Unit 11 – Aggregate Demand and Aggregate Supply

This unit discussed aggregate supply and aggregate demand and general economic fluctuations.

The book outlines explains that economic fluctuations are irregular and unpredictable, that many economic variables fluctuate together and as output falls, unemployment rises. Now the book explains many different reasons why the markets fluctuate, however I believe the one reason they left out is humans are rationally bounded and therefore are not always predictable because they may or may not make decisions that better them.

Aggregate demand curve is when the quantity of all goods and services demanded in the economy at any given price. A change in price will cause a change in quantity of output within an economy. The aggregate demand curve is downwards sloping because of three reasons:

· Because a decrease in price level makes consumers feel more wealthy, so they will spend more increasing the amount of goods and services demanded.

· As the price level decreases it encourages people to invest more into investment goods and therefore increasing the amount of good and services demand.

· When the currency of a country decreases in relative terms against other countries ( real exchange rate), the currency exports more goods and services overseas because the goods and services are more attractive to people from other countries. This will increase net exports, therefore increasing net exports. However, the book mentioned that net exports would be stimulated (increasing goods and services demand), however did not explain if the curve has an affect on imports (i.e. total decrease value of imports could be greater than the total of increase value of exports, when the exchange rate depreciates). The imports do not have an effect on the curve because the aggregate demand is for all goods and services demanded within an economy? Or does imports have an effect on the aggregated demand curve? I would be guessing at this stage imports does have an effect on the aggregated demand curve. I will do more research and fill you in another blog.

The aggregate demand curve will shift pretty much for any other reason than a change in price level (i.e. law changes, new instruction of products, changes in money supply).

The book argues that the long run aggregate supply curve is vertical due to in the long run an economy’s supply of goods and services depends on the supply of capital and labour plus the availability of technology.

The short-term curve is up-sloping, illustrating that as price increases the quantity of output will increase also. The book does not explain this very well, however I would imagine that the reason why it is upwards slopping is because as the price level increases, companies will want to produce therefore hiring more workers creating less unemployment, therefore possibly making a labour shortage and therefore competition for labour increase and i.e. increasing employees wages which would increase the price level of products.

The supply curves will move with changes in natural resources, physical and human capital and also technology. Also peoples price expectations will also move the curve. I.e. anything other than price level.

The two causes of a recession is a left shift in the aggregate demand curve and also a upwards shift in the aggregate supply curve. If the aggregate demand curve moves to the left, there is less output being demanded for a same price level, the short run aggregate supply curve will have to move to the left to allow the all three curves to find equilibrium, and i.e. creating a situation at the natural rate of output (i.e. the LRAS) the aggregate goods and services have decreased within the market.

Unit 10 - International Economics

This unit discussed the basic principles of international economics. The unit described the trade balance of a country is total exports – total imports. As seen in the following graph New Zealand has a negative trade balance with imports being greater than exports for most of the since 2004, meaning New Zealand has had a negative trade balance since 2004.

Figure 1-New Zealand Income and Exports

Regarding New Zealand’s current account balance, which is made up of Net Imports, Net Income and Net Transfers, as shown in the table below. It can be seen that New Zealand’s is negative largely due to net income being negative, i.e. meaning that New Zealand pays a lot more investment income to foreigners compared to the amount it receives by its own residents investment income. This means that New Zealand has a large number of foreigners investing in New Zealand. It is interesting to note that New Zealand has a positive negative transfer, even though New Zealanders give a large amount of aid to foreign countries each year. The positive net transfers is probably mainly due to the large number of English retirees receiving their pension from the British Government in New Zealand.

The negative current account balance correlates that New Zealand has a net foreign investment. I.e. that New Zealand has more domestic assets purchased by foreigners than foreign assets purchased by New Zealand residents. This would help explain why New Zealand has a large negative net income. Having a negative net foreign investment is not a bad thing as it means there is more money being invested into infrastructure within New Zealand than the New Zealanders would likely invest without foreigners. More investment into infrastructure should help New Zealand’s productivity and i.e. economic and wage growth.

Table 1 – Current Account Balance 2004-2009

As show in the following graph New Zealand’s current account balance has been declining since at least 1990.

Figure 2 – Current Account Balance 1990 to 2009

As a side note to this unit, using the purchasing-power parity New Zealand has a relatively low inflation and therefore it should have a appreciating currency. ( However, this is to be discussed in a later blog).

