Exam format:

Part 1 (20 marks): 20 Multiple choice questions covering both macroeconomics and
microeconomics
Part 2 (30 marks): 3 essay questions covering: 1) money market; 2) open market
macroeconomics, and 3) AD-AS analysis.
The questions will be similar to the tutorial questions, and with real-world applications.

Topics summary:
Topic 1: GDP
1. Definition
2. Components of GDP
3. Real and nominal GDP
4. GDP and economic wellbeing

Topic 2: CPI
1. Definition
2. How to calculate CPI?
3. Problems in measuring costs of living

Topic 3: Economic growth

1. How is labour productivity determined?
2. Economic growth and public policy (what factors will lead to economic growth in the
future)

Topic 4: Financial system

1. Financial institutions
2. Market for loanable funds
3. How government policies can affect saving and investment

Topic 5: Unemployment
1. How is unemployment measured?
2. Classical unemployment

Topic 6: monetary system

1. The meaning of money and Reserve Bank of Australia
2. Banks and the money supply (process of money creation in the banking system)
[Link] case of 100 per cent reserve banking
▪ Example: Suppose that currency is the only form of money and the total amount of
currency is $100.
▪ A bank is created as a safe place to store currency; all deposits are kept in the vault
until the depositor withdraws them.
- Reserves: Deposits that banks have received but have not lent out.
 - Under the example described above, we have 100 per cent reserve banking.
▪ The financial position of the bank can be described with a T-account:

▪ Note that the money supply in this economy is unchanged.

- Before the bank was created, the money supply consisted of $100 worth of currency.
- Now, with the bank, the money supply consists of $100 worth of deposits.
▪ This means that, if banks hold all deposits in reserve, banks do not influence the
supply of money.
[Link] creation with fractional-reserve banking
▪ Fractional-reserve banking: A banking system in which banks hold only a fraction of
deposits as reserves.
▪ Reserve ratio: The fraction of deposits that banks hold as reserves.
▪ Example: Same as above, but the bank decides to set its reserve ratio equal to 10
per cent and loan out the remainder of the deposits.
- The bank’s T-account would look like this:

- When the bank makes these loans, the money supply changes.
- Before the bank made any loans, the money supply was equal to the $100 worth of
deposits.
- Now, after the loans, deposits are still equal to $100, but borrowers now also hold
$90 worth of currency from the loans.
- Therefore, when banks hold only a fraction of deposits in reserve, banks create
money.
The money multiplier
• The creation of the money does not stop at this point.
• Borrowers usually borrow money to purchase something and then the money likely
becomes redeposited elsewhere.
• Suppose a person borrowed the $90 to purchase something and the funds then get
redeposited in the second bank.
- Each time the money is deposited and a bank loan is created, more money is
created.
- How much money is eventually created in this economy?

▪ Money multiplier: the amount of money the banking system generates with each
dollar of reserves. Money multiplier = 1 /reserve ratio
 ▪ Total assets = total liabilities
▪ Bank capital is financial resources that a bank gets from issuing equity
▪ Leverage: use of debt to supplement existing funds for investment purposes
- The leverage ratio = total bank assets / bank capital.

Topic 7: inflation
1. The causes of inflation
2. The costs of inflation

Topic 8: Open economy

1. The international flows of goods and capital
- flow of goods: Exports, imports and net exports
▪ Trade balance (net exports): value of a nation’s exports - value of its imports
- flow of financial resources: net foreign investment
▪ Net foreign investment: purchase of foreign assets by domestic residents -
purchase of domestic assets by foreigners
- current account and the capital and financial accounts
▪ current account measures the imbalance between a country’s exports and imports
in world markets for goods and services (NX) as well as the flow of net income (NY)
and net transfers (NT). CAB = NX + NY + NT
▪ capital and financial accounts measure an imbalance between the amount of foreign
assets bought by domestic residents and the amount of domestic assets bought by
foreigners; that is, net foreign investment (NFI).
▪ For an economy: CAB = NFI
- Saving, investment and their relationship to the international flows
▪ GDP: Y = C + I + G + NX
▪ take account of earnings from overseas investments we define gross national
disposable income: GNDY = GDP + NY + NT
▪ Gross national savings: S = GNDY - C - G => S = I + CAB
▪ saving is equal to the sum of domestic investment (I) and net foreign investment
(NFI): S = I + NFI
 2. The prices for international transactions: Real and nominal exchange rates
▪ Nominal exchange rate: The rate at which a person can trade the currency of one
country for the currency of another.
▪ Real exchange rate: The rate at which a person can trade the goods and services of
one country for the goods and services of another.
𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑒𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑟𝑎𝑡𝑒 × 𝐷𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑝𝑟𝑖𝑐𝑒
▪ 𝑟𝑒𝑎𝑙 𝑒𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑟𝑎𝑡𝑒 =
𝐹𝑜𝑟𝑒𝑖𝑔𝑛 𝑝𝑟𝑖𝑐𝑒

