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1 topics by class/month Poor Satisfactory Good Excellent Aggregate demand James, B. 100% Tests 12 Steven, A. 96% Tests 15 Jones, T. 80% Tests 8 Clarke, K. 50% Tests 5 Download site guide Price level (PL) The AD/AS model AS AS2 Homework Do 5 tests on Aggregate demand Aggregate supply Exchange rates. PL2/PL1 AD2 AD Y1 Y2 Real output GDP (Y)

2 PUBLISHED by Rennie Resources Ltd 54 Knightsbridge Drive Forrest Hill Auckland 0620 New Zealand Telephone Fax This book is copyright. Except for the purposes of fair reviewing, no part of this publication may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, recording or any information storage and retrieval system, without permission in writing from the publishers. Infringers of copyright render themselves liable to prosecution. ISBN (Student s book) First published 2001 New editions 2005, 2007 Revised editions 2009, D Rennie Printed in New Zealand by Ligare, Auckland Design and production: BookNZ ( Cover artwork: Jane Meder Acknowledgments Thank you to the following who assisted in various ways and made this publication possible: My immediate family Sue, Nicole, Jacob and Brooke Lesley Hooper and Jason Attewell of Statistics New Zealand for their assistance on BOP and Alison McConnell for GDP. Notes to the Student (i) Do all the activities set by your teacher, making sure you mark these accurately and correct any errors. (ii) Ask questions and ask for assistance with topics or questions that you have difficulty with, it is the way to improve your understanding of topics or questions you are unsure of. (iii) The solutions to all activities are in the Teachers Guide. (iv) All the best.

3 Contents Introduction/Learning Activities 4 Basic concepts Demand 5 Supply 8 The market 11 Core Consumers and producers 14 Household incomes (Y) 16 Inflation 18 Consumption spending (C) 20 Investment spending (I) 22 Government spending (G) 24 Net exports (X M) 26 The changing level of economic activity 28 Establishing the New Zealand dollar 30 The New Zealand dollar and economic activity 32 Interest rates 34 Aggregate demand (AD) 36 Aggregate supply (AS) 40 Aggregate demand and/or aggregate supply 44 Economic growth (Real output GDP) 50 The current account 52 Inflation A comparison of values 54 The business cycle and inflation 60 The quantity theory of money MV PQ 72 The causes of inflation 84 The impact of inflation 100 Trade The changing nature of trade 112 Exchange rates and the Trade Weighted Index 124 The balance of payments 136 The two country model 150 The one country model 164 The flow-on effects of trade 184 Economic growth Measures of economic growth 196 Production possibility frontier 208 The circular flow model 224 The causes of economic growth 238 The impacts of economic growth 252 Cue/flash cards

4 Introduction Understanding Economic Issues NCEA Level 2 has been written for students who are studying Economics at Level Two (Year 12). It is a self-supporting workbook course which provides a multitude of activities, sometimes repeated, to develop students ability to interpret and present economic data and arguments in a clear, concise and coherent manner. Economics is an academic subject and students need to have the economic language and ideas as set out in the prescription rather than rely on common knowledge or skills used in other subjects. Understanding Economic Issues NCEA Level 2 should be used in conjunction with textbooks, classroom tasks and assignments, and classroom notes rather than be used in isolation. It can be used either as a source of homework or revision but it is primarily designed for providing teaching activities for the whole year s course. I hope that this workbook will save teachers time in writing, preparing and photocopying activities while providing students with hours of successful work and study. Dan Rennie, Rosmini College Learning Activities Use some or all of the suggestions listed below to assist student engagement and outcomes by providing them with the opportunity to participate and ultimately drive their own learning experiences. Tick ( ) the activities that you select. Learning Activities Student notes. Read text at the start of each chapter (or from another source) and in the space provided take relevant (responsible) notes on the concepts outlined in the Achievement Standard. Questions and tasks. Complete the activities and questions set in each chapter. Mark your work accurately and correct any errors. Group review questions. Use the review questions from the supplementary pages to discuss the concepts covered. The group should come to a consensus about the answer to each question posed. Flash (cue) cards. Use the subject matter in each chapter to make flash (cue) cards. These cards require students to write a question on each side and the answer overleaf. The flash (cue) cards can cover vocabulary, formulas or any other subject matter. Use the cards made to test yourself and/or classmates. Study the cards that you don t know well i.e., the ones that you are unsure of or make a mistake on. Mind-map. Intuitively arrange important concepts in a diagram around the central theme of each chapter. The mind-map will act as an aid in study and the organisation of content required for each Achievement Standard. Visit the TKI website. Review previous exam papers and model answers. Teacher questions. Write down a number of questions and ideas or content that you have had difficulty with and ask your teacher for assistance. Videos, field trips, on-line learning activities. Making up an activity. Create your own worksheet, crossword, PowerPoint presentation of the content covered in each chapter. Key Competency (curriculum link) Managing self. Persisting, managing impulsivity and taking relevant (responsible) notes. Participating and contributing. Applying past knowledge and persisting. Using language, symbols and texts. Striving for accuracy, applying past knowledge to new situations, thinking and communicating with clarity and precision. Relating to others. Listening with understanding and empathy. Thinking. Thinking flexibly; remaining open to continuous learning and shared problem solving. Participating and contributing. Content and contexts. Managing self. Taking responsible notes. Using language, symbols and texts. Gathering data, striving for accuracy and applying past knowledge. Managing self and thinking. Thinking about thinking (metacognition) and managing own learning. Managing self. Thinking about thinking (metacognition) and managing own learning. Using language, symbols and texts. Gathering data through all senses and finding humour. Participating and contributing. Questioning and problem posing, make connections, capacity to contribute. Tick ( ) 4 Subscribe to elearneconomics at: ISBN (Student s book)

5 Basic concepts: Demand Individual (or Consumer) Demand Consumer (or individual) demand is the amount of a good or service that one consumer is willing and able to buy at given prices. A demand differs from a want, because demand must be backed by an ability to pay. An individual s demand can be illustrated in a demand schedule, which is a table of figures that relates price to quantity demanded. The information in the schedule can be used to draw a demand curve (graph), as shown below. Gavin s demand schedule for sausage rolls each week Price $ Quantity demanded Price $ 4 P' 3 2 Gavin s demand curve for sausage rolls each week d P 1 d Quantity demanded Q' Q A movement along a demand curve is caused by a change in the price of the product only. A price increase will lead to a decrease in quantity demanded. This change can be illustrated on a demand curve as shown above, with P showing the original price and P' the new (increased) price. The original price (P) relates to a specific original quantity demanded which is labelled Q, with Q representing the new quantity demanded (which has decreased) from the new price (P ). The arrows on the diagram show the direction of the change. Market Demand Market demand is the sum of everyone s individual demand at each price or the horizontal sum of all individual curves at each price. When determining market demand add up the quantity demanded from the individual demand curve, demand schedules or the information given. Price $ per kg Consumer A Consumer B Market demand Quantity demanded (kgs) Quantity demanded (kgs) Consumer A + Consumer B (kgs) ISBN (Student s book) Subscribe to elearneconomics at: 5

6 A Shift of the Demand Curve A change in price of a product will cause a change in quantity demanded. A change in price causes a movement along the demand curve. With a shift of the demand curve there is a change in demand and the whole curve shifts to a new position, this change represents that at each and every price there is a new quantity demanded. When the curve shifts to the right this is an increase in demand, while a shift to the left is a decrease in demand. A demand curve will shift if there is a change in conditions (or determinants) of demand, other than the price, such as consumer incomes, taste, advertising, the price of a substitute or the price of a complement. An increase in demand (a shift to the right) as shown opposite could be caused by: an increase in disposable incomes; a decrease in direct tax; increased advertising for a product; an increase in the price of a substitute; a decrease in the price of a complement; or whether the product is in fashion. P A decrease in demand (a shift to the left) as shown opposite could be d' d caused by: a decrease in disposable incomes; an increase in direct tax; decreased advertising for a product; a decrease in the price of a substitute; d' d an increase in the price of a complement; or whether the product is not in fashion. Demand Q 1 Jacob discussed his demand for pies, at $1.50 he will buy 10 pies each week. When the price is $3.00 he will only buy two pies each week. When the price is $1.00 Jacob will buy eighteen pies each week. P d d' d d' Q (a) Draw Jacob s demand curve for pies in the grid below. Label the graph fully. Price $ Jacob s demand curve for pies each week (b) P 3 d d' 2 P' 1 d d' (c) Q Q' (b) (c) On the graph above, show the effect on Jacob s demand for pies of a change in price from $3.00 to $1.00. Label the changes fully. Show an increase in demand. Label the changes fully. 6 Subscribe to elearneconomics at: ISBN (Student s book)

7 2 (a) Explain the difference between a substitute and a complement. Use examples. A substitute is a good that can be used in place of another, e.g., tea and coffee. A complement is a good used in conjunction with another, e.g., bread and butter, cars and petrol. (b) List two causes (other than changing the price of substitutes for DVDs) that could shift the demand curve for DVDs to the right, i.e., increase the demand for DVDs. For each cause, give the reason to explain why the demand curve will shift to the right. Cause 1: Increase in income/decrease in income tax (direct). Reason: Can afford more/can buy more DVDs at each price. Cause 2: Change in taste/fashion towards DVDs. Reason: Idea that watching DVDs becomes more popular because they are better quality or have more features than videos so demand increases. (c) Explain why an increase in price does not result in a decrease in demand. An increase in price results in a decrease in quantity demanded. (d) Complete the graphs below to show the situations indicated by the title. Label the changes fully. Graph one A decrease in quantity demanded Graph two A decrease in demand P d P d' d P' P d d' d Q' Q Q Q Graph three An increase in quantity demanded P d Graph four An increase in the price of a substitute P d d' P P' d d d' ISBN (Student s book) Graph five Q Q' Q Q Subscribe to elearneconomics Graph six at: 7

8 Basic concepts: Supply Individual Supply Individual supply is the amount of a good or service that one firm is willing and able to supply at given prices. An individual firm s supply can be illustrated in a supply schedule, which is a table of figures that relates price to quantity supplied, as shown in the table below. The information in the schedule can be used to draw a supply curve (graph). Bob s bakery supply schedule for sausage rolls each day Price $ Quantity supplied Price $ 1.60 P P Bob s bakery supply curve for sausage rolls each day s 0.40 s Quantity supplied Q2 Q1 A movement along a supply curve is caused by a change in the price of the product only. A price decrease will lead to a decrease in quantity supplied. This change can be illustrated on a supply curve as shown above, with P1 showing the original price and P2 the new (decreased) price. The original price (P1) relates to a specific original quantity supplied which is labelled Q1, with Q2 representing the new quantity supplied (which has decreased) from the new price (P2). The arrows on the diagram show the direction of the change. The supply curve illustrates the law of supply a decrease in price will lead to an increase in quantity supplied, ceteris paribus (everything else held constant) or, other things being equal, an increase in price will lead to a rise in quantity supplied. Firms will supply less as price falls because there is insufficient profit, they cannot cover costs or they decide to use resources in another way. Market Supply Market supply is the sum of all firms individual supply at each price or the horizontal sum of all individual supply curves at each price. When determining market supply add up the quantity supplied from the individual supply curve, supply schedules or information given. Price $ per kg Firm A Firm B Market supply Quantity supplied (kgs) Quantity supplied (kgs) Firm A + Firm B (kgs) Subscribe to elearneconomics at: ISBN (Student s book)

9 A Shift of the Supply Curve With a shift of the supply curve, there is a change in supply and the whole curve shifts to a new position. When the curve shifts to the right this is an increase in supply, while a shift to the left is a decrease in supply. A supply curve will shift if there is a change in conditions (or determinants) of supply, other than the price, such as changes in costs of production, technology and the level of workers productivity, indirect tax changes, subsidies or the price of a related good. An increase in supply (a shift to the right) as shown opposite could be caused by: costs of production decrease; new technology and workers productivity increases; indirect tax decreases e.g. GST, sales tax; a subsidy is given to the firm by government; a tax on imports (a tariff) is lifted; or the price of a related good decreases. Supply 1 Jane discusses her supply for secondhand books each month. She will supply 25 books at $2 and 100 books at $4. When the price is $14 she would supply 225 books and at $8 she would supply 175 books. P s s' s s' Q (a) Graph the information in the extract. Price $ Jane s supply curve for secondhand books each month s s Quantity supplied (b) Explain why the supply curve slopes up to the right. As the price of the good increases, the quantity supplied by the firm will increase. This enables the producer to increase their profits/revenue. As price increases firms are more able to cover costs as revenue earned will be higher. ISBN (Student s book) Subscribe to elearneconomics at: 9

10 Price $ per kg Supply schedule for Product X North Island Quantity supplied (kgs) South Island Quantity supplied (kgs) Market supply for product X in New Zealand Price $ per kg Quantity supplied (kgs) (a) Prepare a market supply schedule for product X in New Zealand in the table provided above. Price $ 120 per kg Market supply curve for product X in New Zealand s s' 40 s 20 s' Quantity supplied kg (b) (c) Draw a fully labelled market supply curve for product X in New Zealand from the information provided. Give two specific reasons, for the supply curve for product X to shift to the left (decrease in supply). (i) An increase in the costs of production for X. An increase in the indirect tax e.g. sales tax, GST. (ii) An increase in the price of a related good for X/subsidy for X is removed firm that produces X leaves the market. (d) (e) On the graph above, show the effects of a decrease in costs. Label this answer fully. Explain how the quantities for a market supply curve are derived. Market supply is the sum of all firms supply at each price or the horizontal sum of all supply curves/schedules at each price. 10 Subscribe to elearneconomics at: ISBN (Student s book)

11 Basic concepts: The market Markets and the Equilibrium A market is a place or situation where buyers and sellers interact to exchange goods and services. Goods and services are traded in a variety of markets ranging from retail stores, mail order, private sales, web pages on the internet and fleamarkets. The market equilibrium is the price at which the quantity demanded by consumers equals the quantity supplied by firms (shown as price P and quantity Q on the diagram opposite). At the market equilibrium there is neither a shortage or surplus. Any move away from the market equilibrium position will set up automatic forces to re-establish the equilibrium position. Surplus A surplus (or excess supply) is when the quantity supplied by manufacturers is larger than the quantity demanded by buyers, i.e. firms find they have stock left over or unsold. To get rid of this surplus firms are willing to accept a lower price, so sales increase, and the price will fall to the equilibrium. At $25 on the diagram the quantity supplied is 8 000, while the quantity demanded by consumers is 3 000, so there is a surplus at At $20 there is a surplus of 2 000, as quantity demanded is and quantity supplied is Price $ d market equilibrium Price $ d s P s d Q Quantity surplus s surplus s d Quantity (000) Qd surplus Qs Shortage A shortage (or excess demand) is when the quantity demanded by consumers is greater than the quantity supplied by firms. Some consumers are willing to pay a higher price, so price rises to the equilibrium. In the diagram at a price of $8, the quantity demanded is and quantity supplied is 1 000, there is a shortage of At $15 there is a shortage of 4 000, as quantity supplied is and quantity demanded is Price $ 15 8 s d s shortage shortage d Quantity Qs Qd shortage ISBN (Student s book) Subscribe to elearneconomics at: 11

12 Changes in Equilibrium Price and Quantity When ceteris paribus is broken and the conditions of demand or supply change then there will be a new equilibrium price and equilibrium quantity as one or both curves (demand and supply) shift. To illustrate a change in the market due to a shift of a curve, these conventions are followed: (i) The new demand and/or supply curves are drawn parallel to the original curves, with appropriate labels for the new curves including direction arrows. (ii) The new equilibrium price is labelled P' and the new equilibrium quantity is labelled Q'. Direction arrows are used to show the increase or decrease in price and/or quantity that result in the market. P d' A decrease in demand d s P d A decrease in supply s' s P P' P' P s' s d' d s d Q' Q Q Q' Q Q The Market 1 (a) On the grid below, draw the market for milk each week and identify the equilibrium price and quantity, as Pe and Qe respectively. Market for milk each week Price ($ per litre) Quantity demanded (litres) Quantity supplied (litres) Price $ per litre 4.00 d Market for milk each week s Pe 1.00 s d 5 10 Quantity (00 litres) Qe (b) Identify a price at which: (i) a shortage will occur. Any price below $1.50 per litre. (ii) a surplus will occur. Any price above $1.50 per litre. 12 Subscribe to elearneconomics at: ISBN (Student s book)

13 2 Complete each diagram to show the change indicated by the title on each. Label the change fully. (a) A decrease in direct tax. (b) An increase in indirect tax. P d d' s P d s' s P' P' P P s d d' s' s d Q Q' Q Q' Q Q (c) A decrease in workers wages. (d) The price of a complement increases. P P d s s' P d' d s P' P s s' d P' s d' d Q Q' Q Q' Q Q 3 (a) Write increase or decrease for the impact on the equilibrium price and the equilibrium quantity for each situation indicated. Situation Market for apples Impact on equilibrium price Impact on equilibrium quantity (i) A subsidy is given to apple growers. decrease increase (ii) A health report states the benefits of eating apples. increase increase (iii) The price of oranges increases. increase increase (iv) The price of bananas falls. decrease decrease (v) A decrease in direct tax. increase increase (vi) A decrease in indirect tax. decrease increase (vii) An adverse growing season for apples. increase decrease (viii) Increased advertising for pears. decrease decrease (ix) The price of a related good increases. increase decrease (x) The price of a related good decreases. decrease increase (b) Explain how a market will react to excess demand. Price will increase and the quantity supplied will increase and the quantity demanded will decrease. (c) Explain why a surplus in the market will not last long. Price will decrease and the quantity supplied will decrease and the quantity demanded will increase. ISBN (Student s book) Subscribe to elearneconomics at: 13

14 Core: Consumers and producers Consumers have limited incomes and cannot afford everything they want, so they must choose the option they desire the most. As price of a product increases the quantity demanded falls, ceteris paribus, because consumers cannot afford as much. Consumers will also look to buy a relatively cheaper substitute product to use in place of the good or service that had a price increase. Most producers aim to maximise profits. They do this by either increasing sales or reducing costs. Resources used in the production process can often be used to produce another product (a related good). For example, milk can be used to make milk powder, butter or cheese. Firms will switch resources into the product that is relatively more profitable. When the price of a good increases a firm will increase quantity supplied because it will be more able to cover costs because it will be earning a higher revenue and it will be more profitable. WORKED EXAMPLES Demand curve for lamb P D P2 P Demand curve for chicken P1 D D D2 Q2 Q1 Q As the price of lamb increases (from P1 to P2) the quantity demanded decreases (from Q1 to Q2) because consumers are less willing and able to buy lamb because they cannot afford it. The demand for chicken will increase (there will be an increase in quantity demanded at each and every price) as shown by the demand curve shifting outward (from D to D2) because chicken is now relatively cheaper. P P1 Supply curve for apple juice S P Supply curve for cider S S2 Q P2 Q2 Q1 Q Q As the price of apple juice falls (from P1 to P2) the quantity supplied by firms will decrease (from Q1 to Q2) because they are less able to cover costs because they earn less revenue and are less profitable. Firms will switch resources into producing cider (a related good) because it is relatively more profitable, as shown by the supply curve shifting outward (from S to S2). 14 Subscribe to elearneconomics at: ISBN (Student s book)

15 Questions: Consumers and producers (a) P P1 Explain, in detail, what the graphs below show. Demand curve for pork P D Demand curve for beef P2 D D2 D Q1 Q2 Q Q Pork and beef are substitutes because they can be used in place of each other. As the price of pork falls (from P1 to P2) the quantity demanded increases because consumers are more willing and able to buy pork because they can afford it. There will be a decrease in demand for beef (a decrease in quantity demanded at each and every price) because it is relatively more expensive, shown as the demand curve shifting inward (to the left from D to D2). (b) Explain, in detail, what the graphs below show. P P2 Supply curve for wool S P Supply curve for mutton S2 S P1 S Q1 Q2 Q Q Wool and mutton are related goods because the resources used to produce each are similar (farm land, workers, fences). As the price of wool increases (from P1 to P2) the quantity supplied increases (from Q1 to Q2) because the farmers are more able to cover costs because the revenue earned is higher and it is more profitable. Farmers will switch resources into producing wool. The supply curve for mutton will decrease as shown by the supply curve shifting inward (from S to S2) because it is less profitable to produce mutton. ISBN (Student s book) Subscribe to elearneconomics at: 15

16 Core: Household income (Y) A household is either a person or a group of people living under one roof. A household s income (Y) comes from supplying labour (human) resources to and firms in return for wages. Disposable income is income after direct (income) taxes are paid and any transfers received. When direct (income) tax rates are cut or transfers increase then disposable incomes rise. A household can either spend or save the income they receive. Consumption spending (C) is household spending on goods and services and is likely to increase when incomes rise. Savings (S) represents income not spent. The level of savings a household has will depend on several factors including interest rates, expectations about the future and attitudes towards thrift. Individuals may save more if they are concerned about the future and desire to have funds for an emergency, such as an unexpected bill for repairs to a house or car. As interest rates increase individuals are likely to save more because they are receiving a higher return on funds put aside to use later. A household s discretionary income is a household s disposable income minus all essential payments required. Essential payments would include items such as mortgage repayments, insurance, rates, groceries, utilities such as power and water, and other necessities. What is left over from a household s disposable income after other commitments are accounted for is a household s discretionary income. The remaining income can either be used for additional spending or can be saved. When interest rates paid on a variable mortgage fall then a household will pay less for its mortgage, this will result in an increase in discretionary income rather than disposable income. 16 Subscribe to elearneconomics at: ISBN (Student s book)

17 Questions: Household income (Y) (a) Explain the difference between disposable income and discretionary income. A household is either a person or a group of people living under one roof. A household s income (Y) comes from supplying labour (human) resources to firms in return for wages, while a household s discretionary income is a household s disposable income minus all essential payments required. (b) Explain the different effect that an increase in direct tax and an increase in interest rates will have on a household s disposable income and/or discretionary income and their level of consumption spending. An increase in direct tax will decrease a household s disposable income. A decrease in disposable incomes will result in a decrease in consumption spending because households can not afford as much. An increase in interest rates will increase the reward for savings, so savings will increase and consumption spending will fall. As interest rates increase this will increase the cost of borrowing, therefore households will be less likely to increase debt to finance their spending. When interest rates paid on a variable mortgage increase then a household will pay more for its mortgage, this will result in a decrease in discretionary income rather than disposable income. ISBN (Student s book) Subscribe to elearneconomics at: 17

18 Core: Inflation An increase or decrease in the general (average) price level can reflect that inflation, disinflation or deflation has taken place. An increase or decrease in the price of a particular good or service in a market does not necessarily mean that there has been a change in the general price level because this represents the change in the price of a single good or service. The rate of change in the general price level is measured by using the Consumer Price Index (CPI) to calculate the percentage change indicated by the index numbers. Change in general price = Change in the Consumer Price Index (CPI) index numbers Original Consumer Price Index number multiplied by 100 e.g. The CPI in Year 1 was and in Year The rate of change in the general price level equals 45/1 000 multiplied by 100 which equals a 4.5% increase in the general price level. Inflation is an increase in the general price level. Deflation is a decrease in the general price level. Inflation is a negative and the Consumer Price Index will be falling. Disinflation occurs when the rate of inflation is falling, that is, there is an increase in the general price level but at a slower rate (percentage) than a previous time period. Price level (PL) Demand-pull inflation and the AD/AS model AS Price level (PL) Cost-push inflation and the AD/AS model AS2 AS PL2 PL2 AD' PL1 AD PL1 AD Y1 Y2 Real output GDP (Y) Y2 Y1 Real output GDP (Y) A change in the general price level (PL) can be illustrated on an AD/AS model. An increase in the general price level (inflation) is illustrated on both diagrams as the change from PL1 to PL2, either as a result of an increase in aggregate demand (AD) or a decrease in aggregate supply (AS). 18 Subscribe to elearneconomics at: ISBN (Student s book)

19 Questions: Inflation (a) Define the term inflation. An increase in the general price level. (b) Define the term deflation. A decrease in the general price level. (c) Define the term disinflation. A fall in the inflation rate. (d) Calculate the change in the general price level for the sets of figures provided to 1 decimal point. (Show your working). (i) Consumer Year Price Index = 2.5% (ii) Consumer Year Price Index = 4.58 = 4.6 (e) State the economic term that describes: (i) a rise in the percentage increase in the CPI Inflation (ii) a decrease in the CPI Deflation (f) Complete the table by calculating the annual inflation rate. Round your answer to 1 decimal point. Year Quarter CPI Annual inflation 1 March June September December March ( 30 ) = June ( 25 ) = September ( 22 ) = December ( 24 ) = 2.1 ISBN (Student s book) Subscribe to elearneconomics at: 19

20 Core: Consumption spending (C) Consumption spending (C) is household spending (or expenditure) on goods and services. Consumption spending (C) is a component of Aggregate Demand (AD). As consumption spending increases the aggregate demand curve will shift outward (to the right) causing an increase in real output GDP (growth) and an increase in the price level (inflation), ceteris paribus. Consumption spending (C) will increase if: Household disposable incomes (HDI) increase. When household disposable incomes increase they can afford more. Household disposable incomes will increase if direct (income) taxes are cut and/or transfer payments are increased. Interest rates fall. If interest rates fall there is less incentive for households to save, because they get a lower return and this will discourage savings therefore consumption spending will increase. If interest rates fall then it is possible that households will get a loan to buy items they desire (whiteware, cars, furniture) or to do renovations to homes or buy a property (home), this will increase consumption spending. Inflationary expectations increase. If households are concerned that the general price level is going to increase, then they will buy now, rather than later when goods and services are more expensive. This will cause consumption spending to increase. Wealth effect: if property and house prices increase then households may be encouraged to borrow more from banks and financial institutions by asking for a loan based on the increased equity they have in their home and/or property. As borrowed funds are spent on goods and services consumption spending (C) increases. A change in households attitudes can influence consumption spending, for example, households may decide to reduce levels of debt. An increase in income that arises from direct tax may see little change in consumption spending because the additional disposable income households receive is used to pay back loans. Consumer confidence can influence the level of consumption spending. If households are more concerned about the future they may decide to save more and reduce consumption spending. As more households participate in (or join) savings schemes (e.g., Kiwisaver) and/or increase their contributions then consumption spending (C) will decrease, causing aggregate demand to decrease. Consumption spending (C) will impact on firms because as households demand more goods and services, firms will need to increase production. As a part of increasing production firms will need to use additional resources and employ more workers or pay existing workers overtime. Therefore household incomes will rise and additional consumption spending will occur. Firms will collect more indirect tax from the increased spending on goods and services by households. As firms incomes increase from increased sales it is likely that profits will increase, as profits increase firms will pay direct (company) tax to the government. Overall the prospects of profits in the future may lead to an increase in business confidence, with firms deciding to expand their operations and subsequently buy new capital goods (invest) to increase output. 20 Subscribe to elearneconomics at: ISBN (Student s book)

21 Questions: Consumption spending (C) (a) State factors that can influence consumption spending. Disposable income, direct taxes, transfer payments, expectations about the future, interest rates, wealth effect, attitudes towards debt level, attitude towards savings. (b) Explain in detail the likely effect of an increase in interest rates on consumption expenditure. As interest rates increase it is likely that households will save more because they are receiving a higher return on funds put aside, therefore consumption spending will fall. As interest rates increase households will pay more on mortgages and credit cards, discretionary income will fall. Households are likely to take out fewer loans because the cost of borrowing has increased and this will cause consumption spending to fall. (c) Compare and contrast the effect of a decrease in direct taxes and an increase in transfer payments. A decrease in direct taxes and increase in transfer payments will both increase households disposable incomes and increase consumption spending. A decrease in direct taxes is likely to have a greater effect on consumption spending than an increase in transfer payments because more households earn an income than those that receive a benefit. ISBN (Student s book) Subscribe to elearneconomics at: 21

22 Core: Investment spending (I) Investment spending (I) or capital formation takes place when firms buy capital. For example, a farmer buys a quad bike, a horticulturist builds a dam for irrigation purposes or a manufacturer installs new machinery. Investment spending (I) is a component of aggregate demand (AD). Businesses are more likely to increase their level of investment spending (capital expenditure) if they are confident about the prospects of a venture or project being successful. As part of this process of deciding to invest (purchase new capital items) or not, firms will consider the cost of borrowing the funds required (i.e., interest rates), the level of risk involved as well as the profitability of the decision. As interest rates increase then firms are less likely to invest because the risk is higher and the profitability is reduced because the cost of borrowing funds has increased. Investment spending will fall and decrease aggregate demand. There exists a link between investment spending and the balance of payments on the current account because some capital items have to be purchased from overseas suppliers if New Zealand does not produce these items (machinery, equipment, tools). As imports of capital goods from overseas rise it will increase the current account deficit or make a current account surplus smaller. A stable exchange rate will make business decisions more predictable because firms will be more assured about their costs and incomes. This is likely to increase business confidence in future profits and increase their willingness to buy capital goods (investment). Greater investment will result in an increase in aggregate demand and an increase both in real output GDP (economic growth) and the general price level (inflation). Before investment funds are available to firms, those funds need to be saved by households with financial institutions, this enables financial institutions to have funds available to advance (lend) to firms who want to buy capital. When interest rates fall investment should increase, however this is not always the case. Financial institutions may be unable to find credit worthy firms to make advances to, or firms may not wish to invest despite lower interest rates because they are not confident about the future or simply have little or no desire to expand because they have a goal of satisficing. Satisficing is a business goal of being content with a certain profit or sales target rather than maximising profit or sales. Sales 22 Subscribe to elearneconomics at: ISBN (Student s book)

23 Questions: Investment (I) (a) In economics what is meant by the term investment and who will undertake it? Investment spending (I) or capital formation takes place when firms buy capital. (b) In what circumstances is investment likely to increase? Investment is likely to increase when firms are confident about new business ventures. When interest rates fall firms are more likely to invest because the risk is lower and the profitability of new ventures increased because the cost of borrowing funds has decreased. (c) When interest rates fall investment should increase. Explain why this is not always the case. Investment may not take place when interest rates fall because firms are not confident about the future and perceive the risks to be higher and the profitability of ventures as being lower. Some firms may be content will the status quo and not desire to expand the size of their business and/or market. Banks may find they are unable to find credit worthy firms to make advances to, despite interest rates falling. (d) Explain the possible link between an increase in investment spending and the current account balance. Investment spending involves the buying of capital goods, some of which will need to be imported from overseas. This will cause import payments in the balance of goods to increase. As import payments increase the current account deficit could increase or a current account surplus become smaller. ISBN (Student s book) Subscribe to elearneconomics at: 23

24 Core: Government spending (G) Government spending (G) is a component of aggregate demand. In times of a boom there is more economic activity, more goods and services are produced and unemployment decreases. The government will collect more in direct tax because there are more people employed, also the government will collect more in indirect tax from firms because household spending increases due to higher incomes. The government will pay less in transfer payments because unemployment decreases. Overall increased tax revenues and decreased government spending will increase the operating balance, resulting in a greater surplus or smaller deficit. Fiscal policy is where government controls the level of economic activity by changing its own spending and income. The level of government activity will depend on the state of the economy. If the level of economic activity is near capacity and there is inflationary pressure, then the government will run a budget surplus (contractionary fiscal policy) to dampen down the level of economic activity. This contractionary fiscal policy will involve an increase in taxes and/or a decrease in government spending causing aggregate demand to decrease. The price level will decrease and real output GDP will fall. The AD/AS model illustrating an operating (budget) surplus (contractionary fiscal policy) AS Price level (PL) PL PL2 AD Y2 Y AD2 Real output GDP (Y) 24 Subscribe to elearneconomics at: ISBN (Student s book)

25 Questions: Government spending (G) Government operating balances ($m) Year 1 Year 2 Year 3 $8 000 deficit $4 500 deficit $1 500 deficit (a) Discuss the effect of an operating deficit on the economy. Describe how the operating balance is calculated. Explain a fiscal policy the government could use in times of a recession to stimulate growth. Explain the link between a recession and the operating balance. The operating balance is calculated by taking government revenue (income) away from the government expenses (spending). To stimulate economic growth the government should implement an expansionary fiscal policy by running a budget (operating) deficit. This will involve increasing government spending and/ or decreasing taxes. For example if the government cuts direct taxes households disposable incomes increase and consumption spending will increase. This will increase aggregate demand and stimulate economic activity. In times of a recession there is less economic activity and unemployment will increase. The government will collect less in direct tax because there are fewer people employed, also the government will collect less in indirect tax from firms because household spending will fall due to lower incomes. The government will pay more in transfer payments as unemployment increases. Also because students stay longer in education or delay leaving school then education spending will increase. Overall decreased tax revenues and increased government spending will decrease the operating balance, resulting in a smaller surplus or greater deficit. ISBN (Student s book) Subscribe to elearneconomics at: 25

26 Core: Net exports (X M) Net exports (exports minus imports) is a component of aggregate demand. Influences on net exports include the state of the global economy, tariffs and exchange rates. Exports of goods and services (X) represents an inflow (an injection) into a country s circular flow of income and spending adding to aggregate demand. Imports of goods and services (M) represents an outflow (a leakage or withdrawal) from the circular flow of income and spending. When there is a global downturn or recession, overseas countries incomes fall resulting in a fall in demand for New Zealand made goods and services. This decrease in exports will affect firms, consumers and the government. As exports decrease New Zealand firms produce fewer goods and services, requiring fewer resources and firms will lay off workers or pay existing workers less overtime. Firms revenue will fall and they are likely to make smaller profits and pay less company tax. Some firms may close down or look to increase sales in the domestic market. Investment decisions may be put on hold as business confidence falls. Consumers incomes will fall because exporting firms will hire fewer workers. The fall in household incomes will result in a fall in consumption spending. Falling business profits will result in less company tax being collected by the government. The decrease in employment results in lower income tax (PAYE) and lower consumer spending will result in less indirect tax being collected. The government will have to pay more in transfer payments. A decrease in exports will result in a fall in consumption spending and investment. Overall this will decrease aggregate demand causing a decrease in real output GDP (growth) and a fall in the general price level. 26 Subscribe to elearneconomics at: ISBN (Student s book)

27 Questions: Net exports (X M) An increase in export receipts will impact on several sectors. (a) Explain the immediate impact of increased export receipts on the producer sector and explain the flow on effects for consumers, government revenue and the overall level of economic activity in New Zealand. As exports increase New Zealand firms produce more goods and services, requiring more resources. Firms will hire more workers or pay existing workers more overtime. Firms revenue will rise and they are likely to make a greater profit and pay more company tax. Some firms will look to invest as business confidence increases. Consumers incomes will rise because exporting firms will hire more workers. The increase in household incomes will result in an increase in consumption spending. Increasing business profits will result in more company tax being collected by the government. Increased employment results in greater income tax (PAYE). Higher consumer spending will result in more indirect tax being collected. The government will pay less in transfer payments. An increase in exports will result in an increase in consumption spending and investment. Overall this will increase aggregate demand causing an increase in real output GDP (growth) and an increase in the general price level. ISBN (Student s book) Subscribe to elearneconomics at: 27

28 Core: Changing level of economic activity The level of economic activity will impact on the economy in a variety of areas including household income, business confidence, government income, economic growth and the general price level. As an economy experiences a recession or a fall in the level of economic activity, firms will find that stock (inventory) levels build up as sales fall. This will cause firms to decrease output and employ fewer workers and resources. As employment falls household incomes will decrease and consumption spending will fall. Business confidence is likely to decline resulting in a fall in investment spending because firms view the risks of starting a new venture or purchasing capital as being higher and less profitable. A fall in consumption spending and investment will cause aggregate demand to decrease causing a fall in inflationary pressures, a fall in real output GDP. During a recession the government will collect less in direct tax because fewer workers are hired (employed) and firms lay off staff or pay less overtime to workers because of reduced output. Business profits decline with fewer sales and revenue. Firms will pay less company tax to the government. Government spending on transfer payments will increase because unemployed workers now receive a benefit. The government will collect less in indirect tax, such as GST because household consumption spending falls. 28 Subscribe to elearneconomics at: ISBN (Student s book)

29 Questions: changing level of economic activity (a) Explain how a boom in the global economy will impact on households, firms and the government. As an economy experiences a boom or an increase in the level of economic activity, firms will find that stock (inventory) levels fall as sales increase. This will cause firms to increase output and employ more workers and resources. As employment rises household incomes will increase and consumption spending will rise. Business confidence is likely to rise resulting in an increase in investment spending because firms view the risks of starting a new venture or purchasing capital as being lower and more profitable. A rise in consumption spending and investment will cause aggregate demand to increase causing an increase in inflationary pressures and an increase in real output GDP. During a boom the government will collect more in direct tax because more workers are hired (employed) because firms hire staff or pay more overtime to existing workers to cover increased output. Business profits rise with greater sales and revenue. Firms pay more company tax to the government. Government spending on transfer payments will decrease because fewer people receive a benefit. The government will collect more in indirect tax, such as GST because household consumption spending increases. ISBN (Student s book) Subscribe to elearneconomics at: 29

30 Core: Establishing the New Zealand dollar The New Zealand dollar is determined by the demand for it and the supply of it in the foreign exchange (forex) market. The New Zealand dollar will depreciate if there is a decrease in demand for it and/or an increase in supply of it in forex markets. A decrease in demand for the New Zealand dollar could be due to a decrease in the number of tourists visiting New Zealand. Fewer visitors means there will be less demand for New Zealand dollars in the forex market. A global downturn means that incomes in overseas countries fall, which will result in a decrease in demand for New Zealand-made goods and services therefore less demand for New Zealand dollars in forex markets. Weaker commodity prices will mean that foreign buyers of New Zealand-made goods will need to buy (demand) fewer New Zealand dollars in the forex market to purchase the commodities they require, causing the New Zealand dollar to depreciate. Price of $NZ The New Zealand dollar S$NZ er1 er2 Q2 Q1 D2$NZ D$NZ Quantity of $NZ The supply of the New Zealand dollar will increase when New Zealanders travel overseas because New Zealand travellers will sell (supply) New Zealand dollars to purchase foreign exchange to use in the country or countries they visit. New Zealand firms that import will also need to sell New Zealand dollars to purchase foreign exchange to pay overseas suppliers (firms) in their own currency. Therefore, if New Zealand imports more goods and services, the supply of New Zealand dollars increases in the forex market and the New Zealand dollar will depreciate. Price of $NZ The New Zealand dollar S$NZ S2$NZ er1 er2 D$NZ Q1 Q2 Quantity of $NZ 30 Subscribe to elearneconomics at: ISBN (Student s book)

31 Questions: establishing the New Zealand dollar (a) (b) Explain how the value of the New Zealand dollar is established. The New Zealand dollar is determined by the demand for it and supply of it in the foreign exchange (forex) market. Fully explain, with the aid of a diagram, what could cause the value of the New Zealand dollar to appreciate. The New Zealand dollar will appreciate if there is an increase in demand for it and/or a decrease in supply of it in forex markets. An increase in demand for the New Zealand dollar could be due to an increase in the number of tourists visiting New Zealand. More visitors means there will be greater demand for New Zealand dollars in the forex market. A global upturn means that incomes in overseas countries rise, which will result in an increase in demand for New Zealand-made goods and services therefore greater demand for New Zealand dollars in forex markets. Higher commodity prices will mean that foreign buyers of New Zealand-made goods will need to buy (demand) more New Zealand dollars in the forex market, to purchase the commodities they require, causing the New Zealand dollar to appreciate. Price of $NZ The New Zealand dollar S$NZ er2 er1 Q1 Q2 D2$NZ D$NZ Quantity of $NZ The supply of the New Zealand dollar will decrease when fewer New Zealanders travel overseas because New Zealand travellers will sell (supply) fewer New Zealand dollars to purchase foreign exchange to use in the country or countries they visit. New Zealand firms that import also need to sell New Zealand dollars to purchase foreign exchange to pay overseas suppliers (firms) in their own currency. Therefore, if New Zealand imports fewer goods and services, the supply of New Zealand dollars decreases in the forex market and the New Zealand dollar will appreciate. Price of $NZ The New Zealand dollar S2$NZ S$NZ er2 er1 D$NZ ISBN (Student s book) Q2 Q1 Quantity of $NZ Subscribe to elearneconomics at: 31

32 Core: The New Zealand dollar and economic activity The New Zealand dollar is the value of its currency in terms of another, for example the New Zealand dollar ($NZ) equals $0.86 Australian dollars. If this rate changes to one New Zealand dollar equals $0.84 Australian dollars, then the New Zealand dollar has depreciated (the Australian dollar appreciates as the New Zealand dollar depreciates). A depreciation of the New Zealand dollar occurs when the value of the New Zealand dollar falls in terms of another currency. As the New Zealand dollar depreciates, New Zealand made goods and services will become more price competitive in Australia and exports should increase. New Zealand firms will swap Australian dollars (foreign exchange) for more New Zealand dollars and exporters incomes will increase. This will cause aggregate demand to increase. New Zealand firms that import Australian goods and services will have to pay more and will find that their costs of production will rise. As costs of production increase, profits will decrease and the aggregate supply curve will shift inward. It is likely that imports from Australia will fall because Australian made goods and services will be less price competitive when compared to cheaper domestic products made by New Zealand producers. Overall the impact of an increase in aggregate demand and a decrease in aggregate supply will result in an increase in the price level. The effect of these changes on real output GDP (economic growth) depends on whether the increase in aggregate demand is greater than the fall in aggregate supply. Export receipts (X) Import payments (M) 32 Subscribe to elearneconomics at: ISBN (Student s book)

