mAcroeconomics

4 t h e d i t i o n

r. Glenn

hUBBARdAnne m.

GARnettPhiliP

LeWisAnthony

o’BRien

Copyright © Pearson Australia (a division of Pearson Australia Group Pty Ltd) 2018

Pearson Australia707 Collins StreetMelbourne VIC 3008

www.pearson.com.au

Authorised adaptation from Macroeconomics, 6th edition, ISBN: 0134106229 by Hubbard, R. Glenn and O’Brien, Anthony Patrick, published by Pearson Education, Inc., Copyright © 2017.

First adaptation edition published by Pearson Australia Group Pty Ltd, Copyright © 2018.

The Copyright Act 1968 of Australia allows a maximum of one chapter or 10% of this book, whichever is the greater, to be copied by any educational institution for its educational purposes provided that that educational institution (or the body that administers it) has given a remuneration notice to Copyright Agency Limited (CAL) under the Act. For details of the CAL licence for educational institutions contact:

Copyright Agency Limited, telephone: (02) 9394 7600, email: info@copyright.com.au

All rights reserved. Except under the conditions described in the Copyright Act 1968 of Australia and subsequent amendments, no part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior permission of the copyright owner.

Senior Portfolio Manager: Joanne HobsonDevelopment Editor: Jo HobanProject Manager: Anubhuti HarshProduction Manager: Liz de RomeProduct Manager: Sachin DuaContent Developer: Victoria KerrRights and Permissions Editor: Kim MorganProduction Controller: Bradley SmithLead Editor/Copy Editor: Liz StoneProofreader: Jane TyrrellIndexer: Mary CoeCover and internal design: Natalie BowraCover illustration: Smartwatch © Voin Sveta | Shutterstock.com; Australia icon © Galina Shvets | Shutterstock.com; Nature and Eco iconset © vso | Shutterstock.com Typeset by iEnergizer/Aptara®, Ltd.

Printed in Malaysia

1 2 3 4 5 22 21 20 19 18

National Library of AustraliaCataloguing-in-Publication Data

Creator: Hubbard, R. Glenn, author.Title: Macroeconomics / R. Glenn Hubbard, Anne M. Garnett, Philip Lewis, Anthony Patrick O’Brien.Edition: 4th edition.ISBN: 9781488612527 (paperback)Notes: Includes index.Subjects: Macroeconomics—Textbooks.Economics—Textbooks.Economics.Other Creators/Contributors:Garnett, Anne M., author.Lewis, Philip E. T., author.O’Brien, Anthony P., author.

Every effort has been made to trace and acknowledge copyright. However, should any infringement have occurred, the publishers tender their apologies and invite copyright owners to contact them.

Pearson Australia Group Pty Ltd ABN 40 004 245 943

vi

When George Lucas was asked why he made Star Wars, he replied, ‘It’s the kind of movie I like to see, but no one seemed to be making them. So I decided to make one.’ We realised that no one seemed to be writing the kind of textbook we wanted to use in our courses. So, after years of supplementing texts with fresh, lively, real-world examples from websites, newspapers, magazines and professional journals, we decided to write an economics text that delivers complete economics coverage with many real-world examples.

neW to the FoURth editionThe core ideas of economics remain unchanged: opportunity costs, demand and supply, comparative advantage, marginal analysis, the role of the entrepreneur in markets, aggregate demand and aggregate supply, the importance of long-run economic growth to rising living standards, and the role of economic incentives in the design of policy. What does change is the context in which lecturers and instructors present these ideas in class and the policy debates of the time. In the past few years, to take just a few examples relevant to macroeconomics, we have witnessed renewed policy debate on issues such as government debt, the impact of innovation such as robotics on growth and jobs, the slowing growth rates of developing and newly-industrialised countries, and widespread economic contractions and recessions, and debated the effectiveness of economic policies aimed at minimising the impact of these contractions and recessions. This new edition helps students understand these changing economic realities.

In this fourth edition we retain the focus of presenting economics in the context of real-world businesses and real-world policy debates that have proved effective for teaching and learning. We have made a number of important improvements, which include suggestions from lecturers currently using the text, and from reviewers. The fourth edition includes the following key changes:

• New material on the rapid growth in the use of robotics in the workplace in Chapter 1.

• New material focusing on the issues and problems when using GDP for international comparisons of living standards in Chapter 4.

• Expanded coverage on economic catch-up between poor and rich countries in Chapter 6.

• Updated coverage of economic contractions and recessions that began with the Global Financial Crisis in a number of chapters, including features in Chapters 5, 7, 12, 13 and 15.

• Updated and new discussion and case studies on money and monetary policy in Chapters 11 and 12.

• New material on the Millennium Development Goals and the Sustainable Development Goals in Chapters 6 and 14.

• Updated coverage of government debt crises in Europe in Chapters 11 and 15.

• New material on world currencies, including the management of the Chinese yuan in Chapter 14 and the survival of the euro in Chapter 15.

• More international case studies, including China, Japan, Singapore, countries in Africa, the United States and the United Kingdom.

• Updated and new chapter-opening cases for many chapters.

• A number of new and substantially revised Making the Connection features, with others containing updated data and information, to help students tie economic concepts to current events and policy debates.

• All new An Inside Look news articles and analyses, to enable students to apply economic concepts to current events and policy debates.

• Updated figures and tables, using the latest data available.

• A number of updated and new end-of-chapter questions to reflect updates to content.

PReFAce

vii

contextUAL LeARninG And modeRn oRGAnisAtionWe believe a course is a success if students can apply what they have learned in both personal and business settings and if they have developed the analytical skills to understand what they read in the media. That’s why we explain economic concepts by using many real-world business and economic policy examples and applications, in both Australia and other countries, in the chapter openers, graphs, Making the Connection features, An Inside Look features and end-of-chapter problems. This approach helps students become educated consumers, voters and citizens. In addition, we also have a modern organisation and place interesting policy topics early in the book to pique student interest.

Students come to study macroeconomics with a strong interest in understanding events and developments in the economy. We try to capture that interest and develop students’ economic intuition and understanding in this text. We present macroeconomics in a way that is modern and based in the real world of business and economic policy. And we believe we have achieved this presentation without making the analysis more difficult. We avoid the recent trend of using simplified versions of intermediate models, which are often more detailed and more complex than is necessary to allow students to understand the basic macroeconomic issues. Instead, we use a more realistic version of the familiar aggregate demand–aggregate supply model to analyse short-run fluctuations and monetary and fiscal policy. We also avoid the ‘alternative schools of thought’ approach often used to teach macroeconomics at the principles level, while providing some of this material in selected appendices for those who want to investigate further. We emphasise the many areas of macroeconomics where most economists agree, which gives students a better context for understanding those issues where disagreements have not yet been resolved. And throughout the book we present many diverse real-world business and policy situations to develop students’ intuition.

The following points illustrate our approach:

• A strong set of introductory chapters. Our introductory chapters provide students with a solid foundation in the basics. We emphasise the key issues of scarcity, trade-offs, marginal analysis and economic efficiency. In Chapter 1 we introduce students to the economic way of thinking through the growing use by Australian businesses of offshoring to the Philippines, the rapid rise in the use of robotics in the workplace, the debate on minimum wages and the debate on immigration to Australia. Chapter 2 examines the trade-offs and marginal analysis that managers and economies have to face, presented in the context of Tesla deciding on the mix of vehicles to produce. Chapter 3 introduces demand and supply and how the market works, using the examples of demand for and supply of tablet computers, the rising demand for fitness trackers and the changing nature of demand due to population ageing, to help contextualise the issues and concepts. The macroeconomic chapters continue this approach by relating concepts, principles and models to relevant examples and current economic policy and events.

• Early coverage of long-run topics. We place key macroeconomic issues in their long-run context in Chapter 5, ‘Economic growth, the financial system and business cycles’, and Chapter 6, ‘Long-run economic growth: sources and policies’. Chapter 5 puts the business cycle in the context of underlying long-run growth. In this chapter we discuss what actually happens during the phases of the business cycle. We believe this material is important if students are to have the understanding of business cycles they will need to interpret economic events, yet this material is often discussed only briefly or omitted entirely in other books. We know that many lecturers prefer to have a short-run orientation to their macroeconomic courses, with a strong emphasis on policy. Accordingly, we have structured Chapter 5 so that its discussion of long-run growth would be sufficient for instructors who want to move quickly to short-run analysis. Chapter 6 uses a simple neo-classical growth model to understand important growth issues. We apply the model to topics such as the decline of the Soviet economy, and the importance of the consistent enforcement of property rights to enable continued economic growth in China. And we challenge students with a discussion of ‘Why isn’t the whole world rich?’

• A broad discussion of macro statistics. Many students pay at least some attention to the financial news and know that the release of statistics by government departments can cause movements in share and bond

the FoUndAtion

viii

prices. A background in macroeconomic statistics helps clarify some of the policy issues encountered in later chapters. In Chapter 4, ‘GDP: measuring total production, income and economic growth’, Chapter 7, ‘Unemployment’, and Chapter 8, ‘Inflation’, we provide students with an understanding of the uses and potential shortcomings of the key macroeconomic statistics, without getting bogged down in the finer points of how the statistics are constructed.

• A dynamic model of aggregate demand and aggregate supply. We take a fresh approach to the standard aggregate demand–aggregate supply (AD–AS) model. We realise there is no good, simple alternative to using the AD–AS model when explaining movements in the price level and in real GDP. But we know that more instructors are dissatisfied with the AD–AS model than with any other aspect of the macroeconomics principles course. The key problem, of course, is that the AD–AS model is a static model that attempts to account for dynamic changes in real GDP and the price level. Our approach retains the basics of the AD–AS model, but enables it to be more accurate and useful by making it more dynamic. We emphasise two points: first, changes in the position of the short-run (upward-sloping) aggregate supply curve depend mainly on the state of expectations of the inflation rate; second, the existence of growth in the economy means that the long-run (vertical) aggregate supply curve shifts to the right every year. This ‘dynamic’ AD–AS model provides students with a more accurate understanding of the causes and consequences of fluctuations in real GDP and the price level. We introduce this model in Chapter 10, ‘Aggregate demand and aggregate supply analysis’, and use it in Chapter 12, ‘Monetary policy’ and Chapter 13, ‘Fiscal policy’.

