View the step-by-step solution to:

Using a money market diagram and a diagram of aggregate demand and aggregate supply, explain how the Reserve Bank of Australia (RBA) can eliminate an...

Using a money market diagram and a diagram of aggregate demand and aggregate supply,  explain how the Reserve Bank of Australia (RBA) can eliminate an inflationary gap. Be sure to include in your answer a  discussion of what happens to the money supply, interest rates, and the components of aggregate    demand.

Top Answer

Aggregate... View the full answer

2 comments
  • In this topic we explore the concept of the business cycle. A business cycle occurs due to the fluctuations that an economy experiences over time resulting from changes in economic growth. Understanding business cycles is the essence of a course in macroeconomics. Economists try to discern where the economy is located and more importantly where it is heading in order to deal with possibly adverse future economic events. When the economy is at or is heading in an undesirable direction, economists may apply fiscal or monetary policy tools to change the course of the economy. In general, a business cycle describes changes in the demand-side of the economy as measured by GDP, where: GDP = C + I + G + NX Over time, GDP does not remain constant and will change for many reasons, economic and non-economic. Economic reasons include changes in government policies such as taxes and interest rates. The non-economic reasons are too many to even consider listing, but include factors such as war, drought, natural and man-made disasters. Using Figure 7-1 as a guide, the horizontal axis measures time, while the vertical axis yields the real GDP growth rate. As the graph shows, we begin with an increasing growth rate of real GDP during an economic expansion. Eventually, growth approaches and then reaches a peak. Why are peaks reached, or why doesn't economic growth continue to increase indefinitely? The answer is prolonged periods of economic growth (or short periods of very intensive economic growth) are eventually accompanied by rising inflation rates (or the threat of higher inflation). The higher prices (inflation) bring forth counter cyclical policies used to dampen inflationary pressures. Business Cycle Overview Percentage of time that the US Economy is in a recession Average length of the recession Before - 1945 40% 21 months After - 1945 17% 11 months Since 1980 10% The defining part of the business cycle is a recession. Without a recession, the economy doesn't really experience a business cycle, just a period of a prolonged economic expansion. Between 1992 and 2000, the U.S. economy did not see a recession and set the record for the longest period of economic expansion without a recession. There were changes in real GDP growth during this time period, GDP even decreased in the first quarter of 2003, but no recession. The table above shows how the business cycle evolved in the 20th century. Prior to 1945, periods of recession were almost as common as days when the economy was growing. As we will discuss in Unit 9, until the Great Depression of the 1930s, economic policy makers generally did little to counteract the forces that drove the business cycle, choosing instead to allow the economy to take its own course. The result was long (typically almost 2 years) and frequent recessions that we usually much more severe than modern-day recessions. Modern economic thought is characterized by the use of both fiscal and monetary policies to counteract and smooth out the business cycle. As the table shows, economists have had success in using these policies to make the dealings of U.S. firms, as well as the life of Americans who work and save in financial markets less turbulent. To better understand the use of fiscal and monetary policies, take another look at the GDP equation: GDP = C + I + G + NX GDP is the sum of consumption + investment + government spending + net exports (exports - imports). This equation can be written in further detail as: GDP = C(Y - T) + I(r) + G + NX Y is equal to income and T represents taxes. (Y - T) gives us disposable income and thus consumption depends on the level of disposable income C(Y - T). r represents the interest rate and investment responds to changes in the interest rate. As r increases, I will decrease. As r decreases, I will increase. Fiscal Policy is represented by the executive and legislative branches of government and captures changes in taxes (T) and government spending (G). In the United States, the president and Congress make these decisions. As we can see from the equation, a decrease in T will increase disposable income (Y - T), increasing C and therefore increasing the growth rate of GDP. Government spending (G) directly affects GDP growth. If the economy is in a recession, a combination of tax cuts and increases in government spending can stimulate economic activity. For example, the U.S. economy saw its first recession in a decade in 2001. Taxes were reduced in 2001, 2002 and 2003 in combination with a 13% jump in government spending over those years. In part, due to the tremendous fiscal stimulus, by late 2003, real GDP growth was in the 7% (at an annual rate) range. Monetary Policy is conducted by the central bank of a country - in the United States this is the Federal Reserve Board. Details will be present later in the class, but the Federal Reserve can increase and decrease interest rates to change business investment (I) in the equation above. Changes in interest rates will also influence consumption, but our focus in this class will be the effect on investment. For example, in the year 2000, the federal funds interest rate was 6.5% and by the summer of 2003, the interest rate had fallen to 1%. Since the majority of interest rates key off the federal funds rate, interest rates fell across the board along with the federal funds interest rate. A critical contributor to the rapid economic growth seen as 