Compiled from the Topic 1–7 lecture slides.
(Textbook Ch. 2)
Macroeconomics is the study of the economy as a whole — the study of the aggregate (total) effects of the choices made by individuals, businesses and governments, e.g. inflation, unemployment, economic growth.
PPF: a curve showing the maximum attainable combinations of two products that may be produced with available resources and current technology.
Assumptions when graphing a PPF: only two goods, a fixed amount of inputs, a given level of technology.
Shape of the PPF — increasing marginal opportunity cost - The PPF is bowed outward (concave to the origin). - Rule: the more resources already devoted to an activity, the smaller the payoff from devoting additional resources to that activity. - As the economy moves down the PPF, increasing production of one good by a given quantity requires larger and larger decreases in production of the other good.
Worked example: Increasing wheat production from 0→200 (point A→B) only costs 50 units of wool. But increasing wheat by a further 200 (B→C) costs 150 units of wool — the opportunity cost of wheat rises as more of it is produced.
Shifts of the PPF - Economic growth = expansion of society’s production potential → PPF shifts outward (more of both goods can be produced), caused by more resources becoming available and/or overall technological change. - Technological change in one industry only shifts the frontier out along just that good’s axis (the maximum of the other good is unchanged).
Worked example (apples & cherries): Without trade, you pick 20kg apples (0 cherries) or 20kg cherries (0 apples); your neighbour can pick 30kg apples or 60kg cherries. - Your opportunity cost of 1 apple = 1 cherry (20/20); your opportunity cost of 1 cherry = 1 apple. - Your neighbour’s opportunity cost of 1 apple = 2 cherries (60/30); of 1 cherry = 0.5 apples. - You have the lower opportunity cost of apples (1 cherry vs 2 cherries) → you have comparative advantage in apples. - Your neighbour has the lower opportunity cost of cherries (0.5 apples vs 1 apple) → they have comparative advantage in cherries. - Each specialises in their comparative-advantage good and trades — both end up consuming more of both goods than they could without trade (gains from trade).
(Textbook Ch. 4)
Gross Domestic Product (GDP): the market value of all final goods and services produced in a country during a period of time. - Final good/service: the new, end product purchased by the final user (as opposed to an intermediate good used up in production of something else). - GDP includes only current production — production that takes place domestically during the indicated time period.
All three methods give the same GDP figure — this is illustrated by the circular flow of income: firms pay households (wages, interest, rent, profit) for factors of production; households spend that income buying goods/services, paying taxes, and saving; every dollar of expenditure is a dollar of income for someone else.
\[Y = C + I + G + NX\]
| Component | Definition |
|---|---|
| C — Consumption | Household spending on goods & services (excludes new houses) |
| I — Investment | Firm spending on new factories, offices, machinery, and inventories, plus household spending on new houses |
| G — Government purchases | Federal/state/local government spending on goods & services (excludes transfer payments) |
| NX — Net exports | Exports − Imports |
(For Australia, imports have often exceeded exports, so NX is frequently negative.)
GDP does not include: - Household production — goods/services people produce for themselves outside the market (cooking, cleaning, childcare, gardening). - The underground economy — buying/selling concealed from government to avoid tax/regulation, or because it is illegal.
Consequently GDP comparisons can understate living standards in countries with large non-market production (e.g. subsistence agriculture in Indonesia) or large informal economies.
Shortcomings of GDP as a measure of wellbeing: - Doesn’t capture the distribution of income. - Doesn’t value leisure. - Doesn’t measure the level/quality/access of health care and education. - Not adjusted for pollution or other negative production side-effects. - Not adjusted for crime and other social problems.
GDP deflator — a broad measure of the price level: \[\text{GDP deflator} = \frac{\text{Nominal GDP}}{\text{Real GDP}} \times 100\]
Worked example: An economy produces only strawberries and cream.