• Extensive coverage of monetary policy. Because of the central role money and monetary policy plays in the economy and in students’ curiosity about business and financial news, we devote two chapters—Chapters 11 and 12—to these topics. We emphasise the way in which monetary policy is carried out in Australia through interest rate targeting (not the outdated approach of targeting the money supply that still appears in some textbooks) and the role of credit in the economy.

• Coverage of both the demand-side and supply-side effects of fiscal policy. Our discussion of fiscal policy in Chapter 13 carefully distinguishes between automatic stabilisers and discretionary fiscal policy. We also have significant coverage of the supply-side effects of fiscal policy.

• A self-contained—but thorough—discussion of the Keynesian 45º line aggregate expenditure model. The Keynesian aggregate expenditure approach (the ‘45º line diagram’ or ‘Keynesian cross’) is a useful way of introducing students to the short-run relationship between spending and production. Many instructors, however, prefer to omit this material. Therefore, we use the income-expenditure approach only in Chapter 9, ‘Aggregate expenditure and output in the short run’. The discussion of monetary policy and fiscal policy in later chapters uses only the dynamic AD–AS model, making it possible to omit the material in Chapter 9.

• Extensive international coverage. We include two chapters devoted to international topics: Chapter 14, ‘Macroeconomics in an open economy’, and Chapter 15, ‘The international financial system’. Having a good understanding of the international trading and financial systems is essential to an understanding of the macroeconomy and to satisfying students’ curiosity about the economic world around them. In addition to the material in our two international chapters, we weave international comparisons into the narrative of several chapters, including our discussions of unemployment, inflation, central banking and government debt.

• Flexible chapter organisation. Because we realise that there are a variety of approaches to teaching principles of macroeconomics, we have structured our chapters for maximum flexibility. For example, our discussion of long-run economic growth in Chapter 5 makes it possible for instructors to omit the more thorough discussion of these issues in Chapter 6. Our discussion of the Keynesian 45° line model is confined to Chapter 9, so that instructors who do not use this approach can proceed directly to aggregate demand–aggregate supply analysis in Chapter 10. While we devote two chapters to money and monetary policy, the first of these—Chapter 11—is a self-contained discussion focusing on the role of money and the creation of money. So instructors may safely omit the material in Chapter 11 if they choose to. Finally, instructors may choose to omit the material in the two international chapters (Chapters 14 and 15) or cover just Chapter 14, ‘Macroeconomics in an open economy’. Please refer to the flexibility chart on page xxv to help you select the chapters and order best suited to your course needs.

t h e f o u n d at ion

ix

sPeciAL FeAtUResA REAL-WORLD, HANDS-ON APPROACH TO LEARNING ECONOMICS

oPeninG cAses And AN INSIDE LOOK neWs ARticLesEach chapter-opening case provides a real-world context for learning, sparks students’ interest in economics, and helps to unify the chapter. The opening case describes real situations facing actual companies and countries. The company or economic issue is integrated into the narrative, graphs and pedagogical features in the chapter. For example, we look at companies such as Tesla, Google, Apple, Bayer, JB Hi-Fi, Wesfarmers, Hills, David Jones and Harvey Norman.

Here are a few examples of chapter opening cases:

• Google’s dilemma in China (Chapter 6).

• Why is the unemployment rate important to Wesfarmers? (Chapter 7).

• How JB Hi-Fi survived the economic cycle (Chapter 10).

• Can Greece function without banks? (Chapter 11).

• Australian universities experience crunch from high dollar (Chapter 14).

LONG-RUN ECONOMIC

GROWTH: SOURCES AND

POLICIES

6

HAS THE RISE OF CHINA AFFECTED YOUR JOB OPPORTUNITIES?

Prior to 1978, the Chinese economy was growing very slowly and its people were very poor. However, China has been experiencing very rapid economic growth over the past two decades. How does it affect you as someone about to start a career? Also, how does the current high-growth, high-export Chinese economy affect you as a consumer? As you read the chapter, see if you can answer these questions. You can check your answers against those we provide on page 170 at the end of this chapter.

E C O N O M I C S I N Y O U R L I F E

6C H A P T E R

Getty Images Australia Pty Ltd

GOOGLE’S DILEMMA IN CHINAGOOGLE WAS FOUNDED in 1998 by Larry Page and Sergey Brin. By 2016, Google had over 60 000 full-time employees and annual revenues exceeding $76 billion. But Google encountered problems when expanding into China in 2006. The Chinese government insisted on regulating how people in that country access the Internet. In setting up Google.cn, Google had to agree

After studying this chapter you should be able to:

6.1 Describe global trends in economic growth.

6.2 Use the economic growth model to explain why economic growth rates differ between

countries.

6.3 Discuss the fluctuations in productivity growth in Australia.

6.4 Explain economic catch-up and discuss why many poor countries have not experienced

rapid economic growth.

L E A R N I N G O B J E C T I V E S

to block searches of sensitive topics, such as the 1989 pro-democracy demonstrations in Tiananmen Square.

In late 2009, hackers stole some of Google’s most important intellectual property by breaking into its computer system. Company executives suspected that Chinese government officials were involved in the theft. In January 2010, Google decided it would no longer cooperate with the Chinese government to censor Internet searchers and moved its Chinese search service from the mainland to Hong Kong. Google’s decision has been a costly one for both Google and for businesses in China. In 2016, there were an estimated 700 million potential Chinese customers for Google. Also, China’s national interests are hurt as doing business has become increasingly globalised with the Internet assuming a huge role in business and therefore in economic growth.

Google’s problems highlight one of the paradoxes of China in recent years: very rapid economic growth occurring in the context of government regulations that can stifle that growth. Throughout the first half of the twentieth century China was wracked by revolution and war. From the time the Communist Party seized control of China in 1949 until the late 1970s, the government controlled production and the country experienced very little economic growth. Mao Tse Tung, the Communist Party leader, died in 1976, and two years later, Deng Xiaoping, the new leader of the Party, began moving China away from a centrally planned economy towards a more market-oriented system. Statistics on the Chinese economy are not considered completely reliable, particularly for the period before 1978. However, the best estimates available indicate that real GDP per capita grew at an average annual rate of 1.8 per cent between 1952 and 1978. Between 1979 and 1995, real GDP per capita grew at a rate of 6.5 per cent per year; it grew at the white-hot rate of more than 9 per cent per year between 1996 and 2010, before slowing to between 7 and 8 per cent in the three years that followed. These rapid growth rates have transformed the Chinese economy: real GDP per capita today is 10 times higher than it was 50 years ago.

But, as the experience of Google has shown, China is not a democracy, and the Chinese government has failed to fully establish the rule of law, particularly with respect to the consistent enforcement of property rights. This is a problem for the long-term prospects of the Chinese economy because, without the rule of law, entrepreneurs cannot fulfil their role in the market system of bringing together the factors of production—labour, capital, natural resources and entrepreneurial ability—to produce goods and services.

SOURCE: Shira Ovide (2016), ‘China has moved on without Google’, Bloomberg Gadfly, 7 June, at <www.bloomberg.com/gadfly>, viewed 18 September 2016; Steven Levy (2011), ‘Inside Google’s China misfortune’, Fortune, 15 April, viewed 20 September 2016; Kathrin Hille (2011), ‘China renews Google’s website license’, The Financial Times, 7 September, at <www.ft.com>, viewed 20 September 2016; Alphabet Investor Relations (2016), News, at <https://abc.xyz/investor/>, viewed 20 September 2016.

M06_HUBB2527_04_SE_C06.indd 144-145 6/8/17 9:18 AM

Here are some examples of the articles featured in An Inside Look:

• ‘Youth unemployment: The Sydney hotspots’, The Sydney Morning Herald (Chapter 7).

• ‘Housing boom lifts Harvey Norman’s profits’, The Sydney Morning Herald (Chapter 10).

• ‘Japan cabinet approves $175b fiscal boost’, News.com.au (Chapter 13).

• ‘Brexit tipped to push $A higher, RBA to cut rate’, The Age (Chapter 14).

AN INSIDE LOOK

SOURCE: Candice Zachariahs (2016), ‘How Australia has come out on top in this currency war’, The Sydney Morning Herald, Fairfax Media, 1 February, at <www.smh.com.au>, viewed 6 December 2016.

How Australia has come out on top in this currency warby Candice Zachariahs

THE SYDNEY MORNING HERALD

The Australian dollar’s plunge to a seven-year low is turning out to be a blessing as China steers its slowing economy away from the heavy industries that helped fuel the country’s mining boom.A It’s more than four years since a record-high Aussie

threatened to destroy manufacturing and hamstring the economy. Instead, the currency’s steepest three-year slide since it was floated in 1983 is working its magic—a weaker local dollar has spurred record tourist arrivals and education income. And it’s tempered the drag from iron ore’s plunge to unprecedented lows while making the nation home to the world’s lowest-cost miners.

Australia stands out in getting the currency boost it needs at a time when economies the world over are grappling with exchange rates considered undesirable. The Aussie is in line with economic fundamentals, after being 25 per cent or more overvalued in 2013. China is struggling to curb yuan declines and Saudi Arabia is burning through reserves to maintain its peg to a strengthening greenback. Policy-makers in Europe and Japan have pushed interest rates below zero, risking accusations of competitive devaluations.

‘The fall in the Australian dollar has helped support the recovery and restructure the economy, so it is a good example of how a floating exchange rate should act,’ said Greg Gibbs, director of Amplifying Global FX Capital in Colorado, who has spent over two decades in the currency markets including stints at the Reserve Bank of Australia and with lenders in Sydney, New York, London and Singapore.B The impact of the Aussie’s decline has been

particularly apparent in the ‘sizeable contribution’ of services exports to growth, the RBA said in November,

acknowledging the labour-intensive sector’s role in helping to push unemployment to a two-year low. The currency has also absorbed much of the impact of a more than 60 per cent slide in prices for iron ore and coal from their 2011 highs. Earnings from goods shipments fell just 14 per cent till November from a peak two years earlier, also aided by rising volumes of Australia’s main resources as the mining boom’s bounty comes on line.

