A2 Economics – National income equilibrium

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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Contributions to GDP in the NZ Economy 2007 – 2024

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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Inflation today – what is the best response?

The Inflation globally has been on the increase and above the target band in most developed economies. This applies to both Headline and Core inflation.

Headline Inflation – all goods and services
Core Inflation – all goods and services excluding food and energy.

Economic theory suggests that inflation could accelerate and return to levels seen in the 1970’s. A lot will depend how policymakers react to the challenge of bringing inflation down to their specific target level – RBNZ 1-3% but CPI in NZ is 5.9%. See chart for inflation breakdown in OECD countries.

Source: IMF

Key reasons for inflationary pressure.

Supply chain bottlenecks: Lockdowns and shipping problems (container shortages) but latterly the demand side has accelerated – economic recovery and demand for durable goods as well as panic buying.

Demand for more goods than services: Much of the inflation has been in durable goods whilst service inflation has only seen a small increase. This is dependent on which country – for instance demand for used cars in the US has soared.

Fiscal and Monetary stimulus: Approximately US$16.9trn of government spending has been injected into the global economy. This is accompanied by expansionary monetary policy (low interest rates) is conducive to more spending and higher inflation. Savings that accumulated during the lockdowns were now being spent. There was a debate between leading economists whether the inflation would be transitory or persistent. It seems that the data now supports those of the persistent camp. Whether it persists depends on central banks.

Labour supply: Labour participation rates have dropped – for instance for every job opening in the US there is only 0.77 unemployed people per job. See previous post – US Economy – potential for wage-price spiral. This is due to continue meaning that there is a job seekers market where there is likely to be pressure on wages.

Russian invasion of Ukraine: Russia and Ukraine are big exporters of food and major commodities so higher prices have been inevitable with major disruptions to the supply either through sanctions or conflict areas. They supply 30% of global wheat exports so prices have been increasing.

Source: IMF

What should central banks do?

Mainstream policy by central bankers should ignore supply-side shocks like higher commodity prices as this is only temporary. When central banks have intervened and raised interest rates they have ended up worsening economic conditions – ECB raising rates post GFC in 2008 and 2011. Already inflation globally is increasing but there is little central banks can do with higher global energy prices. A focus on home grown inflation (core) might be a better indicator to watch as well as the labour market – fast wage growth might mean higher interest rates. Economist John Cochrane argues that bringing down inflation through higher interest rate is a blunt tool, especially when prices have risen predominately through a loose fiscal policy. He states that inflation might get worse if people doubt the government’s ability to repay its debt without a discount from inflation.

Ultimately the outlook for inflation depends on how determined central banks are to rein in inflation and the confidence of the bond market to governments willingness to pay their debts. Below is a good video from the IMF on the inflationary problem.

Sources: IMF – Will Inflation Remain High? The Economist – ‘War and Price’ – March 5th 2022

A2 Economics – Multiplier

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.

Multiplier Process

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

=   $5m

=> $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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Could there be Demand-Pull inflation in New Zealand?

The recent GDP figures the March Quarter 2021 and the Annual figure were significantly different from those predicted by the Reserve Bank. The key component of GDP is Private Consumer Expenditure which increased way above the 0.5% of the RBNZ – see table.

This no doubt encouraged more investment which saw an increase by 15.5%. This suggests that the economy is creeping towards the threat of demand-pull inflation – i.e. the economy is running hot and demand is outstripping supply – see graph.

Source: BNZ Markets Outlook.

While New Zealand’s GDP growth might pale against global comparisons this year, it’s already strong enough to be telling of rapidly diminishing economic slack and rising core inflation. Indeed, that excess demand is now arguably the order of the day in NZ, partly as the ability to supply goods and services is compromised in many ways, compared to pre-COVID times.

Furthermore the weakening NZ$ – has made exports cheaper. This is also part of the overall aggregate demand in the economy. So with C+I+G+(X-M) all increasing there is pressure on the supply-side. The NZ trade-weighted exchange is at 73.2 this morning whilst the RBNZ forecasted 75.3. However predicting anything in an economy today is very difficult considering what we have experienced with COVID 19.

