With most schools approaching their mid-year exams in both CIE and NCEA here is a mindmap which covers the main points when studying perfect competition. This can be a popular essay in CIE Paper 4 making a comparison with imperfect competition and NCEA AS 3.2 – 91400 Demonstrate understanding of the efficiency of different Market Structures using Marginal Analysis
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Central Banks have often used the term ‘the neutral rate’ which refers to a rate of interest that neither stimulates the economy nor restrains economic growth. This rate is often defined as the rate which is consistent with full employment, trend growth, and stable prices – an economy where neither expansionary nor contractionary measures need to be implemented. The neutral interest rate is the rate of interest where desired savings equal desired investment, and can be thought of as the level of the OCR that is neither contractionary nor expansionary for the economy.
OCR > Neutral Rate = Contractionary and slowing down the economy
OCR < Neutral Rate = Expansionary and speeding up the economy
This neutral rate dictates when the RBNZ end their tightening or loosening cycle. If the neutral rate is seen to be 3% it is the expectation that the RNBZ will increase the OCR to 3%. The graph below shows the difference between the estimated neutral rate and the OCR. Note that:
2008 – positive gap as RBNZ trying to bring inflation under control – contractionary level 2019 – the gap narrows and monetary policy becomes less stimulatory as the neutral of the OCR is likely lower.
What determines the neutral rate of interest in an economy?
Supply of loanable funds (people who save money) and Demand to borrow money – neutral rate generates a level of savings and borrowing that delivers the economy to maximum sustainable employment and inflation – 2% in NZ but with Policy Target Agreement of 1-3%. Potential growth rate of an economy – if people expect more growth = higher incomes = higher borrowing = upward pressure on neutral rates. Economists tend to look at the production function and how much we can produce in the long-run therefore impacting aggregate supply. With higher potential growth rates investment spending is expected to increase and with it interest rates. Population growth – strong population growth = larger labour force = larger national output which supports the neutral rate of interest. Age and life expectancy – higher life expectancy increases the amount that people save during their working years. If consumers buy now rather than later = potentially either lower saving rates and/or higher borrowing = neutral rate of interest rises. Superannuation / retirement age – burden of funding retirees fall on a smaller working age population. This could require higher taxes which leads to less spending putting downward pressure on interest rates. Debt – with low mortgage rates, debt servicing have been at record lows. People have therefore borrowed a lot money and now have high level of indebtedness levels. Therefore higher mortgage rates mean that consumers disposable income will be reduced. Government debt – COVID-19 has led to increased government spending and bigger budget deficits. New Zealand economy is probably as sensitive to higher interest rates and an increase in rates by the RBNZ will be very influential, limiting how far interest rates have to rise. And with households and the Government already loaded up on debt, future borrowing capacity is now reduced, which will put downwards pressure on interest rates too. Overseas investment – as New Zealand comes a more attractive place to invest it increase the supply of loanable funds to New Zealanders. The investment will also strengthen the dollar which make exports less competitive but imports cheaper. Global capital flows mean that we can’t get too far out of sync with other advanced economies – as long as global neutral rates continue their relentless move south, so too will New Zealand’s.
Outlook In New Zealand, as in most economies, estimates of the real neutral interest rate have been trending downwards over several decades. In recent years, the RBNZ indicator suite suggests that the real neutral interest rate has stabilised at low levels. The RBNZ current average estimate for the real neutral OCR is around 0 percent. However, the wide range between the maximum and minimum values of RBNZ estimates demonstrates that there is significant uncertainty about the level of neutral interest rates, particularly since the beginning of the COVID-19 pandemic. RBNZ Monetary Policy Statement – November 2022. P. 30
Source: NZ Insight: Neutral interest rates – 20th August 2021 – ANZ Bank
At the end of last year OpenAI launched ChatGPT – Generative Pre-trained Transformer. It has the ability to impact traditional assessment methods by generating answers to questions which are often indistinguishable from a student response.
ChatGPT operates using algorithms that process data, allowing it to string words together in response to a prompt. Unlike humans, ChatGPT has access to vast troves of information available on the internet and uses large language modelling to recognise patterns in the words in each prompt to mimic human writing when dispensing knowledge.
The two tests were conducted with thousands of economics students from US universities and were sat before the start and at the end of the semester. The pre and post results would enable educators to measure the impact of particular pedagogy over this time period. The results were as follows with most students answer around 40–50% of questions correctly. The authors then put the two tests through ChatGPT and found that it answered 19 of 30 microeconomics questions correctly and 26 of 30 macroeconomics questions correctly, ranking in the 91st and 99th percentile, respectively – see graph for microeconomics test.
