Topic 1: Introduction to Economics

Microeconomics: focuses on individual agents in the economy

Macroeconomics: looks at the economy as a whole
Principle 1: People face trade-offs
Due to the scarcity of resources, decision-making requires trading
off one goal for another.
- To get one thing you need to give up something else
Principle 2: The cost of something is what you give up to get it
Opportunity cost: value of the next-best alternative you give up to
obtain that item.
- The cost of something is:
o EXPLICIT monetary costs + IMPLICIT costs
Principle 3: Rational people think at the margin
Marginal change: small incremental adjustment to a plan of action
- The cost associated is marginal cost (MC) while the benefit is
called marginal benefit (MB)
Principle 4: People respond to incentives
Incentives: rewards/punishments inducing a person to act (or not
act) in a certain way
- Govt policies often use incentives to encourage/discourage
certain behaviours
Topic 2: The market forces of supply and demand Market demand: the sum of all individuals demands for a
Markets particular good or service
Market: group of buyers and sellers interacting to trade a
particular good or service
Competitive markets: so many buyers and sellers each with a
negligible impact on the market $
- The smaller the ability of each buyer/seller to affect market $,
the more competitive the market
- Perfectly competitive (PC), goods offered are homogenous,
and no influence on price by buyers and sellers
Monopoly: firm that is sole seller of a product without close subs
- No competition
- Cause: barriers to entry – monopoly remains the only seller
- Alters the $ of its good by adjusting the quantity it supplies
Monopolistic competition:
- Many sellers
- Product differentiation – have a degree of control over $
- Imperfect competition Movements along the demand curve:
- E.g. restaurants, clothing
Oligopoly: market with only a few sellers
- Key feature: tension between cooperation and self-interest
- Oligopolists are best off when they cooperate and act like a
monopolist (collusion)
- Because each firm care about its own profits, there are
incentives to compete on $
Demand
Quantity demanded: amount of a good buyers are willing and able
Shifts in the demand curve:
to purchase
- Depends on price of goods, tastes, incomes, etc
Law of demand: quantity demanded of a good falls when $ of
good rises, vice versa
- Holding constant all other factors (apart from $) may affect
quantity demanded

Other factors other than price that affect demand:

Income: relationship between income and demand depends on Market supply: the sum of all individual supplies for a particular
type of good the product is good or service
- Normal good:  in income leads to  in demand
- Inferior good:  in income leads to  in demand
Prices of related goods: relationship between $ of related good
and demand depends on what type of goods the products are
- Substitutes: two goods for which a  in $ of one good leads to
a  in demand for the other
- Complements: two goods for which a  in $ of one good leads
to an  in demand for other good
Tastes: if you like something you buy it more
Shifts in the supply curve:
Expectations: could be for the future such as income or price of
good
Number of buyers: because market demand is derived from
individual demands, it positively depends on the number of buyers

Other factors other than $ that affects supply include:

Input prices: quantity supplied is negatively related to $ of inputs
- If the $ of input rises, the supply decreases
Supply Technology: improvement in production technology increases
Quantity supplied: amount of a good that sellers are willing and productivity – with the same inputs, producer can supply more
able to sell Expectations: e.g. if suppliers expect $ to rise they will more likely
Law of supply: quantity supplied of a good rises when $ of the store some of the goods and supply less to the market today
good rises No. of sellers: because market supply is derived from individual
supply, it positively depends on the number of sellers
Topic 3: Equilibrium and Elasticity
Equilibrium
Equilibrium: supply and demand are in balance
Equilibrium price: $ that sets QD = QS – also known as market
clearing price
Equilibrium quantity: QD and QS at equilibrium $
Surplus: market $ is higher than equilibrium $ (excess supply)
- Suppliers lower $ to increase sales, moving toward equilib.
Shortage: market $ is lower than equilibrium $ (excess demand)
- Suppliers raise $ to reduce demand, moving toward equilib.
The actions of buyers and sellers naturally move the $ towards
equilibrium.
Law of supply and demand: $ of any good adjusts to bring S and D
into balance
Changes in equilibrium
- An event that changes D or S is exogenous event/change
- The subsequent change in equilibrium is said to be
endogenous change
- The analysis of a change in equilibrium is called comparative
statics:
1. Decide whether the exogenous even shifts S &/or D
2. Decide which direction the curve shifts
3. Use S and D diagram to see how the shift changed
equilibrium (endogenous change)
Increase in demand:
Suppose one summer gets very hot and more people buy ice-
cream – high temps in summer lead to increase in $ and QE
 - E.g. 10% increase in $ of milk leads to 20% decrease in QD 
PED = 20%/10% = 2
- If price elasticity > 1, demand is elastic (buyers respond
strongly to change in $) -- % change in $ leads to larger $
change in QD
- If price elasticity < 1, demand is inelastic (buyers don’t
respond strongly to change in $) -- % change in $ leads to
smaller % change in QD
- If price elasticity = 1, demand has unitary elasticity -- %
change in $ leads to equal change in QD
Determinants of price elasticity of demand (PED):
- Availability of close substitutes – Price elasticity is higher with
many close substitutes
- Necessities vs luxuries – elasticity is higher for luxuries
Decrease in supply: - Scope of the market – elasticity is higher when market is
Suppose bushfires destroy several ice-cream factories – bushfire narrowly defined
destroys several ice-cream factories increases $ and decreases QE - Time horizon – elasticity is higher the longer the time period
considered
The steeper the demand curve, the lower the PED and vice versa.

Change in both supply and demand: Price elasticity allows us to compare the responsiveness to price
Suppose there is a combination – bushfires and hot weather. Both changes of goods that are measured with different units of
lead to higher PE but QE is not clear on how it changes. measurement.
Example
As price of milk increases from $1 to $3 per litre, demand of
milk decrease from 7 to 3 litres.
As price of cereal increases from $1 to $3 per kg, demand of
cereals decrease from 3 to 1 kg.
Milk:
Q 2−Q 1 −4
 % change in Q: = =−80 %
(Q 2+Q 1) ÷ 2 5
All cases:  Percentage change in price:
P 2−P 1 2
= =1=100 %
( P 2+ P 1)÷ 2 2
−80 %
 Elasticity: =−0.8
100 %
Cereals:
 Percentage change in quantity:
Q 2−Q 1 −2
= =1=−100 %
(Q 2+Q 1) ÷ 2 2
Free markets and the role of prices:  Percentage change in price:
Free market: price is allowed to freely adjust P 2−P 1 2
- Prices are a mechanism for allocating scarce resources
= =1=100 %
( P 2+ P 1)÷ 2 2
- The market mechanism of S and D means that any buyer who
−100 %
is willing and able to pay the equilibrium price can purchase  Elasticity: =−1
the good 100 %
- Similarly, an seller who is willing and able to produce and sell Hence, the demand for cereals is more price elastic than
the good at the equilibrium price, will do so demand for milk.
Elasticity Price elasticity changes depending on the specific point on the D
Elasticity: measure of how much a variable responds to a change curve that you consider.
in one of its determinants
Price elasticity of demand:
PED = % change in QD/% change in $
 - Necessities are income inelastic (i.e. low positive income
elasticity < 1)
- Luxuries are income elastic (i.e. high positive income elasticity
> 1)
Cross price elasticity of demand (CPED):
CPED: how much the QD of one goods responds to a change in the
price of a related good
CPED = % change QD of good 1/% change in $ of good 2
Complements have negative cross price elasticity
Substitutes have positive cross price elasticity