Year P (straw) Q (straw) P (cream) Q (cream) 2019 (base) $4 200 kg $3 300 kg 2020 $5 225 kg $3.50 500 kg
- Nominal GDP 2019 = 4(200) + 3(300) = $1,700
- Real GDP 2019 (base year, so = nominal) = $1,700
- GDP deflator 2019 = 1700/1700 × 100 = 100
- Nominal GDP 2020 = 5(225) + 3.50(500) = 1,125 + 1,750 = $2,875
- Real GDP 2020 (valued at 2019 prices) = 4(225) + 3(500) = 900 + 1,500 = $2,400
- GDP deflator 2020 = 2,875/2,400 × 100 ≈ 119.8
- Price level rose by (119.8 − 100)/100 ≈ 19.8% between 2019 and 2020.
(Textbook Ch. 5)
Economic growth: the sustained expansion of the PPF over time — the economy’s ability to produce increasing quantities of goods and services.
\[\text{Economic growth rate} = \frac{\text{Real GDP}_{\text{current}} - \text{Real GDP}_{\text{previous}}}{\text{Real GDP}_{\text{previous}}} \times 100\]
Worked example: Real GDP 2014/15 = $1.621tn; 2015/16 = $1.669tn. Growth = (1.669 − 1.621)/1.621 × 100 ≈ 3.0%.
Worked example: At 2.3% growth, doubling time ≈ 70/2.3 ≈ 30 years. At 4.3% growth, doubling time ≈ 70/4.3 ≈ 16 years.
Long-run economic growth: the sustained rise in a nation’s productive capacity over an extended period — driven by rising labour productivity (output per worker / per hour worked).
Two key determinants of labour productivity: 1. Capital per hour worked - Physical capital: goods used to produce other goods (machines, buildings, computers). - Human capital: workers’ accumulated knowledge/skills from education, training, experience. 2. Technological change: improvement in the ability to produce a given output with given inputs. Accumulating more inputs alone does not guarantee growth — technological change is essential.
Potential GDP: the level of real GDP when inputs are employed at the full-employment level. It rises as the labour force, capital stock and technology grow. Actual real GDP fluctuates around potential GDP due to the business cycle.
Saving identities (own-time): \[S_{private} = Y - C - T \qquad S_{public} = T - G \qquad S = S_{private}+S_{public} = Y-C-G\] (where T = net taxes = taxes − transfer payments)
In a closed economy (NX = 0): since \(Y = C+I+G\), then \(I = Y-C-G\), and since \(S=Y-C-G\), we get S = I — total saving equals total investment.
The market for loanable funds: interaction of borrowers and lenders that sets the real interest rate and quantity of funds exchanged. - Supply of loanable funds ← household/government saving (interest rate = the reward for lending). - Demand for loanable funds ← firm investment (interest rate = the cost of borrowing). - E.g. more profitable investment opportunities raise loan demand → higher interest rate & more growth; a government budget deficit raises demand for funds (reduces national saving), pushing interest rates up.
Business cycle: alternating periods of economic expansion and contraction relative to the long-term growth trend. - Recession: production, employment and income are falling; growth is negative. Technical definition: two successive quarters of negative growth. - A contraction often begins with falling firm spending on capital goods and/or household spending on new houses/consumer durables (durables are hit harder than non-durables, as purchases can be postponed). - Inflation and the cycle: inflation usually rises during expansions (unless the expansion is productivity/potential-GDP driven) and falls during contractions (unless caused by a supply shock). - Unemployment keeps rising for a while after a recession ends, because discouraged workers re-enter the labour force needing time to find jobs, and firms are slow to re-hire (operating below capacity).
(Textbook Ch. 7)
\[\text{Unemployment rate} = \frac{\text{Unemployed}}{\text{Labour force}} \times 100\]
\[\text{Labour force participation rate} = \frac{\text{Labour force}}{\text{Working-age population}} \times 100\]
| To the economy | To the individual |
|---|---|
| Loss of GDP | Loss of income |
| Loss/deterioration of human capital | Loss of skills |
| Retraining costs | Retraining costs |
| Net drain on federal budget (benefits paid) | Loss of self-esteem |
| Opportunity cost of benefit funds | Social costs — family breakdown, health/mental illness, crime, political unrest |
| Loss of tax revenue |
The labour market model: households supply labour, firms demand labour; the real wage is the price of labour. - Labour demand slopes down (higher real wage → higher cost of hiring → less labour demanded). - Labour supply slopes up (higher real wage → greater reward for working → more labour supplied). - Equilibrium is where demand = supply. A minimum wage set above the equilibrium wage creates unemployment (quantity of labour supplied exceeds quantity demanded at that wage).