Some interesting findings regarding ChatGPT answers include:
Choosing all 4 options as an answer to a multiple choice question
Being unable to process images
Questions answered wrong in the micro exam include: Supply and Demand x2, Factors of Production, Utility, Elasticity, Comparative Advantage, Externalities, Market Structure and it did not answer Profit Maximisation. Profit Maximisation not applicable
Questions answered wrong in the macro exam include: Components of GDP, Tools of Monetary Policy x2, Exchange Rates.
Where to from here? Using software tools such as Turnitin may not be sufficient to spot a student answer using ChatGPT therefore educators need look at designing assessments that focus on critical thinking and analytical skills that cannot be easily duplicated by AI.
Assessments need to reward students that know the content and not those that are able to source answers through classmates or ChatGPT. By introducing time restrictions those students who have knowledge of the material are in a much better position to answer more questions.
It is important to highlight that although ChatGPT looks to be very valid in its response to a question it doesn’t mean that it is correct. A popular recommendation amongst teachers is to produce ChatGPT with errors and have students to identify as many as they can.
There are other ways to engage students in learning experiences that can’t be replicated through ChatGPT namely classroom presentations, data response type questions, in-class writing assignments, collaborative learning project with students in different countries, quizzes etc. This goes beyond the simple memorisation of notes and theory and addresses the complex nature of economics with a deeper understanding.
Tools like ChatGPT are likely to become a common part of the writing process, just as calculators and computers have become essential tools for learning mathematics and science. The challenge of universities is to adapt their curriculum to this new reality and to embrace the new era with innovative and effective assessment strategies.
This year I am trying to get students to develop a deeper understanding of economic issues and to improve their evaluation skills for the written exam. The goal is that students will arrive at a collective meaning, rather than seek a “right” answer. Below is a plan of how you could structure the discussion.
Subject content – Economic schools of thought. Keynes v Hayek – this is part of Unit 9 of the CAIE A2 syllabus.
Content knowledge: Types of economies (left and right wing) covered at CAIE AS Level. The schools of thought are taught in class and questions (MCQ) and short answer are used to test student understanding of the characteristics of each. The two videos below are useful to consolidate knowledge.
Austrian economics and Keynesian economics explained in 1 minute. See below
Music (rap) video ‘Fear the boom and bust’ – Keynes v Hayek. See below
One of the challenges is to keep students on task and try and get contributions from all students. In order to overcome these issues I have developed a set of playing cards with certain statements on each. Students receive 8 playing cards with different assessment objectives/ skills/ elements of written work in economics – see photo. Students can only talk when they place a card on the table. Once a student has used up all their cards they can no longer contribute to the discussion. The link below has more detail on this method:
Students read a media extract on the topic. Extract selection is important – not too long and must be easy to relate to core knowledge. I have picked the article by Larry Elliott in the Guardian newspaper as this is media that is different to what students tend to be exposed to.
Number of students in a group is a determining factor – 8 to a group.
Tutorial/discussion over 2 periods
Opening question – essential that this is pitched at the level appropriate to the group as the intention is for the discussion to proceed through student interactions.
The new variant of capitalism should be the dominant policy option for governments.
If this is question doesn’t engage the students you could ask some of the following questions:
Start off with a simple question that is referenced from the text – ‘What aspects of Keynesian economics are evident in the extract?’
Allow each student to answer the opening question – 30 seconds. Other responses can spark conversation once everyone has replied.
Get students to continually reference the text so to keep the conversation relevant
Coaching – there may be the need to encourage deeper and more critical thinking. Need to avoid teaching by offering analysis and possible evaluations. Some questions to encourage critical thinking:
Why was the Keynesian variant relinquished in the 1970’s?
How did the 2008 GFC influence government policy?
Was austerity the answer to the issues caused by the GFC?
How did COVID-19 impact policy for left right and centre governments?
Should allow students to respond from their own perspective but must be related to the extract.
Student reflection – the hope is that students are able to develop a deeper understanding of the complexities of the subject content and read newspaper/magazine articles with a more holistic view of the how an economy works. The level of scaffolding for reflection will vary with each student but there is potential for all students to feel more confident in their knowledge and participation in future discussions.
