INFLATION
Inflation is an increase in the general level of prices over time. It is measured as a percentage change in Consumer Price Index (CPI). It will reduce the purchasing power of the money.
GENERAL PRICE RISES occur when the average level of prices increases, e.g. CPI on the rise
PRICE RISES IN PARTICULAR MARKETS occur when the price of one good/service or one industry sector increase, e.g. Building costs increase 9%
Inflation – is an increase in the general level of prices over time.
Disinflation – is a decrease in the rate of inflation. Prices are still increasing but at a declining rate.
Deflation – is a decrease in the general level of prices over time.
Simple Price Index = x 1000
Limitations of the CPI
- It omits prices that are difficult to measure, eg. Second-hand goods.
- Spending patterns are constantly changing, as incomes, tastes, and fashions, family circumstances change. Thus there will always be a problem with weighting the various categories.
- Many products are changing in design, quality, and performance. You only have to look at the computer industry, where the specifications and performance always seem to improve.
- New products are always coming into the market.
- It includes interest payments. Most countries do not include interest charges on loans in the CPI.
Other Measures of Inflation
- Producer Price Index (PPI). This measure gives us a useful view of inflation in the cost of production.
- The Food Price Index.
- Imported Goods Price Index & Exported Goods Price Index.
- Capital Expenditure Price Index (CEPI) measures inflation in prices of capital goods (investment goods), which are goods, used to make other goods and services.
Nominal values are values in current dollars, whereas real values are in terms of constant dollars. To calculate real values for interest, wages, GDP, or other measures, we divide nominal value by the CPI and multiply by 1000.
Real Value = x 1000
INEQUALITY
Equity – refers to fairness and justice in an economic situation.
Equal – refers to equal/same treatment in an economic situation.
Situations where equality and inequality can either be inequitable or equitable:
- Equality and Equitable (equal and fair) eg. If a dessert has been prepared for your family, each member of the family is allowed a serving.
- Inequality and Equitable (unequal and fair) eg. Some people have their drivers licence and some do not.
- Equality and Inequitable (equal and unfair) eg. If all the competitors at the Olympics receive a gold medal, regardless of how they perform.
- Inequality and Unequal (unequal and unfair) eg. Ethnic cleansing, where people are killed because of their race.
Income is the flow of money to a person or household, it is a return on the factors of production. (FOP = Capital – Interest, Entrepreneurship – Profit, Land – Rent, Labour – Wages)
Wealth is a stock of income generating assets, eg; Shares, Businesses, Gold, Houses, Commercial buildings etc.
The Lorenz curve is used to demonstrate distribution of income within an economy.
Limitations:
- Any figure which gives an average is an indication only. Out of a whole population, very few people will truly be ‘average’.
- A sample may be skewed or biased. It may not reflect the whole population.
- Households vary in size and make-up.
- Average, totals, and statistical trends do not give any indication of the distribution of income or wealth in an economy.
- Indicators of standard of living are just that – indicators. They give a rough idea of an average expectation. However, a standard of living must be seen in the context of that society. What is the expectation of the society? Anyone who cannot access what their society considers essential is poor, so there is little point in telling a New Zealander earning $9.00 per hour that they would be considered very wealthy in Rwanda such comparisons are spurious (meaningless).
Economics 2.2: Examine Economic Issues.
GROWTH
Production Possibility Curve
A Production Possibility Curve (PPC) shows all combinations of two goods which can be produced assuming all resources are used efficiently and there is a fixed level of technology.
Because of scarcity, only certain combinations of X and Y can be produced. Also, producing any combinations of goods X and Y beyond the PPC frontier is unattainable. Producing a combination inside the frontier illustrates the under-utilization (unemployment) of some resources (C). Choosing to increase production of X (going from A to B) involves an opportunity cost which means foregoing the next best alternative. In this case the opportunity cost means giving up some production of Y.
A shift outwards of the PPC illustrates increased productive capacity and will result in economic growth if the economy operates on the new PPC.
