CHAPTER 10 SUMMARY: MACROECONOMICS Macroeconomics, like microeconomics, looks at such issues as output, employment and prices; but it looks

ks at them in the context of the whole economy. The four main macroeconomic goals that are generally of most concern to governments are economic growth, reducing unemployment, keeping inflation low and stable, and avoiding balance of payments and exchange rate problems. The circular flow of income model depicts the flows of money around the economy. The inner flow shows the direct flows between firms and households. Money flows from firms to households in the form of factor payments, and back again as consumer expenditure on domestically produced goods and services. Not all incomes get passed on directly around the inner flow. Some is withdrawn in the form of saving, some is paid in taxes, and some goes abroad as expenditure on imports. Likewise, not all expenditure on domestic firms is by domestic consumers. Some is injected from outside the inner flow in the form of investment expenditure, government expenditure and expenditure on the countrys exports. Planned injections and withdrawals are unlikely to be the same. If injections exceed withdrawals, national income will rise. As a result, unemployment will tend to fall, inflation will tend to rise, imports will tend to rise and exports fall. The reverse will happen if withdrawals exceed injections. If injections exceed withdrawals, the rise in national income will lead to a rise in withdrawals. This will continue until W=J. At this point the circular flow will be in equilibrium. Actual growth must be distinguished from potential growth. The actual growth rate is the percentage annual increase in the capacity of the economy to produce (whether or not it is actually produced). Actual growth will fluctuate with the course of the business cycle. The cycle can be broken down into four phases: the upturn, the expansion, the peaking out, and the slow down or recession. In practice, the length and magnitude of these phases will vary: the cycle is thus irregular. Actual growth is determined by potential growth and by the level of aggregate demand. If actual output is below potential output, actual growth can temporarily exceed potential growth, if aggregate demand is rising sufficiently. In the long term, however, actual output can grow only as fast as potential output will permit. Potential growth is determined by the rate of increase in the quantity of resources: capital, labour, land and raw materials; and by the productivity of resources. The productivity of capital can be increased by technological improvements and the more efficient use of the capital stock; the productivity of labour can be increased by better education, training, motivation and organisation. Unemployment can be divided into equilibrium and disequilibrium unemployment. Equilibrium unemployment occurs when there are people unable or unwilling to fill job vacancies. This may be due to poor information in the labour market and hence a time lag before people find suitable jobs (frictional unemployment), to a changing pattern of supply and demand in the economy and hence a mismatching of labour with jobs (structural unemployment specific types being technological and regional unemployment), or to seasonal fluctuations in the demand for labour. Disequilibrium unemployment occurs when the actual employment rate is above the equilibrium unemployment rate. It can arise for two reasons. First, the real wage rate may come to be higher than the wage rate at which the overall labour market is in equilibrium. Thus the aggregate supply of labour is greater than the aggregate demand for labour. Second, and more common, is demand-deficient unemployment which arises when the aggregate demand for goods and services falls and as a result firms reduce the number of people they employ to produce goods and services. Inflation is a general rise in the level of prices. It is measured by the annual percentage increase in the Consumer Price Index.

The costs of inflation include menu costs (the costs involved in changing prices), uncertainty, a redistribution of income, and balance of payments difficulties. Inflation can be caused either by continuing increases in the demand for goods and services or by continuing rises in costs. There are three ways of measuring a countrys GDP (its total output or income). These are the product method, the income method and the expenditure method.