(Textbook Ch. 8)
Recall: the GDP deflator (Topic 2) is one measure of the price level. The more commonly used measure is the Consumer Price Index (CPI).
CPI: measures the average of prices paid by consumers for a fixed “basket” of goods/services, based on a representative household survey conducted by the ABS. About half the basket is housing, transport, and food (across 11 broad categories).
Calculating the CPI (3 steps): 1. Find expenditure on the basket in the base year. 2. Find expenditure on the same basket at current-year prices. 3. \[\text{CPI} = \frac{\text{Expenditure on basket at current-year prices}}{\text{Expenditure on basket in base year}} \times 100\]
| Bias | Cause |
|---|---|
| Substitution bias | Fixed basket ignores consumers switching to cheaper alternatives when relative prices change |
| Quality bias | Price rises reflecting genuine quality improvements aren’t fully adjusted out |
| New product bias | New goods aren’t added to the basket for years, missing their typical early rapid price decline |
| Outlet bias | Doesn’t capture consumers shifting to cheaper, modern retail outlets |
Purchasing power: how much a given amount of money can actually buy — falls as prices rise.
To compare purchasing power of a dollar amount across two years: \[\$Y \text{ (year a) in year-b dollars} = \$Y \times \frac{\text{CPI}_{\text{year b}}}{\text{CPI}_{\text{year a}}}\]
Worked example: CPI(2016) = 109, CPI(1990) = 59. A $30,000 salary in 1990 is equivalent to $30,000 × (109/59) ≈ $55,423 in 2016 purchasing power.
Worked example (real vs nominal wages):
Year Nominal weekly earnings (\() | CPI (2012=100) | Real weekly earnings (\)) 2014 1454.10 105.9 1373.09 2015 1483.10 107.5 1379.63 2016 1516.00 108.6 1395.95 Real wage = Nominal wage ÷ CPI × 100. % change in real wage 2015→2016 ≈ (1395.95−1379.63)/1379.63 ≈ 1.18%, noticeably smaller than the % change in the nominal wage over the same period ((1516.00−1483.10)/1483.10 ≈ 2.22%) — inflation erodes part of the nominal pay rise.
Anticipated inflation still imposes costs: - Income redistribution away from those whose income lags inflation (e.g. pensioners on fixed nominal incomes). - Erodes the purchasing power of cash holdings. - Raises firms’ menu costs (cost of changing listed prices). - Can push nominal income into higher tax brackets (bracket creep).
Unanticipated inflation creates winners/losers depending on whether actual inflation is higher or lower than expected: - Fixed-nominal-income earners lose if inflation is higher than expected. - Borrowers on fixed-rate contracts gain (and lenders lose) if inflation is higher than expected.
Hyperinflation: extreme, rapid, out-of-control price increases that destroy a currency’s real value; people rush to avoid holding money; often linked to political instability and severe recession. (Example: Zimbabwe, Nov 2008 — inflation rate of 79.6 billion percent.)
Deflation: a decline in the price level. - Increases the real burden of debt. - Reduces asset values/wealth. - Real interest rate rises above the nominal rate → discourages borrowing/investment. - Prolonged deflation can severely damage growth.
(Textbook Ch. 9)
\[Y = C + I + G + NX\]
(1) Consumption (C) | Factor | Effect on C | |—|—| | Current disposable income | + | | Household wealth | + | | Expected future income | + | | Price level | − | | Real interest rate | − |
Consumption function: \(C = a + b(Y-T)\) where: - \(a\) = autonomous consumption — spending that occurs even at zero income (e.g. drawing down savings). - \(b\) = MPC (marginal propensity to consume, \(0<b<1\)) = slope of the consumption function = the fraction of an extra dollar of income that is spent.