Price elasticity of supply (PES):

Total revenue and PED: Price elasticity of supply: how much quantity supplied of a good
Total revenue (TR): the product of price and quantity responds to a change in $ of that good – it is positive
TR = P x Q PES = % change in QS/% change in $
It is the: - Elastic if PES is > 1
- Amount received by sellers - Inelastic if PES is < 1
- Amount paid by buyers - Unit elastic if PES = 1
- Total revenue = total expenditure Determinants of PES:
Ability of suppliers to change the amount of the good they sell
- The supply of Picasso painting or beach front land is inelastic
- The supply of manufacture goods (e.g. books, cars, etc) is
elastic
Time period being considered
- Supply is more elastic over longer periods

If demand is inelastic   in P  less proportional  in Q   in TR

If demand is elastic   in P  a proportionally larger in Q 
 in TR
If demand is unit elastic  change in P  proportionally equal
change in Q  TR are unaffected
Topic 4: Markets and government policies
Control on prices
Price controls: restrictions, set in place by governments, on prices
that can be charged for goods and services in a market
- Can maintain affordability or ensure minimum income for
providers, or try to achieve a living wage
Price ceiling: legal maximum on $ at which good is sold
Price floor: legal minimum on $ at which good is sold
Price ceilings:
Two possible outcomes:
1. If ceiling is above equilibrium $ (not binding)  no effect
2. If ceiling is below equilibrium $ (binding)  shortage

Income elasticity of demand (IED):

Income elasticity of demand: how much the quantity demanded of
a good responds to a change in consumers’ income
IED = % change in QD/% change in income
Normal goods: positive income elasticity (> 0)
Inferior goods: negative income elasticity (< 0)
Among normal goods:
 Tax on buyers:
Suppose the government passes a law requiring buyers of ice-
cream to pay $0.50 to the government for each unit bought.
Buyers have to pay the $ to sellers plus any tax to gov. To induce
buyers to demand any given quantity, the market $ must now be
$0.50 lower than it was before.
- D curve shifts down by an amount equal to tax
- New equilibrium is at point B (lower quantity, lower $)

Price floors:
Two possible outcomes:
1. If floor is below equilibrium $ (not binding)  no effect
2. If floor is above equilibrium $ (binding)  surplus
-- Who pays the tax?
Taxes and market outcomes
- Market (sellers) $ falls from $3 to $2.80
Tax on sellers:
- What price do buyers pay?
Government passes a law requiring sellers of ice-cream to send
o $2.80 + $0.50 = $3.30
$0.50 to the gov. for each unit sold.
Tax makes both buyers and sellers worse off – share the burden. In
For sellers, tax is an additional production cost. At any given
the new equilibrium, buyers pay more for the good and sellers
quantity, sellers require $ to be $0.50  to cover extra cost of tax.
receive less.
- Supply curve shifts up by amount equal to tac
- New equilibrium is at point B ( equilibrium and  $)

Impact of taxes:
In the new equilibrium, quantity traded is  regardless whom the
tax is levied on
-- Who pays the tax? - Taxes discourage market activity
- Market $  from $3 to $3.30 - However, necessary to raise revenue to finance projects and
- What $ do sellers receive? services
o $3.30 - $0.50 = $2.80 Buyers pay more, sellers receive less, regardless of whom the tax is
The tax makes both buyers and sellers worse off. levied on.
In the new equilibrium buyers pay more for the good and sellers Elasticity and tax incidence:
receive less. Tax incidence: what proportions is the burden of tax divided
between buyers and sellers
- Burden of tax falls more heavily on the side of the market
that is less elastic
To identiy $ buyers pay and sellers sell, don’t shift D or S – take two Topic 5: Consumers, producers and efficiency of
points whose distance is exactly equal to size of tax.
markets
Welfare economics: study of how the allocation of resources
affects economic wellbeing
Welfare of market participants is measured using participants’
surplus – consumer surplus (CS) and producer surplus (PS)
Consumer surplus
Willingness to pay (WTP): maximum amount a buyer is willing to
pay for a good
Consider the case in which D is less elastic than S. The burden falls - Measure (in $) of the value of the good to the buyer
more heavily on consumers. - Subjective measure – depends on what the buyer thinks the
good is worth to her
Consumer surplus (CS): buyer’s willingness to pay for a good (i.e.
value to buyer) minus amount buyer actually pays
- Measure of buyer’s benefit from purchasing the good
Example
- Suppose I am willing to pay $13 for a burger and actual price is $10. CS
from buying the burger is $3.
- We have many consumers in the market, each with her own WTP.
- If you know the WTP of each consumer in the market AND the market
price, then you can calculate the CS for each individual consumer. Then by
summing these up, you can find the total CS.
Now consider the case in which S is less elastic than D. The burden
Using the demand curve to measure CS:
falls more heavily on producers.
The market demand curve shows buyers’ WTP.
Suppose there are only 4 buyers, and each buyer is interested in
purchasing only one copy of Pink Floyd’s album.
The willingness to pay of each buyer is:

Subsidies Given WTP, we can derive the market demand schedule:

Subsidy: payment from the gov to consumers or sellers for each
unit of good bought or sold (regarded as negative taxes)
Subsidy to sellers:
Suppose the gov paid sellers a subsidy of $1.00 for each unit sold.
S shifts down by amount of subsidy – market equilibrium moves
down. Like a tax, subsidy creates a wedge between $ buyers pay
and $ sellers receive. Subsidy is paid to sellers, benefits enjoyed by
buyers and sellers.