The Aussie is 1.2 per cent overvalued according to the purchase price parity (PPP) measure. It reached about fair value at the end of September from being about 30 per cent overvalued as recently as three years ago.C China has run down reserves, squeezed traders in

Hong Kong with 67 per cent overnight borrowing costs and used state media to warn speculators, including billionaire investor George Soros, to deter bets on rapid yuan depreciation. Saudi Arabia, the world’s largest oil exporter, used 16 per cent of its currency stockpile last year to defend the riyal while Mexico’s shrank to a two-year low in November amid intervention to bolster the peso.

Australia’s transition toward non-mining activity is synchronised with China’s move toward consumer-driven growth, opening up opportunities for the nation’s most populous states, New South Wales and Victoria, which had been at the periphery of the mining boom, Treasurer Scott Morrison said last month.

The Aussie’s drop ‘makes us far more competitive,’ he said. ‘Our economy is broadening, it’s diversifying and this is very important. Our economy in the future, and even now, will be less dependent on one market, one commodity, one part of what we do.’ ■

THE SYDNEY MORNING HERALD 1 FEBRUARY 2016

PA R T 7 T H E IN T E R N AT ION A L EC ONOM Y458

KEY POINTS IN THE ARTICLE

Australia had a highly regulated economy until the government began a series of reforms to the economy in the 1980s that significantly increased the degree of competition in Australia, with the aim of stemming the tide of economic decline in Australia. These reforms included the floating of the Australian dollar and an end to restrictions on the flow of capital into and out of Australia. The article maintains that the floating of the Australian dollar has played an important role in the structural adjustment of the Australian economy, and in particular, in recent years as the mining boom ends and the economy diversifies.

ANALYSING THE NEWS

A The chapter pointed out that under a fixed exchange rate regime, changes could be made to the exchange rate, which would then flow through to economic effects within the economy. But with a floating exchange rate, exchange rate adjustments, and therefore economic adjustments to external trade and investment conditions, occur much more quickly. The floating of the Australian dollar allows the supply of and demand for the dollar in international markets to decide on the appropriate value of the dollar rather than politicians, and has freed monetary policy to focus on domestic economic issues.B Figure 1 shows the depreciation of the Australian

dollar relative to the US dollar that occurred after the December 1983 float, the rise in the currency associated

with the mining boom in the mid-2000s, and the subsequent decline following the end of the boom. As the article states, the floating currency has cushioned the impact of the fall in iron ore prices since 2011, as the depreciation boosted the export of services. Services are generally more labour intensive and hence the increase in the supply of services increased the demand for labour and reduced unemployment.C The article contrasts the ease of adjustment in Australia with its floating currency with other countries that have fixed or pegged rates such as China, Mexico and Saudi Arabia. In China’s case, the attempts to control the value of the yuan renminbi has meant a significant rundown in its foreign exchange reserves and high costs of borrowing. Oil-rich Saudi Arabia fixes its currency against the US dollar and, with falling oil prices, this has meant a large reduction in its currency reserves. As we learned in this chapter, controlling or fixing exchange rates to boost exports comes at a high cost and reduces the ability of the domestic economy to adjust to external changes.

THINKING CRITICALLY

1 Do you think it is better for markets to determine the value of currencies rather than governments or central banks?

2 Why wouldn’t it be possible for the RBA to pursue independent monetary policy if it also needed to maintain a fixed exchange rate?

C H A P T E R 15 T H E IN T E R N AT ION A L F IN A NCI A L S Y S T E M 459

FIGURE 1 The Australian–US exchange rate, 1984–2016

$US

per

one

$A

0.401984 1986 1988 1990 1992 1994 1996 1998 2000 2002 20062004 2008 2010 2012 2014 2016

0.50

0.60

0.70

0.80

0.90

1.00

1.10

1.20

SOURCE: Based on Reserve Bank of Australia (2016), ‘Exchange rates’, Statistics, Table F11, at <www.rba.gov.au>, viewed 6 December 2016.

M15_HUBB2527_04_SE_C15.indd 458-459 6/8/17 11:01 AM

An Inside Look is a two-page feature that shows students how to apply the concepts of a chapter to the analysis of a news article. Articles are from sources such as The Sydney Morning Herald, The Age, The Australian Financial Review, The Conversation, and sometimes overseas news articles. The An Inside Look feature presents analysis of the article, a graph(s) and critical thinking questions.

x

economics in YoUR LiFeAfter the chapter-opening real-world case, we have added a personal dimension to the chapter opener, with a feature titled Economics in Your Life, which asks students to consider how economics affects their own lives. This feature piques the interest of students and emphasises the connection between the material they are learning and their own experiences.

At the end of the chapter, we use the chapter concepts to answer the questions posed at the beginning of the chapter.

6

Has THE risE of cHina affEcTEd yoUr Job oPPorTUniTiEs?

Prior to 1978, the Chinese economy was growing very slowly and its people were very poor. However, China has been experiencing very rapid economic growth over the past two decades. How does it affect you as someone about to start a career? Also, how does the current high-growth, high-export Chinese economy affect you as a consumer? As you read the chapter, see if you can answer these questions. You can check your answers against those we provide on page 170 at the end of this chapter.

E C O N O M I C S I N Y O u R L I F E

Getty Images Australia Pty Ltd

to block searches of sensitive topics, such as the 1989 pro-democracy demonstrations in Tiananmen Square.

In late 2009, hackers stole some of Google’s most important intellectual property by breaking into its computer system. Company executives suspected that Chinese government officials were involved in the theft. In January 2010, Google decided it would no longer cooperate with the Chinese government to censor Internet searchers and moved its Chinese search service from the mainland to Hong Kong. Google’s decision has been a costly one for both Google and for businesses in China. In 2016, there were an estimated 700 million potential Chinese customers for Google. Also, China’s national interests are hurt as doing business has become increasingly globalised with the Internet assuming a huge role in business and therefore in economic growth.

Google’s problems highlight one of the paradoxes of China in recent years: very rapid economic growth occurring in the context of government regulations that can stifle that growth. Throughout the first half of the twentieth century China was wracked by revolution and war. From the time the Communist Party seized control of China in 1949 until the late 1970s, the government controlled production and the country experienced very little economic growth. Mao Tse Tung, the Communist Party leader, died in 1976, and two years later, Deng Xiaoping, the new leader of the Party, began moving China away from a centrally planned economy towards a more market-oriented system. Statistics on the Chinese economy are not considered completely reliable, particularly for the period before 1978. However, the best estimates available indicate that real GDP per capita grew at an average annual rate of 1.8 per cent between 1952 and 1978. Between 1979 and 1995, real GDP per capita grew at a rate of 6.5 per cent per year; it grew at the white-hot rate of more than 9 per cent per year between 1996 and 2010, before slowing to between 7 and 8 per cent in the three years that followed. These rapid growth rates have transformed the Chinese economy: real GDP per capita today is 10 times higher than it was 50 years ago.

But, as the experience of Google has shown, China is not a democracy, and the Chinese government has failed to fully establish the rule of law, particularly with respect to the consistent enforcement of property rights. This is a problem for the long-term prospects of the Chinese economy because, without the rule of law, entrepreneurs cannot fulfil their role in the market system of bringing together the factors of production—labour, capital, natural resources and entrepreneurial ability—to produce goods and services.

SOURCE: Shira Ovide (2016), ‘China has moved on without Google’, Bloomberg Gadfly, 7 June, at <www.bloomberg.com/gadfly>, viewed 18 September 2016; Steven Levy (2011), ‘Inside Google’s China misfortune’, Fortune, 15 April, viewed 20 September 2016; Kathrin Hille (2011), ‘China renews Google’s website license’, The Financial Times, 7 September, at <www.ft.com>, viewed 20 September 2016; Alphabet Investor Relations (2016), News, at <https://abc.xyz/investor/>, viewed 20 September 2016.

M06_HUBB2527_04_SE_C06.indd 145 6/12/17 7:10 PM

The following are examples of the topics we cover in the Economics in Your Life feature:

• Has the rise of China affected your job opportunities? (Chapter 6).

• Should you change your career plans if you graduate during a recession? (Chapter 7).

• What would you do with $500? (Chapter 13).

• The Australian dollar and your new car price (Chapter 14).

PA R T 3 M A C R OEC ONOMI C F O U N D AT ION S A N D EC ONOMI C GR O W T H170

(continued from page 145)

Has THE risE of cHina affEcTEd yoUr Job oPPorTUniTiEs?

At the beginning of the chapter we asked whether your job opportunities in your own country have been affected by the rapid economic growth experienced by China. How does it affect you as someone about to start a career? We also asked how the current high-growth, high-export Chinese economy affects you as a consumer.

It’s impossible to walk into stores in Australia or any developed economy without seeing products imported from China. Some of these products, like clothing and footwear, were once made in Australia. Imports from China replace domestically produced goods when the imports are either less expensive or of higher quality than the domestic goods they replace. As you begin your career, there are some Australian industries that, because of competition from Chinese firms, will have fewer jobs to offer. However, it is important to understand that expanding trade changes the types of products each country makes and therefore the types of jobs available, but it does not reduce the total number of jobs. Also, the rapid economic growth that has enabled Chinese firms to be competitive with firms in developed countries has benefited you as a consumer, because you have lower-priced goods and better goods available for purchase than you would have had if China had remained very poor.

CONCLUSION

For much of human history, most people have had to struggle to survive. Although there have been substantial reductions in extreme poverty over the past 30 years, even today around 12 per cent of the world’s people live in extreme poverty, according to World Bank estimates. The differences in living standards between countries today are the result of many decades of sharply different rates of economic growth. According to the economic growth model, increases in the quantity of capital per hour worked and increases in technology determine how rapidly real GDP per hour worked and a country’s standard of living will increase. The keys to higher living standards seem straightforward enough: establish the rule of law, provide basic education and health care for the population, increase the amount of capital per hour worked, adopt the best technology, and participate in the global economy. However, for many countries these policies have proved very difficult to implement.

Read ‘An inside look’ for a discussion of the role foreign investment is playing in the economic growth in India.

E C O N O M I C S I N YO U R L I F E

M06_HUBB2527_04_SE_C06.indd 170 6/12/17 7:15 PM

mAKinG the connectionIn each chapter, Making the Connection features present relevant, stimulating and provocative cases from various countries, including applications to businesses and other significant world economic events or policy issues. These features link the concepts and models covered in the chapter with a real-world application.

Here are some examples of the Making the Connection features:

• Is income all that matters? (Chapter 6).