▪ The real exchange rate measures the price of a basket of goods and services
available domestically relative to the price of a basket of goods and services
available abroad.
 A depreciation in the Australian real exchange rate means that Australian goods
have become cheaper relative to foreign goods. Australian exports will rise, imports
will fall and net exports will increase.
3. theory of exchange-rate determination: purchasing-power parity
4. macroeconomic theory of the open economy
The market for loanable funds
▪ The supply of loanable funds comes from national saving.
▪ The demand for loanable funds comes from domestic investment and net foreign
investment.
▪ The quantity of loanable funds demanded and the quantity of loanable funds supplied
depend on the real interest rate (the price):
- A higher real interest rate encourages people to save and thus raises the quantity of
loanable funds supplied.
- A higher interest rate makes borrowing to finance capital projects more costly,
discouraging investment and lowering the quantity of loanable funds demanded.
- A higher real interest rate in a country will also lower net foreign investment. All else
being equal, a higher domestic interest rate implies that purchases of foreign assets
by domestic residents will fall and purchases of domestic assets by foreigners will
rise.
The market for foreign-currency exchange
▪ Net foreign investment represents the quantity of dollars supplied for the purpose of
buying assets abroad.
▪ The current account balance represents the quantity of dollars demanded for the
purpose of buying Australian net exports of goods and services and net income and
transfers.
▪ The real exchange rate is the price that balances the supply and demand in the
market for foreigncurrency exchange:
- When the Australian real exchange rate appreciates, Australian goods become more
expensive relative to foreign goods, lowering Australian exports and raising imports.
Thus, an increase in the real exchange rate will reduce the quantity of dollars
demanded.
- The key determinant of net foreign investment is the real interest rate. Thus, as the
real exchange rate changes, there will be no change in net foreign investment.

Net foreign investment: the link between the two markets

▪ In the market for loanable funds, net foreign investment is a part of demand.
▪ In the foreign-currency exchange market, net foreign investment is the supply of
dollars.
 ▪ When the real interest rate is high, owning domestic assets is more attractive and
thus, net foreign investment is low.
Simultaneous equilibrium in two markets

▪ The real interest rate is determined in the market for loanable funds.
▪ This real interest rate determines the level of net foreign investment.
▪ Because net foreign investment must be paid for with foreign currency, the quantity of
net foreign investment determines the supply of dollars.
▪ The equilibrium real exchange rate brings into balance the quantity of dollars
supplied and the quantity of dollars demanded.
▪ Thus, the real interest rate and the real exchange rate adjust simultaneously to
balance supply and demand in the two markets. As they do so, they determine the
levels of national saving, domestic investment, net foreign investment and net
exports.

Government budget deficits

A government budget deficit occurs when the government spending exceeds government
revenue.
 ▪ Because a government deficit represents negative public saving, it lowers national
saving. This leads to a decline in the supply of loanable funds.
▪ The real interest rate rises, leading to a decline in both domestic investment and net
foreign investment.
▪ Because net foreign investment falls, people need less foreign currency to buy
foreign assets so the supply of dollars declines.
▪ The real exchange rate rises, making Australian goods more expensive relative to
foreign goods. Exports will fall, imports will rise and net exports will fall.
▪ In an open economy, government budget deficits raise real interest rates, crowd out
domestic investment, cause the dollar to appreciate and push the trade balance
toward deficit.
Trade policy
▪ Two common types of trade policies are tariffs (taxes on imported goods) and quotas
(limits on the quantity of imported goods).
▪ Example: the Australian government increases the tariff on imported cars.
- Note that the tariff will have no effect on the market for loanable funds. Thus, the real
interest rate will be unaffected.
- The tariff will lower imports and thus increase net exports. Since net exports are a
component of the current account balance, which is the source of demand for dollars
in the market for foreign-currency exchange, the demand for dollars will increase.
 - The real exchange rate will rise, making Australian goods relatively more expensive
than foreign goods. Exports will fall, imports will rise and net exports will fall.
- In the end, the quota reduces both imports and exports but net exports remain the
same.
- Thus, trade policies do not affect the trade balance.