2003 wrapped up was due to the economic stimulus provided by the Federal Reserve. Observers have concluded that economics is a somewhat imprecise field, especially when it comes to dealing with business cycles. Economic indicators such as GDP and the inflation rate are trailing indicators. They tell us a good deal about the economy, but importantly they tell us where the economy is at or has been, but not where it is going. For example, the latest quarterly GDP number informs us of economic growth in the past quarter. However, the statistic is not a reliable indicator of economic growth in the current or following calendar quarter. Although there is often a correlation between future GDP growth and past GDP growth, the relationship is easily disrupted and conditions can change rapidly. Economists need to be able to identify changes in the growth trend and to spot these variations by using leading indicators such as changes in business inventories. Knowing current economic conditions is useful information for economists, but knowing where it is going is critical. As noted, economists use leading indicators to try to accurately predict future changes in GDP and the inflation rate. Interpreting the signals given by the leading indicators on what direction the economy is taking is often weakly understood by economists, sometimes the indicators give conflicting signals and the conclusions made are often controversial. The goal of this topic is to discover how economic policy makers interpret and react to business cycles. The two most important macroeconomic variables are the real growth rate of GDP and inflation (the unemployment rate is also crucial, but is closely tied to GDP growth). The goals of economic policymakers are simple: To maintain real GDP growth at a relatively constant, positive level. For example, economists may desire 3.0% annual growth in GDP (1). Compatible with the growth in real GDP, keep the unemployment rate at a level consistent with the full-employment level of unemployment. Remember, full-employment is not zero unemployment, but a level where all those in the labor force seeking work, can find a job fairly quickly. Minimize the level of inflation and keep it there. Optimally, the economy will have a sustained low inflation rate, 3% or below for example. Taking the perspective of the Federal Reserve, ranking the above goals in order of importance yields: Most important - minimize the inflation rate. The Federal Reserve will force economic growth to slow down or even fall into a recession if it sees inflation as too high. Evidence is given by the 1982 recession when the Federal Reserve raised interest rates until the economy tumbled and inflation was taken down. Economists recognize that once high rates of inflation are established, they are very difficult to reduce and should be avoided in the first place. Once the inflation rate is tamed, the Federal Reserve will try to lower the unemployment rate to a level consistent with full employment - currently about 4% in the United States. And once the economy is at full employment, the Federal Reserve will attempt to maintain real GDP growth at a rate equal to the economy's supply side growth rate. (1) Once the unemployment rate is minimized, the Federal Reserve targets a the non-inflationary growth rate of real GDP. This rate is based on supply-side factors of the growth in the labor supply and worker productivity. For example, if the U.S. labor force increases by about 1.0% annually and the yearly increase in worker productivity or output per worker at private nonfarm businesses is estimated to average about 2% each year then the target growth rate equals 3%. It is critical to note that monetary and fiscal policies have no effect on the supply-side growth rate. The policies are used to change demand-side (GDP) growth. No problem we say. It goes without saying that accomplishing these three simple goals simultaneously is equivalent to having a job as the circus lion tamer. The hungry lions in this case are leaping inflation, plunging GDP, snapping politicians and a roaring public. The economic policymaker/lion tamer must not lose his vigilance or these lions may take a large bite out of his rump. Before we go into the details of the business cycle, here is a summary of some important points to remember. The policymakers desire to smooth out the business cycle by minimizing the magnitude of variations in economic growth over the course of the business cycle. It is crucial to understand where the economy is going in the future. If the path is not desired, then changes in economic policy can be made today to prevent that path from being realized. For example, assume that real GDP is growing at a desired 3% annual rate. If the Federal Reserve determines that GDP growth will soon slow down to a significantly lower growth rate, it can reduce interest rates today to stimulate future economic growth and try to maintain real GDP growth at 3% in the future. Leading economic indicators are the crystal ball for economic policymakers, and are used to predict the economy's future. Unlike your neighborhood fortune-teller, the economic crystal ball is usually cloudy. As a result, errors in judgment and public policy are possible. Economic policy errors include: GDP growth is too rapid and inflation rates increase to uncomfortable levels, GDP growth slows down too much, leading to an increase in the unemployment rate and possibly a recession. In an attempt to reduce inflationary pressures, economic policymakers will attempt to slow economic growth. The reduction in the growth rate of real GDP corresponds to an economic downturn, where GDP growth has fallen from its peak level. Are economic policymakers stupid? Historically, economic downturns are eventually followed by a recession when real GDP growth actually becomes negative. Recessions are often synonymous with rising rates of unemployment. Rising unemployment rates certainly get the attention of