Circular Flow Model
Households own resources, such as their labour, which they may be able to sell to firms in return for an income (Y). They can use this income to buy goods and services. This spending is called consumption spending (C).
Households con choose to spend their income on consumption expenditure or save it for later (S). Money can be saved in financial institutes (eg. Banks) that can lend this money on to others, in particular to producers for investment. Investment (I) in economics refers to adding to capital resources such as new factories and machinery.
Government spending is shown by flow (G) and includes spending on roads, schools, and hospitals. The money comes from taxes (T) paid by households and firms. Government also pays benefits to the sick or unemployed and income support. This flow is known as government transfer payments (Tr).
The flow (X) refers to export receipts, which is money flowing back to NZ from sales of goods and services to other countries. The flow (M) refers to import payments made when NZ firms buy goods and services from overseas.
GDP is the value of all goods and services produced in a country.
Measuring GDP
The Incomes Approach – GDP (Incomes approach) =
Compensation of employees (wages and salaries)
+ Operating surplus (company profits)
+ Consumption of fixed capital (depreciation)
+ Indirect taxes (eg. GST) – Subsidies
The Expenditure Approach – GDP (Expenditure approach) =
Final consumption expenditure by public & private
+ Gross fixed capital formation
+ Changes in stocks
+ Exports
- Imports
Expenditure on GDP = C + I + ∆R + G + (X – M)
Investment
Investment is probably the most important determinant of growth, because investment will mean we are able to produce more goods and services. It can come from the private sector, eg. Building a new factory, or from the public, such as building a new school. Investment increases production and therefore national income (GDP).
Opportunity cost of investment
Investing in more capital goods means we have to sacrifice production of goods for immediate consumption. The opportunity cost of investment is the consumption goods that are given up.
Level of savings
Saving is defined as the part of income which is not consumed. The circular flow diagram showed that funds for investment come from the fiancé sector which obtains funds from the savings of households. Investment can only occur if there are sufficient savings. Lack of savings will mean a country has to borrow the savings of people overseas, or encourage foreign investment. Therefore all investment requires some sacrifice.
New Technology & Productivity
Investment in new technology enables existing resources to be used more effectively and increase productivity. To develop new technology research and development (R&D) is required. The amount an economy spends on R&D has a strong influence on growth. New technology can improve the productivity of labour. Increased productivity means more can be made from the same number of resources, so economic growth has taken place.
Obstacles to growth in developing economies:
The least developed countries start with low growth and rapidly rising population. This results in a low standard of living.
- The low standards of living restrict the education and training opportunities, which result in a work force with a lack of skills and generally low productivity.
- The low incomes mean that savings are low. People can’t afford to save, using all their incomes to meet basic human needs. Funds available for investment will be restricted.
- R&D will take a low priority and will slow the development of new appropriate technology which is vital to bring about the growth in productivity and ability to increase incomes.
Positive effects of Growth
- Increased living standards
- Increased leisure
- Decreased working hors for the same pay or output
- Increased tax revenue without rasing tax rates
- Increased household incomes and savings
- Increased job opportunities
- Less poverty
Negative effect of Growth
- Resource depletion
- Pollution (environmental problems)
- Capital replacing labour – creating unemployment
- Increased diseases of affluence – heart disease, obesity
- Inflation
TRADE
International trade will occur as some degree of specialisation, interdependence and exchange takes place. This requires a market. Therefore, we can use supply and demand analysis to demonstrate how trade works, explain some of the factors influencing trade, and explore likely consequences.
The Reasons for International Trade
The pattern of world trade is so complicated that no single explanation will satisfy this question. However we can say that the following are applicable to the situation.
- The most obvious reason for trading with other countries is to obtain goods which cannot be produced in our country, or which can be produced but at great expense.
- Climatic and geological differences account for a proportion of the exports of the poorer countries of the world.
- Less obviously, perhaps, differences in the skills of the labour and in the accumulation of capital account for some of the exports of the wealthy countries.
The Foreign Exchange Market for the New Zealand Dollar
Demand for the New Zealand dollar (NZD) comes from buyers from overseas who want to buy our exports – buyers of carpet, wines, tourist’s visiting our ski fields, or people from overseas wanting to deposit money in New Zealand to gain better interest rates.