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Wage Rate:- The price of labour as determined by market supply and demand. The demand for labour is said to be derived demand: – the demand for labour is dependent on the demand for the goods & services produced. Key factors that affect the quantity of labour supplied:-
age of population
Difficulty in acquiring qualifications – eg. doctors
social attitudes to employment
Change in Demand for labour Change in Supply of labour
Wages A more realistic version of the market model measures the price of labour in real wages rather than in nominal or money wages. The difference is that nominal wages are the actual dollars that are paid for any job while real wages are a measure of the ability of those dollars (earnings) to buy goods and services. Therefore real wages consider the purchasing power of your income.
Sticky Wages Actual wages will rise much more easily than they will fall. Labour markets are extremely rigid when it comes to reducing wage levels. Several factors encourage wages to stick at higher levels and so prevent the market from clearing, as shown in ‘Supply and Demand Applications’ and below.
Equilibrium and Real Wages
Some of these factors occur through the natural operation of the labour market.
Strong trade unions can operate as ‘monopoly suppliers’ of labour. This keeps wages above the equilibrium equilibrium. Fewer workers are hired.
Hiring cheap labour may backfire on employers. This labour may not have the same level of skills as that of the firm’s existing workforce. This will increase costs for the firm if it has to provide too much training. Existing workers therefore hold the balance of power and can demand higher wages.
The idea that a job has a certain worth, an intrinsic value regardless of the action of demand and supply, can keep wages above equilibrium.
The influence of humanity values can be strong. It is easy to pay less for resources other than labour.
Some factors are imposed on the market by the government.
Legislated minimum wages prevent the market from clearing. Although these wages aim to protect the incomes of those in the lower paid jobs, the result is fewer jobs for those same workers.
Welfare benefits can be over-generous and this may discourage the unemployed from seeking jobs.
Unit 9 of the new CAIE Economics course looks at national income and the 45 degree line graph. The graph below covers what you need to know and is one of the more complex graphs in the course. Aggregate expenditure shows the quantity of goods and services which households, firms and government are prepared to buy at different values of the general price level. The early classical economists believed that the size of the aggregate expenditure for output would be sufficient to employ everyone who wanted to work. John Maynard Keynes suggested that the achievement of a full and stable level of employment required the government to play an active part in determining the level of total expenditure. This policy known as demand management, was adopted by most governments in the post-war period. If a government is to manage aggregate demand effectively, it must be capable of influencing the components of aggregate demand i.e.. C+I+G+X-M. Government spending and taxation will be important instruments for this purpose, and by running budget deficits (spend more than they earn) or surpluses(spend less than they earn), the government can inject or withdraw purchasing power into or from the economy. Demand management policies were applied with considerable success in the two decades following the end of Second World War. Unemployment and inflation remained at very low levels throughout this period. However, these policies have proved to be much less successful since the mid-1960s.
The components of Aggregate Demand – AD = C + I + G + X – M
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Below is a useful graph from ANZ Bank which looks at the breakdown of components that make up GDP in New Zealand. The GDP of a country is made up of four things: C+I+G+(X-M).
C = Private Consumption
I = Business Investment
G = Government Consumption
(X-M) = Net Exports
Notice the movement in GDP over the years with the GFC in 2008 where exports revenue brought economic growth into positive territory. However up to 2020 it was private consumption that was the most prevalent with investment. COVID-19 saw a significant downturn with consumption and investment again helping GDP. Overall, domestic demand is set to get smaller, but the exports services such as education and tourism and less demand for imports should counterbalance the lack of domestic demand – see the graph. But the RBNZ has signaled that in order to get inflation down they need the domestic economy to experience a recession (two consecutive quarters of negative GDP) with private consumption falling significantly.
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Following on from my last post on the multiplier, below is a type of question which has been quite popular in the last couple of exam sessions. I have changed the data from the original CAIE question.
The table shows the values of selected macroeconomic variable over a two-year period.
What is the value of the multiplier?
A. 3 – B. 4 – C. 6 – D. 12
From the data both years are in equilibrium Year 1 NI = 3800 – Injections = 260+160+200 = 620 Withdrawals = 300+140+180 = 620 Year 2 NI = 4600 – Injections = 360+210+250 = 820 Withdrawals = 350+210+260 = 820
The increase in injections has been 200 but the increase in NI has been 800 (4600-3800) – therefore the multiplier is 4 – (4 x 200 = 800).