TWI – An index that measures the value of $NZ in relationship to a group (or “basket”) of other currencies. The currencies included are from NZ’s major export markets i.e. Australia, USA, Japan, Euro area, UK, China. – $A, $US, ¥, €,  £, Yuan.

With this, there are cracks appearing amongst central banks around the world, as to how long they can reasonably continue with their extreme monetary policy settings. Interest rate markets have been asking the question and at least some central bankers have now given a bit of ground –notably the US Federal Reserve last week. Yes, there is still the debate about how much of the ramp-up in headline CPI inflation, globally,is transitory. However, there is also the fundamental question of whether underlying inflation is firm enough, and labour markets recovered enough, to recommend policy rates to start to normalise, whatever that means. It’s a different question, with more important implications.

Source: BNZ Markets Outlook

China looking to domestic sector to maintain growth.

Neoliberal policies of the last 30 years have seen income inequality grow and the collapse of consumer spending (C) the main driver of any domestic economy. There has been an increase in the proportion of income accruing to assets which worsens inequality in many countries. While China’s economy is synonymous with exports, private consumption has been the largest component of Chinese GDP growth since 2014. With household spending at 39% of GDP in 2018, compared with nearer 70% for more developed economies such as the U.S. and the U.K., it also has considerable potential for further growth. Remember that Aggregate Demand = C+I+G+(X-M).

S&P Global

At the annual planning meeting last month China decided to focus on expanding domestic demand and achieving a major breakthroughs in core technologies. President Xi Jinping’s administration is looking at being self-sufficient in a range of technologies that have in the past been dominated by US firms. An obvious reason for the switch to domestic consumers is that with COVID-19 there is increasing instability and uncertainty around the international environment. A temporarily suspended trade war with the US has emphasised the importance of ending its dependence on foreign technology supplies. President Xi Jinping outlined a new dual circulation economic strategy which came about with the potential decoupling with the US and deglobalisation which would negatively impact the demand for Chinese exports. The dual circulation economic strategy consists of:

• The importance of strengthening domestic demand
• Technological innovation over closer integration with the outside world

Growth targets
China has set targets for economic growth in its 5 year plans – this is its 14th 5 year plan. It is expected that annual average growth to be around 5% down from previous years where it was expected to be 6.5% – 7.5%.

Final thought
China needs a lot more domestic consumption as newly produced goods will just become surplus to requirements. This will also mean increased levels of corporate debt.

Reduced inflation in New Zealand with Covid-19

The inflation rate in New Zealand, as in many countries, is on a downward trajectory – it will take a lot of stimulus form the Reserve Bank to meet its policy target agreement of maintaining the CPI between 1-3%. Westpac have forecast a drop to 0.2% in 2021 and to remain below 1% until the middle of 2022. There have been some obvious reasons for less pressure on inflation:

• Demand for goods and services both in NZ and overseas has dropped significantly and tamed any inflation. Most notably there has been a major drop in oil prices.
• The use of ecommerce and, without the overheads of rents / staff, prices are often much lower than the high street.
• With zero net migration and as excess capacity in long term rental market prices haven’t moved. Add to this the Government’s rent freeze.
• A lack of tourist dollars has meant a shift inwards of the aggregate demand curve as exports of services fall – AD = C+I+G+(X-M).
• With people having the growing uncertainty of job security there has been little additional spending or borrowing with the threat of redundancy hanging over them.
• The wage subsidy has kept some companies afloat but there has been no room for wages increases/negotiations for such uncertain times. Therefore consumer spending has been limited compared to previous years.

Important to note that inflation figures that are quoted are usually on a yearly basis so it is the change in prices from today to this time last year. It will be interesting to see what state the economy will be in this time next year.