33 Questions: the New Zealand dollar and economic activity Overseas funds managers have shied away from the American Greenback which has boosted the New Zealand dollar. Explain the impact that a strong New Zealand dollar has on the New Zealand economy. In your answer: Describe what is meant by a strong New Zealand dollar. Explain how a strong New Zealand dollar would impact on aggregate demand and/or aggregate supply. Explain the overall impact of these changes on the price level and economic growth in the New Zealand economy. A strong New Zealand dollar means that it has appreciated, this is a rise in the value of the New Zealand dollar when compared with other currencies. As the New Zealand dollar appreciates exports become less price competitive and exporters swap forex for fewer $NZ, so incomes will fall. The AD curve will shift inward. As the New Zealand dollar appreciates the cost of raw materials becomes cheaper. This lowers costs of production/increases profit so the AS shifts to the right as planned output increases. The AD curve shifting inward will be offset by the AS curve shifting outward, therefore there could be an increase, decrease or no change in real output GDP (economic growth). The general price level will decrease. ISBN (Student s book) Subscribe to elearneconomics at: 33

34 Core: Interest rates Interest rates can be viewed as the reward for savings or the cost of borrowing. Changes in interest rates can have a significant effect on economic activity because it will affect both aggregate demand and aggregate supply. Actions taken by the Reserve Bank of New Zealand to influence interest rates, the money supply and the availability of credit is termed monetary policy. As interest rates rise, consumption spending will fall because households will be encouraged to save more because they are receiving a higher return on funds put aside i.e., savings (or income not spent) with financial institutions. As savings increase, aggregate demand will shift inward and economic activity will decrease. As interest rates increase, households will pay more on mortgages and credit cards, it will mean their discretionary income will fall. Also households are less likely to borrow funds because the increase in interest rates will make repayments higher. Overall this will cause aggregate demand to decrease. As interest rates increase it is likely that investment (capital) expenditure by firms will decrease because the risk of a new venture is higher and the profitability is reduced because the cost of borrowing funds will increase. As investment spending falls, aggregate demand will decrease. As interest rates increase, the New Zealand dollar is likely to appreciate because the demand for the New Zealand dollar will increase due to overseas investors being attracted by the relatively higher returns for their funds in New Zealand. The supply for the New Zealand dollar will decrease on the forex market because New Zealand investors will keep their funds in New Zealand rather than look to invest overseas. As the New Zealand dollar appreciates, New Zealand exports will become less price competitive and New Zealand exporters will swap forex for fewer New Zealand dollars. As exporters incomes fall, aggregate demand will decrease. As the New Zealand dollar appreciates, imports will cost less. As firms costs of production fall, profits will increase, the aggregate supply curve will shift outward which will reduce the price level and increase real output (GDP). 34 Subscribe to elearneconomics at: ISBN (Student s book)

35 Questions: Interest rates (a) A decrease in interest rates is likely to stimulate economic activity. Explain in full the effects of a decrease in interest rates on both aggregate demand and aggregate supply. Changes in interest rates can have a significant effect on economic activity because it will affect both aggregate demand and aggregate supply. As interest rates fall, consumption spending will rise because households will be less likely to save because they are receiving a lower return on funds put aside i.e., savings (or income not spent) with financial institutions. As consumption spending increases, aggregate demand will shift outward and economic activity will increase. As interest rates decrease households will pay less on mortgages and credit cards, it will mean their discretionary income will increase. Also households are more likely to borrow funds because the decrease in interest rates will make repayments lower. Overall this will cause aggregate demand to increase. As interest rates decrease it is likely that investment (capital) expenditure by firms will increase because the risk of a new venture is lower and the profitability is increased because the cost of borrowing funds will decrease. As investment spending increases aggregate demand will increase. As interest rates decrease the New Zealand dollar is likely to depreciate because the demand for the New Zealand dollar will decrease because overseas investors will be less attracted by the lower returns for their funds in New Zealand. The supply of the New Zealand dollar will increase on the forex market because New Zealand investors will look to invest their funds offshore rather than look to invest in New Zealand. As the New Zealand dollar depreciates New Zealand exports will become more price competitive and New Zealand exporters will swap forex for more New Zealand dollars. As exporters incomes increase, aggregate demand will increase. As the New Zealand dollar depreciates imports will cost more. As firms costs of production increase, profits will decrease, this will cause the aggregate supply curve will shift inward which will increase the price level and decrease real output (GDP). ISBN (Student s book) Subscribe to elearneconomics at: 35

36 Core: Aggregate demand (AD) Aggregate demand (AD) is total demand in the economy and is equivalent to national income (Y). AD = C + I + G + (X M) The aggregate demand curve slopes downward to the right as the price level (PL) increases, the aggregate demand for all goods and services will decrease. The aggregate demand curve will shift inward (to the left) if: (a) consumption spending decreases due to income (direct) tax increasing or reduced transfer payments; (b) investment spending falls due to a lack of business confidence or an increase in interest rates which makes it less likely that firms will invest; (c) the government runs a budget surplus and spends less than it receives in revenue, there will be a net withdrawal and a decrease in aggregate demand; and/or (d) net exports fall. Price level (PL) The aggregate demand curve AD AD' Real output GDP (Y) 36 Subscribe to elearneconomics at: ISBN (Student s book)

37 Questions: Aggregate demand (AD) 1 (a) Indicate which component or components of aggregate demand is affected for the situation or event in the table below and whether aggregate demand will increase or decrease. If aggregate demand does not shift place a double cross (XX) in the space provided. Situation Component of AD (or XX does not affect AD) (i) Insurance costs increase. (XX) AD increases or decreases (ii) Capital expenditure on irrigation increases. I increases (iii) Business confidence falls. I decreases (iv) Interest rates increase. C, I, X decreases (v) Direct tax cuts. C increases (vi) Transfer payments are cut. C decreases (vii) Expansionary fiscal policy. G increases (viii) A government operating deficit. G increases (ix) Petrol prices fall. (XX) (x) Increased emigration to Australia. C decreases (xi) Greater uptake of KiwiSaver. C decreases (xii) An increase in business confidence. I increases (xiii) Interest rates decrease. C, I, X increases (xiv) The payout to dairy producers is higher than I, X increases forecast. (xv) Contractionary fiscal policy. G decreases (xvi) The New Zealand dollar depreciates. X increases (b) State, for each situation, which event or situation will have a larger impact on economic activity and explain why. (i) A decrease in interest rates or an increase in wool export earnings. A decrease in interest rates will have a larger impact on economic activity because it will impact on consumption spending, investment spending and net exports. An increase in wool exports only impacts the wool industry and therefore only a small part of exports overall. (ii) A decrease in transfer payments or an increase in direct taxes. An increase in direct taxes will have a greater impact on economic activity because most households earn an income while there are fewer people on a benefit (transfer payments). (iii) An increase in capital expenditure or an appreciation of the New Zealand dollar. An appreciation of the New Zealand dollar will have a larger impact on economic activity because it will affect both AD (exports) and AS (imports), while an increase in capital expenditure (investment) only affects one component of aggregate demand (AD). ISBN (Student s book) Subscribe to elearneconomics at: 37

38 2 (a) List the components of Aggregate Demand. Standard abbreviations are acceptable. AD = C + I + G + (X M) + ΔR (b) Indicate the direction the aggregate demand curve will shift for the situations given in the table below. If the aggregate demand curve does not shift place a cross (X) in the space provided. Situation Direction that AD shifts inward or outward (i) Income tax rates decrease outward (ii) A rise in business confidence outward (iii) A larger than expected budget surplus inward (iv) Interest rates rise as the OCR is raised inward (v) The government announces that GST will outward increase in six months time (vi) New technology (vii) Costs of production fall (viii) A fall in business confidence inward (ix) Transfer payments are increased outward (x) Net exports $1 912m surplus outward (xi) The Reserve Bank Governor lowers the outward OCR and interest rates fall (xii) Contractionary fiscal policy inward (xiii) A net migration loss inward (xiv) A budget surplus inward (xv) A large increase in households starting to inward save for their retirement (xvi) Consumers go on a spending spree fearing outward price rises in the future (c) (i) On the axes provided, sketch and label an aggregate demand curve. Price The AD curve level (PL) AD curve does not shift place a cross (X) X X AD1 AD2 (ii) (iii) Real output GDP (Y) Show the effect of a resurgent housing market due to increased consumer confidence and spending, as house prices rise. Explain why the AD curve shifted. As consumer spending increases because house prices have increased (wealth increases) which increases consumer confidence or consumers are prepared to borrow more (or save less), this will cause AD to shift outward from AD1 to AD2. 38 Subscribe to elearneconomics at: ISBN (Student s book)

39 3 (a) Complete the table with a tick ( ) to indicate which of the following will cause the aggregate demand curve to shift. Shifts aggregate demand curve (i) Levels of business confidence (ii) Changes in workers wages (iii) Changes in household incomes (iv) Costs of production (v) Indirect tax e.g., GST, sales tax (vi) A tax collected by a third party and passed on to the government (vii) Expectation about future inflation levels (viii) Net exports (ix) Changes in interest rates (x) Changes in net migration (xi) New technology and an increase in workers productivity (xii) Changes in the value of the New Zealand dollar, e.g., depreciation (b) For each event listed below explain which direction the aggregate demand curve will shift. (i) The Reserve Bank of New Zealand lowers interest rates. inward outward (circle your choice) Explanation: When the OCR falls this will lower interest rates, this results in less savings and increased consumption spending by households and increased investment by firms, this will cause AD to increase. (ii) Inflationary expectations rise. inward outward (circle your choice) Explanation: Households (consumers) buy today to avoid future expected price increases, so increasing AD. (iii) The New Zealand dollar depreciates. inward outward (circle your choice) Explanation: A falling New Zealand dollar results in exporters swapping foreign earnings for more New Zealand dollars. The increased earnings enable more spending so cause AD to increase. (iv) Government provides additional financial support for low and middle income families. inward outward (circle your choice) Explanation: Additional financial support for low and middle income families will raise their disposable income. This will increase consumption spending so AD shifts right. ISBN (Student s book) Subscribe to elearneconomics at: 39

40 Core: Aggregate supply (AS) Aggregate supply (AS) is total production of all firms in the economy. The aggregate supply curve will shift with a change in the costs of production. Costs of production for firms could fall due to increased worker productivity which makes the production process more efficient or an appreciation of the New Zealand dollar reduces the cost of imported raw materials. As costs decrease, profits will increase, so firms will plan to produce more at each price level thereby shifting the aggregate supply outward (to the right). Price level (PL) The aggregate supply curve AS AS2 Real output GDP (Y) The aggregate supply curve shows the real output that firms are willing to supply at each price level. At low levels of output (on the relatively flat part) of the aggregate supply curve firms are willing to increase output with a small increase in the price level, because they have idle capacity. The slope becomes steeper as much larger increases in price are needed to induce firms to invest or add extra shifts and pay overtime. As the economy approaches capacity, it is more difficult to increase output because there is less spare capacity. There may be hold-ups and bottlenecks, so prices rise. The AS curve rises as the economy reaches full capacity. Price level (PL) The aggregate supply curve Steep or rising part of the AS curve, high levels of national output AS low levels of national output, flat part of AS curve Real output GDP (Y) 40 Subscribe to elearneconomics at: ISBN (Student s book)

41 Questions: Aggregate supply (AS) 1 (a) Indicate which direction the aggregate supply curve will shift for the situations given. If the aggregate supply curve does not shift place a cross (X) in the space provided. Situation Direction that AS curve will shift inward or outward (i) New technology is developed outward (ii) Workers productivity falls as machinery inward wears out and depreciates (iii) Workers wages rise inward (iv) New Zealand dollar appreciates resulting in outward a fall in the price of imported raw materials AS curve does not shift place a cross (X) (v) The government runs a budget surplus (X) (vi) Rising oil prices inward (vii) An increase in investment spending by firms (X) (viii) Household incomes fall (X) (iv) An increase in GST inward (b) (i) On the axes provided, sketch and label an aggregate supply curve. Price level (PL) AS curve AS1 AS2 Real output GDP (Y) (ii) Fully label the effects of increased immigration on the AS curve. (iii) Fully explain the change to the AS curve. The AS curve shifts right (outward) because there is an increase in the supply of workers, so more resources are available. Costs of production to firms will fall. Costs decrease, increase in profits, so firms plan to produce more, therefore AS shifts right as shown from AS1 to AS2. (c) Define aggregate supply. Total production of all firms in an economy. ISBN (Student s book) Subscribe to elearneconomics at: 41

42 2 (a) Complete the table with a tick ( ) to indicate which of the following will cause the aggregate supply curve to shift. Shifts aggregate supply curve (i) Levels of business confidence (ii) Changes in workers wages (iii) Changes in household incomes (iv) Costs of production (v) Indirect tax e.g., GST, sales tax (vi) A tax collected by a third party and passed on to the government (vii) Transfer payments (viii) Net exports (ix) Changes in interest rates (x) Changes in net migration (xi) New technology and an increase in workers productivity (xii) Changes in the value of the New Zealand dollar, e.g., depreciation (b) List several factors that will cause the aggregate supply curve to shift inwards. The costs of production rise, e.g., a wage rate increase, the cost of imported raw materials increases as a result of the New Zealand dollar depreciating. An increase in indirect taxes, or other government charges. (c) Identify and explain the effect of an appreciating New Zealand dollar on aggregate supply. Effect: Increase Decrease (circle one) Explanation: Cheaper price for imported raw materials (which lowers the costs of production for New Zealand firms). Decreased costs increase profits, so firms plan to produce more, thereby shifting AS to the right. (d) Explain the link between a decrease in interest rates and a shift of the AS curve. The decrease in interest rates causes the New Zealand dollar to depreciate so imported raw materials are more expensive. This raises costs of production/decreases profit so the AS shifts to the left as planned output decreases. (e) Identify and explain the effects of unions getting a wage increase on which direction the aggregate supply curve will shift. Identify: inward or outward (circle your choice) Explanation: As unions get workers a wage increase the costs of production for firms will rise. Increase costs, decrease profits so firms plan to produce less thereby AS shifts left (inward). 42 Subscribe to elearneconomics at: ISBN (Student s book)

43 3 (a) Complete the following table. Situation Curve that shifts AD or AS Inward or outward (i) Households expect prices to rise so buy now rather than later. AD outward (ii) Households decide to increase their level of savings. AD inward (iii) Firms are confident about future sales and prospects so AD outward increase investment. (iv) Workers productivity improves. AS outward (v) Workers wages increase. AS inward (vi) Direct tax cuts. AD outward (vii) Indirect tax increases. AS inward (viii) A decrease in net exports. AD inward (ix) The government runs a larger than expected budget surplus. AD inward (x) The New Zealand dollar strengthens. AD inward and AS outward (xi) The New Zealand dollar weakens. AD outward and AS inward (xii) Interest rates rise. AS outward and AD inward (b) Justify your answer to (xii) in the table above. (i) Aggregate supply curve. The increase in interest rates causes the New Zealand dollar to appreciate so imported raw materials are cheaper. This lowers costs of production/increases profit so the AS shifts to the right as planned output increases. (ii) Aggregate demand curve. Increased interest rates decrease spending and so AD because C falls as households save more because of the higher return, or C falls because cost of borrowing higher so can t afford as much. I falls, borrowing cost higher so the profitability of future projects is reduced. Net exports fall (X M ), as $NZ appreciates making M cheaper or X more expensive. (c) Write each word or phrase in the correct column in the table: costs of production, technology, income tax, sales tax, GST, interest rates, transfer payments, level of workers productivity, cost of imported raw materials, government spending, savings, expectations about inflation, level of labour force, a wage award, net exports, business confidence. Shifts AD income tax interest rates transfer payments government spending savings expectations about inflation net exports business confidence Shifts AS costs of production technology sales tax GST level of workers productivity cost of imported raw materials interest rates level of labour force a wage award ISBN (Student s book) Subscribe to elearneconomics at: 43

44 Core: Aggregate demand and/or aggregate supply Some economic conditions or factors will influence both aggregate demand and aggregate supply, for example the New Zealand dollar and interest rates as previously indicated. Migration is another factor that can impact both on aggregate demand and aggregate supply. When migrants arrive in New Zealand they will look to set up homes and are likely to buy whiteware and furniture, consumption spending will increase and aggregate demand will increase. When migrants arrive they will add to the size of the labour force and wages will fall, ceteris paribus. As wages fall, firms costs of production will decrease. As costs of production decrease, profits will increase and aggregate supply will shift outward. Individuals who join the KiwiSaver scheme or existing members who decide to increase the size of their contribution to the scheme will be increasing their level of savings, therefore consumption spending will decrease which will decrease aggregate demand. Firms must contribute to the KiwiSaver scheme, so costs of production will increase. As firms costs increase, profits decrease and the aggregate supply curve will shift inward. When the AD and AS curves shift, the change in the general price level and real output GDP will depend on the relative size of the change in each curve. For example, a net migration gain will increase both AD and AS, they may cancel each other out with an increase in real output GDP but no change in the general price level as illustrated on the AD/AS model below. If, however, the AD shifts outward more than the increase in AS then the price level will increase. Price level (PL) The AD/AS model AS AS2 PL2/PL1 AD2 AD Y1 Y2 Real output GDP (Y) 44 Subscribe to elearneconomics at: ISBN (Student s book)

45 Questions: aggregate demand and/or aggregate supply 1 (a) Indicate if the following situations impact on aggregate demand (AD) curve and/or aggregate supply (AS), and in what direction (inward or outward). Situation AD and/or AS Direction of the shift (i) A better educated workplace. AS outward (right) (ii) Unions accept wage cuts to preserve jobs. AS outward (right) (iii) Capital expenditure by firms decreases AD inward (left) (iv) Interest rates increase AD inward (left) AS outward (right) (v) New technology improves workers productivity AS outward (right) (vi) A government operating deficit AD outward (right) (vii) Direct tax cuts AD outward (right) (viii) Indirect tax rates are increased AS inward (left) (ix) Business confidence increases AD outward (right) (x) An increase in petrol prices AS inward (left) (xi) The New Zealand dollar appreciates AD outward (right) AS inward (left) (xii) Cheaper credit AD outward (right) (b) Explain how a decrease in interest rates can affect aggregate demand and aggregate supply. When interest rates decrease household consumption spending will increase because savings will decrease as households receive lower returns. Borrowing will increase because the cost of a loan will fall. Since some households pay less on mortgage repayments, their discretionary incomes will increase and therefore increase the funds they have to spend or save. These changes will cause AD to shift outward. As interest rates fall firms are likely to increase spending on capital goods because the lower cost of borrowing will reduce the risks involved and increase the profitability of new activities. AD will shift outward. The New Zealand dollar will depreciate when interest rates fall because this decreases demand for the New Zealand dollar and increases supply of it on the forex market. Firms that export will find that their products are more price competitive and they are able to swap forex for more $NZ. Exporters incomes increase, causing AD to shift outward. As the New Zealand dollar depreciates the cost of imported raw materials/ equipment rises. This increases the costs of production/decreases profits so the AS curve shifts inward. ISBN (Student s book) Subscribe to elearneconomics at: 45

46 Net migration gain to impact on the economy. 2 Explain the effects of a net migration gain on the economy. In your answer you should: Draw and fully label an AD/AS model to show the effect of migration changes. Explain the changes to the AD and AS curves. Explain how a net migration gain has impact on inflation and growth. AD/AS model showing net migration gain Price level (PL) AS AS1 PL2 PL1 AD AD1 Y1 Y2 Real output GDP (Y) When new migrants arrive in a country they will look to set up house and buy whiteware (appliances) and other household effects. They will also buy or build houses. Aggregate demand will therefore shift outward. The AS curve shifts right (outward) because there is an increase in the supply of workers, so more resources are available. Costs of production to firms will fall. Costs decrease, profits increase, so firms plan to produce more, therefore AS shifts right. The AD and AS curves have both shifted outward (to the right), and this has resulted in an increase in real output GDP which is economic growth, shown as the change from Y1 to Y2. It has also resulted in an increase in the general price level shown as the change from PL1 to PL2, which is inflation. 46 Subscribe to elearneconomics at: ISBN (Student s book)

47 The New Zealand dollar continues to rise and economists are unsure of the impact on the economy. 3 Explain the effect of an appreciation of the New Zealand dollar on the economy. In your answer you should: Use an AD/AS model to illustrate the changes. Label fully. Explain the effect of an appreciation on AD and AS. Use your graph to explain the overall impact on inflation and growth. Price level (PL) AD/AS model showing the effects on the economy of NZ dollar appreciating AS1 AS2 PL1 PL2 AD2 AD1 Y1 Y2 As the New Zealand dollar appreciates exports become less competitive and exporters swap forex for fewer $NZ, so incomes will fall. The AD curve will shift inward. Real output GDP (Y) As the New Zealand dollar appreciates the cost of raw materials are cheaper. This lowers costs of production/increases profit so the AS shifts to the right as planned output increases. The AD curve shifting inward has been offset by the AS curve shifting outward, there has been no change in real output GDP (economic growth) because Y1 and Y2 are in the same place on the graph. The general price level has decreased as shown by the change from PL1 to PL2. Student answers will vary depending on the relative changes to AD and AS. ISBN (Student s book) Subscribe to elearneconomics at: 47

48 During the global downturn the OCR fell from 8% to 2.5%. 4 Explain the effect of a cut in the interest rates on inflation and economic growth. In your answer you should: Draw and fully label an AD/AS model to show the effects of interest rate cuts. Explain the effect on households and firms. Explain the overall effect on inflation and economic growth. Price level (PL) Effect of interest rate cuts on the AD/AS model AS2 AS1 PL2 PL1 AD2 Y2 Y1 AD1 Real output GDP (Y) When interest rates decrease household consumption spending would increase because savings would decrease as households receive lower returns. Borrowing would increase because the cost of a loan would fall. Since some households pay less on mortgage repayments, their discretionary incomes would increase and increase the funds they have to spend or save. These changes will cause AD to shift outward from AD1 to AD2. As interest rates fall firms are likely to increase spending on capital goods because the lower cost of borrowing will reduce the risks involved and increase the profitability of new activities. AD will shift outward. The decrease in interest rates is likely to cause the dollar to depreciate. Firms that export will find that their products are more price competitive and they are able to swap forex for more $NZ. Incomes of exporters increase, causing AD to shift outward. As the exchange rate depreciates the cost of imported raw materials increases. This increases costs of production/decreases profit so the AS curve shifts inward as planned output decreases. The overall impact is an increase in the general price level as shown in the increase from PL1 to PL2. On the diagram there is a fall in real output GDP, shown as the decrease from Y1 to Y2, therefore a fall in economic growth. 48 Subscribe to elearneconomics at: ISBN (Student s book)

49 Farmers are looking at increased capital expenditure on irrigation projects 5 Explain the effects of increased capital expenditure on irrigation projects. In your answer you should: Show the effects on the AD/AS model. Explain the effect on economic growth. Refer to your diagram. Price level (PL) AD/AS model of an economy AS PL2 PL AD2 Y Y2 AD Real output GDP (Y) The increased investment (capital expenditure) by farmers on irrigation projects will increase economic growth (shown as the increase in real output GDP from Y to Y2) because the aggregate demand curve shifts outward/right from AD to AD2. ISBN (Student s book) Subscribe to elearneconomics at: 49

50 Core: Economic growth (real output GDP) Real GDP is the total market value of all goods and services produced in an economy, with prices held constant from a base year. When there is an increase in real output GDP, this means that an economy has produced more goods and services than the previous year and the economy has experienced economic growth. Growth will result in a higher standard of living for individuals because more goods and services are being produced and household incomes will rise because firms will have to use additional resources to increase output. As part of using additional resources to make goods and services firms will hire additional workers or pay existing workers overtime. As household incomes increase, consumption spending will increase and aggregate demand will shift outward. A goal of government is economic growth because government income will increase and expenditure will fall because it will collect more in direct tax because more individuals are employed. Government pays less transfer payments because more people have a job (employment). Indirect tax receipts for the government will increase because as household consumption spending increases firms will collect more Goods and Services Tax (GST) and pass this on to the government. An AD/AS model can be used to illustrate economic growth as illustrated below, with the increase in real output GDP shown as the change from Y1 to Y2. Price level (PL) Economic growth as a result of an increase in aggregate demand AS Economic growth as a result of an increase in aggregate supply Price AS level (PL) AS2 PL2 AD2 PL1 PL1 AD PL2 AD Y1 Y2 Real output GDP (Y) Y1 Y2 Real output GDP (Y) Growth will benefit firms because they will generate higher revenue and profits due to greater consumption spending by households as household incomes increase. However, firms may face increased costs because of the need to bid these resources away from other industries. If inflation occurs firms may need to charge higher prices for the products they sell making them less price competitive in either domestic or overseas markets. Growth may cause the current account to deteriorate because economic growth leads to higher disposable incomes that can lead to higher spending on imported goods and services e.g., cars, overseas trips. As import payments increase the current account will become a greater deficit or smaller surplus. 50 Subscribe to elearneconomics at: ISBN (Student s book)

51 Questions: economic growth (real output GDP) (a) Define real GDP. Real GDP measures the value of output using a base year. Real GDP is the market value of all goods and services produced in an economy, in constant dollars. (b) Describe the link between real GDP and economic growth. Real GDP is the total market value of all goods and services produced in an economy, with prices held constant from a base year. When there is an increase in real output GDP, this means that an economy has produced more goods and services than the previous year and the economy has experienced economic growth. (c) Why is economic growth a goal of government? Growth will result in a higher standard of living for individuals because more goods and services are being produced and households incomes will rise because to increase output firms will have to use additional resources. As part of using additional resources to make goods and services firms will hire additional workers or pay existing workers overtime. As households incomes increase, consumption spending will increase and aggregate demand will shift outward. A goal of government is economic growth because government income will increase and expenditure will fall because it will collect more in direct tax because more individuals are employed and it will pay less transfer payments because more people have a job (employment). Indirect tax receipts for the government will increase because as household consumption spending increases firms will collect more Goods and Services Tax (GST) and pass this on to the government. During a period of economic growth the size of a government operating surplus will increase or the operating deficit will become smaller. ISBN (Student s book) Subscribe to elearneconomics at: 51

52 Core: The current account The current account consists of the following four accounts: (i) The balance of goods which is the export of goods minus the import of goods, e.g., meat, oil, timber, cars. (ii) The balance of services which is the export of services minus the import of services, e.g., tourism, education, insurance, transport. (iii) The balance on income from profit, interest and dividends. (iv) The balance on current transfers which includes gifts, foreign aid and money sent to relatives and friends. An improvement in the current account (a greater surplus or a smaller deficit) will arise if export receipts increase, import payments fall and/or export receipts rise faster (or fall slower) than import payments. The quantity of goods and services that New Zealand exports depends on several factors, i.e., the value of the New Zealand dollar, the quality of New Zealand-made products, overseas countries incomes, tastes and preferences, the price of overseas countries substitute goods and services. When the New Zealand dollar appreciates, New Zealand goods and services become less price competitive and the quantity demanded for them may fall. As incomes rise in overseas countries then these countries may demand more New Zealand goods and services. The demand for New Zealand dairy and meat products can depend on the perceived real or imagined quality of these products by overseas consumers. Bad press or publicity over the quality of commodities will influence the demand for exports and therefore export earnings. The quantity of goods imported into New Zealand depends on the factors similar to those that determine the demand for our exports. As New Zealand household incomes rise households may buy a greater number of luxury items such as a new car or electrical goods, or decide to travel. Economic growth in New Zealand will result in higher disposable incomes with some of this increased income spent on imported goods (e.g., cars, electrical products) and services (e.g., overseas travel), this will impact on the current account. Inflation in New Zealand will impact on the current account because an increase in the rate of inflation in New Zealand will mean that New Zealand firms will have to increase prices to cover costs and maintain profit margins. As prices increase for New Zealand-made products they will be less price competitive overseas. Export sales are likely to fall causing lower export receipts. Imported products are likely to be more price competitive compared with New Zealand made products, with consumers buying more imports. As import payments increase and export receipts fall the current account balance is likely to deteriorate, i.e., there will be a smaller surplus or greater deficit. Export receipts (X) Import payments (M) 52 Subscribe to elearneconomics at: ISBN (Student s book)

53 Questions: The current account (a) List the components of the current account balance of the balance of payments. The balance of goods, the balance of services, the balance on income and the balance on current transfers. (b) Which component of the current account would the following transactions be recorded. Transaction Component of current account (i) New Zealand apples. Balance on goods (ii) A foreign film crew working in the South Island. Balance on services (iii) Honey from Hawke s Bay. Balance on goods (iv) Competitors for a world championship event in New Zealand. Balance on services (v) Transport by Maesrk (a foreign owned shipping firm). Balance on services (vi) Australian owned bank profits. Balance on income (vii) Dividends earned by overseas shareholders of a New Zealand Balance on income power company. (viii) Dairy products from the Waikato. Balance on goods (ix) Overseas students attending a university in New Zealand. Balance on services (c) State some factors that will determine the level of exports. The quality of New Zealand made goods and services, overseas countries tastes and preferences, the price of overseas countries substitutes, goods and services, the value of the New Zealand dollar, overseas countries income. (d) With reference to low inflation in New Zealand explain how the current account could improve. Inflation in New Zealand will impact on the current account because a decrease in the rate of inflation in New Zealand will mean that New Zealand firms who export will become more price competitive because they are less likely to increase their prices to cover costs and maintain profit margins. Exports will be more price competitive. Export sales are likely to increase causing higher export receipts. Imported products are likely to be less price competitive compared with New Zealand-made products, with consumers buying fewer imports. Overall, as export receipts increase and import payments decrease the current account balance is likely to improve, i.e., be a smaller deficit or greater surplus. ISBN (Student s book) Subscribe to elearneconomics at: 53

54 Inflation: A comparison of values Terms/Ideas Nominal and real values, real wages, real interest rates, real GDP. Nominal and Real Values A nominal value is the money value in current year prices and can be used for comparison within a year. A real value is in constant dollars and can be used for comparison over a number of years. Real values are adjusted to take into account changes in the general (average) price level. Nominal and Real Wages The nominal wage is the return to labour measured in current dollars or the money wage received by wage and salary earners in the workforce. The real wage or purchasing power of wages is the nominal wage adjusted for changes in inflation. If inflation increases and nominal wages remain constant, individuals can buy fewer goods and services than before. Their purchasing power or real wage has fallen. To calculate real wages when the inflation rate is given, the real wage equals the nominal wage minus the inflation rate, for example, if nominal wages increased by 4.2% and the inflation rate is 2.8%, then real wages have increased by 1.4% (4.2% 2.8%). It is possible for an individual to have an increase in nominal wages but a fall in real wages, e.g., if nominal wages increase by 2% while the price level (or inflation) increased by 2.5%, then real wages have declined by 0.5%. Nominal and Real Interest Rates The nominal rate of interest is the price paid for the use of money. The real rate of interest is the rate of return after inflation (the price level) has been allowed for. The real rate of interest may be calculated by subtracting the rate of inflation from the nominal rate of interest. If the nominal interest rate is 5% and the inflation rate is 2%, then the real interest rate is 3% (that is, 5% 2%). When there is an increase in the general price level (inflation) future prices will be greater, therefore the real value of savings (its purchasing power) and the real interest rate are likely to decrease. Both these factors will discourage savings. An increase in the general price level is likely to encourage borrowing because the repayment of interest and the sum borrowed (i.e., the principal) is with lower-valued money. Inflation reduces the real value of the amount owed, because the sum repaid has less purchasing power. Households that are able to get a wage increase greater than the rate of inflation find that real incomes will increase, making debt repayments easier. Inflation may encourage households to borrow more now for spending to beat expected increases in the general price level. Nominal and Real GDP The value of national output (GDP) and the total incomes in producing that output can be shown in nominal terms or in real terms (i.e., the values are deflated using a price index). Nominal GDP refers to the value of output at current market prices, whereas real GDP refers to the nominal GDP adjusted for price changes relative to some base year. It is the changes in real GDP that allow for measuring economic growth in real terms and determining increases in the standard of living. Economic growth is indicated by a percentage increase in real output GDP Key Concepts and Definitions Nominal values Real value The money value of wages or national output (GDP) in current year prices. A real value adjusts a nominal value to take into account changes in the general price level. A real value is in constant dollars and allows for a comparison to be made over a number of years. 54 Subscribe to elearneconomics at: ISBN (Student s book)

55 STUDENT NOTES REAL VALUES Nominal wage the money wage actually paid to workers measured in current dollars. Real wage the purchasing power of wages, nominal wages adjusted for changes in the general price level. Real wages are in constant dollars and can be used for comparison over a number of years. Real wage % = Nominal wage % minus inflation rate %. Nominal wage % inflation rate % Real wage % 3.2% 2.7% 0.5% increase Nominal interest rate price paid for the use of money, e.g., 7% return on funds in a term deposit. Real interest rate is the nominal interest rate minus the inflation rate, for example, if the nominal interest rate was 7% and the inflation rate 4% the real interest rate is 3%. Nominal GDP is the value of national output at current market prices, i.e., the money value of all goods and services produced in an economy in a year. Real GDP is the value of output in an economy measured in constant prices. It is real GDP that allows for a comparison of changes in actual output between years so that changes in economic growth can be observed. Economic growth is indicated by a percentage increase in real output GDP. ISBN (Student s book) Subscribe to elearneconomics at: 55

56 Activities 1 (a) Distinguish between nominal wages and real wages. Nominal wages are the return to labour measured in current dollars, whereas real wages are wages adjusted for change in the level of prices. (b) (c) Complete the table. Nominal wage rate Inflation rate Real wage % % % (i) (ii) (iii) Indicate if the following statements are correct or incorrect. (i) Nominal wages are the actual dollars that are paid for any job. correct (ii) Real wages are a measure of the ability of nominal wages to buy goods and services. correct (iii) Real wages adjust nominal wages for any change in the general price level, inflation. correct (d) Define the terms below. (i) Rate of interest: price paid for the use of money (ii) Real interest rate: rate of return after inflation has been allowed for (e) (f) Complete the table. Nominal interest rate % Inflation rate % Real interest rate % (i) (ii) The rate of inflation increases from 2% to 3% p.a. while at the same time interest rates rise from 7.75% to 9.75%. What has happened to real interest rates from year to year? Real interest rate = Nominal interest rate Inflation rate 7.75% 2% = 5.75% Real interest rates increased by 1% 9.75% 3% = 6.75% (from 5.75% to 6.75%) (g) What is the inflation rate if the real interest rate was 4% and the nominal interest rate was 7%? Inflation rate = Nominal interest rate Real interest rate = 7% 4% = 3% 56 Subscribe to elearneconomics at: ISBN (Student s book)

57 2 (a) Complete the table. (b) Year Nominal GDP $m Real GDP # $m Percentage change in Nominal GDP Percentage change in Real GDP # in Year 4 prices Explain the difference between nominal GDP and real GDP. Nominal GDP measures GDP in current prices whereas real GDP measures the value of output using base year or constant prices, to see if there is an actual increase in output. (c) Economic growth is best measured by changes in: Nominal GDP Real GDP (Circle your choice) (d) (e) Given that the general price level rose by 2.60% in Year 2, complete the table with an appropriate rate of inflation to show what is described. Description Percentage change in the general price level (i) Year 3 Inflation >2.60% (ii) Year 3 Disinflation Above 0 but below 2.60% (iii) Year 3 Deflation negative % figure Describe the following terms. (i) Inflation A rise in the general price level. (ii) Disinflation When the rate of inflation is falling, i.e., when inflation is occurring but at (f) a lower rate than the previous year Explain the reason for the error in this statement: Inflation has to be higher than 2.5% because the price of postage has gone up by 12%. If postage prices go up by 12% then this is the price rise for one product. Inflation of 2.5% implies that the average of all prices has risen by this amount in the whole economy. (g) Complete the table below. Statement Economic term or idea (i) A fall in the inflation rate disinflation (ii) A fall in the general price level deflation (iii) A rise in the general price level of a country inflation (iv) A value that refers to the face value of something nominal value (v) A value that is inflation adjusted real value (vi) A reference point for an index from which all other values are compared base year ISBN (Student s book) Subscribe to elearneconomics at: 57

58 Review (Exam) Questions Question One: Nominal and real values Workers are likely to be more concerned with real wages rather than nominal wages. Complete (a) and (b) to comprehensively explain nominal and real values. (a) Explain in detail the difference between nominal wages and real wages. In your answer you should: Complete the missing values in the table. Explain the difference between nominal and real wages. Explain how real wages are calculated and how an individual might have an increase in nominal wages but a fall in real wages. Year Nominal wage settlement Inflation rate Real wage 1 2% increase 2.5% increase 0.5% decrease 2 nil (zero) 3.0% 3.0% decrease 3 4.2% 2.8% 1.4% The nominal wage is the return to labour measured in current dollars or the money wage received by wage and salary earners in the workforce. The real wage or purchasing power of wages is the nominal wage adjusted for changes in inflation. If inflation increases and nominal wages remain constant, individuals can buy fewer goods and services than before. Their purchasing power or real wage has fallen. Workers will probably supply additional labour in response to a higher real wage. To calculate real wages when the inflation rate is given, the real wage equals the nominal wage minus the inflation rate, for example, if nominal wages increased by 4.2% and the inflation rate is 2.8%, then real wages have increased by 1.4% (4.2% 2.8%). It is possible for an individual to have an increase in nominal wages but a fall in real wages, as is the case in Year 1 as nominal wages increased by 2% while the price level (or inflation) increased by 2.5%, then real wages declined by 0.5%. 58 Subscribe to elearneconomics at: ISBN (Student s book)

59 Real values tell more than nominal values Real GDP is a better measure of economic growth than nominal GDP. Nominal GDP increased from $ million to $ million in Real GDP increased from $ million to $ million. (b) Discuss the difference between nominal GDP and real GDP. In your answer you should: Define real GDP and nominal GDP, and explain why real GDP is a better measure of economic growth. Given that the Government had a macro-economic goal to achieve 3.5% economic growth, use the data to explain whether this goal was achieved. Nominal GDP measures the total market value of all final goods and services produced in an economy in a year and measured in the current year prices. Nominal GDP may increase despite the fact that fewer goods and services are produced, i.e., an increase in nominal GDP may be caused by an increase in the general price level (inflation) without any increase in output or in fact output may fall. Real GDP is the total market value of all final goods and services produced in a year measured in constant prices. Real GDP has the effects of inflation removed, therefore real GDP will reflect changes in real output. An increase in real GDP means that more goods and services have been produced when compared with the previous time period, which signifies that economic growth has taken place. Real GDP is a better measure of increases in national output or the purchasing power of national income because it deflates nominal GDP to remove changes caused by inflation by using a price index to remove the effects of changes in the general price level. Economic growth is calculated using the percentage change in real GDP. The figures provided show a growth rate of 2.27%, therefore the government goal of economic growth of 3.5% was not achieved. ISBN (Student s book) Subscribe to elearneconomics at: 59

60 Inflation: The business cycle and inflation Terms/Ideas An individual price rise, a general price rise, inflation, deflation, disinflation, the business cycle. Changes in the Price Level An increase in general price level reflects an increase in the average level of all goods and services in the entire economy rather than an increase in the price of a particular good or service or in several markets. In individual markets prices for various goods or services may have fallen, risen or remained constant. Changes in the general price level are measured by changes in the Consumer Price Index (CPI). To calculate the change in the general price level, we use the formula below. Rate of inflation (%) (or change in general price level) = change in index numbers original index number 100 For example: The Consumer Price Index in Year 1 was and in Year 2 was Rate of inflation (%) (or change in the general price level) ( ) = = 3.61%. The Rate of Inflation Inflation can be defined as a general increase in the price level of a nation over a period of time. An increase in the price of a particular good or service does not mean that inflation has occurred. Inflation means the average level of prices is rising and a dollar will buy less now compared with a previous time period, i.e., the purchasing power of the dollar is falling. Creeping inflation is a constant, slow, annual increase in the rate of inflation. Hyperinflation is a situation in which the price level rises at a very rapid rate. The value of money declines rapidly and people lose confidence in the currency. Disinflation is the term that describes the process of reducing or eliminating inflation. Disinflation occurs when the rate of inflation is falling, i.e., the average price level is increasing but by a smaller percentage than before. Deflation is the opposite of inflation and occurs when the general price level is falling. Inflation is a negative and the Consumer Price Index will be falling. In times of deflation individuals may be put off spending because they expect prices to fall, this may cause economic activity to slow down. The table below shows inflation, disinflation and deflation. Year Consumer Price Index (CPI) Rate of inflation Term (or description) Reason not applicable not applicable not applicable = 3.10% inflation A rise in the general price level = 3.59% inflation A rise in the general price level inflation The rate of inflation is falling i.e., inflation 100 = 1.12% disinflation is occurring but at a slower rate = 2.78% deflation The general price level is falling 60 Subscribe to elearneconomics at: ISBN (Student s book)