The Multiplier Consider a $300 million increase in business capital investment. This will set off a chain reaction of increases in expenditures. Firms who produce the capital goods that are ultimately purchased will experience an increase in their incomes. If they in turn, collectively spend about 3/5 of that additional income, then $180m will be added to the incomes of others. At this point, total income has grown by ($300m + (0.6 x $300m). The sum will continue to increase as the producers of the additional goods and services realise an increase in their incomes, of which they in turn spend 60% on even more goods and services. The increase in total income will then be ($300m + (0.6 x $300m) + (0.6 x $180m). The process can continue indefinitely. But each time, the additional rise in spending and income is a fraction of the previous addition to the circular flow.
The value of the multiplier can be found by the equation 1 ÷ (1-MPC) You can also use the following formula which represents a four sector economy 1 ÷ MPS+MRT+MPM
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Just covering the multiplier with my A2 and will be later with my NCEA Level 3 class. Think of the multiplier effect as a still pond. Women’s Football World Cup being held in Australia and New Zealand later this year – the direct impact of spending on the World Cup is like a stone hitting the water and creating ripples which will get smaller and smaller. With spectators coming to Auckland to watch a game they will make additional spending on accommodation, transport, food, tourist attractions etc. Where a hotel makes a lot of money form the event they may chose to extend the numbers of rooms which means they will have to employ contractors who will receive more income. The contractor might spend this additional income on a new vehicle for the business which then adds income to the car dealership – and it goes on with the ripples getting smaller and smaller.
Economic forecasters tend to use a simple formula to estimate the multiplier effect of sports event. They will estimate the number of spectators, how long they will stay and what they, on average, will spend whilst at the event.
Problems of forecasting Unrealistic projections of the number of visitors or their potential spending will lead to inaccurate multiplier effects. Factors that might overestimate the true economic impact of a sporting event. Substitution effect: this happens when the spending on a sporting event would have been spent elsewhere in the local economy and therefore doesn’t generate new economic activity. Crowding out: crowds and congestion may dissuade other economic activity from occurring. For example London Olympics 2012 590,000 visitors arrive in connection with the Olympics but the number of visitors fell by 1 million between summers of 2011 and 2012. Leakages: higher costs for restaurants, hotels etc associated with hosting the event doesn’t necessarily mean that employees working in those areas will be paid more. Also where there are guest workers from overseas the money is less likely to be recirculated. For some venues on the coast cruise ships have been used but this is only during the event.
Research into the impact of sporting events whether it would be the Champions League Final, World Cup, Olympic Games etc has found there is little short-run economic effect on the host city. The table above shows the research before and after sporting events with conflicting data. Some economists joke that if you really want to know what the true economic impact of a sporting event is, just take whatever number the promoters give you and then move the decimal point one place to the left.
Source: The Economics of Sport (2018) – M. Leeds, P. Von Allmen and V. Matheson
The theory behind the multiplier. Consider a $300 million increase in business capital investment. This will set off a chain reaction of increases in expenditures. Firms who produce the capital goods that are ultimately purchased will experience an increase in their incomes. If they in turn, collectively spend about 3/5 of that additional income, then $180m will be added to the incomes of others. At this point, total income has grown by ($300m + (0.6 x $300m). The sum will continue to increase as the producers of the additional goods and services realise an increase in their incomes, of which they in turn spend 60% on even more goods and services. The increase in total income will then be ($300m + (0.6 x $300m) + (0.6 x $180m). The process can continue indefinitely. But each time, the additional rise in spending and income is a fraction of the previous addition to the circular flow.
The value of the multiplier can be found by the equation 1 ÷ (1-MPC) You can also use the following formula which represents a four sector economy 1 ÷ MPS+MRT+MPM
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Below is an excellent video from German state broadcaster Deutsche Welle (DW). It outlines the decline in China’s GDP which is now at historic lows. DW look at the problems that have been building in China as for the first time in two decades, its output fell behind that of the rest of Asia. It also addresses the history of economic rise and the mountain of debt that it has accumulated. Add to that the demographic change and international threats. Below are some points from the video:
The draconian measures to contain COVID has sapped domestic consumption crippled small businesses and kept China’s factories closed.
The Chinese government has shielded its economy for years with infrastructure projects – building roads, dams, harbours, rail networks etc. It is the latter that is a good example of excess capacity and mounting financial losses – the network keeps growing even less populated locations where there isn’t much demand and now maintenance costs and interest payments have overtaken the railway’s income.
With the working population declining it is hard to maintain dynamic growth. Less workers puts pressure on wages and for China to maintain its cheap prices it has to improve productivity. Demographic change is a long-term phenomenon so the Chinese government still has room to respond and it has already switched to a three-child policy.
