child wants a $1 smoothie and a 50¢ chocolate bar but has only $1 in her pocket. She faces scarcity. Millionaire tennis professional Lleyton Hewitt wants to spend the weekend improving his game and also filming a Yonex advertisement. He can't do both, so he, too, faces scarcity. As a society, we want to provide better health care and better education, a cleaner environment, and so on. Society faces scarcity. Even parrots face scarcity! Faced with scarcity, we must choose among the available alternatives. The child must choose

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between the smoothie and the chocolate bar. Lleyton must choose between improving his game and filming the advertisement. As a society, we must choose among health care, education, and the environment. The choices that we make depend on the incentives that we face. An incentive is a reward that encourages or a penalty that discourages an action. If the price of a smoothie falls, the child has an incentive to choose the smoothie. If Yonex increases the fee for filming to $1 million, Lleyton has the incentive to make the advertisement. If computer prices tumble, we have an incentive as a society to connect more schools to the Internet. Economics is the social science that studies the choices that individuals, businesses, governments, and entire societies make as they cope with scarcity and the incentives that influence and reconcile those choices. The subject divides into two main parts: o Microeconomics o Macroeconomics

MICROECONOMICS Microeconomics is the study of the choices that individuals and businesses make, the way these choices interact in markets, and the influence of governments. Some examples of microeconomic questions are: Why are people buying more mobile phones? How would a tax on downloading music affect the sales of CDs?

MACROECONOMICS Macroeconomics is the study of the performance of the national economy and the global economy. Some examples of macroeconomic questions are: Why did unemployment fall last year? Why has Japan's economy stagnated? Can the Reserve Bank bring prosperity by keeping interest rates low?

Find stories in today's news that illustrate the definition of economics and that include examples of scarcity, incentives, and choices in Australia and around the world. Find stories in teday's news that illustrate the distinction between microeconomics and macroeconomics. ~.HR·ljIm!) Study Plan 1.1

PART 1

0

Introduction

Economics: A Social Science Economics is a social science and, like all scientists, economists distinguish two types of statement: , Whatis 2 What ought to be

Statements about what is are called positive statements and they might be right or wrong. We test a positive statement by checking it against the facts. When a chemist does an experiment in her laboratory, she is testing a positive statement. Statements about what ought to be are called normative statements and they cannot be tested. When the Australian Parliament debates a motion, it is ultimately deciding what ought to be. It is making a normative statement. To see the distinction between positive and normative statements, consider the following statements about health care. 'Universal health care will cut the amount of work time lost to illness' is a positive statement. 'Every Australian should have equal access to health care' is a normative statement. The task of economic science is to discover positive statements that are consistent with what we observe in the economic world. TIlls task breaks into three steps: o Observation and measurement o Building models o Testing models

OBSERVATION AND MEASUREMENT Economists observe and measure data on such things as the quantities of productive resources natural, human, and capital resources - wage rates and work hours, interest rates, the prices of the different goods and services, taxes and government spending, and the items bought from and sold to other countries.

BUILDING MODELS The second step towards understanding how the economic world works is to build a model. An ec0nomic mod.1 is a description of some aspect of the economic world that includes only those features of

the world that are needed for the purpose at hand A model is simpler than the reality it represents. What a model includes and what it leaves out result from assumptions about what is essential and what are non-essential details. You can see how ignoring details is useful even essential- to our understanding by thinking about a model that you see every day: the TV weather map. The weather map is a model that helps to predict the temperature, wind speed and direction, and rainfall over the next few days. The weather map shows lines called isobars - lines of equal barometric pressure. It doesn't show the main roads because we assume that the pattern of air pressure, not the location of the highways, determines the weather. An economic model is similar to a weather map. For example, an economic model of a mobile phone network will include items such as the cost of using a mobile phone, but it will ignore such details as the tunes people use for ring tones.

TESTING MODELS The third step is testing the model. A model's predictions may correspond or be in conflict with the facts. By comparing the model's predictions with the facts, we are able to test the model and develop an economic theory. An economic theory is a generalisation that summarises what we think we undeIStand about the economic choices that people make and the perfonnance of industries and entire economies. It is a bridge between an economic model and the real economy.