61 Inflation and the Business Cycle A link exists between the rate of inflation and the phases of the business cycle. In a boom, where the overall demand for goods and services exceeds the economy s capacity to sustain the supply of goods and services, the inflation rate is likely to increase. The reason for this can be that the shortage of raw materials forces firms to bid scarce resources away from other industries and this puts upward pressure on prices and the rate of inflation tends to rise. Similarly, when the economy s capacity to produce is greater than demand, then the rate of inflation will tend to fall. In a recession or a depression where there are high levels of unemployment and the economy and firms have spare capacity (because machines are idle) there is less pressure on prices, so inflation rates tend to fall. Fluctuations in Economic Activity The business cycle (sometimes called the trade cycle) describes the recurring fluctuations in economic activity experienced by most economies. These fluctuations in economic activity typically follow four phases expansion, peak, contraction and trough, as shown in the wavelike motion of the graph. These phases can vary in intensity and the length of time over which they occur. The level of economic activity in an economy is likely to vary continuously because economic conditions change on an irregular basis e.g., levels of business confidence, consumer spending patterns and world events. the business cycle Positive Real GDP % change Boom (Peak) Recession Downswing Contraction Expansion Upswing Recovery Boom (Peak) Time Negative Trough (Depression) In the boom phase there is a period of increasing economic activity during which unemployment is falling, investment is taking place and prices are rising. In the recession phase there are increasing levels of unemployment, decreasing levels of investment and more business failures. A recession is said to occur if an economy experiences two or more consecutive quarters of negative growth (i.e., a fall in real GDP). The depression phase is characterised by significant numbers of unemployed, very low levels of business confidence and a slowing of price rises. Economies, sooner or later, emerge from a recession into a period of economic growth (a recovery). ISBN (Student s book) Subscribe to elearneconomics at: 61

62 Key Concepts and Definitions Inflation Disinflation Deflation Consumer Price Index (CPI) A rise in the general level of prices over a period of time. Occurs where the rate of inflation is falling, i.e., the price level is rising but by a smaller percentage than before. Occurs when there is a fall in the general price level. A weighted index which measures the movements in price of a typical basket of household goods and services that represent the average household expenditure pattern. It is used as a measure of inflation. Rate of inflation % (or change in general price level) = change in index numbers original index number 100 Rise in the general price level Trade (business) cycle A general price rise occurs when the average level of prices increases, for example, the CPI rises from to 1 035, the average level of prices has risen by 3.50%. The recurring fluctuations in economic activity that an economy experiences over a number of years from boom to depression to recovery again. Positive the business cycle Real GDP % change Boom (Peak) Recession Downswing Contraction Expansion Upswing Recovery Boom (Peak) Time Negative Trough (Depression) Boom Depression A phase of the business cycle characterised by a peak in economic activity with unemployment falling and possible inflationary pressures. A phase of the business cycle characterised by a severe decline in the level of economic activity. Output and investment will be at very low levels and there is a high rate of unemployment. 62 Subscribe to elearneconomics at: ISBN (Student s book)

63 STUDENT NOTES INFLATION/DISINFLATION/DEFLATION Time period (year ended) Consumer Price Index Percentage change in general price level Inflation or deflation (and also where appropriate, disinflation) Jun Sep deflation Dec inflation March inflation Jun inflation/disinflation Inflation is a general increase in the price level over a period of time. Inflation means the average level of prices is rising and a dollar will buy less now compared with a previous time period, i.e., the purchasing power of the dollar is falling. Disinflation is the process of reducing or eliminating inflation. Disinflation occurs when the rate of inflation is falling, i.e., the price level is increasing but by a smaller percentage than before. Deflation occurs when the general price level is falling. Inflation is a negative. BUSINESS CYCLE/TRADE CYCLE The business cycle measures the activity of the economy through recessions, recoveries and booms. In a boom period the rate of inflation is likely to increase because the demand for goods and services is likely to be greater than the economy s capacity to supply the goods and services. Upward pressure is placed on prices as firms bid scarce resources away from other industries, increasing firms costs of production, causing cost-push inflation. In a down-swing period the rate of inflation is likely to decrease because there is less pressure on prices as the ability of the economy to supply goods and services is greater than the demand. Positive The business cycle Real GDP % change Boom (Peak) Recession Downswing Contraction Expansion Upswing Recovery Boom (Peak) Time Negative Trough (Depression) ISBN (Student s book) Subscribe to elearneconomics at: 63

64 Activities 1 (a) Rearrange the following words to represent the typical sequence of phases that indicate the fluctuations of activity in the business cycle. Start with the word expansion. Expansion Trough Peak Expansion Recession Sequence: Expansion Peak Recession Trough Expansion (b) Match the following words/phrase below to the statements in the table. recovery or upswing downswing or contraction depression boom Statement Word/Phrase Statement Word/Phrase Trough depression Peak boom Recession downswing or contraction Expansion recovery or upswing (c) Indicate if the following statements in the table below are correct or incorrect. (i) The intensity of troughs in a business cycle can vary. correct (ii) The trade cycle follows such a stable pattern, it makes the task of predicting the next phase simple. incorrect (iii) It is possible that a peak in the business cycle could be accompanied by significant correct unemployment. (iv) It is likely that economic conditions of business confidence, interest rates, levels of correct inflation, unemployment and consequently economic activity change continuously. (v) A recovery in an economy may only be partial (i.e., without attaining a peak) with another slump following closely on a past trough. correct (vi) A recession is said to occur if two or more consecutive quarters of negative correct growth are experienced. (vii) In a recession an economy operates inside its PPC and resources are under-utilised. correct (viii) In a boom time there are inflationary pressures as firms compete for scarce correct resources. output (d) Use the diagram to identify the points labelled A to D in the table below. the business cycle Part of the business Points C cycle Potential GDP D A trough/depression B recovery/expansion B Actual GDP C boom/peak A D downturn/downswing/ recession (e) (f) time What is the name given to the regular fluctuations in economic activity that a country experiences over a number of years from boom to depression to recovery again? The trade (or business) cycle. Explain the link between the business cycle and inflation rates. When the overall demand for goods and services exceeds the economy s capacity to sustainably supply goods and services then inflation will rise. Similarly, when the economy s capacity to produce is greater than demand, then the rate of inflation will tend to fall. 64 Subscribe to elearneconomics at: ISBN (Student s book)

65 2 (a) Complete the table (show your working). (b) Year Index Percentage change in the general price level Not applicable = 8.30% 100 = 3.88% Complete the table below by: (i) selecting the term which best describes the rate of inflation in Year 2 and Year 3 from the following list inflation, disinflation or deflation. (ii) Give a reason to justify each term you select. Year Term Reason 2 Inflation A rise in the general price level by 8.30% 3 Disinflation The rate of inflation is falling, i.e., inflation is occurring but at a lower rate than the previous year, i.e., 3.88% compared with 8.30%. (c) (d) Complete the table and calculate the general price level change. Show your working. Year Index General price level change Not applicable = 5.90% = 1.13% Tuckshop prices Pies $ Sausage rolls Rolls 3.50 Distinguish between an individual price rise and a general price rise by explaining what each is. Support your answers with examples from the information above. Individual price rise: Explanation: An individual price rise occurs when the price of a particular product rises. Example: The price of pies rose from $2.50 to $3.00 in the school tuckshop. General price rise: Explanation: A general price rise occurs when the average level of prices increases. Example: The index rose from to 1 059, an inflation rate of 5.90%. or The index rose from to 1 071, an inflation rate of 1.13%. (e) Give the economic term when: (i) The Consumer Price Index is falling. Deflation (ii) Inflation is negative. Deflation (iii) There is an increase in the general price level. Inflation (iv) There is a fall in the rate of inflation. Disinflation (v) There is a fall in the percentage increase of the CPI. Disinflation ISBN (Student s book) Subscribe to elearneconomics at: 65

66 3 Use the data in the tables below to answer the questions that follow. Quarter Year 1 Percentage change in real GDP March 3.5 June 3.5 September 2.8 December 2.0 Quarter Year 2 Percentage change in real GDP March 1.5 June 0.5 September 0.5 December 1.2 Quarter Year 3 Percentage change in real GDP March 0.5 June 1.0 September 2.5 December 4.0 (a) Create a bar graph in the grid provided below, to display the data from the table above. Bar graph of the percentage change in real GDP for year 1 to year Percentage change in real GDP 1 1 S D M J S D M J M J S D One Two Three Year (b) (i) In what quarter was the growth rate the highest? December Year 3 (ii) Identify one quarter when real GDP fell. September Year 2 or December Year 2 (c) (d) When was this economy in recession? Justify your answer. September/December Year 2 because a recession is said to occur if two or more consecutive quarters of negative growth are experienced. Describe the business cycle. The business cycle measures the activity of the economy through recessions, recoveries and booms. (e) Explain how inflation may occur in the recovery and boom phase of the business cycle. (i) Recovery phase: Employment starts to increase and unemployment will fall. Incomes will rise and demand for goods and services will increase. The price level starts to rise (called inflation). (ii) Boom phase: Employment is near its peak, unemployment is very low. Incomes high/rising quickly so demand for goods and services is very high. Prices may also be rising rapidly. 66 Subscribe to elearneconomics at: ISBN (Student s book)

67 Economic growth in countries like China and India has resulted in an increase in the price of oil. Price $US per barrel P1 P World oil market S Q Q1 d d Quantity (barrels) 4 (a) Illustrate the effect of increased demand for oil on the world market. Label the new equilibrium price and quantity as P1 and Q1 respectively. (b) (i) State the situation that would exist in the market if the price remained at the original equilibrium P. Shortage or excess demand (ii) Explain the market forces that result in the new equilibrium price and quantity, at P1 and Q1. The increase in demand creates excess demand or a shortage at the original equilibrium P. Consumers will bid prices up to price P1. The increase in price to P1 causes an increase in quantity supplied to Q1. Equilibrium is restored at P1 because quantity demanded equals quantity supplied. (c) Complete the table with the correct term(s). Time period Percentage change in the general price level Year Deflation Year Inflation Year Inflation Term(s) Year Disinflation/Inflation (d) Is a price rise in a particular market the same as a rise in the general price level? Justify your answer. No. A price rise in a particular market indicates a rise in the price of a single good or service whereas a rise in the general price level means that inflation is occurring and the average price level of all goods and services has increased. ISBN (Student s book) Subscribe to elearneconomics at: 67

68 Review (Exam) Questions Question One: Inflation and the business cycle The Consumer Price Index (CPI) fell 0.5% in the March quarter. In the June quarter it increased 0.4% and it is predicted to increase by 0.2% in the September quarter. The price of cellphone calls went up in the March quarter 1.3%. Complete (a) and (b) to comprehensively explain the link between inflation and the business cycle. (a) Explain the changes in the general price level and the rise in a particular market. In your answer you should: State and explain the economic term that describes what the change in the CPI indicates about the general price level in the March, June and September quarters. Explain why an increase in cellphone calls is not considered inflation. When the CPI fell by 0.5% in the March quarter deflation took place, this means that inflation is negative OR that the general level of price is falling. In the June quarter the increase of the CPI of 0.4% indicates that inflation has taken place, meaning there has been an increase in the general price level. The predicted change of 0.2% in the September quarter indicates that disinflation could take place because this indicates there will be a fall in the rate of inflation. The increase in the price of cellphone calls by 1.3% is a price increase in one market only. For inflation to occur there must be an increase in the general price level. 68 Subscribe to elearneconomics at: ISBN (Student s book)

69 Disinflation and inflation are likely to occur in different phases of the business cycle. (b) Analyse the link between changes in the general price level and phases of the business cycle. In your answer you should: Label the diagram below appropriately and identify the stage of the business cycle during which disinflation and inflation will occur. Compare and contrast how different stages of the business cycle affect inflation. Positive + Percentage change in Real GDP Boom the trade cycle Disinflation will occur in the Recession Downswing Contraction Recovery Upswing Expansion Boom/Inflation will occur Time Negative Depression Disinflation is a decline in the inflation rate. It is likely to occur in a downswing/contraction/ recession or depression of the business cycle because consumption and investment spending are likely to decrease and economic activity will be declining. OR the economy will have excess capacity/idle resources due to economic activity declining. Inflation is an increase in the general price level, it is likely to occur in the boom (peak) phase of the business cycle because in a boom, the overall demand for goods and services exceeds the economy s capacity to sustainably supply the goods and services. The inflation rate is likely to increase because there can be a shortage of raw materials that forces firms to bid scarce resources away from other industries and this puts upward pressure on prices and the rate of inflation tends to rise. As costs of production increase, profits decrease and AS shifts inward, causing the general level of prices to increase (cost-push inflation). ISBN (Student s book) Subscribe to elearneconomics at: 69

70 Question Two: The general price level and the business cycle A change in the general price level can mean one of several things. Complete (a) and (b) to analyse changes in the general price level and stages of the business cycle. (a) Explain what a change in the general price level can indicate. In your answer you should: Explain the term inflation with reference to creeping inflation and hyperinflation. Explain the term disinflation. Explain the term deflation. A change in the general price level could indicate or mean that inflation has taken place. Inflation can be defined as a general increase in the price level of a nation over a period of time. An increase in the price of a particular good or service does not mean that inflation has occurred. Inflation means the average level of prices is rising and a dollar will buy less now compared with a previous time period, i.e., the purchasing power of the dollar is falling. Creeping inflation is a constant, slow, annual increase in the rate of inflation. Hyperinflation is a situation where the price level rises at a very rapid rate, the value of money declines rapidly and people lose confidence in the currency. A change in the general price level could also mean that disinflation or deflation has taken place. Disinflation is the term that describes the process of reducing or eliminating inflation. Disinflation occurs when the rate of inflation is falling, i.e., the average price level is increasing but by a smaller percentage than before. Deflation is the opposite of inflation and occurs when the general price level is falling. Inflation is a negative and the Consumer Price Index will be falling. In times of deflation individuals may be put off spending because they expect prices to fall, this may cause economic activity to slow down. 70 Subscribe to elearneconomics at: ISBN (Student s book)

71 During various stages of the business cycle there will be changes in the general price level. (b) Compare and contrast changes in the general price level during different phases of the business cycle. In your answer you should: Explain the link between inflation rates and the business cycle. A link exists between the rate of inflation and the phases of the business cycle. In a boom, where the overall demand for goods and services exceeds the economy s capacity to sustainably supply the goods and services, the inflation rate is likely to increase. The reason for this can be that the shortage of raw materials forces firms to bid scarce resources away from other industries and this puts upward pressure on prices and the rate of inflation tends to rise. Similarly, when the economy s capacity to produce is greater than demand, then the rate of inflation will tend to fall. In a recession or a depression where there are high levels of unemployment and the economy and firms have spare capacity (because machines are idle) there is less pressure on prices, so inflation rates tend to fall. ISBN (Student s book) Subscribe to elearneconomics at: 71

72 Inflation: The quantity theory of money (MV PQ) Terms/Ideas The quantity theory of money, components of the quantity theory of money equation. The Quantity Theory of Money is derived from the Equation of Exchange which states M V P Q where M equals the money supply and V equals the velocity (or speed) of circulation, i.e., the number of times money changes hands in a given period in order to finance transactions, P equals the general price level and Q (or Y) equals the level of real output (i.e., the volume of transactions or number of goods purchased). The Equation of Exchange is written with three bars to indicate that it is an identity, i.e., it is always true because of the way that the terms have been defined. The money supply multiplied by the number of times each dollar circulates in an economy (M V) must equal the value of nominal Gross Domestic Product (GDP) or national output (P Q). The value of the Equation of Exchange lies in the fact that it identifies different factors which may influence the value of money. The equation represents a refinement of the crude quantity theory of money which held price changes were directly proportional to changes in the quantity of money. This is significant for an economy because ceteris paribus, an increase in the money supply would lead to an increase in the price level (inflation). The crude quantity theory assumed V and Q are constant but evidence shows this is not the case. When prices rise rapidly people will be reluctant to hold money because it is losing purchasing power so they will exchange it for goods and services as quickly as possible. The sophisticated quantity theory acknowledges that velocity is a variable but is relatively predictable so that if the Central bank can predict velocity it should be able to influence nominal Gross Domestic Product by controlling the money supply. Economists acknowledge the role of money in inflation, however, the causes of inflation involve other factors as well. In a recovery period (upswing) of the business cycle, there is likely to be spare or idle capacity in the economy as resources are not fully used. Therefore the increase in output or production (Q) that results due to the recovery is likely to reduce the impact on the price level (P) when the money supply (M) increases. In a boom (peak) period of the business cycle the economy is operating at or near full capacity and there is likely to be a shortage of resources which will result in firms attempting to bid scarce resources away from each other. The restricted ability of output or production (Q) to increase when the money supply (M) increases is likely to result in significant increases in the price level. Key Concepts and Definitions Equation of exchange Quantity Theory Limitations of the quantity theory of money MV PQ is an expression that is used in the quantity theory of money, where M = money supply V = velocity of circulation P = value or price of each transaction/price level in an economy Q = real output/volume of transactions/number of goods purchased Asserts that if the money supply increases, then inflation will increase assuming that V and Q are unchanged (constant). The equation assumes that V and Q are unchanged but this can change, e.g., if V and Q change then increases in M may cause an increase in Q while P remains unchanged, so increases in M do not necessarily lead to increases in P. 72 Subscribe to elearneconomics at: ISBN (Student s book)

73 STUDENT NOTES MV PQ Components of the equation of exchange: M = money supply V = velocity of circulation P = price level Q = real output The relationship suggested by the equation of exchange is that as the money supply (M) increases (decreases) the rate of inflation also increases (decreases). The quantity theory of money asserts that an increase in the money supply (M) can result in an increase in the general price level (inflation) if the velocity of circulation (V) and the real output (Q) remain relatively constant. Given that the money supply (M) is held constant, inflation might occur if the real output (Q) in the economy falls or if the velocity of circulation (V) increases. Real output (Q) may be relatively constant at the top end of the business cycle because the economy is near full capacity (i.e., the peak), resources are almost fully employed and real output (Q) has little or no room to expand any further. In a recovery period (upswing) of the business cycle, there is likely to be spare or idle capacity in the economy as resources are not fully used. Therefore the increase in output or production (Q) that results due to the recovery is likely to reduce the impact on the price level (P) when the money supply (M) increases. In a boom (peak) period of the business cycle the economy is operating at or near full capacity and there is likely to be a shortage of resources which will result in firms attempting to bid scarce resources away from each other. The restricted ability of output or production (Q) to increase when the money supply (M) increases is likely to result in significant increases in the price level. ISBN (Student s book) Subscribe to elearneconomics at: 73

74 Activities The equation of exchange states that MV PQ 1 (a) The equation is an identity. Explain what this means. (b) The equation of exchange is written with three bars to indicate that it is an identity, i.e., it is always true because of the way that the terms have been defined. The money supply multiplied by the number of times each dollar circulates in an economy (M V) must equal the value of nominal Gross Domestic Product (GDP) or national output (P Q). Which symbol in the equation represents: (i) The price level in an economy? P (ii) Real output (GDP)? Q (iii) The number of times money changes hands in a given period (usually one year) in order to finance transactions? V (c) (i) Describe how changes in the money supply might affect inflation. If the money supply increases then inflation will increase assuming that V and Q are unchanged (constant). (ii) Explain one limitation of the quantity theory of money. Equation assumes that V and Q are unchanged but this can change, e.g., if V and Q change then increases in M may cause an increase in Q while P remains unchanged, so increases in M do not necessarily lead to increases in P. (d) (i) Define velocity of circulation. Velocity of circulation is the number of times money changes hands in a given period (usually one year) in order to finance transactions. (e) (ii) Write an equation to work out the variable V. V = PQ M (iii) Calculate V given the following information. M was $24 000m and PQ was $ m. V = $ m $24 000m = 7 Read the extract and answer the question that follows. Gross domestic product (the value of output) for one year was $ million, but the money supply was only $8 198 million. Is it possible that the quantity of money is less than the value of all transactions in the economy? Justify your answer. Yes, because of the idea that the money changes hands rapidly, and is used over and over to finance transactions. Therefore the quantity of money is less than the value of all the transactions. Each unit of money on average was used eleven and a half times to finance transactions during the year. i.e., V = GDP = $94 277m M $8 198m = Subscribe to elearneconomics at: ISBN (Student s book)

75 MV PQ 2 Use the equation above to compare and contrast the effect on the general price level of an increase in the money supply. In your answer you should: State the name of the equation and identify the components in the equation. Explain how increases in M affect P and how there is likely to be a difference in the recovery and boom phases of the business cycle. MV PQ is the equation of exchange. The components or variables are: M = money supply V = velocity of circulation P = price level Q = real output If the money supply (M) increases then inflation (an increase in the general price level) will increase, assuming that V and Q are unchanged (constant). In a recovery period (upswing) of the business cycle, there is likely to be spare or idle capacity in the economy as resources are not fully used. Therefore the increase in output or production (Q) that results due to the recovery is likely to reduce the impact on the price level (P) when the money supply (M) increases. In a boom (peak) period of the business cycle the economy is operating at or near full capacity and there is likely to be a shortage of resources which will cause firms to bid scarce resources away from each other. The restricted ability of output or production (Q) to increase when the money supply (M) increases is likely to result in significant increases in the price level (P). ISBN (Student s book) Subscribe to elearneconomics at: 75

76 3 (a) (i) State the equation of exchange. MV PQ (ii) Identify what variable in the equation represents: M = the Money supply V = Velocity of circulation P = the Price level Q = Quantity produced / real output (iii) Explain at what stage of the business cycle the variable Q is likely to be relatively constant. At the top end of the business cycle when the economy is near full capacity; i.e., resources are almost fully employed and the real output (Q) cannot expand further, Q may be relatively constant. Positive The business cycle Rate of economic growth 0 A Time Negative (b) Assume the economy is at point A. Fully explain, using the Quantity Theory of Money, the impact of an increase in the Money Supply on the price level during this stage of the business cycle. In your answer you should: State the stage of the business cycle A represents. Explain the impact on the other variables in the Quantity Theory of Money equation of an increase in the money supply during this stage. Explain how the economy being in this stage of the business cycle may influence the size of any impact on the price level. Point A represents the recovery (upturn) stage of the business cycle. The Quantity Theory of Money states that MV PQ. If the Money Supply (M) increases, then it is likely that spending will increase and this will result in the price level (P) also increasing. During a recovery phase of the business cycle it is likely that consumer confidence is low, and therefore the velocity of circulation (V) will be low, which will reduce the impact on the price level of an increase in the Money Supply (M). The level of output (Q) in a recovery is able to rise because resources are not being fully used and therefore this will reduce the impact on the price level (P) of an increase in the Money Supply (M). 76 Subscribe to elearneconomics at: ISBN (Student s book)

77 MV PQ P = MV Q V = PQ M 4 (a) Give the symbol for each of the variables used in the Quantity Theory of Money equation. M = the money supply V = the velocity of circulation Q = the real output GDP (b) P = the price level Describe the impact on the price level (P) of a decrease in the money supply (M), if the other factors remain constant. If the velocity of circulation (V) and the real output (Q) are held constant a decrease in the money supply (M) will decrease the price level (P) for the equation to be true. (c) Use the quantity theory to explain in detail the effect on the price level (P) of an increase of 4% in the velocity of circulation, if the other factors remain constant. The quantity theory of money states that the money supply (M) multiplied by velocity of circulation (V) must equal the price level (P) multiplied by the real output (Q). A 4% increase in the velocity of circulation (V) will increase the price level (P) by 4%, assuming that the money supply (M) and real output (Q), are constant for the equation to be true. (d) Use the quantity theory of money to compare and contrast the effect on the price level of an increase in the money supply, while the other variables remain unchanged, with a fall in consumer confidence that is accompanied by an increase in the money supply. An increase in the money supply will increase the price level by the same proportion (percentage) assuming V and Q are constant. A fall in consumer confidence will reduce the velocity of circulation because money is being spent at a lower rate, therefore reducing the price level. A fall in consumer confidence that is accompanied by an increase in the money supply may cause the price level to either increase, decrease or stay the same. The price level will increase if the percentage increase in the money supply is greater than the percentage decrease in the velocity of circulation. If the percentage increase in the money supply is less than the percentage decrease in the velocity of circulation the price level will fall. An increase in the money supply with the velocity of circulation held constant will increase the price level by the same percentage. ISBN (Student s book) Subscribe to elearneconomics at: 77

78 Review (Exam) Questions Question ONE: The quantity theory of money Borrowing by New Zealand households has continued to rise, the Reserve Bank of New Zealand is keeping a close eye on With reference to the quantity theory of money compare and contrast the effect on the price level of a decrease in the money supply with a decrease in the money supply that is accompanied with increased borrowing by households. Explain in detail which event will have a greater impact on the price level. The quantity theory of money states that MV PQ. A decrease in the money supply (M) will cause the price level (P) to decrease, assuming the velocity of circulation (V) and the real output (Q) remain constant, for the equation to remain true. An increase in household borrowing will increase the velocity of circulation because consumers will have greater means (funds) to fund or finance their spending on goods and services, this will result in an increase in the velocity (or speed) of circulation. If the money supply decreases at the same time as velocity increases then the change in the price level will depend on the relative change between both variables, assuming real output (Q) is constant. If the percentage increase in the velocity of circulation offsets the percentage decrease in the money supply then the price level will remain unchanged. If the percentage increase in the velocity of circulation is greater than the percentage decrease in the money supply then the price level will increase. The price level will percentage decrease if the decrease in the money supply is greater than the percentage increase in the velocity of circulation (assuming real output (Q) is constant). Overall a decrease in the money supply will cause a greater decrease in the price level because the velocity of circulation is assumed to be constant, than a decrease in the money supply accompanied by an undefined change in the velocity of circulation because this will determine whether the change in velocity of circulation (V) offsets the decrease in money supply or not. 78 Subscribe to elearneconomics at: ISBN (Student s book)

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80 Question two: The equation of exchange MV PQ Complete (a) and (b) to discuss the equation of exchange. (a) Explain the equation of exchange. In your answer you should: Identify each of the components of the equation. State and explain the economic theory that is based on the relationship in the equation. The components of the equation are: M = money supply V = the velocity or speed of circulation P = the general price level Q (or Y) = the level of real output The economic theory that is based on the relationship in the equation is the quantity theory of money. The value of the Equation of Exchange lies in the fact that it identifies different factors which may influence the value of money. The equation represents a refinement of the crude quantity theory of money which held that price changes were directly proportional to changes in the quantity of money. This is significant for an economy because ceteris paribus, an increase in the money supply would lead to an increase in the price level (inflation). The crude quantity theory assumes V and Q are constant but evidence shows this is not the case. When prices rise rapidly people will be reluctant to hold money because it is losing purchasing power, they will exchange it for goods and services as quickly as possible. The sophisticated quantity theory acknowledges that velocity is a variable but is relatively predictable so that if the central bank can predict velocity it should be able to influence nominal Gross Domestic Product by controlling the money supply. Economists acknowledge the role of money in inflation, however, the causes of inflation involve other factors as well. 80 Subscribe to elearneconomics at: ISBN (Student s book)

81 (b) Explain, using the Quantity Theory of Money, the impact on the price level of an increase in the money supply during the recovery phase of the trade cycle. If there is an increase in the money supply (M) with the other variables held constant, then there will be a proportionate increase in the price level (P). During the upswing or recovery phase of the trade (business) cycle, resources are not being fully utilised, then it is likely that there will be an increase in real output GDP (Q) which will reduce the impact on the price level (P) of an increase in the money supply. Also during the recovery phase consumer confidence could be low or decrease and the velocity of circulation will also be low or decrease, this will reduce the impact of an increase in money supply on the price level. ISBN (Student s book) Subscribe to elearneconomics at: 81

82 Question three: The trade cycle Latest news: Real GDP increased by 1.2% for the year and inflationary pressures are easing Complete (a) and (b) to comprehensively analyse the effects of the trade cycle on inflation. (a) With reference to the Quantity Theory of Money explain in detail the impact an increase in real output will have on the price level. The QTOM states that MV PQ where M is the money supply, V is the velocity of circulation, P is the price level and Q is real output GDP. An increase in real output GDP will result in the price level (P) falling, if all the other variables remain unchanged. By definition the equation must remain true, and if M and V are constant, then P must fall. 82 Subscribe to elearneconomics at: ISBN (Student s book)

83 (b) Discuss how the upswing stage of the trade cycle may affect inflation. In your answer, explain: why the velocity of circulation could increase during the upswing stage of the trade cycle and the impact on the price level of this increase in the velocity of circulation the overall impact on the price level of both real output and the velocity of circulation increasing during the upswing stage of the trade cycle. In the upswing stage of the trade/business cycle consumers are likely to be more confident about the future and their employment and income opportunities or their incomes might be rising because firms are increasing output and hiring more staff or paying overtime. These factors will result in an increase in the velocity of circulation (V) as spending in the economy increases. As consumption spending increases, aggregate demand and the price level will rise. The QTOM states that MV PQ, if the velocity of circulation (V) increases and all other factors remain unchanged then the price level (P) will increase for the equation to remain true. If the real output (Q) increases in the upswing phase then the increase in the price level will be reduced. ISBN (Student s book) Subscribe to elearneconomics at: 83

84 Inflation: Causes of inflation Terms/Ideas Causes of cost-push and demand-pull inflation, illustrate cost-push and demand-pull inflation, using the AD/AS model. A Shift in the AD/AS Model If the AD and/or AS curves shift there will be a change in the price level (or inflation) shown on the vertical axis, with the original price level labelled PL and new price level labelled PL' (or from PL1 to PL2). Changes in employment, national income and output are shown on the horizontal axis, with the original position labelled Y and new position Y' (or Y1 to Y2). Arrows are used to show the direction of the changes. An increase in output per worker (productivity) due to the use of new technology or a better educated workforce will lower costs for firms, causing the aggregate supply curve to shift outward (to the right). The price level will decrease (from PL1 to PL2) while national income, employment and output will increase (from Y1 to Y2). This situation is shown in the diagram below. Price level (PL) The AD/AS model AS AS PL1 PL2 Y1 Y2 AD Real output GDP (Y) Cost-push Inflation The causes of inflation are usually classified as cost-push or demand-pull. As the name implies, costpush inflation describes a situation where the process of rising prices is initiated and sustained by increasing costs which push up the general price level. Cost-push inflation can develop whenever prices are forced upwards by increases in the price of inputs used in the production process. Examples of inputs are cost of wages and salaries, raw materials, power, rent, rates, government charges (e.g., indirect taxes or fees) and many more. Some of the increases in costs firms face are a result of imported inflation. If there is inflation in the countries supplying a component required in the production process this will cause prices to rise. If the New Zealand dollar depreciates the cost of raw materials or components from overseas will rise. The increased costs faced by firms will cause AS to decrease and cause inflation. When faced with cost increases, firms frequently pass on part or all of the costs to consumers in the form of higher prices, rather than accept reduced profit margins. To qualify as a cause of inflation any increase in costs would need to be widespread. The increase in costs is indicated by the decrease in aggregate supply from AS to AS', with the price level rising from PL1 to PL2 as shown on the AD/AS model below. Price level (PL) AD/AS model: Cost-push inflation AS' AS PL2 PL1 AD 84 Subscribe to elearneconomics at: ISBN (Student s book) Y2 Y1 Real output GDP (Y)

85 Demand-pull Inflation Demand-pull inflation is a situation where demand exceeds supply at current prices, so prices are pulled up by aggregate demand. This inflation results from an increase in any of the components of expenditure on GDP that would increase aggregate demand. Some of the reasons for increased aggregate demand are: (i) rising household incomes due to direct tax cuts and increased transfer payments; (ii) increased investment by businesses due to lower interest rates or more confidence in the future prospects of the economy (iii) an export boom due to depreciation of the exchange rate. A falling New Zealand dollar results in exporters swapping foreign earnings for more New Zealand dollars. The increased earnings enable more spending so cause AD to increase and therefore inflation. (iv) an expansionary fiscal policy, i.e., a government budget deficit. (v) If individuals expect that prices will rise they will want to buy goods and services now, rather than wait until later, when they are more expensive and less affordable. By acting in this way inflation will rise faster than otherwise would be the case. This inflationary expectation will effectively increase aggregate demand and bring about demand-pull inflation. The graph of demand-pull inflation below shows prices being pulled up by increased aggregate demand. AD/AS model: Demand-pull inflation Price level (PL) AS PL2 AD2 PL1 AD Y1 Y2 Real output GDP (Y) Key Concepts and Definitions Cost-push inflation Demand-pull inflation Describes a situation where the process of rising prices is initiated and sustained by increasing costs which push up the general price level. Demand-pull inflation is a situation where demand exceeds supply at current prices, so prices are pulled up by aggregate demand. ISBN (Student s book) Subscribe to elearneconomics at: 85

86 STUDENT NOTES AD/AS MODEL To illustrate the effects of an economic event or situation on the AD/AS model the following conventions are followed: the appropriate AD and/or AS curves are shifted in the appropriate direction, with a label for the new curve with arrows drawn to indicate the direction of the change. the equilibrium price level is labelled PL2 (or PL ) and the new equilibrium real output GDP is labelled Y2 (or Y ) using dotted lines. Arrows are used to show the direction of the change in the price level and real output GDP. An increase in the price level will indicate that inflation has taken place. An increase in real output GDP indicates that economic growth has taken place, i.e., an increase in actual output in the economy and an increase in employment (or decrease in unemployment). Cost-push inflation Price level (PL) AS2 AS PL' PL AD Y' Y Real output GDP (Y) Cost-push inflation is inflation caused by rising costs of production, reflected by an inward (left) shift of the aggregate supply curve. The main sources of increase to the costs of production are an increase in nominal wages and an increase in the price of raw material. As costs of production increase, profits for firms decrease, so firms plan to produce less at each price level shifting AS left (inward). As the New Zealand dollar depreciates, imported raw materials are more expensive so costs of production for firms increase. Increased costs decrease profit, so AS shifts left causing the price level to increase. As productivity levels decrease, firms costs of production increase. Increased costs decrease profits, so firms plan to produce less at each price level thereby shifting AS left (inward), causing the price level (inflation) to increase. 86 Subscribe to elearneconomics at: ISBN (Student s book)

87 Demand-pull inflation Price level (PL) AS PL' AD' PL AD Y Y' Real output GDP (Y) Demand-pull inflation is inflation caused by increases in aggregate demand. When household disposable income increases (due to a direct tax cut or an increase in transfer payments) consumption spending (C) will increase and AD will increase. Interest rate cuts will result in households paying less on mortgages and credit cards, savings are likely to decrease and consumption spending (C) will increase, causing AD to increase. If households expect prices to increase in the future they are likely to buy now rather than later so increasing AD. Increased immigration is likely to result in increased spending by the new immigrants as they set up homes, buy furniture/appliances, this will cause AD to increase. As interest rates fall, investment spending (I) by firms in new ventures or on capital items will increase because the borrowing cost is lower so the profitability of future projects is increased and business confidence is likely to be higher, they are more certain about the future so increase investment spending, therefore AD will shift outward (right). An increase in government spending (G) will inject more money into the economy by the funding of new projects. More people will be employed and household disposable income will increase. Consumption spending (C) will increase, therefore AD will increase. Depreciation of the New Zealand dollar makes New Zealand exports more price competitive in overseas markets and exporters swap their foreign earnings for more New Zealand dollars or imports are less competitive in New Zealand. This will increase the value of net exports (X M) receipts, thereby shifting AD outward (right). ISBN (Student s book) Subscribe to elearneconomics at: 87

88 Activities 1 (a) Explain how a depreciating New Zealand dollar causes: (i) Demand-pull inflation A falling New Zealand dollar results in exporters swapping foreign earnings for more New Zealand dollars. The increased earnings enable more spending so cause AD to increase and therefore inflation. (ii) Cost-push inflation A falling New Zealand dollar results in an increase in the cost of importing raw materials. The increased costs faced by firms will cause AS to decrease and cause inflation. (b) Indicate which of the following would result in demand-pull inflation and which would result in cost-push inflation by placing a tick ( ) in the appropriate column. Cost-push inflation (i) An increase in government charges, e.g., GST. (ii) Excess demand for goods and services due to an increase in demand in the economy. (iii) Producers pass on the costs of production to consumers to maintain profit margins. (iv) Increases in household disposable income. (v) Government increases transfer payments and its own level of spending. (vi) Greater investment in the economy by foreign-owned firms. (vii) A government budget deficit (i.e., expansionary fiscal policy). (viii) OPEC reduces the quantity of oil produced, raising prices. (ix) A lack of water in the hydro lakes increases the cost of power generation. (x) Increased competition for resources forces firms to pay more for inputs used in the production process. (xi) A drop in productivity. (xii) An increase in wages. (xiii) Cheap credit. Demand-pull inflation (c) Explain why an increase in the price of electricity is more likely to cause inflation than an increase in the price of onions. An increase in the price of onions affects only one market, whereas an increase in the price of electricity affects many different markets through higher costs for firms so is more likely to lead to an increase in the general (average) price level. OR electricity has a higher weighting in the CPI than onions. 88 Subscribe to elearneconomics at: ISBN (Student s book)

89 Inflation picked to rise Consumer spending looks set to increase as direct tax cuts come into effect, immigration and house prices increase 2 Explain the effect of changes in consumption spending on inflation. In your answer you should: Explain the effect on wealth of increasing house prices. Explain the effect of cuts in direct taxes. Explain the effect of increased immigration. Draw a model to support your answer. As house prices increase, households will feel more wealthy as the equity in their houses increases. This will result in some households increasing the level of borrowing against the increased value of their homes to buy or consume other goods and services. As spending increases AD will shift outward, causing demand-pull inflation as the general price level increases. Cuts in direct (income) tax will increase household disposable income and consumption spending will increase. As spending increases AD will shift outward, causing demand-pull inflation as the general price level increases. When new migrants arrive in a country they will look to set up house and buy whiteware (appliances) and other household effects. They will also buy or build houses. Aggregate demand will therefore shift outward as a result of this increased consumption spending, causing demand-pull inflation as the general price level increases. Price level (PL) AD/AS model of an economy AS PL2 PL AD AD2 Y Y2 Real output GDP (Y) There will be an increase in the price level (inflation) as indicated by the change from PL to PL2 and real output GDP, i.e., growth, as indicated by the change from Y to Y2. ISBN (Student s book) Subscribe to elearneconomics at: 89

90 3 (a) Identify the events listed in the table below that would be likely to cause demand-pull inflation. (i) Situation An increase in nominal wage rates Likely to cause demand-pull inflation ( ) (ii) An increase in GST in ten months time (iii) An increase in household spending (iv) A fall in productivity (v) A fall in interest rates (vi) Cheap credit (vii) An increase in disposable incomes Price level (PL) Ad/AS model AS' AS PL2 PL1 Ad Y2 Y1 real output gdp (Y) (b) (i) Show on the diagram above the effect of an increase in the cost of imported raw materials. Label fully. (ii) Explain the change you have shown in (b) (i) above. (c) The increase in the cost of imported raw materials causes firms costs of production to increase causing aggregate supply to shift inward. This will cause cost-push inflation as shown by the increase from PL1 to PL2. For each event in the table below, describe its likely impact on the AD/AS model by ticking the appropriate column. Event AD AS Price level Real GDP Increase Decrease Increase Decrease Increase Decrease Increase Decrease (i) Increased business confidence. (ii) Wages increase. (iii) A fall in productivity. (iv) A government budget deficit. (v) High prices for dairy exports. (vi) Decrease in direct taxes. (vii) Increase in GST. (viii) Cost of imported raw materials falls. 90 Subscribe to elearneconomics at: ISBN (Student s book)

91 Petrol prices have risen 10% during the past three months as a result of a rise in the price of crude oil on world markets. 4 (a) Explain if a rise in the price of petrol will cause inflation. In your answer you should: Explain why the increase in the price of petrol might not be considered inflation. Draw a fully labelled AD/AS model to explain how an increase in the price of petrol could lead to inflation. An increase in the price of petrol might not be considered inflation because it is an increase in the price of only one good in one market only. An increase in the price of petrol could lead to inflation because petrol is a component in the production of just about every other product (transport costs). Therefore, if the price of petrol goes up, so do the costs of everything else. Prices will increase to cover the costs. The AS curve shifts to the left and will result in cost-push inflation. AS shifts to the left because production is less profitable so PL increases. This is shown on the diagram as PL1 increases to PL2. The AD/AS model showing an increase in the price of petrol Price level (PL) AS2 AS PL2 PL1 AD Y2 Y1 Real output GDP (Y) (b) Complete the table below for shifts in the AD or AS curve. Situation AD or AS curve shifts Impact on real Impact on PL and in what direction output/employment (i) Cost of imported raw materials AS right Decrease Increase decreases due to $NZ appreciating (ii) Productivity of workers improves AS right Decrease Increase (iii) Workers accept a lower wage AS right Decrease Increase award to keep jobs (iv) Recession in New Zealand s major AD left Decrease Decrease trading partners (v) Renewed confidence in the economy by New Zealand business people AD right Increase Increase ISBN (Student s book) Subscribe to elearneconomics at: 91