Supply of the NZD comes from those people wishing to sell their holdings of New Zealand dollars for overseas currency, such as importers, New Zealanders visiting overseas, or foreigners withdrawing their money from New Zealand banks.
Effects of the Exchange Rate
If the New Zealand dollar is low, or depreciates, it:
- Advantages exporters, whose goods are now cheaper on the destination country’s market, so the quantity demanded will increase.
- Disadvantages importers, who now have to pay more for their imports, the price on the New Zealand market rises, and the quantity demanded decreases.
If the New Zealand dollar is high, or appreciates, it:
- Advantages importers, whose goods are now cheaper on the New Zealand market.
- Disadvantages exporters, whose goods are now more expensive on the destination market.
A Case for Exports
The equilibrium is at A with PNZ and QNZ. New Zealand cricket bat suppliers notice the price they receive in NZ (PNZ) is lower than what they could earn from overseas buyers (PW). They are therefore keen to increase the quantity supplied (from QNZ to QNZ’) and earn PW per unit. New Zealand producers operate at point C. However, NZ consumers react to the price increase with a decrease in quantity demanded from (from QNZ to QNZ”). The NZ domestic market operates at point B.
After trade: NZ domestic supply = NZ domestic consumption + Exports
A Case for Imports
If the world price is below the domestic price, local consumers will want to operate at point C, but New Zealand producers will want to operate at B and only supply QNZ’. To fill the shortage between what producers will supply and what consumers will demand, New Zealand will import cricket balls.
Determining the World Price
The two graph model brings together what was shown in the diagrams above (Exports and Imports). If the world price is above a country’s domestic equilibrium price, that country will have a surplus to export. If the world price is below a country’s domestic equilibrium price that country will have a shortage and will want to import. In the above diagram we see that the world price will be between the New Zealand and Australian prices – but NOT necessarily half-way between. The world price will be that prices where the surplus in New Zealand is equal to the shortage in Australia.
This is how the world price is established. This is where QSNZ – Exports = QDNZ and QSAUS + Imports = QDAUS
Cost of Production
The supply and demand analysis we used earlier is a dynamic model it is subject to change without notice. A change of any factor influencing the supply or demand situations in either country will result in changes in the following:
- The domestic consumption in both countries
- The domestic production in both countries
- The quantities exported and imported
- The world price
Consider what would happen if the cost of cricket shoes production increase in Australia. The domestic supply curve in Australia would shift to the left and the two graph model would be affected as follows.
There is a strong link between factor endowment and technology, and cost of production. Countries with abundant resources that lend themselves to the production of certain products will find those products cheaper to produce than another country without resources.
Appropriate technology allows a country to use its resources more efficiently. Both factor endowment and technology help gives a country a comparative advantage.
Changes in Demand
The price of a good is the main influence of demand. If this increases there will be a movement up to the left along the curve. This is called an increase in the quantity demanded. There are a number of factors that will cause the demand curve to shift. These are the price of substitute goods, the price of complementary goods, the income of consumers, as well as the tastes (preferences) of consumers. These principles of demand are equally valid when analysing international trade. The following two figures show the effects of a change in domestic demand as well as changes in foreign demand.
Local Demand
Foreign Demand
Fluctuations in Trade
There is a link between the ups and downs of our trade practises and the economic well being of many New Zealand industries. This includes both those directly involved with trade and those which are not. The fluctuations can be quite pronounced in New Zealand because a high percentage of our exports (over 60%) are primary commodities and markets for primary products are more unpredictable than markets for manufactured goods. There are a number of reasons for this:
- Supply of many primary goods is affected by unpredictable factors including climate, seasons, outbreak of disease, etc.
- ‘Branding’ can improve price stability for manufactures but is not common for primary products
- A huge percentage of primary exports come from third world nations which are often subject to the decisions made in industrialised countries
- The ‘hard’ currencies of industrialised countries are normally more stable than others
- Primary products rely on natural resources; the reserves of these are limited.