Also the demand for China’s exports has decreased as the global economy goes through an economic slowdown with surging inflation. Exports declines from 36% of GDP in 2006 to 20% in 2021 – see graph. Therefore more domestic consumption is needed to maintain growth and an expansionary fiscal policy like that in western economies might be the way to go.
I did a post on this topic earlier in the year but thought to update it with some recent data. In teaching economics I try and relate as much as I an to the interests of the students. I have found that sport is one way of engaging a class especially in the macro indicators of a country – growth, unemployment, inflation, trade, inequality etc. The German economy has been the backbone of the EU for a number of years but has this corresponded to the success/failure of the national football team? The performance at the 2004 Euros were the catalyst to an overhaul of the German coaching system – outlined brilliantly in Raphael Honigstein’s book – Das Reboot. This came to fruition in the 2014 World Cup final when German beat Argentina 1-0 in extra time.
However a year earlier in 2013 there was an all German final in the European Champions League with Bayern Munich defeating Borussia Dortmund 2-1 at Wembley Stadium in London. In order to get to the final both teams beat Spanish counterparts – Real Madrid and Barcelona. What is fitting is that in economic terms German is the powerhouse of the European economy whilst in contrast Spain has suffered greatly from the euro crisis and austerity measures that have been imposed on it. If you look at post-war Germany you can see some correlation between the success of the national side and state of the economy.
The Economist looked at this and made the point that German has opened up its borders to not just traditional labour but also football players. Of the two squads on show at the Champions League Final at Wembley in 2013, 17 were from outside Germany.
Most visibly, Germany opened up. Just as immigrants flock to German jobs (more than 1m net arrivals in 2012), so players join German clubs. Between them Bayern and Dortmund have four Brazilians, three Poles, a Peruvian-Italian, a Serb, a Croat, a Swiss of Kosovar extraction, an Austrian of Filipino/Nigerian stock, a Ukrainian and two Australians—and so on. Of the German players, several have dual citizenship or a “migration background”. If the choice is between a German Europe or a European Germany, as the novelist Thomas Mann once put it, football points to the second.
The 2014 World Cup victory, almost 25 years since they last won it, was achieved largely through the restructuring of German coaching system. The style of play was transformed from a defensive minded ‘park the bus’ attitude to one of free flowing counter attacking style. However the economy was not as buoyant as in previous years with unemployment 6.6% and the spectre of deflation rising its head. Roll on the 2018 World Cup and the defending champions had a disastrous campaign with not even getting out of pool play. This coincided with weakest growth in Germany for five years. The Euro 2020 (played in 2021 because of covid) saw Germany going out to England in the last 16. With regard to the club scene Bayern Munich did win the Champions League in 2020 but no German team made it to the semi-finals in 2021 as both Bayern Munich and Borussia Dortmund were knocked out in the quarter finals.
As with most countries the German economy failed to return to its pre-covid growth rate as shortages of manufacturing inputs have hampered any recovery. However, there are plenty of orders on the books for German companies for a potential rebound when supply constraints ease. On the football side of things under new manager Hansi Flick, ex Bayern Munich, the national side breezed through qualifying for Qatar 2022 in what was a weak group, but are still ranked only 12th in the world which is an improvement on 16th in 2018.
2022 – recent resultsand economic outlook
Recently their poor run of form in the Nations league with just one win in six games and a home defeat to Hungary has left new manager Hansi Flick with a big challenge to get the best out of a talented squad. However, the lack of a real number 9 is a concern and although they can beat other teams it is their lack of consistency that could let them down. As for the German economy it is still a gloomy outlook – high inflation, constant supply chain problems and weaker global demand have impacted their manufacturing industry. Although unemployment figures are low there is pressure on wages which could put further pressure on inflation.
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In preparation for the CIE A2 multiple-choice paper on Thursday here are a couple of A2 type multiple-choice questions that some students have struggled with.
In a closed economy, where the full-employment level of income is $90 million, C = 2/3 Y and I = $(40-3r) million, where C = consumption, Y = income, I =investment and r = the rate of interest. If planned government expenditure is $20 million, what rate of interest would be required for there to be full employment?
A 10% per annum B 12% per annum C 14% per annum D 16% per annum
Y = C + I + G
90 = 2/3(90) + (40 – 3r) + 20
90 = 60 + 20 + 40 – 3r
3r = 30
r = 10%
In a closed economy with no government sector, there is no autonomous consumption and the marginal propensity to consume is 0.7. At the beginning of a time period firms set production targets of goods worth $1000 m of which planned sales to consumers = $800 m and planned additions to stocks = $200m.