Now, given the market demand schedule, we can construct the

market demand curve:

Impact of subsidies:
Market outcomes are identical if the $1 subsidy is paid to buyers
instead of sellers.
- D curve shifts  by $1 but outcomes are identical At any given quantity, the corresponding $ on the D curve (height)
Regardless of whether a subsidy is paid to buyers or sellers, its shows WTP of marginal buyer
effects are the same: - Marginal buyer: the buyer who would leave the market first if
- Quantity traded in equilibrium is higher the $ were any higher
o Subsidies encourage market activity Any given quantity, the corresponding $ on D curve shows the
o However are costly value of the last unit of the good that was bought in the market.
- Buyers pay less and sellers receive more
o Shared benefit regardless of who receives the subsidy
o Subsidy incidence: less elastic side of market receives
larger part of benefit
 can sell the burger at a price of $10.
- Your producer surplus from selling a burger is $10-$8=$2.
- Your WTS a burger is your cost of producing the burger, $8 (at a price below
$8 you would make a loss).
We have many sellers in the market, each with his own cost and WTS. If you know
the costs of each seller in the market AND the market price, then you can
calculate the PS of each individual seller. Then by summing these up, you can find
the total PS.

We now show that we can use the S curve to measure PS.

Using the supply curve to measure (PS):
The market supply curve reflects sellers’ cost.
Suppose there are only 4 painters, and each painter is interested in
painting only one house. Suppose that the cost of each painter is:
We know the demand curve tells us two things:
1. Given price – shows the quantity buyers are willing and able
to purchase
2. Given quantity – shows the WTP for the last unit of the good
(marginal buyer) Given the painters’ costs, we can derive the market supply
Suppose market price of Pink Floyd album is $700. What is the schedule:
total CS?

Given the market supply schedule, we can construct the market

supply curve.

How does a change in price affect CS:

Suppose the market $ is initially P1 : CS is area ABC. How does
CS change if the market $ falls to P2? CS is now area ADF.
Increase in CS is composed of two parts:
- BCED: increase in CS of existing buyers due to the reduction in
We derived the S curve from the cost of the sellers.
the amount they have to pay for Q 1 At any given quantity, the $ given by the S curve (height) shows
- CEF: increase in CS due to new sales (Q ¿ ¿ 2−Q 1)¿ as the cost of the marginal seller.
either new consumers enter the market and/or existing - Marginal seller: seller who would leave the market first if the
buyers decide to buy more $ were any lower

At any given quantity, the $ given by the S curve shows the cost of
the last unit produced.
Producer surplus
Producer surplus (PS): amount a seller is actually paid minus the
seller’s cost
- Measure (in $) of the benefit a producer receives from selling
the good
- Willingness to sell (WTS): lowest $ a seller would accept for
providing his good/service
Example
Suppose you sell burgers. Suppose it costs you $8 to produce a burger and you
 How to judge market outcomes:
We address this issue in the following way:
1. We consider the level of society’s welfare associated to a
market outcome
2. We then ask whether a benevolent and all-knowing social
planner would leave the market outcome as it is or change it
in order to increase welfare
Market efficiency
Market-outcome/resource-allocation that maximises TS is efficient
– good should be produced by those with lowest cost of
Supply curve tells two things: production and consumed by the buyers who value it the most.
1. Given a price – shows quantity that sellers are willing and Evaluating market equilibrium:
able to sell
Market outcome equilibrium price Pe and equilibrium quantity
2. Given a quantity – shows the sellers’ cost to produce the last
unit of the good Qe.
Suppose the market $ for painting a house is $3,200. What is the - Is the outcome sufficient? – does the market generate the
total PS? largest TS possible given D and S curves?

At any quantity below equilibrium level (Q 1 <Q 2 ), the value to

the marginal buyer exceeds the cost to marginal sellers:
- Increasing Q produced and consumed  TS
- Continues to be true until Q reaches equilibrium level

How the price affects PS:

P1 : PS is the area ABC. How
Suppose the market $ is initially
does PS change is market $ increases to P2? PS is area ADF. The
increase in PS is composed of two parts: Instead, if the planner produced Q 1 <Q e 1, TS is only equal to
- BCED: increase in PS of existing sellers due to increase in shaded area.
amount they are paid for Q 1 At any quantity above equilibrium level (Q 2 >Q e ) , the value to

- CEF: increase in PS due to new sales (Q 2−Q 1 ) as either marginal buyer is < cost to marginal seller.
- Decreasing Q produced and consumed  TS
new producers enter the market and/or existing producers
- Continues to be true until Q reaches equilibrium level
decide to sell more

Instead, if the planner produced Q 1 >Q e 1, TS is equal to blue

Total surplus area minus red one.
Total surplus (TS) = CS + PS Conclusion: to maximises total welfare, the planner chooses Q
- CS = value to byers – amount paid by buyers where S and D intersect
- PS = amount received by sellers – costs of sellers This is the outcome achieved by a competitive market.
TS = CS + PS = value to buyers – cost to sellers
Therefore, a competitive market is efficient since it maximises
welfare.

Three insights concerning competitive markets: Welfare with a tax:

Free markets: Consumer surplus with tax
1. Allocate supply of goods to the buyers who value them most - A
highly Producer surplus with tax
2. Allocate demand for goods to the sellers who can produce - F
them at least cost Loss in consumer and producer surplus from tax
3. Produce the quantity of goods that maximises the sum of - B+C+D+E
consumer and producer surplus, i.e. the equilibrium outcome The tax allows gov to collect revenue
is efficient
- Adam Smith’s Invisible Hand – market prices coordinate
buyers and sellers, and the result is efficiency
- Laissez-faire: social planner with goal of maximising TS –
leaves market outcome as is
Non-competitive markets – rarely efficient
Competitive markets are not always efficient (First Fundamental
Theorem of Welfare Economics)
Criticisms of efficiency as a measure of welfare:
- WTP reflects how much the good is like and reflects ability to
pay
- Looking at TS to measure welfare, we ignore how it is
distributed among consumers and producers – focus on
efficiency and not equity We use tax revenue to measure gov benefit from tax
Topic 6: The costs of taxation - T = size of per unit tax
The cost of taxation - Q2 = quantity of the good sold
- Causes buyer’s $ to rise and sellers’ $ to fall Government’s tax revenue = T x Q 2:
- Causes Q sold and bought to fall
- B+D
- Allows government to collect revenues to fund goods and
Gov tax revenue is < loss in CS and PS
services for society
The deadweight loss:
The area C + E is the deadweight loss. It is the reduction in TS that
results when a tax is introduced.