92 5 (a) (i) Show the change on each AD/AS model indicated by the title. Price level (PL) Graph One An increase in lamb export earnings AS Price level (PL) Graph Two An increase in insurance costs for businesses AS2 AS PL2 PL AD AD2 PL2 PL AD Y Y2 Real output GDP (Y) Y2 Y Real output GDP (Y) (ii) Contrast and compare the effects on inflation of an increase in lamb export earnings and an increase in insurance costs for businesses. In your answer you should refer to the diagrams. Explain in detail the changes made on both graphs. Explain in detail why an increase in lamb export earnings may have a smaller effect on inflation than an increase in insurance costs. An increase in lamb export earnings will increase exporters incomes and increase aggregate demand causing an increase in inflation (illustrated by the increase in the price level from PL to PL2) as shown on Graph One. An increase in insurance costs will affect most businesses because they insure their property, buildings, stock, equipment, etc. Costs of production will increase and profits will decrease. The aggregate supply curve will shift inward causing the price level to increase (inflation) as shown by the change in Graph Two from PL to PL2. An increase in lamb export earnings will have a smaller effect on the price level because it only affects the export earnings of the lamb industry. The increase in insurance costs will affect all businesses and cause a decrease in aggregate supply that is larger than the increase in aggregate demand. 92 Subscribe to elearneconomics at: ISBN (Student s book)

93 6 (a) (i) Show the change on each AD/AS model indicated by the title. Price level (PL) Graph One An increase in petrol prices AS2 Price level (PL) Graph Two A depreciation of the New Zealand dollar AS2 AS AS PL2 PL3 PL2 AD2 PL AD PL AD Y2 Y Real output GDP (Y) Y Y2 Real output GDP (Y) (ii) Compare and contrast the effects on inflation of an increase in petrol prices and a depreciation of the New Zealand dollar. In your answer you should refer to the diagrams. Explain in detail the changes made on both graphs. Explain in detail why the depreciation of the New Zealand dollar may have a greater effect on inflation than an increase in petrol prices. An increase in petrol costs will affect the transport costs of firms. As costs of production increase, profits will decrease. The AS curve will shift inward, causing the general price level to increase (as shown on Graph One as PL to PL2) as firms increase prices to maintain profits. A depreciation of the New Zealand dollar would mean that New Zealand exports would become more price competitive and exporters would swap forex for more New Zealand dollars. AD would shift outward from AD to AD2 on Graph Two as exporters incomes increase. A depreciation of the New Zealand dollar would increase the cost of imports. As costs increase, profits decrease and the AS curve will shift inward (from AS to AS2 on Graph Two) causing inflation. The overall increase in the price level is from PL to PL3. Both events cause inflation (shown on both diagrams as the increase in the price level). The depreciation of the New Zealand dollar would have a greater effect on inflation than an increase in petrol prices because it impacts on both AS and AD. The increase in AD caused by the depreciation of the New Zealand dollar causes a further increase in the price level (PL) on Graph Two to PL3 as shown. ISBN (Student s book) Subscribe to elearneconomics at: 93

94 Review (Exam) Questions Question One: The AD/AS model Complete questions (a) (d) to comprehensively analyse the effects of a decrease in workers productivity and a depreciation of the New Zealand dollar on inflation. (a) Define inflation. Inflation is an increase in the general (average) price level. The workplace is still not as productive as it could be (b) On Graph One, show how a decrease in output per worker could affect inflation. Fully label the change. Price level (PL) Graph One AD/AS model of the New Zealand economy AS' AS PL2 PL1 Y2 Y1 AD Real output GDP (Y) (c) Explain in detail the change you made in (b). A decrease in output per worker (or a fall in productivity) will mean that a firm s costs of production rise. As costs increase a firm will increase prices to maintain profit margins, as costs increase profit will decrease and the AS curve will shift to the left. The price level increases from PL1 to PL2, which is inflation. 94 Subscribe to elearneconomics at: ISBN (Student s book)

95 The New Zealand dollar has depreciated over the past few months. (d) Compare and contrast the effects on inflation of a decrease in worker productivity with a depreciation of the New Zealand dollar. In your answer you should: explain in detail how a depreciation of the New Zealand dollar could affect inflation explain why a depreciation of the New Zealand dollar may have a greater effect on inflation than a decrease in worker productivity show changes from both events on Graph Two (below) refer to the changes you make on Graph Two to support your explanation. Price level (PL) Graph Two AD/AS model of the New Zealand economy AS3 ( $NZ) AS2 ( workers productivity) AS PL3 PL2 PL1 AD2 ( $NZ) AD Y2 Y1 Y3 Real output GDP (Y) A falling New Zealand dollar results in exporters swapping foreign earnings for more New Zealand dollars. The increased earnings enable more spending so cause AD to increase (AD to AD2) and therefore demand-pull inflation. Also, a falling New Zealand dollar results in an increase in the cost of importing raw materials. The increased costs faced by firms will cause AS to decrease (AS to AS3) and cause cost-push inflation. A depreciation of the New Zealand dollar will have a greater impact on inflation than a decrease in worker productivity because it causes both demand-pull inflation and cost-push inflation. A decrease in worker productivity causes cost-push inflation only. The depreciation of the New Zealand dollar will cause the price level to increase from PL1 to PL3, while the decrease in worker productivity will cause the price level to increase from PL1 to PL2, which is a smaller increase in inflation. ISBN (Student s book) Subscribe to elearneconomics at: 95

96 Question Two: The AD/AS model Timber exports boom as world recovery picks up Complete (a) and (b) to comprehensively analyse the effects of an increase in timber exports and an increase in insurance costs on inflation. (a) Price level (PL) Explain in detail the impact on inflation of increased timber exports. In your answer: fully label Graph One to show the impact of increased timber exports explain in detail how increased timber exports could affect inflation. Refer to the change you made on Graph One to support your answer. Graph One The AD/AS model of the New Zealand economy AS PL2 PL1 AD2 (timber exports) Y1 Y2 AD Real output GDP (Y) An increase in timber exports will increase net exports. As exporters incomes increase and they increase spending then aggregate demand will shift outward from AD to AD2. The price level will increase from PL1 to PL2, which is demand-pull inflation. OR as timber exports increase, the incomes of households that are involved in the timber industry will increase because they work overtime or more people are employed. This will increase consumption spending and increase AD, causing the price level to increase. 96 Subscribe to elearneconomics at: ISBN (Student s book)

97 (b) Compare and contrast the impact on inflation of increased timber exports and an increase in insurance costs. In your answer you should: fully label Graph Two to show the impact of increased insurance costs explain how insurance costs would affect inflation in detail explain why an increase in timber exports may have a greater or smaller impact on inflation than increased insurance costs refer to the changes on Graphs One and Two to support your explanations. Price level (PL) Graph Two AD/AS model of the New Zealand economy AS2 (insurance costs) AS PL2 PL1 Y2 Y1 AD Real output GDP (Y) An increase in insurance costs will increase costs of production. As costs of production increase, firms will look to increase prices to maintain profit margins. As costs increase the AS shifts inwards from AS to AS2, causing the price level to increase from PL1 to PL2, which is cost-push inflation. An increase in timber exports will have a smaller impact on inflation than an increase in insurance costs because an increase in insurance costs would affect all New Zealand industries, whereas an increase in timber export earnings only affects the timber industry. On my graphs I have shown the AS curve increasing, therefore there is a larger increase on the price level on Graph Two (of insurance costs increasing) than on Graph One (of an increase in timber exports). ISBN (Student s book) Subscribe to elearneconomics at: 97

98 Question Three: The AD/AS model A change in interest rates and business confidence will have an impact on inflation Compare and contrast the effects on inflation of a decrease in interest rates and an increase in business confidence. In your answer, you should: show the change on each AD/AS model indicated by the title on Graph One and Graph Two explain in detail the changes made on both graphs explain in detail why a decrease in interest rates may have a greater effect on inflation than an increase in business confidence. Refer to the diagrams in your answer. Graph One A decrease in interest rates Graph Two An increase in business confidence Price level (PL) AS2 AS Price level (PL) AS PL2 AD2 PL2 AD2 PL AD PL AD Y Y2 Real output GDP (Y) Y Y2 Real output GDP (Y) A fall in interest rates will increase consumption spending because households will pay less on mortgage repayments. Discretionary incomes will increase, some of which will be spent. OR households will borrow more because the cost of borrowing has decreased. People will also save less because the return on saving is lower. Investment is likely to increase when firms are confident about new business ventures. When interest rates fall firms are more likely to invest because the risk is lower and the profitability of new ventures increases because the cost of borrowing funds has decreased. 98 Subscribe to elearneconomics at: ISBN (Student s book)

99 As interest rates fall the New Zealand dollar is likely to depreciate. A falling New Zealand dollar results in exporters swapping foreign earnings for more New Zealand dollars. The increased earnings enable more spending so cause AD to increase and therefore demand-pull inflation. Also a falling New Zealand dollar results in an increase in the cost of importing raw materials. The increased costs faced by firms will cause AS to decrease and cause cost-push inflation. An increase in business confidence will result in an increase in investment spending. This will shift the aggregate demand curve (shown on Graph Two as the change from AD to AD2) outward causing inflation (shown as the change from PL to PL2). Both events cause an increase in inflation. A decrease in interest rates will have a larger impact on inflation than an increase in business confidence because a fall in interest rates affects more components of AD, such as consumption spending and exports. Also the decrease in aggregate supply will further increase inflation, caused by the New Zealand dollar depreciating due to the decrease in interest rates. The price level change is greater on Graph One than that shown on Graph Two. ISBN (Student s book) Subscribe to elearneconomics at: 99

100 Inflation: The impact of inflation Terms/Ideas The effects of inflation on households and firms, the effects of inflation on trade and economic growth Households Inflation is viewed as being undesirable because of some serious economic and social effects. Inflation impacts on income distribution making an arbitrary redistribution of real income. Those receiving fixed money incomes (e.g., pensioners, beneficiaries, etc.) are usually disadvantaged because often their incomes are not adjusted upwards fast enough to compensate for the effects of continually rising prices. Their real incomes (i.e., the goods and services that their incomes will buy) will fall. Individuals whose incomes rise more rapidly than the inflation rate will experience increasing real incomes. Generally, the pattern of income distribution tends to become more unequal than it was before inflation. If the rate of inflation is high, individuals with money tend to buy real assets such as property, gold and antiques, which often increase in value faster than the rate of inflation. This group will gain by increasing the size of their share of the nation s wealth. Savings Inflation tends to increase spending and encourage borrowing at the expense of savings. If prices are rising quicker than incomes, individuals will tend to buy at current prices before goods and services become more expensive and less affordable. Some consumers may buy using higher levels of debt (i.e., borrowing) than otherwise might be the case. Savings may be discouraged because with high inflation when the money saved is repaid, it can be worth much less than when it was lent and the real rate of interest may be low. The real rate of interest equals the nominal interest rate after subtracting the rate of inflation. If real interest rates fail to keep pace with inflation the saver loses purchasing power, i.e., their ability to buy things falls. Rising prices are a boon to borrowers, because the repayment of interest and the sum borrowed (i.e., the principal) is with lower-valued money. Inflation reduces the real value of the amount they owe, as the sum repaid has less purchasing power. Of course, any gain by borrowers must be weighed against the interest they must pay. Firms and Growth Investment, in economics, means the creation of new capital goods. Investment can only take place if there is savings. Inflation encourages spending and discourages savings, so funds that might otherwise have been available for investment tend to dry up. With lower levels of investment there is likely to be a slowing of the rate of growth of national output (GDP). This in turn leads to a reduction in new jobs and so can increase the level of unemployment. Inflation can distort market price signals and the market may fail to allocate resources efficiently. Planning and investment decisions become more difficult to predict because firms are unsure what will happen to prices and costs during times of inflation. If firms are unable to pass on the increase in costs to consumers this will have an impact on profits, possibly causing some firms to close or cut back production and subsequent employment. Trade When New Zealand s inflation is rising at a faster rate relative to our trading partners it can harm exporters and benefit importers. New Zealand firms exporting their products overseas will find it more difficult to sell their products because they are less competitive price wise. Local producers may find it difficult to compete in domestic markets because of relatively cheaper foreign imports. Declining exports and increasing imports can lead to a deterioration in the balance of payments. High inflation in New Zealand may see nations trading elsewhere, while a lack of business confidence because of the perceived higher risks may see firms investing elsewhere. This high inflation will slow growth and employment through the dampening effects on investment and declining exports. 100 Subscribe to elearneconomics at: ISBN (Student s book)

101 Key Concepts and Definitions Impact of inflation on savings Impact of inflation on fixed incomes e.g., beneficiaries, pensioners Impact of inflation on firms Impact of inflation on trade Inflation increases the price of goods and services requiring a greater portion of household income, this will reduce level of savings. As the future purchasing power of savings may fall, households will be less inclined to save. The purchasing power of the income of households whose income fails to keep pace with increasing prices will fall. Rising prices can make it more difficult for firms to plan or budget and this creates uncertainty about the future prospects for firms, so investment is likely to fall. If firms are unable to pass on the increase in costs to consumers, profits may fall and cause businesses to close down. Inflation in New Zealand at higher rates than our trading partners can reduce the quantity of exports sold as they become less price competitive. Local firms may struggle to compete against cheaper imported products. If export receipts are less than import payments then the current account is likely to be a greater deficit or smaller surplus. STUDENT NOTES EFFECTS OF INFLATION Households on fixed incomes (e.g., beneficiaries) or those unable to get nominal wages that keep pace with inflation will experience a fall in the purchasing power of their income (i.e., real income will fall). Inflation discourages saving because the purchasing power (real value) of savings is eroded by high rates of inflation. Fewer savings mean less funds are available for investment and may mean lower growth in the future. Firms that are unable to pass on the increased costs of production to consumers with higher prices in times of inflation may experience a fall in profits and be forced to close down. Local (domestic) producers may find it difficult to compete with cheaper imported goods and services from overseas in times of inflation, so decreased production or shutdown will result in job losses. ISBN (Student s book) Subscribe to elearneconomics at: 101

102 Activities 1 (a) Discuss the statement Some households are likely to be more disadvantaged than others in times of high rates of inflation. Fixed income earners are disadvantaged because their incomes are less likely to keep up with inflation, those on adjustable incomes may receive pay rises to cover the increasing price level. Incomes are likely to become less evenly distributed, as those on a higher income receive more additional pay when getting the same percentage increase as a lower-income earner, or those on fixed incomes become relatively worse off. (b) Explain the likely impact of an increase in the rate of inflation in New Zealand on exports and imports. Exports: Exports are relatively more expensive to overseas buyers so export receipts might fall; our exports are less competitive for our trading partners. Imports: Imported products are cheaper relative to New Zealand goods so locally produced goods are less competitive and fewer are sold, revenue for local firms is likely to fall, causing some to close or cutback on production and/or staff. (c) Complete the table below to explain the effect on the group listed. (i) Group Borrowers Effect of inflation on group listed Borrowers may benefit because if inflation is high the real value of the amount borrowed decreases. (ii) Savers Savers may lose out because inflation decreases the real value (purchasing power) of savings. 102 Subscribe to elearneconomics at: ISBN (Student s book)

103 2 (a) Indicate if the following statements are facts or opinions. (i) (ii) The government must ensure that keeping a low rate of inflation is its main priority. Expectations of continuing high levels of inflation may make some consumers buy now rather than waiting until later, this will have an inflationary effect. opinion fact (iii) There are some groups or individuals in society or an economy who may benefit from inflation. fact (b) Indicate with a tick ( ) if the following are winners or losers when inflation occurs. Situation or statement Winners Losers (i) Income earners whose incomes fail to keep pace with inflation. (ii) Individuals on fixed incomes, e.g., pensions, benefits. (iii) A local importer of foreign-made products whose products are cheaper than domestically produced items. (iv) Owners of a firm who are squeezed out of the market by rising costs. (v) Lenders who do not charge interest on loans at a sufficiently high rate to compensate for inflation. (vi) Exporters who cannot sell their products overseas because their products are less competitive price wise. (vii) Local firms who have difficulty competing against cheaper foreign products. (viii) Income earners whose incomes are able to keep pace with inflation. (ix) Firms who are able to pass on part or all of price increases to consumers and whose profits rise in times of demand-pull inflation. (x) Government whose tax revenue rises as inflation pushes taxpayers into higher tax brackets, thereby increasing the average rate of tax they pay. (c) Explain the impact of unions seeking a wage increase on inflation and businesses. In your answer you should explain the impact of wage increases on inflation and how wage increases and inflation will affect employment levels and output of businesses. In times of inflation, wages may fail to keep pace with the increases in the general price level so real wages fall. Unions will seek wage awards to keep up with inflation which will increase costs to the firm. As costs of production increase, profits decrease and the AS curve shifts inward causing cost-push inflation. With inflation occurring because of wage increases, firms costs will increase and the firms will increase prices to retain profit margins. As prices increase the quantity demanded by consumers will fall. Firms may find that stock (inventory) levels build up so they will reduce output and cut back production. As production falls, firms will need fewer resources and they will cut back on workers hours or even make some workers redundant, therefore employment will fall. ISBN (Student s book) Subscribe to elearneconomics at: 103

104 3 (a) Explain how an increase in the rate of inflation would impact on overseas trade. Exports relatively more expensive to overseas buyers so export receipts might fall; our exports are less competitive for our trading partners. Imports are cheaper relative to New Zealand goods so import payments rise; locally produced goods are less competitive to imports so import payments will increase. (b) Outline the negative impact of inflation on: (i) Firms: Rising costs (includes increase in wages, raw materials, interest rates); difficult to replace old equipment; planning difficulties; exports become relatively less competitive; speculative rather than productive investment is encouraged; less investment. (ii) Households: Incomes become less evenly distributed; inflation hurts those who save; borrowing is encouraged, saving is discouraged; as your income increases, you move into higher tax brackets, i.e., fiscal drag; it is difficult to budget and plan; decrease in purchasing power; lower real incomes; increase in cost of a mortgage. (c) To reduce inflation interest rates may rise and the New Zealand dollar appreciates. Justify the government position for keeping prices stable from a trade perspective. One benefit of low inflation is that if New Zealand s inflation rate is below that of our trading partners, then New Zealand exports will be relatively more price competitive, therefore exports will increase (imports to New Zealand will be relatively more expensive), so more export-led growth/demand for New Zealand goods. Therefore, the long-term gains of low inflation will outweigh the short-term costs due to high interest/exchange rates. The main benefit of lower inflation is a stable economy, which allows firms/households to plan with greater certainty/firms more likely to expand/invest/better price signals, which will lead to long-term growth. Therefore the (long-term) gains will outweigh the (shortterm) costs due to high interest/exchange rates (such as less demand for goods and services/less growth, etc). 104 Subscribe to elearneconomics at: ISBN (Student s book)

105 Inflation rates affect exports and imports. 4 Compare and contrast how a decrease in inflation rates affects net exports. In your answer you should: Explain the effect on exports. Explain the effect on imports. Explain the impact on the current account. A fall in the rate of inflation can have a positive impact on exports. If the rate of inflation in New Zealand is low, then firms are less likely to have to increase the price of their products to cover costs and their products will become more price competitive overseas. If their products are more competitive overseas then New Zealand firms export sales should increase, revenue will increase and profits will increase. A low inflation rate is likely to keep interest rates low, therefore the $NZ is likely to depreciate, New Zealand-made goods and services will be more price competitive and exports should increase, exporters will swap forex for more New Zealand dollars. Overall, export receipts will increase. Imported products are likely to be relatively less price competitive compared with locally made New Zealand products, so New Zealand consumers buy fewer imported goods. A depreciation of the $NZ is likely to increase the price of imported goods, therefore fewer imports. Overall, import payments could decrease. The impact of an increase in export receipts and a fall in import payments is likely to result in an improvement in the current account, either a greater surplus or a smaller deficit. ISBN (Student s book) Subscribe to elearneconomics at: 105

106 Review (Exam) Questions Question One: The impact of inflation Inflationary expectations will influence household behaviour. Complete (a) and (b) to comprehensively analyse the effects of low inflation rates on households and firms. (a) Explain in detail the impact of lower inflationary expectations on households behaviour. In your answer you should: Explain the impact of lower inflationary expectations on household consumption. Explain the impact of lower inflationary expectations on the level of borrowing by households and household debt. Lower inflationary expectations will reduce household consumption spending because it will curb the desire to spend and borrow. Consumption spending by households is likely to fall because there will be less need for spending to take place before prices increase when inflationary expectations are low. When consumption spending falls household savings will increase. Lower inflation rates mean that the real value of any interest paid on debt is increased, making debt less desirable, therefore households will pay down debt and borrow less. Benefits or gains that might have been achieved through the repayment of debt by the falling real value of the sum of the loans borrowed will decline. 106 Subscribe to elearneconomics at: ISBN (Student s book)

107 Low levels of inflation have a positive effect on producers as interest rates fall. (b) Explain the benefits of low levels of inflation for producers. In your answer you should: Define inflation and explain the effect of low levels of inflation on exporters and growth. Explain the effect of low levels of inflation on investment and growth. Inflation is an increase in the general price level. Exporters prefer low levels of inflation because exports will be more price competitive and exports will increase. As exporters produce more to satisfy the extra demand for their goods and/or services, real output increases. Therefore, economic growth increases. Low levels of inflation are likely to mean that the exchange rate remains relatively stable so exporters will be able to plan for the future with greater confidence. As interest rates fall, the New Zealand dollar is likely to depreciate and exporters will swap forex for more New Zealand dollars. As exporters incomes increase and spending increases, AD shifts outward causing an increase in the general price level (demandpull inflation) and an increase in real output GDP which is growth. Low levels of inflation are likely to mean lower interest rates. Lower interest rates will mean that firms will be more inclined to invest (purchase capital goods) because the cost of borrowing has decreased, reducing the risk of failure because ventures are likely to be more profitable. As investment spending increases, AD shifts outward causing the general price level to increase (demand-pull inflation) and an increase in real output GDP, which is economic growth. Low levels of inflation mean that firms are able to plan with more confidence because costs and prices are more certain. Also, domestic producers will be more able to compete with cheaper imported products because low inflation will mean that their products remain price competitive. ISBN (Student s book) Subscribe to elearneconomics at: 107

108 Question Two: Effects of inflation on various groups Complete (a) and (b) to comprehensively analyse the effects of an increase in inflation on businesses and households. High rates of inflation can have an adverse impact on producers. (a) Explain the effects of high rates of inflation on businesses. In your answer you should: Explain the impact on revenue, costs of production and profit. Explain the effects on investment. An increase in the general price level (inflation) will result in workers seeking higher wages to keep pace with the higher prices. Other inputs used by firms in the production process are likely to cost more. As costs of production increase, producers will have to increase prices to maintain profit margins. Higher priced goods may be unable to compete with cheaper imported products, so sales fall. As costs increase and revenue decreases, profits will decline. Firms that have difficulties covering costs will cut back production, hire fewer workers and may even shut down. When firms are less confident about the future they are likely to invest less because they are less certain about the profitability of new ventures because of the greater risks involved. High rates of inflation are likely to see interest rates increase so it will be more expensive for firms to borrow and invest. Higher interest rates will result in higher costs to firms which will increase the risk of failure and lower the profitability of ventures, so investment spending will decrease. 108 Subscribe to elearneconomics at: ISBN (Student s book)

109 (b) Compare and contrast the effects of an increase in inflation between (i) savers and borrowers (ii) a household on a fixed income with a property investor. When there is an increase in the general price level (inflation) future prices will be greater, therefore the real value of savings (its purchasing power) will decrease. The households who save will be worse off if inflation is high. An increase in the general price level is likely to encourage borrowing because the repayment of interest and the sum borrowed (i.e., the principal) is with lower-valued money. Inflation reduces the real value of the amount owed, because the sum repaid has less purchasing power. Households that are able to get a wage increase greater than the rate of inflation find that real incomes will increase, making debt repayments easier. Borrowers are therefore better off. Inflation may encourage households to borrow more now for spending to beat expected increases in the general price level. A household on a fixed income will be worse off because as their income fails to keep pace with inflation they will suffer a decline in real income because the purchasing power of their income falls. Property investors are likely to be better off due to the possibility of increased capital gains if house prices increase with inflation. ISBN (Student s book) Subscribe to elearneconomics at: 109

110 Question Three: The impact of inflation Recent Consumer Price Index figures indicate that the price level has risen 0.8% over the past year. This is in part due to increased prices for alcohol (up 10%), gas (up 4%) and rents for households (up 8%). Complete (a) and (b) to comprehensively analyse the effects of inflation on low-income and highincome households. (a) Explain the effect on low-income households of the changes mentioned in the extract. As the Consumer Price Index rises by 0.8% this means that the general price level has increased and inflation has taken place. It is likely that the purchasing power (real income) of low-income households has fallen and they will be worse off than before. It is likely that households on low incomes rent their house rather than own it. The impact of the increase in the price of alcohol (10%), gas (4%) and rent (10%) will mean that they will have less to spend on other goods and services. 110 Subscribe to elearneconomics at: ISBN (Student s book)

111 The increase in prices for alcohol, gas and rents have partly been offset by decreases in the price of whiteware (down 15%) and overseas travel (down 8%). (b) Compare and contrast the effect of inflation on low-income households with high-income households who do not have a mortgage. In your answer: explain how the price changes mentioned in the extract above could impact on high-income households without a mortgage explain which group (low-income or high-income households) might be more disadvantaged by the price changes indicated in both extracts in this question. High-income households without a mortgage own their houses and will not be affected by the increase in rents (4%) so the effect of the increase in the general price level (inflation of 0.8%) is likely to be less. High-income households spend proportionately more of their income on luxuries, for example, whiteware (down 15%) and overseas travel (down 8%) so will be better off because the price of these items has decreased. High-income households are likely to be in the position that their incomes will rise faster than the rate of inflation so it is unlikely that the purchasing power of their incomes will fall. ISBN (Student s book) Subscribe to elearneconomics at: 111

112 Trade: The changing nature of trade Terms/Ideas Regional and international trade, reasons for trade, trade in goods and services, main destinations (markets) for trade, main exports and main imports. Regional Trade and Factor Endowment Regional (or domestic) trade occurs between regions in the same country under the same government using the same currency. The basis of regional trade in New Zealand lies in the fact that economic resources (or factor endowments) are spread unevenly throughout the country. Some regions have land and climate suited to horticulture (the Bay of Plenty or Hawke s Bay) or forestry (the volcanic plateau), while others have an abundance of minerals (coal in Westland). Regions in New Zealand should concentrate on activities best suited to these factor endowments, i.e., specialise and increase output to make the most efficient use of scarce resources. By trading surplus production, regions can mutually gain, with individual standards of living increasing. Some regions in New Zealand are more favourably endowed with resources than others, so may enjoy faster economic progress and growth. Individuals may benefit with greater employment opportunities, incomes and wealth. As resources within a region are discovered or exhausted then a region s fortune can fluctuate. For example, a downturn or decline in demand for products from a region may see industries cut back or close, with fewer employment opportunities and/or workers made redundant. With a decline in incomes, the standard of living in the region will go down. The prospect of finding a job, a better job or higher incomes will tempt people to move from one region to the next. International Trade and Factor Endowments International trade occurs across national borders and could involve different currencies. The basis of international trade lies in the fact that the world resources or factor endowments are spread unevenly across the globe. Some nations have land and climate suited to produce various agricultural products (e.g., New Zealand), while others have an abundance of metal ores and minerals (e.g., Australia). Other nations have highly skilled workforces and technology to produce sophisticated capital and consumer products (e.g. Japan). International trade, based on specialisation and trading surplus production enables higher living standards for the countries involved. It enables New Zealand to import goods we cannot produce ourselves, e.g., coffee, tea and rubber; or goods we can produce but not in sufficient quantity to satisfy demand, e.g., oil. A change in a country s factor endowments will impact on its trading patterns. For example, the discovery of oil in New Zealand would reduce the need for imports of oil. Trade in Goods and Services Trade can be in goods or services. Visibles are goods, tangible products (something that can be touched), but which must be transported to the market where it is used. Invisibles, are services, intangible products, with people doing things for someone else. Services (or invisibles) include transport charges, royalties paid on the use of inventions, education and insurance. As with trade in goods some nations are better at providing services than others. Sources of Imports and Export Markets New Zealand traditionally exported many primary products in a relatively unprocessed form, e.g., coarse wool, unsawn logs and whole lamb carcasses. In the past, New Zealand also relied on a narrow range of products sold to a few countries. This reliance on a limited number of products and countries has lessened as the process of diversification has taken place. This diversification has seen New Zealand widen its base of trading partners and range of products. New Zealand firms and industries have developed new crops or varieties of products to meet the demand of overseas markets. Local New Zealand producers now look to add value to primary products by processing their products here, e.g., prepacked meat cuts, fashion carpets. 112 Subscribe to elearneconomics at: ISBN (Student s book)

113 Services such as education and tourism are contributing more to exports, while there has been growth in a range of manufactured products to niche markets, e.g., boatbuilding. New Zealand is now less reliant on a narrow range of markets, with growth in sales to markets in Europe, North America, Asia and the Pacific rim. New Zealand has a small population and a limited range of resources. Therefore it is dependent on other countries to produce final products that we are unable to produce ourselves. A large quantity of our imports are likely to remain essential inputs such as oil, machinery, minerals and chemicals. New Zealand s Main Markets and Commodities In recent years the main export destinations for New Zealand goods and services are Australia, China, United States of America and Japan. These nations are also New Zealand s main source of imports. New Zealand s main exported goods, by dollar value, are dairy products, meat, forest products, machinery and oil. New Zealand s main imported goods, by dollar value, are fuel and oils, machinery, motor vehicles and electrical machinery. New Zealand s trade overseas is affected by a number of factors such as the price of competitors goods on the world market, prices of overseas substitutes, and the level of overseas countries incomes. Overseas countries preferences and tastes and the quality of New Zealand-made products will affect New Zealand s trade position. The New Zealand exchange rate is also a factor that influences our trade situation but it is not the only factor. An Increase in Exports Exports can increase when there is growth in the global economy or when free trade agreements are signed that allow greater access for New Zealand products in overseas markets. When a free trade agreement is signed export receipts increase as export firms find that demand for their products increase. As export firms increase production/supply to satisfy increased sales they will need to employ additional workers or pay existing workers overtime. Export firms are likely to switch production to the overseas market rather than the domestic market because it is relatively more profitable. Producers in the export sector may have to offer higher wages to attract the workers they need to increase output. As confidence in the export sector rises firms are likely to buy new capital to expand their current production, so investment spending will increase. Households will have increased income, either as a result of increased employment or because they derive some income from higher profits. Consumption spending is likely to increase. The government sector will increase its revenue because of increases in direct tax (from greater employment), increases in company tax from increasing profits and higher consumption spending will result in increased GST receipts. Overall as consumption spending, investment spending and net exports increase aggregate demand will increase which will cause an increase in real output GDP (economic growth) and an increase in the general price level (inflation). Key Concepts and Definitions Changes in New Zealand s trading pattern Regional trade International trade New Zealand s main export/import markets New Zealand s main exports New Zealand s main imports New Zealand has developed a wider variety of products to meet the demand of overseas markets and found a greater range of markets to sell to. Trade between regions in the same country under the same government using the same currency. Trade across national borders. Australia, China, USA and Japan. Dairy products, meat, forest products, oil, machinery. Fuel and oils, machinery, motor vehicles and electrical machinery. ISBN (Student s book) Subscribe to elearneconomics at: 113

114 STUDENT NOTES EXPORTS/IMPORTS New Zealand s main export/import markets are Australia, USA, Japan and China. New Zealand s main exported goods, by dollar value, are dairy products, meat, forest products, machinery, oil. New Zealand s main imported goods, by dollar value, are fuel and oils, machinery, motor vehicles and electrical machinery. New Zealand lacks the raw materials necessary for large scale manufacturing industries, which means that certain goods and services must be sourced from overseas e.g., oil, minerals, pharmaceuticals, tea, coffee, heavy machinery and vehicles. Trade between countries depends on a variety of factors e.g., the price of overseas substitutes, quality, whether the goods or services can be delivered on time, exchange rates, overseas countries incomes, trade barriers and the state of the global economy. Countries specialise in producing what they have a comparative advantage in because it means they are using their resources efficiently. New Zealand has a comparative advantage in primary products (dairy, forestry, wine) because it has the soils and climate to produce these products and has developed an expertise in these areas. New Zealand then exports the output it does not consume and imports goods and services it does not or can not produce. 114 Subscribe to elearneconomics at: ISBN (Student s book)

115 Activities 1 (a) Complete the table by matching the products below to the regions or places in New Zealand. tourism forestry salt production energy projects steel production coal mining wine and horticulture dairy output sheep farming aluminium oysters New Zealand region or place Product(s) (i) Hawke s Bay wine and horticulture (ii) Lake Grassmere salt production (iii) Tiwai Point aluminium (iv) Taupo tourism (v) New Plymouth energy projects (vi) Central North Island forestry (vii) Waikato (viii) South Island high country dairy output sheep farming (ix) West Coast South Island coal mining (x) Bluff oysters (xi) Glenbrook steel production (b) (c) (d) Explain why some regions (or places) in New Zealand specialise in the production of certain products as outlined in the table above. Idea that these regions have resources that are suited to this particular product. Indicate for each statement whether they are correct or incorrect. (i) (ii) Some regions are better at producing certain products than others. correct Regions tend to specialise in producing products that they are the best at producing. correct (iii) As regions specialise in producing certain products they become more independent. incorrect Complete the table below by matching the products outlined in the table to the following countries: China, New Zealand, Middle East, Sri Lanka, Japan, Fiji, Switzerland, South Africa Products Country/Region (i) Wool, mutton, beef, lamb, pastoral products New Zealand (ii) Sugar cane and tourism Fiji (iii) Tea Sri Lanka (iv) Cars and electrical goods Japan (v) Clothing and children s toys China (vi) Oil Middle East (vii) Banking and watches Switzerland (viii) Gold and diamonds South Africa (e) Outline the reason why some countries specialise in the production of certain goods and services. Idea that countries tend to specialise in the production of goods and services in which they have a comparative advantage. ISBN (Student s book) Subscribe to elearneconomics at: 115

116 2 (a) Describe what is meant by resource endowments. The natural resources within a region. Must relate to resources available to a region. (b) How have resource endowments in different parts of New Zealand led to regional specialisation and trade? Because different regions have different natural resources, they specialise in producing particular products and trade their surplus with other regions to get other products they want. (c) Complete the table by matching up the area in the list below to the product indicated. Gore Kaikoura Marlborough Ohakune Waitomo Queenstown Product New Zealand area or region (i) Wine Marlborough (ii) Adventure tourism Queenstown (iii) Glow worm caves Waitomo (iv) Whale watching Kaikoura (v) Carrots Ohakune (vi) Trout fishing Gore (d) Specialisation is at the heart of regional and international trade. Explain how both manufacturers and consumers are likely to gain. Idea that by concentrating production on a commodity, costs of production are lowered, manufacturers gain through extended markets, economies of scale, and higher profits; consumers gain through lower prices and greater variety and quality. (e) Read the extract and answer the question that follows. New Zealand depends on other countries for the supply of certain goods it does not produce. List some of the goods that New Zealand does not produce and explain why this is the case. Examples could include tea, coffee, bananas, tea, oil, machinery, tobacco, pharmaceutical supplies. Reasons include New Zealand s lack of certain resources in sufficient quantities to produce the good, or that New Zealand could produce them with great difficulty but not very efficiently, or the climate and soil in New Zealand are not appropriate for these products. 116 Subscribe to elearneconomics at: ISBN (Student s book)

117 3 (a) Indicate if the following statements are facts or opinions. Statement (i) Trade can allow a nation or region to make the most efficient use of scarce resources and raise individual standards of living. (ii) The uneven distribution of resources means that countries must trade to acquire vital goods and services they lack. (iii) New Zealand could, with great difficulty grow bananas and coffee using hothouses, but these items are much more efficiently grown elsewhere where the climate is appropriate. (iv) When a region or country specialises they can produce a larger output and gain economies of scale. (v) Small independent firms have no place in world markets, so should concentrate on local markets only. (vi) However efficient New Zealand is at producing pastoral products, if the rest of the world is not prepared to buy them at the price New Zealand wants, it must lower prices or start producing something else. (vii) New Zealand exports to countries in every corner of the globe, including developed and developing countries. (viii) There is always a link between a country s standard of living and the amount and quality of natural resources available to a nation, e.g., oil rich Middle East countries where individuals enjoy high standards of living. (ix) Because New Zealand has few minerals or ores some of our export revenues are directed at importing these products. (xi) New Zealand is part of a world-wide economy. Developments in the rest of the world will have some impact on the New Zealand economy. Fact or opinion fact fact fact fact opinion fact fact opinion fact fact (b) (i) Complete the percentage change column. New Zealand s imports by commodity (year ended June) Commodity Year 1 Year 9 Percentage change Mechanical machinery Vehicles Mineral fuels Electrical machinery Textiles and textile articles Plastic and plastic articles Optical, medical and measuring equipment All imports (ii) What percentage is mineral fuels of the total of all imports in Year 1 and Year 9? Year 1: 5.78% Year 9: 11.10% (iii) Discuss the statement New Zealand must import goods and services because they can not be produced locally. Idea that New Zealand lacks certain resources so it must import certain goods and services because it is impossible to produce them or produce them in the sufficient quantities required, e.g., New Zealand and oil. However while New Zealand could produce the good or service in some instances it is cheaper to import the product from overseas because of the differing costs of production, overseas producers are more efficient at producing the item. ISBN (Student s book) Subscribe to elearneconomics at: 117

118 4 (a) Complete the table below to classify the products as New Zealand exports or imports and as a good or service. Product (i) Circle one Export (X) or Import (M) Circle one Good or Service Disney decides to use the Weta Workshop for its new movie X or M Good or Service (ii) A Greymouth family going on holiday in Bali X or M Good or Service (iii) A New Zealand firm assists to build a bridge in Bangladesh X or M Good or Service (iv) Otago lamb X or M Good or Service (v) Holden cars X or M Good or Service (vi) A British family fly Air New Zealand to visit grandchildren in Auckland X or M Good or Service (vii) Tea X or M Good or Service (viii) Sugar cane X or M Good or Service (ix) Reef shipping insuring its cargo on the way up to the islands with a New Zealand firm X or M Good or Service (b) Complete the table. New Zealand s most important export markets, by dollar value Australia, USA China, Japan New Zealand s most important exported goods, by dollar value Dairy products, meat Forestry (wood) products, machinery (c) (i) List New Zealand s most important imported goods by dollar value. Fuel and oils, machinery, motor vehicles, electrical machinery. (ii) List New Zealand s most important import markets, by dollar value. Australia, USA, China, Japan. (d) Australia is one of New Zealand s top trading partners. Explain why this is the case. Australia is one of New Zealand s top trading partners because transport costs between both countries are low, making New Zealand goods cheaper to export/import compared with other nations. New Zealand and Australia have a free trade agreement, Closer Economic Relations (CER), so there are no barriers to trade making goods cheaper to export/import compared with other countries. 118 Subscribe to elearneconomics at: ISBN (Student s book)

119 New Zealand exports to the Asia-Pacific Rim countries have increased dramatically over the last fifty years. 5 Explain why New Zealand exports to the Asia-Pacific Rim countries have increased. In your answer you should: Discuss the reasons for the increase. Discuss the effect on New Zealand s standard of living. Exports of New Zealand-made products to Asia-Pacific Rim countries have increased because New Zealand has sought new export markets for its products so it is less reliant on a narrow range of destinations. Therefore the risks of exporting have been reduced because exports are now spread over a greater number of markets. The other advantage of these markets now is that many countries (Singapore, Malaysia, Thailand, China, Brunei) have signed free trade agreements with New Zealand, which has improved access to these markets for New Zealandmade goods. This region has enormous markets that have experienced high levels of growth and have higher levels of income and consumption than other economies. They will purchase a greater quantity of exports from New Zealand as a consequence. Exporting firms revenue would increase and producers employ more workers, so household income would increase along with consumption spending. As exports increase, output or production by New Zealand firms increases. Aggregate demand shifts outward, causing an increase in Real GDP (growth) and therefore a higher standard of living for New Zealanders. ISBN (Student s book) Subscribe to elearneconomics at: 119

120 Review (Exam) Questions Question One: The impact of trade Export receipts look set to increase when new free trade agreements are signed (a) Explain the impact of increased export receipts on various sectors in the economy. In your answer you should: Explain the impact on the producer sector. Explain the impact on the consumer sector Explain the impact on the government sector and the overall level of economic activity. When a free trade agreement is signed export receipts increase as export firms find that demand for their products increase. As export firms increase production/supply to satisfy increased sales they will need to employ additional workers or pay existing workers overtime. Export firms are likely to switch production to the overseas market rather than the domestic market because it is relatively more profitable. Producers in the export sector may have to offer higher wages to attract the workers they need to increase output. As confidence in the export sector rises firms are likely to buy new capital to expand their current production, so investment spending will increase. Households will have increased income, either as a result of increased employment or because they derive some income from higher profits. Consumption spending is likely to increase. The government sector will increase its revenue because of increases in direct tax (from greater employment), increases in company tax from increasing profits and higher consumption spending will result in increased GST receipts. Overall as C, I, and X aggregate demand will increase which will cause an increase in real output GDP (economic growth) and an increase in the general price level (inflation). 120 Subscribe to elearneconomics at: ISBN (Student s book)