Which one of the following statements is correct?
A The economy is in equilibrium, with planned savings and investment equal to $200m.
B The economy is in disequilibrium, with planned investment greater than planned savings.
C The economy is in disequilibrium, with planned aggregate demand of $800 in, and planned aggregate supply of $1000m.
D There will be an unplanned increase in stocks in $100in.
D NY = $1000m and MPC = 0.7, thus planned consumption is $1000 x 0.7 = $700m while planned sales by firms = $800. This will lead to an increase in unplanned stocks by $100m.
Within the OECD are annual inflation has been rising at an average of 9.6% – its ranges from 2.5% in Japan to 73.5% in Turkey. The US and the UK has inflation of 9.1%, Australia 6.3% and NZ 7.3%. Most of the bigger economies target a 2% inflation rate and in response to these higher rates the US Fed increased its interest rates by 75 basis points to 1.5-1.75% with a potential 50 or 75 basis point rise in July. The Reserve Bank of Australia also lifted its interest rate by 50 basis points to 1.35% in July. In order to tackle this inflationary pressure it is normal for central banks to sell bonds / assets back into the market which is turn reduces the money supply and raises interest rates. This should depress aggregate demand as there is now less money in the circular flow and the cost of borrowing goes up. However, the Bank of Japan (BoJ) is out of kilter with accelerating interest rates as it has committed to its policy of yield curve control intended to keep yields on 10-year bonds below 0.25% by buying as much public debt as is required – see graph below:
How to Bond Yields work? Say market interest rates are 10% and the government issue a bond and agree to pay 10% on a $1000 bond = annual return of $100. 100/1000 = 10% If the central bank increase interest rates to 12% the previous bond is bad value for money as it pays $100 as compared to $120 with the a new bond. The value of the new bond is effectively reduced to $833 as in order to give it annual payment of $100 a year the price would have to be $833 to it a market based return. 100/833 = 12%
Yield curve control Yield curve control (YCC) involves the BOJ targeting a longer-term interest rate by buying as many bonds as necessary to hit that rate target. It has been buying Japanese Government Bonds (JGB) at a monthly rate of ¥20trn which is double its previous peak of bond buying in 2016. Although there is no theoretical limit on its buying ability it has impacted the currency which has fallen to a 24 year low against the US dollar. This will push up the price of imports and inflation although the BOJ is confident that the price rises in its economy are transitory. If inflation does start to consistently hit levels above the BOJ’s target of 2% will they reverse their bond purchasing policy and shift to a higher yield cap?
Shorting JGB’s A lot of investment banks are looking to short JGB’s. In this situation the trader suspects that bond prices will fall, and wishes to take advantage of that bearish sentiment—for instance, if interest rates are expected to rise. This will likely happen if the Japanese relax their YCC with interest rates rising and bond prices falling – see image below for a simple explanation of shorting.
The Economist: – BoJ v the markets. June 25th 2022.
Financial Times: Investors crank up bets on BoJ surrendering yield curve controls. June 23rd 2022
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A price index is a means of comparing a set of prices as they change over time. Index numbers allow for a comparison of prices with those in an arbitrary chosen reference (base year), a year that current values can be compared against. This base year is usually given a numerical value of 100 or 1000. The index number allows for percentage changes to be calculated between various time periods.
If we look at the last few years some of the current inflation increases has been exaggerated by what are known as base-year effects. What has happened is that annual inflation has been measured against a time during the COVID-19 pandemic when economies were locked down and prices slumped. Therefore the inflation figures around the world have been increasing quite rapidly but soon they will be measured against the current higher prices which shouldmean a lower inflation figure. Regions such as Europe that rely on imported energy may see a greater fall in inflation than others if the price of fuels like oil and gas were to quickly cool. But that doesn’t seem likely in the current climate especially with the war in the Ukraine and come October the northern hemisphere heads back into winter with greater energy use. The graph above is a little out-of-date in that inflation in the UK is now 9.1% and the Bank of England expect it to exceed 11% in October. The USA has an inflation rate of 8.6% and it is expected to reach 9%.
Central Bank rate increases in 2022 Below are the central bank rate hikes this year and the big question is have they got their timing and rate increases right.
With the threat of inflation should banks have increased their rates earlier?
If they tighten too quickly will that tip their economy into recession and a hard landing?