New Zealand is affected by the fluctuations in the primary commodity export market as well as the import markets. Therefore the fluctuations can have a sort of ‘double effect’. The issue of ‘branding’ is interesting. Primary products are seldom ‘branded’, so as a competitor’s price decrease (because of an actual price decrease or a change in exchange rates) a non New Zealand buyer will switch from the NZ product in favour of the competition.
Industries will grow when there is stability and confidence supported by a steady demand. Signs of growth for an industry may be a combination of: increased sales, increased production, low stock levels, need for more staff and/or overtime and increased profits. Contraction occurs in cases where the opposite is true.
Clearly fluctuations in trade affect the industries directly involved with exporting and importing. There are also flow-on effects for many others. For example, if there is an increase in exports of forestry products, those in that industry benefit, and so also do:
- Members of their households
- Shops with which the household members do business
- Employees and suppliers of these businesses
- The service industries that deal with the households and business.
INFLATION
Function of Money
Money has four important functions. It acts as a means of exchange enabling exchange to occur, and is used as a measure of value, thus overcoming two difficulties of using barter. It also acts as a store of value, enabling us to save it now to spend later, and as a means of deferred payment, so we can use credit.
Qualities of Money
Homogenous
Easy to make, hard to copy
Limited in supply
Portable
Recognisable
Durable
Acceptable
Divisible
The Money Supply and the Rate of Inflation
The quantity theory of money helps us explain causes of demand-pull inflation.
M x V = P x Q
In this equation:
P = the general level of prices in the economy, i.e. inflation
Q = the number of transaction, i.e. GDP
M = the volume of money in the economy
V = the velocity of circulation
Both MV and PQ are ways to measure the level of economic activity. The theory states that Q (representing GDP) was constant, and that V (velocity of circulation) was constant. If this was true, then any increase in the money supply would lead directly to an increase in the price level.
Demand-Pull Inflation
Demand-Pull inflation occurs where aggregate demand increases and the price level is being pulled upwards. It is usually seen at times of full employment, or where government is trying to stimulate the economy with expansionary policies. An increase in any of the components of expenditure on GDP will increase AD.
Cost-Push Inflation
Cost-push inflation occurs when there is a decrease in aggregate supply, originating from any increase in raw material prices, interruption in supplies (war-time), or any rising cost of production. Increased costs lead to a decrease in supply which pushes up the general price level.
Some examples include:
- Increased competition between producers for resources forces them to pay more because the resources are becoming increasingly scarce in relation to the demand for them
- Increased costs of production such as when there is an increase in resource costs, eg. oil prices
- Increased trade union pressures causing wage rates to rise faster than productivity rises.
- Increased profit margins maintained at fixed percentages.
Impact of Inflation
Households suffer because the purchasing power of their income is reduced. High inflation also encourages people to spend, often on credit, rather than wait and accumulate the cash; because they are worried the price will rise. Overall, inflation reduces the standard of living.
Effect of Inflation on Trade
Effect on Exports (X)
If New Zealand inflation is greater than in our trading partners, New Zealand exports will become less competitive on the domestic markets, and exports will fall.
Effect on Imports (M)
If New Zealand inflation is greater than inflation in our trading partners, imports will become more competitive on the domestic market, therefore imports will increase.
Effect of Inflation on Growth
Inflation distorts investment patterns because interest rates are kept high, which discourages productive investment in such things as in factories and equipment. Investors are instead encouraged into speculative investment such as property, where tax-free capital gains can be expected to keep pace with inflation. These projects are unlikely to contribute to growth and employment. This distortion will also limit growth in the standard of living.
Effect of Inflation on Inequality
Income is redistributed from savers to borrowers. This is because borrowers tend to benefit because they will be repaying their loans at a later date in dollars that have been devalued, while savers will suffer because they will be repaid in dollars that have a reduced value, and their rewards are reduced as real interest rates fall.
Inflation discourages people from saving because:
- Inflation erodes the value of savings
- The rewards of saving will be insufficient to keep pace with inflation
- People tend to buy now before the price level increases, which further increases demand and thus inflation.