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122 Question two: The changing trade pattern for New Zealand. In the past it was said that New Zealand had a dependent economy. In recent times recessions and downturns in the global economy have shown that New Zealand is still, by world standards, heavily dependent on the rest of the world. New Zealand trade with the United Kingdom (% of the total value) Exports 66% Exports 6% Imports 60% Imports 6% Complete (a) and (b) to comprehensively analyse the changing pattern of trade for New Zealand. (a) Explain in detail the changing pattern of trade with the United Kingdom and dependence on countries. In your answer you should: Discuss the relationship New Zealand had with Britain. Explain New Zealand s ongoing dependence on other countries. Explain how New Zealand has reduced its dependence. New Zealand was heavily dependent on the UK for exports and imports in the 1950s. New Zealand is less dependent on the UK as a trading partner today, as shown exports and imports have fallen from 66% and 60% to 6%, respectively. The UK was New Zealand s major trading partner because it was a safe, reliable customer and supplier, ready to accept all New Zealand offered at good prices, with preferential trading arrangements, and able to provide New Zealand with the imports it required. New Zealand is still a dependent economy because, as a small country, New Zealand s dependence on other countries is not matched by their dependence on us. New Zealand firms bargaining position is weak because we cannot do without our customers, while they can do without us. New Zealand must accept prices and conditions that prevail in world markets, it cannot hope to influence them much, i.e., world markets are highly competitive. In the past New Zealand was heavily dependent on a narrow range of products and markets. New Zealand s dependence has been reduced over the years because the range of products (timber, paper, wine, tourism, education, organic crops) and markets has widened. Less dependent on some imports as we produce more of our own requirements. 122 Subscribe to elearneconomics at: ISBN (Student s book)

123 In 1960 New Zealand s export trade to Korea and China (Mainland) was virtually nothing. Australia is New Zealand s top market and is the market in which most New Zealanders start their export activities. The Top Seven Trading partners for New Zealand Exports Rank st United Kingdom Australia 2nd United States of America United States of America 3rd Japan Japan 4th Australia United Kingdom 5th Canada South Korea 6th West Germany China 7th France Germany New Zealand exports of new products usually go to countries where markets are already established rather than new markets. (b) Explain New Zealand s changing pattern of export destinations. In your answer you should: Make several observations about New Zealand s changing trading partners. Explain why new products that New Zealand exports usually go to established markets. Explain why Australia is New Zealand s top export market. New Zealand s trading partners have changed over time. Australia is now the major trading partner for New Zealand. Korea and China, who did not feature in the 1960s and 1970s, have become significant markets for New Zealand exports. New Zealand s new exports usually go to established markets because it is easier to use existing trade and transport links that have been established. Costs are generally lower and more expertise and knowledge is on hand from firms that operate in these markets. It is more difficult to experiment with new markets because of the costs and risks involved. New Zealand s top trading partner is Australia because transport costs are lower, making New Zealand goods cheaper to export/import compared with other nations. New Zealand and Australia have a free trade agreement, Closer Economic Relations (CER), so there are no barriers to trade making goods cheaper to export/import compared with other countries. ISBN (Student s book) Subscribe to elearneconomics at: 123

124 Trade: Exchange rates and the Trade-Weighted Index Terms/Ideas How the New Zealand exchange rate is established and its impact on exports and imports, the relationship between the Trade-Weighted Index and New Zealand s current account. Exchange Rate An exchange rate is the price at which one currency exchanges for another. In the past, New Zealand had a fixed exchange rate. Often an exchange rate would be fixed between the national currency and some key currency considered as relatively stable. An appreciation of the exchange rate is when there is a price rise of one currency in terms of another. When $NZ1.00 = $A0.80 ($A = Australian dollar) changes to $NZ1.00 = $A0.84 the New Zealand dollar has appreciated while the Australian dollar has depreciated. A depreciation is a fall in the price of one currency in terms of another. When the New Zealand dollar appreciates, New Zealand-made goods and services will become more expensive to overseas buyers, New Zealand-made products become less competitive relative to other countries selling the same goods and services, and exports are likely to decrease. With the New Zealand dollar appreciating, imports will cost less and imports into New Zealand are likely to increase and make the deficit worse (that is, larger) or a smaller surplus. Setting the rate A flexible or floating exchange rate is where the price of currencies in terms of each other are determined entirely by the demand for and supply of the New Zealand dollar in the foreign exchange market. As the conditions for the demand of and supply of the New Zealand dollar change constantly, so will the value of the New Zealand dollar. The supply of the New Zealand dollar depends on New Zealand firms who want to import foreignmade goods and services, New Zealand tourists travelling overseas, and New Zealand investors seeking to invest overseas in foreign firms or government securities. The demand for the New Zealand dollar depends on foreign firms who want to import New Zealand-made goods and services, foreign tourists travelling to New Zealand, and foreign investors seeking to invest in New Zealand firms or New Zealand government securities. Interest rates have a double effect on the exchange rate. When interest rates are high in New Zealand relative to overseas then New Zealand investors will find New Zealand a relatively more attractive place to keep their money. This causes a smaller outflow of the New Zealand dollar and there is a decrease in the supply of it, and this causes the New Zealand dollar to appreciate. Overseas investors will be attracted by the returns in New Zealand, and demand for the New Zealand dollar will increase again, causing the dollar to appreciate further. A boom or economic revival in our trading partners will probably lead to a higher demand for New Zealand exports and increased demand for the New Zealand dollar, causing the New Zealand dollar to appreciate. The exchange rate diagram Draw the exchange rate diagram, showing the price of the New Zealand dollar or some other currency, as indicated, with the correct labelling of the axes and curves. $ Australian per $NZ This label indicates the value of some other currency per the New Zealand dollar. In this case 80 Australian cents equals one New Zealand dollar. 80c Price of the $NZ title S $NZ D $NZ 0 Qe Quantity of $NZ 124 Subscribe to elearneconomics at: ISBN (Student s book)

125 If there is an increase in demand for New Zealand wool in Australia, demand for New Zealand dollars will increase. The diagram below shows what will happen, the New Zealand dollar will appreciate. $ Australian per $NZ Price of the $NZ S $NZ 82c 80c D' $NZ D $NZ 0 Q Q' Quantity of $NZ The Trade-Weighted Index (TWI) The Trade-Weighted Index (TWI) measures the value of the New Zealand dollar in terms of a weighted average of the currencies of our major trading partners: the Australian dollar, the United States dollar, the Japanese yen, the United Kingdom pound and the European Union euro. The weightings are based on the relative share of each country in our overseas trade transactions. They are also weighted against the size of each country s GDP. Since the value of the currencies of our trading partners in relation to each other is constantly changing, the trade-weighted index should provide a more balanced measure of the overall value of the New Zealand dollar than an exchange rate expressed in terms of a single currency. The TWI is a summary statistic of the strength (stronger or weaker) of the New Zealand dollar. Key Concepts and Definitions Exchange rate The Trade-Weighted Index (TWI) Appreciation Depreciation Impact of appreciation on export/import and why the reaction Price at which one currency exchanges for another. A measure of the value of the New Zealand dollar in terms of a weighted average of the currencies of our major trading partners. Price of New Zealand dollar rises in terms of another currency. Price of New Zealand dollar falls in terms of another currency. The New Zealand dollar is worth more so that New Zealand-made goods and services cost more and become less competitive overseas. Exports are likely to decrease. Imports will cost less so are likely to increase. ISBN (Student s book) Subscribe to elearneconomics at: 125

126 STUDENT NOTES $ NEW ZEALAND The exchange rate is the price of the New Zealand dollar measured in units of a foreign currency. An appreciation of the New Zealand dollar means the price of the New Zealand dollar rises, e.g., the New Zealand dollar was 60c US but is now worth 62c US. The foreign exchange (forex) market involves all the firms and individuals engaged in exchanging one currency for another. The Trade Weighted Index (TWI) gives an indication of changes in the average value of the New Zealand dollar. This gives a more balanced measure of the strength or weakness of the New Zealand dollar than an exchange rate expressed in terms of a single currency. Demand for New Zealand dollars include export proceeds being returned to New Zealand, foreigners wishing to invest in New Zealand and New Zealand firms borrowing from overseas or repatriating interest, dividends and capital from abroad. Supply of New Zealand dollars includes New Zealand firms paying for imports, New Zealand firms investing abroad or foreign owners of New Zealand firms repatriating interest, dividends or capital from New Zealand. 126 Subscribe to elearneconomics at: ISBN (Student s book)

127 Activities 1 (a) Briefly describe how the exchange rate for the New Zealand dollar is established. By the interaction of supply of and demand for the New Zealand dollar in the foreign exchange market. (b) Explain what factors influence demand for and supply of New Zealand dollars under a flexible exchange rate. Supply is determined by importers and investors taking money out, New Zealand tourists going overseas. Demand is determined by investors bringing money into New Zealand, tourists coming to New Zealand, overseas buyers of New Zealand-made products. (c) Draw a fully labelled diagram to show what happens to the value of the New Zealand dollar in the following situations. (i) Fletcher Forest buys a forest in Chile. Chilean peso per $NZ S $NZ S' $NZ er er' D $NZ Q Qe' Quantity $NZ (ii) The Fijian government buys a New Zealand-made frigate. $ Fijian per $NZ S $NZ er' er D' $NZ D $NZ Q Qe' Quantity $NZ ISBN (Student s book) Subscribe to elearneconomics at: 127

128 2 (a) Label the axes to illustrate the changes indicated, and then indicate the change on the value of the New Zealand dollar ($NZ). (i) An increase in revenue received from milk product sales to Korea. Korean won per $NZ Price of $nz S $NZ er' er D' $NZ D $NZ Q Qe Quantity $NZ Value of $NZ appreciates (ii) Upgrading New Zealand army with American-built army personnel carriers. $ USA per $NZ Price of $nz S $NZ S' $NZ er er' D $NZ Q Qe Quantity $NZ (b) Value of $NZ depreciates Complete the table below for the New Zealand dollar in the situations indicated. Situation Demand for $NZ or Appreciation or Direction of shift supply of $NZ? depreciation of $NZ? (i) New Zealand tourists travelling overseas supply right depreciation (ii) New Zealand importers paying for raw materials supply right depreciation (iii) New Zealand firm setting up in Fiji supply right depreciation (iv) The Fijian government buying New Zealand goods and services demand right appreciation (v) Loss of overseas markets for New Zealand demand left depreciation (c) According to the table below, what has happened to the New Zealand dollar in relation to the other currencies? Currency Today s rate Last month s rate Indonesian rupiah Japanese yen US dollar Pound sterling The New Zealand dollar has appreciated against the US dollar, pound sterling and Japanese yen and depreciated against the Indonesian rupiah. 128 Subscribe to elearneconomics at: ISBN (Student s book)

129 An appreciation or depreciation of the New Zealand dollar will impact on the earnings of New Zealand exporters. 3 (a) If the New Zealand dollar appreciated from $NZ1 = $US0.50 to $NZ1 = $US0.80, calculate the change in earnings for a New Zealand exporter who earns $US $NZ1 = $US0.50 $NZ2.00 = $US1 $NZ1 = $US0.80 $NZ1.25 = $US1 $NZ = $US $NZ = $US Change in earnings: $NZ Increase / Decrease (Circle the correct one) (b) Identify and explain the effect of an appreciating New Zealand dollar on: (i) Aggregate Demand in New Zealand Effect: Increase Decrease (circle one) Explanation: Fall in demand for New Zealand exports and/or increase in demand for overseas (vs. NZ made) goods (therefore (X-M) in AD function is reduced). (ii) Aggregate Supply in New Zealand Effect: Increase Decrease (circle one) Explanation: Cheaper price for imported raw materials (which lowers the costs of production for New Zealand firms) (c) If the New Zealand dollar depreciated from $NZ1 = $AUS1.00 to $NZ1 = $AUS0.80, calculate the change in earnings for a New Zealand exporter who earns $AUS $NZ1 = $AUS1 $NZ = $AUS $NZ1 = $AUS0.80 $NZ1.25 = $AUS1.00 $NZ = $AUS Change in earnings: $NZ Increase / Decrease (Circle the correct one) (d) Explain the effect a weak New Zealand dollar will have on New Zealanders travelling overseas. New Zealand dollars will be exchanged for less foreign currency. The cost of travelling will rise for New Zealanders and fewer Kiwis will travel because the overseas trip costs more in New Zealand dollars. (e) How does a weak New Zealand dollar assist the export sector? Overseas buyers find that New Zealand goods and services are cheaper in terms of their currency, or it is cheaper to buy New Zealand dollars to purchase the same amount of New Zealand goods or New Zealand exporters will convert the overseas currency they receive for their goods into more New Zealand dollars than previously received. ISBN (Student s book) Subscribe to elearneconomics at: 129

130 4 (a) Describe why it is necessary for New Zealand importers to buy foreign exchange. So they are able to pay overseas producers for their goods in their own currency; or because overseas producers do not accept New Zealand currency. (b) Explain the impact New Zealand s distance from world markets has on the current account. It will contribute to the balance on services with consequently high freight and insurance costs. The TWI continues to fall (c) Explain the effect of a fall in the TWI on the current account. In your answer you should: Explain what the TWI measures. Explain the effect of a fall in the TWI on New Zealanders travelling overseas and the export sector. Explain the impact of a fall in the TWI on the balance of goods. The Trade-Weighted Index (TWI) measures the New Zealand exchange rate in relation to a basket of currencies (comprising New Zealand s major trading partners/weighted). A weak New Zealand dollar will mean that New Zealand dollars will be exchanged for less foreign currency. The cost of travelling will rise for New Zealanders and fewer Kiwis will travel because the overseas trip costs more in New Zealand dollars. A weak New Zealand dollar will assist the export sector because overseas buyers find that New Zealand goods and services are cheaper in terms of their currency, or it is cheaper to buy New Zealand dollars to purchase the same amount of New Zealand goods or New Zealand exporters will convert the overseas currency they receive for their goods into more New Zealand dollars than previously received. If the current downward trend of the TWI continues then this means the New Zealand dollar is depreciating. This will make exports more price competitive overseas and increase export receipts. Imports will become more expensive and New Zealand is likely to import less. Greater export receipts and less import payments will have a positive impact on the balance of goods. 130 Subscribe to elearneconomics at: ISBN (Student s book)

131 5 (a) Complete the table below for the New Zealand dollar in the situations indicated. Situation Demand for $NZ and/or supply of $NZ Direction of shift Depreciation or appreciation of $NZ (i) An influx of tourists into New Zealand. Demand $NZ Outward Appreciation (ii) A decrease in export commodity prices. Demand $NZ Inward Depreciation (iii) An increase in overseas investors investing in New Zealand-owned businesses. Demand $NZ Outward Appreciation (iv) Overseas firms repatriate profits back to their own country from New Zealand. Supply $NZ Outward Depreciation (v) An increase in import commodity prices. Supply $NZ Outward Depreciation (vi) New Zealand firms set up a factory in South America. Supply $NZ Outward Depreciation (vii) An increase in interest rates in New Zealand Demand $NZ Supply $NZ Outward Inward Appreciation Appreciation (b) Explain, in detail, how an increase in interest rates would affect the value of the New Zealand dollar. When interest rates are high in New Zealand relative to overseas then New Zealand investors will find New Zealand a relatively more attractive place to keep their money. This causes a smaller outflow of the New Zealand dollar and there is a decrease in the supply of it, this causes the New Zealand dollar to appreciate. Overseas investors will be attracted by the returns in New Zealand and demand for the New Zealand dollar will increase again, causing the dollar to appreciate further. ISBN (Student s book) Subscribe to elearneconomics at: 131

132 Review (Exam) Questions Question One: The New Zealand dollar. Visitor numbers to New Zealand from China set to increase over the next few years. Complete (a) and (b) to comprehensively analyse the effects of increased visitor numbers from China and increased interest rates on the value of the New Zealand dollar. (a) Explain in detail the impact on the value of the New Zealand dollar of increased visitors from China to New Zealand. In your answer: On Graph one below show how an increase in tourist numbers from China to New Zealand would affect the value of the New Zealand dollar. Explain in detail the change(s) you made on Graph One. Price of $NZ in Yuan Graph One: Market for the New Zealand dollar S$NZ Er2 Er D$NZ D$NZ2 Q Q2 Quantity $NZ The demand for $NZ would increase (shown as D$NZ shifts outward to D$NZ2) because Chinese tourists need to buy $NZ to spend in New Zealand, therefore the value of the New Zealand dollar will appreciate, as shown by the change from Er to Er Subscribe to elearneconomics at: ISBN (Student s book)

133 (b) Compare and contrast the effects on the value of the New Zealand dollar of an increase in interest rates in New Zealand with an increase in visitors from China. In your answer you should: Explain how an increase in interest rates in New Zealand would affect the value of the New Zealand dollar. Explain why an increase in interest rates may have a greater effect on the value of the New Zealand dollar than an increase in tourists from China. Show the effects of increased interest rates in New Zealand on Graph Two below. An increase in interest rates in New Zealand will attract foreign investors because the return on their funds is relatively greater in New Zealand than elsewhere. This will increase the demand for the $NZ causing it to appreciate. The supply of $NZ will decrease because New Zealand investors will be less likely to invest overseas, thereby causing a further appreciation of the New Zealand dollar. The increase in overseas visitors from China only affects the demand for the $NZ so it is likely to have a smaller effect on the $NZ, while an increase in interest affects both the demand for and supply of the New Zealand dollar. Graph Two: Market for the New Zealand dollar Price of S$NZ2 $NZ in S$NZ overseas currencies Er2 Er D$NZ2 D$NZ Quantity $NZ ISBN (Student s book) Subscribe to elearneconomics at: 133

134 Question Two: The New Zealand dollar. Global downturn Decreased export receipts have impacted on the foreign exchange market Complete (a) and (b) to comprehensively analyse the foreign exchange market. (a) On Graph One below, show the effect of decreased export receipts on the foreign exchange market by: Drawing and labelling any appropriate curve shifts, clearly identify the new equilibrium exchange rate as Er2 and quantity as Q2. Explaining the cause of the change you have shown. Exchange rate ($NZ) Graph One: Market for the New Zealand dollar S$NZ Er Er2 D$NZ2 D$NZ Q2 Q Quantity $NZ A fall in export receipts will result in exporters converting less overseas currency into New Zealand dollars, causing the demand for New Zealand dollars to decrease and the exchange rate to depreciate. OR Overseas importers will swap less of their currency to pay for the goods and services they import from New Zealand. 134 Subscribe to elearneconomics at: ISBN (Student s book)

135 A falling dollar is seen as a possible boon for New Zealand exporters (b) Explain the effect of a falling dollar on exporters. In your answer you should: Explain why a weak dollar is positive for the export industry, including flow-on effects. Explain why a weak dollar may not have the expected impact explained above. A weaker dollar means the New Zealand dollar is depreciating and New Zealand exports will become more price competitive/less expensive to overseas buyers because they would require less foreign exchange to buy the same quantity of exports. Export sales would increase, revenue earned increases and profits could rise. OR exporters would swap forex for more New Zealand dollars in the foreign exchange market so revenues increase. As export incomes increase then firms would be more confident about the future and this would result in an increase in investment spending to make the most of opportunities that are available. Aggregate demand will increase because investment spending and export receipts have increased, therefore there will be an increase in real output GDP (economic growth) and an increase in the general price level (inflation). The impact explained above might not occur because if there is a worldwide downturn (recession), demand for exports may fall because overseas buyers incomes have fallen, their consumption spending on imported products may decrease, therefore less New Zealand exports are purchased by overseas buyers. Firms may decide to wait and see instead of investing if they are uncertain about future economic conditions and the higher risks that may be apparent. Fewer exports and less investment will cause AD to shift inward rather than outward, causing reduced inflationary pressure and less growth. ISBN (Student s book) Subscribe to elearneconomics at: 135

136 Trade: The balance of payments Terms/Ideas Components of the balance of payments, events and the current account. The Balance of Payments The balance of payments is the account that records all the transactions of one country with the rest of the world. It is divided into three sections. These are the current account, the capital account and the financial account. The current account The current account is subdivided into: The balance on goods (or merchandise trade balance) the export of goods minus import of goods, for example, cheese, wool, timber, oil, chemicals, equipment. The balance on services the export of services minus the import of services, for example, transport, insurance, tourism, royalties and government services. The balance on income dividends, interest and profit transmitted between countries. The balance of current transfers includes gifts of goods, services, foreign aid and money sent to relatives and friends overseas. The balance on income for New Zealand has traditionally been a negative figure. This is because foreignowned firms earn more in New Zealand than New Zealand-owned firms do overseas. New Zealand also has a high degree of foreign debt leading to a large outflow of international investment income. The current account balance is the sum of the balance on goods, balance on services, balance on income and balance on current transfers. A current account deficit implies New Zealand is spending more money than it is earning from the rest of the world. Changes in the current account Changes in the current account are a result of changes in receipts and payments related to imports and exports of goods and services, international investment income, and current transfers. If the global economy is experiencing a recession then there will be a flow on effect on New Zealand s current account. The resulting fall in overseas countries incomes is likely to see a fall in demand for exports which is likely to result in either an increase in the current account deficit or a smaller surplus. Economic growth in New Zealand leads to higher disposable incomes leading to higher spending on imports. This may cause the current account balance to be a greater deficit or smaller surplus (ceteris paribus). An influx of tourists for a Rugby World Cup or a World Rowing Championships is likely to contribute to a greater surplus or smaller deficit on the balance of services. If the New Zealand dollar depreciates, exporters become more price competitive and get greater returns for their exported goods and services. Importers will pay more and the volume of imports will fall. If export receipts are greater than import payments then the current account balance will improve, i.e., a greater surplus or smaller deficit. Funding a current account deficit The current account deficit is funded by borrowing from overseas, this can have a negative effect on economic growth because overseas funds are attracted to New Zealand by higher interest rates in New Zealand relative to those overseas. Higher interest rates in New Zealand are likely to see consumption spending and investment decrease, aggregate demand (AD) shifts inward, resulting in a fall in real output GDP (i.e., growth). The capital account The capital account covers transactions in capital transfers and acquisition disposal of non-produced, non-financial assets. Capital transfers include migrants transfers, or the assets that people bring with them when they move from one country to another. The outright sale or purchase of an intangible asset such as copyright or a patent is included in the capital account. An example of a non-produced non-financial asset is land, acquisition and disposal is buying and selling. 136 Subscribe to elearneconomics at: ISBN (Student s book)

137 The financial account The financial account records transactions involving a country s claims on (assets), and liabilities to, the rest of the world. In the financial account, increases in assets or decreases in liabilities are credit transactions, decreases in assets and increases in liabilities are debit transactions. Financial account transactions are classified according to the type of investment they relate to. Direct investment is ownership in another economy that reflects a lasting interest. The definition of direct investment is ownership of 10 percent or more. If a New Zealand company is foreign-owned or if an overseas company is New Zealand-owned then this would be direct investment. Direct investment transactions in the financial account include equity capital, reinvested earnings and other capital. Other capital is the borrowing and lending of funds between the parent and its subsidiary. Portfolio investment is separated into equity securities and debt securities. Equity securities denote ownership (less than 10 percent ownership) such as shares. Debt securities are bonds and notes or money market instruments. Other investment is a residual investment category. Included in this category are things like loans, trade credits, deposits and any other asset or liability. Trade credits are things like prepayments for goods or services. Reserve Assets are special assets held by New Zealand s monetary authority such as foreign currency reserves and Special Drawing Rights (SDRs) with the International Monetary Fund (IMF). Together the capital account and financial account explain how the current account is financed. The flow of investment funds The flow of investment funds in the financial account tends to fluctuate from year to year as foreign investors and New Zealand investors compare the opportunities at home and abroad. If an economy is buoyant and economic conditions are favourable it is likely a country will attract funds. Investors will view factors such as the security offered, risks involved, the expected rate of return before deciding which international market to invest in and in what form (for example, to buy shares or debt securities such as bonds, notes or other money market instruments). Investment from investors abroad allows New Zealand to access funds that might otherwise be unavailable in New Zealand. Investment from abroad may provide New Zealand firms with access to the latest technology and expertise that is vital to success or provide an avenue to enter overseas markets (that might otherwise be difficult to access). Foreign ownership will result in an inflow of capital into New Zealand over a period producing a surplus on the financial account. The ongoing effect of the outflow of profits from New Zealand will produce a decrease in the surplus or an increase in the deficit on the current account. Key Concepts and Definitions Balance on goods Balance on services Balance on income Balance on current transfers Export of goods minus import of goods, e.g., meat, wool, chemicals, machinery, oil, coffee. Export of services minus import of services, e.g., education, tourists, transport, insurance. Includes dividends, interest, profit transmitted between countries. Gifts, foreign aid. ISBN (Student s book) Subscribe to elearneconomics at: 137

138 STUDENT NOTES THE BALANCE OF PAYMENTS Exports are goods and services produced in New Zealand and sold to overseas countries or individuals. Export receipts are money paid to New Zealand. Imports are goods and services produced overseas and purchased by New Zealand individuals or firms. Import payments are money paid to another country. Goods (or commodities) are physical (tangible) items, e.g., cars, oil, meat, timber, cell phones. Services are output comprising the direct use of labour, e.g., education, tourism or intangible output like insurance, transport or banking services. The current account comprises of exports and imports of goods and services, international investment income and transfers. The current account deficit is an important issue for New Zealand because it is funded by borrowing from overseas. Overseas funds are attracted to New Zealand when interest rates are high relative to other countries. High interest rates in New Zealand will result in a fall in consumption and investment, aggregate demand shifts inward, resulting in a negative impact on growth. 138 Subscribe to elearneconomics at: ISBN (Student s book)

139 1 (a) Use the following terms to indicate under which category the transactions below would be included in the Balance of Payments. Export of good Investment income receipt Import of good Investment income payment Import of service Balance on current transfers Export of service Transactions Category (i) Foreign tourists using domestic airline. Export of service (ii) Premiums paid to an overseas insurance company. Import of service (iii) Interest paid by domestic companies for foreign bank loans. Investment income payment (iv) Aluminium hub caps sold in Detroit by a New Zealand firm. Export of good (v) Foreign aid to a tsunami ravaged Pacific neighbour. Balance on current transfers (vi) Dividends received by domestic shareholders from overseas. Investment income receipt (vii) A New Zealand firm buys cars from Japan. Import of good (viii) (ix) (b) Activities A New Zealander flies on a plane operated by Singapore Airlines. An Australian firm uses a New Zealand firm to ship its produce to an Asian destination. Import of service Export of service What is the relationship between the Balance on goods, the Balance on services, the Balance on income, the Balance on current transfers, and the Balance on current account? The Balance on current account is equal to the Balance on goods plus the Balance on services plus the Balance on income and Balance on current transfers. (c) (i) List four of New Zealand s most important import markets, by dollar value. Australia, USA, Japan, China. (ii) List four of New Zealand s most important export markets, by dollar value. Australia, USA, Japan, China. (d) Explain in detail how trade agreements can improve New Zealand s current account balance. A free trade agreement will allow New Zealand exports of goods and services to gain greater access to overseas markets because trade barriers are relaxed or removed. This is likely to result in an increase in exports and export receipts which will improve the current account balance. ISBN (Student s book) Subscribe to elearneconomics at: 139

140 2 (a) Which of the categories in the table would not be included in the current account? New Zealand investment abroad Foreign investment in New Zealand Balance on capital account $m Balance on goods 380 Balance on services 264 Balance on income Balance on current transfers 73 New Zealand investment abroad 245 Foreign investment in New Zealand Balance on capital account 240 (b) In which of the seven categories above would the following transactions be recorded? Transaction Category (i) Telecom receives dividends from its overseas investment. Balance on income (ii) The New Zealand government providing aid to a Pacific Island nation. (iii) A New Zealand firm sets up a business operation in Chile. (iv) The profits from the business operation in (iii) above. (v) Imports of Australian wine. (vi) Fairfax (Australia) buys Trade Me. (vii) A premium paid to Lloyds of London by Team NZ. (viii) Export of lamb. (ix) The purchase of government Treasury Bills by an overseas fund manager. (x) The payment of interest on government stock. (xi) A New Zealand family acquires land in Fiji. Balance on current transfers New Zealand investment abroad Balance on income Balance on goods Foreign investment in New Zealand Balance on services Balance on goods Foreign investment in New Zealand Balance on income Balance on capital account (c) (d) Explain why a permanent surplus and/or persistent deficit on the current account is not good for New Zealand. The purpose of exporting is to get income to buy imports to maintain or raise the standard of living. If imports are not bought, it means that money earned is not being spent (a surplus), living standards are lower than they could be. A persistent deficit, in that more imports are demanded than there is money to buy means we are living beyond our means. Explain the likely effect of a major sporting event (e.g., World Championship) on New Zealand s current account. Tourist numbers will increase and they will spend more on goods and services, so these will increase export receipts, this should decrease the current account deficit. 140 Subscribe to elearneconomics at: ISBN (Student s book)

141 3 (a) Complete the table. New Zealand s most important import markets, by dollar value Australia, USA, China Japan New Zealand s most important imported goods, by dollar value Fuel and oils, machinery Motor vehicles, electrical machinery (b) Place the following transactions in the table below. Use the number of each transaction only. Not all items need to be placed in the table. (i) Korean student attending Auckland University (ii) Puhoi cheese (iii) Nokia cellphone (iv) Foreign tourist taking a scenic flight around Mount Cook (v) A John Deere tractor for a South Otago farmer (vi) Bruce Dagg from Westport going on holiday in Australia (vii) Government aid for a Pacific Island nation (viii) A New Zealand family going to live permanently in Fiji (ix) A premium paid to Lloyds of London (x) Emirates flies Team New Zealand to Europe for an America s Cup regatta (xi) Toyota cars (xii) Dividends for overseas owners of ANZ Export of a good Import of a good Export of a service Import of a service (ii) (iii) (i) (vi) (ix) (x) (v) (xi) (iv) (c) Why is the balance on income traditionally a negative for New Zealand? Foreign-owned firms earn more in New Zealand than New Zealand-owned firms do (d) overseas. Explain why economic growth might result in a deterioration in the current account. Economic growth leads to higher disposable incomes leading to higher spending on imports. This may cause the current account balance to be a greater deficit or smaller surplus. (e) Explain why concerns are expressed about the size of New Zealand s current account deficit. The current account deficit is funded by borrowing from overseas, this can have a negative effect on economic growth because overseas funds are attracted to New Zealand by higher interest rates in New Zealand relative to those overseas. Higher interest rates in New Zealand are likely to see consumption spending and investment decrease, AD shifts inward, resulting in a fall in real output GDP (i.e., growth). ISBN (Student s book) Subscribe to elearneconomics at: 141

142 Review (Exam) Questions Question One: The balance of payments. Government has just announced an increase in spending on promoting New Zealand to overseas visitors. Complete (a) and (b) to analyse the effects of various factors on the balance of payments. (a) Fully explain how the impact of an increase in government spending on tourism would affect the balance of payments. In your answer you should: Explain the effect of increased government spending on tourism promotion on the tourism industry in New Zealand. Explain the effects on the current account section of the balance of payments. When the government increases spending on tourism promotion this will attract overseas visitors to New Zealand as a destination. More firms will set up as tourism operators or existing firms may decide to increase spending on capital goods (investment). An increase in overseas visitors will result in increased sales, revenue and profits for tourist operators as demand for their goods and services increases. There would be greater opportunities for tourist operators because of the increased number of visitors and firms confidence in the future could result in greater investment, while some firms will hire more workers to cope with increased visitor numbers. An increase in tourists visiting New Zealand will increase export receipts, therefore the balance on the current account would improve because tourists would improve the balance on services (which is part of the current account). 142 Subscribe to elearneconomics at: ISBN (Student s book)

143 Overseas investment impacts on the Balance of Payments. (b) Explain the impact of overseas investment on the Balance of Payments. In your answer you should: Explain the impact on the account in the Balance of Payments that is affected by overseas investment funds. Explain the impact of overseas investment on the current account. Overseas investors will supply funds in return for the interest or profits/dividends they receive. When overseas investment funds flow into New Zealand this will put the financial account into a surplus to offset the current account deficit. The increase in overseas investment funds into New Zealand will likely result in an increase in outflow of interest, profit and dividends that is part of the balance of income outflow. The increase in the balance of income is likely to increase the size of the current account deficit or make a surplus smaller. ISBN (Student s book) Subscribe to elearneconomics at: 143

144 Question two: The current account and economic events. Year Balance on goods $m Balance on services $m Balance on income $m Balance on current transfers $m Financial account $m Balance on current account $m Complete (a) and (b) to discuss the link between the current account and economic growth. (a) Explain in detail the link between the current account and economic growth. In your answer you should: Fill in the missing values in the table and list the components of the current account. State which column heading in the table is not part of the current account. Explain why economic growth might result in a deterioration in the current account. Explain why concerns are expressed about the size of New Zealand s current account deficit. The components of the current account balance are: balance on goods plus balance on services, balance on income and balance on current transfers. The Financial account is not part of the current account. Economic growth leads to higher disposable incomes leading to higher spending on imports, OR greater demand for materials or equipment from overseas, leading (ceteris paribus) to a deterioration in the current account balance (i.e., a smaller surplus or greater deficit). The current account deficit is funded by borrowing from overseas, this can have a negative effect on economic growth because overseas funds are attracted to New Zealand by higher interest rates in New Zealand relative to those overseas. Higher interest rates in New Zealand are likely to see consumption spending and investment decrease, AD shifts inward, resulting in a fall in real output GDP (i.e., growth). 144 Subscribe to elearneconomics at: ISBN (Student s book)

145 Balance of payments New Zealand trade figures $m Year 1 Year 2 Year 3 Balance on income New Zealand investment abroad Foreign investment in New Zealand (b) Explain changes in the financial account and its impact on the current account. In your answer you should: Outline several reasons why the flow of investment funds in the financial account tends to fluctuate from year to year. Explain why some New Zealand firms have welcomed investment from overseas companies and investors. Explain the effect that increasing foreign ownership of New Zealand companies will have on the financial account and on the current account. Flows of investment funds in the financial account fluctuate from year to year because of the economic climate in New Zealand, availability of funds at home and overseas, changes in interest rates, opportunities for investment in other countries and regulations encouraging or discouraging investment applied by the New Zealand government or overseas governments. New Zealand firms have welcomed investment from overseas because they are able to access funds or capital goods which they could not otherwise afford, access the latest technology in particular fields, access markets for the output of the enterprise or access managerial expertise (or marketing) which may be lacking, a possible lack of savings in New Zealand means funds aren t available for investment. Increasing foreign ownership will result in an inflow of capital into New Zealand over a period producing a surplus on the financial account. The ongoing effect of the outflow of profits from New Zealand will produce a decrease in the surplus or an increase in the deficit on the current account. ISBN (Student s book) Subscribe to elearneconomics at: 145

146 Question three: The New Zealand dollar. Portfolio diversification towards the American dollar and Euro by forex dealers has weakened the New Zealand dollar. Complete (a) and (b) to comprehensively analyse the effects of decreased foreign investment and free trade agreements on the value of the New Zealand dollar. (a) Explain in detail the impact on the value of the New Zealand dollar of decreased investment in New Zealand by overseas investors. In your answer: Show on Graph One the impact of decreased investment by overseas investors on the market for the New Zealand dollar. Explain the changes you made on Graph One. Price of $NZ in other currencies Graph One: Market for the New Zealand dollar S $NZ Er Er2 D2 $NZ D $NZ Q2 Q Quantity $NZ The demand for the New Zealand dollar will decrease from D $NZ to D2 $NZ because decreased investment by overseas investors will mean fewer overseas investors want to buy New Zealand dollars for portfolio investment purposes. This will cause the New Zealand dollar to depreciate from Er to Er Subscribe to elearneconomics at: ISBN (Student s book)

147 (b) Compare and contrast the impact on the New Zealand dollar of decreased investment in New Zealand by overseas investors with the impact of increased trade between New Zealand and China. In your answer: Explain how increasing imports from China would affect the value of the New Zealand dollar. Explain how increased exports to China would affect the value of the New Zealand dollar. On Graph Two, show the effects of increased imports and exports. Explain why decreased investment in New Zealand by overseas investors may have a greater impact on the New Zealand dollar than increased trade with China. Refer to Graphs One and Two in your answer. Price of $NZ in Yuan Graph Two: Market for the New Zealand dollar S $NZ S2 $NZ Er2 Er D2 $NZ D $NZ Q Q2 Quantity $NZ With increased imports from China, New Zealand firms will need to sell $NZ to obtain Yuan to buy Chinese goods and services. The supply of the New Zealand dollar will increase (shown as S $NZ to S2 $NZ). As New Zealand exports to China increase, there will be an increase in demand for New Zealand dollars from Chinese buyers/or New Zealand exporters who need to swap Yuan for New Zealand dollars. This is shown as D $NZ increasing to D2 $NZ. The increase in demand for $NZ offsets the increase in supply of $NZ so the New Zealand dollar appreciates from Er to Er2. (Student answers may vary as the two effects could offset each other, resulting in no change in the exchange rate.) The change in trade with China could result in no change to the exchange rate or cause it to appreciate or depreciate. Decreased foreign investment will cause the New Zealand dollar to depreciate and will have a larger impact on the New Zealand dollar because it considers the impact of a large group of investors rather than just New Zealand s trade with one country. ISBN (Student s book) Subscribe to elearneconomics at: 147

148 Question four: The current account and the New Zealand dollar. Complete (a) (c) to comprehensively analyse factors that affect the New Zealand dollar and the current account. (a) State two of the top four destinations for New Zealand exports. China, Australia, USA, Japan The New Zealand dollar has strengthened after commodity prices for New Zealand exports rose. (b) (i) On Graph One, show how an increase in export commodity prices would affect the value of the New Zealand dollar. Graph One: Market for the New Zealand dollar Price S$NZ of $NZ Er Er Q Q D$NZ2 D$NZ Quantity $NZ (ii) Explain in detail the change you made in (i). An increase in export commodity prices will increase demand for $NZ from D$NZ to D$NZ2, causing the New Zealand dollar to appreciate (from Er to Er ). 148 Subscribe to elearneconomics at: ISBN (Student s book)

149 (c) Contrast and compare the effects on the current account of a depreciation of the New Zealand dollar compared with an increase in foreign fee-paying students. In your answer, you should explain in detail: how a depreciation of the New Zealand dollar would affect the current account. how an increase in foreign fee-paying students would affect the current account. why a depreciation of the New Zealand dollar could have a greater impact on the current account than an increase in foreign fee-paying students. A depreciation of the New Zealand dollar will result in exports becoming more price competitive and exporters will swap forex for more New Zealand dollars. Export receipts are likely to increase. Imports will be expensive, so it is likely that imports will fall then the current account will improve (a greater surplus or smaller deficit). An increase in foreign fee-paying students will increase export receipts of services (BOS). A depreciation of the New Zealand dollar is likely to have a greater impact on the current account than an increase in foreign paying students because foreign fee-paying students only affect the balance on services in the current account while a depreciation of the New Zealand dollar will increase export receipts and decrease import payments. ISBN (Student s book) Subscribe to elearneconomics at: 149

150 Trade: The two country model Terms/Ideas Supply and demand analysis to show the prevailing world prices, the quantities exported and imported, using the two country model and the model with New Zealand as a price taker. The Basis for Trade The Two Country Model Demand and supply analysis can be used to justify trade. In the diagrams below we assume that there are only two countries (New Zealand and Japan), a single good or service. The price of each good is expressed in New Zealand dollars, so relative prices of the product in each country can be compared. The initial curves show domestic demand and supply for beef before trade takes place. In New Zealand the pre-trade price for beef is $NZ30 and in Japan $NZ60. The difference between these two equilibrium prices means that there is a potential for trade to take place. New Zealand producers could sell beef to the Japanese consumers for more than $NZ30, this would encourage an increase in output. Japanese consumers would be willing to purchase more beef at prices less than the $NZ60 they currently pay. The equilibrium trade price will lie between $NZ30 and $NZ60. As with any equilibrium price it will be found where the quantity demanded equals the quantity supplied. The trade will take place at $NZ40 because the New Zealand surplus (exported) equals the shortage (imported in Japan) because both quantities are tonnes. Price $NZ 70 new Zealand beef market Price $NZ 70 Japanese beef market s 60 s Pe tonnes exported Pe 40 Pe Pe tonnes imported d 10 d X (000 tonnes) (Exports) M (000 tonnes) (Imports) Changes in world prices affect New Zealand s ability to compete and therefore the amount of our exports. If world prices fall due to a decrease in costs for overseas producers, New Zealand firms will lose market share. New Zealand is vulnerable because much of its trade is in products that are dependent on seasonal weather patterns that may result in a poor season domestically or abundant crops overseas that cause a glut in the world market and lower the world price. 150 Subscribe to elearneconomics at: ISBN (Student s book)