Welfare without a tax:

Consumer surplus without tax
- A+B+C
Producer surplus with tax
- D+E+F Taxes cause deadweight loss because some potential gains from
Total surplus without tax trade are lost to buyers and sellers.
- CS + PS = A + B + C + D + E + F
 To understand fully how subsidies affect economic wellbeing, we
must compare the increased welfare of buyers and sellers with the
cost of the subsidy to the government.
- Gov pays cost of subsidy (the size of the subsidy times the
quantity bought and sold)
- Each dollar spent as a subsidy is a dollar that cannot be spent
on the provision of other goods and services

Because of the tax, any unit between Q2 and Q1 is NOT produced

and consumed! Each of these units was worth being produced and
consumed.
Determinants of the deadweight loss
Size of deadweight loss depends on PES and PED. The greater the
elasticities of D and S:
- The larger will be the decline in equilibrium Q, and
- The greater the deadweight loss of tax
Cost of subsidy exceeds welfare gains. The area F is the
deadweight loss from the subsidy.
Taxes cause deadweight losses because some potential gains from
trade are lost to buyers and sellers. Subsidies instead lead to
quantities where the value to consumers is less than the cost to
producers.

The cost of subsidies:

A subsidy for a good  Q bought and sold. Both buyers and sellers
are better off; subsidy lowers $ buyers pay and raises $ sellers Topic 7: Externalities
receive. Market failures
- Markets fail achieving efficient allocation – gov intervention
increases welfare
- Externalities cause market equilibrium to not be efficient
(produces too much/little) and fails to allocate resources
- Market failures include public goods, asymmetric info, non-
competitive markets
Externalities and market inefficiency
Externality: uncompensated impact of one person’s actions on
wellbeing of a bystander
- Impact on bystander is adverse – negative externality
CS is increased by the subsidy – buyers purchase a higher Q at a - Impact on bystander is beneficial – positive externality
lower $. PS is increased by the subsidy – sellers sell a higher Q at a Externalities arise because person taking the action does NOT take
higher $. into account the effect their action has on wellbeing of bystander.

Examples of externalities
Negative Positive
Air pollution: suffered by bystanders Increase in productivity: enjoyed by a
from industries burning fossil fuels bystander from research and
development done by other firms
Climate change: suffered by Not catching a virus: enjoyed by a
bystanders because of industries bystanders from nearby people being
emitting greenhouse gases vaccinated
Catching a virus: suffered by Increased business activity: enjoyed by
bystanders from sick nearby people a bystander from locally restored
violating a pandemic lockdown historic buildings
Passive smoking: suffered by Higher productivity: enjoyed by a
bystanders from smokers around bystander from an educated workforce
them around them
Negative externalities:
Consider market for aluminium and assume that factories pollute: - Internalising the externality: Altering incentives so that
- For each unit produced, certain amount of pollution enters buyers/sellers consider all the effects of their actions.
the atmosphere - Solution: introduce a tax on each unit of aluminium traded
This is a negative externality: (i.e. a per unit tax on aluminium).
- Pollution creates health problems The graph shows the case in which the tax is levied on sellers.
- For each unit of aluminium produced, the “true” cost to - If the size of the tax is equal to the cost of pollution, the
society is the private cost to aluminium producers + cost to supply curve shifts up to the Social Cost curve.
bystanders whose health is negatively affected by pollution New market equilibrium after the tax will be at point A and the
The “true” cost to society is called the social cost efficient quantity will be produced.
- Larger than private cost by amount = to cost of negative - NOTE: a tax levied on buyers would work as well
externality (red curve)

Positive externalities in production

What is the efficient quantity of aluminium we should produce in When an activity yields benefits on third parties – the latter
the presence of a negative externality? doesn’t compensate producer for generating such benefits.
To maximise TS a social planner would produce all (and only) those Example: production of industrial robots generate tech spillover
units for which the social cost is smaller than the social value. beneficial to other sectors of the society.
The efficient quantity is now at the intersection between the Social - Social cost of producing robots is smaller than private cost
Cost Curve and the Demand curve (Q optimum ).
The private and social value curves are assumed to be the same
instead because there are no externalities in consumption

The efficient quantity is at the intersection between the Social

Cost curve and D curve (Q optimum ).
- Since Q optimum >Q market we have a market failure
An efficient quantity (Q optimum ), TS is measured by blue area.
- Green area ABC shows deadweight loss of the externality
Does the free market for aluminium achieve this efficient - The loss is in the form of surplus left on the table
outcome? - Market fails to be efficient – producers consider only private
- The aluminium market is in equilibrium at point B cost of production and neglect benefits on bystanders
- The market produces more than the efficient quantity - Market $ in equilibrium no longer reflects true cost of
( Qmarket > Qoptimum ) product or service for society as a whole
- Market fails to be efficient so producers consider only private
cost of production and neglect cost on bystanders
- Market price in equilibrium no longer reflects true costs of
that product or service for society as a whole

How can a social planner (i.e. the government) internalise the

positive externality?
One solution is to introduce a subsidy in the market for robots.
Example: per-unit subsidy paid to robot producers would shift
What is the cost of this failure? down the Supply curve towards the Social Cost curve.
- For each unit the market trades between Q optimum and After the subsidy, the market would reach the equilibrium at
point A where the efficient quantity is traded.
Qmarket we lose surplus – social cost exceeds social value.
NOTE: a subsidy paid to buyers would work as well
- The green area ABC identifies the welfare cost (or loss in total
surplus to society) of the externality.
- This is the deadweight loss of the externality.
Is there a solution?
 Barney’s offer and agree to stop partying

But what if Barney had the legal right to a quiet night?