CHAPTER 11 SUMMARY: GROSS DOMESTIC PRODUCT In the simple Keynesian model, equilibrium GDP is where withdrawals equal injections, and where GDP equals the total expenditure on domestic products: where W=J and where GDP=E. The relationships between GDP and the various components of the circular flow of income can be shown on a diagram, where GDP is plotted on the horizontal axis and the various components of the circular flow are plotted on the vertical axis. Equilibrium GDP can be shown on this diagram either at the point where the W and J lines cross, or where the E line crosses the 45 line. If injections rise (or withdrawals fall), there will be a multiplied rise in GDP. The multiplier is defined as GDP/J. Thus if a $10 million rise in injections led to a $50 million rise in GDP, the multiplier would be 5. The size of the multiplier depends on the marginal propensity to withdraw (mpw). The smaller the mpw, the less will be withdrawn each time incomes are generated around the circular flow, and thus the more will go around again as additional demand for domestic product. The multiplier formula is 1/mpw or 1/(1-mpcd). If equilibrium GDP is below the full employment level of GDP, there will be a deflationary gap. This gap is equal to GDP-e. This gap can be closed by increasing injections or reducing withdrawals. This will then cause a multiplied rise in GDP and will eliminate demand-deficient unemployment. If equilibrium GDP exceeds the full-employment level of income, the inability of output to expand to meet this excess demand will lead to demand-pull inflation. This excess demand gives an inflationary gap, which is equal to e-GDP. This gap can be closed by reducing injections or increasing withdrawals. Keynesians explain cyclical fluctuations in the economy by examining the causes of fluctuations in the level of aggregate demand. A major part of the Keynesian explanation of the business cycle is the instability of investment. The accelerator theory helps us to understand this instability. It relates the level of investment to changes in GDP and consumer demand. An initial increase in consumer demand can result in a very large percentage increase in investment; but as soon as the rise in consumer demand begins to level off, investment will fall; and even a slight fall in consumer demand can reduce investment to virtually zero. Keynesians identify other causes of cyclical fluctuations, such as the cycles in the holding of stocks, time lags, bandwagon effects, the interaction of the multiplier and accelerator, ceilings and floors to output, echo effects, swings in government policy and random shocks.

CHAPTER 12 SUMMARY: INFLATION The price level and the level of output in the economy are jointly determined by aggregate demand and aggregate supply. There are four components of aggregate demand: consumer expenditure, private investment, government expenditure on goods and services, and exports net of imports. The aggregate demand curve shows how many goods and services will be demanded at each level of prices. Aggregate demand decreases as the price level increases. There are three main reasons for this. First, the higher price level makes exports less competitive overseas and increases imports. Thus exports less imports

decline. Second, the real value of peoples money balances fall. They lose wealth and demand fewer goods and services. Third, the higher price level causes interest rates to rise and thus investment falls. The aggregate demand curve shifts if any of its four component parts changes independently of a change in the price level. The aggregate supply curve shows how many goods and services will be supplied at each price level. It is drawn on the assumption that money wages are fixed. It slopes upwards. To induce firms to supply more, the price level must rise. The reason for this is that as output increases firms face increasing marginal costs due to the law of diminishing marginal returns. In other words, the aggregate supply curve has a similar shape to the supply curves of individual firms. The aggregate supply curve shifts if any of the variables held constant when the curve is drawn change. These are money wages, technology and the stock of capital. Macroeconomic equilibrium occurs when aggregate demand and supply are equal. Demand-pull inflation occurs as a result of an increase in aggregate demand. This causes prices and GDP to increase: unemployment falls due to the increase in GDP. The increase in price level causes real wages to fall. Employees negotiate for higher wages to restore their real wages. As wages rise, the aggregate supply curve shifts upwards and prices rise further. However, the shift in the aggregate supply curve causes GDP to fall back towards its original level, and thus unemployment to increase towards its original level. The line relating supply to the price level in the long run is called the long-run aggregate supply curve. It is more or less vertical at the full-employment level of GDP. In the short run, changes in aggregate demand cause increases in GDP. There is some dispute among economists as to how long it takes for increases in wages (and thus upward shifts in the aggregate supply curve) to eliminate the increase in GDP. Keynesian economists think its a matter of years. New classical economists think wage and price adjustment will take place very quickly. Cost-push inflation occurs where there are increases in the costs of production independent of rises in aggregate demand. This might be due to an increase in import prices or its employee attempts to increase wages. In practice, demand-pull and cost-push inflations will often interact and make it difficult to identify the initial cause.