economic policy makers who furiously enact expansionary policies (the durations of recessions tend to be much shorter than positive growth periods). The closest that economic policymakers come to nirvana is during the expansionary phase. The worst is over, economic growth is increasing (often very quickly), jobs are being created, and inflation remains muted. Everyone deserves their day in the sun, but after a brief interlude of happiness, rising inflation causes a storm of tears for even the most optimistic economists. Leading Economic Indicators As noted earlier, economic policymakers try to predict where the economy is heading in the near future based on leading economic indicators. The Fed follows many economic indicators which can give signs regarding changes in future economic growth and inflation. For example, as these economic indicators reach the danger zone, there is increasing likelihood that the economy is overheating and increasing the danger of rising inflation in the near future. Important leading economic variables that the Fed closely monitors include: 1) The unemployment rate: in relation to full-employment. On average, labor comprises roughly 2/3 of total production costs for businesses. When the unemployment rate reaches and then falls below full-employment, labor shortages build. As producers trying to expand production find new workers becoming increasingly scarce, they are forced to add costly overtime and offer higher wages to entice non-labor force members to work. The result is upward wage pressures. Wage increases translate into higher production costs, higher prices for goods and services and an increase in the inflation rate. Another important indicator related to employment is new jobless claims. Released every Thursday, new jobless claims give the number of people who are making an initial claim for unemployment benefits. If the number of new jobless claims is rising over time, the indication is that firms are increasingly laying off workers who then are filing for unemployment. A persistent increase in claims indicates that demand for goods and services is falling and unemployment rates will be rising. On the other hand, if new jobless claims remain constant or are falling, then labor markets are in good shape. Currently, economists consider 400,000 new weekly jobless claims to be the dividing line between a labor market to is adding jobs (on a net basis) and one that is experiencing net job losses. Even in the best of times, workers lose jobs and a number of 300,000, for example, signifies that the economy and labor market are doing very well. The lower the number of new jobless claims, the better for the labor market and people seeking employment. 2) The Labor Cost Index: measures what the title indicates – the cost in terms of wages, salaries and benefits paid by firms to their employees. This is a very important indicator since even in the high technology US economy, labor still comprises about 2/3 of the total production costs to a firm. If the index is rising at a fairly rapid pace, and consumer demand is strong, firms are likely to pass on their higher production costs to the consumer by raising prices. In contrast, if the index remains steady, then strong consumer demand may not lead to higher prices and inflation. 3) The utilization of productive capacity: capacity utilization refers to the amount of physical capital available to firms that is in use. At any time, firms have a given stock of capital equipment such as machinery, office space, factories, computers and telecommunications infrastructure available to assist workers in the production of goods and services. In the short run, a firm's, industry's or economy's capital stock is considered fixed, as it often takes awhile to invest in additional capital equipment, especially when new office or factory space is required to increase output to meet growing demand. The Fed regularly surveys different producers to estimate how much of the capital stock in place is actually being used. As various producers within an industry reach full-capacity (100% use of the capital available) due to high demand for their product, firms are likely to begin charging customers higher prices to satisfy additional demand. This is the result of higher production costs resulting from additional shifts, overtime and other costs relating to increased use of the available capital. For the economy as a whole, the Fed becomes cautious as the capacity utilization rate approaches 84%. The Fed considers this to be the threshold at which inflationary pressures will build in some parts of the manufacturing sector. Although 84% is well below 100%, at this point the Fed judges that some important industries will be approaching 100% capacity utilization. Industries that are likely to reach full capacity before the economy as a whole include manufacturers of basic commodities such as steel, aluminum and paperboard used in shipping final goods. As an example, consider the auto industry. When demand for autos is growing due to robust economic growth, auto manufacturers increase their output and the use of their capacity. Excess capital equipment and factory space, which had previously been idled, is put into production. Steel is an important input in automobile production and as auto manufacturers increase their output they order more steel used in production. At first, steel producers may also have some spare capacity (also known as slack) or unused capital equipment. However, as orders from the auto producers continue to grow, soon all available capital used in steel production is put into use. Adding extra capital would take several years, so the only way steel firms can boost production to meet additional demands is to add overtime and extra shifts - using the capital more intensively. In most cases, workers are paid higher wages for working overtime or extra shifts, and these higher production costs are passed on to the auto manufacturers. As auto producers pay higher prices for their steel inputs, they pass on the higher cost to the consumer by raising the prices of their final goods. 