Covid-19 and GDP components in New Zealand

New Zealand has been seen by many as a country which has so far done well to restrict the spread of Covid-19 and hopefully limit the longer term impact on the economy. Like many countries the economic consequences have been significant with the contraction of GDP and rising unemployment. New Zealand is now in a deep recession – negative GDP for two consecutive quarters – with GDP set decline by 17% through the six months of the year. By comparison NZ only fell by 2.7% during the GFC in 2008 and part of 2009.

The graph (from Westpac) below shows the importance of government spending in 2020 and continuing into 2021. But the reduction in household spending, residential construction and business investment are a major concern and invariable this will lead to a further loss of job. However the forecast for GDP in 2021 is more promising with household spending and government consumption being the engines of growth. Although some are saying that the recovery will be faster than after the GFC one has to remember that the GDP figures will be a lot higher as they coming from a very low base – even negative. So even a small increase in economic activity will give you a very large percentage change from the previous year. The government have spent approximately $22bn in support measure which is equivalent to around 7% of annual GDP and no doubt there is more to come.

Source: Westpac Economic Overview – Covid-19 Special Edition May 2020

Aggregate demand is crucial here and it is important for both Cambridge and NCEA students to understand its components and how it generates growth – see midmap below.

Adapted from Susan Grant – CIE A Level Revision

New Zealand economy and Covid-19 – importance of C+I+G+(X-M)

Below is a useful graph from the ANZ Quarterly Economic Outlook – full publication here. It covers Aggregate Demand in the New Zealand economy and the relative importance of each of the four components AD = C+I+G+(X-M).

C = Private Consumption
I = Business Investment
G = Government Consumption
(X-M) = Net Exports

Notice how consumption and investment become negative during the Covid-19 pandemic – over 15% of GDP in the first quarter of 2021. However it could be expected that net exports will start to bring in much needed growth in the economy – New Zealand is lucky to be a producer of food an inelastic product meaning the demand remains quite stable. With weak domestic demand there is no such need for imported capital goods as business investment starts to dry up. With net exports, Government spending also will be a significant part of a recovery and to offset the deficit in consumption (C) and investment (I).

Income from the tourism industry will be limited in New Zealand as the country closes its borders although domestic demand could offset some of this loss. But with a loss of income and job insecurity this spending might not be forthcoming.

The recovery will require a massive stimulus – monetary and stimulus. For the RBNZ negative interest rates might be considered as a policy option especially with a depressed labour market and the threat of deflation. As the ANZ point out in their publication there are plenty of long-term challenges ahead. But New Zealand is resilient, and has come into this crisis with a lot of advantages:

• We have been in a position to respond to the outbreak quickly;
• We produce a lot of essential goods domestically and our exports are still in demand;
• We have a well-functioning health system and government;
• We have plenty of fiscal firepower to respond;
• The financial system is resilient; and
• The exchange rate and monetary policy can provide a buffer.

China’s ghost cities – there needs to be another plan

Below is a very good report from 60 Minutes Australia that gives you an update on China’s ghost cities. Roughly 22 percent of China’s urban housing stock is unoccupied, according to Professor Gan Li, who runs the main nationwide study. That adds up to more than 50 million empty homes, he said. One solution that the government could use is property or vacancy taxes to try to counter the issue, but neither appears imminent and some researchers, including Gan, say what actually counts as vacant could be tricky to determine.

For so long China has relied on major infrastructure projects including building cities to drive growth figures in their economy. Historically China’s economic model was based on export-led growth, massive government injections into the economy and access to cheap money. This is not sustainable and although you can keep blowing up bridges and build cities that nobody lives in at some point it becomes unsustainable. Furthermore since the global financial crisis economies have increased protectionist policies to look after their own economy and this has been followed with by the potential trade war with the USA. Therefore the Chinese government need to refocus the growth of the economy on domestic consumption rather than building things – Gross Fixed Capital Formation. So much more C than I in the GDP Expenditure equation. EG:

GDP = C↑+ I↓+ G + (X-M)

New Zealand election: economic impact of new Government’s policies.