CHAPTER 13 SUMMARY: MONEY AND THE FINANCE SYSTEM Moneys main function is as a medium of exchange. In addition, it is a means of storing wealth, a means of evaluation and a means of establishing the value of future claims and payments. What counts as money depends on how narrowly it is defined. All definitions include cash, but they vary according to what other financial assets are included. Narrow definitions of money include items that can be directly spent: cash and money in cheque accounts. Broad definitions of money also include items that cannot be spent directly but can, nevertheless, be readily converted into cash. Financial intermediaries include banks, credit unions and finance companies. They provide several important functions, including channelling funds to areas of highest return, maturity transformation and risk transformation. Banks aim to make profits but they must also maintain sufficient liquidity. Liquid assets, however, tend to be unprofitable and profitable assets tend to be illiquid. Banks therefore hold a range of assets of varying degrees of profitability and liquidity. The Reserve Bank of New Zealand is the central bank. It issues notes, acts as a banker to the government and to banks, holds the official reserves of foreign currency, and is responsible for monetary policy.

Money supply can be defined in a number of ways, depending on what items are included. The most useful measure is broad money which includes cash in circulation plus all bank deposits and all borrowings by (or deposits with) non-bank financial intermediaries. Bank deposits expand through a process of credit creation. If banks liquid assets increase, they can be used as a base for increasing loans. When the loans are re-deposited in banks they form the base for yet more loans, and thus takes place a process of multiple credit expansion. The ratio of the increase in money to an expansion of the liquidity base is called the bank multiplier. It is the inverse of the liquid ratio. In practice, it is difficult to predict the precise amount by which money supply will expand if there is an increase in banks liquidity. The reasons are that banks may choose to hold a different liquidity ratio; customers may not take up all the credit on offer; there may be no simple liquidity ratio, given the range of near money assets; and some of the extra cash may leak away into extra cash holdings by the general public. Simple monetary theory assumes that the supply of money is independent of interest rates. In practice, a rise in demand for money and hence a rise in interest rates will often lead to an increase in money supply. The three motives for holding money are the transactions, precautionary and assets motives. The demand for money will be higher, (a) the higher the level of nominal GDP (i.e. the higher the level of real GDP and the higher the price level), (b) the less frequently people are paid, (c) the greater the advantages of holding money in bank accounts, such as access to cash machines and the use of debit cards, (d) the more risky alternative assets become and the more likely they are to fall in value, and the more likely the exchange rate is to rise, and (e) the lower the opportunity cost of holding money in terms of interest foregone on alternative assets. The demand for money curve with respect to interest rates is downward sloping. Equilibrium in the money market is where the supply of money is equal to the demand. Equilibrium is achieved through changes in the interest rate. The interest rate mechanism works as follows: a rise in money supply causes money supply to exceed money demand; interest rates fall; this causes investment expenditure on consumer durables and on housing to rise; this causes a multiplied rise in GDP. The fall in the interest rate will cause the exchange rate to depreciate. This in turn will lead to increased exports and decreased imports.

CHAPTER 14 SUMMARY: MACROECONOMIC POLICY An expansionary fiscal policy involves raising government expenditure and/or reducing taxes. A deflationary policy involves the reverse. If expansionary policy is followed, this will lead to a fiscal deficit (or a reduction in the fiscal surplus). A deflationary fiscal policy will lead to a fiscal surplus (or a reduction in the fiscal deficit). Automatic fiscal stabilisers are tax revenues that rise and government expenditures that fall as GDP rises. Discretionary fiscal policy is where the government deliberately changes taxes or government expenditure in order to alter the level of aggregate demand. Changes in government expenditure on goods and services will have a full multiplier effect. Changes in taxes and benefits will have a smaller multiplier effect as some of the tax/benefit changes will merely affect other withdrawals and thus have a smaller net effect on consumption of domestic product. The effectiveness of fiscal policy depends on the accuracy of forecasting. It also depends on the predictability of the outcome of the fiscal measures: the effect of changes in G and T on other injections and withdrawals, and the size and timing of the multiplier and accelerator effects. It also depends on whether there are any random shocks. There are five possible time lags associated with fiscal policy: the time lag before the problem is recognised; the lag between recognition and action; the lag between action and the changes being implemented; the lag