What is the right rate increase for the current inflation figure?
How long (pipeline effect) will it take for interest changes to impact the inflation figure?
These are the challenging questions that central bankers face in today’s environment.
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With the mid-year exams next week here are a couple of mindmaps I produced using OmniGraffle (Apple software). I found it a useful starting point for students to discuss the effectiveness of each policy and the conflicts within macro objectives. This is a very common essay question in CIE Paper 4. My question would be:
What policies has the government in your country implemented since Covid-19 and how successful have they been in meeting macro economic objectives? (25)
This is a very good podcast on inflation and for anyone new to the subject it explains a lot concepts in very simple language. Concepts like fiscal policy, monetary policy, recession, stagflation etc. Click link below:
The question that the economists try and answer is will the global economy go through a recession in order to get inflation down. Both central banks and governments cushioned the economic shock of the pandemic with low interest rates and spending respectively but this action has been blamed for increased inflation.
Larry Summers suggested that the US Fed had mistakenly seen the inflationary problem as transitory but there is a bit more stubbornness about price increases today. As he put it – some central banks need to go through their ‘full course of antibiotics’ (interest rate hikes) to control inflation as failure to do so means that inflation will return promptly and another course of antibiotics will need to be administered. The longer you leave it the more damaging the downturn/recession will be. He also states that every time the US economy has had an inflation rate greater than 4% and an unemployment rate below 4% the US economy has gone into a recession within two years. Those figures align with US inflation 8.5% and unemployment 3.6%.
Some great discussion and would be useful for a macro policy essay at CIE AS or A2 level. Good for revision of policies and their usefulness today.
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Went through the consumption function this morning with my A2 class and I recalled the superb cake that A2 student Lara Hodgson made for the class a few years ago – here’s hoping for a similar cake this term. Remember that the standard Keynesian consumption function is written as follows:
C = a + c (Yd) – where:
C = total consumer spending
a = is autonomous spending
c (Yd) = the propensity to spend out of disposable income
Autonomous spending (a) is consumption which does not depend on the level of income. For example people can fund some of their spending by using their savings or by borrowing money from banks and other lenders. A change in autonomous spending would in fact cause a shift in the consumption function leading to a change in consumer demand at all levels of income. The key to understanding how a rise in disposable income affects household spending is to understand the concept of the marginal propensity to consume (mpc). The marginal propensity to consume is the change in consumer spending arising from a change in disposable income. The higher the mpc the steeper the gradient of the consumption function line. As you can imagine the consumption of cake was fairly rapid.
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Just been looking at the multiplier with my A2 class and here are some notes and a mindmap. An initial change in AE can have a greater final impact on equilibrium national income. This is known as the multiplier effect and it comes about because injections of demand into the circular flow of income stimulate further rounds of spending.
Consider a $300 million increase in business capital investment. This will set off a chain reaction of increases in expenditures. Firms who produce the capital goods that are ultimately purchased will experience an increase in their incomes. If they in turn, collectively spend about 3/5 of that additional income, then $180m will be added to the incomes of others. At this point, total income has grown by ($300m + (0.6 x $300m). The sum will continue to increase as the producers of the additional goods and services realize an increase in their
incomes, of which they in turn spend 60% on even more goods and services. The increase in total income will then be ($300m + (0.6 x $300m) + (0.6 x $180m). The process can continue indefinitely. But each time, the additional rise in spending and income is a fraction of the previous addition to the circular flow.
The value of the multiplier can be found by the equation 1 ÷ (1-MPC)
You can also use the following formula which represents a four sector economy
1 ÷ MPS+MRT+MPM
MPS = Marginal propensity to save
MRT = Marginal rate of tax
MPM = Marginal propensity to import
MPC = Marginal Propensity to Consume (of additional income how much of it spent)
e.g. $1m initial spending; MPC=.8
=> income generated = 1/(1-.8) = 1/.2 = 5
=> $4m extra spending ($1m initial, $4m extra spending, $5m total)
Use different equations depending on the information given.
e.g.: a) if the MPC is 0.5 – 50% of the income will be spent, 50% will be saved.
then MPS is 0.5 then the multiplier is 2 = 1/0.5 = 2
b) if the MPC is 0.8 – 80% of the income will be spent then MPS is 0.2 then the multiplier is 1/0.2 = 5
c) if the MPC is 0.9 – 90% of the income will be spent then MPS is 0.1 then the multiplier is 1/0.1 = 10
What is the effect of MPT – the marginal propensity to tax or t.
greater MPT would lead to less income being spent in the economy
Below is a very informative mind map that I copied from an old textbook.