Political instability and capital flight

▪ Capital flight: a large and sudden reduction in the demand for assets located in a
country.
▪ Capital flight often occurs because investors feel that the country is unstable, due to
either economic or political problems.
▪ Example: Investors around the world observe political problems in Indonesia and
begin selling Indonesian assets and buying Australian assets.
- Indonesian net foreign investment will rise because investors are selling Indonesian
assets and purchasing assets from another country.
- Since net foreign investment determines the supply of rupiah, the supply of rupiah
increases.
- Since net foreign investment is also a part of the demand for loanable funds, the
demand for loanable funds rises.
- The increased demand for loanable funds causes the equilibrium real interest rate to
rise.
 - The increased supply of rupiah lowers the equilibrium real exchange rate.
- Thus, capital flight from Indonesia increases Indonesian interest rates and lowers the
value of the rupiah in the market for foreign-currency exchange

Topic 9: short-run economic fluctuations

1. basic model of economic fluctuations: AD-AS
▪ Aggregate-demand curve: A curve that shows the quantity of goods and services that
households, firms and the government want to buy at any inflation rate.
▪ Aggregate-supply curve: A curve that shows the quantity of goods and services that
firms choose to produce and sell at any inflation rate.

- On the vertical axis is the inflation rate in the economy.

- On the horizontal axis is the overall quantity of goods and services, real GDP.
- In this model, the inflation rate and the quantity of output adjust to bring aggregate
demand and aggregate supply into balance.
 2. The aggregate-demand curve
Why the aggregate-demand curve is downward-sloping
▪ GDP: Y = C + I + G + NX
▪ Each of the four components is a part of aggregate demand.
- Government purchases are assumed to be fixed by policy.
- This means that to understand why the aggregate-demand curve slopes downward,
we must understand how changes in the rate of inflation affect consumption,
investment and net exports:
+ The inflation rate and investments: interest-rate effect:
A lower inflation rate induces the central bank to reduce the interest rate, which encourages
greater spending on investment goods => increases the quantity of goods and services
demanded.
+ The inflation rate and wealth: Pigou’s wealth effect:
A decrease in the inflation rate makes consumers feel wealthy. In turn, it encourages them to
spend more.
+ The inflation rate and net exports: Mundell-Fleming’s exchange-rate effect:
A lower inflation rate lowers the interest rate in Australia. Australian investors will seek higher
returns by investing abroad, increasing Australian net foreign investment. The increase in net
foreign investment raises the dollar supply, lowering the real exchange rate. Australian
goods become relatively cheaper compared to foreign goods. Exports rise, imports fall and
net exports increase. Therefore, when a fall in the Australian inflation rate causes Australian
interest rates to fall, the real exchange rate depreciates and Australian net exports rise,
thereby increasing the quantity of goods and services demanded.
 All three of these effects imply that, all else being equal, there is an inverse
relationship between the rate of inflation and the quantity of goods and services
demanded.

Why the aggregate-demand curve might shift

Shifts arising from consumption, investment, government purchases.
 3. The aggregate-supply curve
The relationship between the inflation rate and the quantity of goods and services supplied
depends on the time horizon.

Why the aggregate-supply curve is vertical in the long run

• In the long run, an economy’s supply of goods and services depends on its supplies of
resources along with the available production technology.
• Because the inflation rate does not affect the determinants of output in the long run, the
long-run aggregate-supply curve is vertical at the natural rate of output.

Why the long-run aggregate-supply curve might shift

• The position of the aggregate supply curve occurs at an output level sometimes referred to
as potential output or full-employment output.
• This is the level of output that the economy produces when unemployment is at its natural
rate.
• Any change in the economy that alters the natural rate of output shifts the long-run
aggregate supply curve.
• Shifts arising from labour:
– Increases in immigration increase the number of workers available. The long-run
aggregatesupply curve would shift to the right.
– Any change in the natural rate of unemployment will alter long-run aggregate supply as
well.
• Shifts arising from capital:
– An increase in the economy’s capital stock raises productivity and thus shifts long-run
aggregate supply to the right.
– This would also be true if the increase occurred in human capital rather than physical
capital.