• Does technological change create unemployment? (Chapter 10).

• Are bitcoins money? (Chapter 11).

• Greece and Germany: diverse economies, common currency (Chapter 15).

S P eCi a L f e at u R e S

PA R T 3 M A C R OEC ONOMI C F O U N D AT ION S A N D EC ONOMI C GR O W T H154

What explains the economic failure of the Soviet Union?The economic growth model can help explain one of the most striking events of the twentieth century: the economic collapse of the Soviet Union. The Soviet Union was

formed from the old Russian Empire following the communist revolution of 1917. Under communism, the Soviet Union was a centrally planned economy where the government owned nearly every business and made all production and pricing decisions. In 1960, Nikita Khrushchev, the leader of the Soviet Union, addressed the United Nations in New York City. He declared to the  United States and the  other democracies, ‘We will bury you. Your grandchildren will live under communism.’

Many people at the time took Khrushchev’s boast seriously. Capital per hour worked grew rapidly in the Soviet Union from 1950 to the 1980s. At first, these increases in capital per hour worked also produced rapid increases in real GDP per hour worked. Rapid increases in real GDP per hour worked during the 1950s caused some economists in the United States

to predict incorrectly that the Soviet Union would someday surpass the United States economically. In fact, diminishing returns to capital meant that the additional factories the Soviet Union was building resulted in smaller and smaller increases in real GDP per hour worked.

The Soviet Union did experience some technological change, but at a rate much slower than in the United States and other high-income countries. Why did the Soviet Union fail the crucial requirement for growth: implementing new technologies? The key reason is that in a centrally planned economy, the people in charge of running most businesses are government employees and not entrepreneurs or independent business people, as is the case in market economies. Soviet managers had little incentive to adopt new ways of doing things. Their pay depended on producing the quantity of output specified in the government’s economic plan, not on discovering new, better and lower-cost ways to produce goods. In addition, these managers did not have to worry about competition from either domestic or foreign firms.

In contrast, entrepreneurs and managers of firms in market economies such as Australia, Hong Kong and the United States are under intense competitive pressure from other firms. They must constantly search for better ways of producing the goods and services they sell. Developing and using new technologies is an important way to gain a competitive edge and higher profits. The drive for profit provides an incentive for technological change that centrally planned economies are unable to duplicate. In market economies, decisions about which investments to make and which technologies to adopt are made by managers and entrepreneurs with their own money on the line. In the Soviet system, these decisions were usually made by salaried bureaucrats trying to fulfil a plan formulated in Moscow. Nothing concentrates the mind like having your own funds at risk.

In hindsight, it is clear that a centrally planned economy, such as the Soviet Union’s, could not, over the long run, grow faster than a market economy. The Soviet Union collapsed in 1991, and contemporary Russia now has a more market-oriented system, although the government continues to play a much larger role in the economy than governments in many other market economies.

Makingthe

Connection6.3

SOLVED PROBLEM 6.1 Using THE Economic growTH modEL To anaLysE THE faiLUrE of THE soviET Union’s Economy

Use the economic growth model and the information in making the connection 6.3, ‘what explains the economic failure of the soviet Union?’, to analyse the economic problems the soviet Union encountered.

solving the problemsTEP 1 review the chapter material. This problem is about using the economic growth model to explain the failure of the Soviet

economy, so you may want to review Making the connection 6.3, ‘What explains the economic failure of the Soviet Union?’ above.

sTEP 2 draw a graph like figure 6.3 to illustrate the economic problems of the soviet Union. For simplicity we can assume that the Soviet Union experienced no technological change.

Peter Turnley | Corbis

In the former Soviet Union there were frequent shortages and unhappy consumers often had to wait in long lines to shop for groceries and other goods.

M06_HUBB2527_04_SE_C06.indd 154 6/12/17 7:14 PM

xi

soLVed PRoBLems

Many students have great difficulty handling applied economics problems. We help students overcome this hurdle by including worked-out problems tied to select chapter learning objectives and the associated quantitative information. Our goals are to keep students focused on the main ideas of each chapter and to give students a model of how to solve an economic problem by breaking it down step by step. Additional exercises in the end-of-chapter material are tied to every Solved Problem.

don’t Let this hAPPen to YoUWe know from many years of teaching which concepts students find most difficult. Each chapter contains a box feature called Don’t Let This Happen to You which alerts students to the most common pitfalls in that chapter’s material. We follow up with a related question in the end-of-chapter Problems and Applications section.

C h A P T E R 14 M A C R OEC ONOMI C S IN A N OP E N EC ONOM Y 417

case they would have shown up in the current account—they must have been spent on investments in Australia or not spent at all. In the latter case, they would have been added to foreign holdings of dollars. Changes in foreign holdings of dollars are known as official reserve transactions. Foreign investment in Australia or additions to foreign holdings of dollars both show up as positive entries in the Australian financial account.

Therefore, a current account deficit must be exactly offset by a capital and financial account surplus, leaving the balance of payments equal to zero. Similarly, a country that runs a current account surplus, such as China or Japan, must run a capital and financial account deficit of exactly the same size. If a country’s current account surplus is not exactly equal to its capital and financial account deficit, or if a country’s current account deficit is not exactly equal to its capital and financial account surplus, some transactions must not have been accounted for.

Don’t confuse the balance of trade, the current account balance and the balance of payments

The terminology of international economics can be tricky. Remember that the balance of trade on goods and services is the value of net exports, which in Australia is frequently negative as export earnings are often less than expenditure on imports. The current account balance includes the balance of trade in goods and services plus net investment income, which is the sum of net primary income and net secondary income (net transfers). Australia is normally the recipient of huge amounts of foreign investment and therefore net primary income is

usually negative and large, which increases the current account deficit. In 2015/2016, the balance on goods and services was –$36.898 billion and the net primary income balance was –$34.198 billion.

Even though the balance of payments is equal to the sum of the current account balance and the capital and financial account balances—and must equal zero—you may sometimes see references to a balance of payments ‘surplus’ or ‘deficit’. The most likely explanation for these references is that the person making the reference has confused the balance of payments with either the balance of trade on goods and services or the current account balance. This is a very common mistake.

DON’T LET THIS HAPPEN TO YOU

Test your understanding by doing related problem 1.6 on page 437 at the end of this chapter. yOurTURN

SOLVED PROBLEM 14.1 UNDERSTANDING ThE ARIThMETIC OF OPEN ECONOMIES

Test your understanding of the relationship between the current account and the financial account by evaluating the following assertion by a political commentator: ‘The industrial countries are committing economic suicide. Every year they invest more and more in developing countries. Every year more Japanese and US manufacturing firms move their factories to developing countries. with extensive new factories and low wages, developing countries now export far more to the industrial countries than they import.’

Solving the problemSTEP 1 Review the chapter material. This problem is about the relationship between the current account and the financial account, so

you may want to review the section ‘Why is the balance of payments always zero?’, which begins on page 416.

STEP 2 Explain the errors in the commentator’s argument. The argument sounds plausible. It would not be difficult to find almost identical statements to this one in books and articles published during the past few years by well-known political commentators. But the argument contains an important error. The commentator has failed to understand the relationship between the current account and the financial account. The commentator asserts that developing countries are receiving large capital inflows from industrial countries. In other words, developing countries are running financial account surpluses. The commentator also asserts that developing countries are exporting more than they are importing. In other words, they are running current account surpluses. As we have seen in this section, it is impossible to run a current account surplus and a financial account surplus simultaneously. A country that runs a current account surplus must run a financial account deficit, and vice versa.

M14_HUBB2527_04_SE_C14.indd 417 6/7/17 10:23 AM

GRAPhs And sUmmARY tABLesGraphs are an indispensable part of principles of economics courses but are a major stumbling block for many students. Every chapter includes end-of-chapter problems that require students to draw, read and interpret graphs. Interactive graphing exercises can be found on the book’s supporting MyLabTM Economics website. We use four devices to help students read and interpret graphs:

1. Detailed captions

2. Boxed notes

3. Colour-coded curves

4. Summary tables with graphs.

S P eCi a L f e at u R e S

C h A P T E R 14 M A C R OEC ONOMI C S IN A N OP E N EC ONOM Y 425

currently operating below potential GDP, then, holding all other factors constant, a depreciation in the domestic currency should increase net exports, which will increase the rate of growth of aggregate demand and real GDP.

SOLVED PROBLEM 14.2 ThE EFFECT OF ChANGING EXChANGE RATES ON ThE PRICES OF IMPORTS

In June 2004, the average price of goods and services imported into Australia from the United States rose considerably from the average price of goods and services only four months earlier, in February. Furthermore, over the decade from January 2004 to January 2014, the exchange rate between the Australian dollar and the US dollar changed from an average of approximately A$1.00 = US$0.77 to A$1.00 = US$0.88 (with a lot of fluctuations during this time, as we would expect).

1 Is it likely that the value of the Australian dollar appreciated or depreciated relative to the US dollar between February and June 2004?

2 Were the Australian prices of goods and services of imports from the United States cheaper or more expensive in 2014 than in 2004, assuming ceteris paribus?

Solving the problemSTEP 1 Review the chapter material. This problem is about changes in the value of a currency, so you may want to review the section

‘How movements in the exchange rate affect exports and imports’, which begins on page 424.

STEP 2 Explain whether the value of the Australian dollar appreciated or depreciated against the US dollar. We know that if the Australian dollar depreciates against the US dollar, it will take fewer US dollars to purchase one Australian dollar, and, equivalently, more Australian dollars will be required to purchase one US dollar. A US consumer or business will need to pay fewer US dollars to buy products imported from Australia: a good or service that had been selling for US$100 will now sell for less than US$100. An Australian consumer or business will have to pay more Australian dollars to buy products imported from the United States: a good or service that had been selling for A$100 will now sell for more than A$100. We can conclude that if the price of goods imported into Australia from the United States rose, the value of the Australian dollar must have depreciated relative to the US dollar.

STEP 3 Explain whether the Australian prices of goods and services of imports from the United States were cheaper or more expensive in 2014 than in 2004 (ceteris paribus). The change in the exchange rate between the Australian dollar and the US dollar in 2004 and 2014 was substantial. In 2014, one Australian dollar was worth around 15 per cent more US dollars than in 2004. Therefore, goods and services imported into Australia from the United States were cheaper in Australian dollars in 2014 than in 2004, assuming all other factors remained the same.