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Below is a useful flow diagram from the ANZ bank which adds Large Scale Asset Purchases (LSAP) and Funding for Lending Programme (FLP) to the Official Cash Rate (OCR – Base Rate)
LSAP – this is the buying of up $100 billion of government bonds – quantitative easing FLP – this gives banks cheap lending based on the Official Cash Rate – could be about $28 billion based on take up OCR – wholesale interest rate currently at 0.75%. Commercial banks borrow at 0.5% above OCR and can save at the Reserve Bank of New Zealand (RBNZ) at 1% below OCR.
With FLP and more LSAP this will mean lower lending rates and deposit rates. This should provide more stimulus in the economy and allay fears of future funding constraints making banks more confident about lending. Add to this a third stimulus – an OCR of 0.75%. Although there is currently a tightening policy the rate is probably still stimulatory. The flow chart shows the impact that these three stimulus policies have on a variety of variables including – exchange rates – inflation -unemployment – consumer spending – investment – GDP. Very useful for a class discussion on the monetary policy mechanism.
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Consumer prices in New Zealand rose 5.9% annually in the December quarter. Core inflation measures rose to 5.4% annually. Core inflation excludes certain items that are known for their volatility — namely, food and energy. With this figures it seems that ‘transitory’ inflation is not as relevant and inflation does have some momentum. There is a lot inflation coming in from abroad with Tradable inflation at 6.9%.
Domestic inflation was also strong with non-tradable inflation at 5.3%. Some of the main movers in the CPI:
Construction costs up by 15.7%annually – major supply chain issues here
Petrol prices up by 30.5% annually – reflects rises in oil prices globally and a weak NZ dollar making imports more expensive.
Food – annual change in food prices was 4.1% although the quarterly change was -0.1%
40% of CPI is made up of imports and with inflationary pressure prevalent in the global economy this has led to higher import prices.
Higher inflation in a tight labour market – wage price spiral. With a tight labour market comes pressure on wages and if they increase and are not accompanied by an increase in output/worker, companies have two choices. Either they absorb the higher costs or they put their prices up. Then with higher prices there is pressure on wages again as employees try to maintain their purchasing power which in turn could lead to a wage-price spiral.
Theory behind the wage-price spiral
As from previous posts, the Phillips Curve analysed data for money wages against the rate of unemployment over the period 1862-1958. Money wages and prices were seen to be strongly correlated, mainly because the former are the most significant costs of production. Hence the resulting curve purported to provide a “trade-off’ between inflation and unemployment – i.e. the government could ‘select’ its desired position on the curve. During the 1970’s higher rates of inflation than previously were associated with any given level of unemployment. It was generally considered that the whole curve had shifted right – i.e. to achieve full employment a higher rate of inflation than previously had to be accepted.
Milton Friedman’s expectations-augmented Phillips Curve denies the existence of any long-run trade off between inflation and unemployment. In short, attempts to reduce unemployment below its natural rate by fiscal reflation will succeed only at the cost of generating a wage-price spiral, as wages are quickly cancelled out by increases in prices.
Each time the government reflates the economy, a period of accelerating inflation will follow a temporary fall in unemployment as workers anticipate a future rise in inflation in their pay demands, and unemployment returns to its natural rate.
The process can be seen in the diagram below – a movement from A to B to C to D to E
Friedman thus concludes that the long-run Phillips Curve (LRPC) is vertical (at the natural rate of unemployment), and the following propositions emerge:
1. At the natural rate of unemployment, the rate of inflation will be constant (but not necessarily zero).
2. The rate of unemployment can only be maintained below its natural rate at the cost of accelerating inflation. (Reflation is doomed to failure).
3. Reduction in the rate of inflation requires deflation in the economy – i.e. unemployment must rise (in the short term at least) above its natural rate.
Some economists go still further, and argue that the natural rate has increased over time and that the LRPC slopes upwards to the right. If inflation is persistently higher in one country that elsewhere, the resulting loss of competitiveness reduces sales and destroys capacity. Hence inflation is seen to be a cause of higher inflation.
Rational expectations theorists deny Friedman’s view that reflation reduces unemployment even in the short-run. Since economic agents on average correctly predicted that the outcome of reflation will be higher inflation, higher money wages have no effect upon employment and the result of relations simply a movement up the LRPC to a higher level of inflation.
Source: ANZ Research December 2021 Quarter CPI Review