In this case, it is Fred that has to offer a price to convince
Barney to allow partying.
Easy to check that private bargaining will still guarantee that
the efficient outcome is achieved.
Conclusion: The initial distribution of rights does not matter for
the ability of the market to reach the efficient outcome.
However, the initial distribution of legal rights does affect the
Externalities in consumption direction of the payment and how well off the two parties to
Externalities can also arise when people consume goods: the agreement end up.
- Negative externality in consumption: Consumption of Why private solutions do not always work
excessive alcohol, smoking cigarettes Private individuals often fail to resolve the problems caused by
- Positive externality in consumption: Vaccination, education externalities by bargaining.
The analysis mirrors that of externalities in production. The “true” Transaction costs: costs that parties incur un the process of
benefit to society is called social value. agreeing and following through on a bargain
- If transaction costs are too high, bargaining is
- Social and private value curves are now different impossible/inconvenience and priv agreements can’t be
- The market fails to be efficient reached
- Market $ in equilibrium no longer reflects true benefit of that Public policies on externalities
product or service for society as a whole Command and control policies (regulation):
Usually take the form of regulations: certain activities may be
required or forbidden
Examples: gov rules that forbid smoking in certain places, gov
limits on pollution emission levels
Market-based policy 1: corrective taxes and subsidies
Government can use taxes and subsidies to align private incentives
with social efficiency.
Negative externalities: lead markets to produce a larger quantity Taxes (or subsidies) enacted to correct the effects of a negative
than is socially desirable externality are called Pigovian taxes.
The government can remedy this by taxing goods that have Without externalities, taxes/subsidies move the allocation of
negative externalities (internalising the negative externality) resources towards socially efficient outcome ( deadweight loss).
Positive externalities: lead markets to produce a smaller quantity Market-based policy 2: tradeable permits
than is socially desirable As an alternative to taxes, gov can create a market for tradeable
The government can remedy this by subsidising goods that have pollution permits (Cap-and-Trade policies).
positive externalities (internalising the positive externality) - Each permit allows owner to emit a certain Q of pollution
Private solutions to externalities The total amount of permits is fixed and determined by pollution
Any solution to externalities requires intro of incentives that: cap set by gov – perfectly inelastic supply of pollution.
- Reduce activities with neg externalities
- Promote activities with pos externalities
Examples:
- Moral codes and social sanctions
- Private donations
- Contracts
The Coase theorem:
Coase Theorem: if priv parties can bargain without cost over
allocation of resources, they can reach agreements or bargains
that solve the problem of externalities (i.e. the outcome is Which firms demand pollution permits?
efficient) on their own (i.e. without gov intervention). - Firms that need to pollute to produce goods and services
Example - WTB from firms to buy permits determined the market for
Fred likes to party late at night, and this disturbs his neighbour demand for pollution permits
Barney. The intersection between S and D for pollution permits determine
Suppose that Fred has a legal right to party. the $ at which each permit is sold.
Further suppose that: - Firms willing to pay equilibrium $ will buy permits and pollute
- Fred estimates the benefit of partying to be $1000
- Firms not willing to pay equilibrium $ will not buy permits
- Barney’s estimates the cost of being disturbed (i.e. the
and will not pollute
negative externality) is $1600
First, note that the efficient solution is to stop late night
partying
- I.e. benefit to society (Fred and Barney) from partying is
smaller than costs to society
This solution can be reached if Barney offers Fred any price
between $1000 and $1600 to stop partying.
- This is a mutually beneficial agreement (they are both better
off).
The equivalence of Pigovian taxes and pollution permits:
- Indeed, despite his legal right to party, Fred will accept
 Inflation: persistent  in average level of $ for G and S over time
- Reduces purchasing power of money
- Represents an increase in firm costs
- Creates uncertainty for firms and makes business planning
more difficult
- Measured using price index
The consumer price index:
A number representing the weighted average $ of G and S bought
by consumers.
- Step 1: choose base year, and survey consumers in that year
Topic 8: GDP and Price Indexes to determine fixed basket of goods
Gross Domestic Product (GDP) - Step 2: find prices of each good in all years
Gross domestic product: the market value of all financial goods - Step 3: calculate cost of basket of goods in each year
and services produced within a country in a given time period - Step 4: calculate the CPI in each year
GDP (Y): Y = C + I + G + X – M Example: A simple economy with two goods over 3 years
- C = consumption Step 1:
Base year – 2014
- G = gov spending Basket – four apples, two movie tickets
- I = investments Step 2:
- X = exports Year Price of apples Price of movie tickets
2014 $1.50 $6
- M = imports 2015 $2.50 $8
- X – M = NX = Net Exports = Trade balance 2016 $3.00 $10
Components of GDP: Step 3: calculate the cost of the basket of goods in each year
Step 4: calculate the CPI in each year
Step 3 Step 4
Year Cost of basket CPI
2014
$ 1.5 ×4 + $ 6 ×2=18
( 18 ÷ 18 ) × 100=100
2015
$ 2.5 × 4+ $ 8 ×2=26
( 26 ÷ 18 ) ×100=144
2016
$ 3 ×4 + $ 10 ×2=32
( 32 ÷18 ) × 100=178
GDP vs CPI:
The GDP deflator The CPI
Reflects the prices of all final goods Reflects only the prices of all goods
Real vs nominal GDP: and services produced domestically and services bought by consumers
Nominal GDP: the output of goods and services measured at Excludes imports Includes imports
current (variable) $ The economy determines the basket The ABS determines the basket,
updating it every four or five years
Real GDP: output of goods and services measured at constant $
To measure inflation, we use price index (P) – either GDP deflator
GDP deflator is a general price index
or CPI to get inflation rate
GDP deflator = Nominal GDP/Real GDP x 100
P
Example: Numerical example of a simple 2 good economy: P = $; Q = quantity Inflation rate= × 100 % per time period
Year P(pizza) Q(pizza) P(instant
noodles)
Q(instant
noodles)
P
2014 (Base $5 (base 100 $3 (base year 75 P = change in P over time period
year) year $) $) P = value of P, usually at the start of the time period
2015 $6 150 $4 100
Examples
2016 $7 200 $5 180
GDP Deflator – Annual Inflation Rate
Example: Nominal GDP, real GDP (base year 2014) Year GDP Deflator Annual Inflation Rate
Year Nominal GDP Real GDP 2014 100 --