For more practice, do related problem 2.10 on page 439 at the end of this chapter. yOurTURN

The real exchange rateWe have seen that an important factor in determining the amount of exports and imports between countries is the relative prices of each country’s goods. The relative prices of two countries’ goods are determined by two factors: the relative price levels in the two countries, and the nominal exchange rate between the two countries’ currencies. Economists combine these two factors in the real exchange rate. The real exchange rate is the price of domestic goods and services in terms of foreign goods and services. Recall that the price level is a measure of the average prices of goods and services in an economy. We can calculate the real exchange rate between two currencies as:

Real exchange rate nominal exchange rate domestic price levelforeign price level

Notice that changes in the real exchange rate reflect both changes in the nominal exchange rate and changes in the relative price levels. For example, suppose that the exchange rate

Real exchange rateThe price of domestic goods and services in terms of foreign goods and services.

M14_HUBB2527_04_SE_C14.indd 425 6/7/17 10:24 AM

C h a p t e r 14 M a C r OeC ONOMI C S IN a N Op e N eC ONOM Y 413

SOURCE: based on Australian bureau of Statistics (2016), Balance of Payments and International Investment Position, Australia, Cat. No. 5302.0, Time Series Workbook, Table 30, at <www.abs.gov.au>, viewed 7 November 2016.

TABLE 14.1 Balance of payments, Australia, 2015/2016$ BILLIONS $ BILLIONS

CURRENT ACCOUNTNet exports

exports of goodsImports of goods

Balance of merchandise (goods) tradeexports of servicesImports of services

Net servicesBalance on goods and servicesNet primary income

Income into australia (credits)Income going overseas (debits)

Total net primary incomeNet secondary income

transfers into australia (credits)transfers overseas (debits)

Total net secondary incomeCURRENT ACCOUNT BALANCE

243.934–271.761

67.922–76.993

55.805–90.003

8.630–10.362

–27.827

–9.071–36.898

–34.198

–1.732–72.828

CAPITAL ACCOUNT BALANCEFINANCIAL ACCOUNTNet direct investment

Direct investment abroad (assets)Direct foreign investment in australia (liabilities)

Total net direct investmentNet portfolio investment

portfolio investment abroad (assets)Foreign portfolio investment in australia (liabilities)

Total net portfolio investmentFinancial derivativesOther investmentReserve assetsFINANCIAL ACCOUNT BALANCECAPITAL AND FINANCIAL ACCOUNT BALANCE

4.98150.261

–35.81331.491

–0.531

55.242

–4.322–12.248

35.3692.394

76.43575.904

Net errors and omissions –3.076

and services was more often in deficit than surplus. Of particular note is the huge trade deficit experienced between 2003 and 2008. During this time, a nation-wide drought caused a significant fall in agricultural export earnings, and imports rose by a large amount, as strong economic growth and a booming minerals sector led to increased importation of machinery and equipment. In 2009 and again in 2011, the balance on goods and services moved into surplus due to a recovery of agricultural exports as droughts ended and also due to a large increase in export earnings from minerals and energy. A significant fall in commodity prices, particularly in the minerals and energy sector, was in large part responsible for the move into deficit from 2013 to 2016.

Net primary incomeThe net primary income component on Australia’s current account has been consistently negative, or in deficit. This can be clearly seen in Figure 14.2, which shows the net primary income component of Australia’s current account from 1960 to 2016. Remember that net primary income includes profits, dividends, rental income and interest repayments on loans. Domestic saving in Australia is low, meaning that there is insufficient saving to provide funds available to be borrowed for investment. Therefore, Australian businesses and governments borrow from overseas to finance investment and spending. This means that a large component of net primary income is composed of interest repayments on overseas loans. Australia is also a net recipient of foreign investment. Foreign financial institutions, corporations and

M14_HUBB2527_04_SE_C14.indd 413 6/7/17 10:22 AM

PA R T 7 T h E IN T E R N AT ION A L EC ONOM Y414

individuals buy bonds, securities and shares in Australia, and also own many businesses in Australia. The outflow of profits and dividends usually exceeds the inflow that Australian residents receive from overseas investments, which also contributes to the deficit in net primary income.

Figure 14.2 also shows that the deficit in net primary income began to grow during the second half of the 1980s, with the deficit accelerating in the 2000s. As we will discuss later in this chapter, the value of the Australian dollar fell after the currency was ‘floated’ in 1983, which meant that loans denominated in foreign currencies required more Australian dollars to repay them after this time. From the early 1990s to 2007, the continual period of strong economic growth led to increased levels of domestic borrowing, largely for investment, together with increased foreign investment. This can be seen particularly during the mining boom of the 2000s. During this time, both interest repayments on borrowings and the repatriation of profits and dividends overseas increased. Subsequent to the economic contraction of 2008–2009 resulting from the Global Financial Crisis (GFC), the generally subsequent below-trend economic growth rates saw a decrease in the deficit on net primary income, as the sum of the returns on shares and interest earnings flowing out to overseas investors fell, particularly from 2012 to 2016, which was a time of historically low interest rates on foreign borrowings.

As Table 14.1 shows, for the 2015/2016 financial year, primary income outflows to overseas countries exceeded inflows into Australia by $34.198 billion—which is a significantly lower amount than during the boom years of the 2000s. Later in this chapter we examine whether or not the current account deficit is a problem for Australia.

F I G U R E 1 4 . 1

Balance on goods and services, Australia, 1960–2016

From 1980 to the mid-1990s, the goods trade balance fluctuated between positive and negative, while the balance on total goods and services was more often in deficit than surplus. Of particular note is the huge trade deficit experienced between 2004 and 2008. In 2009 and again in 2011, the balance on goods and services moved into surplus, before again moving into deficit from 2013 onwards.

Bill

ions

of

do

llars

–35

–40

–30

–25

–20

–15

–10

–5

0

5

10

15

20

25

30

Balance on goods and servicesBalance on goods

20102005200019951990198519801975197019651960 2015

SOURCE: based on Australian bureau of Statistics (2016), Balance of Payments and International Investment Position, Australia, Cat. No. 5302.0, Time Series Workbook, Table 30, at <www.abs.gov.au>, viewed 28 November 2016.

M14_HUBB2527_04_SE_C14.indd 414 6/7/17 10:22 AM

xii

ReVieW QUestions And PRoBLems And APPLicAtions—GRoUPed BY LeARninG oBJectiVe to imPRoVe AssessmentAll the end-of-chapter material—Summary, Review Questions and Problems and Applications—is grouped under learning objectives. The goals of this organisation are to make it easier for instructors to assign problems based on learning objectives, both in the book and in MyLab Economics, and to help students efficiently review material that they find difficult. If students have difficulty with a particular learning objective, an instructor can easily identify which end-of-chapter questions and problems support that objective and assign them as homework or discuss them in class. Similar exercises to every exercise in a chapter’s Problems and Applications section are available in MyLab Economics. Using MyLab Economics, students can complete these and many other exercises online, get tutorial help and receive instant feedback and assistance on exercises they answer incorrectly. Also, student learning will be enhanced by having the summary material and problems grouped together by learning objective, which will allow students to focus on the parts of the chapter they found most challenging. Each major section of the chapter, paired with a learning objective, usually has at least two review questions and three problems.

As in the previous editions, we include one or more end-of-chapter problems that test students’ understanding of the content presented in the Solved Problem and Don’t Let This Happen to You special features in the chapter. Instructors can cover a feature in class and assign the corresponding problem for homework.

S P eCi a L f e at u R e S

PA R T 7 T H E IN T E R N AT ION A L EC ONOM Y C H A P T E R 15 T H E IN T E R N AT ION A L F IN A NCI A L S Y S T E M460 461

CHAPTER SUMMARY AND PROBLEMSKey Terms

euro 445fixed exchange rate system 444floating currency 444

ma naged float exchange rate system 444

pegging 452

purchasing power parity 446quota 447tariff 447

summary

A country’s exchange rate can be determined in several ways. A floating currency is the outcome of a country allowing its currency’s exchange rate to be determined by the demand for and supply of its currency. A managed float exchange rate system is when the value of the currency is determined by the demand for and supply of the currency, with occasional central bank or government intervention, which is the system used by most countries. A fixed exchange rate system is a system under which a country keeps its exchange rate fixed to another country’s currency. Under the gold standard, the exchange rate between two currencies was automatically determined by the quantity of gold in each currency. By the end of the Great Depression of the 1930s, every country had abandoned the gold standard. Under the Bretton Woods System, which was in place from 1944 until the early 1970s, the United States agreed to exchange dollars for gold at a price of $35 per ounce. The central banks of all other members of the system pledged to buy and sell their currencies at a fixed rate against the dollar.

review QuesTions

1.1 What is the difference between a fixed exchange rate system and a managed float exchange rate system?

1.2 How were exchange rates determined under the gold standard? How did the Bretton Woods System differ from the gold standard?

L 15.1ExchangE RatE SyStEmSPAGES 444–445

L E A R N i N G O Bj EC T i v E Describe how different exchange rate systems operate.LearningobjecTive

ProbLems and aPPLicaTions

1.3 [Related to Don’t let this happen to you] Briefly explain whether you agree with the following statement: ‘The RBA is limited in its ability to issue paper currency by the amount of gold reserves it holds. To issue more paper currency, the RBA first has to buy more gold.’

1.4 Australia and most other countries abandoned the gold standard during the 1930s. Why would the 1930s have been a particularly difficult time for countries to have remained on the gold standard? (Hint: Think about the macroeconomic events of the 1930s and about the possible problems with carrying out an expansionary monetary policy while remaining on the gold standard.)

1.5 If a country is using the gold standard, what is likely to happen to the country’s money supply if new gold deposits are discovered in the country? Is this change in the money supply desirable? Briefly explain.

1.6 After World War II, why might countries have preferred the Bretton Woods System to re-establishing the gold standard? In your answer, be sure to note the important ways in which the Bretton Woods System differed from the gold standard.