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'23

Global Markets in Action

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CHAPTER 7

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FIGURE 7.9

Effects of E.U. and U.S. Farm Subsidies an a Small Ecanamy E

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The demand for sugar in Australia is D... and the supply by Australian producers is SA' With free internatianal trade, the world price is $A per kilogram. Australia produces 14 millian Ionnes per year, consumes 1 million Ionnes, and exports 13 million Ionnes. E.U. and U.S. suwidies lower the world price 10

$2 per kilogram. Australian production and export! shrink and consumption increases. In part (b), Australia's consumer surplus expands from A to A + S, producer surplus shrinks from S + C + D 10 C, and Iotal surplus decreases by D - a deadweight loss.

Figure 7.9(b) shows the gains and losses for Austmlians. Consumer surplus increases from the green area A to the mea A plus B. Producer surplus shrinks from the sum of the areas B, C, and D to C. And a deadweight loss shown by area D arises.

The deadweight lo'se' created by E.U. and U.S. funn subsidies that full on the poor nations of Africa, Asia, and Central and South America me a source of tension and disagreement among nations today and remain a challenge for the WIO.

What are the tools that a country can use 10 restrict intematianaltrade' Have tariffs and quotas been on the increase ar the

decrease! Why' Explain the effects of tariffs on a country's autput and the price of the product on which a tariFF is applied when the importer is a small country in world trade. Who gains and who loses From the imposition of a IariFR What is the deadweight loss From a IarifFf How da E.U. and U.S. farm subsidies affect fanners and consumers in Australia'

The powerful forces of demand and supply shape the fortunes of families, businesses, and nations in the same unrelenting way that tides and winds shape rocks and coastlines. You've seen in Chaplers 3 to 7 how these forces raise and lower prices, increase and decrease quantities bought and said, and sometimes send resources to their higheshalued uses. These powerful forces begin quietly and privately with the choices thot each one of us makes. Chopter 8 probes these choices and shows you the neat idea of mapping people's preferences. We make our choices against the backdrop of ever-chonging technology. Every year, new goods appear and old ones disappear. New firms are born and old ones die. This process of change is managed by firms operating in markets. We begin our study of firms in Chapter 9 by learning about their costs and the relationship between technology and cost. Then we see how firms operate in various Iypes of markets. Some markets, like the ones we've studied sa far, are competitive. The most extreme competition, called perfect competition, is the topic of Chopter 10. At the other extreme is monopoly, a single firm with no competitors, which we study in Chapter 11. Then, in Chapter 12, we study a blend of competition and monopoly to explain the behaviour of the firms that produce the huge variely of brands and Aavaurs that confront us. Chapter 13 explores situations in which firms, like armies, act strategically, guessing the effects of their choices on the choices of others. Finally, in Chapter 14, we study markets for factors of production.

CHAPTER 8

CHAPTER 9

CHAPTER 10

CHAPTER 11

CHAPTER 12

CHAPTER 13

CHAPTER 14

PART 3

a

Households, Firms, and Iv'Iarkeffi

Predicting Consumer Behaviour

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New Yorker Collection 1988 Robert Weber from cartoonbank.com. All RighI! Reserved.

quickly does the marginal rate of substitution diminish. Poor substitutes for each other have tightly curved indifference curves, approaching the shape of those shown in Fig. 8.5(c). & you can see in the cartoon, according to the waiter's preferences, Coke and Alsatian white wine are perfect substitutes and each is a complement of pork. We hope the customers agree with him.

We are now going to predict the quantities of movies and soft drink that Usa chooses to buy. Figure 8.6 shows Usa's budget line from Fig. 8.1 and her indifference curves from Fig. 8.3(b). To get the most value from her limited budget, Usa consumes at her best affordable point, which Is 2 movies and 6 Illres of soft drink - at point C. Here, Usa a Is on her budget line. a Is on her highest attainable indifference curve. a Has a marginal rate of substitution between movies and soft drink equal to the relative price of movies and soft drink. For every point inside the budget line, such as point I, there are points on the budget line that Usa prefers. For example, she prefers all the points

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FIGURE 8.6

The Best Affordoble Point 1:

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;Ji What is an indifference curve and how does an indifference map show preferences? Why does an indifference curve slope downward and why is it bowed towards the origin? What do we call the magnitude of the slope of an indifference curve? What is the key assumption about a consumer's marginal rate of substitution?