151 New Zealand A Price Taker New Zealand is a price taker for the goods and services that it sells on world markets because it has to accept the world price determined by global markets overseas because it is too small to influence the world price. When the price is lower in the domestic market in New Zealand than in an overseas market, there is potential for New Zealand producers to export (X) because the firm will receive a higher price. In the New Zealand milk powder market, as price increases from Pnz to Pw the New Zealand producers will increase the quantity supplied (from Q to Qs) because they are more able to cover costs, they will earn higher revenue and producing milk powder will be more profitable. New Zealand firms will switch resources into producing milk powder because it is relatively more profitable. P New Zealand milk powder market SNZ P PEU European milk powder market S PW PW PNZ D DNZ Qd Q Q QS QSeu Qdeu Exports (X) Imports (M) QX Q As price increases the quantity demanded for milk powder in the New Zealand domestic market will decrease (from Q to Qd), and the quantity supplied with increase (from Q to Qs). The excess supply is exported (X) by New Zealand producers to take advantage of the higher price in overseas markets. Overseas consumers will buy more milk powder (Qdeu) at the lower world price (Pw), while European suppliers will produce less milk powder (Qseu at the world price (Pw). The New Zealand government will benefit from trade because as exporters incomes increase they will make higher profits and pay more tax. The government is likely to receive more direct tax revenues because exporters need to hire additional workers or pay overtime as they increase output to satisfy overseas demand. As households incomes increase, consumption spending will increase, resulting in the government collecting more indirect tax from goods and services tax (GST). ISBN (Student s book) Subscribe to elearneconomics at: 151

152 Key Concepts and Definitions The graph below shows that New Zealand has a comparative advantage in the production of cheese products compared with other countries. The New Zealand price for cheese (Pnz) is lower than in the other country (Pos) because costs of production are lower. The New Zealand producer is able to export cheese at a world price (Pw), above the domestic price (Pnz) and below the price in the other country (Pos). New Zealand producers obtain a higher price and New Zealand consumers now pay the world price and will consume less. The new quantity demanded by New Zealand consumers is Qd, while the quantity exported is the gap between Qd and Qs. Producers in the importing country would have to lower their prices. Consumers in the other country are able to buy cheese at a lower price than they would without trade. The market for cheese New Zealand Another country P P SOS exports SNZ POS SOS plus NZ Pw Pw imports PNZ DOS DNZ Qd Q Qs Q Q Q X M 152 Subscribe to elearneconomics at: ISBN (Student s book)

153 STUDENT NOTES TWO COUNTRY MODEL When New Zealand exports products overseas less will be available on the domestic market, local consumers will be faced with an increase in price and quantity demanded will fall. Consumers may switch to a relatively cheaper domestic substitute. New Zealand firms who export will receive a higher price, revenue will increase and profits are likely to rise. Some firms may need to invest and/or hire extra staff to cope with the extra sales. New Zealand The market for cheese Another country P P SOS exports SNZ POS SOS plus NZ Pw Pw imports PNZ DOS DNZ Qd Q Qs Q Q Q X M Export calculations: Total revenue from sales = PW x QS, Domestic sales = PW x Qd, Export sales = PW x Exports (difference between Qd + QS) ISBN (Student s book) Subscribe to elearneconomics at: 153

154 Activities 1 Study the diagrams below and answer the questions that follow. Price $NZ (000) 16 new Zealand secondhand car market SNZ Price $NZ (000) 16 Japanese secondhand car market P SJapan exported Pw 8 Pw 8 imported DNZ 6 4 P DJapan Quantity M (000) X Quantity (000) (a) (b) State the pre-trade equilibrium price in New Zealand and Japan. New Zealand pre-trade: $NZ Japanese pre-trade: $NZ4 000 Complete the table. Price $NZ (000) New Zealand secondhand car market surplus or shortage (of how many) Japanese secondhand car market surplus or shortage (of how many) 10 shortage surplus shortage surplus shortage surplus (c) Explain the basis on which trade will take place. The trade price lies between $NZ and $NZ4 000 and will occur where the quantity (d) (e) demanded equals the quantity supplied. The trade price is $NZ On the diagram above show: (i) The original price as P and the world price as Pw. (ii) Which country exports (X) and the quantity. (iii) Which country imports (M) and the quantity. Explain the impact of trade on New Zealand consumers. Consumers will now pay $NZ8 000 (Pw) instead of $NZ (P) for a secondhand car. The quantity demanded will increase from secondhand cars to because they are more affordable. 154 Subscribe to elearneconomics at: ISBN (Student s book)

155 2 (a) Draw up the market for clothes in Korea and market for clothes in New Zealand on the grid provided. Korean clothes market New Zealand clothes market Price $NZ Demand Supply Price $NZ Demand Supply Price $NZ 70 Korea clothes market Price $NZ 70 new Zealand clothes market Pw 40 export 50 Pw 40 import snz dnz 10 sk dk X Quantity (000) M Quantity (000) (b) (c) Indicate on your diagrams: The world price, label as Pw, the country that will export and the quantity, the country that will import and the quantity. State and explain the effect trade would have on: (i) NZ clothing producers: The quantity supplied would decrease and decrease the level of sales because NZ producers will not be able to compete as well because imports will now be cheaper than before so NZers will buy more imported products and fewer NZ made products. Firms would find the clothing business less profitable as less revenue is received. (ii) NZ clothing consumers: Consumers will be better off as price decreases, quantity demanded increases as clothes will be more affordable. Consumers will be able to save more or spend the discretionary income on something else. (iii) Inflation: It is likely that the rate of inflation will decrease because clothing is a major part of consumer spending and so any impact on the price of clothing will impact on inflation. The price of clothing has fallen, therefore having an effect of lowering the rate of inflation. ISBN (Student s book) Subscribe to elearneconomics at: 155

156 3 Use the diagram below to answer the questions that follow. 100 New Zealand crayfish market PJapan 100 Japan crayfish market Price $ NZD 80 s New Zealand Price $ NZD 80 Pw 60 exports Pw 60 imports PNZ d New Zealand s Japan d Japan 1 3 X 5 Quantity (000 tonnes) 2 4 M 6 Quantity (000 tonnes) (a) (i) Label the original price in New Zealand and Japan appropriately. (ii) Show a world price of $60 as Pw and indicate which nation imports crayfish and exports crayfish. (b) (c) Complete the statements below. (i) The original price paid in New Zealand is $30, while in Japan it was $100, the world price is $60. (ii) New Zealand exports tonnes of crayfish and Japan imports tonnes of crayfish. (iii) New Zealand exports crayfish at the world price of $60. Domestic consumption falls from tonnes to tonnes from tonnes to tonnes., while production increases (iv) Japan imports crayfish at the world price of $60. Domestic consumption increases from tonnes to tonnes, while domestic production in Japan falls from tonnes to tonnes. Complete the spaces in the sentences below. When New Zealand exports products overseas the price that domestic consumers pay increases and the quantity purchased decreases, as supply to the domestic market falls. When New Zealand imports products from overseas the price that domestic consumers pay decreases and the quantity purchased increases. (d) The prices on each model are measured in the same currency, New Zealand Dollars. Why is it necessary, when using this model, to use the same currency on both diagrams? So relative prices in each country can be compared. (e) (i) State the total revenue at the world price for New Zealand firms of NZ$60. $60 x = $ (ii) Domestic sales revenue $60 x = $ (iii) Export sales revenue $60 x = $ Subscribe to elearneconomics at: ISBN (Student s book)

157 The two-country model Australian pork market New Zealand pork market PSNZ S PSNZ S PNZ Pw X Pw M PA D D QA X Q QNZ M Q 4 (a) The two-country model illustrates trade in pork between New Zealand and Australia. When trade is allowed, identify on the model: the price at which trade would occur, label this as Pw; use a double-headed arrow to show the quantity of exports, X and the quantity of imports, M. (b) Given that there is an increase in the costs of producing pork in New Zealand, identify the likely impact on the quantity of pork imported to New Zealand from Australia. Rise/increase (c) Explain why exporting and importing have occurred in the pork market. Australian pork producers will export (X) to New Zealand because they receive a higher price in New Zealand and will receive higher revenue. New Zealand firms will import (M) pork from Australia because the price is lower than the New Zealand price. ISBN (Student s book) Subscribe to elearneconomics at: 157

158 Review (Exam) Questions Question One: trade. The diagram shows the apple market between Australia and New Zealand. Show the impact on trade after the World Trade Organisation ruling to allow New Zealand apples access to Australian markets. New Zealand apple market Australian apple market Price Price SAust SNZ PA PW PNZ DAust dnz QNZ X QNZ M Explain the impact of the World Trade Organisation ruling. In your answer you should: Explain why apple growers in Australia were opposed to the ruling. Explain the impact on New Zealand apple consumers and growers. Explain the impact on the New Zealand government. Australian apple growers opposed the ruling because the price they received fell from PA to Pw. Australian growers will receive a lower price and sell less, therefore their incomes and profits will fall. Some firms will find that they will be unable to cover the costs of producing apples and may have to close down or do something else more profitable, for this reason they will be opposed to the WTO ruling. New Zealand apple consumers will now pay a higher price (Pw) and the quantity demanded of apples will fall. Some apple consumers will buy a substitute product which is relatively cheaper. New Zealand apple growers will now receive a higher price and export apples to Australia. Sales, income and profit will increase for apple gowers in New Zealand. 158 Subscribe to elearneconomics at: ISBN (Student s book)

159 The New Zealand government will be better off because there will be: * more company/direct tax from apple exporters due to greater profits greater income tax from apple workers who are employed or working overtime due to increased demand increased GST/indirect tax from increased spending by apple workers decreased transfer payments because of greater employment as apple producers hire additional workers to increase output. ISBN (Student s book) Subscribe to elearneconomics at: 159

160 Question two: lamb exports. Lamb is an important export commodity. Explain the importance of lamb exports. In your answer you should: On diagram one show the quantity of lamb produced in New Zealand. Label this Qs; domestic demand for lamb before trade as Q; domestic demand for lamb after trade as Qd and the quantity of lamb exported to the United Kingdom. On diagram two show the quantity of lamb imported by the United Kingdom. Explain why the domestic market price for lamb in New Zealand increases. State firms total revenue at the world price and indicate how much is from domestic and export sales. Explain the change to the domestic and export markets that has occurred. Diagram one Diagram two The New Zealand lamb market The United Kingdom lamb market P P SUK 80 DNZ exports SNZ imports SUK plus NZ 50 DUK Qd Q Qs Q (millions) M Q (millions) X The domestic market price for lamb in New Zealand increases because of trade. The supply to the domestic market decreases as lamb is exported overseas. At the world price, total revenue is $1 200m ($80 x 15m) of which domestic sales are $560m ($80 x 7m) and $640 from export sales ($80 x 8m). 160 Subscribe to elearneconomics at: ISBN (Student s book)

161 The change that has occurred to the domestic and export market is that the price is higher in the UK than New Zealand so New Zealand producers will want to export as much as possible to gain the high price. The price in the domestic market increases from $50 to $80 to match the overseas price, the quantity demanded falls from 10m to 7m, exports are 8m units. The export market will see an increase in sales and revenue, with firms increasing output, hiring extra workers and possibly looking to invest and expand the size of their operations. ISBN (Student s book) Subscribe to elearneconomics at: 161

162 Question three: the two country model. Trade impacts on various groups. Complete (a) and (b) to comprehensively analyse the effects of trade on various groups. (a) Price Explain the impact of trade using the two country model. In your answer: On the two country model below, label (i) the equilibrium price and quantity for both markets (Pc Qc Pnz and Qnz) before trade (ii) the price (Pt) at which trade would occur (iii) the quantity of exports (using an X beside a double-headed arrow) (iv) the quantity of imports (using an M beside a double-headed arrow). Use your labelled model to explain why trade will occur. The two country model The New Zealand clothes market S Price The Chinese clothes market S PNZ PT PT D PC D QNZ M Quantity QC X Quantity The price of clothes is greater in New Zealand compared to China, so there is potential for China to export clothes to New Zealand. New Zealand consumers will buy more clothes at prices below the pre-trade New Zealand price (Pnz). Chinese clothes producers will sell/supply clothes to New Zealand for a higher price than they receive in China, that is Pt rather than Pc. 162 Subscribe to elearneconomics at: ISBN (Student s book)

163 (b) Discuss the impact of trade on: New Zealand consumers of clothes New Zealand clothes producers and their employees the New Zealand government refer to the changes you made on the two country model to support your explanation. New Zealand consumers of clothes will be better off, they now pay Pt rather than Pnz, they can now afford more clothes. New Zealand clothes producers will be worse off because the price they receive now (Pt) is lower than before trade (Pnz). As the price falls, they will be less able to cover their costs, earn less revenue and will be less profitable. Some producers may close down or switch resources into more profitable activities. Employees in the clothing industry will be worse off because as sales fall, firms will produce less and need fewer workers. The New Zealand government could be better or worse off. They will have to pay transfer payments to workers in the clothing industry unless they are able to find other jobs. The government might receive more indirect tax from the increased consumption spending on clothes. ISBN (Student s book) Subscribe to elearneconomics at: 163

164 Trade: The one country model Terms/Ideas The one country model and the quantity exported or imported, the importance of the world price, consequences for consumers, producers and government. Exports (X) If New Zealand goods are traded overseas (exported) then the price domestic consumers pay for the product will rise because supply to the local market will decrease. Most New Zealand firms will export goods and services overseas when they receive a higher price than they do on the local market. The price on the domestic market to local consumers rises to P w (shown below), the new quantity demanded by New Zealand consumers is Q d, while the quantity exported is the gap between Q d and Q s. Price ($) Pw Domestic market for lamb in New Zealand Exports (X) S NZ Sworld P D NZ Qd Q Qs Quantity (million) Exports (X) Question Formula or idea Answer from the graph 1 What is the equilibrium price before? What is the equilibrium price after? 2 What is the local firms output before? What is the local firms output after? P $14 P or P w $20 Q 7 million Q s 9 million 3 What is the change in local firms output? Difference between Q and Q s 2 million increase 4 How many goods are exported? Difference between Q s and Qd 7 million 5 Value of sales before Value of sales domestically after 6 Change in value of sales domestically P x Q P w x Qd Difference between P x Q and P w x Qd $14 x 7 million = $98m $20 x 2 million = $40m decreased by $58m 7 Local firms income (revenue) before P x Q $14 x 7 million = $98m 8 Local firms income (revenue) after P w x Q s $20 x 9 million = $180m 9 Value of export sales P w x Exports $20 x 7m = $140m 164 Subscribe to elearneconomics at: ISBN (Student s book)

165 Horizontal world supply curve New Zealand faces a horizontal supply curve for imports set at the world price because the New Zealand market is so small in relation to the output from the world, so overseas suppliers are able to supply as much as New Zealand can buy at the world market price. The New Zealand market is too small to affect world prices so unlimited quantities are supplied at the world price. Imports (M) Price $ New Zealand shoe market S NZ P 50 Pw 40 World S D NZ QL Q Q' Imports (M) Quantity (000) When goods are imported this will increase domestic supply so the price domestic consumers pay will decrease. The diagram illustrates the impact of goods imported into New Zealand. The original equilibrium price is P and original quantity Q. The new price is Pw and the quantity consumers buy is Q. Question Answer from the graph (a) What is the equilibrium price before trade? $50 P (b) What is the equilibrium price after trade? $40 Pw (c) What is the equilibrium output before trade? Q (d) What is the equilibrium output after trade? Q (e) What is the local firm s output before trade? Q (f) What is the local firm s output after trade? Ql (g) What is the change in local firm s output with trade? Formula or Idea Difference between Q and Ql (h) How many goods are imported? Value of the gap between Ql and Q (i) What is the importers revenue? $40 = $ Imports Pw (or P ) (j) What is the value of sales before trade? $ = $ P Q (k) What is the value of sales after trade? $ = $ Pw Q (l) What is the change in the value of sales? increased by $ Difference between (P Q) and (Pw Q ) ISBN (Student s book) Subscribe to elearneconomics at: 165

166 Tariff A tariff is a tax on imports to protect domestic firms against overseas competition. The effects of a tariff per unit are shown on the diagram. The tariff lifts the price to Pw and local firms output increases from QL to QL2. The quantity sold at Pw' is Q2 while imports are represented by the gap between Q2 and QL2. The government raises the shaded area in tax revenue (that is tariff imports). Price $ SNZ 35 P 25 Pw' S world and tariff 20 Pw S world DNZ QL 2 QL2 5 Q 8 Q2 12 Q1 15 M2 M Worked example of a tariff Quantity (million) With a tariff in place, state or calculate the: Formula or idea Answer from the graph (i) The value of the tariff per unit. Gap between Sworld and Sworld and tariff $5 (ii) Price paid by consumers. Pw $25 (iii) Quantity produced in New Zealand. QL2 5 million (iv) Quantity imported. Gap between QL2 and Q2 7 million (v) Revenue received by government. Imports x tariff $35 million (vi) Change in sales by New Zealand firms. Difference between QL and QL2 3 million increase (vii) Change in New Zealand firms revenue. Difference between (Pw x QL) and (Pw x QL2) $85 million increase Key Concepts and Definitions When New Zealand exports goods and services New Zealand consumers will be worse off because they have to pay a higher price and the quantity demanded will decrease. New Zealand firms will be better off because they are receiving a higher price and sales will increase. The world supply curve is drawn as a horizontal line because New Zealand is too small to influence the world price and is a price taker. Any amount can be imported at the world price to satisfy New Zealand demand. 166 Subscribe to elearneconomics at: ISBN (Student s book)

167 As goods and services are imported (M) the price in the domestic market falls from P to Pw. New Zealand producers must lower prices to compete with the cheaper imported products. As the price falls, New Zealand producers produce Qs because firms are less able to cover costs, the revenue received is lower and it is less profitable. Some producers will look to produce another (related) product or leave the industry. The spending on imports is equal to the quantity imported (Q to Qd) multiplied by the world price (Pw). New Zealand domestic market for shoes Supply (NZ) P Pw Supply world Demand (NZ) QS Q Imports (M) Qd If New Zealand producers leave the industry, supply will decrease (as illustrated by the shift from Supply (NZ) to Supply2 (NZ). The price will stay the same at Pw because New Zealand is a price taker and is too small to influence the world price. This means that the quantity demanded by consumers remains unchanged (Qd). The quantity of goods imported has increased (represented by the gap between Qs2 and Qd). The value of spending on imports will increase, because more imported goods are bought at the same world price. New Zealand domestic market for shoes Supply2 (NZ) Supply (NZ) P Pw Supply world Demand (NZ) QS2 Qs Q Imports2 (M) Qd ISBN (Student s book) Subscribe to elearneconomics at: 167

168 STUDENT NOTES Exports (X) New Zealand firms export goods and services overseas when they receive a higher price than they do on the local market. Price New price Pw Exports (X) S NZ Sworld Original price P Q d New quantity demanded domestically Exports (X) Q Original quantity Qs D NZ Quantity New quantity sold at the world price, made up of quantity sold domestically and overseas sales (exports) Consumers in the local (domestic) market will pay more and consume less (i.e., quantity demanded will fall). Producers will receive a higher price when they export and total revenue will increase. Some of the firms revenue will come from domestic sales and the rest from export sales. 168 Subscribe to elearneconomics at: ISBN (Student s book)

169 Imports (M) When goods are imported this will increase domestic supply so the price domestic consumers pay will decrease and quantity demanded will increase. Local firms will have to lower price to compete with cheaper imported goods. Price S local supply (old price) P (new price) P' IMPORTS World price NZ and imported D Local (NZ) firms supply at new price QL Q Quantity sold before Q' IMPORTS (M) Quantity New quantity sold after trade ISBN (Student s book) Subscribe to elearneconomics at: 169

170 Activities 1 Study the graph below and answer the questions that follow. Price ($) D New Zealand market for running shoes S P 250 Pw S Quantity (000) Qs Imports (M) Qd D (a) (b) On the graph above, clearly show: (i) the quantity of running shoes imported at the world price Pw of $150 using the label M (ii) the level of New Zealand demand for running shoes at Pw using the label Qd (iii) the quantity of running shoes supplied by New Zealand running shoe producers at Pw using the label Qs. Explain the consequences for consumers and producers if there is a further reduction in the world price of running shoes below Pw. For consumers, more running shoes will be purchased and the price they pay will fall. More shoes are available because of an increase in imports. Importers revenue will increase if the increase in the quantity demanded is proportionately more than the decrease in the price. Importers will have an increase in sales/market share because of the increase in quantity demanded from the lower price. Importers will need to import more running shoes to satisfy the extra quantity demanded. 170 Subscribe to elearneconomics at: ISBN (Student s book)

171 Graph One: New Zealand market for clothes Price ($) Supply NZ P Pws Pws Demand NZ2 Demand NZ Qs Q M Qd Qd2 Quantity M2 2 (a) (i) Show on Graph One above a world price of $50 (Label as Pws). Label the quantity of exports (X) or imports (M). (ii) Show the effect on the graph of an increase in demand for clothes in New Zealand. Label the new exports (X2) or imports (M2). (b) Explain the effect on the market for clothes in New Zealand of an increase in demand. In your answer discuss: The impact on the price The impact on the consumer The increase in demand for clothes in New Zealand will have no impact on the world price because New Zealand is a price taker, it is too small to influence the world price of clothes, any amount of clothes may be imported at Pws to satisfy the New Zealand demand. New Zealand consumers will buy more imported clothes as shown by the change from M to M2, the total value of spending on clothes will increase as more clothes are purchased at the same price. Spending on domestic firms clothing remains the same. ISBN (Student s book) Subscribe to elearneconomics at: 171

172 3 The world price for snapper is above the market equilibrium in New Zealand and is the same for all levels of quantity. Price ($ per kg) 30 New Zealand snapper market S Pw D Quantity (kg) (million) Qd Exports (X) (a) (i) Draw the world price at $25 per kg and label it Pw on the diagram above. Show the quantity of snapper exported as X. (ii) Show the level of New Zealand demand for snapper at Pw, using the label Qd. (iii) Show the quantity of snapper supplied by New Zealand producers at Pw using the label Q2. (b) Explain the consequence for consumers and exporters of snapper of an increase in the world price (Pw) above $25 per kg. Snapper becomes less affordable to New Zealand consumers because of the higher price, they will look to buy a relatively cheaper substitute good. Less snapper will be purchased because the price is higher, so consumers will be worse off, less snapper is available. Exporters of snapper will have to export more snapper because of the increased demand by overseas buyers. Revenue for exporters will increase because they are receiving a higher price and selling more. Q2 172 Subscribe to elearneconomics at: ISBN (Student s book)

173 New Zealand exporters of apples are likely to have their reputations harmed by a bacterial disease outbreak. 4 Fully explain the impact of the bacterial disease outbreak on New Zealand apple exporters. In your answer you should: Show the original quantity of exports as X. Clearly illustrate the loss of apple production and the new quantity of exports as X2. Explain the likely impact on the price New Zealand apple exporters will receive. Explain the impact of the loss of apple production on exports, producers and industries associated with the apple industry. Price The market for New Zealand apples S2 S Pw D X2 X Quantity New Zealand apple growers will receive the world price for apples in the market Pw because the production from New Zealand is so small compared to the world output it will have no effect. OR if the demand for New Zealand apples decreases because of concerns over the bacterial disease then the price apple exporters receive will fall. The loss of production shifts the supply curve from S to S2. As New Zealand apple exporters receive the world price Pw they will now export fewer apples (shown as X2). Apple exporters sales, revenue and profit will decrease. Apple exporters confidence will fall, they are less likely to invest and they will employ fewer workers because output has fallen. Sales revenue and profits of firms that supply apple growers will also fall which will reduce the output in these industries. ISBN (Student s book) Subscribe to elearneconomics at: 173

174 5 Study the diagram below and answer the questions that follow. Price $ (000) 18 The New Zealand market for secondhand cars snz 12 6 World price dnz (a) (b) (c) Before trade, state or calculate the: (i) quantity demanded by New Zealand consumers (ii) the value of sales. $ At the world price, state or calculate the: (i) new price for secondhand cars in New Zealand. $6 000 (ii) total value of sales for secondhand cars. $ (iii) quantity of vehicles imported (iv) Quantity (000) the current account balance in which import of cars is recorded. the balance on goods From your analysis, describe the effects on car buyers, vehicle dealers and other New Zealand industries. New Zealand buyers of secondhand will be able to buy more because secondhand cars will be cheaper. Trade-in values of their existing cars will fall. They will have increased real income. New Zealand motor vehicle dealers sales will be at higher levels, profit may increase. The effects on other New Zealand industries will vary, panel beaters and mechanics may find business increases because there are more cars on the roads and more accidents, or need repairs or servicing done, however, business activity may decrease as consumers may decide to buy another secondhand car rather than face bills on repairing or servicing cars. 174 Subscribe to elearneconomics at: ISBN (Student s book)

175 6 (a) (i) Draw up the market for DVD players in New Zealand using the grid below. Price $NZ Quantity demanded Quantity Supplied (ii) Before trade what was the equilibrium price and how many DVD players were sold? Price $700 Quantity Price $NZ Market for DVD players in New Zealand d s Sworld plus tariff s d Sworld Quantity (000) (b) (i) Assume free trade. Show the world price at $200. Label as Sworld. (ii) State at $200: (a) The price of DVD players now. $200 (b) How many DVD players are sold in total (c) How many DVD players are produced by New Zealand firms (iii) (d) How many DVD players are imported Who benefits and loses from trade in this instance. Justify your answers. Benefits: Consumers lower price (by $500), increased quantity (increased by ) Loses: New Zealand producers fewer sales (decreased by ), revenue falls from $24.5m to $2m (c) (i) Assume $200 tariff unit is levied on DVD players. Draw a new supply curve, including the tariff, and label Sworld plus tariff. (ii) With the tariff in place, state or calculate the Quantity supplied by New Zealand firms Quantity imported (iii) Revenue received by the government as a result of the tariff. $ = $6m How can the government justify the tariff placed on DVD players? Raises revenue, protects local industry allows infant industry to develop. Prevents dumping. ISBN (Student s book) Subscribe to elearneconomics at: 175

176 Review (Exam) Questions Question One: milk solids. Milk prices have increased in recent years. Complete (a) and (b) to comprehensively analyse milk prices on sectors of the New Zealand economy. (a) State the current account balance in which exports of milk would be classified. The balance of goods. (b) (i) Label at the original world price (Pw), the quantity demanded by New Zealand consumers as Qd and the quantity supplied by New Zealand firms as Qs. Label the exports (X) or imports (M) at the world price. Price Graph One: New Zealand milk market SNZ Pw2 Pw DNZ Qd2 Qd X Qs Qs2 Quantity X2 (ii) On Graph One, show the effect on New Zealand milk exports of an increase in the world price of milk. Label as Pw2. Clearly label the rest of the changes. Refer to the changes you have made to Graph One and compare and contrast how each group below may be better or worse off from the increase in the world price of milk solids. New Zealand consumers milk producers in New Zealand farm workers the New Zealand government As the price of milk rises from Pw to Pw2 New Zealand consumers will be worse off because quantity demanded falls from Qd to Qd2 because consumers cannot afford it. New Zealand consumers may look to buy a relatively cheaper substitute product. 176 Subscribe to elearneconomics at: ISBN (Student s book)

177 New Zealand milk producers will be better off because as the price they receive rises, they will be more able to cover their costs because they will be earning higher revenue and it will be more profitable. They will switch resources into producing milk and may look to expand/invest in new equipment. Farm workers will be better off because as output increases they will have more income or have jobs. They may be able to find job opportunities in other parts of the country where opportunities did not exist before. The New Zealand government will be better off because the tax take will increase from more direct tax being collected from more people finding jobs and the profits earned by businesses in the dairy sectors. Unemployment benefits are likely to fall. ISBN (Student s book) Subscribe to elearneconomics at: 177

178 Question two: world prices Adventure tourism plays an important role in the New Zealand economy Complete (a) and (b) to comprehensively analyse the effects of a change in world prices. (a) (i) State the current account in which tourism would be classified. The balance of services. (ii) State two of the top four countries for New Zealand exports. China Australia United States of America Japan (b) Discuss the impact that a decrease in the world price of adventure tourism would have on the following: New Zealand consumers New Zealand tourist operators the New Zealand government. In your answer, you should show on Graph One: The effect of a decrease in the world price on New Zealand adventure tourism exports. Compare and contrast the effects on the three groups by explaining how each could be better or worse off from a decrease in the world price for adventure tourism activities (refer to the changes in your graph to support your answer). Price Graph One: New Zealand adventure tourism market SNZ Pw Pw2 DNZ Qd Qd2 X2 Qs2 Qs Quantity X A decrease in world price of adventure tourism will benefit New Zealand consumers because as the price decreases from Pw to Pw2, the quantity demanded increases from Qd to Qd2 because consumers can afford more. 178 Subscribe to elearneconomics at: ISBN (Student s book)

179 New Zealand tourist operators will be worse off because as the price decreases they are less able to cover their costs because they are earning less revenue and it is less profitable. The quantity supplied decreases from Qs to Qs2, tourist operators may decide to switch resources into a related good that is relatively more profitable The New Zealand government will be worse off because the tax take decreases as employment falls as a result of reduced output, they will receive less direct (income) tax from workers and less direct tax on business profits. Also, as workers receive less income and consumption spending falls, the government will collect less in indirect taxes such as GST. As unemployment increases the government will have to pay more transfer payments. ISBN (Student s book) Subscribe to elearneconomics at: 179

180 Question three: one country model Imports of pig meat and products has risen over the years and accounts for over 40 percent of domestic consumption in New Zealand. Complete (a) to (d) to comprehensively analyse the New Zealand pork market by using the price taker model. (a) Explain why New Zealand could be considered a price taker in the market for pork. New Zealand is a price taker in the market for pork because it is too small to influence the world price OR it has to accept the world price determined overseas. (b) On Graph One below, show at Pw: (i) The quantity demanded of pork products by New Zealand consumers (label as Qd). (ii) The quantity supplied of pork product by New Zealand producers (label as Qs). (iii) Show the quantity imported at Pw (label as M1). (iv) Show a reduction in the New Zealand supply of pork products as pork producers switch resources into other activities. Label the new supply curve S2. Label the new quantity of imported pork products as M2. Price $ Graph One: New Zealand market for pork products with New Zealand as a price taker S2 SNZ Pw DNZ Qs2 Qs Qd M1 Quantity M2 (c) Explain what would happen to New Zealand consumer spending on imported pork products as a result of the changes you made to Graph One in (b) (iv). As New Zealand pork producers switch resources into other activities supply will decrease. The supply curve shifts inward (to the left) as quantity supplied decreases at each and every price (S2). Consumer spending on locally produced pork falls from PW multiplied by Qs to PW multiplied by Qs2. Consumer spending on imported goods increases as more pork is being imported (M2 instead of M) because of the decrease in supply by New Zealand pork producers. 180 Subscribe to elearneconomics at: ISBN (Student s book)

181 (d) Compare and contrast the impact of a decrease in the New Zealand supply of pork products with a fall in the world price on New Zealand consumer spending on imported pork products. In your answer you should: Explain the effect of a fall in the world price of pork products on New Zealand consumer spending on imported pork products. Explain if a decrease in the New Zealand supply of pork products or a fall in the world price of pork products would have a greater effect on New Zealand consumer spending on pork products. On Graph Two below show the effects of a fall in the world price of pork products. Label the original quantity imported as M and the new quantity imported as M2. You must refer to the changes you make on Graph Two to support your explanation. Graph Two: New Zealand market for pork products with New Zealand as a price taker Price $ SNZ Pw Pw2 DNZ Qs2 Qs M Qd Qd2 Quantity M2 As the world price for pork falls from Pw to Pw2 the quantity demanded by New Zealand consumers increases. As the price decreases consumer spending on imported pork will increase because of the increase in quantity demanded and the fall in the quantity supplied by New Zealand firms (Qs to Qs2). The decrease in supply by New Zealand producers would increase consumer spending on imported pork because more pork is being imported and sold at the same price. A fall in world price might not offset the increase in imports of pork so consumer spending on pork may be less. One could argue that consumer spending on imported pork increases if the world price falls because this will increase the quantity demanded and reduce the quantity supplied so the increase in imports will be more than the New Zealand decrease in supply (which just reduces the quantity supplied at Pw). ISBN (Student s book) Subscribe to elearneconomics at: 181

182 Question four: new zealand imports and tariffs Tariffs on a range of products have been cut. Complete (a) and (b) to comprehensively analyse the effects of falling tariffs and increased household incomes on imports of camping equipment. (a) Explain how a reduction in New Zealand tariffs imposed on imported camping equipment could affect the quantity imported. In your answer: On Graph One below, show the effect of tariff reductions on the quantity imported. Label the original imports M and the new level of imports M2. Explain the changes you have made on your graph. Graph One: New Zealand market for camping equipment Price SNZ Pw Pwt DNZ Qs2 Qs M Qd Qd2 Quantity M2 As the tariff is reduced the world price would fall from Pw to Pwt, so there would be an increase in quantity demanded by consumers and a fall in quantity supplied by New Zealand producers of camping equipment. Imports of camping equipment increase from M to M2, to satisfy the increase in quantity demanded from the lower price. 182 Subscribe to elearneconomics at: ISBN (Student s book)

183 (b) Compare and contrast the impact of a reduction in tariffs on imported camping equipment with the impact of an increase in household incomes on camping equipment in New Zealand. In your answer: On Graph Two, show how an increase in income for households would affect the quantity of camping equipment imported. Label the original imports M and the new level of imports M2. Explain how an increase in income for households would affect the imports of camping equipment. Explain whether a reduction in tariffs or an increase in household incomes would have a greater impact on the quantity of imports of camping equipment. Refer to both graphs in your explanation. Graph Two: New Zealand market for camping equipment Price S Pw D D2 Qs M Qd Qd2 Quantity M2 As household incomes increase they can afford more and there will be an increase in quantity demanded for camping equipment at each and every price as shown with the demand curve shifting outward from D to D2. The quantity of imports would increase from M to M2. If household incomes increase some of this increased income will be saved or spent on other goods and services rather than camping equipment so the increase in demand may be insignificant when compared to a fall in the price that results due to a tariff reduction, which may increase quantity demanded more. On Graph One the quantity supplied decreases from Qs to Qs2 and quantity demanded increases from Qd to Qd2 while in Graph Two, with the increase in income only, the quantity demanded will increase from Qd to Qd2. ISBN (Student s book) Subscribe to elearneconomics at: 183

184 Trade: The flow-on effects of trade Terms/Ideas Firm, industry, flow-on effects of fluctuations in trade on industry. The Effect of Fluctuations in Trade on Industry A firm is a single business while an industry is the sum of all firms which produce one type of product. The dairy industry in New Zealand includes all those firms involved in producing dairy products for sale from the farmers who milk cows, firms who process the milk into final or intermediate products, and firms who market the final product. If prices for dairy products in world markets rise, the industry as a whole will prosper and grow. Dairy farmers will be encouraged to invest more in milk production. For example, farmers may purchase land, converting sheep farms to dairy production. This will involve the purchase of capital items such as milking sheds, tractors and equipment. Milk production will increase, farmers incomes will rise and they may employ extra workers. Factories processing milk and firms marketing the final product will also increase output and sales. Employment will rise and spending will increase beyond the dairy industry. The hospitality and travel industry may well benefit as individuals with increased disposable incomes take holidays and travel. Regions whose economies are dependent on the dairy industry are likely to benefit the most from the expansion in economic activity. The changing nature of demand in local and world markets As domestic and global economies go through the trade cycle of recession, recovery and boom, it is likely that the part of the trade cycle that the New Zealand economy is in will differ from a number of its trading partners. If there is a downturn in overseas demand, there are likely to be reduced incomes and possibly business closures for firms that rely heavily on export orders. Unemployment is likely to rise and living standards in the affected areas and communities will be lower. The converse applies for a recovery and increase in overseas demand. While some industries may be experiencing a decline in activities it is possible that other industries are experiencing growth, e.g., while the car and shoe manufacturing industries have declined, other industries such as tourism, wine, education and dairy have grown in size and importance in the New Zealand economy. The changing demand for a product in local or world markets may be temporary or permanent. Resources will switch from declining industries (sunset) into growth industries (sunrise) where prospects and profits are likely to be better. There is always likely to be a change in the fortune of various industries within an economy at any given point in time. The change will mean some individuals losing jobs in some industries, while new opportunities arise in other industries, some firms profits declining while others are growing, firms may close down or may go through a process of restructuring. Key Concepts and Definitions Firm Industry Sunrise industry Sunset industry A single business. The sum of all firms which produce one type of product. A growth (expanding) industry where prospects and profits are likely to be improving. A declining industry where resources will be shifted away into other industries where their prospects are better and the returns to the owners are higher. 184 Subscribe to elearneconomics at: ISBN (Student s book)

185 STUDENT NOTES TRADE EFFECTS New Zealand firms import products because the price is lower than the New Zealand price. As New Zealand firms import goods and services, local (domestic) firms must match the world (overseas) price or lose sales. As the price falls, some domestic producers may be unable to cover the costs of production so decide to close down or produce another good or service. The fall in price will cause the quantity demanded in the local market to increase. An increase in export receipts will encourage New Zealand firms to increase production and invest in new capital. Resources may switch out of less profitable ventures/industries and into these growth industries, for example, the growth of the dairy industry. ISBN (Student s book) Subscribe to elearneconomics at: 185

186 Activities Government economic reform and changes in domestic and international demand patterns have transformed the New Zealand economy. Businesses have shifted from old sunset industries to innovative sunrise industries. 1 (a) Indicate if the following industries are sunset or sunrise industries. (i) boat-building sunrise (ii) organics sunrise (iii) car manufacturing sunset (iv) wine sunrise (v) education sunrise (vi) tourism sunrise (vii) film making sunrise (viii) shoe manufacturing sunset (ix) dairying sunrise (x) wool and sheep sunset (b) The difficulty with economic reform is the short-term losses, and long-run gains. Outline some possible short-term losses and long-run gains that resulted in New Zealand from reform policies that have liberalised trade. (i) Short-term losses: Idea of businesses making less profit or closing down, workers made redundant, unemployment and the lowering of standards of living in the affected communities and areas. (ii) Long-term gains: Idea of more efficient resource use, development of new industries and new employment opportunities as sunrise industries develop. (c) Indicate if the following statements are facts or opinions. Justify your answers. (i) A sunset industry will always be a sunset industry. opinion Justification: While an industry may be in decline for a certain time period, demand domestically and internationally may change and cause a sunset industry to grow at a later date. (ii) The growth and contraction of some New Zealand industries will depend on what goes on in the global economy. fact Justification: New Zealand is part of a world-wide (global) economy with exports contributing 30% to New Zealand GDP. Recessions and booms in overseas economies and changes in international demand will therefore impact on many New Zealand industries. For some industries it will mean contraction while for others expansion. 186 Subscribe to elearneconomics at: ISBN (Student s book)

187 2 (a) (i) Complete the table to indicate if the following event or situation will result in growth or contraction of industries. (ii) Complete the table with a tick ( ) to indicate which industries are likely to be affected by the situation or event outlined. Situation or event Growth or contraction of industries Education industry Tourism industry Marine industry Farming (agriculture/ horticulture) industry New Zealand wins the Americas Cup. growth An outbreak of mad cow disease in Europe and America. growth A SARS outbreak in Asia and downturn in Asian economies. contraction A reduction in quotas and tariffs on New Zealand made products by the European Union. growth (b) Complete the table with a tick ( ) to indicate if the situation outlined is likely to occur when the economy is expanding or contracting. Situation Expanding economy Contracting economy (i) A rise in the number of business closures. (ii) A decrease in the number of building consents. (iii) An increase in the level of business confidence. (iv) Workers are being made redundant and levels of unemployment are rising. (v) Firms are paying workers overtime and there is a scarcity of resources available. (vi) Increased investment by firms and Real GDP is rising. (vii) Firms are recording record sales and company profits rise. (c) (i) Describe what happens in an industry when the industry expands. Sales increase, revenue increases, profits increase, output increases. Firms expand or carry out investment plans. Workers are hired or paid overtime. (ii) Explain the effect of the dairy industry success on New Zealand s dairy regions. Increase in regional growth for those areas associated with dairy, an increase in sales and revenue for retailers as dairy farmers purchase goods and services. Employment opportunities will increase and people will be attracted into these regions. ISBN (Student s book) Subscribe to elearneconomics at: 187

188 3 Refer to Graph 1 below to answer the questions that follow. Price $NZ per tonne 800 Graph 1: The New Zealand steel market SNZ Sw + T 650 Sw DNZ 600 (a) (b) (c) Tonnes (000) SW shows the world supply of steel. State, assuming free trade: (i) the price of steel in New Zealand. $NZ 650 per tonne. (ii) the quantity of steel sold in New Zealand tonnes. Assume that a tariff of $50 per tonne is levied on imported steel. On Graph 1 draw the new supply curve, including the tariff, and label Sw+T. With the tariff in place, state or calculate the: (i) quantity supplied by New Zealand firms tonnes. (ii) quantity imported tonnes. (iii) revenue received by the government as a result of the tariff 4 Read the extract and answer the questions that follow. $ 5 million An outbreak of mad cow disease in Europe is predicted to have an impact on the level of economic activity in New Zealand immediately and in the long term. Recent years have seen an increase in global demand for agricultural product. (a) (i) List several economic effects on the New Zealand farming industry of mad cow disease in Europe. Increased production; increased exports; higher incomes; jobs created; an improvement in New Zealand s current account; inflationary pressures. (ii) Identify the likely impact on economic growth in New Zealand indicated by the information in the extract. (b) Economic growth will increase, i.e., real GDP will increase. Suggest one possible reason for the increasing global demand for agricultural products. Increased standards of living / increased incomes. Increase in global population or economic growth. 188 Subscribe to elearneconomics at: ISBN (Student s book)