With the level of savings decreased, there are fewer funds available for investment and growth will be reduced.
INEQUALITY
Advantages of Economic Inequality
Incentives
The market offers financial incentives (eg. Wages, profits etc) as a reward for effort and enterprise, a return for taking risks and an incentive for being prepared to initiate. Some people may not be primarily motivated by the hope of financial rewards. In these cases, the financial incentive offered by the market is an ‘additional’ not primary reason for what they do.
Efficient use of resources
Another positive outcome of the market system may be that resources will be used efficiently. For example, if cabinet makers produce lots of book cases when there is little demand, their products may then be stored, damages etc through lack of buyers. The resources used for these book cases will be wasted. This will encourage the cabinet makers to make only those items for which there is a demand, thus reducing waste.
Availability of investment finance
Investment finance is channelled from financial institutes to businesses by those wanting to invest in business. Funds can only be deposited with financial institutions by people who save part of their income. Those on higher incomes save a greater proportion of their income than those with lower incomes. If everyone was on the same income, i.e. no income inequality, savings and therefore investment would decrease.
Innovation and invention
The incentives offered by economic inequality not only encourage people to work harder but also to work ‘smarter’. They will not only take risks with their finances but also with their creativity.
Increased donations to public assets
Wealthy people can make a valuable contribution to society, eg One Tree Hill domain in Auckland was donated to the city by Sir John Logan Campbell, an early Mayor of the city who also had considerable wealth.
Negative Effects of Economic Inequality
Poverty
When we allow variations in income because of either free market activities or other policies we not only get modest differences between the rich and poor but extremes of rich and poor. That is, the market system produces differences in income and wealth – and some of these differences are very large indeed. Problems arise when people at the bottom end are below the ‘poverty line’
Absolute poverty - Some people do not have the basics to maintain life and health. They fall short of certain minimum standard of living. This standard is to do with having the necessary food, shelter, and warmth to survive.
Relative poverty - People whose standard of living is below the community’s norm. This measure will vary greatly from place to place around the world. It is based on a person or household’s standard of living as it relates to those of the other households in the community.
Lack of Opportunities
Economic inequality does not allow the poor the same opportunities to become involved in education and training programmes that the average and high income people have.
Political Isolation
Those with money have more political influences than those without. In many cases, the voice of the politically dislocated is not heard unless someone with the time, the financial means, the abilities, and the motivation decides to ‘champion their cause’.
Inefficient use of resources
Economic inequality can affect the use of resources, both positively and negatively. Market signals can mean resources are ‘exploited’ for short term gain and therefore not efficiently used – especially with natural resources. In New Zealand’s pioneer days farmers would ‘bash and burn’ hundreds of square kilometres of native bush to clear the land and sow grass for pastoral farming.
Social ills
There is a debate about whether economic inequality can lead to an increasing number of ‘social ills’. These are such things as anti-social behaviour (eg. crime), ill health (both physically and mentally), serious truancy, unwanted pregnancy, family break-up, gross indebtedness, low self esteem and a build up of resentments.
Poverty cycle and Structural poverty
For many, poverty is not a temporary situation. Poverty, with its associated lack of opportunities, political isolation, and social problems, will often lead on to greater poverty.
The longer a family is caught in this cycle of poverty the longer and harder it will be to break out. ‘Structural poverty’ refers to poverty that is embedded within the nature of the system and will not be eradicated by economic growth.
Economic 2.3: Demonstrate an awareness of government policies related to economic issues.
Main points of current legislation
Fiscal Responsibility Act (1994)
- The government must show it is acting in ‘accordance with the principles of responsible fiscal management’.
- The government must signal its fiscal intentions through a Budget Policy Statement (BPS) prior to the delivery of the Budget.
- The government must work to reduce Crown debt to prudent levels.
- A Fiscal Strategy Report (FSR) is to be published on Budget night demonstrating the government is keeping within its long-term goals.