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The two components of the model of household choice are now in place: the budget line and the preference map. We will now use these components to work out the household's choice and to predict how choices change when prices and income change.

Lisa's best affordable point is C. At that point, she is on her budget line and also on the highest attainable indifference curve. N a point such as H, Lisa is Willing to give up more movies in exchange for soft drink than she has to. She can move to point I, which is just as good as point H, and have some unspent income. She can spend that income and move to C, a point that she prefers to point I.

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Forget about writing Q shopping list your shopping trolley can now do your thinking for you. Shopping trolleys with their own checkout consoles attachedyou just scan the item when you drop it in - were on show at Q retail technology expo in Sydney this week. The trolleys will be used in the US from next month, and may make it into Australian supermarkets as early

as next year. The console allows you to download your shopping list and, backed by a network of in-store sensors, warns you when you are approaching an item you wish to buy. It will advertise shop specials as you pass them, and you can scan your loyalty card into the system as well. You can even place Q deli order and receive a message when it is ready for collection. Self-service checkout systems are being malled by all the big supermarket chains, and they are proving to be popular as an alternative to the old-fashioned manual checkout. Vernon Slack, of the system's manufacturer, Fujitsu, said one of the biggest problems supennarkets faced was losing shopping trips to convenience stores. So they are looking for ways to entice customers into their stores by making the shopping experience itself more convenient. And if you think you can add a few items to your trolley on the sly, think again. The number of items, and even the items themselves, will be cross-checked when they are bagged. Fujitsu's U-Scan trolley and similar technologies on show from the computer giant IBM and others promise to transform shopping - but isn't it just another way to cut costs and get rid of checkout staff? Not according to Mr Slack. He said checkout staff could be moved into more personalised customer service roles to provide improved customer service. Rob O'Neill

""""'" Morning Houdd

21 July 2005

Essence of the Sto"L- o Items are scanned as they are o

Supermarkets now have the option of investing in new smart trolleys that have scanners attached.

placed in the trolley and the customer can then check out at a self-service checkout.

PART 3

0

Households, Firms, and Markets

EFFICIENCY AND RENT SEEKING WITH PRICE DISCRIMINATION

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With perfect price discrimination, output increases to the point at which price equals marginal cost at the intersection of the marginal cost curve and the demand curve. This output is identical to that of perfect competition. Perfect price discrimination pushes consumer surplus to zero but increases producer surplus to equal the sum of consumer surplus and producer surplus in perfect competition. Deadweight loss with perfect price discrimination is zero. So, perfect price discrimination achieves efficiency. The more perfectly the monopoly can price discriminate, the closer its output gets to the competitive output and the more efficient is the outcome.

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Dozens of fares discriminate among many different types of business travellers and many new low fares with restrictions appeal to holiday travellers. With perfect price discrimination, Global's demand curve becomes its marginal revenue curve. Economic profit is maximised when the lowest price equals marginal cost. Here, Global sells 11,000 trips and makes an economic profit of $9.35 million a year.

The new fares between $900 and $1,200 have attracted 3,000 additional travellers and extracted the entire consumer surplus. Global is making an economic profit of more than $9 million a year. Real-world airlines are just as creative as Global, as you can see in the cartoon!

But there are two differences between perfect competition and perfect price discrimination. First, the distribution of the total surplus is different. It is shared by consumers and producers in perfect competition, while the producer gets it all with perfect price discrimination. Second, because the producer grabs the total surplus, rent seeking becomes profitable. People use resources in pursuit of rents, and the bigger the rents, the more resources get used in pursuing them. With free entry into rent seeking, the long-run equilibrium outcome is that rent seekers use up the entire producer surplus.

What is price discrimination and how is it used to increase a monopoly's profit? Explain how consumer surplus changes when a monopoly price discriminates. Explain how consumer surplus, economic profit, and output change when a monopoly perfectly price discriminates. What are some of the ways that real-world airlines use to price discriminate?

~i!i!M4+mS!) Study Plan 11.4

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You've seen that monopoly is inefficient and costly for consumers. Because of these features of monopoly, it is regulated. We'll now study the key monopoly regulation policy issues.