New Zealands increasing negative net foreign investments (NFI) is putting pressure both real interest rates and real exchange rates to move upwards. Using the open economy models in the Net foreign Investment curve has moved to the left since 1990. Now two things happen here, we will fix one variable to show the effect on the other. If we fix the real exchange rate, with the NFI curve moving to the left, the supply of dollars (from NFI) will decrease and move to the left, if the demand of dollars curve stays in the same position the real exchange rate will so increase to find equilibrium can be found between supply of dollars and demand of dollars.

The other case is where the supply of dollars remains constant. With the NFI curve moving to the left, there will be pressure to drop interest rates. Therefore, either the supply or demand or both will move so that they can find equilibrium with the natural exchange rate.

Unit 9 – Money, Inflation and Interest Rates

The chapter introduced the main two kinds of financial institutions; financial markets, which includes bond and share markets and financial intermediates, which savers can indirectly provide funds to borrowers in means such as banks.

Recently in New Zealand there have been a number of new law changes that will affect the market of loanable funds. The first initiative was the introduction of kiwisaver, a saving policy encouraging New Zealanders to save part of their income for their retirement or for buying first time house. The kiwisaver will have an effect on the loanable funds because it will increase the supply of funds available and therefore the interest rate will drop as equilibrium is found again after the supply curve move to the left.

Another new law which was passed in 2010 is to increase GST from 12.5% to 15% for all goods and services and lower the business and top tax rate from 38% to 33%. In doing this it will move the loanable fund curve to the right as the tax on investments will be less therefore creating extra demand, however with GST increasing to 15% it may lessen consumption of the public and therefore increasing savings, which would move the supply curve to the right. Therefore it is unpredictable whether the interest rate will increase or decrease or stay the same as both curves will move to the right. However, the about of loanable funds will increase, which might have appositive effect for New Zealand as it may correlate to more investments in capital.

Also the in the last three years the government has announced large budget deficits. In a closed economy this would move the supply funds to the left i.e. decreasing quantity of loanable funds available and increasing interest rates.

The above three law, taxation and government deficits will have a definite effect on New Zealand. However, as New Zealand is a open economy some of these effects will be mitigated by the availability of cheap loanable funds from overseas. Loanable funds from overseas have decrease because of the GFC and that was notable in the margins between the official cash rate and the banks interest rates. The Margin noticeably increased during the GFC as banks struggled to obtain cheap credit from overseas.

The Reserve Bank of New Zealand (RBNZ) has similar polices in controlling the inflation rate of New Zealand. The RBNZ uses the official cash rate (OCR) to control inflation to between 1% and 3%. One of the main causes of inflation in New Zealand is the residential property market. This is a major source of investment for New Zealanders. The housing prices in New Zealand increase significantly between 2002-2008, as shown in the figure 1.

FIGURE 1

FIGURE 2

As can be seen the OCR has an effect on the housing prices in New Zealand. When the OCR increase it increases the interest rates that people can borrow at. When the cost of borrowing increases the amount of people willing to borrow to buy houses decrease. When borrowing decreases on the houses it moves the demand curve in the property market to the left and therefore decreases the quantity of the houses sold and also reduces the price of houses sold. Also people who already have mortgages when the OCR increase, feel the affect because when the OCR increases, interest rates increase which means the repayments mortgagees have also increase. If mortgagees are spending more of their income on their mortgage repayments, they have less income available for consumption, which means that the products they cut back on will move the demand curve to the left for those products and therefore putting pressure on the price of the products to decrease for equilibrium to be found again. However this effect from mortgagees is normally a delayed effect because most mortgagees are fixed into term of 1,2 or 5 years. Therefore as can be seen from graphs above the increase in OCR did have some effect initially however much of the effect was not notice until 2007/2008 where house prices crashed dramatically. Since then the OCR has been decreased to 2.5% to try and stimulate economic growth in the New Zealand economy.

FIGURE 3

The lastest RBNZ policy was enforced in the early 1990’s. And as shown in figure 3 the inflation has been kept pretty steady around 1 to 5% (compared to before 1990 where inflation was as high as 19%. Therefore, it could be inferred than the RBNZ policy is working. Some interesting things to note in inflation is some of the large peaks. One of the main causes in the 1970’s was the increase in oil prices because of the oil crisis. As consumption of oil is relativiely large in the New Zealand economy a small increase can be felt through many industries. Because oil is used for transport, power, etc and therefore an increase in oil prices can dramatically increase inflation. Oil increases around 2005/2006 can also be notice on this graph of inflation with a small peak in 2005/2006.