4) Commodity prices: as noted above, higher raw material and commodity prices (e.g., steel, copper, aluminum, paperboard) are often passed on to the final product. 5) Changes in business inventories: rapid growth in demand for goods and services will deplete business inventories. As businesses increase production to meet additional demand and to rebuild inventories to desired levels, inflationary pressures may build. Of course, falling inventories can also be a sign of weak consumer demand. The trend has to be placed in the context of overall economic conditions. 6) Worker productivity gains: worker productivity refers to output per worker, or how much of a good or service a worker produces during a given time period (e.g. per hour or day). As workers gain job experience, knowledge and skills, they become better at their jobs and their productivity improves. Increases in worker productivity helps to dampen inflationary pressures by decreasing production costs. Rates of change in worker productivity vary only slightly from year-to-year and significant changes are due to long-run economic dynamics. Presently, U.S. worker productivity improves by about 2.0% annually. The above leading indicators: the unemployment rate, capacity utilization, commodity prices, changes in business inventories and gains in worker productivity all help to give economists a picture of where the economy is going. Consider the U.S. economy in the beginning of 1994. The unemployment rate had fallen into a range consistent with what the Federal Reserve considers to be full employment (a shade below 6%). Capacity utilization had run up past 84%, commodity prices were beginning to show upward spikes and business inventories continued to fall. Combined with other economic indicators followed by the Fed, these conditions signaled an increase in the inflation rate in the near future. Consequently, by raising interest rates, the Fed took action to slow economic growth before inflation rates actually increased. Bottlenecks and Inflation The correlation of wages and inflation is fairly evident: higher wages paid to workers (an input in production) are often passed on to consumers in the form of higher prices for final goods and services. In 1994 this item was of little concern to the Fed, as wage gains remained very low. In fact, the U.S. Department of Labor reported that inflation-adjusted (real) wages fell 2.7% from March 1994 through March 1995. However, by late 1994, the unemployment rate had fallen to a level considered by the Fed to be consistent with full employment. In contrast to the calm wage picture, uncertainty in labor markets, combined with events taking place in the area of productive capacity during 1993, gave the Fed serious alarm. In the area of capacity utilization, we need to consider two key points: The growth in productive capacity: which refers to the number and skills of workers, the size and quality of the capital stock, and changes in technology. Changes in the degree to which the capacity is used. Growth rates in productive capacity tend to remain fairly constant over long intervals and respond positively to increases in the labor force and additions to the capital used in production. The current growth rate of productive capacity is about 3% annually for the U.S. economy. Another way of expressing growth in a nation's productive capacity is as an expansion of the production possibilities frontier. An economy's capability to produce goods and services grows over time at relatively constant annual rates as the population and capital stock increase and technology improves. A contrast to the steady, long-run growth in productive capacity is the fluctuation in the use of the productive capacity (capacity utilization) that occurs during the course of a business cycle. Consider the relation of a typical business cycle to changes in capacity utilization. We can identify three stages: Recession: Workers are laid off and the unemployment rate climbs. Factories and machinery are idled and capacity utilization falls significantly. A good deal of slack is created as capacity utilization falls. Noninflationary growth: As the economy emerges from a recession, unemployed resources (workers, factories, machinery, and other capital goods) are put back to work. Economic growth is characterized by a falling unemployment rate and the absorption of excess capacity. Growth is robust, and the combination of excess capacity and the steady growth in productive capacity keep a lid on price pressures. The situation is one where there is a large gap between actual output and potential output. If output is well below its potential (maximum), there is plenty of excess capacity (or slack) in the economy and producers can easily expand output with the existing productive capacity available. Since there is a surplus of unemployed labor, wage demands remain muted and the utilization of mothballed equipment is cheaper than buying new capital. Importantly, higher supplies easily satisfy the increased demand for goods and services.. In a typical business cycle, the period of noninflationary growth correlates to a time of significant job growth in the economy. For the U.S. economy, we can expect over 200,000 new jobs to be created each month on a net basis. For example, during the long economic expansion during the Clinton administration (eight years without a recession, there were almost 22 million new jobs added to the economy with average job growth of 225,000 per month. Inflationary pressures: As the economy continues growing, the excess capacity present begins to shrink. Finally, the economy begins to reach potential output or full capacity. The resulting bottlenecks most often occur in critical areas such as raw materials and commodities (e.g., steel, copper, aluminum). Figure 7-2 shows the case