Since the election businesses seem to be unsure of the new direction of government policy and therefore this has led to a reduction in business confidence. This is not unusual especially with a change of political ideology and the more left leaning government which could make things – regulation, taxes etc – harder for businesses. The government plans to cancel next year’s scheduled tax cuts even though it would have added 0.4% to GDP. This could be partly offset by an increase in expenditure on Working For Families and the free tertiary education for first year students.

The new Government plans to spend more than the national government which is not unusual considering its position of the political spectrum – see graph. This will be partly funded by tax revenue and borrowing $7bn more over the next four years – this is a borrowing and spend fiscal stimulus. The impact of this spending will be influenced by the fiscal multiplier.

Fiscal Multiplier.
It refers to the change in GDP that is due to a change in government fiscal policy – taxes and spending. For example, if increased government spending of $1bn causes overall GDP to rise by $1.5bn, the multiplier effect is 1.5.

There are problems for the new Government in that:

1. Some of this extra spending will go on imports and this will mean an outflow of money from the New Zealand economy and therefore making no contribution to GDP. Remember that GDP expenditure approach = C+I+G+(X-M).

2. There is also the crowding out effect – this is when government spending fails to increase overall aggregate demand because higher government spending causes an equivalent fall in private sector spending and investment. This could include: extra spending on public healthcare leading to less spending on private healthcare; government employment creating labour shortages for firms; and government employment creating labour shortages for firms. Crowding out can also happen indirectly via fiscal stimulus increasing interest rates and consequently the exchange rate making exports less competitive and imports cheaper.

Ultimately the government debt must be repaid by the use of government revenue from taxation. A labour coalition government usually increase taxes during their time in government and this has the tendency to discourage private sector investment. The government’s borrow-and-spend plans will not necessarily make the economy any larger in the long-run but it is expected that government spending (G) will be a larger share of the economy with consumption (C) and investment (I) having a lower share – see graph below. Interesting to note the government spending as a % of GDP for Labour and National – goes up as a % of GDP when Labour are in office and goes down as a % of GDP when National are in office.

Source: Westpac Quarterly Economic Overview – November 2017

Are higher wages the answer to the US economy?

There have been some concerns over the extent of the recovery of the US economy over the last year. The GDP of a country is made up of four things:
C+I+G+(X-M).

C = Private Consumption
I = Business Investment
G = Government Demand
(X-M) = Net Exports

With government spending being very liberal and effective in creating growth there is a need for the other components of GDP to do their part – Private Consumption, Business Investment and Net Exports.

Exports in the US have been disappointing equaling 14% of GDP compared to the euro zone’s 26%.

Business investment has also been subdued as lower profits mean less investment.

Private consumption hasn’t been as strong as anticipated even with the windfall gain of the significant fall in oil price and the growth of outstanding consumer credit. The biggest barrier to increasing private consumption is the level of pay to employees. Across the US median inflation-adjusted wages are not higher today than they were pre GFC.

Why are wages so low?
The Economist identified three things that have been behind the slow growth of wages in the US.

1. America’s Unemployment-Insurance
With the US government cutting back on unemployment benefits the wage expectations of workers fell. Businesses took advantage of this cheaper pool of labour and in 2014 a significant proportion of the 31 million jobs created wherein poorly paid industries.

2. The Behaviour of Firms
When the GFC hit firms found it difficult to reduce the wages of their staff but fired their least productive workers keeping the most productive happy. To compensate for the higher wages paid to the most productive firms were willing to offer new recruits only low wages.

3. Persistent Labour Market Slack
As there are worker available to fill jobs that become available firms are able to offer paltry wages. The number of part-time workers who would rather be full timers – called part-time for economic reasons (PTER) – fell much more slowly than the official unemployment rate following the GFC. The same can be said for discouraged workers i.e. the number of those wanting a job but say there is no point in looking. Research has found that a 1% fall in the PTER rate is associated with 0.4% fall in real wage growth. When the PTER is high, workers may feel unable to ask for higher wages, since what they really want is more hours.

It seems that the US economy lives and dies by what happens to consumer spending.