MPC and MPS: since disposable income is either spent or saved, \(Y-T = C+S\), so (assuming \(T=0\)): \(1 = \frac{\Delta C}{\Delta Y} + \frac{\Delta S}{\Delta Y}\), i.e. \[\text{MPC} + \text{MPS} = 1\] where MPS (marginal propensity to save) is the share of extra income saved.
Worked example:
Y C S = Y−C MPC MPS 9,000 8,000 1,000 — — 10,000 8,600 1,400 0.6 0.4 11,000 9,200 1,800 0.6 0.4 12,000 9,800 2,200 0.6 0.4 13,000 10,400 2,600 0.6 0.4 Each $1,000 rise in income raises C by $600 (MPC = 0.6) and S by $400 (MPS = 0.4); 0.6 + 0.4 = 1 ✓.
(2) Planned investment (I) — determined by: 1. Expectations of future profitability (firm optimism/pessimism). 2. Real interest rate (r) — higher r → lower I. 3. Taxes — higher corporate tax discourages I. 4. Cash flow (cash revenue − cash spending) — more cash flow → easier to finance I. (Investment is historically the most volatile component of GDP.)
(3) Government purchases (G) — set by the political process; treated as exogenous (given, not determined by the model).
(4) Net exports (NX) — determined by: 1. Australia’s price level relative to other countries. 2. Australia’s growth rate relative to other countries. 3. The exchange rate (value of the dollar against other currencies).
| If… | Then… | And… |
|---|---|---|
| AE > Y | Unplanned decrease in inventories | Expansion: Y and employment rise |
| AE = Y | No unplanned inventory change | Economy is in equilibrium |
| AE < Y | Unplanned increase in inventories | Recession: Y and employment fall |
| Symbol | Meaning | Notes |
|---|---|---|
| Y | Real GDP (output) | Variable solved for |
| C | Planned consumption | \(C=a+bY\) |
| I, G, NX | Planned investment, govt spending, net exports | All autonomous |
| AE | Planned aggregate expenditure | \(AE=C+I+G+NX\) |
| MPC (b) | Marginal propensity to consume | \(0<b<1\) |
Equilibrium requires \(Y = AE = (a+I+G+NX) + bY\). Rearranging: \[Y^* = \frac{1}{1-b}\times(a+I+G+NX)\]
The term \(\dfrac{1}{1-b}\) is the expenditure (Keynesian) multiplier. Since \(0<b<1\), the multiplier exceeds 1: a change in autonomous spending produces a larger change in equilibrium output.
\[\text{Expenditure multiplier} = \frac{\Delta \text{Equilibrium real GDP}}{\Delta \text{Autonomous expenditure}} = \frac{1}{1-\text{MPC}}\]
Worked example 1: \(a=50\), \(b=0.8\), \(I=100\), \(G=150\), \(NX=0\) (all $ billion). \[Y^* = \frac{1}{1-0.8}\times(50+100+150+0) = 5 \times 300 = \$1{,}500\text{ billion}\]
Worked example 2 (using data):
Y C I G NX 8,000 6,900 1,000 1,000 −500 9,000 7,700 1,000 1,000 −500 10,000 8,500 1,000 1,000 −500 11,000 9,300 1,000 1,000 −500 12,000 10,100 1,000 1,000 −500
- At Y = 10,000: AE = 8,500+1,000+1,000−500 = 10,000 = Y → equilibrium Y = $10,000.
- MPC = ΔC/ΔY = 800/1,000 = 0.8 → multiplier = 1/(1−0.8) = 5.
- If planned investment rises by $500bn: ΔY = multiplier × ΔI = 5 × 500 = $2,500bn, so new equilibrium Y = 10,000 + 2,500 = $12,500bn.
Worked example 3: Initial equilibrium Y = $960bn, multiplier = 4, potential Y = $1,000bn. Government purchases rise by $10bn: ΔY = 4 × 10 = $40bn → new equilibrium Y = $960 + $40 = $1,000bn (exactly closes the gap to potential output).
Limitation of the simple multiplier: it’s a simplification — it ignores the effect that a change in GDP can have on other variables such as interest rates.
(Textbook Ch. 10)
The AE model (Topic 6) assumes prices are fixed. Prices may be fixed in the very short run but not always — the AD-AS model allows prices to change and explains short-run fluctuations in both real GDP and the price level.