Why the aggregate-supply curve is upward-sloping in the short run

Three theories have been proposed for the upward sloping short-run aggregate supply
curve:
• The new classical misperceptions theory:
– Changes in the inflation rate can temporarily mislead suppliers about what is happening in
the markets in which they sell their output.
– As a result of these misperceptions, suppliers respond to changes in the level of prices,
and thus the short-run aggregate-supply curve is upward-sloping.
– Example: The inflation rate falls below the level that people expected. Suppliers may
mistakenly believe that as the prices of their products fall, it is a drop in the relative prices of
their products. Suppliers may then believe that the reward of supplying their product has
fallen and thus they decrease the quantity that they supply. The same misperception may
happen if workers see a decline in their nominal wage (caused by a fall in the rate of
inflation).
– Thus, a lower inflation rate causes misperceptions about relative prices and these
misperceptions lead suppliers to respond to the lower rate of inflation by decreasing the
quantity of goods and services supplied.
• The Keynesian sticky-wage theory:
– Nominal wages are often slow to adjust in the economy due to long-run contracts between
workers and firms.
– Example: Suppose a firm has agreed in advance to pay workers a certain amount and
then the inflation rate falls below the level that was expected. This implies that the firm is
now paying a real wage that is larger than it intended, raising the costs of production. Thus,
the firm hires less labour and produces a smaller quantity of goods and services.
– Therefore, because wages do not adjust immediately to the inflation rate, a lower rate of
inflation makes employment and production less profitable, leading firms to lower the
quantity of goods and services supplied.
• The new Keynesian sticky-price theory:
– The prices of some goods and services are also sometimes slow to respond to changes in
the economy. This is often blamed on menu costs.
– If the inflation rate falls unexpectedly and a firm does not change the price of its product
quickly, its relative price will rise and this will lead to a loss in sales.
– When sales decline, firms will produce a lower quantity of goods and services.
– Because not all prices adjust instantly to changing conditions, an unexpected fall in
inflation rate leaves some firms with higher-than-desired prices, which depress sales and
induce firms to lower the quantity of goods and services supplied.
• Note that each of these theories suggest that output deviates from its natural rate when the
inflation rate deviates from the rate that people expected.
• Note also that the effects of the change in the inflation rate will be temporary. Eventually
people will adjust their expectations of the inflation rate and output will return to its natural
level; thus, the aggregate-supply curve will be vertical in the long-run.

4. Long-run equilibrium
• Long-run equilibrium is found where the aggregate-demand curve intersects with the long-
run aggregate-supply curve.
• Output is at its natural rate.
• Also at this point, perceptions, wages and prices have all adjusted so that the short-run
aggregatesupply curve intersects at this point as well.
The effects of a shift in aggregate demand
• Example: Pessimism following a worldwide downturn in the stock market causes
household spending and investment to decline.
• This will cause the aggregate demand curve to shift to the left.
• In the short run, both output and the inflation rate fall. This drop in output means that the
economy is in a recession.
• It is possible that policymakers may want to eliminate the recession by boosting
government spending or increasing the money supply. Either way, these policies could shift
the aggregate demand curve back to the right.
• However, even if policymakers do nothing, the economy will eventually move back to the
natural rate of output.
– People will correct the misperceptions, sticky wages and sticky prices that cause the
aggregate supply curve to be upward-sloping in the short-run.
– The expected inflation rate will fall, shifting the short-run aggregate-supply curve to the
right.
• In the long run, the decrease in aggregate demand can be seen solely by the drop in the
rate of inflation. Thus, the long-run effect of a change in aggregate demand is a nominal
change (in the inflation rate) but not a real change (output is the same).
The effects of a shift in aggregate supply
• Example: Firms experience a sudden increase in their costs of production.
– This will cause the short-run aggregate-supply curve to shift to the left. (Depending on the
event, long-run aggregate supply may also shift. We will assume that it does not.)
– In the short run, output will fall and the inflation rate will rise. The economy is experiencing
stagflation.

• Stagflation: A period of falling output and rising prices.

– Policymakers will have a more difficult time with this situation. Policymakers can shift the
aggregate-demand curve but cannot simultaneously offset the drop in output and inflation. If
they increase aggregate demand, the recession will end but the inflation rate will be
permanently higher.
– If policymakers do nothing, inflation expectations will adjust, causing the short-run
aggregate supply curve to shift back to the right.

5. How monetary policy influences aggregate demand

6. How fiscal policy influences aggregate demand