-c » Establishing a constitution Ihat makes despotic and tyrannical rule impossible is relatively easy. The framers of Australia's constitution have designed a sophisticated system of incentives of carrots and sticks - to make govemment responsive to public opinion and to limit Ihe ability of individual special interests ta gain at !he expense of Ihe majority. But no nation has managed to create a constitution !hat effectively blocks !he ability of special interest groups to copture Ihe consumer and producer surpluses that result from specialisation and exchange. Markets fail, and governments might help to overcome Ihat failure far four reasons. First, Ihe market would produce too small a quantity of Ihose public goods and services that we consume logelher, such as national defence and air-traffic contral. Second, monopolies restrict output and raise prices. Third, spill-over effects such as pollution occur. And fourlh, Ihere is too much economic inequality. Governments help to cope wilh Ihese problems. But just as markets fail, so can governments. When governments get involved in Ihe economy, people try to steer government actions in directions that bring personal gain. The four chapters in Ihis port explain !he problems wilh which Ihe market has a hard time coping. They also review Ihe roles of government in seeking better outcomes than Ihe market alone can achieve.

CHAPTER 15

CHAPTER 16

CHAPTER 17

CHAPTER 18

JJ --I

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Bock at hi sIeeI srneher and city in problem 2, govwn"*,' intrudl.lC8l a

aupp0s8 h:rt the polkJfion lax..

What is the lax pet tonne of PM! produced flat Wl1 odl~ on efficient ~ b Explain the connection bttw..n)"OUr cmwer to port to) (mel .. ~ to prob'-m 2. 5 Using lie information pravlcl«f in problem 1, suppose that no one owns th.lok. and that the government iuues two marketoble ponution a

permits, one to the farmer and one to the factory. Each may pollul8 the lake by the same gmount, and the total amount of pollution is the efficient amount.

What is the quantity of putlcid. produced' b What is the mam! prb of 0 polluOOn perm~ Who buys and who sella 0 pennit9 c What is the connection b.tw..n your CJN\IIl'W and the OMll'8l't to~. 1 and 3' 6 Using h inJormotion gr..n In problem 2, auppoH Ihat the gowmm.nl lUl* two marUlable pollution pennib, one to lie city and one to the smehret. Eodl may pol..1e lie air by the same amount, and tne total is the efficient

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b What is the market price of Q penni" Who buys and who sells a permiflil c

What is the connection betMlen your amwer and the answer. to problems 2 and ..,

7 The marginal em! of educating

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student is

$.4,000 a year and is constant. Th. figure at the top of the next column .hows the marginal private benefit curve. o With no government involvement and if the universities are competitive, how many stJdenb Qf'II enrolled and what is !he Iui~

b The e:xIBmaI benefil from education is $2,000 per student per ~r and is COO3k1nt.

I the QO'*TIment provlde,r. tM Jficient amount of education, how many university places does it offer and what it; lie tuition'

• A IIeribe the chong.. in the balance sheets of the Reserve Bank and a commercial bonk

following the open market aperaHon. c Orawa graph like Fig. 27.5 to iIIu,tra18 the effecb of the Reserve Bank's actions in the market for reserves.

5 The

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shows the economy of Freezone. The

aggregate demand curve is AD and the short-

run aggregate supply curve i$ SAS•. Poleniial GOP ;$ $300 billion.

the price level after ten years?

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b Would this type of inRotion torget $srve the Financial markets well and provide an anchor for inRation expectations~

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120

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110

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per cent a year but was also

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required to keep trend inRotion at the midpoint of the rang8. a

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Starting from a price level of 100, what is

the likely price level after "'n years if the bank achieves its target? b Compering this economy with the one In problem 1, which economy has the greeter certainty about inRation over the longer

term' Which has the gneal8r ,hart-term certainty' 3 The cash rate target is .4 per cent a year and the R...rve Bank wan" to increa.se it by 0.25 percentage poi"". a Does the Reserve Bank buy or sell securities in the open market to raise the cosh ratelJ' b o.>eribe the chang., in the balance ,hee" of the Reserve Bonk and a commercial bonk following the open market operation.

c Draw a graph like Fig. 27.5 to illu,trate the efleeb of the Reserve Bank', aeli"", in the market for reserves.