189 The ski industry continues to grow as more tourists visit during the New Zealand winter. 5 Explain the impact of the ski industry on the New Zealand economy. In your answer you should: Explain the effect of increased tourist numbers on the ski industry in New Zealand. Explain the effect on inflation, trade and growth. As tourist numbers increase during the ski season, ski operators revenue and profits will increase because of the higher turnover due to the increased demand. Ski operators may have to hire additional staff and train them, or pay existing staff overtime to satisfy the extra demand from increased numbers of tourists. Ski operators may extend the ski season, open up new ski areas or invest in new snow machines, etc. As ski operators become more confident about the future they may borrow funds to invest in plant and machinery to increase profit, because they have higher expectations about the returns and profits they will make. As investment spending increases AD shifts outward, causing the general price level to increase (demand-pull) inflation and an increase in real output GDP which is economic growth. As tourist numbers increase export receipts will increase and improve the New Zealand current account balance (i.e., a greater surplus/or smaller deficit). Since net exports are a component of AD and cause AD to shift outward this would result in demand-pull inflation and an increase in real output GDP which is growth. ISBN (Student s book) Subscribe to elearneconomics at: 189

190 Review (Exam) Questions Question One: education. Foreign fee-paying numbers continue to decline as the global recession continues and the dollar appreciates. Explain, using the education industry, the effect on the economy when export markets are in decline. In your answer you should compare and contrast the effect on various groups: Explain the effect on producers. Explain the effect on government. Explain the effect on growth and inflation. When the New Zealand dollar appreciates against other currencies the cost of an education in New Zealand for foreign students increases and is more expensive. Since New Zealand is less price competitive, fee-paying students look for a relatively cheaper option. As fewer students come to New Zealand, providers of education services in New Zealand will hire fewer teachers and support staff and put investment plans on hold. Providers of accommodation and meals will also employ fewer workers because of the decrease in demand. Overall, this will reduce spending in the economy because there will be less investment spending as business confidence falls and firms are less certain about the future. Export receipts will fall, AD will shift inward, causing real output GDP to decrease as well as the price level, so there will be reduced inflationary pressure and less growth. Growth declines as aggregate demand falls, and firms will reduce output and employ fewer workers. Less employment will result in the government receiving less direct tax receipts and greater unemployment will increase transfer payments. Government revenue from indirect tax receipts collected by firms is likely to decrease as household incomes fall and consumption spending is reduced. Profits for firms will decline, so they will pay less tax to government. Overall, the outcome of falling numbers of foreign fee-paying students will be less production and less growth. 190 Subscribe to elearneconomics at: ISBN (Student s book)

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192 Question two: events and trade. Lamb exporters under pressure as world price falls and the exchange rate rises. Complete (a) and (b) to comprehensively analyse factors that affect trade. (a) Explain the impacts of events on exports. In your answer you should: On the graph, show how a drop in overseas demand for lamb would affect the world price for New Zealand lamb. Label the new price Pw2 and the new quantity of exports as X2. Explain a consequence for New Zealand consumers. Explain how an appreciation of the exchange rate would affect New Zealand lamb producers. Price Graph One: The market for New Zealand lamb SNZ Pw Pw2 DNZ X2 Quantity A fall in overseas demand for lamb would lower the world price for lamb from Pw to Pw2 and exports of lamb would decrease. New Zealand lamb consumers would pay a lower price for lamb (Pw2) and the quantity demanded for lamb would increase since lamb would now be relatively more affordable because of the lower price. An appreciation of the exchange rate would make exports of New Zealand lamb less competitive/more expensive because overseas buyers of New Zealand lamb would require more foreign exchange to purchase the same quantity of lamb, so exports sales of lamb would decrease and lamb producers revenue fall. OR lamb producers would swap forex for fewer New Zealand dollars in the foreign exchange market, so lamb exporters would earn less revenue. 192 Subscribe to elearneconomics at: ISBN (Student s book)

193 NEW BIRD FLU OUTBREAK FEARED Changes to New Zealand s exports and imports will obviously affect firms and industries involved. However, the effects of changes will be felt beyond the immediate producer and their industry. (b) Explain the statement above. In your answer you should: Explain the difference between a firm and an industry using tourism as your example. Explain clearly how an outbreak of bird flu worldwide would impact on New Zealand firms involved in the tourism industry and the wider community. Outline the likely impact on the level of growth and inflation in New Zealand as a result of an outbreak of bird flu worldwide. A firm is a single business, e.g., a business offering accommodation, tourist activities or attractions. An industry is the sum of all firms who provide goods and services for tourists. Ideas: individual tourist operators (firms) will feel the immediate effects of reduced tourist numbers, bookings will fall and receipts for their services will decline. Some tourist operators will contract, while others may close down, staff will be laid-off or work fewer hours. Incomes for those involved in tourism will fall and this will flow on to other industries in the community, e.g., they are likely to spend less on clothes, renovating homes, eating out. Firms in the wider community will have fewer sales and lower profits. These firms will cut back production, employ fewer staff, pay less overtime, some may close down. Firms will be less confident about the future and investment spending will fall. AD will shift inward, causing real output GDP to decrease, therefore growth rates will slow or decline as less output is produced, there will be less upward pressure on prices. ISBN (Student s book) Subscribe to elearneconomics at: 193

194 Question three: the new zealand dollar. Fonterra announces dairy farms will receive an increase in the price for milk solids. Complete (a) and (b) to comprehensively analyse the effect of the New Zealand dollar. (a) Explain the impact of increased world price of milk solids and a falling New Zealand dollar. In your answer you should: Show on Graph One the quantity of exports (X) at Pw and the quantity of exports (X2) after the increase in the world price (Pw2). Explain the changes on your graph. Explain the effects of a lower New Zealand dollar on dairy producers, with particular reference to export receipts and import payments. Graph One: The New Zealand market for milk solids Price SNZ Pw2 Pw DNZ X X2 Quantity Exports of milk solids will increase from X to X2, as the world price increases from Pw to Pw2. The price in the domestic market will increase to meet the world price, therefore the quantity demanded by local consumers will fall and local producers will increase the quantity supplied. The excess supply (surplus) at the world price Pw2 is exported as exporters take advantage of a higher price because it is relatively more profitable. A depreciation of the New Zealand dollar would make milk solids exports more price competitive/less expensive because overseas buyers require less forex to buy the same amount of milk solids. Export sales would increase and revenue earned increase OR exporters would swap forex for more New Zealand dollars in the foreign exchange market, so greater revenue is earned. Export receipts should increase. The depreciation of the New Zealand dollar will cause the cost of imported machinery and raw materials to increase, if the quantity of imports by dairy producers remains constant (ceteris paribus) import payments will increase. 194 Subscribe to elearneconomics at: ISBN (Student s book)

195 The New Zealand dollar has weakened. (b) Explain the effect of a depreciation of the New Zealand dollar. In your answer, explain the impact of a fall in the New Zealand dollar on exports and why the changes you outlined may not take place. A weaker dollar means the New Zealand dollar is depreciating and New Zealand exports will become more price competitive/less expensive to overseas buyers because they would require less foreign exchange to buy the same quantity of exports. Export sales would increase, revenue earned increases and profits could rise. OR exporters would swap forex for more New Zealand dollars in the foreign exchange market so revenues increase. As export incomes increase then firms would be more confident about the future and this would result in an increase in investment spending to make the most of opportunities that are available. Aggregate demand will increase because investment spending and export receipts have increased, therefore there will be an increase in real output GDP (economic growth) and an increase in the general price level (inflation). The impact explained above might not occur because if there is a worldwide downturn (recession), demand for exports may fall because overseas buyers incomes have fallen, their consumption spending on imported products may decrease, therefore less New Zealand exports are purchased by overseas buyers. Firms may decide to wait and see instead of investing if they are uncertain about future economic conditions and the higher risks that may be apparent. Fewer exports and less investment will cause AD to shift inward rather than outward, causing reduced inflationary pressure and less growth. ISBN (Student s book) Subscribe to elearneconomics at: 195

196 Growth: Measures of economic growth Terms/Ideas Measures of economic growth (changes in real income, productive capacity and net social welfare), nominal and real GDP. Measures of Economic Growth There are various ways to measure economic growth. Economic growth is usually seen as the increase in the production of goods and services in an economy. One measure of growth is real income. Real income refers to actual economic output, i.e., the total number of goods and services produced by an economy. Using the two sector circular flow model it is easy to see that the total value of output of an economy can be obtained by measuring the incomes earned in production or the spending on this same production. This measure equates to the statistic Gross Domestic Product (GDP). If there is an annual increase in a country s real GDP this indicates that there is an increase in the number of goods and services made in the economy, which are available for individuals to enjoy. Another way to measure growth is via productive capacity. Productive capacity is a measure of an economy s economic potential, rather than looking at the actual output of an economy. The OECD (Organisation for Economic Co-operation and Development) measures economic potential and compares it to the actual performance of an economy in its output gaps statistic. If there is a decrease in unemployment this will indicate economic growth, and that an economy is moving towards a point on its production possibility frontier, i.e., its current productive capacity. A final way to measure growth is via net social welfare. This measure includes economic factors (that focus on the output of goods and services); as well as non-economic factors, such as quality of life factors. The Human Development Index (HDI) is a composite index to measure socio-economic progress. It has three components knowledge (educational attainment, measured by adult literacy and mean years of schooling); longevity (based on life expectancy); and income (standard of living, based on real GDP per capita). The index can be used to measure changes to the socio-economic level of a country over time, and allows comparisons between countries. Nominal and Real GDP The value of national output (GDP) and the total incomes in producing that output can be shown in nominal terms or in real terms (i.e., the values are deflated using a price index). Nominal GDP refers to the value of output at current market prices, whereas real GDP refers to nominal GDP adjusted for price changes relative to some base year. It is the changes in real GDP that allow for measuring economic growth in real terms and determining increases in the standard of living. Calculating real GDP Real GDP, in base year dollars, requires that the nominal GDP is deflated by the use of a price index. The formula to work this out is given below. Real GDP in base year dollars = Nominal GDP x base year price index Price Index Using the data above we can calculate GDP in real terms (or base year dollars). 600 x = $500 million in base year dollars 1200 Therefore, GDP has increased by $50m in real terms (i.e., the difference between the $450m in 1990 and the $500m in 1995 adjusted for 1990 dollars), or, in this example, GDP has increased by 11 percent in real terms. Year Nominal GDP Price Index 1990 $450 million $600 million Subscribe to elearneconomics at: ISBN (Student s book)

197 Production Possibility Curve and Measures of Economic Growth Capital goods C A Production possibility curve illustrating an increase in productive capacity T U V B D Consumer goods A production possibility curve can be used to show the current maximum output of an economy based on the assumption that there are only two goods, fixed resources and a given level of technology. The maximum potential output can be illustrated as any point (A, T, U, V, Y or B) on the frontier. The productive capacity of a nation will increase if there is a net migration gain, the discovery of new resources or the development of new technology. This will cause the production possibility frontier to shift outwards from AB to CD to reflect the ability of the economy to be able to produce more capital goods and consumer goods. Capital goods Y Production possibility curve illustrating an increase in real GDP H H2 Consumer goods Given that an economy is currently producing at point H inside the production possibility curve and there is an increase in real GDP, then this will be illustrated by moving to a point closer to the frontier such as H2. This change illustrates that the economy has had an increase in the actual number of goods and services produced. Key Concepts and Definitions Nominal GDP Real GDP Measures of economic growth Real income Productive capacity Net social welfare The value of output at current market prices. Refers to nominal GDP adjusted for price changes relative to some base year. It is the changes in real GDP that allow us to measure growth in real terms or increases in the standard of living. Real income, productive capacity and net social welfare. Refers to actual economic output, i.e., the total number of goods and services produced by an economy. Measures an economy s economic potential, rather than looking at the actual output of an economy. Focuses on economic factors (output of goods and services) as well as non-economic factors such as quality of life factors. ISBN (Student s book) Subscribe to elearneconomics at: 197

198 STUDENT NOTES MEASURES OF GROWTH Real income, productive capacity and net social welfare are different measures of economic growth. Real income (real GDP) shows the actual economic output of an economy - i.e., the total number of goods and services produced. An increase in production can be illustrated on a PPC by moving from a point inside the curve to a point closer to the PPC frontier. Productive capacity shows an economy s potential output i.e., maximum output an economy could produce. This measure could be used to determine the potential for future growth. Productive capacity in an economy will increase with improved methods of production due to new technology or the discovery of new resources; this can be illustrated by an outward shift of the production possibility frontier. Net social welfare focuses on economic and non-economic factors to measure growth. It can be used to determine which country has the best quality of life because it contains data on factors that affect lifestyle such as literacy and numeracy rates, life expectancy as well as income. Imports of goods and services are deducted in the expenditure approach for GDP because they are not produced in New Zealand. New Zealand can improve its rate of economic growth by a variety of means including firms investing, discovery of new resources or increasing the quality of the labour force so that workers are more skilled and productive. An increase in government spending (G) would increase incomes - e.g., transfer payments (Tr). As household disposable income increases, consumption spending increases (C), resulting in firms producing more goods and services, aggregate demand shifts outward resulting in economic growth. If the price level increases while fewer goods and services are actually produced, real GDP would fall, nominal GDP might rise. 198 Subscribe to elearneconomics at: ISBN (Student s book)

199 Activities 1 (a) Match each of the following phrases with the most appropriate measure of economic growth. Write each statement out. focuses on economic factors and non-economic factors the maximum attainable an economy can produce shows an economy s economic potential used to determine which country has a better quality of life used to determine which country is likely to have higher growth in the future contains data on infant mortality rates, literacy and numeracy shows the actual output of an economy illustrated by an outward shift of the production possibility frontier real output GDP increases Productive capacity Real output (real income) the maximum attainable an economy can produce shows an economy s economic potential used to determine which country is likely to have higher growth in the future illustrated by an outward shift of the production possibility frontier shows the actual output of an economy real output GDP increases Net social welfare focuses on economic factors and non-economic factors used to determine which country has a better quality of life contains data on infant mortality rates, literacy and numeracy (b) Complete the table on growth. Situation when comparing different countries Most appropriate measure of growth and explanation (i) (ii) Determining which country will have the highest growth in the future. Determining which country has the best quality of life. Measure Productive capacity Explanation If an economy finds new resources or new technology, a country will increase its productive capacity and show there is potential for future growth. Measure Net social welfare Explanation Includes a range of indicators that give information about factors that affect lifestyle. ISBN (Student s book) Subscribe to elearneconomics at: 199

200 2 (a) Distinguish between real GDP and nominal Gross Domestic Product. Nominal measures GDP in current prices whereas real measures the value of output using base year or constant prices, to see if there is an actual increase in output. (b) State one advantage in measuring growth using real rather than nominal figures. Real measures growth in actual output so is a truer measure of improvements in living standards compared with nominal growth which is clouded by changes in the price level (inflation). In recent years dairy units are increasing in size with a resulting increase in the number of cows (greater herd size). New improved farming methods, with better irrigation and investment in plant and machinery has seen milk production per hectare rise, as well as dairy farm profits. Environmentalists are upset that little has been done about the continued run-off from dairy units. The pollution caused means fewer fish and lower quality water for recreational users. 3 Explain alternative measures of economic growth. In your answer you should: Explain what an increase in productive capacity means. Explain what an increase in real income means. Explain the impact on net social welfare. An increase in productive capacity means that potential output has increased. Therefore, the increase in the number of cows has caused milk output (volume) to increase, or improvements in technology have resulted in greater herd size that indicates productive capacity has increased. An increase in real GDP means that there is more actual/real output. Real income/output has increased because of the increase in milk output per hectare. Must argue that net social welfare has increased or decreased by including both sides of the argument, providing additional information and making a justified choice. Does the economic benefits of increased productive capacity and real income outweigh the damage to the environment i.e., has net welfare increased/decreased? 200 Subscribe to elearneconomics at: ISBN (Student s book)

201 4 (a) Define nominal Gross Domestic Product (GDP). The value of final goods and services produced in an economy in a year. (b) How can nominal GDP increase even though real GDP falls? If the price level increased while fewer goods were actually produced, real GDP would fall while nominal GDP might rise. Must recognise that a fall in real GDP relates to a fall in production/output. (c) What is meant by the term productive capacity? The ability/potential/maximum attainable that a firm or economy can produce. (d) Why might net social welfare be considered a better definition of growth than real income? Real income shows that more goods have been produced whereas net social welfare takes into account non-economic costs, e.g., congestion and pollution, as well as economic aspects. 5 (a) (i) Use the table to calculate how much the GDP has increased or decreased in real terms Nominal GDP $140m $180m CPI Real GDP in 2000 prices $140m $160m $140m in 2000 vs $160m in 2005, therefore real GDP has increased by $20m or 14.29% in real terms. (ii) Calculate how much GDP has increased or decreased in nominal terms. Nominal GDP has increased by $40m or 28.57%. (b) State and explain the main conclusion you can draw from your answers to (a) above. The percentage change in nominal GDP is greater than the percentage change in real GDP, the difference is due to inflation. ISBN (Student s book) Subscribe to elearneconomics at: 201

202 Review (Exam) Questions Question One: production possibility curve. Real GDP is the best measure of economic growth rather than nominal GDP or productive capacity. Explain the statement above. In your answer you should: Use a production possibility curve to illustrate and explain an increase in productive capacity and an increase in real GDP. Explain the terms nominal GDP and real GDP. Explain any other measures of growth and why it may be preferable to real GDP. Capital goods PPC for an economy B A Consumer goods An increase in productive capacity will cause the PPC to shift outward, while an increase in Real GDP will result in a shift from a point inside the frontier to a point further out (A B). Nominal GDP measures the total market value of all final goods and services produced in a year measured in current year. Nominal GDP may increase despite the fact that fewer goods and services are produced, i.e., an increase in nominal GDP may be caused by an increase in the general price level (inflation) without any increase in output or in fact output may fall. Real GDP is the total market value of all final goods and services produced in a year measured in constant prices. Real GDP has the effects of inflation removed, therefore real GDP will reflect changes in real output. An increase in real GDP means that more goods and services have actually been produced when compared with the previous time period, which signifies that economic growth has taken place. 202 Subscribe to elearneconomics at: ISBN (Student s book)

203 Real GDP is a better measure of increases in national output or the purchasing power of national income because it deflates nominal GDP to remove changes caused by inflation by using a price index to remove the effects of changes in the general price level. Net social welfare is another measure of growth that includes real income but also includes non-economic factors (literacy, life expectancy) so is a better measure of the quality of life/ standard of living. ISBN (Student s book) Subscribe to elearneconomics at: 203

204 Question two: measures of economic growth. Economic growth can be measured in various ways Complete (a) and (b) to comprehensively analyse ways of measuring growth. (a) Assuming the economy is currently producing at point A, use Graph One to illustrate the effect of an increase in real GDP and Graph Two to illustrate an increase in productive capacity. Graph One: Production possibility curve for the New Zealand economy Capital goods A A2 An arrow indicates an increase in real GDP closer to the PPC Consumer goods Graph Two: Production possibility curve for the New Zealand economy Capital goods The PPC shifts outward A Consumer goods 204 Subscribe to elearneconomics at: ISBN (Student s book)

205 Economic growth can be measured by changes in net social welfare, productive capacity and changes in real income. (b) Compare and contrast the various strengths and weaknesses of different measures of economic growth. In your answer you should: Explain one strength and one weakness of net social welfare. Explain one strength and one weakness of productive capacity. Explain one strength and one weakness of changes in real income. Choose which measure you think is the best indicator of economic growth and give a reason for your choice. Net social welfare strengths include non-economic welfare to indicate the country s overall wellbeing; takes into account environmental impact, availability of public facilities, etc. The weakness of social welfare is that the difficulty in measuring some factors that contribute to happiness or well-being may distort the overall measure, or may show an increase, even though fewer goods and services are being produced; international comparability. Productive capacity strength shows if the country is able to increase the production of goods and services. The weakness of productive capacity does not indicate if more goods and services have been produced; if standard of living has improved; DIY and craft activities not included; do not know the purchasing power of the household; does not indicate efficiency. The strength of changes in real income is that it shows if the whole country is earning more income; if more goods and services have been produced; that more goods and services can be bought; objective and measurable. The weakness of real income is that it does not show: how income is distributed; the composition of output; impact on the environment; illegal, under the table transactions; does not include wealth. Real income is the best indicator of economic growth because it is the easiest to measure because it shows if more goods have been actually produced. OR net social welfare is the best indicator because it measures economic and non-economic factors. ISBN (Student s book) Subscribe to elearneconomics at: 205

206 Question three: migration and growth. Net migration changes will affect the productive capacity of the New Zealand economy. Complete (a) and (b) to comprehensively analyse the effects of a net migration gain on productive capacity and net social welfare. (a) (i) Show on Graph One the impact of a net migration gain on the productive capacity of the economy. Graph One: Production possibility frontier for the New Zealand economy Capital goods Consumer goods (ii) Explain the changes you made to Graph One. As migrant levels to New Zealand increase this means that New Zealand has more human (labour) resources available to use in the production process. The productive capacity (potential output) of the nation will have increased, resulting in the production possibility curve shifting outward. 206 Subscribe to elearneconomics at: ISBN (Student s book)

207 Net social welfare is a possible way to measure economic growth. (b) Fully explain how a net migration gain in New Zealand could affect net social welfare. In your answer you should: State what net social welfare is. Explain positive and negative impacts on net social welfare that may result from a net migration gain. Explain the effect of a net migration gain on economic growth. Net social welfare is a measure of economic growth that focuses on economic factors (output of goods and services) as well as non-economic factors, such as quality of life factors. A net migration gain will result in an increase in resources available for the economy to use, so productive capacity increases (a positive impact on net social welfare). A net migration gain will place a strain on infrastructure and services, for example, bigger class sizes in schools and more cars on the roads will cause congestion and pollution. These are negative impacts on net social welfare. If the positive impacts of a net migration gain outweigh the negative impacts then net social welfare will increase and growth increase. However, if the negative impacts outweigh the positive impacts net social welfare will decrease and growth will decrease. ISBN (Student s book) Subscribe to elearneconomics at: 207

208 Growth: Production possibility frontier Terms/Ideas The production possibility model to illustrate economic concepts. The Production Possibility Frontier Model The production possibility model is drawn on the assumption that there are two goods only, fixed resources and a given level of technology. The production possibility model can be used to illustrate economic concepts related to scarcity, choice, opportunity cost and growth. The production possibility curve below shows the output of economic goods. Economic goods are scarce and have a cost, and can be either capital (producer) goods, or consumer goods, which are sold to individuals for their own private use (e.g., clothes, food and cars). Consumer goods are for immediate consumption to satisfy consumer wants. Capital goods are man-made goods that are used to make other goods and services, e.g., tools and machinery. If an economy produces more capital goods now, then fewer consumer goods can be produced. This production of capital goods will increase the economy s future productive capacity, but means a lower standard of living now. On the other hand, the production of more consumer goods now will mean fewer capital goods can be produced. This production of consumer goods will increase standards of living now but it is likely that the future output of the economy will fall. A production possibility curve (PPC) shows maximum output of two goods that can be produced given that existing resources and technology are fully utilised, i.e., put to their best possible use with the least cost. The maximum output shown by any point on the production possibility curve shows scarcity, as it is impossible to produce beyond the curve with existing resources or state of technology. Capital goods Production possibility curve for economic goods opportunity cost W 40 X Y Consumer goods (00) Any point inside the curve (for example point X) is production inefficient, i.e., resources are not being fully utilised or put to their best possible use. Currently, the New Zealand economy in relation to its production possibility curve would be at a point inside the frontier because not all New Zealand resources are fully employed, e.g., we have people unemployed, so labour resources are not fully utilised. The slope of the production possibility curve illustrates opportunity cost, so as you move from W to Y the opportunity cost is 40 capital goods foregone. As you move from one end of the curve to the other, the increase in output is at a decreasing rate so this reflects the law of diminishing returns. If the curve is bowed outwards (curved), then the inputs (resources) used are more suited to producing one good than the other. For example, land use for deer and forestry would find land areas that are more suited to say, deer rather than forestry. 208 Subscribe to elearneconomics at: ISBN (Student s book)

209 Illustrating economic growth Economic growth is an increase in the productive capacity of an economy, regardless of whether this extra ability to produce more is used or not. It would be illustrated by a production possibility curve shifting outward. As the economy s productive capacity is increased, it is able to produce beyond its original production possibility curve. This outward shift of a production possibility curve can occur over time as we relax the underlying assumptions of a production possibility curve, of fixed resources and a given level of technology. As new resources are discovered, investment takes place or new technology is developed, the production possibility curve for an economy will shift outward. The production possibility curves below show growth as a result of increases in productive capacity. Consumer goods Consumer goods Consumer goods Capital goods Capital goods Capital goods Graph one Graph two Graph three Graph one shows that there has been an improvement in resources or technology that improves the economy s capacity to produce consumer goods, while still producing the same quantity of capital goods. Graph two shows that there has been an improvement in resources or technology that improves the economy s capacity to produce capital goods, while still producing the same quantity of consumer goods. Graph three shows that there has been an improvement in resources or technology that improves the economy s capacity to produce both consumer and capital goods. Economic growth is an increase in the volume of goods and services produced. This can be shown on a production possibility curve as moving to a position closer to the frontier. This movement closer to the frontier could occur as a result of the better utilisation of existing resources and technology. Graph four illustrates growth occurring as a result of an increase in efficiency with the movement from X to Y. Consumer goods Y X ISBN (Student s book) Capital goods Graph four Subscribe to elearneconomics at: 209

210 Key Concepts and Definitions Production possibility curve (PPC) Capital goods Shows maximum output combinations using resources efficiently, best possible use with a given existing level of technology and resources. It is not possible to produce enough to satisfy all wants so the PPC reflects scarcity. Any point inside the curve is under-utilisation or inefficient use of resources. There is also no opportunity cost as you move from a point inside the curve to a point on the curve. A point outside the curve is impossible with existing resources/ technology. Consumer goods New technology or the discovery of new resources will shift a PPC outward. Capital goods (or producer goods) Consumer goods Man-made goods to produce other goods and services. Production of these will increase future production but means fewer consumer goods now. Goods that households or individuals use in order to satisfy needs and wants. Production of these now mean fewer capital goods now and may lower future productive capacity of an economy. 210 Subscribe to elearneconomics at: ISBN (Student s book)

211 STUDENT NOTES PPC Capital goods The economy Y X Consumer goods X Y indicates an increase in production. As the entire PPC shifts outward at both ends (as indicated by the direction arrows) this shows the economy is able to produce more goods and services, i.e., productive capacity has increased and growth increases. As workers productivity increases due to the use of new technology and increases in physical capital (manufactured goods used in production) the economy is able to produce more with the same number of workers production increases, therefore economic growth increases. ISBN (Student s book) Subscribe to elearneconomics at: 211

212 Capital goods X opportunity cost Y Consumer goods Position X is likely to result in higher economic growth in the future because greater capital stock means firms can produce more at a faster rate or with the same number of workers, thereby increasing productivity and therefore increasing future production and growth. The opportunity cost (as illustrated and labelled on the PPC) shows that capital goods are foregone or given up to obtain more consumer goods, as an economy shifts from position X to Y. 212 Subscribe to elearneconomics at: ISBN (Student s book)

213 Activities 1 Use the table below to answer the questions that follow. Production possibility schedule for economy X A B C D E Capital goods (000) Consumer goods (000) (a) (i) Draw the production possibility curve for economy X in the grid provided below. (ii) Clearly demonstrate and label a position as full employment and another position where there is unemployment. Capital goods (000) 40 A Production possibility curve for economy X B C full employment unemployment D 5 E Consumer goods (000) c(iv) opportunity cost (b) Can economy X produce beyond its production possibility curve? Explain your answer. Idea that it can not currently, given the assumptions under which it is drawn, possibly in the future it can produce beyond its PPC when the assumptions are relaxed. (c) (i) Give one reason why the production possibility frontier may shift outwards over time. Discovery of new resources/development of new technology. (ii) Would producing at point B or point D result in greater future productive capacity? Point B (iii) Identify the opportunity cost of moving from point B to point D capital goods (iv) Identify and clearly label the opportunity cost of moving from point D to point C consumer goods ISBN (Student s book) Subscribe to elearneconomics at: 213

214 2 Use the production possibility curve and your own knowledge to answer the questions that follow. (a) Illustrate and clearly label on the curve: (i) The concept of opportunity cost. (ii) The effect of a net migration loss of individuals. The production possibility curve for an economy Capital (producer) goods a(ii) Z T X Y opportunity cost a(i) Consumer goods (b) Match the points indicated by the letters to the situations described in the table. Situation Letter (i) Full employment. Y, Z (ii) An economy is not utilising all its potentially useful resources. X (iii) New Zealand s current position. X (iv) An economy is making the most efficient use, in terms of current technology, of the resources it has. Y, Z (v) An economy has a deficient market mechanism which fails to allocate resources to their most productive uses. X (vi) individuals are not working. X (vii) A factory is operating below its capacity. X (viii) For each level of output of one good, the maximum of the other good that can be produced. Y, Z (ix) An economy is under-employing its resources. X (x) Potential output to the economy is being lost. X (xi) Resources are idle or under-utilised. X (xii) A position where an economy makes the most of its scarce resources. Z, Y (xiii) A given level of technology and resources mean only so many commodities can be produced. Z, Y (c) Complete the sentences. A production possibility curve is drawn assuming two goods only, fixed resources and a given level of technology. Assuming that all the resources are fully used, the frontier shows the maximum output of each good that the economy can produce. A point on the curve shows full employment of available resources. Points that lie inside the curve (e.g., X) indicate that there are unemployed or inefficiently used resources. Points that lie outside/beyond the curve (e.g., T) are currently unobtainable. This position (T) may be reached in the future when new resources are discovered or when new technology is developed. 214 Subscribe to elearneconomics at: ISBN (Student s book)

215 3 Study the resource material below and answer the questions that follow. Production Possibility Schedule for an economy Combination A B C D E F G H Consumer Goods (million) Capital Goods (million) (a) On the grid below construct a fully labelled and accurate production possibility curve from the data provided. Consumer goods (million) A Production Possibility Curve for an economy B C D V 18 E U F 9 6 G 3 H Capital goods (million) (b) What is the opportunity cost in moving from combination D to combination E? (c) (d) 4 million consumer goods On the graph you have drawn label as: (i) V a point that is unobtainable with current resources and technology. (ii) U a point illustrating under-utilisation of resources. A production possibility is drawn assuming a given level of technology. Explain how this assumption imposes limitations on the production possibility model. Technology changes can be very rapid and make considerable contributions to and productivity output. The potential to influence the PPC model is therefore significant. (e) Indicate if the following statements are correct or incorrect. Statement Correct or incorrect (i) The economy is operating at its capacity at position D. correct (ii) Position A is likely to lead to future economic growth. incorrect (iii) Position G is likely to lead to future economic growth. correct (iv) Position G will likely result in a higher standard of living now but future production will suffer. incorrect ISBN (Student s book) Subscribe to elearneconomics at: 215

216 4 (a) If the economy is currently producing at Point B, use the diagrams below to illustrate the effect on: (i) an increase in productive capacity. (ii) an increase in production. Consumer goods Consumer goods B B (b) Capital goods What would be implied by an inward shift in a production possibility curve? Loss of technology and/or resources, e.g., natural disaster. Capital goods (c) (i) What is implied by a shift outwards of a production possibility curve? It implies more goods are being produced. For this to occur the productive capacity of the economy must increase enabling greater levels of output to be produced. This implies an increase in available resources or an improvement in the state of technology. (ii) Explain why some combinations inside the curve may be preferred to some combinations on the frontier. People may value leisure time and see it as better than producing the goods, or reduced output may be preferred on the basis of preserving the quality of the environment or resources for future generations. (d) Describe what a production possibility frontier illustrates. A production possibility frontier illustrates the maximum output of two goods assuming a given level of technology and fixed resources. 216 Subscribe to elearneconomics at: ISBN (Student s book)

217 Productivity improvements are seen as a key to economic growth as well as foregone current consumption. 5 Explain how improved productivity can affect economic growth. In your answer you should: Use the production possibility curve to illustrate improved productivity and explain how this can affect growth. Explain how, as investment increases as a result of consumption foregone, future growth can result. Capital goods PPC for an economy B Y X A Consumer goods The production possibility curve shows the maximum possible output for an economy. An improvement in productivity (output per worker or machine) means an increase in efficiency and that the economy will move closer to the maximum output possible because the current level of resources can produce more. Therefore, real output GDP will increase as shown by the movement from X to Y which is economic growth. As an economy moves from point A to point B, it is foregoing present consumption (savings) and this results in more capital goods being produced (investment). This will therefore increase the potential possible output of the economy, i.e., the production possibility curve will shift outward. This means that greater output is possible in the future. ISBN (Student s book) Subscribe to elearneconomics at: 217

218 Review (Exam) Questions Question One: growth. Migration set to have an impact on economic growth. Complete (a) and (b) to analyse the effects of migration and decreased saving on economic growth. (a) Explain the impact a net migration gain can have on economic growth. In your answer you should: Define productive capacity and show on the diagram how a net migration gain could affect the productive capacity of the New Zealand economy. Explain the changes you have made to your graph. Consumer goods Production possibility curve for the New Zealand economy Net migration gain impact on the productive capacity of an economy. Capital goods Productive capacity is a measure of economic growth that measures an economy s economic potential, i.e., the total number of goods and services that an economy could produce. A net migration gain means that the New Zealand economy has more resources available, so the productive capacity of the country will increase, this is shown as the production possibility frontier shifting outward (to the right). 218 Subscribe to elearneconomics at: ISBN (Student s book)

219 Consumption impacts on growth. (b) Compare and contrast the impact of present consumption on growth. In your answer you should: Use a production possibility curve and explain the opportunity cost of present consumption in terms of economic growth. Explain how present consumption can positively affect growth. Explain how present consumption can negatively affect growth. Capital goods PPC for an economy Opportunity cost A B Consumer goods A production possibility curve shows the maximum possible output for an economy. If an economy consumes more consumer goods, point B, then there will be a decrease in capital funds (shown and labelled as the opportunity cost) and, therefore, a decrease in economic growth in the future. Growth can be positively affected because if there is an increase in present consumption, firms will find stock levels falling as sales increase, therefore production will increase, resulting in economic growth. OR if present consumption decreases, then more capital goods are produced so there is likely to be more growth in the future. Growth can be negatively affected because if present consumption increases, there will be less saving so less funds are available for investment. Less investment will mean less growth in the future. OR an increase in present consumption means fewer capital goods are produced so there will be less growth in the future. ISBN (Student s book) Subscribe to elearneconomics at: 219

220 Question two: spending and economic growth. Household spending levels are set to increase as direct tax cuts take effect. Complete (a) and (b) to comprehensively analyse the effect of increased spending by households on short-term and long-term economic growth. (a) On Graph One show the effect of increased consumer spending by households on real GDP in the short term. Explain the changes you made. Graph One: AS/AD model of the New Zealand economy Price level AS PL2 PL AD AD2 Y Y2 Real output GDP (Y) A decrease in direct tax will increase household disposable incomes and consumption spending (by households) will increase, causing the aggregate demand curve to shift outward (from AD to AD2). As AD shifts outward there will be an increase in real output GDP, which is economic growth. 220 Subscribe to elearneconomics at: ISBN (Student s book)

221 (b) Discuss the impact of increased spending by households on short-term and long-term economic growth. In your answer: Illustrate on Graph Two how an increase in consumption spending would affect savings, investment and long-term growth in the economy. Assume the economy is initially at point X. Explain why an increase in spending would affect the level of investment in the economy. Explain why an increase in consumption spending would have a more positive effect on shortterm growth compared to long-term growth. Refer to the changes you made to both graphs. Capital goods Graph Two: Production possibility frontier for the New Zealand economy Opportunity cost X X2 Shift with less investment Shift with increased investment Consumer goods As consumption spending increases household savings will decrease, resulting in the shift from X to X2 in the PPC. This will result in a decline in investment because before investment can take place saving needs to occur. A fall in investment means that fewer capital goods are produced/purchased, therefore growth in the long term will be slower or fall, because the future productive capacity of the economy will not be as great as it would have been if investment had taken place. In the short term, growth will occur as shown on Graph One as real output GDP increases from Y to Y2. In the long run the lack of savings will have a detrimental impact on growth because there is a lack of funds available for investment. The outward shift on the production possibility curve will be smaller than if investment was to occur, because fewer capital goods will restrict the ability to increase future output. ISBN (Student s book) Subscribe to elearneconomics at: 221

222 Question three: savings and growth. Households are saving more. Complete (a) and (b) to comprehensively analyse the effect of savings in the short term on economic growth. (a) On Graph One below, show the effect of increased savings. Then give a detailed explanation of the change you made. Graph One: the AS/AD model Price level (PL) AS PL PL2 AD AD2 Y2 Y Real output GDP (Y) Savings is income not spent. As households increase savings, consumption spending will decrease causing the aggregate demand curve to shift inward from AD to AD2. This change will cause a decrease in real output GDP, shown as the change from Y to Y2, therefore in the short run there is a fall in economic growth. 222 Subscribe to elearneconomics at: ISBN (Student s book)

223 For investment to take place savings must take place, this will impact on growth in the short term and longterm. (b) Compare and contrast the effect of greater savings on short-term and long-term growth. In your answer, you should: explain why greater savings could have a more positive impact on long-term growth show the short-term and long-term impacts on Graph Two below to support your answer. Consumer goods C Graph Two: Production possibility frontier A T X B D Capital goods An increase in savings will make funds available for investment by firms because more resources would be available to produce capital goods as fewer consumer goods are produced. This investment will increase long-term growth because the productive capacity of the economy will increase, so more goods and services can be produced in the future. This is illustrated by the outward shift of the PPC curve as shown on Graph Two (from AB to CD). ISBN (Student s book) Subscribe to elearneconomics at: 223

224 Growth: The circular flow model Terms/Ideas The circular flow model (real and money flows, injections and withdrawals). Households and firms Real flows of inputs and goods and services Resources (factors of production) Households Firms Goods and services The real (or physical) flows in the circular flow model are shown above. Resources are owned by households and supplied to firms who use these factor inputs to produce finished goods and services. Real flows and money flows Resources (factors of production) $ Incomes (Y) Households $ Consumption spending (C) Firms Goods and services Money is used to finance the flow of resources, goods and services. Firms pay households incomes (Y) for the use of the resources they supply. Households use this income to purchase the goods and services they desire from firms, this is termed consumption spending (C). As an economy grows (expands) or contracts it will influence the flows in the circular flow model. If consumers demand for goods and services increases, then firms will require additional inputs (resources) to produce the increased output required. In turn, firms will pay households more for the inputs used and households incomes will rise. Savings and financial institutions Households can either spend or save the income they receive. Savings (S) represent income not spent. Households will put money aside for various reasons. They may save to have funds available for an emergency, for example, a trip overseas to see a sick relative, or to fund a future purchase, e.g. saving money for a deposit on the purchase of a car or a house. Savings are made with financial institutions who use these funds to make advances (or loans) to firms, who purchase capital goods. The spending by firms on capital goods is termed investment (I). Investment spending by firms will depend on several factors, including business confidence, interest rates and the availability of funds. Firms are likely to increase investment spending when they are confident about the prospects of a venture being profitable. If interest rates fall or are lower, then spending on a new factory or a piece of equipment is more likely because the cost of borrowing is lower and the associated risks reduced, which make the project likely to be more profitable. 224 Subscribe to elearneconomics at: ISBN (Student s book)

225 Financial institutions and the circular flow $ Consumption spending (C) Households Firms Savings (S) $ Incomes (Y) Financial institutions Investment (I) Before a financial institution can make funds available for investment they must first collect deposits (savings). If the level of savings increases then there are more funds available for investment. This, however, does not necessarily mean that increased investment will take place, for several reasons. Financial institutions may find it difficult to find credit worthy firms to make advances (loans) to, or firms do not wish to invest because they are not confident about the future. The role of government The government collects taxes (direct and indirect) and spends money on goods and services or provides subsidies to firms. These flows are illustrated on the diagram below. Households ($) Transfer payments (Tr) ($) Direct taxes (T) Government ($) Government spending (G) ($) Indirect taxes (IT) e.g. GST Firms Government tax take (income) and level of spending will change with changes in the level of economic activity. As the economy grows and firms hire additional workers or pay existing workers overtime, then the government will collect more direct tax as employment increases. Also as disposable incomes increase and consumption spending increases then firms will collect more indirect tax (GST) and pass this on to the government. The government will pay less on transfer payments because individuals who were unemployed are now able to get a job. Government spending may increase as its revenue increases or it may decide to reduce levels of government debt. Trade/overseas Some economic activity in a country is associated with foreign buyers and sellers. Export receipts (X) represent a money flow into a country for goods and services sold to overseas buyers. Import payments (M) represent a money flow out of a country for goods and services purchased from overseas producers. Trade/overseas money flows $ Export receipts (X) $ Import payments (M) Firms An increase in households incomes could see an increase in import payments (M) because households decide to take overseas holidays or purchase imported goods and services such as electrical goods or cars. If there is a boom in the global economy, with higher incomes for overseas households, then export receipts can increase, which will have a flow-on effect for producers. Producers may become more confident about the future and move expansion plans forward and invest. ISBN (Student s book) Subscribe to elearneconomics at: 225