Reserve Bank Act (1989)
- The sole aim of the Reserve Bank is to achieve price stability.
- The definition of price stability is set out in the Policy Target Agreements (PTAs), which are published agreements between the Minister of Finance and the Governor of the Reserve Bank.
- The current definition of price stability is 1-3% inflation, on average, over the medium term, as measured by the CPIX.
Resource Management Act (1991)
- Sets out how the New Zealand environment should be managed.
- Aims to ensure sustainable use.
- Requires approvals (resource consents) before resources can be used.
TRADE
Trade Agreements
In theory, most counties support the idea of trade without tariffs, quotas, subsidies etc – that is, they support the idea of free trade. However, it is a slow process to work out free trade principles and put them into practise. Few countries seem prepared to reduce or remove barriers to free trade unless other countries are prepared to the same. It is for this reason that trade agreements are formed. Very complex negotiations occur as the different parties try to work out the following questions:
- What is the timing for the removal of trade barriers?
- What are the priorities, eg should tariffs be lowered, or subsidies removed first?
- is free trade a realistic aim?
- What formula is there to compare what each country is doing to ensure a fair outcome?
These issues are common to all types of trade agreements. There are three types of trade agreement.
Bilateral- These are agreements between two countries. These are often between close neighbours with many similarities. Closer Economic Relations (CER) is a bilateral agreement between New Zealand and Australia. The aim is to remove all tariff barriers by the year 2005. This will increase the level of competition and hopefully improve the efficiency of the two markets, and consumers should benefit from access to cheaper goods and service.
Multilateral – these are between a number of countries. Some of these are regional, for example the North American Free Trade Agreement (NAFTA) which aims to reduce tariff barriers between Canada, the USA, and Mexico.
Global – the best, and perhaps the only, example of this is the World Trade Organisation (WTO). This huge organisation, formerly known as the General Agreement on Tariffs and Trade (GATT) has over 150 member countries that negotiate and try to implement strategies to improve free trade.
Some trade agreements become much more that an agreement between two or more countries concerning trade related issues. For example, the European Community (EC) not only has special trade agreements between member states but also has agreements on many other issues, eg. Labour mobility, exchange rates, a common currency (Euro dollar) etc. the EC is an example of the integration of economies.
Trade Regulations
Tariffs
As a trade policy tariffs are now suspect! They may gain revenue for the government and restrict imports but they are not considered to be advantageous for all concerned. A tariff works in the same way as a per unit sales tax – it increases the cost to supply an imported good which is shown by a vertical shift in the supply curve. As a result the price increases and the quantity traded decreases. The imported goods are therefore less competitive than the local goods.
Quotas
A quota is a physical limit on the quantity of a good that can be traded. This limit can be seen as Qqu in the graph below. If NZ was exporting beef to the US and the quota was less than the market quantity, we would be exporting less than we could sell. US beef producers would be happy because there would now be increased demand for their beef even though the price has increased.
Subsidies
The government may choose to subsidise products made in NZ for the local market that open to competition from overseas. This type of financial aid from government will reduce the costs of production, decrease the market price of our product, and make it more attractive (than before) when competing with overseas goods. This will improve the balance of payments on current account by reducing import payments (M).
Another way subsidies can be used is to decrease the cost of production of exported products. This will make our exports more competitive in overseas markets. This will improve the balance of payments on current account by increasing export receipt (X).
Exchange Rate Policies
Exchange rates play a major role in setting the prices of exports and determining our ability to pay for imports.
Fixed Exchange Rate
Some countries have a fixed exchange rate system. Their government sets the price of their currency in terms of other currencies. If the government set the rate above the market equilibrium there will be a surplus of $NZ. The price is unable to decrease – which would have allowed the market to clear. The setting of exchange rates in this way means our currency is over-valued and gives the impression that our goods and services are expensive – which of course they are (in relation to other countries).
GROWTH
Government Economic Policies
We can classify government economic policies into two main types. Macro-economic policies are those that affect the whole economy, and these include fiscal and monetary policies. Micro-economic policies are those that are designed to work on a sector of the economy, or industry.