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a What i$ the price level and real GOP*

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Does freezane have on unemployment

problem or on inRaHan problem? Why' c What do you predict will happen in Freezone if the central bonk tokes no monetary policy actionslJ'

d What monetary policy action would you advise the central bank to toke, and what do you predict will be the eRect of that acHon? 6 Suppose that in Freezone, shown in problem 5, the aggregate demand curve is

AD and

potenHal GOP i$ $300 billion, but the ,hort-run aggregate $UPPIy curve i$ SASs. a What i$ the price level and real GOP*

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and obtain the latest data on M1 and M3 money supply and short-term interest rates. Then answer the following questions.

o Is the Reserve Bonk trying to slow the

critically evaluate the Reserve Bank's cash

rote decisions in 2004, 2005, ond 2006. c Write a note to the Commonwealth treasurer

economy or speed it upi How can you telli b

explaining why you think the Reserve Bank

What open market operations do you think the Reserve Bank has undertaken in the last

should have been more aggressive or les5

few

aggressive in raising the cash rote target.

and the quantity of moneyV

Do you

agree that the cash rote should not

()

Review the three episodes of monetary policy

a

What decision on the interest rate was taken by the Reserve Bank board at its last meetingi

b

What action will the Reserve Bonk be taking in the money market to implement the boardfs decision~

policy easing illustrated in Fig. 27.2 Ip. 645). a

Describe the state of the economy at the

beginning of each episode. b

Was the economy always under an inAation threat when the Reserve Bank tightened~

c

Was the economy always experiencing high unemployment when the Reserve Bank easedi

c

d

Describe the state of the economy at the end of each episode.

d

e

Was the economy always free from an inAation threat when the Reserve Bank

stopped tightening? Was the economy always free from high unemployment when the Reserve Bank stopped easing~ g

What was the state of the economy two years after an episode of tightening or easingi

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What is your overall assessment of the Reserve Bankfs performancei

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d What do you think will be the effect on bond

tightening and the three episodes of monetary

Explain your answer.

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e Do you think that the information on overvaluation and undervaluation is useful to currency speculators? Why or why not?

Describe the key differences in outcome between the two situations in questions 1 and 2 above. surplus if it doesn't choose either of the above options?

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some currencies are overvalued and some ore undervolued?

Employment

a What could the government do with its

Whot is purchosing power parity?

b Which currencies are the most overvalued relative to the U.S. dollar today? c Which currencies are the most undervalued relative to the U.S. dollar today? d Can you offer some suggestions as to why

The reol wage rate

3

When was the last lime the Australian dollar exchange fate was fixed?

d Is there any evidence that the Reserve Bank has intervened in the foreign exchange market in the past 12 months? If so, why might the

infrastructure capital and instead chose to spend some or all of its surplus on tax cuts for all workers. Describe what happens to

a b c d e

When did the Australian dollar appreciate most recently?

the change in the exchange rote on

same)?

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3

The Economist magazine uses the price of a Big Mac to determine whether a currency is undervalued or overvalued. Vist the Economist online and answer the following questions.

a What is the price of a Big Mac in the United States? b Using the current exchange rate, what is the U.S. dollar price of a Big Mac in Australia?

c

Given purchasing power parity, is the Australian dollar undervalued or overvalued

relative ta the U.S. dollar? d Which currencies are undervalued relative to the U.S. dollor? Or is the U.S. overvolued relative to these currencies? Is there a difference?

8

When inAation hits 1,000 per cent a year, as it did in Zimbabwe in 2006, money becomes worthless and the economy collapses. 'InAation is always and everywhere a monelary phenomenon,' said Milton Friedman. But behind the monelary phenomenon is a dire fiscol situation in which government expenditures outstrip revenues and the central bank prints money 10 pay the governmenl's bills. Today, Australia's inAation is mild. But it was not always sa. During the 19705, our inAation hit double digits. Can we count on low inAation' Or is there a danger that one day inRation will become rampont as it was during the 1970s? Chapter 29 examines the inAation challenge. Economic growth, mainlained at a steady rate over a number of decades, is the single most powerful inAuence on any society. It brings transformations that continue 10 amaze. Economic growth that is mainlained at a rapid rate can transform a society in years, not decades. Such transformations are laking place right now in many Asian countries. These transformations are economic miracles. Chapter 30 examines the challenge of economic growth. The Great Depression is now more than 70 years behind us. And recent recessions hove been mild. Have economists conquered the business cycle' Chapter 31 studies this question. Our international trade and payments is an ongoing concern. Are we borrowing 100 much from the rest of the world to suslain our appetite for goods and services'