226 Injections and leakages When money is taken out from the circular flow of economic activity we call it a leakage (or withdrawal), and when money is put into the circular flow we call it an injection. Injections (J) is an expenditure that does not originate from household and will increase the level of economic activity investment spending, government spending or export receipts. Leakages or withdrawals (W) that will decrease the level of economic activity are savings, taxes and import payments. Key Concepts and Definitions Leakages (W) Injections (J) Savings (S) Investment (I) Transfer payment (Tr) A withdrawal within the circular flow model, e.g., savings, taxes, and import payments. An addition to money in the circular flow model that does not originate from households, e.g., investment spending, government spending, and export receipts. That part of disposable income not spent on current goods and services, e.g., buying shares or putting funds aside into superannuation schemes. The creation or purchase of new capital by firms or government, e.g., building a new factory or constructing a motorway. A payment made by government with no exchange (nothing is received in return), e.g., income support or the domestic purposes benefit. 226 Subscribe to elearneconomics at: ISBN (Student s book)

227 STUDENT NOTES CIRCULAR FLOW The circular flow model shows how different sectors of the economy are related, it includes both real flows and money flows. Real flows are the movement of resources or goods and services between sectors. An increase in the flow of goods and services would best indicate economic growth. Money taken out of the circular flow models is called leakage (or withdrawal) and when it is returned it is called an injection. An injection (J) is an expenditure that does not originate from households, it includes investment spending (I), government spending (G) and exports (X). Leakages or withdrawals (W) are savings (S), taxes (T) and imports (M). The circular flow model Incomes (Y) Direct taxes (T) Taxes on production (IT) e.g. indirect taxes Households Government Firms Transfer payments (Tr) Savings (S) Consumption spending (C) Financial Institutions Government spending (G) or subsidies Investment (I) Export receipts (X) Import payments (M) Overseas Sector ISBN (Student s book) Subscribe to elearneconomics at: 227

228 228 Subscribe to elearneconomics at: ISBN (Student s book)

229 Activities Use the information in the diagram to answer the questions that follow. iv Financial I = $30b ii = $42b Households i = $80b Producers Overseas IT = $20b iii = $40b Government G = $21b Tr = $37b T Y 1 (a) Complete the circular flow model above by identifying the missing money flows. Use appropriate symbols or words. (i) Consumption spending (C) (iii) Export receipts (X) (b) (ii) Import payments (M) (iv) Savings (S) Indicate what the following symbols represent in the circular flow model. (i) C Consumption spending (vi) IT Taxes on production (ii) I Investment spending (vii) S Savings (iii) G Government spending (viii) M Import payments (iv) Tr Transfer payments (ix) X Export receipts (c) (v) T Taxes (x) Y National income Complete the table (use appropriate symbols). Injection (J) flows in the circular flow model Leakages (W) flows in the circular flow model I, G, X S, T, M (d) (e) Which sector in the economy saves and which sector invests? Saving sector: Households Investment sector: Firms Discuss the link between savings and investment. Investment spending will often require borrowing, so the level of investment is dependent (f) on the level of savings, i.e., savings makes investment possible. Describe how high levels of saving and investment affect an economy and living standards in the future. High levels of savings make investment possible, so stocks of capital will increase and output in an economy can increase and raise future standards of living. ISBN (Student s book) Subscribe to elearneconomics at: 229

230 2 Use the diagram below to answer the questions that follow. Overseas (i) (ii) Firms (ix) (x) Households (iii) (iv) Government (v) (vi) (vii) (viii) Banks (a) Identify the money flows represented by the arrows which have attached numbers. Choose the appropriate terms from the list below for the money flows. Not all terms need to be used. Do not use any term more than once. Terms for use Goods and services Resources Import payments Savings Consumption spending Direct tax Export receipts Transfer payments Wages Indirect tax Venture finance Government spending (i) Export receipts (vi) Direct tax (ii) Import payments (vii) Savings (iii) Indirect tax (viii) Venture finance (iv) Government spending (ix) Wages (b) (v) Transfer payments (x) Consumption spending Which number in the diagram shows the flow of: (i) A publishing firm paying its employees. (ix) (ii) A business borrows money to buy a new computer. (viii) (iii) A firm pays GST. (iii) (iv) A worker deposits some of their income into a term deposit. (vii) (v) A student buys shares. (vii) (vi) An American firm buys New Zealand-made products. (i) (vii) A New Zealand tourist flies British Airways. (ii) (c) (d) (e) Identify the physical flows in the table above. Goods and services/resources Identify the withdrawals from the circular flow model. Taxes/savings/imports Identify the injection flows into the circular flow of money. Investment spending (I), government spending, subsidies (G) or export receipts (X). 230 Subscribe to elearneconomics at: ISBN (Student s book)

231 Use the diagram below that represents the money flows in a basic economy to answer the questions that follow. Model One A I G Firms J Government H Households F B C E D Overseas Financial Institutions 3 (a) Give letters to identify the money flows in the diagram that best represent the following: (i) Consumption spending B (v) Government spending I (ix) Direct taxes H (ii) Savings C (vi) Incomes A (x) Indirect taxes J (iii) Investment D (vii) Export receipts F (iv) Transfer payments G (viii) Import payments E (b) Explain the effect on the money flow in Model One above that would be directly affected by less overseas funds being deposited or lent to financial institutions in New Zealand and the effect on economic growth. If less overseas funds are deposited or lent to financial institutions in New Zealand this will mean that there are less funds available for banks to make advances or loans to firms for investment. Investment funds will decrease and decrease AD. As AD decreases real output GDP will fall and lower economic growth will result. (c) Indicate which money flow best represents the following situations by placing a tick ( ) in the appropriate box. C I G X S T M (i) A business borrows money to buy a new computer. (ii) A firm pays GST. (iii) A worker deposits some of their income into a term deposit. (iv) A student buys shares. (v) An American firm buys New Zealand-made products. (vi) A New Zealand tourist flies British Airways. (vii) A student from Cambodia studying at a New Zealand school. ISBN (Student s book) Subscribe to elearneconomics at: 231

232 Despite interest rates falling, savings have increased as concern for the future rises. 4 (a) Explain the statement above. In your answer you should: Define savings and explain why when interest rates fall it is likely that savings decrease. Explain the effect of increased savings on financial institutions. Explain how savings may affect economic growth and inflation. Households Savings (S) Financial Institutions Investment (I) Firms Savings are income not spent. As interest rates fall then saving is likely to decrease because people (households) will be getting a lower return on funds set aside, therefore saving less. When financial institutions collect greater deposits from household savings they will have greater funds available to lend out to firms for investment. The increase in savings means more funds for investment. This will increase the ability of New Zealand firms to invest. This will cause aggregate demand to increase (shift outward) and cause an increase in the general price level (demand-pull inflation) and an increase in real output GDP which is economic growth. Increased investment will improve productivity and productive capacity, resulting in increasing output and economic growth will increase. As the aggregate supply curve shifts outward it will reduce inflationary pressures in the economy. (b) Label the missing spaces (i), (ii), (iii), (iv) and (v) on the diagram below (note some are sectors and the rest are money flows). (iii) X Overseas M (iv) G State T (v) I Financial S (i) Firms Consumption spending (C) Incomes (Y) (ii) Households 232 Subscribe to elearneconomics at: ISBN (Student s book)

233 Events such as the rugby and rowing world cups and the world orienteering championships increase total economic activity. 5 Explain how events contribute to increased economic activity. In your answer you should: State the injection flows in the circular flow model. Explain how each injection flow will increase because of events. Explain how events will cause economic growth directly and indirectly. The injection flows in the circular flow model are investment spending (I), government spending or subsidies (G) and export receipts (X). Investment spending (I) by firms will increase before the events take place so that firms can take the opportunities that will arise when the event is on. Visitors will need a place to stay (accommodation), food and transport, therefore firms in these industries will look to replace old plant and machinery and increase capacity to satisfy additional demand. Because infrastructure needs to be built for these events (stadiums, roading) firms in the construction industry will also increase investment spending. Government spending (G) will increase because government and local authorities are involved in funding some of the costs of infrastructure. Export receipts (X) will increase as visitors (tourists) and competitors come to participate in or watch the events, they will consume goods and services in New Zealand such as food, accommodation and transport. A direct effect is the actual spending on the events as they take place, for example, taxis or train trips to the games or spending on merchandise sold during the events. An indirect effect will arise as firms hire additional workers while the events are on or pay existing workers overtime. As their disposable incomes rise then it is likely that consumption spending by households will increase. Both the direct and indirect effects will see AD shift outward and an increase in real output GDP, which is economic growth, as output in the economy increases. ISBN (Student s book) Subscribe to elearneconomics at: 233

234 Review (Exam) Questions Question One: the circular flow model. A few of New Zealand s trading partners in Europe are in a downswing phase of the business cycle. Complete (a) and (b) to comprehensively analyse the effect on economic growth of a few of New Zealand s trading partners in Europe being in the downswing phase of the business cycle, and the effect of an increase in consumer confidence. Model One: Circular flow model for the New Zealand economy (money flows only) Incomes (Y) Direct taxes (T) Taxes on production (IT) e.g. indirect taxes Households Government Firms Transfer payments (Tr) Savings (S) Consumption spending (C) Financial Institutions Government spending (G) or subsidies Investment (I) Export receipts (X) Import payments (M) Overseas Sector (a) Explain in detail which money flow would be directly affected by a few of New Zealand s trading partners in Europe being in a downswing phase of the business cycle. If a few of New Zealand s trading partners in Europe are in a downswing phase of the business cycle the money flow that is affected is export receipts. Export receipts would decrease because lower incomes of overseas buyers would result in less demand for New Zealand goods and services. 234 Subscribe to elearneconomics at: ISBN (Student s book)

235 Consumer confidence is rising (b) Compare and contrast the impact on economic growth of a few of New Zealand s trading partners in Europe being in a downswing phase of the business cycle with the impact of an increase in consumer confidence. In your answer, refer to the relevant money flows from Model One and explain: how a few of New Zealand s trading partners in Europe being in a downswing phase of the business cycle could affect economic growth how an increase in consumer confidence could affect economic growth the combined impact on economic growth of both these events. If a few of New Zealand s trading partners in Europe are in the downswing phase of the business cycle they will demand fewer New Zealand goods and services because their income will be lower. As export receipts fall, aggregate demand will shift inward, causing real output GDP to decrease. As less is produced, growth falls. An increase in consumer confidence will result in an increase in consumption spending which will shift AD outward. This will cause an increase in real output GDP, economic growth. The combined effect is that the increase in AD from consumer confidence is greater than the decrease in AD from a few of New Zealand s trading partners in Europe. A few nations in Europe are not one of New Zealand s major trading partners so the impact of a decreased demand is likely to be small compared with consumption spending by households. Consumption spending contributes a greater component to AD than does exports. It is likely that increased consumption spending by households will cancel the effect of decreased demand for New Zealand exports from a few trading partners in Europe. ISBN (Student s book) Subscribe to elearneconomics at: 235

236 Question two: free trade and the circular flow model. Compare and contrast the impact that signing a free trade agreement (FTA) could have on various money flows in the circular flow model and on economic growth. In your answer: explain how the withdrawal flow associated with the government sector would be affected by a growth in exports associated with a free trade agreement explain the money flow that would be directly affected in the circular flow model diagram by signing a free trade agreement explain how economic growth could result from signing a free trade agreement. The withdrawal flow associated with the government sector is taxes (direct and indirect). The government would receive more direct tax because export growth would result in jobs and more workers being employed. Some workers would move into higher tax brackets and pay more tax. Businesses that export would earn higher incomes and make greater profits and pay more company/direct tax. There would be increased spending by households as incomes increase and the government would receive more indirect tax (GST) revenue. Export receipts would increase with signing a FTA because exporters would be selling more goods and services to overseas buyers/consumers. Import payments would increase because New Zealand consumers would be buying more goods and services from producers in overseas countries. The increased demand for goods and services by overseas buyers would result in New Zealand firms producing more to satisfy demand, this results in economic growth. With increased exports, firms would become more confident about the future and perceive the risks of investment to be lower. As investment increases, AD would increase and result in an increase in real output GDP (economic growth). The cost of imported raw materials would fall. Lower costs of production would increase profitability and result in the AS curve shifting outwards. This would result in an increase in real output GDP (economic growth). 236 Subscribe to elearneconomics at: ISBN (Student s book)

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238 Growth: The causes of economic growth Terms/Ideas The opportunity cost of present consumption, changes in investment and technology and its impact on productivity, the importance of events on economic growth. Trade Off Capital Goods and Consumer Goods Resources are limited and are used to produce either consumer goods (purchased by households for immediate use e.g., clothes, food, cars) or capital goods (man-made items of capital equipment used to produce other goods and services, e.g., tools, machinery) In a fully employed economy a decision to divert resources to produce additional consumer goods can only occur if fewer capital goods are produced. The following analysis illustrates this. The decision to produce more consumer goods from position OE to position OF, results in a fall in production of capital goods of OC to OD. Overall the output of capital goods CD is lost because the resources used to produce capital are now used to produce the additional consumer goods. Capital goods Production possibilities of an economy C opportunity costs D X Y O E F Consumer goods The decision of an economy to produce more consumer goods (shifting from position X to position Y) will result in a higher standard of living now. However future standards of living and output of an economy may increase only gradually. The reason is that as capital goods are not replaced or becomes obsolete, machinery and equipment will wear out and productivity will decline, causing likely future output to increase slowly or decrease. If an economy diverts resources into the production of capital goods it requires that consumer goods are foregone. While current living standards may fall because consumer goods are sacrificed, the production of capital goods will enable the economy to increase its level of productivity and growth in the future. Determinants of growth Economic growth can be increased by either increasing the output from existing resources and/or increasing the quantity of resources available to a country. The discovery of new resources (e.g., coal, gas, oil, new fish stocks) will increase economic growth in the short run. This growth may later slow as these new resources are used up or are overexploited. Growth can result from either an increase in the quantity or quality of human resources, or both. The quantity of human resources can be the result of a net migration gain (when the number of arrivals of migrants is greater than departures), or from a natural increase in the population (i.e., if the death rate is lower than the birth rate). The quality of the workforce has a direct bearing on the output per worker (or productivity). If the same output is produced at a lower cost than before then productivity has increased. Firms that can increase productivity are able to become more competitive because they are producing more with less. The quality of labour can be improved with education from various institutions and training given to staff by firms. In Economics, investment is the addition to capital resources, e.g., a firm installs a new machine or government extends a motorway. Investment (sometimes called capital accumulation or capital formation) is said to be the key to determining growth. 238 Subscribe to elearneconomics at: ISBN (Student s book)

239 Some investment is necessary to replace capital goods that are depreciating. Depreciation is the wear and tear on capital goods that reduces their productive capacity, and includes items of capital that have become obsolete. The opportunity cost of investment for future growth is the consumer goods foregone (or sacrificed). The level of investment depends on the level of savings, as the circular flow model shows, funds for investment come from the financial institutions, which get their funds from the savings of households. Investment which is funded from borrowing can only occur if there is sufficient savings. Firms will only invest if they expect the gains from investment to outweigh the costs involved. Lower rates of interest will make investment projects more profitable and therefore investment levels should increase. Investment in new technology that enables existing resources to be used more efficiently and increases productivity will have a strong influence on growth. To develop new technology requires that research and development (R & D) is carried out. The importance of events Expected and unforeseen events can have a major impact on growth in the economy. Sporting events such as the World Rowing Championships, Rugby and Netball World Cups stimulate growth prior and during the actual events. Facilities will often need to be built or upgraded to meet the requirements for hosting such events causing an increase in output and growth in the economy prior to the event taking place. Business confidence is likely to rise and firms invest to cater for the expected increased visitor numbers causing further growth. During the event demand for goods and services will increase resulting in increased output and production and hence economic growth. World events such as 9/11, SARS, a worldwide recession or boom will impact on growth in New Zealand. If New Zealand is viewed as a safe destination for overseas travel, tourist numbers will increase. Firms sales will increase and output will increase causing economic growth. A loss of export markets or downturn in market overseas will result in exporters incomes falling and aggregate demand decreasing causing lower levels of growth in the economy. Obstacles to growth The productive capacity of an economy is largely determined by the quantity and quality of resources available for the people to use. For some nations growth is difficult to attain because of the obstacles they face. Most of the population in these countries spend most of their time growing crops to feed themselves at a subsistence level. There is little surplus to sell and often any increases in food production are consumed, so there is little savings. Consequently, there is a lack of investment in capital goods to increase future production. A lack of education means that workers are less skilled, so less productive, so growth is hindered. Other problems that these nations must overcome if growth is to be achieved, include the following: (i) The lack of clean water for drinking, cooking and cleaning. (ii) The lack of economic and social infrastructure, such as communications and distribution systems (which hinders the transport of any surplus production to other markets). (iii) The lack of public health systems, such as hospitals, vaccination programmes and sewerage. Key Concepts and Definitions Causes of growth The discovery of new resources or investment. ISBN (Student s book) Subscribe to elearneconomics at: 239

240 STUDENT NOTES CAUSES of GROWTH Productivity is output per worker/output per machine or output per unit of input. Investment is when firms purchase capital, for example plant or machinery. Firms with greater capital stock as a result of investment can produce more at a faster rate or with the same number of workers, thereby increasing productivity. An increase in savings means that there are more funds available for investment. Greater investment will lead to an increase in capital goods and increased productivity, and, therefore increased production and growth. An increase in savings may not result in future growth because it means that if consumption spending falls, firms sell less and cut back production. Further, financial institutions may not be able to find credit worthy firms to make advances to, so less borrowing for investment resulting in less production. Firms may also be unwilling to borrow funds because interest rates are too high or business confidence is low. An increase in export receipts (wine/dairy/tourism) means an increase in revenue for firms in that industry. These firms will be encouraged to export more and investment may increase resulting in greater production and economic growth. Free education in New Zealand is an investment in human capital because it makes education affordable. As the population is educated the workforce will have greater skills and be more productive. 240 Subscribe to elearneconomics at: ISBN (Student s book)

241 Activities 1 (a) Describe the difference between a capital good and a consumer good. Consumer goods are used to satisfy needs and wants. Capital goods are man-made goods used to make other goods/used by producers. (b) Explain how money spent on education can contribute to growth. In your answer you should: Identify the name of the policy that describes increased government spending on education. Explain how increased money spent on education could affect aggregate supply and the inflation rate. Explain how the change in the inflation rate you have described will affect exports, imports and the current account section on the balance of payments. Increased government spending on education is part of an expansionary fiscal policy. Increased spending on education will result in a better educated and skilled workforce. A higher skilled workforce will improve productivity which will reduce costs of production for firms. As costs decrease profits increase and the aggregate supply will increase. An increase in aggregate supply will reduce inflationary pressures in the economy. A fall in the inflation rate in New Zealand will benefit exporters because a decrease in the rate of inflation in New Zealand will mean that New Zealand firms who export will become more price competitive because they are less likely to increase their prices to cover costs and maintain profit margins. Exports will be more price competitive. Export sales are likely to increase causing higher export receipts. Imported products are likely to be less price competitive compared with New Zealand-made products, with consumers buying fewer imports. Overall, as export receipts increase and import payments decrease the current account balance is likely to improve, i.e., be a smaller deficit or greater surplus. ISBN (Student s book) Subscribe to elearneconomics at: 241

242 2 (a) Refer to the diagram below to explain how future growth comes at the cost of present consumption. Capital goods W T Consumer goods Idea that if more resources are used to satisfy present consumption (position T), it will limit future growth, while if more resources are put into the production of capital goods now (position W), or investment, future growth will be much greater. (b) (i) Which position is likely to result in the highest future growth in New Zealand? T or W circle your choice (ii) Which position is likely to result in a higher standard of living in New Zealand? T or W circle your choice (c) Describe the terms productivity and investment. Productivity: Output per unit/output per worker/output per unit of capital. Investment: Purchase of capital or the increase in the stock of capital. (d) Explain the link between investment and productivity. Investment by firms results in greater capital stock, so firms can produce more at a faster rate or with the same number of workers, therefore increasing productivity. 242 Subscribe to elearneconomics at: ISBN (Student s book)

243 3 (a) Explain how savings can result in future growth. Greater savings makes money available for investment. This results in an increase in capital goods and will result in an increase in production and growth. The production possibility curve will shift outward or move from a point inside the curve to one further out. (b) Explain why an increase in savings might not result in future economic growth. An increase in savings results in less consumption, producers sell less, less profit, cut back production. Increased savings may not be available for borrowing for investment. Less investment, less production. While savings may increase, firms are unwilling to borrow because interest rates are too high or there is a lack of business confidence. Less borrowing for investment, less production. (c) (d) Tick ( ) which of the following situations or events are likely to contribute to economic growth. (i) The discovery of new minerals. (ii) A net migration increase. (iii) A net migration decrease. (iv) A natural disaster. (v) An increase in the quantity and quality of the labour force. (vi) A natural decrease in the population. (vii) Large periods of industrial unrest. (viii) Low levels of investment due to a lack of business confidence. (ix) New Zealand gains the right to host the next Winter Olympics. (x) New Zealand wins back the America s Cup. (xi) The productive capacity of the economy increases. (xii) A large influx of foreign investors attracted by business opportunities in New Zealand. (xiii) A large number of New Zealand firms decide to relocate their operations to Australia. Match the measures of economic growth listed below to the description provided in the table. Net social welfare Productive capacity Real income Description (i) Shows that more goods and services have been produced. (ii) The maximum attainable that a firm or economy can produce. (iii) Takes into account non-economic costs, e.g., pollution and congestion, as well as economic factors Measure of economic growth Real income Productive capacity Net social welfare ISBN (Student s book) Subscribe to elearneconomics at: 243

244 4 (a) Assume the economy is operating at point P. Illustrate the effect on the diagrams indicated by the title. Consumer goods Graph one An increase in productive capacity Consumer goods Graph two An increase in production P P Capital goods (b) (i) Define the term physical capital. Manufactured goods used in production. Capital goods (ii) Describe how an increase in physical capital impacts on economic growth. An increase in physical capital increases productive capacity and productivity increases. Firms can produce more with the same number of workers, production increases, therefore growth increases. (c) Explain the importance of events on economic growth. Expected and unforeseen events can have a major impact on growth in the economy. Sporting events such as the World Rowing Championships, Rugby and Netball World Cups stimulate growth prior and during the actual events. Facilities will often need to be built or upgraded to meet the requirements for hosting such events causing an increase in output and growth in the economy prior to the event taking place. Business confidence is likely to rise and firms invest to cater for the expected increased visitor numbers causing further growth. During the event demand for goods and services will increase resulting in increased output and production and hence economic growth. World events such as 9/11, SARS, a worldwide recession or boom will impact on growth in New Zealand. If New Zealand is viewed as a safe destination for overseas travel, tourist numbers will increase. Firms sales will increase and output will increase causing economic growth. A loss of export markets or downturn in market overseas will result in exporters incomes falling and aggregate demand decreasing causing lower levels of growth in the economy. 244 Subscribe to elearneconomics at: ISBN (Student s book)

245 5 Explain how resources affect growth. Increases in physical capital and human capital both play a part in determining growth. In your answer you should: Define physical capital and human capital. Explain how an increase in physical capital affects economic growth. Explain how investment in human capital can impact on growth. Physical capital refers to the manufactured goods used in production. Human capital is the skill and ability of the workforce, acquired through education and experience. An increase in physical capital will increase the productive capacity of an economy and improvements in technology will increase productivity. Improved productivity will mean the economy can produce more with the same number of workers, production will increase, therefore growth increases. Investment in human capital in the form of education and workplace training has the potential to increase the skill level of the workforce in the economy, so productivity improves. Investment in human capital will result in more people able to innovate and develop new ideas and technology, so technology will improve. With increases in productivity and technology the productive capacity of the economy and output will increase, resulting in increased growth. ISBN (Student s book) Subscribe to elearneconomics at: 245

246 Review (Exam) Questions Question One: growth. Growth is caused by increasing the productive capacity of an economy. The production possibility frontier will be extended outwards because the economy is able to produce more capital and consumer goods. Compare and contrast factors that influence growth. In your answer you should: Explain the effect of resources on growth. Explain the effect of investment on growth. Economic growth can be increased by either increasing the output from existing resources and/ or increasing the quantity of resources available to a country. The discovery of new resources (e.g., coal, gas, oil, new fish stocks) will increase economic growth in the short run. This growth may later slow as these new resources are used up or are overexploited. Growth can result from either an increase in the quantity or quality of human resources, or both. The quantity of human resources can be the result of a net migration gain (when the number of migrants arriving is greater than departures), or from a natural increase in the population (i.e., if the death rate is lower than the birth rate). The quality of the workforce has a direct bearing on the output per worker (or productivity). If the same output is produced at a lower cost than before then productivity has increased. Firms that can increase productivity are able to become more competitive because they are producing more with less. The quality of labour can be improved with education from various institutions and training given to staff by firms. 246 Subscribe to elearneconomics at: ISBN (Student s book)

247 In Economics, investment is the addition to capital resources, e.g., a firm installs a new machine or government extends a motorway. Investment (sometimes called capital accumulation or capital formation) is said to be the key to determining growth. Some investment is necessary to replace capital goods that are depreciating. Depreciation is the wear and tear on capital goods that reduces their productive capacity, and includes items of capital that have become obsolete. The opportunity cost of investment for future growth is the consumer goods foregone (or sacrificed). The level of investment depends on the level of savings, as the circular flow model shows, funds for investment come from the financial institutions, which get their funds from the savings of households. Investment which is funded from borrowing can only occur if there is sufficient savings. Firms will only invest if they expect the gains from investment to outweigh the costs involved. Lower rates of interest will make investment projects more profitable and therefore investment levels should increase. Investment in new technology that enables existing resources to be used more efficiently and increases productivity will have a strong influence on growth. To develop new technology requires research and development (R & D) to be carried out. ISBN (Student s book) Subscribe to elearneconomics at: 247

248 Question two: exchange rates and economic growth. A lower exchange rate can encourage economic growth, despite the fact that the cost of imported capital goods and raw materials increase. Complete questions (a) to (c) to comprehensively analyse the impact of a lower exchange rate on economic growth. (a) Fully label Graph One and show how a lower exchange rate would increase real GDP. Graph One: The AD/AS model Price level AS2 AS PL2 AD2 PL AD Y Y2 Real output GDP (Y) (b) Explain in detail how a lower exchange rate would increase economic growth. Refer to the change you made on Graph One to support your explanation. A lower exchange rate will make New Zealand exports more price competitive and exporters will swap forex for more New Zealand dollars. Exporters incomes will increase and AD will shift outward (from AD to AD2) causing an increase in real output GDP, which is economic growth. As the exchange rate weakens, the cost of imported raw materials will increase. As costs increase, profits decrease and the AS curve shifts inward (from AS to AS2). The outward shift of the AD curve is greater than the inward shift of the AS curve, causing real output GDP to increase from Y to Y Subscribe to elearneconomics at: ISBN (Student s book)

249 Business confidence is likely to increase with a stable exchange rate. A stable exchange rate does not alter much from month to month. (c) Compare and contrast the effects on economic growth of a stable exchange rate with those of a lower exchange rate. In your answer you should: label Graph Two to show the likely effect on real output GDP that would result from an increase in business confidence due to a stable exchange rate and explain why this takes place explain in detail why a stable exchange rate may have a greater positive effect on economic growth than a lower exchange rate. Graph Two: The AD/AS model Price level (PL) AS PL2 PL AD AD2 Y Y2 Real output GDP (Y) A stable exchange rate will make businesses more confident about the income they earn and costs involved when they deal with overseas markets. This will increase business confidence about investment because the risks involved by firms will be perceived to be lower and the ventures more profitable. As investment takes place AD shifts outward (from AD to AD2) causing an increase in real output GDP (economic growth). A stable exchange rate is likely to have a greater impact on economic growth than a lower one because the shift in the AS curve may cancel out the shift of the AD curve, resulting in no economic growth. ISBN (Student s book) Subscribe to elearneconomics at: 249

250 Question three: economic growth and migration. Migration changes impact on growth. Complete questions (a) and (b) to comprehensively analyse the relationship between a net migration decrease and economic growth. (a) On Graph One, show the impact of a net migration loss. Explain the effect that a net migration loss has on economic growth. Refer to Graph One in your answer. Consumer goods A C Graph One: Production possibility curve for an economy D B Capital goods A net migration loss will shift the PPC inward (from AB to CD) because it will reduce the productive capacity of an economy because there are fewer labour resources. This will mean that the potential output that the economy is capable of will decrease, economic growth will decline as a result. 250 Subscribe to elearneconomics at: ISBN (Student s book)

251 (b) Discuss the impact of the change in economic growth resulting from a net migration loss. In your answer, you should: explain the costs and benefits of the changes in economic growth to households explain how the impacts on households would affect businesses and the government explain the likely combined impact of the changes you have described above. Households will benefit because they will face less competition in the labour market when seeking a job and property prices may fall due to a decrease in demand and increase in supply as individuals move overseas. The cost to households could be that as firms reduce output due to decreased demand they need fewer workers, so lay off staff. There could be fewer job opportunities and less choice as the demand for goods and services falls. Businesses may reduce output because with fewer individuals to buy goods and services demand decreases. Firms incomes are likely to fall and profitability will fall. Firms are likely to lay off staff and decide to cut back on investment plans. The government will collect less in direct tax because fewer workers are employed and will have to increase transfer payments. As consumption spending falls government will collect less individual tax from firms. Reduced government revenue will possibly result in less spending elsewhere. The combined effect of reduced consumption spending by households and investment spending by businesses will result in AD shifting inward and decrease real output GDP (economic growth). ISBN (Student s book) Subscribe to elearneconomics at: 251

252 Growth: The impacts of economic growth Terms/Ideas The positive and negative outcomes of growth (including environmental impact, inflation and trade), economic growth s uneven impact on the economy. Benefits and Costs of Growth The positive effects of economic growth could include the following: (i) Lower levels of unemployment and therefore fewer social problems and less poverty. (ii) New technology used to create growth should improve working conditions, reduce the working week and increase leisure time. (iii) Growth is an objective of government economic policy because it is one of the keys to higher standards of living. Growth has made it possible for people to achieve better living and working conditions, greater life expectancy and a better way of life. For the government it is desirable because it brings in increasing revenues from a given structure of tax rates. It means that more and better roads, schools, hospitals and other social services can be provided without resorting to raising the rates of taxation. Growth can create greater employment opportunities for individuals and unemployment can fall. Economic growth makes it easier for the government to carry out policies of income redistribution and achieve greater equity of income distribution. (iv) Household incomes should increase and should lead to an increase in the material standard of living. (v) As growth increases, job opportunities may allow workers to seek new job opportunities or challenges where they arise. The negative effects of economic growth could include the following: (i) The accelerated use of scarce resources may mean the growth and standard of living of future generations may be affected as non-renewable (irreplaceable) resources are used up. (ii) Certain types of economic activity may have a detrimental effect on the environment. The waste and pollution generated can destroy native habitats for endangered plants and animals, and toxins can threaten health and life. Global warming impacts on sea levels and may result in climate changes. As the size of the ozone hole increases the incidence of skin cancer increases and damage to agricultural crops and plankton in the world s oceans increases. (iii) The new technology used in achieving growth may result in jobs disappearing or with workers being replaced. Workers may have to seek new opportunities in other parts of the country, possibly disrupting family life. (iv) Higher incomes that may arise with economic growth may result in greater income inequality. As the rich get richer and the poor, poorer, this may create stress and social tension because individuals attempt to keep up with what society expects. Rates of heart disease and obesity can increase as individuals over-indulge due to higher incomes. The Resource Management Act 1991 Periods of high economic growth can result in the accelerated use of scarce resources and damage to the environment. The purpose of the Resource Management Act 1991 (RMA), was to promote sustainable management of natural and physical resources, so they would not be jeopardised or their use would not have adverse effects on the environment. Input is sought from interested parties involved in any development to address the effects of the proposed activity rather than the activity itself. Obtaining a Resource Consent involves time and costs that can stall or even stop developments. The overall effect on growth is difficult to judge. In the short term economic growth may slow, while in the long term, by ensuring adverse effects on the environment are minimised, sustainable economic growth is feasible. 252 Subscribe to elearneconomics at: ISBN (Student s book)

253 The uneven impact of growth Growth is not experienced evenly across sectors or regions within a country. Some industries may be growing (sunrise industries) and stimulate growth, employment and incomes in a region, while other industries may be in decline (sunset industries). Individuals may shift to regions or industries where there are better job prospects or employment opportunities. Some regions and groups can be better placed to take advantage of the opportunities that growth provides, leading to changes in income distribution within a country. Key Concepts and Definitions Positive effects of growth Negative effects of growth Lower levels of unemployment and more job opportunities. Government tax revenue should increase. Household incomes should increase and should lead to an increase in the material standard of living. Accelerated use of resources and the detrimental effect on the environment. New technology used to achieve growth may result in job losses and disruption of family life as individuals seek employment in other regions. Possible health problems as individuals over-indulge due to higher incomes e.g., obesity. STUDENT NOTES IMPACTS OF GROWTH Growth has an unequal impact on different regions because some may be experiencing growth while others are in decline. Regions with high rates of economic growth are likely to have more employment, higher incomes and a higher standard of living. Growth can have an adverse effect on the current account, greater employment and higher incomes that result from economic growth can see an increase in spending on imports (e.g., overseas holidays), this will increase the current account deficit or reduce the size of a surplus. The increased output that accompanies growth may have an adverse effect on the environment with higher levels of pollution, congestion on roads, overcrowding and greenhouse gases. Resources may be used in such a way that they are not sustainable and available for future generations. Growth may result in a greater inequality of income distribution as some groups have access to few or no resources. The positive effects of growth include: Government tax revenue should increase and with less welfare spending on unemployment benefits, government can increase its spending in other areas such as health and education. Household incomes should increase as firms increase output and hire additional workers or pay existing workers overtime, this should lead to an increase in the material standard of living. ISBN (Student s book) Subscribe to elearneconomics at: 253

254 Activities 1 (a) Complete the table to indicate if the event or situation is a positive effect or a negative effect of economic growth. (i) Situation or event Resources are used up so that there are no resources left for future generations. Positive or negative effect of economic growth negative (ii) An increase in the size of the ozone hole. negative (iii) The creation of new jobs and fewer unemployed. positive (iv) Higher living standards for all. positive (v) Technical progress makes production more efficient. positive (vi) Workers made redundant by new improved methods of production. negative (vii) Firms switch resources to their most productive use. (viii) Increased global warming and increased greenhouse gases. (ix) (x) (xi) Over consumption by households due to increased incomes increases the incidence of obesity and heart disease. Income inequality increases substantially with the rich getting richer and the poor poorer. A more equal distribution of income because rising income means that the government can use tax revenue to redistribute income to the less well-off. (xii) Rising levels of pollution, traffic congestion and crime. positive negative negative negative positive negative (b) Outline two reasons why rates of economic growth tend to change over a period of time. Changes in business confidence, investment level, changes in interest rates (monetary policy), changes in government fiscal and/or monetary policy, employment laws, changing demand patterns, both domestic and foreign. (c) Identify two ways in which economic growth benefits households. Increased goods and services, increased employment, increased (real) incomes, increased leisure. 254 Subscribe to elearneconomics at: ISBN (Student s book)

255 2 (a) Divide the phrases in the list below into positive or negative effects of economic growth in the space provided below. increased employment, increased production of goods and services, increased incomes, inflation, resource depletion, environmental damage, increased tax revenue for government, higher standard of living, inequity of income distribution, decreased government spending on welfare. (i) Positive effects of economic growth Increased employment, increased production of goods and services, increased incomes, increased tax revenue for government, higher standard of living, decreased government spending on welfare. (ii) Negative effects of economic growth Inflation, resource depletion, environmental damage, inequity of income distribution. (b) Justify whether the government should encourage growth in the New Zealand economy. While there are negative effects associated with economic growth, they can generally be managed so that steady growth is sustainable (Resource Management Act, Monetary Policy, Fiscal Policy). The benefits of economic growth can make everyone better off, and other tools can be used to ensure that the negative effects are minimised. (c) What is meant by a positive outcome of growth? A benefit/gain/advantage to the country as a result of increased production. The good things that come from growth, e.g., decrease in unemployment. (d) By using an example explain how economic growth could have an unequal regional impact. Resources are unevenly distributed throughout the country, so economic growth will also be uneven. For example, an increase in growth as a result of increased farm production would benefit areas where there is a lot of farming, but have less impact on other regions. ISBN (Student s book) Subscribe to elearneconomics at: 255

256 3 (a) Explain why households might not equally enjoy the benefits of economic growth. Not all households have the same level of resources, so command different incomes. Inflation affects different households unequally, e.g., reduced purchasing power of individuals on fixed incomes. (b) Explain why an increase in economic growth might concern environmentalists. The accelerated use of scarce resources may mean the growth and standard of living of future generations may be affected as non-renewable (irreplaceable) resources are used up. Certain types of economic activity may have a detrimental effect on the environment. The waste and pollution generated can destroy native habitats for endangered plants and animals, and toxins can threaten health and life. Global warming impacts on sea levels and may result in climate changes. As the size of the ozone hole increases the incidence of skin cancer increases and damage to agricultural crops and plankton in the world s oceans increases. (c) Economic growth, to a degree, relies on the development of new technology. Explain one positive effect and one negative effect of new technology used to achieve growth for workers. (i) Positive effect: New technology used to achieve growth should improve working conditions, reduce the working week and increase leisure time. New technology may create new job opportunities. (ii) Negative effect: New technology used in achieving growth may result in jobs disappearing or with workers being replaced by machines. Workers may have to seek new opportunities in other parts of the country, possibly disrupting family life. 256 Subscribe to elearneconomics at: ISBN (Student s book)

257 4 (a) How do financial incentives shift resources away from sunset industries towards sunrise industries? Sunset Industries Sunset industries face falling demand for their products so less workers (resources) required and incomes will fall as derived demand falls, meaning less hours are available or wages fall so these workers will look elsewhere for work (perhaps sunrise industries if they have the necessary skills). Sunrise Industries Sunrise industries face rising demand for their products so to attract the workers (resources) they require they offer higher wages. These workers may come from sunset industries if they have the necessary skills. The Central Otago rail trail and Dunstan trail are attracting more local and overseas visitors than ever. (b) (i) Describe positive effects of the increased tourism on Central Otago economies. Increased consumption, increased employment, increased growth, higher standard of living, more income, greater sales or profits for firms servicing tourist industry. (ii) Describe negative effects of the increased tourism on the region. More pressure on resources, pollution, harm to the environment, higher property prices, resource depletion, more overcrowding. (c) How can the increased tourism lead to economic growth in the Central Otago region? The increased demand for goods and services will result in increased output/production and economic growth. (d) How can the increased tourism lead to economic growth in other centres? The increase in tourism will result in more people visiting other regions as well, so the demand for goods and services in other regions will increase resulting in an increase in output/production and economic growth. ISBN (Student s book) Subscribe to elearneconomics at: 257

258 Review (Exam) Questions Question One: trade and growth. Trade has an impact on growth. Explain the impact of trade on growth. In your answer you should: State the injection flow and withdrawal flow associated with trade. Explain how the withdrawal flow would be affected by the upturn in the economy and global boom. Explain how the injection flow would be affected by increased global and domestic trade. Explain the effect on government operating balance. The injection flow associated with trade is export receipts while the withdrawal flow is import payments. An upturn in the global and domestic economies will increase the withdrawal flow because import payments would increase. Many New Zealand firms rely on an imported component in the production process so demand for imported material by New Zealand firms would increase as they produce more to satisfy increased demand for goods and services both locally and from overseas. An upturn in the global and domestic economies would increase the injection flow because export receipts would increase. Export receipts would increase because New Zealand exporters would be selling/exporting more goods and services to satisfy the increased demand for exports by overseas buyers/consumers. The government will collect more direct and indirect tax. Direct tax receipts will increase because firms will need to hire extra workers to cope with the increased demand for goods and services. Firms profits are likely to rise because sales will increase, as will revenue, therefore they will pay more company tax receipts to the government. As households incomes increase consumption spending will increase and firms will collect more indirect tax receipts (e.g., GST) which they will pass on to the government. As more individuals find jobs, the government will pay less in transfer payments. Overall, the government operating surplus will be a larger surplus or a smaller deficit. 258 Subscribe to elearneconomics at: ISBN (Student s book)