2014
5 ×100+3 × 75=725
$ 5 ×100+ $ 3 ×75=725 2015 124
124−100
2015
6 ×150+ 4 × 100=1300
$ 5 ×150+ $ 3 ×100=1050 ×100 %=24 % p .
100
2016
7 ×200+ 5× 180=2300
$ 5 ×200+ $ 3 ×180=1540 2016 149.35
149.35−124
The GDP deflator is calculated as: ×100 %=20.44
Example: Nominal GDP, real GDP (base year 2014) 124
Year Nominal GDP Real GDP GDP deflator
2014
725 725 725 ÷ 725× 100=100 CPI – Annual Inflation Rate
Year CPI Annual Inflation Rate
2015
1300 1050 1300 ÷ 1050× 100=124 2014 100 --
2016
2300 1540 2300 ÷ 1540× 100=149.35 2015 144
144−100
GDP and economic wellbeing
×100 %=44
100
GDP does not include: 2016 178
178−144
- Leisure ×100 %=23
- Quality of environment 144
- Inequalities of income or wealth Nominal and real variables
- Volunteer work Money, wealth, and wages:
Why is GDP important? The nominal value of a sum of money is measured in $ – could be
- Having a large GDP enables a country to afford better schools, a single, stored up amount (wealth – money in the bank) or wages
health care, etc. paid each week for doing a job.
- Many indicators of the quality of life are positively correlated - If M = $1000, then its nominal value is simply $1000
with GDP - Real value (RV): sum of money is its purchasing power over G
Inflation and S: how many units of goods and services can it buy?
- If the avg $ level is $5, the RV of $1000 is $1000/$5 = 200 - Occurs during recessions and depressions – vary in
units of G and S severity and length
RV = $M/$P 4. Wage Induced Unemployment (U WI )
Interest rates: - Caused by workers getting wages above market-clearing
Nominal interest rate is the additional money paid per year as a wage
return on your deposit, expressed as a % a) Unions exercise market power to increase wages
- 5% p.a. on a $100 deposit translates into $5 per year above market-clearing – higher wage reduces
Real interest rate is the additional purchasing power that you are demand for labour below that required for full
paid per year expressed as % -- depends on inflation. employment
If $ have risen significantly, the nominal interest you get will not b) Gov uses legislative power to set wages above
translate into as much extra purchasing power. equilibrium wage
R=r- Wages above market-clearing level
R = real interest rate - Labour supply > labour demand  excess supply of labour =
r = nominal interest rate unemployment
 = inflation
Topic 9: Unemployment and Inflation
Unemployment
Refers to people who:
- Want to work
- Are able to work, but
- Are without work
Classifications for unemployment:
To measure unemployment, the ABS conducts regular survey of
0.45% of Australian households (Labour Force Survey). Based on
the answers, the ABS places each person 15 years and older into
one of the following categories:
- Employed: if a person spent on hour or more of the previous
week working in a paid job or family business Total unemployment:
- Unemployed: all those who are willing and able to work, and - The sum of all different types of U existing at any time
actively looking for work, but don’t have a job U T =U F +U S +U DD +U WI but all types do not have to occur
- Not in the labour force: those not willing or able to work or at the same time.
not actively looking - U F and U S are always present in a changing economy.
Measuring unemployment:
Labour force = no. of employed + no. of unemployed
U DD and U WI are usually present to some degree but
Unemployment rate = no. of unemployed/labour force x 100% depends on circumstances.
Participation rate = labour force/adult population x 100% Full employment (FE):
True unemployment and official unemployment: - When economy is FE, there may still be some unemployment
Underemployment: measure of total no. of people in economy - This is called the ‘natural’ rate of unemployment, U N
unwilling to work in low-skill and low-paying job or only part-time - Includes frictional and structural unemployment. In both
because they cannot get a full time job. cases, jobs are available but unfilled. With U F , what
- If you want to work 40 hrs/wk and are working 1 hr/wk in
prevents the jobs from being filled is search time, while with
that week, your 39 hours of unemployment are not counted
Discouraged workers: those who want to work but have stopped
U S it is wrong skills or location.
looking for work. - U N may not be constant over time, but may vary according
Types and causes of unemployment: to the determinants of U F and U S
1. Frictional Unemployment (U F ) Inflation
- Caused by search times needed for Hyperinflation: inflation at astronomically high levels
o Workers to fin jobs, and Demand-pull inflation (DP):
o Firms to find workers When aggregate demand exceeds economy’s ability to produce
- Workers have right skills and locations, just haven’t goods and services.
found or chosen jobs. E.g. new graduates If grows strongly – output increases.
- Searching is a ‘friction’ that slows down job-finding and To produce more output, need more labour.
vacancy filling As economy approaches full employment, competition for labour
2. Structural Unemployment (U S) increases, fewer unemployed and increase in wages.
- Technological progress and large demand swings cause Cost-push Inflation (CP):
changes in structure of economy Originates on the supply side of the economy – incomes obtained
- Exists due to mismatches of skills and location from involvement in production process are also costs.
- Workers want to increase wages, done through bargaining
3. Demand Deficient Unemployment (U DD )
and firms need to increase prices (cost push)
- Economy is not generating enough jobs to employ all - Firms want to increase profits, so they increase prices in
who want to work – firms not hiring due to insufficient price-setting decisions (profit push)
demand for G and S
- Unemployed are willing to work, but jobs are unavailable
Topic 10: Aggregate demand and supply
Economic fluctuations
Fact 1: Economic fluctuations are irregular and unpredictable Suppose P rises, the $ people hold buy fewer goods and services,
- Fluctuations in the economy are often called the business so real wealth is lower. People feel poorer and spend less so C falls.
cycle (boom and bust, economic growth and recession, If C falls then AD falls and Y falls.
economic upturns and downturns etc) The exchange rate effect (P and NX):
- When real GDP grows rapidly, business is good Suppose P rises, interest rises, more foreign investors want to
- Firms find customers are plentiful and that profits are invest in Australian bonds and more money flows into Australia.
growing Higher demand for $AUD increases its value (AUD appreciates).
- When real GDP falls, businesses can struggle This makes Australian exports more expensive to foreigners but
- In recessions, most firms experience declining sales and imports cheaper. Thus NX = (X – M) decreases.
profits If NX falls, AD falls and Y falls.
- Recessions do not come at regular intervals – sometimes they Shifts in the AD curve:
are close together and sometimes the economy goes many For a given P, any event that changes C, I, G or NX will shift the AD