CHAPTER 29

CHAPTER 30

CHAPTER 31

CHAPTER 32

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FROM ROME TO RIO At the end of the third century AD, the Roman emperar Diodetian struggled to contain an inAation that raised prices by more than 300 per cent a year. At the end of the 20th century, Brazil's inAation rate hit 40 per cent per month - or 5,600 per cent a year. Today, Australia has remarkable price slability, but during the 1970s, the Australian price level more than doubled - an inAation rate of more than 100 per cent over the decade. Why do inAation rates vary? And why do serious inflations break out from time to time? Can we be confident that the Reserve Bank will keep inAation in check? Or might inflation increase so our sovings buy less? Or might inAation decrease so our debts are harder to repay? To make good decisions, we need good forecasts of inAation, and not for just next year but for many years inla the future. How do people try to forecast inAation? And how do expeclations of inflation influence the economy? In its attempt to keep inflation in check, does the Reserve Bank foce a tradeoff between inAation and unemploymenl? And does a low unemployment rate signal a rising inflation rate? How does inflation affect the interest rate? We'll answer these questions in this chapter. We explain the forces that generate inflation and study the inAation process. We'll end, in Reading Between Lines, by looking at Australia's recent inAation experience and the challenge it poses for the Reserve Bank.

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PART 7

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Moacroeconomlc Polley Challenges

FIGURE 29.1

Inflation: Demand-pull and Cost-push The main task of the Reserve Bank is to keep inflation under control. You will learn about the tools and strategies that the Reserve Bank. uses in the next chapter. Here, we explain what causes inflation and explore the short-run tradeofD between inflation and output and between inflation and unemployment We begin by distinguishing between inflation and a change in the price level.

INFLATION AND A CHANGE IN THE PRICE LEVEL Inflation is a process in which the price level is rising and money is losing value. A change in one price is not inflation. For example, if the price of a meat pie jumps to $10 and all other money prices fall slightly so that the price level remains constant, there is no inflation. Instead, the relative price of a meat pie has increased. But if the price of a meat pie and all other prices rise by a similar percentage, then there is inflation. Inflation is an ongoing process, so a one-time jump in the price level is not inflation. Figure 29.1 illustrates this distinction. The red line shows the price level rising continuously. That is inflation. The blue line shows a one-time jump in the price level. That is not inflation. To measure the inflation rate, we calculate the

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InAation versus a One-time Rise in the Price Level 160 • Inflation, on ongoinll proc:_ of ri,inll price I_I

140 •

S-O; 130_ l120 _ 1110 _

]100 _ .!..

90 __ 2002

•

2000

•

2004

•

2005

•

2006

•

2007

Along the red line, an economy experiences inAaHon because the price level is rising persistently. Along the blue line, an economy experiences 0 one-time rise in the price level.

annual percentage change in the price level. For example, if this year's price level is 126 and last year's price level was 120, the inflation rate is 5 per cent per year. That is, Inflation rote = 126 - 120 x 100

120

= 5 per cent per year.

This equation shows the connection between the inflation rote and the price level. A high price level isn't the same as a high inflation rate. For a given price level last year, the higher the price level in the current year, the higher is the inflation rote. If the price level is rising, the inflation rote is positive. And if the price level is falling, the inflation rate is negative. If the price level rises at a faster rate, the inflation rate increases. And if the price level rises at a slower rote, the inflation rote decreases. Inflation can result from either an aggregate demand shock or an aggregate supply shock.. These two sources of impulses are called o Demand-pull inflation o Cost-push inflation We'll first study demand-pull inflation.

Go to eMS3· ,i;D for solution. to oddnumbered problems and additional exercises. 1 The figure shows an economy's long;un

level was 200, ond the velocity of circulation of money was 20. In year 2, the quantity of money was 20 per cent higher than in year 1. a

aggregate supply curve lAS; three aggregate

b Whot was the quontity of money in yeor 2?

demand curves ADo, AD1, and AD2 ; and three short;un aggregate supply curves SASo, SAS1, and SAS2 • The economy starts out on the curves

c

What was the price level in year 2?

d Whot was the level of real GDP in year 2?

ADo and SAS.

e LAS

What was the quantity of money in year 1lJ

4

What was the velocity of circulation in year 2?