L 15.2cuRREnt ExchangE RatE SyStEmPAGES 445–455

L E A R N i N G O Bj EC T i v E Discuss the three key features of the current exchange rate system.LearningobjecTive

summary

The current exchange rate system has three key features: (1) the Australian dollar floats against other major currencies, (2) most countries in Western Europe have adopted a common currency, and (3) some developing countries have fixed their currencies’ exchange rates against the US dollar or against another major currency or basket of currencies. Since 1983, the

value of the Australian dollar has fluctuated widely against other major currencies. The theory of purchasing power parity states that in the long run exchange rates move to equalise the purchasing power of different currencies. This theory helps to explain some of the long-run movements in the value of the Australian dollar relative to other currencies. Purchasing power parity does not provide a complete explanation of movements in exchange rates for several reasons, including the existence of

tariffs and quotas. A tariff is a tax imposed by a government on imports. A quota is a government-imposed limit on the quantity of a good that can be imported. Currently, 19 European Union member countries use a common currency, known as the euro. The experience of the countries using the euro will provide economists with information on the costs and benefits to countries of using the same currency.

When a country keeps its currency’s exchange rate fixed against another country’s currency, it is pegging its currency. Pegging can result in problems similar to the problems countries encountered with fixed exchange rates under the Bretton Woods System. If investors become convinced that a country pegging its exchange rate will eventually allow the exchange rate to decline to a lower level, the demand curve for the currency will shift to the left. This illustrates the difficulty of maintaining a fixed exchange rate in the face of destabilising speculation.

review QuesTions

2.1 What is the theory of purchasing power parity? Does it give a complete explanation for movements in exchange rates in the long run? Briefly explain.

2.2 Briefly describe the four determinants of exchange rates in the long run.

2.3 Why did many European countries agree to replace their previous currency with the euro?

2.4 What does it mean when one currency is ‘pegged’ against another currency? Why do countries peg their currencies? What problems can result when a country pegs its exchange rate?

ProbLems and aPPLicaTions

2.5 Consider the following: An Australian manufacturing representative said that weak currencies overseas, particularly in Europe and Asia, had dragged down its sales 2 per cent worldwide, ultimately costing it $35 million in net income. What is meant by a ‘weak currency’? Why would weak currencies overseas hurt Australian manufacturers’ sales?

2.6 Following the floating of the Australian dollar in 1983, the trade-weighted index of the Australian dollar fell substantially. Does this indicate that the Australian dollar was overvalued or undervalued? Explain your answer.

2.7 Consider this statement: ‘It usually takes around 100 yen to buy one Australian dollar and more than two Australian dollars to buy one British pound. These values show that Australia must be a much wealthier country than Japan and that the UK must be wealthier than Australia.’ Do you agree with this reasoning? Briefly explain.

2.8 The Australian dollar appreciated significantly against the US dollar and some other currencies between 2010 and early 2012, and remained relatively strong for some years after. Discuss which consumers and industries benefited, and which ones were disadvantaged by the appreciation.

2.9 [Related to the opening case] The German firm Bayer reported that its pharmaceutical group experienced a 6 per cent increase in profit for the third quarter of 2016. However, the firm stated that during 2016, its earnings were ‘held back by negative currency effects’ (Bayer, 2016).1

a Briefly explain what the firm means by ‘negative currency effects’.

b How would negative currency effects decrease Bayer’s profit?

c Would these effects still have reduced Bayer’s profit if all of the firm’s production and all of its sales were within Europe? Briefly explain.

2.10 According to the theory of purchasing power parity, if the inflation rate in Australia is higher than the inflation rate in New Zealand, what should happen to the exchange rate between the Australian dollar and the New Zealand dollar? Briefly explain.

2.11 [Related to Making the connection 15.1] Assume that the Big Mac is selling for $5.04 in the United States. Calculate the implied exchange rate between each of the currencies in the following table relative to the US dollar, and explain whether each currency is overvalued or undervalued in terms of Big Mac purchasing power parity.

counTry big mac Price

imPLied

eXcHange

raTe

acTuaL eXcHange

raTe

Chile Pesos 2300 651.12 pesos per US$

Hong Kong HK$19.20 7.76 HK$ per US$

israel Shekels 16.90 3.86 shekels per US$

Norway Kroner 46.80 8.49 kroner per US$

Russia Rubles 130.00 63.41 rubles per US$

Switzerland Swiss Francs 6.50 0.99 francs per US$

SOURCE: Based on The Economist (2016), ‘The Big Mac index’, 21 july, at <www.economist.com/content/big-mac-index>, viewed 7 December 2016.

2.12 [Related to Making the connection 15.2] Britain decided not to join other European Union countries in using the euro as its currency. Opponents of adopting the euro argued that it is not possible to manage the entire economy of Europe with just one interest rate policy. For instance, how would you alleviate a recession in Germany and curb inflation in Ireland?

a What interest rate policy would be used to alleviate a recession in Germany?

b What interest rate policy would be used to curb inflation in Ireland?

c What does adopting the euro have to do with interest rate policy?

2.13 In January 2016, the exchange rate for the Australian dollar against the euro was A$0.65 per euro. By November 2016, the exchange rate was A$0.70 per euro. Was this change in the euro–Australian dollar exchange rate good news or bad news for Australian firms exporting goods and services to Europe? Briefly explain.

M15_HUBB2527_04_SE_C15.indd 460-461 6/8/17 11:01 AM

xiii

edUcAtoR ResoURces

A suite of resources are provided to assist with delivery of the text, as well as to support teaching and learning. These resources are downloadable from the Pearson website: www.pearson.com.au/9781488612527.

soLUtions mAnUALThe Solutions Manual provides educators with answers to all of the end-of-chapter questions and problems in the textbook.

test BAnKAvailable in Word® format, the Test Bank provides educators with a wealth of accuracy-verified testing material for homework and quizzing. Revised to match the 4th edition, each Test Bank chapter offers a wide variety of multiple-choice and short-answer questions, ordered by key topics.

PoWeRPoint LectURe sLidesA comprehensive set of PowerPoint slides can be used by educators for class presentations or by students for lecture preview or review. They include key figures and tables, as well as a summary of key concepts and examples from the text.

xiv

MyLab Economics for Hubbard/Garnett/Lewis/O’Brien Macroeconomics, 4th edition

A guided tour for students and educators

Auto-generated tests and assignments

each myLabtm comes with preloaded assignments, all of which are automatically graded and include selected end-of-chapter questions and problems from the textbook.

Unlimited practice

many study Plan and instructor-assigned exercises contain algorithms to ensure students get as much practice as they need.

As students work through study Plan or homework exercises, instant feedback and tutorial resources guide them towards understanding.

e d u C atoR R e S o u R C e S

xv

MyLab Economics www.pearsonmylabsandmastering.com

Learning resources

to further reinforce understanding, study Plan and homework problems link to additional learning resources. • Step-by-stepGuided

solutions• GraphingTool• eTextlinkedtosectionsfor

all study Plan questions

study plan

A study Plan is generated from each student’s results on quizzes and tests. students can clearly see which topics they have mastered and, more importantly, which ones they need to work on.

e d u C atoR R e S o u R C e S

xvi

ReVieWeRs

Mark Buchanek, deakin university

Elizabeth Manning, deakin university

Sveta Angelopoulos, RMit

Ishita Chatterjee, university of Western australia

Simone Marsiglio, university of Wollongong

Timothy Kam, australian national university

Muni Perumal, university of Canberra

MyLab Economics www.pearsonmylabsandmastering.com

digital interactives

digital interactives help students to learn core economic concepts in an engaging and experiential way. digital interactives topics are delivered as scenarios that require students to do tasks and answer questions. each digital interactives scenario is broken into a series of graduated levels that become more challenging as the student progresses through the scenario.

e d u C atoR R e S o u R C e S

xviii

DETAILED CONTENTS

About the authors vPreface viThe foundation viiSpecial features ixEducator resources xiiiReviewers xviFlexibility chart xxvCopyright acknowledgement xxvi

part 1 INTRODUCTION 1

ChAPTER 1

Economics: foundations and models 2

THREE KEY ECONOMIC IDEAS 4People are rational 4People respond to economic incentives 5Optimal decisions are made at the margin 5

• Solvedproblem1.1Apple makes a decision at the margin 6

SCARCITY, TRADE-OFFS AND THE ECONOMIC PROBLEM THAT EVERY SOCIETY MUST SOLVE 6

What goods and services will be produced? 6How will the goods and services be produced? 7Who will receive the goods and services produced? 7Centrally planned economies versus market economies 7The modern ‘mixed’ economy 8Efficiency and equity 8

ECONOMIC MODELS 9The role of assumptions in economic models 10Forming and testing hypotheses in economic models 10Normative and positive analysis 11

• Don’tletthishappentoyouDon’t confuse positive analysis with normative analysis 11

Economics as a social science 12

• Makingtheconnection1.1Good economics doesn’t always mean good politics 12

MICROECONOMICS AND MACROECONOMICS 13

CONCLUSION 13

• AninsidelookRobotics will hit finance jobs harder than offshoring 14

CHAPTER SUMMARY AND PROBLEMS 16

CHAPTER 1 APPENDIx 20

Using graphs and formulas 20

Graphs of one variable 21Graphs of two variables 21Formulas 27APPENDIX QUESTIONS AND PROBLEMS 30

ChAPTER 2

Choices and trade-offs in the market 32

PRODUCTION POSSIBILITY FRONTIERS AND REAL-WORLD TRADE-OFFS 34

Graphing the production possibility frontier 34Increasing marginal opportunity costs 35

• Makingtheconnection2.1Trade-offs and emergency aid relief 36

Economic growth 37

COMPARATIVE ADVANTAGE AND TRADE 38Specialisation and gains from trade 38Absolute advantage versus comparative

advantage 39

• Don’tletthishappentoyouDon’t confuse absolute advantage with comparative advantage 40