Aussie still relying on consumer sector

The graph from National Australia Bank below shows the components of Australian GDP March Quarter 2014. This is particularly useful when doing GDP Expenditure approach in Unit 5 of the A2 Cambridge course where you can breakdown the equation C+I+G+(X-M).

C = Private Consumption
I = Business Investment
G = Government Demand
(X-M) = Net Exports

Consumption is still the largest contributor to Australia’s GDP. Over the next couple of years GDP  is expected to grow around 3% but key to meeting that target is a solid consumer sector. Household consumption growth in recent quarters has been solid, contributing 0.3 percentage points to growth in Q1 – only exports have contributed more to growth over the past year. However sustaining solid consumption growth in years ahead requires the labour market to improve and consumer confidence levels to recover from their recent lows.

Aussie GDP – from Consumption to Net Exports

Below is an interesting look at the components of GDP in Australia. Capital intensive and net exports are the mainstay of growth this year. However it wasn’t always like this and notice the changes in consumption that reflect the GFC and the role of net exports in the recovery. Remember the equation:

AD = C+I+G+(X-M)

Consumers to Prosumers

In the March edition of the University of Otago publication EcoNZ@Otago there was a good article on ‘Prosumers’.

In markets, firms produce goods and services and consumers buy them (see Figure 1). This is the underlying set-up embodied in many economic models. Most of the time, the buyer-seller dichotomy is an accurate representation of market activity. Since the early 1990s, however, another paradigm has emerged. The advent of the internet has allowed some industries to assign a stronger role in the production of goods and services to those
who purchase them (see Figure 2). Consumers are becoming prosumers and firms are benefiting (immensely) by consumer-led marketing and design.

A key feature of prosumers is that they are not paid for the work that they do. Every time you post a review about a product online, for example, you are either doing marketing for the firm (in the case of good reviews) or providing them with information about their product’s shortcomings which they can use to improve their wares (i.e. quality control, in the case of bad reviews). The firm pays you nothing for this. In some cases, prosumers work for the firm without even knowing it. Some websites monitor the buying activities of other users so they can suggest products to you based on the goods in your shopping cart. By simply buying online, you help the firm cross-sell products to others in the future.

But there is an even stronger role in the production process for prosumers! Occasionally, prosumers will take it upon themselves to build products from scratch and share them with other prosumers (see Figure 3). One example of this is the production of open-source software. In the 1980s, such software was made available under General Public Licensing (also known as copylefting), a licensing procedure developed by the Free Software Foundation. Anyone is allowed to use and modify copylefted software under the conditions that: (1) they do not attempt to impose licensing restrictions on others, and (2) all enhancements to the code are licensed on the same terms.This means that any programmer who makes alterations to the code can claim ‘bragging rights’ for their work, but they cannot charge others to use it.

Oil Shocks – are they bad for the global economy?

Tobias Rasmusses and Agustin Roitman, two IMF economists, in a recent paper have argued that oil shocks are not that bad for an importing country. They have suggested that a 25% increase in oil prices will cause a loss of real GDP in oil-importing countries of less than 0.5%, spread over two to three years.
“One likely explanation for this relatively modest impact is that part of the greater revenue accruing to oil exporters will be recycled in the form of imports or other international flows, thus contributing to keep-up demand in oil-importing economies”
However in considering the impact of higher oil prices one must look at what caused them to rise in the first place. There have been supply-side and demand-side reasons.

1973 – 400%↑ – supply-side– Yom Kippur War oil embargo
1979 – 200%↑ – supply-side – Iran Iraq War
1990 – 50%↑ – supply-side – Iraq War
2000 – 75%↑ – demand-side – Global growth.

What it is important to remember is that when there is higher global growth there likely to be higher oil prices, which is a positive. Supply-side policies also play a role – 1970’s and 1990-91 – especially the disruption to supply in Libya this year. “Finding that the negative impact of higher oil prices has generally been quite small does not mean that the effect can be ignored.”
Rasmusses and Roitman do not rule out more adverse effects from a future shock that is driven largely by lower oil supply than the more demand-driven increases in oil prices that have been the norm in the last two decades.