In Quantecon described in problem 3, in year 3

a

List the events that might cause a demand-

b

Using the figure, describe the initial effects of a demand-pull inAation.

c

Using the figure, describe what happens as a demand-pull inAation spiral unwinds.

pull inflation.

2

In the economy described in problem 1, some events then occur that generate a cost-push inAation. a

List the events that might cause a cost-push inAation.

b

Using the figure, describe the initial effects of a cost-push inflation.

c

Using the figure, describe what happens as a cost-push inflation spiral unwinds.

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What is the quantity of money in year 3?

c

Whot is the level of real GDP in yeor 3?

d

What is the velocity of circulation in year 3?

e

If it takes more than one year for the full quantity theory effect to occur, what do you predict happens to real GDP in Quantecon

in yeor 3? Why?

a

List the events that might cause a perfectly anticipated inflation.

b

Using the figure, describe the initial effects of on anticipated inAation.

c

Using the figure, describe what happens as on anticipated inAation proceeds.

In the economy described in problem 1, suppose

that people anticipate deflation (0 falling price level) but aggregate demand turns out not to change. a

What happens to the short-run and long-run aggregate supply curves? IDraw some new curves if you need to.)

b

Using the figure, describe the initial effects of on anticipated deAation.

c

Using the figure, describe what happens as it becomes obvious to everyone that the anticipated deflation is not going to occur.

3 Quaniecon is a country in which the quantity theory of money operates. The country has a constant population, capital stock, and technology. In year 1, real GDP was $400 million, the price

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a

5 The economy described in problem 1 starts out on the curves ADo and SASo. Some events now occur that generate a perfectly anticipated inAation.

6

o

~

Real GOP (billions of 2003/04 dollars)

Some events occur that generate a demand-pull inAation.

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the quantity of money falls to on..fikh of its year 2 level. b Whot is the price level in yeor 3?

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1 Study Reading aetween the Un.. on pp. 706-07 ond then onswer the following questions. 0

Why did

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Use the links on following exerci.e.: 1

some economists think that the

Reserve Bank would soon act to raise the interest rateV

b Why did other economists think thot the Reserve Bank would wait to raise the cash rate? c Can you tell from looking at Figs 1 and 2 on p. 707 what will happen to inAation over 2005? Why or why not? d Use the AD-AS model to exploin whot must be believed for the Reserve Bonk to tighten monetary policy. Explain how the Reserve Bank's policy works to hold down the

On its website, the Reserve Bank of Australia maintains a series of graphs that summarise macroeconomic and financial market trends in

Australia. It is called Chart Pack. Visit Chart Pack and use information from the relevant graphs to answer the follOWing questions. It is normally very difficult to attribute any particular period of inAation to either a cost-push source or a demand-pull source because usually there will be a number of different but interconnected sources. Use the graphs from Chart Pack to determine these causes for the most recent two quarters. a

What has happened to the inflation rate on a year-on-year basis for the most recent two quartersi

b

Are you able to recognise any demand pressures on the price level? What are they?

c

Are you able to recognise any cost pressures on the price level? What are they?

inAation rate.

2 Do you agree with the Reserve Bank's policy of trying to keep the inflation rote inside a target range of 2-3 per centV Explain your answer in detail with reference to all the relevant indicators of economic welfare that you think ore relevant.

3 If the Reserve Bank used monetary policy to lower the inflation rate to 1 per cent, what do you predict would happen to a

d Explain the large jump and then drop in the inflation rote for 2000/01. e

Unemployment in the short run and long run?

not.

b Inflation in the short run and long runi

Were expectations of inRation, on average, higher or lower than actual inAation for these two quartersi How would these expectations influence the actual inAation rate?

c The short-run and long-run Phillips curves? d Reol GOP ond the growth rote?

e

The real wage rate in the short run and the long run?

Is there any evidence that wages have contributed to inAation? Explain why or why

g Use an AD-AS model to explain how the various pressures you have mentioned impact on the price level.

2 Obtain dato on the growth rote of money and the inAation rate in Australia since 2000. a

Calculate the average growth rate of the quantity of money.

b

Calculate the average inAation rate.

c Make a groph of the money growth rate and the inflation rate. What does it tells you about the forces that generate inAation and the relationship between money growth and inflation.

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