Comparative advantage and the gains from trade 40

• Solvedproblem2.1Comparative advantage and the gains from trade 41

THE MARKET SYSTEM 42The gains from free markets 42The market mechanism 43

• Makingtheconnection2.2Story of the market system in action: I, pencil 43

The role of the entrepreneur 44

THE LEGAL BASIS OF A SUCCESSFUL MARKET SYSTEM 45

Protection of private property 45

• Makingtheconnection2.3Illegal downloads from cyberspace 46

Enforcement of contracts and property rights 46

CONCLUSION 47

• AninsidelookExpansion and production mix at BMW 48

CHAPTER SUMMARY AND PROBLEMS 50

part 2 HOW THE MARKET WORKS 55

ChAPTER 3

Where prices come from: the interaction of demand and supply 56

THE DEMAND SIDE OF THE MARKET 58Demand schedules and demand curves 58The law of demand 58

xix

holding everything else constant: the ceteris paribus condition 59

What explains the law of demand? 59Variables that shift market demand 60

• Makingtheconnection3.1The ageing of the Baby Boom generation 63

a change in demand versus a change in quantity demanded 63

THE SUPPLY SIDE OF THE MARKET 64Supply schedules and supply curves 64the law of supply 64Variables that shift supply 65a change in supply versus a change in

quantity supplied 67

MARKET EQUILIBRIUM: PUTTING DEMAND AND SUPPLY TOGETHER 68

how markets eliminate surpluses and shortages 68demand and supply both count 69Shifts in a curve versus movements along a curve 70

THE EFFECT OF DEMAND AND SUPPLY SHIFTS ON EQUILIBRIUM 70

• Don’tletthishappentoyouRemember: a change in a good’s price does not cause the demand or supply curve to shift 70

the effect of shifts in supply on equilibrium 71the effect of shifts in demand on equilibrium 71the effect of shifts in demand and supply

over time 72

• Solvedproblem3.1Demand and supply both count: pharmacists and accountants 72

• Makingtheconnection3.2The rise and rise of fitness trackers 74

• Solvedproblem3.2Demand and supply both count: the Australian housing market 75

CONCLUSION 77

• AninsidelookPC shipments fall record 10.6% in 4Q: IDC 78

ChaPteR SuMMaRY and PRoBLeMS 80

PArt 3 MACROECONOMIC FOUNDATIONS

AND ECONOMIC GROWTH 87

chAPteR 4

GdP: measuring total production, income and economic growth 88

GROSS DOMESTIC PRODUCT MEASURES TOTAL PRODUCTION 90

Measuring total production: gross domestic product 91Measuring GdP using the value-added method 91other measures of total production and total income 92

• Solvedproblem4.1Calculating GDP 92

METHODS OF MEASURING GROSS DOMESTIC PRODUCT 93

Production, expenditure and income and the circular-flow diagram 93

Components of GdP 95

• Don’tletthishappentoyouRemember what economists mean by investment 96

an equation for GdP and some actual values 96

DOES GDP MEASURE WHAT WE WANT IT TO MEASURE? 97

Shortcomings in GdP as a measure of total production 97

• Makingtheconnection4.1Why do many developing countries have such large underground economies? 98

Shortcomings of GdP as a measure of wellbeing 99

• Makingtheconnection4.2How else can we measure economic wellbeing? 100

REAL GDP VERSUS NOMINAL GDP 101Calculating real GdP 101

CALCULATING THE ECONOMIC GROWTH RATE 102

• Makingtheconnection4.3How did the standard of living in Nigeria almost double overnight? 102

the GdP deflator 103

CONCLUSION 104

• AninsidelookThe four factors that drag Australia down 105

ChaPteR SuMMaRY and PRoBLeMS 107

chAPteR 5

economic growth, the financial system and business cycles 112

LONG-RUN ECONOMIC GROWTH IS THE KEY TO RISING LIVING STANDARDS 114

• Makingtheconnection5.1The connection between economic prosperity and health 116

Calculating growth rates and the rule of 70 117What determines the rate of long-run economic

growth? 117

• Solvedproblem5.1Where does long-run growth come from? 119

• Makingtheconnection5.2Can India sustain its rapid growth? 119

Potential GdP 120

SAVING, INVESTMENT AND THE FINANCIAL SYSTEM 121an overview of the financial system 121the macroeconomics of saving and investment 123the market for loanable funds 124

de ta iL e d C on t e n t S

xx

• Makingtheconnection5.3Ebenezer Scrooge: accidental promoter of economic growth? 126

• Solvedproblem5.2Are future budget deficits a threat to the economy? 128

THE BUSINESS CYCLE 129Some basic business cycle definitions 129What happens during the business cycle 130

• Don’tletthishappentoyouDon’t confuse short-run fluctuations with long-run trends 133

• Makingtheconnection5.4Why did the Global Financial Crisis occur? 135

Why are business cycle fluctuations less severe? 136

CONCLUSION 137

• AninsidelookAre vehicle sales warning of a US slowdown? 138

ChaPteR SuMMaRY and PRoBLeMS 140

chAPteR 6

long-run economic growth: sources and policies 144

ECONOMIC GROWTH OVER TIME AND AROUND THE WORLD 146

economic growth over time 146Small differences in growth rates are important 147

• Makingtheconnection6.1Why did the Industrial Revolution begin in Britain? 148

• Don’tletthishappentoyouDon’t confuse average annual percentage change with total percentage change 148

Why do growth rates matter? 149‘the rich get richer and . . .’ 149

• Makingtheconnection6.2Is income all that matters? 149

WHAT DETERMINES HOW FAST ECONOMIES GROW? 151the per-worker production function 151Which is more important for economic growth: more

capital or technological change? 152technological change: the key to sustaining

economic growth 153

• Makingtheconnection6.3What explains the economic failure of the Soviet Union? 154

• Solvedproblem6.1Using the economic growth model to analyse the failure of the Soviet Union’s economy 154

new growth theory 155Joseph Schumpeter and creative destruction 157

ECONOMIC GROWTH IN AUSTRALIA 157economic growth and labour productivity in

australia since 1940 158What caused the productivity slowdown of the

1970s and 1980s? 159Can australia maintain high rates of productivity

growth? 160

WHY ISN’T THE WHOLE WORLD RICH? 160Catch-up: sometimes but not always 161

• Solvedproblem6.2The economic growth model’s prediction of catch-up 163

Why don’t more low-income countries experience rapid growth? 164

• Makingtheconnection6.4What explains rapid economic growth in Botswana? 165

the benefits of globalisation 168is economic growth good or bad? 168

CONCLUSION 170

• AninsidelookThe FDI big bang 171

ChaPteR SuMMaRY and PRoBLeMS 173

PArt 4 UNEMPLOYMENT AND INFLATION 179

chAPteR 7unemployment 180

MEASURING THE UNEMPLOYMENT RATE AND THE LABOUR FORCE PARTICIPATION RATE 182

the labour force survey 182Problems with measuring the unemployment rate 184

• Solvedproblem7.1What would happen if the ABS labour force survey included the military? 184

trends in labour force participation 185how long are people usually unemployed? 186Job creation and job destruction 187

• Makingtheconnection7.1What explains the increase in welfare recipients? 188

• Solvedproblem7.2Correctly interpreting labour force data 189

THE COSTS OF UNEMPLOYMENT 190Costs to the economy 191Costs to the individual 191the distribution of unemployment 191

TYPES OF UNEMPLOYMENT 192Cyclical unemployment 193frictional unemployment and job search 194Structural unemployment 194full employment 195

• Makingtheconnection7.2How should we categorise unemployment in Australia? 195

de ta iL e d C on t e n t S

xxi

• Don’tletthishappentoyouDon’t confuse full employment with a zero unemployment rate 196

ExPLAINING FRICTIONAL AND STRUCTURAL UNEMPLOYMENT 196

Government policies and the unemployment rate 196Social security and other payments to the unemployed 196

LABOUR MARKET REGULATION AND DEREGULATION 197

Minimum wages 198trade unions 199efficiency wages 199

• Makingtheconnection7.3Why did Henry Ford pay his workers twice as much as other car manufacturers? 199

CONCLUSION 200

• AninsidelookYouth unemployment: the Sydney hotspots 201

ChaPteR SuMMaRY and PRoBLeMS 203

chAPteR 8

inflation 208

MEASURING INFLATION 210the consumer price index 211is the CPi accurate? 212

• Don’tletthishappentoyouDon’t confuse the price level with the inflation rate 213

the producer price index 213

USING PRICE INDExES TO ADjUST FOR THE EFFECTS OF INFLATION 214

• Solvedproblem8.1What has been happening with real wages in Australia? 214

NOMINAL INTEREST RATES VERSUS REAL INTEREST RATES 215

• Makingtheconnection8.1Why a lower inflation rate is like a tax cut for Wesfarmers’ bond holders 217

DOES INFLATION IMPOSE COSTS ON THE ECONOMY? 218inflation affects the distribution of income 218the problem with anticipated inflation 218the problem with unanticipated inflation 219hyperinflation 219deflation 220

• Makingtheconnection8.2What’s so bad about falling prices? 220

WHAT CAUSES INFLATION? 221

CONCLUSION 222

• AninsidelookAll eyes on inflation next week, but not everything is as it seems… 223

ChaPteR SuMMaRY and PRoBLeMS 225

PArt 5 SHORT-RUN FLUCTUATIONS 229

chAPteR 9

Aggregate expenditure and output in the short run 230

THE AGGREGATE ExPENDITURE MODEL 232aggregate expenditure 232the difference between planned investment and

actual investment 233Macroeconomic equilibrium 233adjustments to macroeconomic equilibrium 233

DETERMINING THE LEVEL OF AGGREGATE ExPENDITURE IN THE ECONOMY 234

Consumption 235the relationship between consumption

and national income 238income, consumption and saving 240

• Solvedproblem9.1Calculating the marginal propensity to consume and the marginal propensity to save 241

Planned investment 242Government purchases 243net exports 244

• Makingtheconnection9.1The iPhone is made in China . . . or is it? 246

GRAPHING MACROECONOMIC EQUILIBRIUM 246Showing a contraction or recession on the 45°

line diagram 250the important role of inventories 251

• Makingtheconnection9.2Business attempts to control inventories, then . . . and now 251

a numerical example of macroeconomic equilibrium 252

• Don’tletthishappentoyouDon’t confuse aggregate expenditure with consumption spending 252

• Solvedproblem9.2Determining macroeconomic equilibrium 253

THE MULTIPLIER EFFECT 253a simple formula for the multiplier 256

• Makingtheconnection9.3The multiplier in reverse: the Great Depression of the 1930s 257

Summarising the multiplier effect 257

• Solvedproblem9.3Using the multiplier formula 258

the paradox of thrift? 259

THE AGGREGATE DEMAND CURVE 260

CONCLUSION 262

• AninsidelookNo recession but Singapore may see some quarters of negative growth: MTI 263