where the steel industry has reached full capacity. Capacity limits are shown by a nearly vertical portion of the supply curve, indicating that increases in demand bring forth little additional output. All firms can do to increase output is to add overtime, since all capital used in production is utilized. The main impact is an increase in prices when supply bottlenecks are present and demand increases. Consequentially, the growth in demand outraces the long-term growth in supply, forcing up steel prices. For critical commodities like steel, that is an intermediate good used in many final consumer goods (such as automobiles, washing machines, household gutters). Higher prices are often passed along. As automobile manufacturers pay higher prices for their steel inputs, they will raise the price to the consumer to recoup the added cost. Returning to the recent business cycle in the United States, the recession of the early 1990s created a good deal of excess capacity. As economic growth resumed in 1992, accelerating through 1993 and into 1994, the excess capacity was rapidly absorbed and the economy approached potential output. The warning number the Fed uses is roughly an 84% capacity utilization rate, and this was reached in early 1994. Although an economy with a 84% capacity utilization rate is well below 100%, this number is for the general economy. Specific industries may be reaching a capacity of 100% (such as steel and aluminum). Those industries reaching full capacity will soon experience bottlenecks, creating increased inflationary pressures on the overall economy. Thus, in 1994 the Fed attempted to slow U.S. economic growth by raising interest rates. In the next section we will investigate the topic of business cycles using the tools of aggregate demand and aggregate supply. Macroeconomic Equilibrium We have studied the demand and supply curves for individual markets. Now we take all the markets in a domestic economy and combine them into an aggregate. The aggregate demand curve accounts for the purchases of all consumers, businesses, the government, and foreign trade in an entire domestic economy. The aggregate supply curve looks at the total production in an economy. Studying the concepts of aggregate demand and supply is fundamental to understanding macroeconomics. We will begin by looking at each in isolation and then combine the two. As you will see, the topic is very similar to the analysis of demand and supply for a specific good. Aggregate Demand and Supply Figure 7-3 illustrates the aggregate demand curve for an economy. Note the labels on the axes. The horizontal axis measures total economic output or GDP. The vertical axis uses the overall price level for the economy as a measure of prices. The aggregate demand curve shows the relationship between the price level and output. As the curve shows, there is an inverse relationship between prices and output. Figure 7-4 illustrates the aggregate supply curve for an economy that has the same measures as aggregate demand on the horizontal and vertical axis. The aggregate supply curve shows the total output by producers of all goods and services in our economy. Note that the aggregate supply curve has a relatively flat region that rapidly becomes vertical. The flat section of aggregate supply is characterized by an economy with a good deal of excess capacity or slack. The vertical section of the aggregate supply curve indicates that our economy has reached full capacity, or potential output. Potential output is noted on the graph as Yf, or full-employment. Full employment is consistent with an unemployment rate where all those who desire to work can find employment. Individuals who are unemployed, are considered voluntarily unemployed. Potential output is not a static concept but changes over time as our economic capability to produce goods and services expands. This concept is analogous to an outward shift in the production possibilities frontier (PPF). As you may recall, the PPF shifts outward with growth in the labor supply, improvements in technology, and the addition of new productive resources such as capital. Figure 7-5 shows the rightward shift in aggregate supply as potential output increases along with the economy's productive capacity. We see that the vertical portion of the aggregate supply that corresponds to potential output has expanded. The expansion of aggregate supply is consistent with growth in the labor force and the creation of new jobs. As a result, the level of output consistent with full-employment moves from Yf 0 to Yf 1. Changes in productive capacity move gradually as the factors that influence it tend to move in long-term cycles. For example, changes in the labor supply are predominantly reflected in birth rates, which take generations to show any substantial change. The research and development that allow for technological change also take years to mature and be effectively implemented. Technological advancement tends to be self-reinforcing, leading to moderate increases and decreases in the pace of change over time.
    • smaina885
    • May 08, 2016 at 8:27pm
  • are you sure all this is your work?????
    • Dr_expert
    • May 08, 2016 at 8:33pm

Sign up to view the full answer

Other Answers

the reserve bank would employ contraction monetary policies reducing... View the full answer

Why Join Course Hero?

Course Hero has all the homework and study help you need to succeed! We’ve got course-specific notes, study guides, and practice tests along with expert tutors.

-

Educational Resources
  • -

    Study Documents

    Find the best study resources around, tagged to your specific courses. Share your own to gain free Course Hero access.

    Browse Documents
  • -

    Question & Answers

    Get one-on-one homework help from our expert tutors—available online 24/7. Ask your own questions or browse existing Q&A threads. Satisfaction guaranteed!

    Ask a Question
Ask a homework question - tutors are online