years without one curve.
Fact 2: Most macroeconomic quantities fluctuate together
- Real GDP measures the value in constant prices of all final
goods and services produced within a given period of time
- Also measures the total income of everyone in the economy
- When real GDP falls in a recession, so do personal income,
corporate profits, consumer spending, investment spending,
industrial production, retail sales, home sales, car sales, etc
- Although macroeconomic variables fluctuate together, they
fluctuate by different amounts
- When economic conditions deteriorate, much of the decline Changes in C:
is attributable to reductions in spending on new factories, - Stock market boom/crash
housing and inventories - Changes in preferences
Fact 3: As output falls, unemployment rises - Taxes reduced
- When real GDP declines, the rate of unemployment rises Changes in I:
- When the real GDP starts to expand, the unemployment rate - Firms buy new tech, equipment, factories
gradually declines - Expectations change
- Unemployment rate never approaches zero - Interest rates change
- Instead, it fluctuates around its natural rate - Investment incentives
Basic model of economic fluctuations Changes in G:
- The aggregate demand curve shows the quantity of goods - Gov spending is increased or reduced
and services that households, firms and the government want - State and local spending is increased or reduced
to buy at any inflation rate Changes in NX:
- The aggregate supply curve shows the quantity of goods and - Booms/recessions in countries that buy our exports
services that firms that firms produce and sell at any inflation - Appreciation/depreciation of $AUD resulting from
rate international speculation in foreign exchange market
- The model determines the equilibrium price level and The aggregate supply (AS) curves:
equilibrium output (real GDP) - The AS curve shows the total quantity of goods and services
firms produce and sell at any given price level
- It is upward sloping in the short-run
- Vertical in the long-run
Long-run aggregate supply curve (LRAS):
- The natural rate of output
- Y N is the amount of output the economy produces when
unemployment is at its natural rate
- Y N is also called potential output or full employment output
Aggregate demand (AD) curve:
- Shows the quantity of all goods and services demanded in the
economy at each level of $
- Tells us Q of all goods and services demanded in the economy
at any given inflation rate
- Downward sloping – fall in inflation raises Q demanded
Why is it downward sloping
Interest-rate effect (P and I): Shifts in LRAS curve:
Suppose P rises, buying goods and services requires more $ - Any event that changes any of the determinants of Y N will
because everything is now more expensive.
shift LRAS
To get these $, people try to borrow more money – increase in
- Example: immigration increases, causing Y N to rise
demand for borrowing drives up interest rates (r).
When interest rate rises, firms reduce investment spending. Thus, o Changes in U N or natural rate of unemployment:
‘I’ falls, AD falls and Y falls. Immigration, Baby boomers retire, Govt policies reduce
The wealth effect (P and C): natural unemployment rate
 o Changes in physical capital or human capital: Investment - At price P1, firms are prepared to supply Y 1
in factories, equipment, More people get college - What happens if money wages fall?
degrees, Factories destroyed by a hurricane - Holding price at P_1 and everything else constant, firm profits
o Changes in natural resources: Discovery of new mineral will rise
deposits, Reduction in supply of imported oil, Changing
- So at a price of P1firms will be willing to supply more and
weather patterns that affect agricultural production
o Changes in technology: Productivity improvements from supply will rise (to Y 2)
technological progress - This will be true at any price, so SRAS curve shifts right
Short run aggregate supply (SRAS) - In general, any fall in costs ( P E) shifts the SRAS right
The SRAS curve is upward sloping: Short-run equilibrium
Over the period of 1-2 years, an increase in P causes an increase in Occurs where AD and SRAS intersect.
the quantity of goods and services supplied. The positive slope of
the SRAS is the key to understanding short-run fluctuations
Why SRAS is upward sloping
1. Sticky Wage Theory
Imperfection: Nominal wages are sticky in the short run. They
adjust sluggishly due to labour contracts, social norms, etc.
Firms and workers set the nominal wage in advance based on PE
Long-run equilibrium
(price-expectations) – the price level they expect to prevail.
In the long-run equilibrium, P E=P , Y =Y N , and
If P> P E (prices then turn out to be higher than expected)
unemployment is at its natural rate – The economy is at full
revenue is higher, but labour cost is not. Production is more
employment equilibrium.
profitable, so firms increase output and employment.
If P increases, real wages falls, labour is now cheaper, firms hire
more labour, and can produce more output.
2. Sticky Price Theory
Imperfection: Many prices are sticky in the short run – Cost of
printing new menus (menu cost), time required to change prices.
Firms set sticky prices in advance based on P E.
If money supply increases unexpectedly, P will rise. In the SR, firms Economic fluctuations
without menu costs can raise prices immediately. Firms with menu Caused by events that shift the AD and/or AS curves.
costs wait to raise prices. Meanwhile, their prices are relatively Four steps to analysing economic fluctuations:
low, which increases demand for their products, so they increase 1. Determine whether the event shifts AD or AS
output and employment. 2. Determine whether curve shifts left or right
Hence, higher P is associated with higher Y, so SRAS curve slopes 3. Use AD-AS diagram to see how the shift changes Y and P in
upward. the short run
3. Misperception Theory 4. Use AD-AS diagram to see how economy moves from new SR
Imperfection: Firms may confuse changes in the average price equilibrium to new LR equilibrium
level P with changes in the relative price of the products they sell. Demand shock: A shift of AD curve
If P rises above P E, a firm sees its price rise before realising all - Economy starts at point A
- AD falls and economy moves to point B. Prices and output
prices are rising. The firm may believe its relative price is rising,
both fall
and may increase output and employment (temporarily until they
realise all prices have risen). - But at B, because Y 2 <Y N unemployment is above the
So, an increase in P can cause an increase in Y, making the SRAS natural rate and workers might accept a cut to money wages
curve upward sloping.
Shifts in SRAS curve:
- At price P1, firms are prepared to supply Y 1
- What happens if money wages rise?
- Holding price at P1and everything else constant, firm profits
will fall.
- So at a price ofP1firms will not be willing to supply as much
and supply will fall (to Y 1)
- This will be true at any price, so SRAS curve shifts left
- In general, any increase in costs ( P E) shifts the SRAS left