ChaPteR SuMMaRY and PRoBLeMS 265

de ta iL e d C on t e n t S

xxii

CHAPTER 9 APPENDIx 270

the algebra of macroeconomic equilibrium 270

aPPendiX PRoBLeMS 271

chAPteR 10

Aggregate demand and aggregate supply analysis 272

AGGREGATE DEMAND 274Why is the aggregate demand curve

downward sloping? 274Shifts of the aggregate demand curve versus

movements along it 276the variables that shift the aggregate demand curve 276

• Don’tletthishappentoyouBe clear why the aggregate demand curve is downward sloping 276

• Makingtheconnection10.1Should Germany reduce its reliance on exports? 279

• Solvedproblem10.1Movements along the aggregate demand curve versus shifts of the aggregate demand curve 280

AGGREGATE SUPPLY 281the long-run aggregate supply curve 281Shifts in the long-run aggregate supply curve 281the short-run aggregate supply curve 282Shifts of the short-run aggregate supply curve

versus movements along it 283Variables that shift the short-run aggregate

supply curve 283Variables that shift the short-run and long-run

aggregate supply curves 284

MACROECONOMIC EQUILIBRIUM IN THE LONG RUN AND THE SHORT RUN 285

Recessions, expansions and supply shocks 286

A DYNAMIC AGGREGATE DEMAND AND AGGREGATE SUPPLY MODEL 289

What is the usual cause of inflation? 290

• Makingtheconnection10.2Does technological change create unemployment? 292

• Solvedproblem10.2Showing the oil shock of 1974 on a dynamic aggregate demand and aggregate supply graph 293

CONCLUSION 294

• AninsidelookHousing boom lifts Harvey Norman’s profit 295

ChaPteR SuMMaRY and PRoBLeMS 297

CHAPTER 10 APPENDIx 302

macroeconomic schools of thought 302

the monetarist model 302the new classical model 302

the real business cycle model 303the austrian model 303

• Makingtheconnection10A.1Karl Marx: capitalism’s severest critic 304

PArt 6 MONETARY AND FISCAL POLICY 305

chAPteR 11

money, banks and the reserve bank of Australia 306

WHAT IS MONEY AND WHY DO WE NEED IT? 308Barter and the invention of money 308

• Makingtheconnection11.1Money in a World War II prisoner-of-war camp 309

the functions of money 309What can serve as money? 310

• Makingtheconnection11.2Coca-Cola dries up as the Zimbabwe currency no longer serves as money 311

HOW DO WE MEASURE MONEY TODAY? 312M1: the narrowest definition of the

money supply 312Broader definitions of money 312

• Don’tletthishappentoyouDon’t confuse money with income or wealth 314

• Makingtheconnection11.3Are bitcoins money? 314

HOW DO FINANCIAL INSTITUTIONS CREATE MONEY? 315

Bank balance sheets 315using t-accounts to show how a bank can

create money 316the simple deposit multiplier 318

• Solvedproblem11.1Showing how banks create money 319

the simple deposit multiplier versus the real-world deposit multiplier 321

THE RESERVE BANK OF AUSTRALIA 321how the RBa manages financial liquidity and

interest rates 322exchange rate management 324

THE QUANTITY THEORY OF MONEY 324Connecting money and prices: the equation

of exchange 324the quantity theory explanation of inflation 325high rates of inflation 326

• Makingtheconnection11.4The German hyperinflation of the early 1920s 326

CONCLUSION 327

• AninsidelookInnovation in electronic payments to accelerate demise of cheques 328

ChaPteR SuMMaRY and PRoBLeMS 330

de ta iL e d C on t e n t S

xxiii

chAPteR 12

monetary policy 336

WHAT IS MONETARY POLICY? 338the goals of monetary policy 338

THE DEMAND FOR AND SUPPLY OF MONEY 340the demand for money 340Shifts in the money demand curve 340how the RBa manages the supply of cash 341equilibrium in the money market 343a tale of two interest rates 344

MONETARY POLICY AND ECONOMIC ACTIVITY 345

how interest rates affect aggregate demand 345the effects of monetary policy on real GdP and

the price level 346Can the RBa eliminate contractions and

recessions? 347using monetary policy to fight inflation 348

• Makingtheconnection12.1Central banks, quantitative easing and negative interest rates 349

• Solvedproblem12.1The effects of monetary policy 352

is monetary policy always effective and fair? 353

• Makingtheconnection12.2Why does the share market care about monetary policy? 354

• Don’tletthishappentoyouRemember that with monetary policy, it’s the interest rate—not the money—that counts 354

SHOULD THE RESERVE BANK OF AUSTRALIA TARGET INFLATION? 355

• Makingtheconnection12.3How does the RBA measure inflation? 356

IS THE INDEPENDENCE OF THE RESERVE BANK OF AUSTRALIA A GOOD IDEA? 357

the case for RBa independence 357the case against RBa independence 357

CONCLUSION 358

• AninsidelookRBA independence on interest rates: a tick for a resilient economy 359

ChaPteR SuMMaRY and PRoBLeMS 361

chAPteR 13

Fiscal policy 366

WHAT IS FISCAL POLICY? 368What fiscal policy is and what it isn’t 368automatic stabilisers versus discretionary

fiscal policy 368an overview of government spending and taxes 368

USING FISCAL POLICY TO INFLUENCE AGGREGATE DEMAND 371

expansionary fiscal policy 371Contractionary fiscal policy 372

• Don’tletthishappentoyouDon’t confuse fiscal policy and monetary policy 373

GOVERNMENT PURCHASES AND TAx MULTIPLIERS 373the effect of changes in tax rates 376taking into account the effects of aggregate supply 376the multipliers work in both directions 377

• Solvedproblem13.1Fiscal policy multipliers 377

THE LIMITS TO USING FISCAL POLICY TO STABILISE THE ECONOMY 378

• Makingtheconnection13.1Why was the United States’ recession of 2007–2009 so severe? 379

does government spending reduce private spending? 380Crowding out in the short run 380Crowding out in the long run 381

DEFICITS, SURPLUSES AND FEDERAL GOVERNMENT DEBT 381

how the federal budget can serve as an automatic stabiliser 382

Should the federal budget always be balanced? 384

• Solvedproblem13.2The effect of economic fluctuations on the budget deficit 385

is government debt a problem? 385

• Makingtheconnection13.2Government bankruptcy in Europe 386

THE EFFECTS OF FISCAL POLICY IN THE LONG RUN 387

the long-run effects of tax policy 388tax simplification 388the economic effect of tax reform 389how large are supply-side effects? 390

CONCLUSION 390

• AninsidelookJapan cabinet approves $175b fiscal boost 391

ChaPteR SuMMaRY and PRoBLeMS 393

CHAPTER 13 APPENDIx 1 398

is there a short-run trade-off between unemployment and inflation? 398

the Phillips curve 398explaining the Phillips curve with aggregate demand

and aggregate supply curves 399is the Phillips curve a policy menu? 400is the short-run Phillips curve stable? 400the long-run Phillips curve 400the role of expectations of future inflation 401do workers understand inflation? 402

aPPendiX QueStionS and PRoBLeMS 403

de ta iL e d C on t e n t S

xxiv

CHAPTER 13 APPENDIx 2 404

A closer look at the multiplier 404

an expression for equilibrium real GdP 404a formula for the government purchases multiplier 405a formula for the tax multiplier 405the ‘balanced budget’ multiplier 406the effects of changes in tax rates on the multiplier 406the multiplier in an open economy 407

PRoBLeMS 408

PArt 7 THE INTERNATIONAL ECONOMY 409

chAPteR 14

macroeconomics in an open economy 410

THE BALANCE OF PAYMENTS: LINKING AUSTRALIA TO THE INTERNATIONAL ECONOMY 412

the current account 412the capital account 415the financial account 415Why is the balance of payments always zero? 416

• Don’tletthishappentoyouDon’t confuse the balance of trade, the current account balance and the balance of payments 417

• Solvedproblem14.1Understanding the arithmetic of open economies 417

THE FOREIGN ExCHANGE MARKET AND ExCHANGE RATES 418

equilibrium in the market for foreign exchange 419

• Makingtheconnection14.1Exchange rates listings 420

• Don’tletthishappentoyouDon’t confuse what happens when a currency appreciates with what happens when it depreciates 420

how do shifts in demand and supply affect the exchange rate? 421

Some exchange rates are not determined by the market 422

• Makingtheconnection14.2The Chinese yuan: the world’s most controversial currency 423

how movements in the exchange rate affect exports and imports 424

• Solvedproblem14.2The effect of changing exchange rates on the prices of imports 425

the real exchange rate 425

THE INTERNATIONAL SECTOR AND NATIONAL SAVING AND INVESTMENT 426

Current account balance equals net foreign investment 427

domestic saving, domestic investment and net foreign investment 428

THE EFFECT OF A GOVERNMENT BUDGET DEFICIT ON INVESTMENT 429

is australia’s current account deficit a problem? 430

• Makingtheconnection14.3International debt relief for poor countries 432

MONETARY POLICY AND FISCAL POLICY IN AN OPEN ECONOMY 433

Monetary policy in an open economy 433fiscal policy in an open economy 433

CONCLUSION 434

• AninsidelookBrexit tipped to push $A higher, RBA to cut rate 435

ChaPteR SuMMaRY and PRoBLeMS 437

chAPteR 15

the international financial system 442

ExCHANGE RATE SYSTEMS 444

• Don’tletthishappentoyouRemember that modern currencies are fiat money 445

THE CURRENT ExCHANGE RATE SYSTEM 445the floating dollar 445What determines exchange rates in the long run? 446

• Makingtheconnection15.1The Big Mac theory of exchange rates 447

the four determinants of exchange rates in the long run 448the euro 449

• Makingtheconnection15.2Greece and Germany: diverse economies, common currency 450

Pegging against the uS dollar 451

• Solvedproblem15.1Coping with fluctuations in the value of the Australian dollar 455

INTERNATIONAL CAPITAL MARKETS 456

CONCLUSION 457

• AninsidelookHow Australia has come out on top in this currency war 458

ChaPteR SuMMaRY and PRoBLeMS 460

CHAPTER 15 APPENDIx 464

the gold standard and the bretton woods system 464

the gold standard 464the Bretton Woods System 464

aPPendiX QueStionS and PRoBLeMS 468

Glossary 470index 475

de ta iL e d C on t e n t S