while the multiplier and the accelerator work themselves out; and the lag before consumption fully responds to new economic circumstances. Discretionary fiscal policy can involve side effects, such as disincentives, higher costs and adverse effects on social programs. Monetary policy attempts to alter the level of aggregate demand by changing interest rates and the supply of money. The main objective of monetary policy in New Zealand is to keep inflation between 1-4%. The interest rate under the direct control of the Reserve Bank is the overnight cash rate. If this changes, there is a follow-on effect to all other interest rates: for example, the mortgage interest rate and credit-card interest rates. On occasions when the Reserve Bank wishes to increase interest rates, it undertakes market operations to reduce the supply of money. It does this by selling government securities to banks and other financial institutions. This reduces their cash reserves and limits their ability to make loans. Thus the money supply is reduced. When the Reserve Bank reduces the overnight cash rate, it purchases government securities from banks and so on, and this increases their cash reserves and hence their ability to lend. Monetary policy affects aggregate demand because there are three types of expenditure that are sensitive to interest rates and the availability of credit. These are investment, house purchases, and consumption expenditure that is financed by borrowing. There are problems in the use of interest rates. With an inelastic demand for loans, interest rates may have to rise to very high levels in order to bring the required reduction in monetary growth. Controlling aggregate demand through controlling interest rates is made even more difficult as a result of fluctuations in the demand for money. Then fluctuations are made more severe by speculation against changes in interest rates, exchange rates and the rate of inflation. Nevertheless, controlling interest rates is a way of responding rapidly to changing forecasts and can be an important signal to markets that inflation will be kept under control, especially when, as in New Zealand, there is a firm target for the rate of inflation. The case against discretionary policy is that it involves unpredictable time lags, which can make the policy destabilising. The case in favour of rules is that they help to reduce inflationary expectations and thus create a stable environment for investment and growth. The case against sticking to inflation or money supply rules is that they may cause severe fluctuations in interest rates and thus create a less stable environment for business planning. Also, given the changing economic environment in which we live, rules adopted in the past may no longer be suitable for the present. The determinants of economic growth in the long run lie primarily on the supply side. They can be put into two broad categories: an increase in the quantity of factors, and an increase in the productivity of factors. An increased saving rate will lead to higher investment and hence to an increase in the capital stock. This, in turn, will lead to a higher level of national income. A larger capital stock, however, will require a higher level of replacement investment. Once this has risen to absorb all the extra investment, national income will stop rising: growth will cease. An increased saving rate will therefore lead only to a rise in output, not to a longterm rise in the rate of growth. A higher long-term rate of growth will normally require a faster rate of technological progress. Endogenous growth theory argues that the rate of technological progress and its rate of diffusion depend on economic institutions and incentives. Supply-side policy could be used to alter these. Supply-side policies ain to shift the aggregate supply curve to the right, increasing the level of output at a given level of prices. Supply-side policies in New Zealand include policies to increase competition, policies to increase labourmarket flexibility, tax reform, and support for research and development.