AD curve: shows the (negative) relationship between the price level and the quantity of real GDP demanded by households (C), firms (I), government (G) and net exports (NX), holding other factors constant.
Why AD slopes downward — three effects of a rise in the price level: 1. Wealth effect: reduces the real value of money holdings → consumption falls. 2. Interest-rate effect: raises the amount of money needed for transactions → raises the real interest rate → investment and consumption fall. 3. International-trade effect: makes domestic output relatively more expensive than foreign output → net exports fall.
Long-run aggregate supply (LRAS): firms supply at potential real GDP regardless of the price level → a vertical line at potential GDP. (In the long run, wages and other resource prices adjust proportionally with the price level.) - LRAS shifts right as potential GDP grows, due to: (1) more resources, (2) more capital, (3) new technology (recall Topic 3’s growth drivers).
Short-run aggregate supply (SRAS): shows a positive relationship between the price level and quantity of real GDP supplied, other factors constant — firms produce more in response to higher prices because input prices (wages) are slower to adjust than output prices (due to wage contracts and menu costs). - A change in the price level → movement along SRAS. - SRAS shifts due to: (1) expected changes in the future price level, (2) adjustment of past expectation errors, (3) unexpected changes in input prices, (4) changes in potential output. - E.g. if firms/workers expect prices to be 3% higher next year, SRAS shifts left now (reflecting expectations of rising costs).
Negative demand shock (AD shifts left): - Short run: real GDP falls below potential — a recessionary gap opens; price level falls (or rises more slowly). - Long run: as firms/workers adjust to prices being lower than expected, costs fall and SRAS shifts right, restoring output to potential GDP (this adjustment can take years). (Examples: Great Depression, GFC 2007–09.)
Positive demand shock (AD shifts right): - Short run: output and price level rise above potential (an expansionary gap). - Long run: rising costs eventually shift SRAS left, bringing output back down to potential GDP but at a higher price level.
Negative supply shock (SRAS shifts left) — an unexpected event reducing aggregate supply (e.g. a sharp rise in energy prices, such as the 1973–74 and 1979–80 oil shocks): - Short run: real GDP falls and the price level rises simultaneously → stagflation (recession + inflation together) — this is the “cost-push inflation” from Topic 5. - Long run: SRAS eventually shifts back right as wages/prices adjust down, restoring potential GDP (can take years).
Key distinction: negative demand shocks move output and prices in the same direction (both fall); negative supply shocks move them in opposite directions (output falls, prices rise) — this is what makes supply shocks (stagflation) particularly hard for policymakers to manage.
In a normally-growing economy, all three curves shift right every year: 1. LRAS shifts right continually as potential GDP grows. 2. AD shifts right in most years (rising income/population raise C, I, G). 3. SRAS usually shifts right too (same growth factors) — except when firms/workers expect high inflation, which limits or reverses the SRAS shift.
| Short run | Long run | |
|---|---|---|
| Equilibrium condition | AD = SRAS | AD = SRAS = LRAS |
| Output vs potential | Can be above or below | Equals potential GDP |
| Negative demand shock | Output ↓, price ↓ (recessionary gap) | SRAS shifts right → output restored to potential |
| Positive demand shock | Output ↑, price ↑ (expansionary gap) | SRAS shifts left → output restored, price permanently higher |
| Negative supply shock | Output ↓, price ↑ (stagflation) | SRAS shifts back right → output restored to potential |
The AD-AS/Keynesian framework above is widely used but not universally accepted. Briefly: - Keynesian revolution: Keynes’s model, built to explain the Great Depression; New Keynesians emphasise sticky wages/prices. - Monetarism (Milton Friedman): advocates a constant, rule-based rate of money-supply growth. - New classical economics (Robert Lucas): emphasises workers/firms having rational expectations. - Real business cycle model: attributes business cycles to real (not monetary) shocks, e.g. technology. - Austrian school: favours minimal government interference; sees the business cycle as supply-side driven. - Marx: labour theory of value; believed capitalist exploitation of labour would eventually cause the collapse of the market system.
End of Topics 1–7 summary.