- Economy starts at point A

- AD falls and economy moves to point B. prices and output
both fall.
- But at B, because Y 2 <Y N unemployment is above the
natural rate and workers might accept a cut to money wages
- This shifts the SRAS curve to the right. We move to point C.
 Money supply:
Quantity of money available in the economy.
Currency: notes and coins in the hands of non-bank public
Current deposits: balances on bank accounts that depositors can
access on demand by using cards or cheques
Money supply = currency + current deposits
Money demand:
Money is one of a number of forms in which wealth can be held:
Bonds (issued by govt or firms), Stocks and Houses, etc
Topic 11: Monetary Policy and Fiscal Policy
The benefit of holding money is its liquidity: the fact that it can
Policy options
easily be exchanged for anything in the economy. The opportunity
Monetary policy: manipulation of the amount of money in the
cost of this liquidity is foregone interest.
economy or interest rates to affect the level of aggregate demand.
As the interest rate rises, demand for money falls (and vice versa).
Fiscal policy: the manipulation of government spending and taxes
Liquidity preference model:
to affect the level of aggregate demand.
Market in which agents who demand or want money meet the
The idea is to shift the AD curve back to the right in order to
agents who supply, have or can generate money.
increase output and possibly the price level too.
Determines the interest rate:
Policy shift of the AD curve:
- A simple theory of the interest rate (denoted r)
- r adjusts to balance supply and demand for money
- Money supply: assume fixed by central bank, does not
depend on interest rate
- Money demand reflects how much wealth people want to
hold in liquid form
- A household’s “money demand” reflects its preference for
liquidity
- The variables that influence money demand: Y, r, P
How r is determined:
Monetary policy
MS curve is vertical: Changes in r do not affect MS, which is fixed
It is typically conducted by a country’s central bank. In Australia
by the central bank.
this is the Reserve Bank of Australia (RBA).
MD curve is downward sloping: A fall in r increases the quantity of
When the economy goes into recession, output falls and
money demand.
unemployment rises, it makes sense for the central bank to inject
money and reduce interest rates.
When the economy experiences inflation, it makes sense for the
central bank to withdraw money and increase interest rates.
Australian Central Banking:
- The RBA operates independently of executive government
- Its functions are:
o The conduct of monetary policy;
o Maintenance of financial stability (emergency lending to
banks); and
o Operate the non-cash payments system
- RBA takes an inflation targeting approach to monetary policy: Monetary policy and Aggregate demand:
o Inflation between 2 and 3% is the primary target for To achieve macroeconomic goals, the RBA can use monetary policy
monetary policy; to shift the AD curve.
o Time frame is the medium term which allows inflation to The RBA’s policy instrument is MS. The news often reports that the
temporarily go outside the band in pursuit of other goals RBA targets the interest rate.
o If inflation is too high, the RBA increases the interest rate More precisely, the cash rate, which banks charge each other on
 slows down borrowing and spending  lower short-term loans.
inflation and output To change the interest rate and shift the AD curve, the RBA
o If inflation is too low, the RBA lowers the interest rate  conducts open market operations to change MS
higher borrowing and spending  higher inflation and Effects of reducing money supply:
output

Effects of increasing money supply:

Monetary policy: the money market
Market in which agents who demand money meet agents who can
supply money – determined interest rates (nominal interest rate).
Liquidity Preference Model: explains the process of interest rate
determination – simplified description of Australian Cash Market
where cash rate is determined.
 slow down the production of goods an services compared to
previous levels.
G – AD – Y – growth 
b) Tax rates. Suppose government increases company tax rates.
This makes investment less profitable so I will typically fall.
Company tax rate – expected profits – I – AD – Y –
growth
Or the government could increase personal income tax
The transmission mechanism:
rates to encourage lower C and AD.
- Changing money supply and interest rates leads to changes in
Government Budget
AD which feeds into prices (inflation) and output (and jobs)
- The government budget is the difference between
- This effect is “transmitted” through various “mechanisms”
government revenue and government spending
1. r – I, provided firms are confident about the future
- In our simplified model, we write these as T and G
2. r – C, provided households are confident about the
respectively
future
- The government budget can be in 3 possible states:
3. r – ER, – X and M, provided net exports are elastic
o Budget surplus BS = T – G with T > G
- Reverse outcomes if r is raised
o Budget deficit BD = G – T with G > T
Fiscal policy
o Budget balance BS = 0 with T = G
- FP is the use of government spending and revenue
- There is always much discussion about budgetary policy.
instruments to influence the levels of aggregate demand,
When is it appropriate to run budget deficits or budget
output, employment and economic growth
surpluses? This question combines both economic and
1. On the spending side, the main instrument is G,
political factors.
expenditure on final g and s by the government. E.g.
The overall impact of fiscal policy
infrastructure projects such as railways, schools,
- The overall impact that fiscal policy has on output and
hospitals, ports, etc.
employment is the outcome of two main effects:
- A second instrument is transfer payments such as
o A multiplier effect where the impact on output from a
unemployment benefits or subsidies to firms, but these work
certain amount of government has a bigger effect than
indirectly by encouraging households and firms to spend
the size of the government spending
more on C and I. We ignore transfer payments for simplicity.
o A crowding out effect where the extra government
2. On the revenue side, the main instrument is taxation
rates on income (personal or company income) or on spending leads to a reduction in other components of
expenditure (GST). These also operate indirectly by aggregate demand
encouraging households and firms to spend less or more The multiplier effect
on C and I. We also ignore GST for simplicity. - The multiplier effect:
Stimulatory FP and AD Each $1 increase in G can generate more than a $1 increase in
1. Suppose economy is in recession or growing too slowly. The AD
government can respond by increasing G or lowering tax - Also true for the other components of GDP
rates. Example: Suppose a recession overseas reduces demand for
a) G. Suppose government decides to fund the building of Australian net exports by $10b
a second Sydney airport by the private sector. This Initially, aggregate demand falls by $10b.
directly affects the production of g and s, with the effects The fall in Y causes C to fall, which further reduces aggregate
spread out over time. demand and income.
G – AD – Y – economic growth 
b) Tax rates (t) . Suppose government lowers personal A $20b increase in G initially shifts AD to the right by $20b.
income tax rates (t). This directly increases the The increase in Y causes C to rise, which shifts AD further to the
disposable income of households but only affects AD if right.
this leads to more consumption expenditure on g and s
(as against just saving more or paying off existing debts).
Personal tax rate  – Y disposable  – C – AD – Y – growth .
Similarly, decreases in company tax rates will encourage higher I
and AD.

- How big is the multiplier effect?

It depends on how much consumers respond to increases in
income.
- Marginal propensity to consume (MPC):
The fraction of extra income that households consume rather
Contractionary FP and AD
than save
2. Suppose the economy is booming or growing too fast. The
- Multiplier = 1/1—MPC
government can respond by decreasing G or increasing tax
- Example: if MPC = 0.8, the multiplier is 1/1—0.8 = 5
rates
a) G. The government can reduce the amount of infrastructure
The size of the multiplier depends on MPC.
it is prepared to finance. This will directly decrease and hence
E.g. if MPC = 0.5 multiplier = 2
 if MPC = 0.75 multiplier = 4
if MPC = 0.0 multiplier = 10

Example: if the government expenditure increase by $20b, Y

increases by (assuming MPC = 0.8)

The crowding effect

- Fiscal policy is another effect on AD that works in the
opposite direction
- A fiscal expansion raises r, which reduces investment, which
then reduces the net increase in aggregate demand
- So, the size of the AD shift may be smaller than the initial
fiscal expansion
- This is called the crowding out effect

Topic 12: The external sector – Balance of Payments and

Excahnge rates