CHAPTER 15 SUMMARY: INTERNATIONAL TRADE The balance of payments account records all payments and receipts from foreign countries. The current account records payments for the imports and exports of all goods and services, plus incomes and transfers of money to and from abroad. The capital account records all transfers of capital to and from abroad. The financial account records inflows and outflows of money for investment and as deposits in banks and other financial institutions. It also includes dealings the countrys foreign exchange reserves. The whole account must balance, but surpluses or deficits can be recorded on any specific part of the account. Thus the current account could be in deficit, but it would have to be matched by an equal and opposite capital plus financial account surplus. The rate of exchange is the rate at which one currency exchanges for another. Rates of exchange are determined by demand and supply in the foreign exchange market. Demand for the domestic currency consists of all the credit items in the balance of payments account. Supply consists of all the debit items. The exchange rate will depreciate (fall) if the demand for the domestic currency falls or the supply increases. These shifts can be caused by a fall in the domestic interest rates, higher inflation in the domestic economy than abroad, a rise in domestic incomes relative to incomes abroad, relative investment prospects improving abroad, or the belief by speculators that the exchange rate will fall. In a free foreign exchange market, the balance of payments will automatically balance, since changes in the exchange rate will balance the demand for the currency (credits on the balance of payments) with the supply (debits on the balance of payments). There is no guarantee, however, that there will be a balance on each of the separate parts of the balance of payments account. The Reserve Bank can attempt to prevent the rate of exchange falling by purchasing the domestic currency in the foreign exchange market, either by selling foreign currency reserves or by using foreign loans. Alternatively, the Reserve Bank can raise interest rates. The reverse actions can be taken if it wants to prevent the rate from rising. In the longer term, the government can attempt to prevent the rate from falling by pursuing deflationary policies, protectionist policies of supply-side policies to increase the competitiveness of the countrys exports. Fixed exchange rates bring the advantage of certainty for the business community, which encourages trade and foreign investment. They also help to prevent governments from pursuing irresponsible macroeconomic policies. However, with fixed rates domestic policy is entirely constrained by the balance of payments. What is more, they can lead to competitive deflation worldwide; there may be problems of excessive of insufficient international liquidity; there may be difficulty in adjusting to external shocks; and speculation could be very severe if people came to believe that a fixed rate was about to break down. The advantages of free-floating exchange rates are that they automatically correct balance of payments disequilibria; they eliminate the need for reserves; and the give governments a greater independence to pursue their chosen domestic policy. On the other hand, a completely free exchange rate can be highly unstable, especially when the elasticities of demand for imports and exports are low and there are rapid shifts in currency demand and supply; also speculation may be destabilising. This may discourage firms from trading and investing abroad. What is more, a flexible exchange rate, by removing the balance of payments constraint on domestic policy may encourage governments to pursue irresponsible domestic policies for short-term political gain. In practice most countries have floating exchange rates, but from time to time they intervene to influence the rate of exchange. Nonetheless, exchange rates have become very volatile.

Changes in the aggregate demand of one country will affect the amount of imports purchased and thus the amount of exports sold by other countries and hence their national income. There is thus an international trade multiplier effect. Changes in aggregate demand in one country will affect financial flows to and from other countries, and hence their exchange rates, interest rates and national income. To prevent problems in one country spilling over to other countries and to stabilise the international business cycle will require co-ordinated policies between nations. Leaders of the G7 countries meet regularly to discuss ways of harmonising their policies. Usually, however, domestic issues are more important to the leaders than international ones, and frequently they pursue policies that are not in the interests of other countries. After the 1973 oil crisis many developing countries borrowed heavily in order to finance their balance of trade deficits and to maintain a program of investment. After the 1979 oil price rises the debt problem became much more serious. There was a world recession and real interest rates were much higher. Debt increased dramatically, with much of it at variable interest rates. Rescheduling can help developing countries cope with increased debt in the short run and various schemes have been adopted by creditor countries and the banks. If the problem of developing countries debt is to be tackled, then simple rescheduling is not enough. The International Monetary Fund (IMF) favours harsh structural adjustment programs, involving deflation and market-orientated supply-side policies. A more complete structural adjustment, however, would involve more open access to the markets of the rich countries, more aid and debt relief being channelled into health and education, and greater research and development in areas that will benefit the poor. In 1996 the World Bank and the IMF launched the HIPC initiative to help reduce the debts of heavily indebted poor countries to sustainable levels. HIPC relief has been criticised, however, for being made conditional on the debtor countries pursuing excessively tough IMF adjustment programs, for being too modest in the amount of debts cancelled, for having an excessively long qualifying period and for delays in its implementation. A better approach might be to target debt relief directly at programs to help the poor.

FINANCE